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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Set forth below are the audited financial statements for the Company as of and for the fiscal years ended December 31, 2016 and 2015 and the report thereon of Paritz & Co., P.A. ACCOUNTING FIRM To the Board of Directors and Stockholders of Cyberspace Vita, Inc. We have audited the accompanying balance sheets of Cyberspace Vita, Inc. as of December 31, 2016 and 2015, and the related statements of income, stockholders’ deficit, and cash flows for the years then ended. Cyberspace Vita’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cyberspace Vita, Inc. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As described in Note 3 to the financial statements, the Company has not generated any revenue and has accumulated losses of $666,301 since inception. As of December 31, 2016, the Company had a working capital deficit of $622,023. These factors, among others, raise substantial doubt regarding the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 3 to the accompanying financial statements. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Paritz & Company, P.A. Hackensack, NJ March 27, 2017 Cyberspace Vita, Inc. Balance Sheets See accompanying notes to financial statements. Cyberspace Vita, Inc. Statements of Operations See accompanying notes to financial statements. Cyberspace Vita Inc. Statement of Stockholders’ Deficit See accompanying notes to financial statements. Cyberspace Vita, Inc. Statements of Cash Flows See accompanying notes to financial statements. CYBERSPACE VITA, INC. (A Development Stage Company) NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 (audited) NOTE 1. ORGANIZATION AND DESCRIPTION OF BUSINESS Business description Cyberspace Vita, Inc. (the “Company”) was incorporated under the laws of the State of Nevada on November 7, 2006. The purpose for which the Corporation is organized is to engage in any lawful act or activity for which a corporation may be organized under the General Corporation Law of the State of Nevada. The Company’s original business plan was to create and conduct an online business for the sale of vitamins and supplements, however, the Company never generated any meaningful revenues. On May 5, 2008, the Company discontinued its prior business and changed its business plan. The Company’s current business plan is to seek, investigate, and, if warranted, acquire one or more properties or businesses, and to pursue other related activities intended to enhance shareholder value. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. BASIS OF PRESENTATION The Company’s financial statements are presented in accordance with accounting principles generally accepted (GAAP) in the United States. Effective December 31, 2014, the Company elected to early adopt Accounting Standards Update No. 2014-10, Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements. The adoption of this ASU allows the Company to remove the inception to date information and all references to development stage. B. CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. C. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. D. BASIC EARNINGS PER SHARE The Company computes net loss per share in accordance with FASB ASC 260 “Earnings per Share”, which specifies the computation, presentation and disclosure requirements for earnings (loss) per share for entities with publicly held common stock. FASB ASC 260 supersedes the provisions of APB No. 15, and requires the presentation of basic earnings (loss) per share and diluted earnings (loss) per share. CYBERSPACE VITA, INC. (A Development Stage Company) NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 (audited) Basic net loss per share amounts is computed by dividing the net income by the weighted average number of common shares outstanding. Diluted earnings per share are the same as basic earnings per share due to the lack of dilutive items in the Company. E. INCOME TAXES Income taxes are provided in accordance with FASB ASC 740 “Income Taxes”. A deferred tax asset or liability is recorded for all temporary differences between financial and tax reporting and net operating loss carryforwards. Deferred tax expense (benefit) results from the net change during the year of deferred tax assets and liabilities. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. F. REVENUE RECOGNITION The Company has not recognized any revenues from its operations. G. SHARE-BASED PAYMENT The Company records stock-based compensation in accordance with the guidance in ASC 718. ASC Topic 718 requires the Company to recognize expense related to the fair value of its employee stock option awards. This eliminates accounting for share-based compensation transactions using the intrinsic value and requires instead that such transactions be accounted for using a fair-value-based method. The Company recognizes the cost of all share-based awards on a graded vesting basis over the vesting period of the award. During the years ended December 31, 2016 and 2015, there were no stock options granted or outstanding. H. FAIR VALUE MEASUREMENTS The Company adopted the provisions of ASC Topic 820, “Fair Value Measurements and Disclosures”, which defines fair value as used in numerous accounting pronouncements, establishes a framework for measuring fair value and expands disclosure of fair value measurements. The estimated fair value of certain financial instruments, payables to related parties, and accounts payable and accrued expenses are carried at historical cost basis, which approximates their fair values because of the short-term nature of these instruments. ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 describes three levels of inputs that may be used to measure fair value: Level 1 - quoted prices in active markets for identical assets or liabilities Level 2 - quoted prices for similar assets and liabilities in active markets or inputs that are observable Level 3 - inputs that are unobservable (for example cash flow modeling inputs based on assumptions) CYBERSPACE VITA, INC. (A Development Stage Company) NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 (audited) I. NEW ACCOUNTING PRONOUNCEMENTS From time to time new accounting pronouncements are issued by the Financial Accounting Standards Board or other standard setting bodies that may have an impact on the Company’s accounting and reporting. The Company believes that such recently issued accounting pronouncements and other authoritative guidance for which the effective date is in the future will not have an impact on its accounting or reporting or that such impact will not be material to its financial position, results of operations and cash flows when implemented. Recently adopted and pending accounting pronouncements In June 2014, the FASB issued ASU No. 2014-10: Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation , to improve financial reporting by reducing the cost and complexity associated with the incremental reporting requirements of development stage entities. The amendments in this update remove all incremental financial reporting requirements from U.S. GAAP for development stage entities, thereby improving financial reporting by eliminating the cost and complexity associated with providing that information. The amendments in this Update also eliminate an exception provided to development stage entities in Topic 810, Consolidation, for determining whether an entity is a variable interest entity on the basis of the amount of investment equity that is at risk. The amendments to eliminate that exception simplify U.S. GAAP by reducing avoidable complexity in existing accounting literature and improve the relevance of information provided to financial statement users by requiring the application of the same consolidation guidance by all reporting entities. The elimination of the exception may change the consolidation analysis, consolidation decision, and disclosure requirements for a reporting entity that has an interest in an entity in the development stage. The amendments related to the elimination of inception-to-date information and the other remaining disclosure requirements of Topic 915 should be applied retrospectively except for the clarification to Topic 275, which shall be applied prospectively. The Company has elected early adoption of this ASU. In August 2014, the FASB issued Accounting Standard Update No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40), (ASU No. 2014-15), which requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. Specifically, ASU 2014-15 provides a definition of the term substantial doubt and requires an assessment for a period of one year after the date that the financial statements are issued (or available to be issued). It also requires certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans and requires an express statement and other disclosures when substantial doubt is not alleviated. ASU No. 2014-15 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, and early application is permitted. CYBERSPACE VITA, INC. (A Development Stage Company) NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 (audited) NOTE 3. GOING CONCERN The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The Company has not generated any revenue and has accumulated losses of $666,301 since inception. As of December 31, 2016, the Company had a working capital deficit of $622,023. These conditions, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The Company’s continuation as a going concern is dependent on its ability to meet its obligations, to obtain additional financing as may be required and ultimately to attain profitability. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. The Company intends to seek additional working capital advances from the Company’s majority shareholder and other sources. There is no assurance that the working capital advances will continue in the future nor that Company will be successful in raising additional funds through other sources. NOTE 4. RELATED PARTY TRANSACTIONS At December 31, 2016, the Company had a Note outstanding from a related party (Fountainhead Capital Management Limited in the aggregate amount of $496,611, which bears interest at 6% per annum and represents amounts loaned to the Company to pay the Company’s operating expenses. On December 31, 2016, the Payee under the Note and the Company agreed to extend the maturity date of the Note to December 31, 2017. The Company entered into a Services Agreement with a related party (Fountainhead Capital Management Limited (“FHM”)), a shareholder who holds approximately 80.8% of the Company’s issued and outstanding common stock. The initial term of the Services Agreement was one year and the Company is obligated to pay FHM a quarterly fee in the amount of $10,000, in cash or in kind, on the first day of each calendar quarter commencing May 5, 2008. The term of the Services Agreement has been extended to December 31, 2017. Total fees paid to FHM for the years ended December 31, 2016 and 2015 were $40,000 and $40,000, respectively. NOTE 5. INCOME TAXES The components of the Company’s deferred tax asset as of December 31, 2016 and 2015 are as follows: CYBERSPACE VITA, INC. (A Development Stage Company) NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 (audited) A reconciliation of income taxes computed at the statutory rate to the income tax amount recorded is as follows: As of December 31, 2016 and 2015, we have provided a 100% valuation allowance for all deferred tax assets as management has detemined that it is more-likely-than-not that we will not realize the use of our net operating loss carryforwards. Upon adoption of ASC 740 as of January 1, 2008, the Company had no gross unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. At December 31, 2016, the amount of gross unrecognized tax benefits before valuation allowances and the amount that would favorably affect the effective income tax rate in future periods after valuation allowances were $0. The Company has not accrued any additional interest or penalties as a result of the adoption of ASC 740. The Company files income tax returns in the United States federal jurisdiction and certain states in the United States. No tax returns are currently under examination by any tax authorities. NOTE 6. STOCKHOLDERS’ DEFICIT The stockholders’ deficit section of the Company’s financial statements contains the following classes of capital stock as of December 31, 2016: * Preferred stock, $0.001 par value: 10,000,000 shares authorized; -0- shares issued and outstanding. * Common stock, $0.001 par value: 100,000,000 shares authorized; 247,550 shares issued and outstanding. NOTE 7. SUBSEQUENT EVENTS The Company has evaluated subsequent events through the date of these financial statements were issued and no events subsequent to December 31, 2016 have occurred that require recognition or disclosure to the financial statements.
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Based on the provided excerpt, here's a summary:
Financial Statement Overview:
- The company reported a net loss of $666,301
- The statement includes standard financial reporting disclosures about potential variations between estimated and actual financial results
- The company calculates net loss per share according to FASB (Financial Accounting Standards Board) guidelines
Note: The excerpt seems incomplete, so the summary is limited to the available information.
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Item 8 - See notes to consolidated financial statements. - 48 - See notes to consolidated financial statements. - 49 - See notes to consolidated financial statements. See notes to consolidated financial statements. - 50 - See notes to consolidated financial statements. - 51 - See notes to consolidated financial statements - 52 - December 31, 2016, 2015 and 2014 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation-The consolidated financial statements include the accounts of MidSouth Bancorp, Inc. (the “Company”) and its wholly owned subsidiaries MidSouth Bank, N.A. (the “Bank”), Financial Services of the South, Inc. (the “Finance Company”), which has liquidated its loan portfolio, and Peoples General Agency (“PGA”). All significant intercompany accounts and transactions have been eliminated in consolidation. We are subject to regulation under the Bank Holding Company Act of 1956. The Bank is primarily regulated by the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”). We are a financial holding company headquartered in Lafayette, Louisiana operating principally in the community banking business by providing banking services to commercial and retail customers through the Bank. The Bank is community oriented and focuses primarily on offering competitive commercial and consumer loan and deposit services to individuals and small to middle market businesses in Louisiana and central and east Texas. The accounting principles we follow and the methods of applying these principles conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices within the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from those estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses, the valuation of real estate acquired in connection with or in lieu of foreclosure on loans, the assessment of goodwill for impairment, and valuation allowances associated with the realization of deferred tax assets which are based on future taxable income. Given the current instability of the economic environment, it is reasonably possible that the methodology of the assessment of potential loan losses, losses on other real estate owned, goodwill impairment, and other fair value measurements could change in the near term or could result in impairment going forward. A summary of significant accounting policies follows: Cash and cash equivalents-Cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits in other banks with original maturities of less than 90 days, and federal funds sold. Investment Securities-We determine the appropriate classification of debt securities at the time of purchase and reassesses this classification periodically. Trading account securities are held for resale in anticipation of short-term market movements. Debt securities are classified as held-to-maturity when we have the positive intent and ability to hold the securities to maturity. Securities not classified as held-to-maturity or trading are classified as available-for-sale. We had no trading account securities during the three years ended December 31, 2016. Held-to-maturity securities are stated at amortized cost. Available-for-sale securities are stated at fair value, with unrealized gains and losses, net of deferred taxes, reported as a separate component of stockholders’ equity. The amortized cost of debt securities classified as held-to-maturity or available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity or, in the case of mortgage-backed securities, over the estimated life of the security. Amortization, accretion, and accrued interest are included in interest income on securities. Realized gains and losses on the sale of securities available-for-sale are included in earnings and are determined using the specific-identification method. Management evaluates investment securities for other than temporary impairment on a quarterly basis. A decline in the fair value of available-for-sale and held-to-maturity securities below cost that is deemed other than temporary is charged to earnings for a decline in value deemed to be credit related and a new cost basis for the security is established. The decline in value attributed to non-credit related factors is recognized in other comprehensive income. Other Investments-Other investments include Federal Reserve Bank and Federal Home Loan Bank stock, as well as other correspondent bank stocks and our CRA investment, which have no readily determined market value and are carried at cost. Due to the redemption provisions of the investments, the fair value equals cost and no impairment exists. - 53 - Loans-Loans that we have the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses and any deferred fees or costs on originated loans. Interest income on commercial and real estate mortgage loans is calculated by using the simple interest method on the daily balance of the principal amount outstanding. Unearned income on installment loans is credited to operations based on a method which approximates the interest method. In-house legal counsel and the collections department are responsible for validating loans past due for reporting purposes. Once loans are determined to be past due, the collections department actively works with customers to bring loans back to current status. We consider a loan to be impaired when, based upon current information and events, we believe it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans classified as special mention, substandard, or doubtful, based on credit risk rating factors, are reviewed for potential impairment. Our impaired loans include troubled debt restructurings and performing and nonperforming major loans in which full payment of principal or interest is not expected. Although our policy requires that non-major homogenous loans, which include all loans under $250,000, be evaluated on an overall basis, our current volume of impaired loans allows us to evaluate each impaired loan individually. We calculate the allowance required for impaired loans based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. A loan may be impaired but not on nonaccrual status when available information suggests that it is probable the Bank may not receive all contractual principal and interest, however, the loan is still current and payments are received in accordance with the terms of the loan. Payments received for impaired loans not on nonaccrual status are applied to principal and interest. All impaired loans are reviewed, at minimum, on a quarterly basis. Reviews may be performed more frequently if material information is available before the next scheduled quarterly review. Existing valuations are reviewed to determine if additional discounts or new appraisals are required. After this review, when comparing the resulting collateral valuation to the outstanding loan balance, if the discounted collateral value exceeds the loan balance no specific allocation is reserved. All loans included in our impairment analysis are subject to the same procedure and review, with no distinction given to the dollar amount of the loan. Our Special Assets Committee meets monthly to review loans with adverse classifications. Loan officers, loan review officers, and in-house legal counsel contribute updated information on each credit, reviewing potential declines or improvements in the borrower’s repayment ability and our collateral position. If deterioration in our collateral position is determined, additional discounts may be applied to the impairment analysis before the new appraisal is received. The committee makes a determination of whether the loans reviewed have reached a point of collateral dependency and sufficient doubt exists as to collectibility. As a matter of policy, loans are placed on nonaccrual status when, in the judgment of committee members, the probability of collection of interest is deemed insufficient to warrant further accrual. For loans placed on nonaccrual status, the accrual of interest is discontinued and subsequent payments received are applied to the principal balance. Interest income is recorded after principal has been satisfied and as payments are received. Additionally, loans may be placed on nonaccrual status when the loan becomes 90 days past due and any of the following conditions exist: it becomes evident that the borrower will not make payments or will not or cannot meet the Bank’s terms for the renewal of a matured loan, full repayment of principal and interest is not expected, the loan has a credit risk rating of substandard, the borrower files bankruptcy and an approved plan of reorganization or liquidation is not anticipated in the near future, or foreclosure action is initiated. When a loan is placed on nonaccrual status, previously accrued but unpaid interest for the current year is deducted from interest income. Prior year unpaid interest is charged to the allowance for loan losses. Some loans may continue accruing after 90 days if the loan is in the process of renewing, being paid off, or the underlying collateral fully supports both the principal and accrued interest and the loan is in the process of collection. Nonaccrual loans may be returned to accrual status if all principal and interest amounts contractually owed are reasonably assured of repayment within a reasonable period and there is a period of at least six months to one year of repayment performance by the borrower depending on the contractual payment terms. When loans are returned to accrual status, interest income that was previously applied to the principal balance is not reversed but is recognized into interest income as an adjustment to the yield over the remaining life of the loan. Our Special Assets Committee must approve the return of loans to accrual status as well as exceptions to any requirements of the non-accrual policy. Generally, commercial, financial, and agricultural loans; construction loans; commercial real estate loans; consumer loans; and finance leases which become 90 days delinquent are either in the process of collection through repossession or foreclosure or are deemed currently uncollectible. The portion of loans deemed currently uncollectible, due to insufficient collateral, are charged-off against the allowance for loan losses. All loans requested to be charged-off must be specifically authorized by in-house legal counsel and the CEO. Requests may be initiated by collection personnel, bank counsel, loan review, and lending personnel. - 54 - Charge-offs will be reviewed by in-house legal counsel and the CEO to ensure the propriety and accuracy of charge-off recommendations. Factors considered when determining loan collectibility and amount to be charged off for all segments in our loan portfolio include delinquent principal or interest repayment, the ability of borrower to make future payments, collateral value of outstanding debt, and the adequacy of guarantors support. It is the responsibility of in-house legal counsel to report all charge-offs to the Board of Directors or its designated Committee for ratification. Credit Risk Rating-We manage credit risk by observing written underwriting standards and lending policy established by the Board of Directors and management to govern all lending activities. The risk management program requires that each individual loan officer review his or her portfolio on a quarterly basis and assign recommended credit ratings on each loan. These efforts are supplemented by independent reviews performed by a loan review officer and other validations performed by the internal audit department. The results of the reviews are reported directly to the Audit Committee of the Board of Directors. Additionally, Bank concentrations are monitored and reported quarterly for risk rating distributions, major standard industry classification segments, real estate concentrations, and collateral distributions. Consumer and residential real estate loans are normally graded at inception, and the grade generally remains the same throughout the life of the loan. Loan grades on commercial, financial, and agricultural; construction; commercial real estate; and finance leases may be changed at any time when circumstances warrant, and are at a minimum reviewed quarterly. Loans can be classified into the following three risk rating groupings: pass, special mention, and substandard/doubtful. Factors considered in determining a risk rating grade include debt service capacity, capital structure/liquidity, management, collateral quality, industry risk, company trends/operating performance, repayment source, revenue diversification/customer concentration, quality of financial information, and financing alternatives. Pass grade signifies the highest quality of loans to loans with reasonable credit risk, which may include borrowers with marginally adequate financial performance, but have the ability to repay the debt. Special mention loans have potential weaknesses that warrant extra attention from the loan officer and other management personnel, but still have the ability to repay the debt. Substandard classification includes loans with well-defined weaknesses with risk of potential loss. Loans classified as doubtful are considered to have little recovery value and are charged off. Allowance for Loan Losses-The allowance for loan losses is a valuation account available to absorb probable losses on loans. All losses are charged to the allowance for loan losses when the loss actually occurs or when a determination is made that a loss is likely to occur. Recoveries are credited to the allowance for loan losses at the time of recovery. Quarterly, we estimate the probable level of losses in the existing portfolio through consideration of such factors including, but not limited to, past loan loss experience; estimated losses in significant credits; known deterioration in concentrations of credit; trends in nonperforming assets; volume and composition of the loan portfolio, including percentages of special mention, substandard and past due loans; lending policies and control systems; known inherent risks in the portfolio; adverse situations that may affect the borrower’s ability to repay; the estimated value of any underlying collateral; current national and local economic conditions, including the unemployment rate, the price of oil, and real estate absorption time; the experience, ability and depth of lending management; collections personnel experience; and the results of examinations of the loan portfolio by regulatory agencies and others. Based on these estimates, the allowance for loan losses is increased by charges to earnings and decreased by charge-offs (net of recoveries). The allowance is composed of general reserves and specific reserves. General reserves are determined by applying loss percentages to segments of the portfolio. The loss percentages are based on each segment’s historical loss experience, generally over the past three to five years, and adjustment factors derived from conditions in the Bank’s internal and external environment. All loans considered to be impaired are evaluated on an individual basis to determine specific reserve allocations in accordance with GAAP. Loans for which specific reserves are provided are excluded from the calculation of general reserves. We have an internal loan review department that is independent of the lending function to challenge and corroborate the loan grade assigned by the lender and to provide additional analysis in determining the adequacy of the allowance for loan losses. Management and the Board of Directors believe the allowance for loan losses is appropriate at December 31, 2016. While determination of the allowance for loan losses is based on available information at a given point in time, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize additions or deductions to the allowance based on their judgment and information available to them at the time of their examination. - 55 - Premises and Equipment-Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation are: Leasehold improvements are amortized over the estimated useful lives of the improvements or the term of the lease, whichever is shorter. Other Real Estate Owned-Real estate properties acquired through, or in lieu of, loan foreclosures are initially recorded at fair value less estimated costs to sell based on a current valuation at the time of foreclosure. After foreclosure, valuations are periodically performed by management and a charge to earnings is recorded if the carrying value of a property exceeds its fair value less estimated costs to sell. Revenues and expenses from operations and changes in the valuation allowance are charged to earnings. Goodwill and Other Intangible Assets-Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in a business combination. Goodwill and other intangible assets deemed to have an indefinite useful life are not amortized but instead are subject to review for impairment annually, or more frequently if deemed necessary. Also, in connection with business combinations involving banks and branch locations, we generally record core deposit intangibles representing the value of the acquired core deposit base. Core deposit intangibles are amortized over the estimated useful life of the deposit base, generally on either a straight-line basis not exceeding 15 years or an accelerated basis over 10 years. The remaining useful lives of core deposit intangibles are evaluated periodically to determine whether events and circumstances warrant revision of the remaining period of amortization. Cash Surrender Value of Life Insurance-Life insurance contracts represent single premium life insurance contracts on the lives of certain officers of the Company. The Company is the beneficiary of these policies. These contracts are reported at their cash surrender value and changes in the cash surrender value are included in other noninterest income. Derivatives-Derivative financial instruments are recognized as assets and liabilities on the consolidated balance sheets and, as required by ASC 815, the Company records all derivatives at fair value. Accounting for changes in fair value of derivatives differs depending on whether the derivative has been designated and qualifies as part of a hedge relationship, and further, on the type of relationship. Derivatives Designated as Hedging Relationships The Company has entered into forward interest rate swap contracts to minimize the variability of future cash flows that is caused by changes in interest rates or other economic factors. These derivative instruments were designated as cash flow hedges under ASC Topic 815, Derivatives and Hedging. For cash flow hedges, the effective portion of the gain or loss related to the derivative instrument is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings or when the hedge is terminated. The ineffective portion of the gain or loss is reported in earnings immediately. Derivatives Not Designated as Hedging Relationships The Company offers certain derivative instruments directly to qualified commercial lending clients seeking to manage their interest rate risk. These derivative instruments, including interest rate swap agreements, are not designated for hedge accounting and changes in fair value are recognized in earnings immediately. Interest rate swaps are contracts in which a series of interest rate cash flows are exchanged over a prescribed period. The notional balance of interest rate swap agreements held by the Company at December 31, 2016 and 2015 was minimal and not material to the consolidated balance sheets. Repurchase Agreements-Securities sold under agreements to repurchase are secured borrowings treated as financing activities and are carried at the amounts at which the securities will be subsequently reacquired as specified in the respective agreements. - 56 - Deferred Compensation-We record the expense of deferred compensation agreements over the service periods of the persons covered under these agreements. Income Taxes-Deferred tax assets and liabilities are recorded for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Future tax benefits, such as net operating loss carry forwards, are recognized to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. In the event the future tax consequences of differences between the financial reporting bases and the tax bases of our assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such assets is required. A valuation allowance is provided when it is more likely than not that a portion or the full amount of the deferred tax asset will not be realized. In assessing the ability to realize the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies. A deferred tax liability is not recognized for portions of the allowance for loan losses for income tax purposes in excess of the financial statement balance. Such a deferred tax liability will only be recognized when it becomes apparent that those temporary differences will reverse in the foreseeable future. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50 percent more likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. Stock-Based Compensation-We expense stock-based compensation based upon the grant date fair value of the related equity award over the requisite service period of the employee. Basic and Diluted Earnings Per Common Share-Basic earnings per common share (“EPS”) excludes dilution and is computed by dividing net earnings by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. Diluted EPS is computed by dividing net earnings by the total of the weighted-average number of shares outstanding plus the dilutive effect of outstanding options. The amounts of common stock and additional paid-in capital are adjusted to give retroactive effect to large stock dividends. Small stock dividends, or dividends less than 25% of issued shares at the declaration date, are reflected as an increase in common stock and additional paid-in capital and a decrease in retained earnings for the market value of the shares on the date the dividend is declared. Comprehensive Income-Generally all recognized revenues, expenses, gains and losses are included in net earnings. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net earnings, are components of comprehensive income. We present comprehensive income in a separate consolidated statement of comprehensive income. Statements of Cash Flows-For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and interest-bearing deposits in other banks with original maturities of less than 90 days. Generally, federal funds are sold for one-day periods. Recent Accounting Pronouncements - ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities is the first ASU issued under the FASB's financial instruments project. ASU 2016-01 primarily affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The guidance in this ASU requires all equity securities with readily determinable fair values to be measured at fair value on the balance sheet, with changes in fair value recorded through earnings. For financial liabilities that are measured at fair value in accordance with the fair value option, the guidance requires changes in the fair value of a financial liabilities attributable to a change in instrument-specific credit risk to be recorded separately in other comprehensive income. This ASU eliminates the requirement to disclose the methods and significant assumptions used to estimate fair value. It does require public entities to use the exit price when measuring the fair value of financial instruments - 57 - measured at amortized cost for disclosure purposes. In addition, the new guidance requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The effective date of this Update is for fiscal years beginning on or after December 15, 2017. The Company is evaluating the impact, if any, that ASU 2016-01 will have on its financial position, results of operations, and its financial statement disclosures. ASU 2016-02, Leases (Topic 842) was issued with the intention of improving financial reporting about leasing transactions. Under the new guidance, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months. Consistent with current GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily will depend on its classification as a finance or operating lease. However, unlike current GAAP - which requires only capital leases to be recognized on the balance sheet - the guidance in the ASU will require both types of leases to be recognized on the balance sheet. The ASU also will require disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases. These disclosures include qualitative and quantitative requirements, providing additional information about the amounts recorded in the financial statements. The effective date of this Update is for fiscal years beginning on or after December 15, 2018. The Company is evaluating the impact that ASU 2016-02 will have on its financial position, results of operations, and its financial statement disclosures. ASU 2016-09, Compensation - Stock Compensation (Topic 718) was issued as part of the FASB's simplification initiative. Under the new guidance, several aspects of the accounting for share-based payment award transactions are simplified, including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. The effective date of this Update is for fiscal years beginning on or after December 15, 2016. The Company is evaluating the impact that ASU 2016-09 will have on its financial position, results of operations, and its financial statement disclosures. ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments was issued with the intention of improving financial reporting by requiring timely recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The ASU requires the measurement of all expected credit losses for financial assets not recorded at fair value based on historical experience, current conditions, and reasonable and supportable forecasts. This ASU will be required to be implemented through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the amendments are effective. The effective date of this Update is for fiscal years beginning on or after December 15, 2019. The Company is evaluating the impact that ASU 2016-13 will have on its financial position, results of operations, and its financial statement disclosures. We expect the new accounting guidance to increase the allowance for loan losses with a resulting negative adjustment to retained earnings, and we will be implementing a new software program during 2017 to enable us to determine the extent of the impact, which could be material. ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments was issued to address diversity in practice of how certain cash receipts and cash payments are currently presented and classified in the statement of cash flows. The amendments in the ASU provide guidance on the following issues: debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies, distributions received from equity method investees and beneficial interests in securitization transactions. Further, the ASU addresses the topic of separately identifiable cash flows and application of the predominance principle. The effective date of this Update is for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company is evaluating the impact that ASU 2016-15 will have, if any, on its financial statement disclosures. Reclassifications-Certain reclassifications have been made to the prior years’ financial statements in order to conform to the classifications adopted for reporting in 2016. The reclassifications had no impact on net income or stockholders’ equity. 2. INVESTMENT SECURITIES The portfolio of securities consisted of the following (in thousands): - 58 - With the exception of two private-label collateralized mortgage obligations ("CMOs") with a combined balance remaining of $18,000 and $27,000 at December 31, 2016 and 2015, respectively, all of the Company’s CMOs are government-sponsored enterprise securities. - 59 - The amortized cost and fair value of debt securities at December 31, 2016 by contractual maturity are shown below (in thousands). Actual maturities may differ from contractual maturities because of rights to call or repay obligations with or without penalties and scheduled and unscheduled principal payments on mortgage-backed securities and collateralized mortgage obligations. Details concerning investment securities with unrealized losses are as follows (in thousands): - 60 - Management evaluates whether unrealized losses on securities represent impairment that is other than temporary on a quarterly basis. For debt securities, the Company considers its intent to sell the securities or if it is more likely than not the Company will be required to sell the securities. If such impairment is identified, based upon the intent to sell or the more likely than not threshold, the carrying amount of the security is reduced to fair value with a charge to earnings. Upon the result of the aforementioned review, management then reviews for potential other than temporary impairment based upon other qualitative factors. In making this evaluation, management considers changes in market rates relative to those available when the security was acquired, changes in market expectations about the timing of cash flows from securities that can be prepaid, performance - 61 - of the debt security, and changes in the market’s perception of the issuer’s financial health and the security’s credit quality. If determined that a debt security has incurred other than temporary impairment, then the amount of the credit related impairment is determined. For equity securities, management reviews the near term prospects of the issuer, the nature and cause of the unrealized loss, the severity and duration of the impairments and other factors when determining if an unrealized loss is other than temporary. If a credit loss is evident, the amount of the credit loss is charged to earnings and the non-credit related impairment is recognized through other comprehensive income. As of December 31, 2016, 80 securities had unrealized losses totaling 1.93% of the individual securities’ amortized cost basis and 1.29% of the Company’s total amortized cost basis. 10 of the 80 securities had been in an unrealized loss position for over twelve months at December 31, 2016. These 10 securities had an amortized cost basis and unrealized loss of $25.8 million and $879,000, respectively. The unrealized losses on securities at December 31, 2016 and 2015 resulted from changing market interest rates over the yields available at the time the underlying securities were purchased. Management identified no impairment related to credit quality. At December 31, 2016 and 2015, management had both the intent and ability to hold impaired securities, and no impairment was evaluated as other than temporary. As a result, no impairment losses were recognized on securities during the years ended December 31, 2016, 2015, or 2014. During the year ended December 31, 2016, the Company sold 2 securities classified as available-for-sale at a gross gain of $20,000. During the year ended December 31, 2015, the Company sold 22 securities classified as available-for-sale at a net gain of $1.2 million. Of the 22 securities sold, 12 were sold with gains totaling $1.4 million and 10 securities were sold at a loss of $135,000. Securities with an aggregate carrying value of approximately $293.4 million and $285.4 million at December 31, 2016 and 2015, respectively, were pledged to secure public funds on deposit and for other purposes required or permitted by law. 3. LOANS The loan portfolio consisted of the following (in thousands): The amounts reported in other loans at December 31, 2016 and 2015 includes the overdrawn demand deposit accounts and loans primarily made to non-profit entities reported for each period. An analysis of the activity in the allowance for loan losses is as follows (in thousands): - 62 - The Company monitors loan concentrations and evaluates individual customer and aggregate industry leverage, profitability, risk rating distributions, and liquidity for each major standard industry classification segment. At December 31, 2016, one industry segment concentration, the oil and gas industry, aggregates more than 10% of the loan portfolio. The Company’s exposure in the oil and gas industry, including related service and manufacturing industries, totaled approximately $237.4 million, or 18.5% of total loans. Of the $237.4 million loans to borrowers in the oil and gas industry, $31.9 million or 13.4% were on nonaccrual status at December 31, 2016. Additionally, the Company’s exposure to CRE loans. At December 31, 2016, CRE loans (including commercial construction and multifamily loans) totaled approximately $559.4 million, 48% of which are secured by owner-occupied commercial properties. Of the $559.4 million in loans secured by commercial real estate, $28.7 million or 5.1% were on nonaccrual status at December 31, 2016. A rollforward of the activity within the allowance for loan losses by loan type and recorded investment in loans for the years ended December 31, 2016 and 2015 is as follows (in thousands): - 63 - An aging analysis of past due loans (including both accruing and non-accruing loans) is as follows (in thousands): - 64 - Non-accrual loans are as follows (in thousands): The amount of interest that would have been recorded on nonaccrual loans, had the loans not been classified as nonaccrual, totaled approximately $3.4 million, $2.0 million, and $594,000 for the years ended December 31, 2016, 2015, and 2014. Interest actually received on nonaccrual loans at December 31, 2016, 2015, and 2014 was $168,000, $47,000, and $105,000, respectively. - 65 - Loans that are individually evaluated for impairment are as follows (in thousands): - 66 - Loans are categorized into risk categories based on relevant information about the ability of borrowers to serve their debt, such as: current financial information, historical payment experience, credit documentation, public information, current economic trends, and other factors. Loans are analyzed individually and classified according to their credit risk. This analysis is performed on a continuous basis. The following definitions are used for risk ratings: Special Mention: Weakness exists that could cause future impairment, including the deterioration of financial ratios, past due status, and questionable management capabilities. Collateral values generally afford adequate coverage but may not be immediately marketable. Substandard: Specific and well-defined weaknesses exist that may include poor liquidity and deterioration of financial ratios. Currently the borrower maintains the capacity to service the debt. The loan may be past due and related deposit accounts experiencing overdrafts. Immediate corrective action is necessary. Doubtful: Specific weaknesses characterized as Substandard exist that are severe enough to make collection in full unlikely. There is no reliable secondary source of full repayment. Loans classified as Doubtful will usually be placed on non-accrual status. The probability of some loss is extremely high but because of certain important and reasonably specific factors, the amount of loss cannot be determined. Loans not meeting the criteria above that are analyzed individually as part of the above-described process are considered to be Pass rated loans. - 67 - The following tables present the classes of loans by risk rating (in thousands): - 68 - Troubled Debt Restructurings A troubled debt restructuring (“TDR”) is a restructuring of a debt made by the Company to a debtor for economic or legal reasons related to the debtor’s financial difficulties that it would not otherwise consider. The Company grants the concession in an attempt to protect as much of its investment as possible. - 69 - Information about the Company’s TDRs is as follows (in thousands): During the year ended December 31, 2016, there was one loan relationship with a pre-modification balance of $5.5 million identified as a TDR after conversion of the loans to interest only for a limited amount of time. This one TDR subsequently defaulted on the modified terms and totaled $5.5 million at December 31, 2016. During the year ended December 31, 2015, there was one loan relationship with a pre-modification balance of $21.4 million identified as a TDR after conversion of the loans to interest only for a limited amount of time. This one TDR subsequently defaulted on the modified terms and totaled $20.3 million at December 31, 2015. For purposes of the determination of an allowance for loan losses on these TDRs, as an identified TDR, the Company considers a loss probable on the loan and, as a result, the loan is reviewed for specific impairment in accordance with the Company’s allowance for loan loss methodology. If it is determined losses are probable on such TDRs, either because of delinquency or other credit quality indicator, the Company establishes specific reserves for these loans. As of December 31, 2016, there were no commitments to lend additional funds to debtors owing sums to the Company whose terms have been modified in TDRs. In the opinion of management, all transactions entered into between the Company and such related parties have been and are made in the ordinary course of business, on substantially the same terms and conditions, including interest rates and collateral, as similar transactions with unaffiliated persons and do not involve more than the normal risk of collection. An analysis of the 2016 activity with respect to these related party loans and commitments to extend credit is as follows (in thousands): - 70 - 4. PREMISES AND EQUIPMENT Premises and equipment consisted of the following (in thousands): Depreciation expense totaled approximately $5.9 million, $6.2 million, and $6.1 million for the years ended December 31, 2016, 2015, and 2014, respectively. 5. GOODWILL AND OTHER INTANGIBLE ASSETS The carrying amount of goodwill for each of the years ended December 31, 2016 and 2015 was approximately $42.2 million. Goodwill is recorded on the acquisition date of each entity. A summary of core deposit intangible assets as of December 31, 2016 and 2015 is as follows (in thousands): Amortization expense on the core deposit intangible assets totaled approximately $1.1 million in 2016, 2015 and 2014. The estimated amortization expense on the core deposit intangible assets for the five succeeding years and thereafter is as follows (in thousands): - 71 - 6. DEPOSITS Deposits consisted of the following (in thousands): Time deposits held consist primarily of certificates of deposits. The maturities for these deposits at December 31, 2016 are as follows (in thousands): Deposits from related parties totaled approximately $17.6 million and $9.1 million at December 31, 2016 and 2015, respectively. 7. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE Securities sold under agreements to repurchase totaled $94.5 million and $86.0 million at December 31, 2016 and 2015, respectively. At December 31, 2016 and 2015, retail repurchase agreements, defined as securities sold under agreements to repurchase from our customers, totaled $82.0 million and $73.5 million, respectively. These retail repurchase agreements are secured overnight borrowings from customers, which may be drawn on demand. The agreements bear interest at a rate determined by us. The average rate of the outstanding agreements was 0.46% and 0.48% at December 31, 2016 and 2015, respectively. The Company had pledged securities with an approximate market value of $86.5 million and $75.1 million as collateral at December 31, 2016 and 2015, respectively. Also included in securities sold under agreements to repurchase is a $12.5 million repurchase agreement the Company entered into with CitiGroup Global Markets, Inc. (“CGMI”) effective August 9, 2007. Under the terms of the repurchase agreement, interest is payable quarterly based on a floating rate equal to the 3-month LIBOR for the first 12 months of the agreement and a fixed rate of 4.57% for the remainder of the term. The rate at December 31, 2016 and 2015 was 4.57%. The repurchase date is scheduled for August 9, 2017; however, the agreement may be called by CGMI quarterly. The Company had pledged securities with a market value of $13.9 million and $17.6 million as collateral at December 31, 2016 and 2015, respectively. In 2016, 2015, and 2014, the Company did not have an average balance in any category of short-term borrowings including retail repurchase agreements, reverse repurchase agreements, federal funds purchased, or short-term FHLB advances that exceeded 30% of our stockholders’ equity for such year. 8. SHORT-TERM FEDERAL HOME LOAN BANK ADVANCES Short-term FHLB advances totaled $25.0 million at December 31, 2015. There were no short-term FHLB advances outstanding at December 31, 2016. The short-term FHLB advances at December 31, 2015 consisted of one FHLB advance with a maturity of 4 months at a fixed interest rate of 0.30%. - 72 - The short-term and long-term FHLB advances at December 31, 2016 and 2015 are collateralized by a blanket lien on first mortgages and other qualifying loans totaling $265.9 million and $268.6 million, respectively. As of December 31, 2016 and 2015, the Company had $240.9 million and $218.5 million, respectively, of additional FHLB advances available. 9. LONG-TERM FEDERAL HOME LOAN BANK ADVANCES Long-term FHLB advances totaled $25.4 million and $25.9 million at December 31, 2016 and 2015, respectively. The scheduled maturities of long-term FHLB advances at December 31, 2016 are summarized as follows (in thousands): 10. JUNIOR SUBORDINATED DEBENTURES A description of the junior subordinated debentures outstanding is as follows (in thousands): The trusts are considered variable-interest entities (“VIE”). The Trusts are not consolidated with the Company since the Company is not the primary beneficiary of the VIE. Accordingly, the Company does not report the securities issued by the Trusts as liabilities, and instead reports as liabilities the junior subordinated debentures issued by the Company and held by the Trusts, as these are not eliminated in the consolidation. The Trust Preferred Securities are recorded as junior subordinated debentures on the balance sheets, but subject to certain limitations qualify for Tier 1 capital for regulatory capital purposes. 11. COMMITMENTS AND CONTINGENCIES At December 31, 2016, future annual minimum rental payments due under non-cancellable operating leases are as follows (in thousands): - 73 - Rental expense under operating leases for 2016, 2015, and 2014 was approximately $2.2 million, $2.5 million, and $2.5 million, respectively. The Company is party to various legal proceedings arising in the ordinary course of business. In management’s opinion, the ultimate resolution of these legal proceedings will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows. At December 31, 2016, the Company had borrowing lines available through the Bank with the FHLB of Dallas and other correspondent banks. The Bank had approximately $240.9 million available, subject to available collateral, under a secured line of credit with the FHLB of Dallas. Federal funds lines of credit were available through correspondent banks with approximately $53.5 million available for overnight borrowing at December 31, 2016. Additionally, $180.5 million in loan collateral is pledged under a Borrower-in-Custody line with the FRB-Atlanta. 12. INCOME TAXES Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities as of December 31, 2016 and 2015 are as follows (in thousands): Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, the Company believes that it is more likely than not that it will realize the benefits of these deductible differences existing at December 31, 2016. Therefore, no valuation allowance is necessary at this time. The net deferred tax assets for 2016 and 2015 are included in other assets on the consolidated balance sheets. Components of income tax expense are as follows (in thousands): - 74 - The provision for federal income taxes differs from the amount computed by applying the U.S. Federal income tax statutory rate of 35% on pre-tax income as follows (in thousands): The Company’s federal income tax returns are open and subject to examination from the 2013 tax return year and forward. The various state income and franchise tax returns are generally open from the 2013 and later tax return years based on individual state statutes of limitation. We are not currently under examination by federal or state tax authorities for the 2013, 2014, or 2015 tax years. 13. EMPLOYEE BENEFITS The Company sponsors a leveraged employee stock ownership plan (“ESOP”) that covers all employees who meet minimum age and service requirements. The Company makes annual contributions to the ESOP in amounts as determined by the Board of Directors. These contributions are used to pay debt service and purchase additional shares. Certain ESOP shares are pledged as collateral for this debt. As the debt is repaid, shares are released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. During 2014, the ESOP borrowed $283,000 payable to MidSouth Bank, N.A for the purpose of purchasing additional shares of MidSouth Bancorp, Inc.’s common stock. The note payable matures on June 25, 2018. The loan proceeds were used to purchase a total of 16,000 shares at an average price of $17.71 per share. During 2015, the ESOP borrowed an additional $997,000 payable to MidSouth Bank, N.A. The notes payable mature on February 20, 2019 and October 5, 2019. A total of 76,526 shares at an average price of $13.02 per share were purchased with the loan proceeds. During 2016, the ESOP borrowed an additional $499,000 payable to MidSouth Bank, N.A. The note payable matures on July 29, 2020. A total of 62,014 shares at an average price of $8.05 were purchased with the loan proceeds. The balances of the notes payable of the ESOP were $1.2 million and $1.1 million at December 31, 2016 and December 31, 2015, respectively. Because the source of the loan payments are contributions received by the ESOP from the Company, the related notes receivable is shown as a reduction of stockholders’ equity. In accordance with GAAP, compensation costs relating to shares purchased are based on the fair value of shares committed to be released. The difference between the average fair market value and the cost of the shares allocated by the ESOP is recorded as an adjustment to additional paid-in capital. The unreleased shares are not considered outstanding in the computation of earnings per common share. Dividends on unreleased shares are recorded as compensation expense; dividends on allocated ESOP shares are recorded as a reduction of stockholders’ equity. Dividends received on ESOP shares are allocated based on shares held for the benefit of each participant and used to purchase additional shares of stock for each participant. ESOP compensation expense consisting of both cash contributions and shares committed to be released for 2016, 2015 and 2014 was approximately $603,000, $720,000 and $720,000, respectively. ESOP shares as of December 31, 2016 and 2015 were as follows: The Company has deferred compensation arrangements with certain officers, which will provide them a fixed benefit after retirement. During 2016, distributions related to these agreements totaled $49,000. The Company recorded a liability of approximately $1.4 million at December 31, 2016 and 2015 in connection with these agreements. Deferred compensation expense recognized in 2016, 2015, and 2014 was approximately $60,000, $82,000, and $80,000, respectively. - 75 - The Company sponsors defined contribution post-retirement benefit agreements to provide death benefits for the designated beneficiaries of certain of the Company's executive officers. Under the agreements, split-dollar whole life insurance contracts were purchased on certain executive officers. The increase in the cash surrender value of the contracts, less the Bank's cost of funds, constitutes the Company's contribution to the agreements each year. In the event the insurance contracts fail to produce positive returns, the Company has no obligation to contribute to the agreements. During 2016, 2015, and 2014, the Company incurred expenses of $2,000, $14,000 and $7,000, respectively, related to the agreements. The Company has a 401(k) retirement plan covering substantially all employees who have been employed for 90 days and meet certain other requirements. Under this plan, employees can contribute a portion of their salary within the limits provided by the Internal Revenue Code into the plan. The Company made contributions to the plan totaling $60,000 in 2016, 2015 and 2014, respectively. 14. EMPLOYEE STOCK PLANS In May of 2007, our stockholders approved the 2007 Omnibus Incentive Compensation Plan to provide incentives and awards for directors, officers, and employees. “Awards” as defined in the Plan includes, with limitations, stock options (including restricted stock options), restricted stock awards, stock appreciation rights, performance shares, stock awards and cash awards, all on a stand-alone, combination, or tandem basis. The 2007 Omnibus Incentive Compensation Plan replaces the 1997 Stock Incentive Plan, which expired February of 2007. A total of 525,000 of our common shares authorized were reserved for issuance under the Plan, of which 136,093 were available to be granted as of December 31, 2016. Stock Options - The 298,995 options outstanding at December 31, 2016 were all issued under the 2007 Omnibus Incentive Compensation Plan. All options outstanding at December 31, 2016 are incentive stock options with a term of ten years, 256,493 of which vest 20% each year on the anniversary date of the grant and 42,502 of which vest 16.67% each year. The following table summarizes activity relating to stock options: - 76 - A summary of changes in unvested options for the period ended December 31, 2016 is as follows: As of December 31, 2016 there was a total of $291,000 in unrecognized compensation cost related to nonvested stock option grants that is expected to be recognized over a weighted-average period of 1.7 years. The total amount of options expensed during the years ended December 31, 2016, 2015 and 2014 was $162,000, $336,000 and $442,000, respectively. The fair value of each option granted is estimated on the grant date using the Black-Scholes Option Pricing Model. This model requires management to make certain assumptions, including the expected life of the option, the risk free rate of interest, the expected volatility, and the expected dividend yield. The risk free rate of interest is based on the yield of a U.S. Treasury security with a similar term. The expected volatility is based on historic volatility over a term similar to the expected life of the options. The dividend yield is based on the current yield at the date of grant. The following assumptions were made in estimating the fair value of the options granted in 2016 and 2015: The total intrinsic value of the options exercised was $10,000, and $217,000 for the years ended December 31, 2015 and 2014, respectively. There were no options exercised during the year ended December 31, 2016. Restricted Stock Awards - During 2016 and 2015, the Compensation Committee of the Board of Directors of the Company made restricted stock grants under the Company’s 2007 Omnibus Incentive Compensation Plan. The restricted shares of stock, which are subject to the terms of a Restricted Stock Grant Agreement between the Company and each recipient, will fully vest on the third anniversary of the grant date. Prior to vesting, the recipient will be entitled to vote the shares and receive dividends, if any, declared by the Company with respect to its common stock. Compensation expense for restricted stock is based on the fair value of the restricted stock awards at the time of the grant, which is equal to the market value of the Company’s common stock on the date of grant. The value of the restricted stock grants that are expected to vest is amortized monthly into compensation expense over the three year vesting period. The weighted average grant date fair value of restricted stock awards was $10.97 and $13.92 for the years ended December 31, 2016 and 2015, respectively. For the year ended December 31, 2016 and 2015, compensation expense of $48,000 and $19,000, respectively, was recognized related to non-vested restricted stock awards. There was no compensation expenses related to these awards in 2014. As of December 31, 2016, there was $125,000 of unrecognized compensation cost related to non-vested restricted stock awards granted under the plan. The unrecognized compensation cost related to restricted stock awards at December 31, 2016 is expected to be recognized over a weighted-average period of 2.1 years. The following table summarizes activity relating to non-vested restricted stock awards: - 77 - 15. STOCKHOLDERS’ EQUITY The payment of dividends by the Bank to the Company is restricted by various regulatory and statutory limitations. At December 31, 2016, the Bank had approximately $8.8 million available to pay dividends to the parent company without regulatory approval. In August 2011, the Company redeemed 20,000 outstanding shares of Series A Preferred Stock associated with its participation in the Treasury’s Capital Purchase Plan (“CPP”) under the Troubled Asset Relief Program at its stated value of $1,000 per share with funds from our issuance of 32,000 shares of Series B preferred stock in connection with the Company’s participation under the U.S. Treasury’s Small Business Lending Fund (“SBLF”). The additional $12.0 million of net proceeds from the issuance was provided to the Bank as additional capital. The dividend rate on the Series B preferred stock was set at 1.00% for the fourth quarter of 2013 due to attaining the target 10% growth rate in qualified small business loans during the second quarter of 2013. On February 25, 2016, the dividend rate increased to 9% per annum, consistent with the Securities Purchase Agreement which states that the rate would increase if the funding was not repaid within 4.5 years after issuance. The Series B preferred stock is nonvoting except for class voting rights on matters that would adversely affect the rights of the holders of the Series B preferred stock. On December 28, 2012, the Company issued 756,511 shares of common stock and 99,971 shares of Series C Preferred Stock in connection with the PSB acquisition. The Series C Preferred Stock is entitled to the payment of noncumulative dividends, if and when declared by the Company’s Board of Directors, at the rate of 4.00% per annum, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, beginning on April 15, 2013. The Series C Preferred Stock ranks pari passu with the existing Senior Non-Cumulative Perpetual Preferred Stock, Series B, issued in connection with the Company’s participation under the Treasury’s SBLF and senior to the Company’s common stock. The Company may redeem the Series C Preferred Stock, subject to regulatory approval, beginning on or after the fifth anniversary of the closing date of the Merger, at a redemption price equal to the liquidation value of the Series C Preferred Stock, plus declared but unpaid dividends, if any. The Company may also redeem the Series C Preferred Stock, subject to regulatory approval, at the same redemption price prior to the fifth anniversary of the closing date in the event the Series C Preferred Stock no longer qualifies for "Tier 1 Capital” treatment by the applicable federal banking regulators. Holders may convert the Series C Preferred Stock at any time into shares of the Company’s common stock at a conversion price of $18.00 per share, subject to customary anti-dilution adjustments. In addition, on or after the fifth anniversary of the closing date, the Company will have the option to require conversion of the Series C Preferred Stock if the closing price of the Company’s common stock for 20 trading days within any period of 30 consecutive trading days, exceeds 130% of the conversion price. - 78 - 16. DERIVATIVES On July 6, 2016, the Company entered into two forward interest rate swap contracts on a reverse repurchase agreement and long-term FHLB advances. The interest rate swap contracts were designated as derivative instruments in a cash flow hedge under ASC Topic 815, Derivatives and Hedging to convert forecasted variable interest payment to a fixed rate and the Company has concluded that the forecasted transactions are probable of occurring. For cash flow hedges, the effective portion of the gain or loss related to the derivative instrument is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings or when the hedge is terminated. The ineffective portion of the gain or loss is reported in earnings immediately. No ineffectiveness related to the interest rate swaps designated as cash flow hedges was recognized in the consolidated statements of income for the year ended December 31, 2016. The accumulated net after-tax income related to the effective cash flow hedge included in accumulated other comprehensive income/loss is reflected in Note 17 - Other Comprehensive (Loss) Income. The following table discloses the notional amounts and fair value of derivative instruments in the Company's balance sheet as of December 31, 2016 and 2015 (in thousands): 17. OTHER COMPREHENSIVE (LOSS) INCOME The following is a summary of the tax effects allocated to each component of other comprehensive (loss) income (in thousands): - 79 - The reclassifications out of accumulated other comprehensive income into net earnings are presented below (in thousands): - 80 - 18. NET EARNINGS PER COMMON SHARE Following is a summary of the information used in the computation of earnings per common share (in thousands): Following is a summary of the securities that were excluded from the computation of diluted earnings per share because the effects of the shares were anti-dilutive (in thousands): 19. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Bank is party to various financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the statements of financial condition. The contract or notional amounts of those instruments reflect the extent of the Bank’s involvement in particular classes of financial instruments. The Bank’s exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and financial guarantees is represented by the contractual amount of those instruments. The Bank uses the same credit policies, including considerations of collateral requirements, in making these commitments and conditional obligations as it does for on-balance sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash requirements. Substantially all of these commitments are at variable rates. - 81 - Commercial letters of credit and financial guarantees are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to its customers. Approximately 77% and 91% of these letters of credit were secured by marketable securities, cash on deposit, or other assets at December 31, 2016 and 2015, respectively. 20. REGULATORY MATTERS The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of common equity Tier 1 capital, Tier 1 and total capital (as defined in the regulations) to risk-weighted assets (as defined) and to average assets (as defined). As of December 31, 2016, the most recent notifications from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum common equity Tier I, total risk-based, Tier I risk-based, and Tier I leverage capital ratios as set forth in the table (in thousands). There are no conditions or events since those notifications that management believes has changed the Bank’s category. The Company’s and the Bank’s actual capital amounts and ratios are presented in the table below (in thousands): - 82 - In July 2013, the Federal bank regulatory agencies issued a final rule that will revise their risk-based capital requirements and the method for calculating components of capital and of computing risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act. The Basel III rules became effective for the Company and the Bank on January 1, 2015 (subject to a phase-in period for certain provisions). The final rule applied to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more and top-tier savings and loan holding companies. The rule established a new common equity Tier 1 minimum capital requirement, increased the minimum capital ratios and assigned a higher risk weight to certain assets based on the risk associated with these assets. Certain provisions of the new rules will be phased in through January 1, 2019. 21. FAIR VALUE MEASUREMENTS AND DISCLOSURES The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans and other real estate. These nonrecurring fair value adjustments typically involve the application of the lower of cost or market accounting or write-downs of individual assets. Additionally, the Company is required to disclose, but not record, the fair value of other financial instruments. Fair Value Hierarchy The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets. Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 3 - Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques. - 83 - Following is a description of valuation methodologies used for assets and liabilities which are either recorded or disclosed at fair value. Cash and cash equivalents-The carrying value of cash and cash equivalents is a reasonable estimate of fair value. Time Deposits in Other Banks-Fair values for fixed-rate time deposits are estimated using a discounted cash flow analysis that applies interest rates currently being offered on time deposits of similar terms of maturity. Securities Available-for-Sale-Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange and U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter market funds. Securities are classified as Level 2 within the valuation hierarchy when the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things. Level 2 inputs are used to value U.S. Agency securities, mortgage-backed securities, municipal securities, single issue trust preferred securities, certain pooled trust preferred securities, and certain equity securities that are not actively traded. Securities Held-to-Maturity-The fair value of securities held-to-maturity is estimated using the same measurement techniques as securities available-for-sale. Other investments-The carrying value of other investments is a reasonable estimate of fair value. Loans-For disclosure purposes, the fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value. The Company does not record loans at fair value on a recurring basis. No adjustment to fair value is taken related to illiquidity discounts. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management uses one of three methods to measure impairment, which, include collateral value, market value of similar debt, and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Impaired loans where an allowance is established based on the fair value of collateral or where the loan balance has been charged down to fair value require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and adjusts the appraisal value by taking an additional discount for market conditions and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. For non-performing loans, collateral valuations currently in file are reviewed for acceptability in terms of timeliness and applicability. Although each determination is made based on the facts and circumstances of each credit, generally valuations are no longer considered acceptable when there has been physical deterioration of the property from when it was last appraised, or there has been a significant change in the underlying assumptions of the appraisal. If the valuation is deemed to be unacceptable, a new appraisal is ordered. New appraisals are typically received within 4-6 weeks. While awaiting new appraisals, the valuation in file is utilized, net of discounts. Discounts are derived from available relevant market data, selling costs, taxes, and insurance. Any perceived collateral deficiency utilizing the discounted value is specifically reserved (as required by ASC Topic 310) until the new appraisal is received or charged off. Thus, provisions or charge-offs are recognized in the period the credit is identified as non-performing. The following sources are utilized to set appropriate discounts: market real estate agents, current local sales data, bank history for devaluation of similar property, Sheriff’s valuations and buy/sell contracts. If a real estate agent is used to market and sell the property, values are discounted 6% for selling costs and an additional 4% for taxes, insurance and maintenance costs. Additional discounts may be applied if research from the above sources indicates a discount is appropriate given devaluation of similar property from the time of the initial valuation. - 84 - Other Real Estate-Other real estate properties are adjusted to fair value upon transfer of the loans to other real estate, and annually thereafter to insure other real estate assets are carried at the lower of carrying value or fair value. Exceptions to obtaining initial appraisals are properties where a buy/sell agreement exists for the loan value or greater, or where we have received a Sheriff’s valuation for properties liquidated through a Sheriff sale. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the other real estate as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and adjusts the appraisal value by taking an additional discount for market conditions and there is no observable market prices, the Company records the other real estate asset as nonrecurring Level 3. Cash Surrender Value of Life Insurance Policies-Fair value for life insurance cash surrender value is based on cash surrender values indicated by the insurance companies. Derivative Instruments-The fair value of derivatives are determined by an independent valuation firm and are estimated using prices of financial instruments with similar characteristics. As a result, they are classified within Level 2 of the fair value hierarchy. Deposits-The fair value of demand deposits, savings accounts, NOW accounts, and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities. The estimated fair value does not include customer related intangibles. Securities Sold Under Agreements to Repurchase-The fair value approximates the carrying value of repurchase agreements due to their short-term nature. Short-term Federal Home Loan Bank advances-The fair value approximates the carrying value of short-term FHLB advances due to their short-term nature. Long-term Federal Home Loan Bank advances-The fair value of of long-term FHLB advances is estimated using a discounted cash flow analysis that applies interest rates currently being offered on similar types of borrowings with similar terms. Junior Subordinated Debentures-For junior subordinated debentures that bear interest on a floating basis, the carrying amount approximates fair value. For junior subordinated debentures that bear interest on a fixed rate basis, the fair value is estimated using a discounted cash flow analysis that applies interest rates currently being offered on similar types of borrowings. Commitments to Extend Credit, Standby Letters of Credit and Credit Card Guarantees-Because commitments to extend credit and standby letters of credit are generally short-term and made using variable rates, the carrying value and estimated fair value associated with these instruments are immaterial. Assets Recorded at Fair Value Below is a table that presents information about certain assets and liabilities measured at fair value on a recurring basis (in thousands): - 85 - Certain assets and liabilities are measured at fair value on a nonrecurring basis and therefore are not included in the table above. Impaired loans are level 2 assets measured using appraisals from external parties of the collateral less any prior liens. Other real estate owned are also level 2 assets measured using appraisals from external parties. Assets measured at fair value on a nonrecurring basis are as follows (in thousands): Limitations Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. - 86 - Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. The estimated fair values of our financial instruments are as follows at December 31, 2016 and 2015 (in thousands): 22. OTHER NON-INTEREST INCOME AND EXPENSE For the years ended December 31, 2016, 2015, and 2014, none of the components of other noninterest income were greater than 1% of interest income and noninterest income. - 87 - Components of other noninterest expense greater than 1% of interest income and noninterest income consisted of the following for the years ended December 31, 2016, 2015, and 2014 (in thousands): 23. SUBSEQUENT EVENTS The Company has evaluated all subsequent events and transactions that occurred after December 31, 2016 up through the date of filing this Annual Report on Form 10-K. No events or changes in circumstances were identified that would have an adverse impact on the financial statements. - 88 - 24. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY Summarized financial information for MidSouth Bancorp, Inc. (parent company only) follows: - 89 - - 90 - ACCOUNTING FIRM Stockholders and Board of Directors MidSouth Bancorp, Inc. and Subsidiaries Lafayette, Louisiana We have audited the accompanying consolidated balance sheets of MidSouth Bancorp, Inc. and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of earnings, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2016. We also have audited the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. - 91 - In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Atlanta, Georgia March 16, 2017 - 92 - - 93 - - 94 - Item 9
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Based on the provided text, here's a summary of the financial statement excerpt:
The financial statement highlights several key points:
1. Potential Losses: The document acknowledges potential losses due to:
- Real estate valuation
- Goodwill impairment assessment
- Deferred tax asset valuation
2. Economic Uncertainty: The current economic environment is unstable, which could impact:
- Loan loss assessments
- Real estate owned valuations
- Fair value measurements
3. Accounting Policies:
- Cash and cash equivalents include cash on hand and short-term bank deposits
- Debt securities are classified based on intent and market strategy
- No trading account securities were held during the reported three-year period
4. Risk Factors: The statement suggests potential future impairments and changes in valuation methodologies due to economic instability.
Note: The excerpt appears to be a partial financial statement, so
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Claude
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COMMERCEHUB, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders CommerceHub, Inc.: We have audited the accompanying consolidated balance sheets of CommerceHub, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income (loss), equity, and cash flows for each of the years in the three-year period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CommerceHub, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP Albany, New York March 6, 2017 COMMERCEHUB, INC. Consolidated Balance Sheets (In thousands, except share data) See accompanying notes to these consolidated financial statements COMMERCEHUB, INC. Consolidated Statements of Comprehensive Income (Loss) (In thousands, except per share data) See accompanying notes to these consolidated financial statements COMMERCEHUB, INC. Consolidated Statements of Equity (In thousands, except share data) See accompanying notes to these consolidated financial statements. COMMERCEHUB, INC. Consolidated Statements of Cash Flows (In thousands) See accompanying notes to these consolidated financial statements COMMERCEHUB, INC. Note 1 - Description of Business CommerceHub, Inc. ("CommerceHub," the "Company," "us," "we" and "our") was founded in 1997 (then known as Commerce Technologies, Inc.) and is headquartered in Albany, New York, with additional locations in Seattle, Washington and the Hertford, England. We are a leading provider of cloud-based e-commerce fulfillment and marketing solutions that integrate supply, demand and delivery for large retailers and consumer brands, manufacturers and distributors. Our end-to-end solutions are provided through the CommerceHub software platform, a hub that streamlines integration and enables more efficient transactions among our retailer and supplier customers and their other trading partners, while also enabling them to access the online marketplaces, search engines, social and product advertising and other digital marketing channels where consumers browse and buy. Our solutions also help our customers integrate with the 3PL providers, including fulfillment and delivery providers, that take purchased products to the consumer’s doorstep. Recent Events Spin-Off from Liberty Interactive Corporation During November 2015, the board of directors of Liberty Interactive Corporation, our former parent company ("Liberty" or "Parent"), authorized a plan to distribute to the holders of Liberty's Series A and Series B Liberty Ventures common stock, shares of CommerceHub (the "Spin-Off"). At the time, CommerceHub was a newly formed Delaware corporation that, pursuant to an internal restructuring, effective July 21, 2016, became the parent of Commerce Technologies, LLC, a Delaware limited liability company that, as a result of the restructuring, is the successor to Commerce Technologies, Inc. ("CTI"), the entity through which CommerceHub transacted prior to the Spin-Off. The Spin-Off was completed on July 22, 2016 and was effected as a pro rata dividend of shares of CommerceHub to the stockholders of Series A and Series B Liberty Ventures common stock of Liberty. The Internal Revenue Service (“IRS”) has completed its review of the Spin-Off and has notified Liberty that it agreed with the nontaxable characterization of the Spin-Off. Following the Spin-Off, CommerceHub now operates as a stand-alone publicly traded company, and neither Liberty nor CommerceHub has any stock ownership, beneficial or otherwise, in the other. In connection with the Spin-Off, CommerceHub entered into certain agreements (effective the date of the Spin-Off) with Liberty and/or Liberty Media Corporation ("Liberty Media"), which are further discussed in Note 8 to these consolidated financial statements. In July 2016, the Company had cash inflows and outflows in conjunction with the Spin-Off, which include the following: • borrowed $50.0 million under our credit facility (see Note 14) to fund cash outflows described below; • fully repaid our note payable due to Liberty, including accrued interest, of $28.7 million and amounts due for state taxes paid of $1.3 million; • paid a dividend of $18.9 million to the holders of CTI common stock, primarily our Parent as a return of Parent's investment, and an additional $0.9 million to Parent, as holder of CTI preferred shares; • collected amounts due from Liberty for federal tax benefits of $8.5 million, which is included in Parent receivables and payables, net on the consolidated statements of cash flows (see Note 13 for further discussion of tax-related transactions that occurred in connection with the Spin-Off); and • received a contribution from Liberty of $6.0 million to compensate the Company for the dilution associated with Parent equity awards. Note 2 - Basis of Presentation The consolidated financial statements include the accounts of CommerceHub and its subsidiaries. All intercompany accounts and transactions have been eliminated in the consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles ("GAAP"). Use of Estimates Preparing these consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates and assumptions. COMMERCEHUB, INC. Segment and Geographic Information Operating segments are components of our business for which discrete financial information is available and evaluated by the chief operating decision maker ("CODM") (our Chief Executive Officer) for purposes of allocating resources and evaluating financial performance. Our CODM reviews consolidated financial information results of the Company to allocate resources and evaluate performance. As such, the Company operates as a single segment. We generate nearly all of our revenue in the United States and Canada. For the years ended December 31, 2016, 2015 and 2014, approximately 96%, 96% and 95%, respectively, of our total retailer and seller program revenue was generated from customers located in the United States. Substantially all of our assets are located within the United States. Reclassifications We made certain reclassifications to our consolidated financial statements which include reclassifying certain sales taxes, in the amounts of $455 thousand and $335 thousand for the years ended December 31, 2015 and 2014, respectively, from cost of revenue to sales and marketing to comply with our current policy for presenting such costs. Note 3 - Significant Accounting Policies Cash and Cash Equivalents The Company considers all highly liquid securities with original maturities of 90 days or less to be cash equivalents. Cash at both December 31, 2016 and 2015 consisted principally of cash held at financial institutions in the U.S. that management believes to be reputable and at times exceed insured limits. Accounts Receivable and Allowance for Doubtful Accounts The Company grants credit in the normal course of business without collateral. Accounts receivable are stated net of allowances for doubtful accounts, which represent estimated losses resulting from the inability of certain customers to make the required payments. When determining the allowances for doubtful accounts, we take several factors into consideration, including the overall composition of the accounts receivable aging, our prior history of accounts receivable write-offs, the types of customers and our experience with specific customers. We write off accounts receivable when they are determined to be uncollectible. Changes in the allowances for doubtful accounts are recorded as bad debt expense and are included in general and administrative expenses in our consolidated statements of comprehensive income (loss). The allowance for doubtful accounts activity, included in accounts receivable, net, was as follows (in thousands): COMMERCEHUB, INC. Property and Equipment Property and equipment are stated at cost. Equipment under capital leases are stated at the present value of minimum lease payments. Repairs and maintenance costs are expensed as incurred. Depreciation of property and equipment is computed using the straight-line method over the following estimated useful lives: Capitalized Software Costs The Company capitalizes the cost of payroll, payroll-related costs and third-party consulting fees incurred in the direct development or enhancement of solutions as internal-use software. During 2016, we changed and further refined our methodologies and processes to estimate the portion of software development costs that is eligible to be capitalized, which is assessed at a project level. Development costs incurred during the preliminary project stage or costs incurred for requirements gathering, data conversion activities, training, maintenance, and minor enhancements are expensed as incurred. Development costs incurred for the coding, configuration, interfacing, automation and testing of new functionality after the preliminary project stage is complete is capitalized. Capitalized software costs are amortized on a straight-line basis over two to three years, based on the nature and estimated useful life of the applicable solution. Amortization of capitalized software costs is included in cost of revenue within the consolidated statements of comprehensive income (loss). Deferred Services Costs The Company defers direct payroll, payroll-related costs and third-party consulting costs incurred for the set-up and integration of new customers on our platform and for enhancements we make to our platform that are particular to specific customers. Deferred services costs associated with the integration of customers on our platform are recognized over the estimated life of our customers. Deferred services costs incurred to enhance existing customer's platforms are recognized over the estimated remaining customer life. Amortization of deferred services costs are included in cost of revenue within the consolidated statements of comprehensive income (loss). Impairment of Long-Lived Assets Long-lived assets, such as property and equipment and intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group to be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value may be determined through various valuation techniques including discounted cash flow models, quoted market values and independent third-party appraisals, as considered necessary. Goodwill Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. Goodwill is reviewed for impairment at least annually as of October 1, and more frequently if events or changes in circumstances indicate that goodwill might be impaired. GAAP provides an entity the option to perform a qualitative assessment to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount prior to performing the two-step goodwill impairment test. If this is the case, the two-step goodwill impairment test is required. If it is more-likely-than-not that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. For the year ended December 31, 2015, we performed a qualitative assessment of goodwill for its single reporting unit and determined that it was more-likely-than-not that the fair value of its reporting unit exceeded the carrying amount, and no impairment loss was recorded in 2015. During the year ended December 31, 2016, we performed step one of the goodwill impairment test utilizing the market capitalization approach to determine whether the fair value of our reporting unit is less than its carrying amount. Based upon our assessment, we believe the fair value exceeds the carrying value, and no impairment loss was recorded in 2016. Revenue and Deferred Revenue The Company generates revenue through delivery of its e-commerce fulfillment and marketing software platform. The Company follows Financial Accounting Standards Board ("FASB") guidance set forth in Accounting Standards Codification ("ASC") Subtopic 985-605-05 related to Hosting Arrangements and ASC Subtopic 605-25 related to Revenue Arrangements COMMERCEHUB, INC. with Multiple Deliverables. The Company recognizes revenue when all of the following conditions are met: there is persuasive evidence of an arrangement, the services have been delivered to the customer, the collection of the related fees is reasonably assured and the amount of the related fees is fixed and determinable. Revenue from new customer acquisition is generated under sales agreements with multiple elements and includes usage fees, subscription fees and related set-up and professional services fees that allow our customers to access our solutions. Customers do not have the contractual right to take possession of our solutions. We evaluate each element in a multiple-element arrangement to determine whether it represents a separate unit of accounting. An element constitutes a separate unit of accounting when the delivered item has stand-alone value and delivery of the undelivered element is probable and within the Company's control. Subscription fees are charged on a stand-alone basis or in association with a minimum usage level required to be maintained by a customer in connection with our Demand Solutions. The Company recognizes subscription fees as revenue in the period in which the subscription is earned. Usage fees are comprised of fees charged to customers based on the level of a customer's utilization of our solutions. Usage fee revenue is generated primarily from customer orders, content services, inventory management and third-party communication services. The Company recognizes usage fee revenue in the period in which the usage fee is earned. Set-up fees provide customers access to our solutions through production launch. They are billed during the implementation phase and recorded as deferred revenue until a customer's subscription period has commenced. We also provide professional services to enhance our solutions based on a particular customer's needs. Set-up and professional services fees related to customer-specific solution enhancements do not have stand-alone value because they are sold only in conjunction with a subscription to our solutions, they are sold only by the Company, a customer could not resell them and they do not represent the culmination of a separate earnings process. Set-up fees without stand-alone value are recognized over the longer of the life of the agreement or the expected customer life. The Company recognizes revenue for fees billed for solution enhancement services over the estimated remaining customer life. In determining the estimated life of our customers, we considered our historical experience with customer contract renewals, type of customer, size of the customer and the period over which the customer will benefit from the related offerings. During 2016, we updated the estimated life of certain customers, which as of December 31, 2016 ranges from 1 to 10 years, reflecting a shorter life for smaller supplier customers to a longer life for our largest retail customers. Deferred revenue consisted of the unearned portion of deferred set-up and professional services fees. Reimbursable costs received for out-of-pocket expenses are recorded as revenue and cost of revenue in the consolidated statements of comprehensive income (loss). Advertising Expenses The Company incurs advertising expense consisting of promotions and public relations to promote our services. Advertising is expensed as incurred and was $100 thousand, $314 thousand and $295 thousand for the years ended December 31, 2016, 2015 and 2014, respectively. Share-based Compensation Share-based awards exchanged for employee services are recorded as expense, on a straight-line basis, at the estimated fair value of these awards over the requisite employee service period (typically 4 years), or where applicable for performance-based awards, over the service period, when the achievement of certain performance-based conditions are considered probable, and expire after 10 years. Prior to the Spin-Off, the Company's share-based awards consisted of CTI-issued stock options and stock appreciation rights ("SARs"), which were classified as liability awards and were included as a share-based compensation liability on the consolidated balance sheets. The Company measured the cost of services received in exchange for these awards based on the fair value of the award, and remeasured the fair value of the award at each reporting date. In connection with the Spin-Off, the outstanding CTI equity incentive awards were adjusted, such that each holder of an option award or a SAR with respect to shares of CTI common stock received an option award to purchase shares of our Series C common stock. Unlike the original CTI options and SARs, which were able to be settled in cash prior to completion of the Spin-Off, the new option awards resulting from the conversion of the original CTI options and SARs may only be settled in shares of CommerceHub's Series C common stock (see Note 12). The Company estimates the fair value of stock options and SAR awards using a Black-Scholes pricing model. The estimation of share-based awards that will ultimately vest requires judgment, and to the extent actual results differ from the Company's estimates, such amounts are recorded as an adjustment in the period in which estimates are revised. In valuing share-based awards, significant judgment is required in determining the fair value of the Company's share price (for awards granted prior to the Spin-Off), the expected volatility of common stock and the expected term for which individuals will hold COMMERCEHUB, INC. their share-based awards prior to exercise. With the assistance of an independent third-party advisory firm, for the years ended December 31, 2015 and 2014 and the three months ended March 31, 2016, we estimated share-price based on an internal valuation using a combination of three different approaches: •Market Multiple Approach; •Guideline Transaction Approach; and •Discounted Cash Flow ("DCF") Approach. The Market Multiple Approach involves the capitalization of revenue and earnings before interest, taxes, depreciation and amortization, and option expense. Multiples are determined through an analysis of certain publicly traded companies, selected on a basis of operational and economic similarity with the principal business and operational revenue model of CommerceHub. Multiples are calculated for the comparative companies based upon their trading prices. The risk analysis incorporates quantitative and qualitative risk factors, which relate to, among other things, the nature of the industry in which we and the other comparative companies are engaged, relative size, profitability and growth rates. The Guideline Transaction Approach is similar to the Market Multiple Approach in that it involves a consideration of multiples of revenue and Adjusted EBITDA. However, multiples used for this approach were determined through the analysis of transactions involving controlling interests in companies with operations similar to CommerceHub's business. Internally prepared financial projections are used to develop the DCF Approach, a valuation method that estimates the present value of the projected cash flows to be generated from the business. In the DCF Approach, a discount rate, reflecting all risks of ownership and associated risks of realizing the stream of projected future cash flows, is applied to the stream of projected cash flows. For the three months ended June 30, 2016, the estimated share-price was based on the fair market value of our Series C common stock traded immediately following the Spin-Off. For awards granted subsequent to the Spin-Off, the share-price is based on the closing price of our Series C common stock on the date of grant. Expected volatility of the stock is based on our peer group in the industry in which we do business because we do not have sufficient historical volatility data for our stock. The expected term of the options considers our historical and expected future employee exercise behavior, and is determined using the simplified method, which was considered to be our best estimate of expected future term as we lack sufficient history of exercise activity as a stand-alone public company. Further, our historical exercise experience is not considered to be representative of our future expected term based on the significant exercise activity that occurred in 2016 in anticipation of the Spin-Off. The risk-free interest rate assumption is based upon observed interest rates for constant maturity U.S. Treasury securities consistent with the expected term of the Company's share-based awards. The Company assumed a zero dividend yield as, following the Spin-Off, we do not expect to pay any cash dividends in the foreseeable future. The following table summarizes the assumptions used for estimating the fair value of share-based awards granted for the years ended December 31: The awards outstanding at Spin-Off were converted at an exchange ratio of approximately 2.18, which reduced the underlying share price and resulting grant fair value of awards granted after the Spin-Off. Our forfeiture rate is estimated based on our historical turnover experience among other qualitative factors. We review and update our forfeiture rate, if necessary, at least annually, or more frequently if facts or circumstances indicate a change is necessary. The fair value of our RSU awards has been determined by using the closing market price per share of our Class C common stock on the date of grant. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred COMMERCEHUB, INC. tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. A tax valuation allowance is established, as needed, to reduce deferred tax assets to the amount expected to be realized. In the event it becomes more-likely-than-not that some or all of the deferred tax asset allowances will not be needed, the valuation allowance will be adjusted. In the ordinary course of business, there is inherent uncertainty in quantifying our income tax positions. We assess our income tax positions and record tax benefits for all years subject to examination based upon management's evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more-likely-than-not that a tax benefit will be sustained, we have determined the amount of the tax benefit to be recognized by estimating the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more-likely-than-not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense when settled. Note 4 - Recent Accounting Pronouncements In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU No. 2014-09"). This standard is effective for fiscal years beginning after December 15, 2017, with two transition methods of adoption allowed, a full retrospective or modified retrospective. In May 2016, FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606) Principal versus Agent Considerations, (Reporting Revenue Gross versus Net). This update was to further clarify the implementation guidance on principal versus agent considerations in the previously issued ASU No. 2014-09. In April 2016, FASB issued ASU No. 2016-10, Identifying Performance Obligations and Licensing, which clarifies implementation guidance on the identification of performance obligations and the licensing implementation guidance in ASU No. 2014-09. In May 2016, FASB issued ASU No. 2016-12, Narrow-Scope Improvements and Practical Expedients, which clarifies the guidance on assessing collectability, presentation of sales taxes, non-cash consideration and completed contracts and contract modifications at transition. In December 2016, FASB issued ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, which clarifies certain narrow aspects of ASU No. 2014-09. We have begun to evaluate the impacts of this new standard on our financial statements, information technology ("IT") systems and business processes and controls. We have developed an implementation plan to adopt this new guidance including determining the method of adoption. As part of this plan, we are currently assessing the potential impact this standard will have on our consolidated financial statements and related disclosures, including the potential impacts to our usage, subscription and set-up and professional services revenues. Further, while we are still evaluating the impact of this standard, our preliminary assessment is that there will be an impact relating to the accounting for costs to acquire a contract. The provisions of the new standard will result in the deferral of additional costs, primarily commission expense to sales representatives, which will be recognized over the estimated customer life. Based on our assessment procedures performed to date, we are currently unable to estimate the impact this standard will have on our consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) ("ASU No. 2016-02"). This topic provides that a lessee should recognize the assets and liabilities that arise from leases. Topic 842 requires an entity to separate the lease components from the nonlease components in a contract. ASU No. 2016-02 is intended to improve financial reporting about lease transactions and is effective for fiscal years beginning after December 15, 2018. We are evaluating the financial statement impact this update will have on the consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting ("ASU No. 2016-09"), which is intended to improve the accounting for share-based payment transactions as part of the FASB's simplification initiative. ASU No. 2016-09 changed the aspects of the accounting for share-based payment award transactions, including: (1) accounting for income taxes; (2) classification of excess tax benefits on the statement of cash flows; (3) forfeitures; (4) minimum statutory tax withholding requirements; and (5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. We are adopting ASU No. 2016-09 in the first quarter of 2017, which will not have a significant impact on the consolidated financial statements. In August 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments (Topic 230) ("ASU No. 2016-15"), which addresses eight specific cash flow matters with the objective of reducing diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. ASU No. 2016-15 is effective for fiscal years beginning after December 15, 2017. We are evaluating the financial statement impact this update will have on the consolidated financial statements. In November 2016, the FASB issued ASU No. 2016-18, Restricted Cash ("ASU No. 2016-18"), which requires that entities show the changes in the total of cash, cash equivalents and restricted cash in the statement of cash flows. Transfers COMMERCEHUB, INC. between cash, cash equivalents and restricted cash should not be presented as cash flow activities on the statement of cash flows. ASU No. 2016-18 is effective for fiscal years beginning after December 15, 2017. We do not expect the adoption of this standard will have a material impact on the consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350) ("ASU No. 2017-04"): Simplifying the Accounting for Goodwill Impairment, which removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. An impairment charge will now equal the amount by which the reporting unit's carrying value exceeds its fair value. ASU No. 2017-04 is effective for fiscal years beginning after December 15, 2019. We do not expect the adoption of this standard will have a material impact on the consolidated financial statements. Note 5 - Earnings (Loss) Per Share For all periods prior to the Spin-Off, basic and diluted earnings (loss) per common share is computed by dividing net income (loss) for the respective period by 42,702,842 common shares, which is the aggregate of 13,522,288 shares of Series A common stock, 711,992 shares Series B common stock and 28,468,562 shares of Series C common stock issued upon completion of the Spin-Off on July 22, 2016. The shares used in the calculation of diluted earnings per share for periods prior to the Spin-Off exclude issuances of 109,354 shares of common stock issued to pre-Spin-Off minority shareholders of CTI and 7,362,933 outstanding awards to purchase shares of our common stock, which occurred after the Spin-Off. For all periods occurring after the Spin-Off, basic earnings (loss) per common share is computed by dividing net income (loss) for the respective period by the weighted average number of common shares outstanding for the period beginning at the Spin-Off through the last day of the reporting period. Diluted earnings (loss) per share gives effect to all dilutive potential shares outstanding resulting from employee stock options and restricted stock units during that period. The following table sets forth net income (loss) and the basic and diluted shares used to calculate earnings per share (in thousands): The shares used in the calculation of diluted earnings per share for periods following the Spin-Off exclude (a) options to purchase shares where the exercise price was greater than the average market price of common shares for the period, using the treasury-stock method, and therefore the effect of the inclusion would be anti-dilutive and (b) awards with performance-based conditions where the performance criteria has not been met as of the reporting date. During the fourth quarter of 2016, there was an increase of approximately 690 thousand diluted shares outstanding due to the performance criteria of certain employee stock options having been met as of the end of the reporting period. Note 6 - Acquisition of Mercent Corporation On January 8, 2015, the Company acquired 100% of the shares of Mercent Corporation ("Mercent"), an online marketing technology and service company that helped merchants optimize performance across online channels, for total cash consideration of approximately $20.2 million, net of cash acquired. During the year ended December 31, 2015, the Company incurred transaction-related costs of approximately $166 thousand, which are included in general and administrative expenses. No additional transaction-related costs were incurred in the year ended December 31, 2016. COMMERCEHUB, INC. Under the acquisition method of accounting, the Company allocated the purchase price to the identifiable assets and liabilities based on their estimated fair value, as follows (in thousands): Methodologies used in valuing the intangible assets included, but were not limited to, the multiple period excess earnings method for developed software technology and customer relationships. The excess of the purchase price over the total net identifiable assets has been recorded as goodwill, which includes synergies expected from the expanded service capabilities and the value of the assembled work force. For federal income tax purposes, the transaction is treated as a stock acquisition and the goodwill is not deductible. Note 7 - Concentrations of Significant Customers and Credit Risk No single customer accounted for more than 10% of our total revenue in either of the years ended December 31, 2016, 2015 or 2014. However, our revenue model is primarily based on retailer and supplier program relationships whereby many revenue-generating supplier transactions conducted through our platform may be attributable to a single retailer ("Total Program Revenue"). There were two customers with Total Program Revenue that accounted for more than 10% of our total revenue in the year ended December 31, 2016, there was one such customer in the year ended December 31, 2015, and there were two such customers in the year ended December 31, 2014. No customer represented more than 10% of accounts receivable at December 31, 2016. Note 8 - Related Party Transactions Prior to the Spin-Off, Liberty, QVC, Inc. (“QVC”), which is a wholly owned subsidiary of Liberty, and other subsidiaries and equity investments of Liberty were related parties of CommerceHub for GAAP purposes and related persons of CommerceHub for purposes of Regulation S-K under the Securities Exchange Act of 1934, as amended. As a result, since this report includes pre-Spin-Off periods, we have disclosed activities with these entities during the periods presented. For future reporting on periods that do not include pre-Spin-Off periods, based on current facts and circumstances, we do not expect Liberty, QVC or other subsidiaries or equity investments of Liberty to be related parties or related persons of CommerceHub, but we will continue to monitor and evaluate these relationships and other potential relationships with related parties and/or related persons. (a) Transactions with QVC We provide our solutions to QVC in the ordinary course of business. For the years ended December 31, 2016, 2015 and 2014, Total Program Revenue with QVC (including QVC and suppliers transacting with QVC on our platform) accounted for approximately 7%, 8%, and 10% of total revenue, respectively. We had accounts receivable owing from QVC of approximately $784 thousand and $511 thousand at December 31, 2016 and December 31, 2015, respectively. (b) Transactions with Liberty During 2016, we had outstanding a promissory note as a lender to Liberty, presented as note receivable-Parent on the consolidated balance sheets. This note carried an interest rate based on one-year LIBOR plus 100 basis points. During the second quarter of 2016, Liberty fully repaid amounts outstanding of $36.4 million pursuant to this promissory note, including accumulated interest of $2.4 million. COMMERCEHUB, INC. During June 2016, to assist the Company in meeting its financial obligations under the SAR Plan and Liquidity Program (see Note 12), the Company entered into a funding arrangement with Liberty pursuant to a previously established intercompany funding agreement, under which Liberty agreed to loan the Company cash at current market interest rates, or make additional equity investments in common stock. During the third quarter of 2016, amounts outstanding pursuant to this arrangement, including accumulated interest, were repaid to Liberty by the Company using borrowings under our credit facility (see Note 14). The funding agreement between the Company and Liberty was terminated as of the Spin-Off. CommerceHub entered into certain agreements (effective July 22, 2016) with Liberty and/or Liberty Media, including a reorganization agreement, a services agreement and a tax sharing agreement. The reorganization agreement provides for, among other things, the principal corporate transactions (including the internal restructuring) required to effect the Spin-Off, certain conditions to the Spin-Off and provisions governing the relationship between CommerceHub and Liberty with respect to and resulting from the Spin-Off. The tax sharing agreement provides for the allocation and indemnification of tax liabilities and benefits between Liberty and CommerceHub and other agreements related to tax matters. Further, under this agreement, we are required to indemnify Liberty, its subsidiaries and certain related persons for taxes and losses resulting from the failure of the Spin-Off to qualify as a tax-free transaction under Internal Revenue Code ("IRC") Section 355 of the to the extent that such taxes and losses (i) result primarily from, individually or in the aggregate, the breach of certain covenants made by us (applicable to actions or failures to act by our Company and our subsidiaries following the completion of the Spin-Off) or (ii) result from the application of IRC Section 355(e) to the Spin-Off as a result of the treatment of the Spin-Off as part of a plan (or series of related transactions) pursuant to which one or more persons acquire, directly or indirectly, a 50% or greater interest (measured by vote or value) in the stock of our Company (or any successor corporation). Our indemnification obligations to Liberty, its subsidiaries and certain related persons are not limited in amount or subject to any cap. If we are required to indemnify Liberty, its subsidiaries or such related persons under the circumstances set forth in the tax sharing agreement, we may be subject to substantial liabilities, which could materially adversely affect our financial position. In July 2016, in conjunction with the Spin-Off, we collected amounts due from Liberty for federal tax benefits of $8.5 million (see Note 13 for further discussion of tax-related transactions that occurred in connection with the Spin-Off) and fully repaid amounts due for state taxes paid of $1.3 million. Further, we received a contribution from Liberty of $6.0 million to compensate the Company for the dilution associated with Parent equity awards and paid a dividend of $18.9 million to the holders of CTI common stock, primarily our Parent as a return of Parent's investment, and an additional $0.9 million to Parent, as holder of CTI preferred shares. Pursuant to the services agreement, Liberty Media provides CommerceHub with general and administrative services including legal, tax, accounting, treasury and investor relations support related to necessary public-company functions. CommerceHub must reimburse Liberty Media for direct, out-of-pocket expenses incurred by Liberty Media in providing these services, and CommerceHub pays a services fee to Liberty Media under the services agreement, which totaled $306 thousand for the year ended December 31, 2016. This fee is included in general and administrative expenses in the consolidated statements of comprehensive income (loss). Liberty Media and CommerceHub evaluate all charges under the services agreement for reasonableness on a quarterly basis and make such adjustments to these charges as the parties mutually agree. Amounts owed to Liberty at December 31, 2016 of $33 thousand in connection with these agreements is included in accounts payable and accrued expenses on the consolidated balance sheets. Note 9 - Capitalized Software Costs Capitalized software costs, net was comprised of the following at December 31 (in thousands): Amortization expense related to capitalized software costs is included in cost of revenue and was approximately $5.0 million, $3.4 million and $2.6 million, for the years ended December 31, 2016, 2015 and 2014, respectively. COMMERCEHUB, INC. Future amortization expense of existing capitalized software costs as of December 31, 2016 is expected to be as follows for the years ending December 31 (in thousands): Note 10 - Property and Equipment Property and equipment consisted of the following (in thousands) at December 31: Depreciation of property and equipment totaled approximately $3.0 million and $2.6 million and $1.8 million during the years ended December 31, 2016, 2015 and 2014, respectively. Note 11 - Goodwill and Intangible Assets There were no changes in the carrying amount of goodwill during the year ended December 31, 2016. Intangibles assets acquired were as follows (in thousands): Amortization expense related to intangible assets was $1.8 million for each of the years ended December 31, 2016 and 2015, and $0 for the year ended December 31, 2014. There is no future amortization expense for intangible assets as of December 31, 2016. Note 12 - Share-Based Awards The Company grants, to certain of its employees, board members and consultants, awards to purchase shares of its common stock. Prior to the Spin-Off, the Company's share-based awards consisted of stock options and SARs issued by the Company's predecessor, CTI. Some of these awards contain service conditions (typically 4 years) and some of these awards contain both service- and performance-based conditions. COMMERCEHUB, INC. Included in the consolidated statements of comprehensive income (loss) are the following amounts of share-based compensation for the years ended December 31 (amounts in thousands): Share-based compensation is recognized net of estimated forfeitures. Our forfeiture rate is estimated based on our historical turnover experience among other qualitative factors. Gross tax related benefits of $87.2 million, $7.5 million and $6.5 million were also recognized for the years ended December 31, 2016, 2015 and 2014, respectively. CTI Options and SARs Activity Prior to the Spin-Off, all of the Company's share-based awards were classified as liability awards as the SARs could have been settled in cash and the stock options could have been settled in cash at the option of the holder, in each case under the Liquidity Program (as defined and discussed below). The Company measured the cost of services received in exchange for a liability classified award based on the current fair value of the award, and remeasured the fair value of the award at each reporting date. The following table summarizes the share-based award activity of the outstanding CTI options and SARs under the 1999 Plan and the SAR Plan (each as defined below) from the beginning of the reporting period through the Spin-Off: *Tendered stock options under the 1999 Plan represent eligible stock options exchanged for cash under the Liquidity Program. The total intrinsic value of options exercised during 2016 under the 1999 Plan prior to the Spin-Off totaled $86.7 million, and totaled $7.5 million and $7.0 million for the years ended December 31, 2015 and 2014, respectively. Cash received from stock option exercises in 2016 under the 1999 Plan prior to the Spin-Off totaled $73 thousand and totaled $33 thousand and $52 thousand for the years ended December 31, 2015 and 2014, respectively, and is included within financing activities in the consolidated statements of cash flows. CommerceHub Options and SARs Activity Post-Spin-Off In connection with the Spin-Off, the outstanding CTI options and SARs were adjusted, such that each holder thereof received an option award to purchase shares of our Series C common stock, with the exercise price and number of shares subject to such new option awards based on the exercise price of and number of shares subject to the original CTI option or SAR and the exchange ratio used in the internal restructuring with respect to the CTI minority holders. On July 22, 2016, 2,663,616 awards, comprised of 33,950 options and 2,629,666 SARs then-outstanding were converted at an exchange ratio of approximately 2.18, to 5,811,150 options to purchase shares of our Series C common stock. Unlike the original CTI options and SARs, which were able to be settled in cash prior to completion of the Spin-Off, the new option awards resulting from the conversion of the original CTI options and SARs may only be settled in shares of CommerceHub's Series C common stock. Except as described above, the terms of these new option awards (including, for example, the vesting terms thereof) are, in all material respects, the same as those of the corresponding original CTI option or SAR award. COMMERCEHUB, INC. Additionally, our internal restructuring in connection with the Spin-Off resulted in a modification of the terms and conditions of the outstanding equity awards upon the Spin-Off, and the classification of the awards from liability to equity awards. As of the July 21, 2016 modification date, the Company performed a fair value analysis of the awards immediately before and immediately after the restructuring. As the Company’s pre-Spin-Off share-based award plans (further described below) contained antidilution provisions, there was no incremental fair value or compensation expense as a result of the restructuring. The fair value of these awards immediately before and immediately after the Spin-Off was approximately $12.5 million. The value of these awards at the time of the restructuring was reclassified from share-based compensation liability to additional paid in capital. The remaining unvested compensation expense is recognized over the remaining service period or, for those awards with performance-based conditions, the service period when such performance conditions are considered probable. The following table summarizes the share-based award activity of options to purchase shares of our Series C common stock under our Legacy Stock Appreciation Rights Plan and Legacy Stock Option Plan (each as defined below) from the time of Spin-Off through the last day of the reporting period: The aggregate intrinsic value of options exercised following the Spin-Off totaled $0.5 million. Cash received from exercises of stock options following the Spin-Off totaled $773 thousand, and is included in financing activities in the consolidated statements of cash flows. CommerceHub RSU Activity (Series C) The following table summarizes the share-based award activity of RSUs in respect of our Series C common stock granted under our Omnibus Plan (as defined below) for the year ended December 31, 2016: As of December 31, 2016, unrecognized compensation cost related to RSUs and options to purchase shares of Series C common stock was approximately $22.1 million and is expected to be recognized over a weighted average remaining vesting period of approximately 3.4 years. COMMERCEHUB, INC. New Parent Option Activity (Series C) The following table summarizes the share-based award activity of options to purchase shares of our Series C common stock under our Transitional Plan (as defined below) from the time of Spin-Off through the last day of the reporting period: New Parent Restricted Stock Awards and New Parent RSU Activity (Series C) As of July 22, 2016, following the Spin-Off, there were 30,409 new Parent restricted stock awards (as defined below) and 1,094 new Parent RSUs (as defined below) with respect to our Series C common stock, issued to holders of original Ventures equity awards (as defined below). Activity in the new Parent restricted stock awards and new Parent RSUs with respect to our Series C common stock under the Transitional Plan from the time of Spin-Off through the last day of the reporting period was not material. The new Parent option awards to purchase shares of, and new Parent restricted stock awards and new Parent RSUs with respect to, our Series C common stock (as defined below) outstanding do not carry unrecognized compensation cost, as any related compensation expense is incurred by Liberty. New Parent Options Activity (Series A) The following table summarizes the share-based award activity of options to purchase shares of our Series A common stock under the Transitional Plan from the time of Spin-Off through the last day of the reporting period: New Parent Restricted Stock Awards and New Parent RSU Activity (Series A) As of July 22, 2016, following the Spin-Off, there were 13,447 new Parent restricted stock awards and 534 new Parent RSUs with respect to our Series A common stock. Activity in the new Parent restricted stock awards and new Parent RSUs with respect to our Series A common stock under the Transitional Plan from the time of Spin-Off through the last day of the reporting period was not material. There is no unrecognized compensation cost related to awards to purchase shares of, and in connection with, our Series A common stock as these awards are held by employees of Liberty and any related compensation expense is incurred by Liberty. New Parent Options Activity (Series B) There were 172,882 new Parent option awards to purchase shares of our Series B common stock, with a weighted average exercise price of $11.89, aggregate intrinsic value of $538 thousand, and weighted average remaining contractual life COMMERCEHUB, INC. of 5.2 years outstanding at December 31, 2016. There was no activity subsequent to the Spin-Off related to these awards. There were 32,052 options exercisable at December 31, 2016, with a weighted average exercise price of $12.49, aggregate intrinsic value of $80 thousand and weighted average remaining contractual life of 5.9 years. There is no unrecognized compensation cost related to options to purchase shares of our Series B common stock as these awards are held by an employee of Liberty and any related compensation expense is incurred by Liberty. Share-Based Award Plans Pre-Spin-Off 1999 Plan During 1999, the Company adopted an incentive and nonqualified stock option plan (the "1999 Plan"). The 1999 Plan authorized grants of options to purchase up to 4,000,000 shares of authorized but unissued common stock. Options granted under the 1999 Plan were to vest over a period of four years and expire ten years from the date of grant. No shares of common stock are available for grants, or have been available for grants under the 1999 Plan, since September 2009 when the 1999 Plan expired. Liquidity Program During 2006, the Compensation Committee of CTI adopted a stock option liquidity program (the "Liquidity Program") for eligible holders of stock options and certain eligible common shares (shares issued as a result of an option exercise). The Liquidity Program provided eligible option holders and stockholders the ability to tender their vested options or sell their eligible common shares in exchange for cash payment. Eligible option holders and stockholders had the opportunity to tender eligible options or shares at any time except for when valuations were being performed. Cash consideration for the purchase and exercises of tendered stock options was based on the fair value of the Company's underlying common stock less the option exercise price. Cash consideration for tendered eligible common shares was based upon the fair value of the common shares. The Company made total cash payments of approximately $13.5 million, $2.4 million and $6.1 million in exchange for the exercise of vested stock options, and $3.6 million, $0.2 million and $0.6 million to repurchase shares outstanding from minority shareholders, under this program during the years ended December 31, 2016, 2015 and 2014, respectively. The Liquidity Program terminated effective as of the completion of the Spin-Off. SAR Plan During 2010, the Company instituted the 2010 Stock Appreciation Rights Plan (the "SAR Plan"). Pursuant to the SAR Plan, a committee appointed by the Company's Board of Directors (or in the absence of such a committee, the Board of Directors acting in the capacity of such committee) was authorized to grant SARs to employees, board members and consultants of the Company. The SAR Plan authorized grants of up to 6 million SARs, which included and was not in addition to shares previously issued, or shares issuable in respect of awards previously issued, under the 1999 Plan. The SARs issued under the SAR Plan typically vested over a period of four years and expired 10 years from the date of grant for service-based awards. SARs that included both service and performance-based conditions vested based on the satisfaction of service requirements and achievement of performance conditions over the period specified in the applicable award agreement, which ranged from 1 to 4 years at the time of the Spin-Off. We made certain assumptions regarding the probability of achieving these performance conditions each period and adjusted the value of the awards in the period our estimates were revised. At times, actual results varied from expected results. The Company made total cash payments of approximately $73.2 million, $5.1 million and $0.9 million during the years ended December 31, 2016, 2015 and 2014, respectively, to settle exercised SARs. The SAR Plan was terminated and replaced with the CommerceHub, Inc. Legacy Stock Appreciation Rights Plan (the "Legacy SAR Plan") in connection with the completion of the Spin-Off. Future grants under the Legacy SAR Plan are not permitted following the Spin-Off. Share-Based Award Plans Post-Spin-Off CommerceHub, Inc. 2016 Omnibus Incentive Plan In connection with the Spin-Off, we adopted the CommerceHub, Inc. 2016 Omnibus Incentive Plan (as amended, amended and restated or otherwise modified from time to time, the “Omnibus Plan”). We amended and restated the Omnibus Plan on October 13, 2016 in order to permit the compensation committee of the Company’s board of directors to delegate award granting authority under the Omnibus Plan. The Omnibus Plan is designed to provide additional remuneration to officers, employees, nonemployee directors and independent contractors for service to CommerceHub and to encourage each plan participant’s investment in CommerceHub. Stock options, SARs, restricted shares, restricted stock units, cash awards, performance awards or any combination of the foregoing may be granted under the Omnibus Plan (collectively, "awards"). The COMMERCEHUB, INC. maximum number of shares of our common stock with respect to which awards may be granted under the Omnibus Plan is 13,200,000 shares of our Series C common stock, subject to anti-dilution, annual share-reserve increases and other adjustment provisions of the Omnibus Plan. The Omnibus Plan is administered by the compensation committee of the Company’s board of directors with regard to awards granted under the Omnibus Plan other than awards granted to the nonemployee directors, which are administered by the full board of directors, and the compensation committee and its designees (and the board of directors with respect to awards granted to non-employee directors) have full power and authority to determine the terms and conditions of such awards. Legacy Stock Appreciation Rights Plan and Legacy Stock Option Plan In connection with the Spin-Off, all of the new option awards with respect to our Series C common stock that were issued as a result of the Spin-Off to holders of CTI SARs and options outstanding immediately prior to the Spin-Off were issued pursuant to the Legacy SAR Plan and the CommerceHub, Inc. Legacy Stock Option Plan (the "Legacy Stock Option Plan"), respectively. The Legacy SAR Plan and the Legacy Stock Option Plan govern the terms and conditions of these new option awards but will not be used to make any new grants following the Spin-Off. Employee Stock Purchase Plan We have adopted an Employee Stock Purchase Plan (the “ESPP”) that was approved by our shareholders prior to the Spin-Off, under which we have reserved 900,000 shares of our Series C common stock for issuance to our employees. Subject to certain restrictions, the ESPP provides employees with the opportunity to invest a portion of their annual eligible compensation to purchase shares of our Series C common stock at a purchase price equal to 85% of the lower of (a) the fair market value of our Series C common stock at the beginning of the applicable six-month offering period, and (b) the fair market value of our Series C common stock at the end of the applicable six-month offering period. The first offering period under the ESPP began on January 1, 2017. Transitional Stock Adjustment Plan All of the new Parent option awards, new Parent RSUs and new Parent restricted stock awards (each as defined below) were issued pursuant to the CommerceHub, Inc. Transitional Stock Adjustment Plan (the “Transitional Plan”). The Transitional Plan governs the terms and conditions of the Parent incentive awards described below but will not be used to make any grants following the Spin-Off. New Parent Options Liberty had granted to certain directors, officers, employees and consultants of Liberty stock options to purchase shares of Liberty Ventures common stock pursuant to applicable incentive plans in place at Liberty. Each holder of an outstanding option to purchase shares of Liberty Ventures common stock (an "original Ventures option award") on the record date for the Spin-Off (the "record date") who was a member of the Liberty board of directors or an officer of Liberty holding the position of Vice President or above received (i) an option to purchase shares of the corresponding series of our common stock and an option to purchase shares of our Series C common stock (such new option awards, "new Parent option awards") and (ii) an adjustment to the exercise price of and the number of shares subject to the original Ventures option award (as so adjusted, an "adjusted Ventures option award"). The exercise prices of and the number of shares subject to the new Parent option awards and the related adjusted Ventures option award were determined based on the exercise price of and the number of shares subject to the original Ventures option award, the distribution ratios used in the Spin-Off, the pre-Spin-Off trading price of Liberty Ventures common stock (determined using the volume weighted average price of the applicable series of Liberty Ventures common stock over the three consecutive trading days immediately preceding the Spin-Off) and the relative post-Spin-Off trading prices of Liberty Ventures common stock and our common stock (determined using the volume-weighted average price of the applicable series of common stock over the three consecutive trading days beginning on the first trading day following the Spin-Off on which both the Liberty Ventures common stock and our common stock traded in the "regular way" (meaning once the common stock trades using a standard settlement cycle)), such that the pre-Spin-Off intrinsic value of the original Ventures option award was allocated between the new Parent option awards and the adjusted Ventures option award. All other holders of original Ventures option awards did not receive any new Parent option awards as a result of the distribution. Rather, the holders' original Ventures option awards were adjusted so as to preserve the pre-Spin-Off intrinsic value of the original Ventures option award based on the exercise price of and number of shares subject to such original Ventures option award, the distribution ratios used in the Spin-Off, the pre-Spin-Off trading price of Liberty Ventures common stock and the post-Spin-Off trading price of Liberty Ventures common stock (determined as described above). COMMERCEHUB, INC. Except as described above, all other terms of an adjusted Ventures option award and the new Parent option awards (including, for example, the vesting terms thereof) are, in all material respects, the same as those of the corresponding original Ventures option award. New Parent Restricted Stock Units Each holder of a restricted stock unit with respect to shares of Series A or Series B Liberty Ventures common stock (an “original Ventures RSU”) on the record date received in the distribution 0.1 of a restricted stock unit with respect to shares of the corresponding series of CommerceHub common stock and 0.2 of a restricted stock unit with respect to shares of CommerceHub Series C common stock (such new restricted stock unit awards, new “Parent RSUs”) for each original Ventures RSU held by them as of the record date, with cash paid in lieu of fractional new Parent RSUs. Except as described herein, the terms of all of the new Parent RSUs (including, for example, the vesting terms thereof) are, in all material respects, the same as those of the corresponding original Ventures RSU. New Parent Restricted Stock Awards Each holder of a restricted stock award with respect to shares of Series A or Series B Liberty Ventures common stock (an “original Ventures RSA” and, together with the original Ventures option awards and the original Ventures RSUs, the "original Ventures equity awards") received in the distribution (i) 0.1 of a restricted share of the corresponding series of CommerceHub common stock and (ii) 0.2 of a restricted share of CommerceHub Series C common stock (such new restricted stock awards, new “Parent restricted stock awards”) for each restricted share of Liberty Ventures common stock held by them as of the record date, with cash paid in lieu of fractional new Parent restricted stock awards. Except as described herein, all new Parent restricted stock awards (including, for example, the vesting terms thereof) are, in all material respects, the same as those of the corresponding original Ventures RSA. Note 13 - Income Taxes For periods prior to the Spin-Off, CTI was part of the Liberty consolidated tax group. Prior to the Spin-Off, federal income taxes were paid (or refunded) to Liberty pursuant to the terms of a tax sharing agreement under which taxes were computed on a separate company basis. After the Spin-Off, CommerceHub is now a separate, standalone, federal taxpayer. The tax provision included in these consolidated financial statements has been prepared on a stand-alone basis, as if CommerceHub was not part of the Liberty consolidated group. Accordingly, the effective tax rate of the Company in future years could vary from its historical effective tax rates depending on, among other factors, future legal structure of CommerceHub and related tax elections. Liberty files income tax returns in the US federal jurisdiction, various state jurisdictions, and within the United Kingdom. In the normal course of business Liberty is subject to examination by various taxing authorities. All tax years prior to 2013 are closed. The IRS has completed its examination of the 2013 - 2014 tax years; however, 2013 remains "open" until the statutory limitations period lapses on September 15, 2017, and 2014 remains "open" until the statutory limitations period lapses on September 15, 2018. Liberty's 2015 and 2016 tax years are being examined currently under the IRS's Compliance Assurance Process ("CAP") program. The statutory limitations periods in the applicable state jurisdictions vary, but they generally expire three to four years from the due date or filing of the tax return. CommerceHub will file income tax returns in the US federal jurisdiction, various state jurisdictions, and within the United Kingdom for the post-Spin-Off period of 2016 and subsequent periods. CommerceHub has historically filed stand-alone income tax returns in various state jurisdictions and will expand the list of states in the post-Spin-Off period and subsequent periods. In the normal course of business, CommerceHub will be subject to examination by various taxing authorities. CommerceHub is not eligible to participate in the CAP program for the July 22, 2016 through December 31, 2016 period. The statutes in the various state jurisdictions in which CommerceHub historically filed stand-alone income tax returns vary, but they generally expire three to four years from the due date or filing of the tax return. COMMERCEHUB, INC. Income tax expense (benefit) consists of the following (in thousands) at December 31: There were no uncertain tax positions as of December 31, 2016 or December 31, 2015. There were no accrued interest and penalties recognized in the balance sheet as of December 31, 2016 and December 31, 2015. Income tax expense differed from the amounts computed by applying the U.S. Federal income tax rate of 35% to income (loss) before taxes as a result of the following (in thousands) for the years ended December 31: The increase in the income tax expense in 2016 as compared to the benefit in 2015 is primarily due to pre-tax book income of $16.3 million, compared to a pre-tax book loss of $6.3 million in 2015. In 2016, actual income tax expense was greater than the amounts computed by applying the U.S. Federal income tax rate of 35%, primarily due to an adjustment recorded in the fourth quarter of 2016 associated with a change in tax law in New York State (“NY”). This tax law change, which was enacted in 2014 and effective January 1, 2015, revised the method used to determine NY revenue apportionment. Under the new method, CommerceHub’s income apportioned to NY decreased, resulting in a reduction to current state income tax expense in future years, but an expense in the current period due to the reduction in the deferred state tax asset. The Company did not appropriately update its NY apportionment rate to reflect the impact of this law change in 2014. As a result, fiscal 2014 deferred income tax expense was understated by approximately $2.3 million, with a corresponding overstatement of deferred tax assets. Current and deferred income tax expense for the fiscal 2015 period was overstated by approximately $0.8 million, with a corresponding $1.0 million understatement of taxes payable (included in Due to Parent), and a $0.2 million overstatement of deferred tax assets. The $1.5 million net effect of these errors was corrected in the fourth quarter of 2016 upon filing the 2015 NY tax return, is incorporated in our 2016 tax expense, and included in “State tax law change” in the table above. Based on our assessment of the quantitative and qualitative factors, the error and related impacts were not considered material to the consolidated financial statements of the 2015 and 2014 prior periods to which they relate, and the correction of this error was not considered material to our 2016 consolidated financial statements. The write-off of Federal net operating loss carryforwards ("NOLs") is the result of forfeiting one year of IRC Section 382 limitations described below and NOLs in conjunction with the Spin-Off, as both the pre- and post-Spin-Off periods in 2016 count against the available number of periods, while the amount of NOLs we are limited to in 2016 does not change. COMMERCEHUB, INC. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below (in thousands) at December 31: As of December 31, 2015, the Company's net deferred tax asset was primarily attributed to temporary differences related to share-based compensation awards. The exercise of a significant portion of share-based compensation awards during 2016 created a tax deductible expense, and reduced the deferred tax asset by $31.3 million. The deductions generated estimated gross federal NOLs of approximately $74.7 million. As allowed under the tax sharing agreement between the Company and Liberty entered into prior to the Spin-Off, $49.1 million of these NOLs were utilized to refund federal income taxes paid to Liberty in the prior two tax years. In accordance with the same tax sharing agreement, subject to finalizing our 2016 pre-Spin-Off federal tax return, the remaining federal NOLs of $25.6 million were forfeited and recorded as an equity distribution to Liberty upon the Spin-Off. State NOLs were also created and the Company intends to file amended state income tax returns for prior years in 2017 to request a refund of approximately $1.1 million of state taxes previously paid in states which allow a carryback claim. In assessing the realizability of deferred tax assets, management considers whether it is more-likely-than-not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considered the scheduled reversal of deferred tax liabilities and projected future taxable income in making this assessment. Based upon the level of projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more-likely-than-not that the Company will realize the benefits of these deductible differences. Before the imposition of IRC Section 382 limitations described below, at December 31, 2016, the Company had unused NOLs that it acquired as part of the Mercent acquisition. Based on studies of the changes in ownership of Mercent at acquisition, it has been determined that IRC Section 382 ownership changes have occurred which limit the amount of NOLs that can be used in future years. Approximately $1.5 million of NOLs are available to be utilized each year from 2017 to 2019 and approximately $0.35 million of NOLs are available to be utilized each year from 2020 to 2033 for a total of $9.4 million. Under IRC Section 382, the use of loss carryforwards may be limited if a change in ownership of a company occurs. If it is determined that, due to transactions involving CommerceHub's shares owned by its 5 percent or greater shareholders, a change of ownership has occurred under the provisions of IRC Section 382, the Company's federal NOLs could be subject to additional IRC Section 382 limitations. Note 14 - Long-Term Debt On June 28, 2016, we entered into a credit agreement governing a $125.0 million revolving credit facility which expires on June 28, 2021. At December 31, 2016, we had $26.0 million in borrowings and no letters of credit outstanding under the facility, and our available borrowings under the facility were $99.0 million. Subsequent to December 31, 2016, we repaid an additional $14.0 million in borrowings under the facility. At December 31, 2016, the fair value of our debt, which holds a floating interest rate of a short duration and is based on Level 2 valuation inputs, approximated the carrying value. COMMERCEHUB, INC. The interest rate applicable to our initial borrowings is LIBOR plus a yield of 1.75%. Interest on the revolving credit facility is based on a base rate or Eurodollar rate plus an applicable margin that increases as our total leverage ratio increases, with the base rate margin ranging from 0.75% to 1.25% and the Eurodollar rate margin ranging from 1.75% to 2.25% respectively. The interest rate on borrowings outstanding under the revolving credit facility was 2.56% at December 31, 2016. The revolving credit facility also carries a commitment fee of 0.25% to 0.50% per annum on the unused portion. In conjunction with entering into this credit facility, we incurred charges totaling $1.1 million. These charges are included in other long-term assets on the consolidated balance sheet and will be recognized over the term of the credit facility. Borrowings under the credit facility are collateralized by substantially all of our assets. The credit agreement contains covenants and restrictions which, among other things, require the maintenance of certain financial ratios, including a total leverage ratio and an interest coverage ratio, and restrict dividend payments and the incurrence of certain indebtedness and other activities, including acquisitions and dispositions. We were in compliance with these covenants and restrictions as of December 31, 2016. Note 15 - Commitments and Contingencies Legal Proceedings From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. We are currently not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, prospects, financial condition, results of operations and/or cash flows. Leases The Company leases its corporate offices and primary operations facility under an operating lease arrangement which expires in March 2022, with renewal provisions to extend the lease through March of 2028. We also lease office facilities in Seattle, Washington and shared office facilities and executive office facilities in Hertford, England. Total rent expense for the Company's office space for the years ended December 31, 2016, 2015 and 2014 was $1.9 million, $1.4 million and $0.6 million, respectively. Future minimum lease payments due under operating lease arrangements contain rent increases over the term of the lease. Rent expense on these operating leases is recognized over the term of the lease on a straight-line basis. The excess of rent expense over future minimum lease payments due totaled $1.1 million and $0 at December 31, 2016 and 2015, respectively and is included in other long-term liabilities on the consolidated balance sheets. At December 31, 2016, contractual minimum payments under operating leases were as follows (in thousands): COMMERCEHUB, INC. Note 16 - Selected Quarterly Information (unaudited) * Share count for pre-Spin-Off periods represent the shares issued at Spin-Off on July 22, 2016.
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I apologize, but the text you've provided appears to be a fragmented and incomplete financial statement excerpt. It contains various sections about revenue, expenses, liabilities, and accounting practices, but lacks a clear, comprehensive summary.
To provide a meaningful summary, I would need:
1. A complete financial statement
2. Specific financial figures
3. Full context of the company's financial performance
The text suggests this is from CommerceHub, Inc.'s financial reporting, and mentions:
- The company operates as a single segment
- Generates revenue primarily in the United States and Canada
- Uses straight-line depreciation method
- Capitalizes certain software development costs
Without more complete information, I cannot provide a detailed financial summary. Would you be able to share the full financial statement?
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MASTERCARD INCORPORATED INDEX TO CONSOLIDATED FINANCIAL STATEMENTS MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of Mastercard Incorporated (“Mastercard”) is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. As required by Section 404 of the Sarbanes-Oxley Act of 2002, management has assessed the effectiveness of Mastercard’s internal control over financial reporting as of December 31, 2016. In making its assessment, management has utilized the criteria set forth in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Management has concluded that, based on its assessment, Mastercard’s internal control over financial reporting was effective as of December 31, 2016. The effectiveness of Mastercard’s internal control over financial reporting as of December 31, 2016 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears on the next page. ACCOUNTING FIRM To the Board of Directors and Stockholders of Mastercard Incorporated: In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of comprehensive income, of changes in equity and of cash flows present fairly, in all material respects, the financial position of Mastercard Incorporated and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express opinions on these financial statements, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP New York, New York February 15, 2017 MASTERCARD INCORPORATED CONSOLIDATED BALANCE SHEET The accompanying notes are an integral part of these consolidated financial statements. MASTERCARD INCORPORATED CONSOLIDATED STATEMENT OF OPERATIONS The accompanying notes are an integral part of these consolidated financial statements. MASTERCARD INCORPORATED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME The accompanying notes are an integral part of these consolidated financial statements. MASTERCARD INCORPORATED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY The accompanying notes are an integral part of these consolidated financial statements. MASTERCARD INCORPORATED CONSOLIDATED STATEMENT OF CASH FLOWS The accompanying notes are an integral part of these consolidated financial statements. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Organization Mastercard Incorporated and its consolidated subsidiaries, including Mastercard International Incorporated (“Mastercard International” and together with Mastercard Incorporated, “Mastercard” or the “Company”), is a technology company in the global payments industry that connects consumers, financial institutions, merchants, governments and businesses worldwide, enabling them to use electronic forms of payment instead of cash and checks. The Company facilitates the switching (authorization, clearing and settlement) of payment transactions, and delivers related products and services. The Company makes payments easier and more efficient by creating a wide range of payment solutions and services through a family of well-known brands, including Mastercard®, Maestro® and Cirrus®. The Company also provides value-added offerings such as safety and security products, information services and consulting, issuer and acquirer processing, and loyalty and reward programs. The Company’s network is designed to ensure safety and security for the global payments system. A typical transaction on the Company’s network involves four participants in addition to the Company: cardholder (an individual who holds a card or uses another device enabled for payment), merchant, issuer (the cardholder’s financial institution) and acquirer (the merchant’s financial institution). The Company’s customers encompass a vast array of entities, including financial institutions and other entities that act as “issuers” and “acquirers”, as well as merchants, governments and other businesses. The Company does not issue cards, extend credit, determine or receive revenue from interest rates or other fees charged to cardholders by issuers, or establish the rates charged by acquirers in connection with merchants’ acceptance of the Company’s branded cards. Significant Accounting Policies Consolidation and basis of presentation - The consolidated financial statements include the accounts of Mastercard and its majority-owned and controlled entities, including any variable interest entities (“VIEs”) for which the Company is the primary beneficiary. Investments in VIEs for which the Company is not considered the primary beneficiary are not consolidated and are accounted for as equity method or cost method investments and recorded in other assets on the consolidated balance sheet. At December 31, 2016 and 2015, there were no significant VIEs which required consolidation and the investments were not considered material to the consolidated financial statements. Intercompany transactions and balances have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform to the 2016 presentation. The Company follows accounting principles generally accepted in the United States of America (“GAAP”). Non-controlling interests represent the equity interest not owned by the Company and are recorded for consolidated entities in which the Company owns less than 100% of the interests. Changes in a parent’s ownership interest while the parent retains its controlling interest are accounted for as equity transactions, and upon loss of control, retained ownership interests are remeasured at fair value, with any gain or loss recognized in earnings. For 2016, 2015 and 2014, income from non-controlling interests was de minimis and, as a result, amounts are included in the consolidated statement of operations within other income (expense). The Company accounts for investments in common stock or in-substance common stock under the equity method of accounting when it has the ability to exercise significant influence over the investee, generally when it holds between 20% and 50% ownership in the entity. In addition, investments in flow-through entities such as limited partnerships and limited liability companies are also accounted for under the equity method when the Company has the ability to exercise significant influence over the investee, generally when the investment ownership percentage is equal to or greater than 5% of the outstanding ownership interest. The excess of the cost over the underlying net equity of investments accounted for under the equity method is allocated to identifiable tangible and intangible assets and liabilities based on fair values at the date of acquisition. The amortization of the excess of the cost over the underlying net equity of investments and Mastercard’s share of net earnings or losses of entities accounted for under the equity method of accounting is included in other income (expense) on the consolidated statement of operations. The Company accounts for investments in common stock or in-substance common stock under the cost method of accounting when it does not exercise significant influence, generally when it holds less than 20% ownership in the entity or when the interest in a limited partnership or limited liability company is less than 5% and the Company has no significant influence over the operation of the investee. Investments in companies that Mastercard does not control, but that are not in the form of common stock or in-substance common stock, are also accounted for under the cost method of accounting. Investments for which the equity method or cost method of accounting is used are recorded in other assets on the consolidated balance sheet. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Use of estimates - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Future events and their effects cannot be predicted with certainty; accordingly, accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of the Company’s consolidated financial statements may change as new events occur, as more experience is acquired, as additional information is obtained and as the Company’s operating environment changes. Actual results may differ from these estimates. Revenue recognition - Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and collectibility is reasonably assured. Revenue is generally derived from transactional information accumulated by our systems or reported by our customers. The Company’s revenue is based on the volume of activity on cards that carry the Company’s brands, the number of transactions processed or the nature of other payment-related products and services. Volume-based revenue (domestic assessments and cross-border volume fees) is recorded as revenue in the period it is earned, which is when the related volume is generated on the cards. Certain volume-based revenue is based upon information reported to us by our customers. Transaction-based revenue is primarily based on the number and type of transactions and is recognized as revenue in the same period as the related transactions occur. Other payment-related products and services are recognized as revenue in the same period as the related transactions occur or services are rendered. Mastercard has business agreements with certain customers that provide for rebates or other support when the customers meet certain volume hurdles as well as other support incentives such as marketing, which are tied to performance. Rebates and incentives are recorded as a reduction of revenue either when the revenue is recognized by the Company or at the time the rebate or incentive is earned by the customer. Rebates and incentives are calculated based upon estimated performance and the terms of the related business agreements. In addition, Mastercard may make payments to a customer directly related to entering into an agreement, which are generally deferred and amortized over the life of the agreement on a straight-line basis. Business combinations - The Company accounts for business combinations under the acquisition method of accounting. The Company measures the tangible and intangible identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquiree, at their fair values at the acquisition date. Acquisition-related costs are expensed as incurred and are included in general and administrative expenses. Any excess of purchase price over the fair value of net assets acquired, including identifiable intangible assets, is recorded as goodwill. Goodwill and other intangible assets - Indefinite-lived intangible assets consist of goodwill and customer relationships. Finite-lived intangible assets consist of capitalized software costs, trademarks, tradenames, customer relationships and other intangible assets. Intangible assets with finite useful lives are amortized over their estimated useful lives, on a straight-line basis, which range from one to twenty years. Capitalized software includes internal and external costs incurred directly related to the design, development and testing phases of each capitalized software project. Impairment of assets - Goodwill and indefinite-lived intangible assets are not amortized and are tested annually for impairment in the fourth quarter, or sooner when circumstances indicate an impairment may exist. Goodwill is tested for impairment at the reporting unit level. The impairment evaluation utilizes a quantitative assessment using a two-step impairment test. The first step is to compare the reporting unit’s carrying value, including goodwill, to the fair value. If the fair value exceeds the carrying value, then no potential impairment is considered to exist. If the carrying value exceeds the fair value, the second step is performed to determine if the implied fair value of the reporting unit’s goodwill exceeds the carrying value of the reporting unit. An impairment charge would be recorded if the carrying value exceeds the implied fair value. Impairment charges, if any, are recorded in general and administrative expenses. The impairment test for indefinite-lived intangible assets consists of a qualitative assessment to evaluate relevant events and circumstances that could affect the significant inputs used to determine the fair value of indefinite-lived intangible assets. If the qualitative assessment indicates that it is more likely than not that indefinite-lived intangible assets are impaired, then a quantitative assessment is required. Long-lived assets, other than goodwill and indefinite-lived intangible assets, are tested for impairment whenever events or circumstances indicate that their carrying amount may not be recoverable. If the carrying value of the asset cannot be recovered from estimated future cash flows, undiscounted and without interest, the fair value of the asset is calculated using the present value of estimated net future cash flows. If the carrying amount of the asset exceeds its fair value, an impairment is recorded. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Litigation - The Company is a party to certain legal and regulatory proceedings with respect to a variety of matters. The Company evaluates the likelihood of an unfavorable outcome of all legal or regulatory proceedings to which it is a party and accrues a loss contingency when the loss is probable and reasonably estimable. These judgments are subjective based on the status of the legal or regulatory proceedings, the merits of its defenses and consultation with in-house and external legal counsel. Legal costs are expensed as incurred and recorded in general and administrative expenses. Settlement and other risk management - Mastercard’s rules guarantee the settlement of many of the Mastercard, Cirrus and Maestro-branded transactions between its issuers and acquirers. Settlement exposure is the outstanding settlement risk to customers under Mastercard’s rules due to the difference in timing between the payment transaction date and subsequent settlement. While the term and amount of the guarantee are unlimited, the duration of settlement exposure is short term and typically limited to a few days. In the event that Mastercard effects a payment on behalf of a failed customer, Mastercard may seek an assignment of the underlying receivables of the failed customer. Customers may be charged for the amount of any settlement loss incurred during the ordinary course activities of the Company. The Company also enters into agreements in the ordinary course of business under which the Company agrees to indemnify third parties against damages, losses and expenses incurred in connection with legal and other proceedings arising from relationships or transactions with the Company. As the extent of the Company’s obligations under these agreements depends entirely upon the occurrence of future events, the Company’s potential future liability under these agreements is not determinable. The Company accounts for each of its guarantees by recording the guarantee at its fair value at the inception or modification date through earnings. Income taxes - The Company follows an asset and liability based approach in accounting for income taxes as required under GAAP. Deferred income tax assets and liabilities are recorded to reflect the tax consequences on future years of temporary differences between the financial statement carrying amounts and income tax bases of assets and liabilities. Deferred income taxes are displayed as separate line items on the consolidated balance sheet. In 2015, the Company early adopted accounting guidance issued by the Financial Accounting Standards Board (“FASB”), which requires all deferred income taxes to be recorded as non-current. Valuation allowances are provided against assets which are not more likely than not to be realized. The Company recognizes all material tax positions, including uncertain tax positions in which it is more likely than not that the position will be sustained based on its technical merits and if challenged by the relevant taxing authorities. At each balance sheet date, unresolved uncertain tax positions are reassessed to determine whether subsequent developments require a change in the amount of recognized tax benefit. The allowance for uncertain tax positions is recorded in other current and noncurrent liabilities on the consolidated balance sheet. The Company records interest expense related to income tax matters as interest expense in its statement of operations. The Company includes penalties related to income tax matters in the income tax provision. The Company does not provide for U.S. federal income tax and foreign withholding taxes on undistributed earnings from non-U.S. subsidiaries when such earnings are intended to be reinvested indefinitely outside of the U.S. Cash and cash equivalents - Cash and cash equivalents include certain investments with daily liquidity and with a maturity of three months or less from the date of purchase. Cash equivalents are recorded at cost, which approximates fair value. Restricted cash - The Company classifies cash and cash equivalents as restricted when the cash is unavailable for withdrawal or usage for general operations. Restrictions may include legally restricted deposits, contracts entered into with others, or the Company’s statements of intention with regard to particular deposits. Fair value - The Company measures certain financial assets and liabilities at fair value on a recurring basis by estimating the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. The Company classifies these recurring fair value measurements into a three-level hierarchy (“Valuation Hierarchy”). MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Valuation Hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument’s categorization within the Valuation Hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of the Valuation Hierarchy are as follows: • Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. • Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in inactive markets and inputs that are observable for the asset or liability. • Level 3 - inputs to the valuation methodology are unobservable and cannot be directly corroborated by observable market data. Certain assets are measured at fair value on a nonrecurring basis. The Company’s assets measured at fair value on a nonrecurring basis include property, plant and equipment, nonmarketable equity investments, goodwill and other intangible assets. These assets are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment. The valuation methods for goodwill and other intangible assets acquired in business combinations involve assumptions concerning comparable company multiples, discount rates, growth projections and other assumptions of future business conditions. The Company uses discounted cash flows for estimating the fair value of its intangible assets and the Company’s market capitalization for estimating the fair value of its reporting unit. As the assumptions employed to measure these assets are based on management’s judgment using internal and external data, these fair value determinations are classified in Level 3 of the Valuation Hierarchy. Investment securities - The Company classifies investments in debt and equity securities as available-for-sale. Available-for-sale securities that are available to meet the Company’s current operational needs are classified as current assets. Available-for-sale securities that are not available to meet the Company’s current operational needs are classified as non-current assets. The investments in debt and equity securities are carried at fair value, with unrealized gains and losses, net of applicable taxes, recorded as a separate component of accumulated other comprehensive income (loss) on the consolidated statement of comprehensive income. Net realized gains and losses on debt and equity securities are recognized in investment income on the consolidated statement of operations. The specific identification method is used to determine realized gains and losses. The Company evaluates its debt and equity securities for other-than-temporary impairment on an ongoing basis. When there has been a decline in fair value of a debt or equity security below the amortized cost basis, the Company recognizes an other-than-temporary impairment if: (1) it has the intent to sell the security; (2) it is more likely than not that it will be required to sell the security before recovery of the amortized cost basis; or (3) it does not expect to recover the entire amortized cost basis of the security. The credit loss component of the impairment would be recognized in other income (expense), net while the non-credit loss would remain in accumulated other comprehensive income (loss). The Company classifies time deposits with maturities greater than 3 months as held-to-maturity. Held-to-maturity securities that mature within one year are classified as current assets while held-to-maturity securities with maturities of greater than one year are classified as non-current assets. Time deposits are carried at amortized cost on the consolidated balance sheet and are intended to be held until maturity. Derivative financial instruments - The Company records all derivatives at fair value. The Company’s foreign exchange forward and option contracts are included in Level 2 of the Valuation Hierarchy as the fair value of these contracts are based on inputs, which are observable based on broker quotes for the same or similar instruments. Changes in the fair value of derivative instruments are reported in current-period earnings. The Company’s derivative contracts hedge foreign exchange risk and are not entered into for trading or speculative purposes. The Company did not have any derivative contracts accounted for under hedge accounting as of December 31, 2016 and 2015. The Company has numerous investments in its foreign subsidiaries. The net assets of these subsidiaries are exposed to volatility in foreign currency exchange rates. The Company uses foreign currency denominated debt to hedge a portion of its net investment in foreign operations against adverse movements in exchange rates. The effective portion of the foreign currency gains and losses related to the foreign currency denominated debt are reported in accumulated other comprehensive income (loss) as part of the cumulative translation adjustment component of equity. The ineffective portion, if any, is recognized in earnings in the current period. The Company evaluates the effectiveness of the net investment hedge each quarter. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Settlement due from/due to customers - The Company operates systems for clearing and settling payment transactions among Mastercard customers. Net settlements are generally cleared daily among customers through settlement cash accounts by wire transfer or other bank clearing means. However, some transactions may not settle until subsequent business days, resulting in amounts due from and due to Mastercard customers. Restricted security deposits held for Mastercard customers - Mastercard requires collateral from certain customers for settlement of their transactions. The majority of collateral for settlement is in the form of standby letters of credit and bank guarantees which are not recorded on the consolidated balance sheet. Additionally, Mastercard holds cash deposits and certificates of deposit from certain customers of Mastercard as collateral for settlement of their transactions, which are recorded as assets on the consolidated balance sheet. These assets are fully offset by corresponding liabilities included on the consolidated balance sheet. Property, plant and equipment - Property, plant and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the estimated useful lives of the assets. Depreciation of leasehold improvements and amortization of capital leases is included in depreciation and amortization expense. The useful lives of the Company’s assets are as follows: Leases - The Company enters into operating and capital leases for the use of premises and equipment. Rent expense related to lease agreements that contain lease incentives is recorded on a straight-line basis over the term of the lease. Pension and other postretirement plans - The Company recognizes the funded status of its single-employer defined benefit pension plans or postretirement plans as assets or liabilities on its consolidated balance sheet and recognizes changes in the funded status in the year in which the changes occur through accumulated other comprehensive income (loss). The funded status is measured as the difference between the fair value of plan assets and the benefit obligation at December 31, the measurement date. The fair value of plan assets represents the current market value of the pension assets. Overfunded plans are aggregated and recorded in long-term other assets, while underfunded plans are aggregated and recorded as accrued expenses and long-term other liabilities. Net periodic pension and postretirement benefit cost/(income) is recognized in general and administrative expenses in the consolidated statement of operations. These costs include service costs, interest cost, expected return on plan assets, amortization of prior service costs or credits and gains or losses previously recognized as a component of accumulated other comprehensive income (loss). Defined contribution plans - The Company’s contributions to defined contribution plans are recorded when employees render service to the Company. The charge is recorded in general and administrative expenses in the consolidated statement of operations. Advertising and marketing - The cost of media advertising is expensed when the advertising takes place. Advertising production costs are expensed as incurred. Promotional items are expensed at the time the promotional event occurs. Sponsorship costs are recognized over the period of benefit. Foreign currency remeasurement and translation - Monetary assets and liabilities are remeasured to functional currencies using current exchange rates in effect at the balance sheet date. Non-monetary assets and liabilities are recorded at historical exchange rates. Revenue and expense accounts are remeasured at the weighted-average exchange rate for the period. Resulting exchange gains and losses related to remeasurement are included in general and administrative expenses on the consolidated statement of operations. Where a non-U.S. currency is the functional currency, translation from that functional currency to U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) using a weighted-average exchange rate for the period. Resulting translation adjustments are reported as a component of accumulated other comprehensive income (loss). Treasury stock - The Company records the repurchase of shares of its common stock at cost on the trade date of the transaction. These shares are considered treasury stock, which is a reduction to stockholders’ equity. Treasury stock is included in authorized and issued shares but excluded from outstanding shares. Share-based payments - The Company measures share-based compensation expense at the grant date, based on the estimated fair value of the award and uses the straight-line method of attribution, net of estimated forfeitures, for expensing awards over the requisite employee service period. The Company estimates the fair value of its non-qualified stock option awards (“Options”) using a Black-Scholes valuation model. The fair value of restricted stock units (“RSUs”) is determined and fixed on the grant date based on the Company’s stock price, adjusted for the exclusion of dividend equivalents. The Monte Carlo simulation valuation model is used to determine the grant date fair value of performance stock units (“PSUs”) granted. All share-based compensation expenses are recorded in general and administrative expenses. Earnings per share - The Company calculates basic earnings per share (“EPS”) by dividing net income by the weighted-average number of common shares outstanding during the year. Diluted EPS is calculated by dividing net income by the weighted-average number of common shares outstanding during the year, adjusted for the potentially dilutive effect of stock options and unvested stock units using the treasury stock method. Recent accounting pronouncements Goodwill impairment - In January 2017, the FASB issued accounting guidance to simplify how companies are required to test goodwill for impairment. Under this new guidance, step 2 of the goodwill impairment test has been eliminated. Step 2 of the goodwill impairment test required companies to determine the implied fair value of the reporting unit’s goodwill. Under this new guidance, companies will perform their annual, or interim, goodwill impairment test by comparing the reporting unit’s carrying value, including goodwill, to the fair value. An impairment charge would be recorded if the carrying value exceeds the reporting unit’s fair value. The guidance is required to be applied prospectively and is effective for periods beginning after December 15, 2020, with early adoption permitted. The Company expects to early adopt this accounting guidance effective January 1, 2017. The Company does not expect any impact from the adoption of the new accounting guidance on its consolidated financial statements. Restricted cash - In December 2016, the FASB issued accounting guidance to address diversity in the classification and presentation of changes in restricted cash on the statement of cash flows. Under this guidance, companies will be required to present restricted cash and restricted cash equivalents with cash and cash equivalents when reconciling the beginning-of-period and end-of-period amounts shown on the statement of cash flows. The guidance is required to be applied retrospectively and is effective for periods beginning after December 15, 2017, with early adoption permitted. The Company expects to adopt this accounting guidance effective January 1, 2018. Upon adoption of this standard, the Company will include restricted cash, which currently consists of restricted cash for litigation settlement and restricted security deposits held for customers in its reconciliation of beginning-of-period and end-of-period cash and cash equivalents on the statement of cash flows. Intra-entity asset transfers - In October 2016, the FASB issued accounting guidance to simplify the accounting for income tax consequences of intra-entity transfers of assets other than inventory. Under this guidance, companies will be required to recognize the income tax consequences of an intra-entity asset transfer when the transfer occurs. The guidance must be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the period of adoption. The guidance is effective for periods beginning after December 15, 2017 and early adoption is permitted. The Company expects to adopt this accounting guidance effective January 1, 2018. The Company is in the process of evaluating the impacts this guidance will have on its consolidated financial statements. However, the Company expects that it will recognize a cumulative-effect adjustment to retained earnings upon adoption of the new guidance related to any deferred income tax consequence from intra-entity asset transfers occurring before the date of adoption. See Note 17 (Income Taxes) for additional information related to intra-entity asset transfers that will be impacted by this guidance. Share-based payments - In March 2016, the FASB issued accounting guidance related to share-based payments to employees. Under this guidance, companies will be required to recognize the tax effects of exercised or vested awards within the income statement, in the period in which they occur, rather than within additional paid-in-capital. In addition, the guidance changes the limit that companies are allowed to withhold for employees without triggering liability accounting and allows companies to make a policy election to either recognize forfeitures as they occur or estimate them. The guidance is effective for periods beginning after December 15, 2016 and early adoption is permitted. The required transition methods for each aspect of the guidance vary MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) between prospective, retrospective and modified retrospective. The Company will adopt the accounting guidance effective January 1, 2017 and the impact on the tax provision during the period will be dependent upon several factors including, the amount and grant value of equity awards that either vest or are exercised, in addition to, Mastercard’s share price on those dates. The requirement to recognize the tax effects of exercised or vested awards in the income statement, rather than within additional paid-in-capital, will be adopted prospectively. If this aspect of the new guidance had been in effect for each of the periods presented, the Company’s tax provision in 2016, 2015 and 2014 would have been adjusted for a tax benefit of $48 million, $42 million and $54 million, respectively, in its income statement. The Company is in the process of evaluating the other potential effects this guidance will have on its consolidated financial statements. Leases - In February 2016, the FASB issued accounting guidance that will change how companies account for and present lease arrangements. The guidance requires companies to recognize leased assets and liabilities for both capital and operating leases. The guidance is effective for periods after December 15, 2018 and early adoption is permitted. Companies are required to adopt the guidance using a modified retrospective method. The Company is in the process of evaluating the potential effects this guidance will have on its consolidated financial statements. Debt issuance costs - In April 2015, the FASB issued accounting guidance that changed the current presentation of debt issuance costs on the consolidated balance sheet. This guidance moved debt issuance costs from the assets section of the consolidated balance sheet to the liabilities section as a direct deduction from the carrying amount of the debt issued. The Company adopted the accounting guidance effective January 1, 2016. The Company applied the guidance retrospectively and, as such, the December 31, 2015 consolidated balance sheet was adjusted to reflect the effects of the standard. This retrospective adjustment resulted in reductions of prepaid expenses and other current assets, other assets and long-term debt by $1 million, $18 million and $19 million, respectively. As of December 31, 2016, $33 million of debt issuance costs were classified as an offset to long-term debt. Revenue recognition - In May 2014, the FASB issued accounting guidance that provides a single, comprehensive revenue recognition model for all contracts with customers and supersedes most of the existing revenue recognition requirements. Under this guidance, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In August 2015, the FASB issued accounting guidance that delayed the effective date of this standard by one year, making the guidance effective for fiscal years beginning after December 15, 2017. The new revenue guidance will impact the timing of recognition for certain of the Company’s customer incentives. Under the new guidance, the Company will recognize certain customer incentives over the life of the contract as revenue is recognized versus as they are earned by the customer. The Company will adopt the new accounting guidance effective January 1, 2018. The accounting guidance permits either a full retrospective or a modified retrospective transition method. The Company expects to adopt the new guidance with the modified retrospective transition method. The Company is in the process of quantifying the potential effects this guidance will have on its consolidated financial statements. Note 2. Acquisitions On July 21, 2016, Mastercard entered into a definitive agreement to acquire a 92.4% controlling interest in VocaLink Holdings Limited (“VocaLink”) for approximately £700 million (approximately $860 million as of December 31, 2016) after adjusting for cash and certain other estimated liabilities. VocaLink’s existing shareholders have the potential for an earn-out of up to an additional £169 million (approximately $210 million as of December 31, 2016) if certain performance targets are met. Under the agreement, a majority of VocaLink’s shareholders will retain 7.6% ownership for at least three years. VocaLink operates payments clearing systems and ATM switching platforms in the U.K., as well as several other regions. While the Company anticipates completing the transaction by the middle of 2017, it is subject to regulatory approval and other customary closing conditions. In 2015, the Company acquired two businesses for $609 million in cash. For these acquisitions, the Company recorded $481 million as goodwill representing the aggregate excess of the purchase consideration over the fair value of the net assets acquired. In 2014, the Company acquired eight businesses, two of which were achieved in stages, with non-controlling interests acquired in previous years. One of the business combinations was a transaction for less than 100 percent of the equity interest. The total consideration transferred was $575 million, of which $509 million was recorded as goodwill. A portion of the goodwill related to the 2015 and 2014 acquisitions is expected to be deductible for local tax purposes. The consolidated financial statements include the operating results of the acquired businesses from the dates of their respective acquisition. Pro forma information related to the acquisitions was not included because the impact on the Company’s consolidated results of operations was not considered to be material. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Note 3. Earnings Per Share The components of basic and diluted EPS for common shares for each of the years ended December 31 were as follows: Note: Table may not sum due to rounding. 1 For the years presented, the calculation of diluted EPS excluded a minimal amount of anti-dilutive share-based payment awards. Note 4. Supplemental Cash Flows The following table includes supplemental cash flow disclosures for each of the years ended December 31: Note 5. Fair Value and Investment Securities Financial Instruments - Recurring Measurements The Company classifies its fair value measurements of financial instruments into a three-level hierarchy (the “Valuation Hierarchy”). There were no transfers made among the three levels in the Valuation Hierarchy for 2016. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The distribution of the Company’s financial instruments which are measured at fair value on a recurring basis within the Valuation Hierarchy was as follows: 1 Excludes amounts held in escrow related to the U.S. merchant class litigation settlement of $543 million and $541 million at December 31, 2016 and December 31, 2015, respectively, which would be included in Level 1 of the Valuation Hierarchy. See Note 10 (Accrued Expenses and Accrued Litigation) and Note 18 (Legal and Regulatory Proceedings) for further details. The fair value of the Company’s available-for-sale municipal securities, government and agency securities, corporate securities and asset-backed securities are based on quoted prices for similar assets in active markets and are therefore included in Level 2 of the Valuation Hierarchy. The Company’s foreign currency derivative asset and liability contracts have also been classified within Level 2 in the Other category of the Valuation Hierarchy, as the fair value is based on broker quotes for the same or similar derivative instruments. See Note 20 (Foreign Exchange Risk Management) for further details. The Company’s U.S. government securities and marketable equity securities are classified within Level 1 of the Valuation Hierarchy as the fair values are based on unadjusted quoted prices for identical assets in active markets. Financial Instruments - Non-Recurring Measurements Certain financial instruments are carried on the consolidated balance sheet at cost, which approximates fair value due to their short-term, highly liquid nature. These instruments include cash and cash equivalents, restricted cash, time deposits, accounts receivable, settlement due from customers, restricted security deposits held for customers, accounts payable, settlement due to customers and accrued expenses. In addition, nonmarketable equity investments are measured at fair value on a nonrecurring basis for purposes of initial recognition and impairment testing. Investments on the consolidated balance sheet include both available-for-sale and short-term held-to-maturity securities. Available-for-sale securities are measured at fair value on a recurring basis and are included in the Valuation Hierarchy table above. Short-term held-to-maturity securities are made up of time deposits with maturities of greater than three months and less than one year and are classified as Level 2 of the Valuation Hierarchy, but are not included in the table above due to their fair values not being measured on a recurring basis. At December 31, 2016 and December 31, 2015, the cost, which approximates fair value, of the Company’s short-term held-to-maturity securities was $452 million and $130 million, respectively. In addition, at December 31, 2016, the Company held $61 million of long-term held-to-maturity securities included in other assets on the consolidated balance sheet, the cost of which approximates fair value, which are classified as Level 2 of the Valuation Hierarchy. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Debt The Company estimates the fair value of its long-term debt based on market quotes for the debt instruments. Long-term debt is classified as Level 2 of the Valuation Hierarchy. At December 31, 2016, the carrying value and fair value of long-term debt was $5.2 billion and $5.3 billion, respectively. At December 31, 2015, the carrying value and fair value of long-term debt was $3.3 billion. Settlement and Other Guarantee Liabilities The Company estimates the fair value of its settlement and other guarantees using market assumptions for relevant though not directly comparable undertakings, as the latter are not observable in the market given the proprietary nature of such guarantees. At December 31, 2016 and 2015, the carrying value and fair value of settlement and other guarantee liabilities were not material. Settlement and other guarantee liabilities are classified as Level 3 of the Valuation Hierarchy as their valuation requires substantial judgment and estimation of factors that are not currently observable in the market. For additional information regarding the Company’s settlement and other guarantee liabilities, see Note 19 (Settlement and Other Risk Management). Non-Financial Instruments Certain assets are measured at fair value on a nonrecurring basis for purposes of initial recognition and impairment testing. The Company’s non-financial assets measured at fair value on a nonrecurring basis include property, plant and equipment, goodwill and other intangible assets. These assets are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment. Amortized Costs and Fair Values - Available-for-Sale Investment Securities The major classes of the Company’s available-for-sale investment securities, for which unrealized gains and losses are recorded as a separate component of other comprehensive income on the consolidated statement of comprehensive income, and their respective amortized cost basis and fair values as of December 31, 2016 and 2015 were as follows: The Company’s available-for-sale investment securities held at December 31, 2016, primarily carried a credit rating of A-, or better. The municipal securities are primarily comprised of tax-exempt bonds and are diversified across states and sectors. Government and agency securities include U.S. government bonds, U.S. government sponsored agency bonds and foreign MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) government bonds with similar credit quality to that of the U.S. government bonds. Corporate securities are comprised of commercial paper and corporate bonds. The asset-backed securities are investments in bonds which are collateralized primarily by automobile loan receivables. Investment Maturities: The maturity distribution based on the contractual terms of the Company’s investment securities at December 31, 2016 was as follows: 1 Equity securities have been included in the No contractual maturity category, as these securities do not have stated maturity dates. Investment Income Investment income primarily consists of interest income generated from cash, cash equivalents and investments. Gross realized gains and losses are recorded within investment income on the Company’s consolidated statement of operations. The gross realized gains and losses from the sales of available-for-sale securities for 2016, 2015 and 2014 were not significant. Note 6. Prepaid Expenses and Other Assets Prepaid expenses and other current assets consisted of the following at December 31: Other assets consisted of the following at December 31: Customer and merchant incentives represent payments made or amounts to be paid to customers and merchants under business agreements. Costs directly related to entering into such an agreement are generally deferred and amortized over the life of the agreement. Amounts to be paid for these incentives and the related liability were included in accrued expenses and other liabilities. Non-current prepaid income taxes, included in the other asset table above, primarily consists of taxes paid in the fourth quarter of 2014 relating to the deferred charge resulting from the reorganization of our legal entity and tax structure to better align with our business footprint of our non-U.S. operations. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Note 7. Property, Plant and Equipment Property, plant and equipment consisted of the following at December 31: As of December 31, 2016 and 2015, capital leases of $23 million and $20 million, respectively, were included in equipment. Accumulated amortization of these capital leases was $16 million and $9 million as of December 31, 2016 and 2015, respectively. Depreciation and amortization expense for the above property, plant and equipment was $152 million, $131 million and $107 million for 2016, 2015 and 2014, respectively. Note 8. Goodwill The changes in the carrying amount of goodwill for the years ended December 31, 2016 and 2015 were as follows: The Company had no accumulated impairment losses for goodwill at December 31, 2016 or 2015. Based on annual impairment testing, the Company’s goodwill is not impaired. Note 9. Other Intangible Assets The following table sets forth net intangible assets, other than goodwill, at December 31: The increase in the gross carrying amount of amortized intangible assets in 2016 was primarily related to capitalized software. Certain intangible assets, including amortizable and unamortizable customer relationships and trademarks and tradenames, are MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) denominated in foreign currencies. As such, the change in intangible assets includes a component attributable to foreign currency translation. Based on the qualitative assessment performed in 2016, it was determined that the Company’s indefinite-lived intangible assets were not impaired. Amortization on the assets above amounted to $221 million, $235 million and $214 million in 2016, 2015 and 2014, respectively. The following table sets forth the estimated future amortization expense on amortizable intangible assets on the consolidated balance sheet at December 31, 2016 for the years ending December 31: Note 10. Accrued Expenses and Accrued Litigation Accrued expenses consisted of the following at December 31: As of December 31, 2016 and 2015, the Company’s provision for litigation was $722 million and $709 million, respectively. These amounts are not included in the accrued expenses table above and are separately reported as accrued litigation on the consolidated balance sheet. See Note 18 (Legal and Regulatory Proceedings) for further discussion of the U.S. merchant class litigation. Note 11. Pension, Postretirement and Savings Plans Defined Contribution The Company sponsors defined contribution retirement plans. The primary plan is the Mastercard Savings Plan, a 401(k) plan for substantially all of the U.S. employees, which is subject to the provisions of the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended. In addition, the Company has several defined contribution plans outside of the U.S. The Company’s total expense for its defined contribution plans was $73 million, $61 million and $57 million in 2016, 2015 and 2014, respectively. Defined Benefit and Other Postretirement Plans During the third quarter of 2015, the Company terminated its non-contributory, qualified, U.S. defined benefit pension plan (the “U.S. Employee Pension Plan”). The U.S. Employee Pension Plan participants had the option to receive a lump sum distribution or to participate in an annuity with a third-party insurance company. As a result of this termination, the Company settled its obligation for $287 million, which resulted in a pension settlement charge of $79 million recorded in general and administrative expense during 2015. The Company maintains a postretirement plan providing health coverage and life insurance benefits for substantially all of its U.S. employees hired before July 1, 2007 (“U.S. Postretirement Plan”). The U.S. postretirement plan was unfunded and the Company’s obligation was $59 million as of December 31, 2016 and 2015, and was recorded in Other Liabilities. The Company’s total expense for its U.S. postretirement plan was not material to the Company’s consolidated financial statements. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company sponsors pension and postretirement plans for non-U.S. employees (“non-U.S. plans”) that cover various benefits specific to their country of employment. The Company recognizes the funded status of its defined benefit pension plans and other postretirement benefit plans, measured as the difference between the fair value of the plan assets and the projected benefit obligation, in the Consolidated Balance Sheet. The non-U.S. plans do not have a material impact on the Company’s consolidated financial statements, individually or in the aggregate. Note 12. Debt In November 2016, the Company issued $2 billion aggregate principal amount of notes (the “2016 USD Notes”). Interest on the 2016 USD Notes is payable semi-annually. In December 2015, the Company issued €1.65 billion ($1.74 billion as translated at the December 31, 2016 exchange rate) aggregate principal amount of notes (the “2015 Euro Notes”). Interest on the 2015 Euro Notes is payable annually. In March 2014, the Company issued $1.5 billion aggregate principal amount of notes (the “2014 USD Notes”). Interest on the 2014 USD Notes is payable semi-annually. The net proceeds, after deducting the original issue discount, underwriting discount and offering expenses, from the issuance of the 2016 USD Notes, the 2015 Euro Notes and the 2014 USD Notes, were $1.969 billion, $1.723 billion and $1.484 billion, respectively. The Company is not subject to any financial covenants under the 2016 USD Notes, the 2015 Euro Notes and the 2014 USD Notes (collectively the “Notes”). The Notes may be redeemed in whole, or in part, at our option at any time for a specified make-whole amount. The Notes are senior unsecured obligations and would rank equally with any future unsecured and unsubordinated indebtedness. The proceeds of the Notes are to be used for general corporate purposes. Long-term debt consisted of the following at December 31: MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Scheduled annual maturities of the principal portion of long-term debt outstanding at December 31, 2016 are summarized below. Amounts exclude capital lease obligations disclosed in Note 16 (Commitments). In November 2015, the Company established a commercial paper program (the “Commercial Paper Program”). Under the Commercial Paper Program, the Company is authorized to issue up to $3.75 billion in outstanding notes, with maturities up to 397 days from the date of issuance. The Commercial Paper Program is available in U.S. dollars. In conjunction with the Commercial Paper Program, the Company entered into a committed unsecured $3.75 billion revolving credit facility (the “Credit Facility”) in October 2015. The Credit Facility amended and restated the Company’s prior credit facility. Borrowings under the Credit Facility are available in U.S. dollars and/or euros. In October 2016, the Company extended the Credit Facility for an additional year to October 2021. The extension did not result in any material changes to the terms and conditions of the Credit Facility. The facility fee and borrowing cost under the Credit Facility are based upon the Company’s credit rating. At December 31, 2016, the applicable facility fee was 8 basis points on the average daily commitment (whether or not utilized). In addition to the facility fee, interest on borrowings under the Credit Facility would be charged at the London Interbank Offered Rate (LIBOR) plus an applicable margin of 79.5 basis points, or an alternative base rate. The Credit Facility contains customary representations, warranties, events of default and affirmative and negative covenants, including a financial covenant limiting the maximum level of consolidated debt to earnings before interest, taxes, depreciation and amortization (EBITDA). Mastercard was in compliance in all material respects with the covenants of the Credit Facility at December 31, 2016 and 2015. The majority of Credit Facility lenders are customers or affiliates of customers of Mastercard. Borrowings under the Commercial Paper Program and the Credit Facility are used to provide liquidity for general corporate purposes, including providing liquidity in the event of one or more settlement failures by the Company’s customers. The Company may borrow and repay amounts under the Commercial Paper Program and Credit Facility from time to time. Mastercard had no borrowings under the Credit Facility and the Commercial Paper Program at December 31, 2016 and 2015. On June 15, 2015, the Company filed a universal shelf registration statement to provide additional access to capital, if needed. Pursuant to the shelf registration statement, the Company may from time to time offer to sell debt securities, preferred stock, Class A common stock, depository shares, purchase contracts, units or warrants in one or more offerings. Note 13. Stockholders’ Equity Classes of Capital Stock Mastercard’s amended and restated certificate of incorporation authorizes the following classes of capital stock: MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Ownership and Governance Structure Equity ownership and voting power of the Company’s shares were allocated as follows as of December 31: Class B Common Stock Conversions Shares of Class B common stock are convertible on a one-for-one basis into shares of Class A common stock. Entities eligible to hold Mastercard’s Class B common stock are defined in the Company’s amended and restated certificate of incorporation (generally the Company’s principal or affiliate customers), and they are restricted from retaining ownership of shares of Class A common stock. Class B stockholders are required to subsequently sell or otherwise transfer any shares of Class A common stock received pursuant to such a conversion. The MasterCard Foundation In connection and simultaneously with its 2006 initial public offering (the “IPO”), the Company issued and donated 135 million newly authorized shares of Class A common stock to The MasterCard Foundation (the “Foundation”). The Foundation is a private charitable foundation incorporated in Canada that is controlled by directors who are independent of the Company and its principal customers. Under the terms of the donation, the Foundation became able to resell the donated shares in May 2010 and to the extent necessary to meet charitable disbursement requirements dictated by Canadian tax law. Under Canadian tax law, the Foundation is generally required to disburse at least 3.5% of its assets not used in administration each year for qualified charitable disbursements. However, the Foundation obtained permission from the Canadian tax authorities to defer the giving requirements for up to ten years, which was extended in 2011 to fifteen years. The Foundation, at its discretion, may decide to meet its disbursement obligations on an annual basis or to settle previously accumulated obligations during any given year. The Foundation will be permitted to sell all of its remaining shares beginning twenty years and eleven months after the consummation of the IPO. Stock Repurchase Programs On February 5, 2013, the Company’s Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $2 billion of its Class A common stock (the “February 2013 Share Repurchase Program”), which became effective in March 2013. On December 10, 2013, the Company’s Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $3.5 billion of its Class A common stock (the “December 2013 Share Repurchase Program”), which became effective in January 2014. On December 2, 2014, the Company’s Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $3.75 billion of its Class A common stock (the “December 2014 Share Repurchase Program”), which became effective in January 2015. On December 8, 2015, the Company’s Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $4 billion of its Class A common stock (the “December 2015 Share Repurchase Program”), which became effective in February 2016. On December 6, 2016, the Company’s Board of Directors approved a share repurchase program authorizing the Company to repurchase up to $4 billion of its Class A common stock (the “December 2016 Share Repurchase Program”). The December 2016 Share Repurchase Program will become effective after completion of the December 2015 Share Repurchase Program. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following table summarizes the Company’s share repurchase authorizations of its Class A common stock through December 31, 2016, as well as historical purchases: The following table presents the changes in the Company’s outstanding Class A and Class B common stock for the years ended December 31: MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Note 14. Accumulated Other Comprehensive Income (Loss) The changes in the balances of each component of accumulated other comprehensive income (loss), net of tax, for the years ended December 31, 2016 and 2015 were as follows: 1 During 2015, the increase in other comprehensive loss related to foreign currency translation adjustments was driven primarily by the devaluation of the euro and Brazilian real. During 2016, the increase in other comprehensive loss related to foreign currency translation adjustments was driven primarily by the devaluation of the British pound and euro. 2 During 2015, $80 million of deferred costs ($51 million after-tax) related to the Company’s defined benefit pension plan and other post retirement plans were reclassified to general and administrative expenses. The deferred costs were driven primarily by the termination of the Company's U.S. defined benefit plan (See Note 11 (Pension, Postretirement and Savings Plans)). During 2016, deferred gains related to the Company’s postretirement plans, reclassified from accumulated other comprehensive income (loss) to earnings, were $1 million before and after tax. 3 During 2015, $15 million of an unrealized loss (no tax impact) on a foreign denominated available-for-sale security was reclassified to other income (expense) due to an other-than-temporary impairment. During 2016, gains and losses on available-for-sale investment securities, reclassified from accumulated other comprehensive income (loss) to investment income, were not significant. Note 15. Share-Based Payments In May 2006, the Company implemented the Mastercard Incorporated 2006 Long-Term Incentive Plan, which was amended and restated as of June 5, 2012 (the “LTIP”). The LTIP is a stockholder-approved plan that permits the grant of various types of equity awards to employees. The Company has granted Options, RSUs and PSUs under the LTIP. The Options, which expire ten years from the date of grant, generally vest ratably over four years from the date of grant. The RSUs and PSUs generally vest after three years. The Company uses the straight-line method of attribution for expensing equity awards. Compensation expense is recorded net of estimated forfeitures. Estimates are adjusted as appropriate. Upon termination of employment, a participant’s unvested awards are forfeited. However, when a participant terminates employment due to disability or retirement more than six months after receiving the award, the participant retains all of their awards without providing additional service to the Company. Retirement eligibility is dependent upon age and years of service. Compensation expense is recognized over the shorter of the vesting periods stated in the LTIP or the date the individual becomes eligible to retire but not less than six months. There are approximately 116 million shares of Class A common stock authorized for equity awards under the LTIP. Although the LTIP permits the issuance of shares of Class B common stock, no such shares have been authorized for issuance. Shares issued as a result of Option exercises and the conversions of RSUs and PSUs were funded primarily with the issuance of new shares of Class A common stock. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Stock Options The fair value of each Option is estimated on the date of grant using a Black-Scholes option pricing model. The following table presents the weighted-average assumptions used in the valuation and the resulting weighted-average fair value per option granted for the years ended December 31: The risk-free rate of return was based on the U.S. Treasury yield curve in effect on the date of grant. The expected term and the expected volatility were based on historical Mastercard information. The expected dividend yields were based on the Company’s expected annual dividend rate on the date of grant. The following table summarizes the Company’s option activity for the year ended December 31, 2016: As of December 31, 2016, there was $30 million of total unrecognized compensation cost related to non-vested Options. The cost is expected to be recognized over a weighted-average period of 2.3 years. Restricted Stock Units The following table summarizes the Company’s RSU activity for the year ended December 31, 2016: The fair value of each RSU is the closing stock price on the New York Stock Exchange of the Company’s Class A common stock on the date of grant, adjusted for the exclusion of dividend equivalents. Upon vesting, a portion of the RSU award may be withheld to satisfy the minimum statutory withholding taxes. The remaining RSUs will be settled in shares of the Company’s Class A MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) common stock after the vesting period. As of December 31, 2016, there was $148 million of total unrecognized compensation cost related to non-vested RSUs. The cost is expected to be recognized over a weighted-average period of 2.0 years. Performance Stock Units The following table summarizes the Company’s PSU activity for the year ended December 31, 2016: Since 2013, PSUs containing performance and market conditions have been issued. Performance measures used to determine the actual number of shares that vest after three years include net revenue growth, EPS growth, and relative total shareholder return (“TSR”). Relative TSR is considered a market condition, while net revenue and EPS growth are considered performance conditions. The Monte Carlo simulation valuation model is used to determine the grant-date fair value. Compensation expenses for PSUs are recognized over the requisite service period if it is probable that the performance target will be achieved and subsequently adjusted if the probability assessment changes. As of December 31, 2016, there was $11 million of total unrecognized compensation cost related to non-vested PSUs. The cost is expected to be recognized over a weighted-average period of 1.7 years. Additional Information The following table includes additional share-based payment information for each of the years ended December 31: MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Note 16. Commitments At December 31, 2016, the Company had the following future minimum payments due under non-cancelable agreements: Included in the table above are capital leases with a net present value of minimum lease payments of $7 million. In addition, at December 31, 2016, $10 million of the future minimum payments in the table above for sponsorship, licensing and other agreements was accrued. Consolidated rental expense for the Company’s leased office space was $62 million, $52 million and $48 million for 2016, 2015 and 2014, respectively. Consolidated lease expense for automobiles, computer equipment and office equipment was $19 million, $17 million and $17 million for 2016, 2015 and 2014, respectively. Included in the Sponsorship, Licensing & Other payments due in 2017 is £700 million (approximately $860 million as of December 31, 2016) related to a definitive agreement for the Company to acquire a controlling interest in VocaLink Holdings Limited (“VocaLink”). See Note 2 (Acquisitions) for further discussion. Note 17. Income Taxes The domestic and foreign components of income before income taxes for the years ended December 31 are as follows: The total income tax provision for the years ended December 31 is comprised of the following components: Mastercard has not provided for U.S. federal income and foreign withholding taxes on approximately $4.0 billion of undistributed earnings from non-U.S. subsidiaries as of December 31, 2016 because such earnings are intended to be reinvested indefinitely outside of the United States. If these earnings were distributed, foreign tax credits may become available under current law to reduce the resulting U.S. income tax liability. However, it is not practicable to determine the amount of the tax and credits. The foreign earnings that the Company may repatriate to the United States in any year is limited to the amount of current year foreign earnings and are not made out of historic undistributed accumulated earnings. The amount of current year foreign earnings MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) that are available for repatriation is determined after consideration of all foreign cash requirements including working capital needs, potential requirements for litigation and regulatory matters, and merger and acquisition activities, among others. The provision for income taxes differs from the amount of income tax determined by applying the U.S. federal statutory income tax rate of 35% to pretax income for the years ended December 31, as a result of the following: 1 Included within the impact of foreign tax credits were repatriation benefits of current year foreign earnings of $116 million, $172 million and $177 million, in addition to other foreign tax credit benefits which become eligible in the United States of $25 million, $109 million and $6 million for 2016, 2015 and 2014, respectively. Effective Income Tax Rate The effective income tax rates for the years ended December 31, 2016, 2015 and 2014 were 28.1%, 23.2% and 28.8%, respectively. The effective income tax rate for 2016 was higher than the effective income tax rate for 2015 primarily due to benefits associated with the impact of settlements with tax authorities in multiple jurisdictions in 2015, the lapping of a discrete benefit relating to certain foreign taxes that became eligible to be claimed as credits in the United States in 2015, and a higher U.S. foreign tax credit benefit associated with the repatriation of current year foreign earnings in 2015. These items were partially offset by a more favorable geographic mix of taxable earnings in 2016. The effective income tax rate for 2015 was lower than the effective income tax rate for 2014 primarily due to settlements with tax authorities in multiple jurisdictions. Further, the information gained related to these matters was considered in measuring uncertain tax benefits recognized for the periods subsequent to the periods settled. In addition, the recognition of other U.S. foreign tax credits and a more favorable geographic mix of taxable earnings also contributed to the lower effective tax rate in 2015. During the fourth quarter of 2014, the Company implemented an initiative to better align its legal entity and tax structure with its operational footprint outside of the U.S. This initiative resulted in a one-time taxable gain in Belgium relating to the transfer of intellectual property to a related foreign entity in the United Kingdom. Management believes this improved alignment will result in greater flexibility and efficiency with regard to the global deployment of cash, as well as ongoing benefits in the Company’s effective income tax rate. The Company recorded a deferred charge related to the income tax expense on intercompany profits that resulted from the transfer. The tax associated with the transfer is deferred and amortized utilizing a 25-year life. This deferred charge is included in other current assets and other assets on our consolidated balance sheet at December 31, 2016 in the amounts of $15 million and $325 million, respectively. The comparable amounts included in other current assets and other assets were $15 million and $352 million, respectively, at December 31, 2015, with the difference driven by changes in foreign exchange rates and current period amortization. The future accounting for this transfer will be impacted by the adoption of the recent accounting pronouncement for intra-entity asset transfers. The Company expects to adopt this accounting guidance effective January 1, 2018. The Company is in the process of evaluating the impacts this guidance will have on its consolidated financial statements. See Note 1 (Summary of Significant Accounting Policies) for additional information related to this guidance. In 2010, in connection with the expansion of the Company’s operations in the Asia Pacific, Middle East and Africa region, the Company’s subsidiary in Singapore, Mastercard Asia Pacific Pte. Ltd. (“MAPPL”) received an incentive grant from the Singapore Ministry of Finance. The incentive had provided MAPPL with, among other benefits, a reduced income tax rate for the 10-year period commencing January 1, 2010 on taxable income in excess of a base amount. The Company continued to explore business opportunities in this region, resulting in an expansion of the incentives being granted by the Ministry of Finance, including a further reduction to the income tax rate on taxable income in excess of a revised fixed base amount commencing July 1, 2011 MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) and continuing through December 31, 2025. Without the incentive grant, MAPPL would have been subject to the statutory income tax rate on its earnings. For 2016, 2015 and 2014, the impact of the incentive grant received from the Ministry of Finance resulted in a reduction of MAPPL’s income tax liability of $49 million, or $0.04 per diluted share, $47 million, or $0.04 per diluted share, and $40 million, or $0.03 per diluted share, respectively. Deferred Taxes Deferred tax assets and liabilities represent the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. The components of deferred tax assets and liabilities at December 31 are as follows: The increase in the valuation allowance balance at December 31, 2016 from the December 31, 2015 balance is attributable to additional foreign losses and capital asset impairments in the United States. The recognition of the foreign losses is dependent upon the future taxable income in such jurisdictions and the ability under tax law in these jurisdictions to utilize net operating losses following a change in control. The recognition of losses with regard to the capital impairments is dependent upon the recognition of future capital gains in the United States. The 2015 valuation allowance related primarily to the Company’s ability to recognize tax benefits associated with certain foreign net operating losses. A reconciliation of the beginning and ending balance for the Company’s unrecognized tax benefits for the years ended December 31, is as follows: The entire unrecognized tax benefits of $169 million, if recognized, would reduce the effective tax rate. During 2015, there was a reduction to the balance of the Company’s unrecognized tax benefits. This was primarily due to settlements with tax authorities in multiple jurisdictions. Further, the information gained related to these matters was considered in measuring uncertain tax benefits recognized for the periods subsequent to the periods settled. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company is subject to tax in the United States, Belgium, Singapore, the United Kingdom and various other foreign jurisdictions, as well as state and local jurisdictions. Uncertain tax positions are reviewed on an ongoing basis and are adjusted after considering facts and circumstances, including progress of tax audits, developments in case law and closing of statutes of limitation. Within the next twelve months, the Company believes that the resolution of certain federal, foreign and state and local examinations are reasonably possible and that a change in estimate, reducing unrecognized tax benefits, may occur. While such a change may be significant, it is not possible to provide a range of the potential change until the examinations progress further or the related statutes of limitation expire. The Company has effectively settled its U.S. federal income tax obligations through 2008, with the exception of transfer pricing issues which are settled through 2011. With limited exception, the Company is no longer subject to state and local or foreign examinations by tax authorities for years before 2009. It is the Company’s policy to account for interest expense related to income tax matters as interest expense in its consolidated statement of operations, and to include penalties related to income tax matters in the income tax provision. For 2016, 2015 and 2014, the Company recorded tax-related interest income of $4 million, $3 million and $2 million, respectively, in its consolidated statement of operations. At December 31, 2016 and 2015, the Company had a net income tax-related interest payable of $9 million and $12 million, respectively, in its consolidated balance sheet. At December 31, 2016 and 2015, the amounts the Company had recognized for penalties payable in its consolidated balance sheet were not significant. Note 18. Legal and Regulatory Proceedings Mastercard is a party to legal and regulatory proceedings with respect to a variety of matters in the ordinary course of business. Some of these proceedings are based on complex claims involving substantial uncertainties and unascertainable damages. Accordingly, except as discussed below, it is not possible to determine the probability of loss or estimate damages, and therefore, Mastercard has not established reserves for any of these proceedings. When the Company determines that a loss is both probable and reasonably estimable, Mastercard records a liability and discloses the amount of the liability if it is material. When a material loss contingency is only reasonably possible, Mastercard does not record a liability, but instead discloses the nature and the amount of the claim, and an estimate of the loss or range of loss, if such an estimate can be made. Unless otherwise stated below with respect to these matters, Mastercard cannot provide an estimate of the possible loss or range of loss based on one or more of the following reasons: (1) actual or potential plaintiffs have not claimed an amount of monetary damages or the amounts are unsupportable or exaggerated, (2) the matters are in early stages, (3) there is uncertainty as to the outcome of pending appeals or motions, (4) there are significant factual issues to be resolved, (5) the existence in many such proceedings of multiple defendants or potential defendants whose share of any potential financial responsibility has yet to be determined, and/or (6) there are novel legal issues presented. Furthermore, except as identified with respect to the matters below, Mastercard does not believe that the outcome of any individual existing legal or regulatory proceeding to which it is a party will have a material adverse effect on its results of operations, financial condition or overall business. However, an adverse judgment or other outcome or settlement with respect to any proceedings discussed below could result in fines or payments by Mastercard and/or could require Mastercard to change its business practices. In addition, an adverse outcome in a regulatory proceeding could lead to the filing of civil damage claims and possibly result in significant damage awards. Any of these events could have a material adverse effect on Mastercard’s results of operations, financial condition and overall business. Interchange Litigation and Regulatory Proceedings Mastercard’s interchange fees and other practices are subject to regulatory and/or legal review and/or challenges in a number of jurisdictions, including the proceedings described below. When taken as a whole, the resulting decisions, regulations and legislation with respect to interchange fees and acceptance practices may have a material adverse effect on the Company’s prospects for future growth and its overall results of operations, financial position and cash flows. United States. In June 2005, the first of a series of complaints were filed on behalf of merchants (the majority of the complaints were styled as class actions, although a few complaints were filed on behalf of individual merchant plaintiffs) against Mastercard International, Visa U.S.A., Inc., Visa International Service Association and a number of financial institutions. Taken together, the claims in the complaints were generally brought under both Sections 1 and 2 of the Sherman Act, which prohibit monopolization and attempts or conspiracies to monopolize a particular industry, and some of these complaints contain unfair competition law claims under state law. The complaints allege, among other things, that Mastercard, Visa, and certain financial institutions conspired to set the price of interchange fees, enacted point of sale acceptance rules (including the no surcharge rule) in violation of antitrust laws and engaged in unlawful tying and bundling of certain products and services. The cases were consolidated for pre-trial proceedings in the U.S. District Court for the Eastern District of New York in MDL No. 1720. The plaintiffs filed a consolidated class action complaint that seeks treble damages. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) In July 2006, the group of purported merchant class plaintiffs filed a supplemental complaint alleging that Mastercard’s initial public offering of its Class A Common Stock in May 2006 (the “IPO”) and certain purported agreements entered into between Mastercard and financial institutions in connection with the IPO: (1) violate U.S. antitrust laws and (2) constituted a fraudulent conveyance because the financial institutions allegedly attempted to release, without adequate consideration, Mastercard’s right to assess them for Mastercard’s litigation liabilities. The class plaintiffs sought treble damages and injunctive relief including, but not limited to, an order reversing and unwinding the IPO. In February 2011, Mastercard and Mastercard International entered into each of: (1) an omnibus judgment sharing and settlement sharing agreement with Visa Inc., Visa U.S.A. Inc. and Visa International Service Association and a number of financial institutions; and (2) a Mastercard settlement and judgment sharing agreement with a number of financial institutions. The agreements provide for the apportionment of certain costs and liabilities which Mastercard, the Visa parties and the financial institutions may incur, jointly and/or severally, in the event of an adverse judgment or settlement of one or all of the cases in the merchant litigations. Among a number of scenarios addressed by the agreements, in the event of a global settlement involving the Visa parties, the financial institutions and Mastercard, Mastercard would pay 12% of the monetary portion of the settlement. In the event of a settlement involving only Mastercard and the financial institutions with respect to their issuance of Mastercard cards, Mastercard would pay 36% of the monetary portion of such settlement. In October 2012, the parties entered into a definitive settlement agreement with respect to the merchant class litigation (including with respect to the claims related to the IPO) and the defendants separately entered into a settlement agreement with the individual merchant plaintiffs. The settlements included cash payments that were apportioned among the defendants pursuant to the omnibus judgment sharing and settlement sharing agreement described above. Mastercard also agreed to provide class members with a short-term reduction in default credit interchange rates and to modify certain of its business practices, including its No Surcharge Rule. Objections to the settlement were filed by both merchants and certain competitors, including Discover. Discover’s objections included a challenge to the settlement on the grounds that certain of the rule changes agreed to in the settlement constitute a restraint of trade in violation of Section 1 of the Sherman Act. The court granted final approval of the settlement in December 2013, and objectors to the settlement appealed that decision to the U.S. Court of Appeals for the Second Circuit. In June 2016, the court of appeals vacated the class action certification, reversed the settlement approval and sent the case back to the district court for further proceedings. The court of appeals’ ruling was based primarily on whether the merchants were adequately represented by counsel in the settlement. Prior to the reversal of the settlement approval, merchants representing slightly more than 25% of the Mastercard and Visa purchase volume over the relevant period chose to opt out of the class settlement. Mastercard had anticipated that most of the larger merchants who opted out of the settlement would initiate separate actions seeking to recover damages, and over 30 opt-out complaints have been filed on behalf of numerous merchants in various jurisdictions. Mastercard has executed settlement agreements with a number of opt-out merchants. Mastercard believes these settlement agreements are not impacted by the ruling of the court of appeals. The defendants have consolidated all of these matters (except for one state court action in New Mexico) in front of the same federal district court that approved the merchant class settlement. In July 2014, the district court denied the defendants’ motion to dismiss the opt-out merchant complaints for failure to state a claim. Deposition discovery in these actions and the class action commenced in December 2016. As of December 31, 2016, Mastercard had accrued a liability of $705 million as a reserve for both the merchant class litigation and the filed and anticipated opt-out merchant cases. As of December 31, 2016 and December 31, 2015, Mastercard had $543 million and $541 million, respectively, in a qualified cash settlement fund related to the merchant class litigation and classified as restricted cash on its consolidated balance sheet. Mastercard believes the reserve for both the merchant class litigation and the filed and anticipated opt-out merchants represents its best estimate of its probable liabilities in these matters at December 31, 2016. The portion of the accrued liability relating to both the opt-out merchants and the merchant class litigation settlement does not represent an estimate of a loss, if any, if the matters were litigated to a final outcome. Mastercard cannot estimate the potential liability if that were to occur. Canada. In December 2010, a proposed class action complaint was commenced against Mastercard in Quebec on behalf of Canadian merchants. That suit essentially repeated the allegations and arguments of a previously filed application by the Canadian Competition Bureau to the Canadian Competition Tribunal (dismissed in Mastercard’s favor) concerning certain Mastercard rules related to point-of-sale acceptance, including the “honor all cards” and “no surcharge” rules. The Quebec suit sought compensatory and punitive damages in unspecified amounts, as well as injunctive relief. In the first half of 2011, additional purported class action lawsuits were commenced in British Columbia and Ontario against Mastercard, Visa and a number of large Canadian financial institutions. The British Columbia suit seeks compensatory damages in unspecified amounts, and the Ontario suit seeks compensatory damages of $5 billion on the basis of alleged conspiracy and various alleged breaches of the Canadian Competition Act. The British Columbia and Ontario suits also seek punitive damages in unspecified amounts, as well as injunctive MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) relief, interest and legal costs. The Quebec suit was later amended to include the same defendants and similar claims as in the British Columbia and Ontario suits. Additional purported class action complaints have been commenced in Saskatchewan and Alberta with claims that largely mirror those in the British Columbia, Ontario and Quebec suits. With respect to the status of the proceedings: (1) several of the merchants’ claims in the British Columbia case have been allowed to proceed on a class basis, and a trial date has been set for September 2018, (2) the British Columbia suit plaintiff is seeking to claim significant additional damages for the period subsequent to March 2010 (currently in front of the British Columbia Court of Appeal), (3) the class certification hearing in the Quebec suit is scheduled for November 2017 and (4) the Ontario, Saskatchewan and Alberta suits are temporarily suspended while the British Columbia suit proceeds. Europe. In July 2015, the European Commission issued a Statement of Objections related to Mastercard’s interregional interchange fees and central acquiring rules within the European Economic Area. The Statement of Objections, which follows an investigation opened in 2013, includes preliminary conclusions concerning the anticompetitive effects of these practices. The European Commission has indicated it intends to seek fines if these conclusions are subsequently confirmed. Although the Statement of Objections does not quantify the level of fines, it is possible that they could be substantial. In April 2016, Mastercard submitted a response to the Statement of Objections disputing the Commission’s preliminary conclusions and participated in a related oral hearing in May 2016. In the United Kingdom, beginning in May 2012, a number of retailers filed claims or threatened litigation against Mastercard seeking damages for alleged anti-competitive conduct with respect to Mastercard’s cross-border interchange fees and its U.K. and Ireland domestic interchange fees (the “U.K. Merchant claimants”), with claimed purported damages exceeding $1 billion. The U.K. Merchant claimants (including all resolved matters) represent approximately 40% of Mastercard’s U.K. interchange volume over the relevant damages period. Additional merchants have filed or threatened litigation with respect to interchange rates in Europe (the “Pan-European claimants”) for purported damages exceeding $1 billion. In June 2015, Mastercard entered into a settlement with one of the U.K. Merchant claimants for $61 million, recorded as a provision for litigation settlement. Mastercard has submitted statements of defense to the remaining retailers’ claims disputing liability and damages. Following the conclusion of a trial for liability and damages for one of the U.K. merchant cases, in July 2016, the tribunal issued a judgment against Mastercard for damages. Mastercard recorded a litigation provision of $107 million in the second quarter of 2016, that includes the amount of the judgment and estimated legal fees and costs. Mastercard has sought permission from the court to appeal this judgment. In the fourth quarter of 2016, Mastercard recorded a charge of $10 million relating to settlements with multiple U.K. Merchant claimants. In January 2017, Mastercard received a liability judgment in its favor on all significant matters in a separate action brought by ten of the U.K. Merchant claimants, who had been seeking in excess of $500 million in damages. These claimants can request permission to appeal this decision. In light of this favorable judgment, Mastercard is not able to estimate a reasonably possible loss, if any, for settlements or judgments relating to the remaining U.K. Merchant claimant litigations. In September 2016, a proposed collective action was filed in the United Kingdom on behalf of U.K. consumers seeking damages for intra-EEA and domestic U.K. interchange fees that were allegedly passed on to consumers by merchants between 1992 and 2008. The complaint, which seeks to leverage the European Commission’s 2007 decision on intra-EEA interchange fees, claims damages in an amount that exceeds £14 billion (approximately $18 billion). In January 2017, the court heard argument on the plaintiffs’ application for collective action, and the parties are awaiting a decision. At this time Mastercard is unable to estimate a probable loss for the matter, if any, and accordingly has not accrued for any loss. ATM Non-Discrimination Rule Surcharge Complaints In October 2011, a trade association of independent Automated Teller Machine (“ATM”) operators and 13 independent ATM operators filed a complaint styled as a class action lawsuit in the U.S. District Court for the District of Columbia against both Mastercard and Visa (the “ATM Operators Complaint”). Plaintiffs seek to represent a class of non-bank operators of ATM terminals that operate in the United States with the discretion to determine the price of the ATM access fee for the terminals they operate. Plaintiffs allege that Mastercard and Visa have violated Section 1 of the Sherman Act by imposing rules that require ATM operators to charge non-discriminatory ATM surcharges for transactions processed over Mastercard’s and Visa’s respective networks that are not greater than the surcharge for transactions over other networks accepted at the same ATM. Plaintiffs seek both injunctive and monetary relief equal to treble the damages they claim to have sustained as a result of the alleged violations and their costs of suit, including attorneys’ fees. Plaintiffs have not quantified their damages although they allege that they expect damages to be in the tens of millions of dollars. Subsequently, multiple related complaints were filed in the U.S. District Court for the District of Columbia alleging both federal antitrust and multiple state unfair competition, consumer protection and common law claims against Mastercard and Visa on MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) behalf of putative classes of users of ATM services (the “ATM Consumer Complaints”). The claims in these actions largely mirror the allegations made in the ATM Operators Complaint, although these complaints seek damages on behalf of consumers of ATM services who pay allegedly inflated ATM fees at both bank and non-bank ATM operators as a result of the defendants’ ATM rules. Plaintiffs seek both injunctive and monetary relief equal to treble the damages they claim to have sustained as a result of the alleged violations and their costs of suit, including attorneys’ fees. Plaintiffs have not quantified their damages although they allege that they expect damages to be in the tens of millions of dollars. In January 2012, the plaintiffs in the ATM Operators Complaint and the ATM Consumer Complaints filed amended class action complaints that largely mirror their prior complaints. In February 2013, the district court granted Mastercard’s motion to dismiss the complaints for failure to state a claim. On appeal, the Court of Appeals reversed the district court’s order in August 2015 and sent the case back for further proceedings. In March 2016, certain of the plaintiffs in the ATM Operators Complaint filed a motion seeking a preliminary injunction enjoining the enforcement of the nondiscrimination rules pending the outcome of the litigation. In November 2016, the U.S. Supreme Court dismissed the appeal and returned the matter to the district court for further proceedings. The district court has scheduled briefing on the ATM operators’ motion for a preliminary injunction. U.S. Liability Shift Litigation In March 2016, a proposed U.S. merchant class action complaint was filed in federal court in California alleging that Mastercard, Visa, American Express and Discover (the “Network Defendants”), EMVCo, and a number of issuing banks (the “Bank Defendants”) engaged in a conspiracy to shift fraud liability for card present transactions from issuing banks to merchants not yet in compliance with the standards for EMV chip cards in the United States (the “EMV Liability Shift”), in violation of the Sherman Act and California law. Plaintiffs allege the damages would be the value of all chargebacks for which class members became liable as a result of the EMV Liability Shift on October 1, 2015. The plaintiffs seek treble damages, attorney’s fees and costs and an injunction against future violations of governing law, and the defendants have filed a motion to dismiss. In September 2016, the court denied the Network Defendants’ motion to dismiss the complaint, but granted such a motion for EMVCo and the Bank Defendants. The case against the Network Defendants is now proceeding with a trial currently scheduled for late 2017. Note 19. Settlement and Other Risk Management Mastercard’s rules guarantee the settlement of many of the Mastercard, Cirrus and Maestro branded transactions between its issuers and acquirers (“settlement risk”). Settlement exposure is the outstanding settlement risk to customers under Mastercard’s rules due to the difference in timing between the payment transaction date and subsequent settlement. While the term and amount of the guarantee are unlimited, the duration of settlement exposure is short term and typically limited to a few days. Gross settlement exposure is estimated using the average daily card volume during the quarter multiplied by the estimated number of days to settle. The Company has global risk management policies and procedures, which include risk standards, to provide a framework for managing the Company’s settlement risk. Customer-reported transaction data and the transaction clearing data underlying the settlement exposure calculation may be revised in subsequent reporting periods. In the event that Mastercard effects a payment on behalf of a failed customer, Mastercard may seek an assignment of the underlying receivables of the failed customer. Customers may be charged for the amount of any settlement loss incurred during the ordinary course activities of the Company. The Company has global risk management policies and procedures aimed at managing the settlement exposure. These risk management procedures include interaction with the bank regulators of countries in which it operates, requiring customers to make adjustments to settlement processes, and requiring collateral from customers. As part of its policies, Mastercard requires certain customers that are not in compliance with the Company’s risk standards in effect at the time of review to post collateral, typically in the form of cash, letters of credit, or guarantees. This requirement is based on management’s review of the individual risk circumstances for each customer that is out of compliance. In addition to these amounts, Mastercard holds collateral to cover variability and future growth in customer programs. The Company may also hold collateral to pay merchants in the event of an acquirer failure. Although the Company is not contractually obligated under its rules to effect such payments to merchants, the Company may elect to do so to protect brand integrity. Mastercard monitors its credit risk portfolio on a regular basis and the adequacy of collateral on hand. Additionally, from time to time, the Company reviews its risk management methodology and standards. As such, the amounts of estimated settlement exposure are revised as necessary. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company’s estimated settlement exposure from Mastercard, Cirrus and Maestro branded transactions was as follows: General economic and political conditions in countries in which Mastercard operates affect the Company’s settlement risk. Many of the Company’s financial institution customers have been directly and adversely impacted by political instability and uncertain economic conditions. These conditions present increased risk that the Company may have to perform under its settlement guarantee. This risk could increase if political, economic and financial market conditions deteriorate further. The Company’s global risk management policies and procedures are revised and enhanced from time to time. Historically, the Company has experienced a low level of losses from financial institution failures. Mastercard also provides guarantees to customers and certain other counterparties indemnifying them from losses stemming from failures of third parties to perform duties. This includes guarantees of Mastercard-branded travelers cheques issued, but not yet cashed of $397 million and $420 million at December 31, 2016 and 2015, respectively, of which $312 million and $332 million at December 31, 2016 and 2015, respectively, is mitigated by collateral arrangements. In addition, the Company enters into business agreements in the ordinary course of business under which the Company agrees to indemnify third parties against damages, losses and expenses incurred in connection with legal and other proceedings arising from relationships or transactions with the Company. Certain indemnifications do not provide a stated maximum exposure. As the extent of the Company’s obligations under these agreements depends entirely upon the occurrence of future events, the Company’s potential future liability under these agreements is not determinable. Historically, payments made by the Company under these types of contractual arrangements have not been material. Note 20. Foreign Exchange Risk Management The Company monitors and manages its foreign currency exposures as part of its overall risk management program which focuses on the unpredictability of financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results. A principal objective of the Company’s risk management strategies is to reduce significant, unanticipated earnings fluctuations that may arise from volatility in foreign currency exchange rates principally through the use of derivative instruments. Derivatives The Company enters into foreign currency derivative contracts to manage risk associated with anticipated receipts and disbursements which are valued based on currencies other than the functional currencies of the entity. The Company may also enter into foreign currency derivative contracts to offset possible changes in value due to foreign exchange fluctuations of earnings, assets and liabilities. The objective of these activities is to reduce the Company’s exposure to gains and losses resulting from fluctuations of foreign currencies against its functional currencies. As of December 31, 2016, the majority of derivative contracts to hedge foreign currency fluctuations had been entered into with customers of Mastercard. Mastercard’s derivative contracts are summarized below: 1 The fair values of derivative contracts are determined using a Level 2 Valuation Hierarchy and are presented on a gross basis on the consolidated balance sheet and are subject to enforceable master netting arrangements, which contain various netting and setoff provisions. MASTERCARD INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The amount of gain (loss) recognized in income for the contracts to purchase and sell foreign currency is summarized below: The fair value of the foreign currency derivative contracts generally reflects the estimated amounts that the Company would receive (or pay), on a pre-tax basis, to terminate the contracts. The terms of the foreign currency derivative contracts are generally less than 18 months. The Company had no deferred gains or losses related to foreign exchange contracts in accumulated other comprehensive income as of December 31, 2016 and 2015, as these contracts were not accounted for under hedge accounting. The Company’s derivative financial instruments are subject to both market and counterparty credit risk. Market risk is the risk of loss due to the potential change in an instrument’s value caused by fluctuations in foreign currency exchange rates, interest rates and other related variables. The effect of a hypothetical 10% adverse change in foreign currency forward rates could result in a fair value loss of approximately $80 million on the Company’s foreign currency derivative contracts outstanding at December 31, 2016 related to the hedging program. Counterparty credit risk is the risk of loss due to failure of the counterparty to perform its obligations in accordance with contractual terms. To mitigate counterparty credit risk, the Company enters into derivative contracts with selected financial institutions based upon their credit ratings and other factors. Generally, the Company does not obtain collateral related to derivatives because of the high credit ratings of the counterparties. Net investment hedge The Company uses foreign currency denominated debt to hedge a portion of its net investment in foreign operations against adverse movements in exchange rates, with changes in the value of the debt recorded within currency translation adjustment in accumulated other comprehensive income (loss). During the fourth quarter of 2015, the Company designated its €1.65 billion euro-denominated debt as a net investment hedge for a portion of its net investment in European foreign operations. As of December 31, 2016, the Company had a net foreign currency transaction pre-tax gain of $20 million in accumulated other comprehensive income (loss) associated with hedging activity. There was no ineffectiveness in the current period. Note 21. Segment Reporting Mastercard has concluded it has one operating and reportable segment, “Payment Solutions.” Mastercard’s President and Chief Executive Officer has been identified as the chief operating decision-maker. All of the Company’s activities are interrelated, and each activity is dependent upon and supportive of the other. Accordingly, all significant operating decisions are based upon analysis of Mastercard at the consolidated level. Revenue by geographic market is based on the location of the Company’s customer that issued the card, as well as the location of the merchant acquirer where the card is being used. Revenue generated in the U.S. was approximately 38% of total revenue in 2016 and 39% in 2015 and 2014, respectively. No individual country, other than the U.S., generated more than 10% of total revenue in those periods. Mastercard did not have any one customer that generated greater than 10% of net revenue in 2016, 2015 or 2014. The following table reflects the geographical location of the Company’s property, plant and equipment, net, as of December 31: MASTERCARD INCORPORATED SUMMARY OF QUARTERLY DATA (Unaudited) Note: Tables may not sum due to rounding.
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Here's a summary of the financial statement:
Revenue:
- Measured by net revenue growth, EPS growth, and relative total shareholder return (TSR)
- TSR is treated as a market condition
- Uses Monte Carlo simulation for fair value determination
- Compensation expenses for PSUs recognized over service period
Profit/Loss:
- Includes provisions for loss of control
- Retained ownership interests are measured at fair value
- Gains/losses recognized in earnings
Expenses:
- Based on fair values at acquisition date
- Includes amortization of excess costs over net equity
- Equity method accounting used for investments with significant influence (>20% ownership)
Assets:
- Categorized as current and non-current
- Available-for-sale securities carried at fair value
- Unrealized gains/losses recorded in comprehensive income
- Regular evaluation for other-than-temporary impairment
Liabilities:
- Listed as current liabilities on consolidated balance sheet
- Interest expense for tax matters recorded separately
- Tax penalties included in income tax provision
- No U.S. federal tax provision on indefinitely reinvested foreign earnings
- Cash and equivalents classified based on availability and maturity
- Fair value measurements organized in three-level hierarchy
The statement follows standard accounting practices with clear categorization of financial elements and emphasis on fair value measurements.
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Claude
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ACCOUNTING FIRM To the Board of Directors and Shareholders of Biglari Holdings Inc. San Antonio, Texas We have audited the accompanying consolidated balance sheets of Biglari Holdings Inc. and subsidiaries (the "Company") as of December 31, 2016 and 2015, and the related consolidated statements of earnings, comprehensive income, changes in shareholders' equity, and cash flows for the years ended December 31, 2016 and December 31, 2015, for the period from September 25, 2014 to December 31, 2014 and year ended September 24, 2014. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Biglari Holdings Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for the years ended December 31, 2016, December 31, 2015, for the period from September 25, 2014 to December 31, 2014 and year ended September 24, 2014, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 3 to the consolidated financial statements, during the years ended December 31, 2016, December 31, 2015 and September 24, 2014, the Company contributed cash and securities with an aggregate value of $19.8 million, $88.5 million and $174.4 million, respectively to investment partnerships. The Company and its subsidiaries have invested in the investment partnerships in the form of limited partner interests. These investments are subject to a rolling five-year lock up period under the terms of the respective partnership agreements for the investment partnerships. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2016, based on Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2017 expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/ DELOITTE & TOUCHE LLP Indianapolis, Indiana February 25, 2017 ACCOUNTING FIRM To the Board of Directors and Shareholders of Biglari Holdings Inc. San Antonio, Texas We have audited the internal control over financial reporting of Biglari Holdings Inc. and subsidiaries (the "Company") as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2016 of the Company and our report dated February 25, 2017 expressed an unqualified opinion on those financial statements and included an emphasis of matter paragraph relating to the contribution of cash and securities to investment partnerships. /s/ DELOITTE & TOUCHE LLP Indianapolis, Indiana February 25, 2017 Management’s Report on Internal Control Over Financial Reporting The management of Biglari Holdings Inc. is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. Pursuant to the rules and regulations of the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers, and effected by the board of directors, management and other personnel, to provide assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that: • Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the Company; • Provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and • Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. Because of inherent limitations, a system of internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2016 based on the criteria set forth in a report entitled Internal Control - Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, we have concluded that, as of December 31, 2016, our internal control over financial reporting is effective based on those criteria. The Company’s independent registered public accounting firm, Deloitte & Touche LLP, has issued an audit report on the Company’s internal control over financial reporting as of December 31, 2016 and its report is included herein. Biglari Holdings Inc. February 25, 2017 BIGLARI HOLDINGS INC. CONSOLIDATED BALANCE SHEETS (dollars in thousands) See accompanying . BIGLARI HOLDINGS INC. CONSOLIDATED STATEMENTS OF EARNINGS (dollars in thousands except per-share amounts) See accompanying . BIGLARI HOLDINGS INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (dollars in thousands) See accompanying . BIGLARI HOLDINGS INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (dollars in thousands) See accompanying . BIGLARI HOLDINGS INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (dollars in thousands) See accompanying . BIGLARI HOLDINGS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Years Ended December 31, 2016 and 2015) (Transition Periods Ended December 31, 2014 and 2013) (Fiscal Year Ended September 24, 2014) (dollars in thousands, except share and per-share data) Note 1. Summary of Significant Accounting Policies Description of Business Biglari Holdings Inc. is a holding company owning subsidiaries engaged in a number of diverse business activities, including media, property and casualty insurance, and restaurants. The Company’s largest operating subsidiaries are involved in the franchising and operating of restaurants. Biglari Holdings is founded and led by Sardar Biglari, Chairman and Chief Executive Officer of Biglari Holdings and its major operating subsidiaries. The Company’s long-term objective is to maximize per-share intrinsic value. All major operating, investment, and capital allocation decisions are made for the Company and its subsidiaries by Mr. Biglari. As of December 31, 2016, Mr. Biglari’s beneficial ownership of the Company’s outstanding common stock was approximately 51.3%. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries including Steak n Shake Inc. (“Steak n Shake”) and Western Sizzlin Corporation (“Western”). The consolidated financial statements also include the accounts of Maxim Inc. (“Maxim”) and First Guard Insurance Company and its agency, 1st Guard Corporation (collectively “First Guard”) from the dates of their respective acquisitions during 2014. Intercompany accounts and transactions have been eliminated in consolidation. Fiscal Year In 2014, the Company’s Board of Directors approved a change in the Company’s fiscal year-end moving from the last Wednesday in September to December 31 of each year. This form 10-K includes an audited statement of earnings, statement of comprehensive income, statement of cash flows and statement of shareholders’ equity for the years ended December 31, 2016 and 2015, transition period for September 25, 2014 to December 31, 2014 (the “2014 transition period”) and fiscal year ended September 24, 2014, and an audited balance sheet as of December 31, 2016 and 2015. Fiscal year 2014 contained 52 weeks. For comparative purposes, an unaudited statement of earnings, statement of comprehensive income and statement of cash flows have been included for September 26, 2013 to December 31, 2013 (the “2013 transition period”). The comparative transition period has not been audited and is derived from the books and records of the Company. In the opinion of management, the comparative transition period reflects all adjustments necessary to present the financial position and results of operations in accordance with accounting principles generally accepted in the United States (“GAAP”). Business Acquisitions On March 19, 2014, the Company acquired the stock of First Guard, a direct underwriter of commercial trucking insurance, selling physical damage and nontrucking liability insurance to truckers. On February 27, 2014 the Company acquired certain assets and liabilities of Maxim. Maxim’s business lies principally in media and licensing. These acquisitions were not material, individually or in aggregate, to the Company. The fair value of the assets and liabilities acquired - other than investments, goodwill and intangibles - was not material. Cash and Cash Equivalents Cash equivalents primarily consist of U.S. Government securities and money market accounts, all of which have original maturities of three months or less. Cash equivalents are carried at fair value. Investments Our investments consist of available-for-sale securities. Available-for-sale securities are carried at fair value with net unrealized gains or losses reported as a component of accumulated other comprehensive income in shareholders’ equity. Realized gains and losses on disposals of investments are determined by specific identification of cost of investments sold and are included in investment gains/losses, a component of other income. (continued) Note 1. Summary of Significant Accounting Policies (continued) Investment Partnerships The Company holds a limited interest in The Lion Fund, L.P. and The Lion Fund II, L.P. (collectively the “investment partnerships”). Biglari Capital Corp. (“Biglari Capital”), an entity solely owned by Mr. Biglari, is the general partner of the investment partnerships. Our interests in the investment partnerships are accounted as equity method investments because of our retained limited partner interests. The Company records investment partnership gains (inclusive of the investment partnerships’ unrealized gains and losses on their securities) as a component of other income based on our proportional ownership interest in the partnerships. The investment partnerships are for purposes of GAAP, investment companies under the AICPA Audit and Accounting Guide Investment Companies. Concentration of Equity Price Risk The majority of our investments are conducted through investment partnerships which generally hold common stocks. We also hold marketable securities directly. Through the investment partnerships we hold a concentrated position in the common stock of Cracker Barrel Old Country Store, Inc. A significant decline in the general stock market or in the prices of major investments may have a materially adverse effect on our earnings and on consolidated shareholders’ equity. Receivables Our accounts receivable balance consists primarily of franchisee, customer, and other receivables. We carry our accounts receivable at cost less an allowance for doubtful accounts, which is based on a history of past write-offs and collections and current credit conditions. Allowance for doubtful accounts was $1,734 at December 31, 2016 and $2,378 at December 31, 2015. Amounts charged to expense and deductions from the allowance in 2016 and 2015, in the 2014 and 2013 transition periods and in fiscal year 2014 were insignificant. Inventories Inventories are valued at the lower of cost (first-in, first-out method) or market, and consist primarily of restaurant food items and supply inventory. Property and Equipment Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are recognized on the straight-line method over the estimated useful lives of the assets (10 to 30 years for buildings and land improvements, and 3 to 10 years for equipment). Leasehold improvements are amortized on the straight-line method over the shorter of the estimated useful lives of the improvements or the term of the related leases. Interest costs associated with the construction of new restaurants are capitalized. Major improvements are also capitalized while repairs and maintenance are expensed as incurred. We review our long-lived assets whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. For purposes of this assessment, assets are evaluated at the lowest level for which there are identifiable cash flows. If the future undiscounted cash flows of an asset are less than the recorded value, an impairment is recorded for the difference between the carrying value and the estimated fair value of the asset. Goodwill and Other Intangible Assets Goodwill and indefinite life intangibles are not amortized, but are tested for potential impairment on an annual basis, or more often if events or circumstances change that could cause goodwill or indefinite life intangibles to become impaired. Other purchased intangible assets are amortized over their estimated useful lives, generally on a straight-line basis. We perform reviews for impairment of intangible assets whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. An impairment loss is recognized when estimated future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying value. When an impairment is identified, we reduce the carrying value of the asset to its estimated fair value. No impairments were recorded on goodwill or intangibles during 2016, 2015, the 2014 and 2013 transition periods, or during fiscal year 2014. Refer to Note 6 for information regarding our goodwill and other intangible assets. (continued) Note 1. Summary of Significant Accounting Policies (continued) Operating Leases The Company leases certain property under operating leases. Many of these lease agreements contain rent holidays, rent escalation clauses and/or contingent rent provisions. Rent expense is recognized on a straight-line basis over the expected lease term, including cancellable option periods when failure to exercise such options would result in an economic penalty. In addition, the rent commencement date of the lease term is the earlier due date when we become legally obligated for the rent payments, the date when we take access to the property, or the grounds for build out. Common Stock and Treasury Stock The Company’s common stock is $0.50 stated value. The following table presents shares authorized, issued and outstanding. Purchases of Equity Securities Shares of the Company’s common stock acquired by the investment partnerships are presented below. Revenue Recognition Restaurant operations We record revenue from restaurant sales at the time of sale, net of discounts. Revenue from the sale of gift cards is deferred at the time of sale and recognized either upon redemption by the customer or at expiration of the gift cards. Sales revenues are presented net of sales taxes. Unit franchise fees and area development fees are recorded as revenue when said-related restaurant begins operations. Royalty fees and administrative services fees based on franchise sales are recognized as revenue as earned. License revenue and rental revenues are recognized as revenue when earned. (continued) Note 1. Summary of Significant Accounting Policies (continued) Restaurant operations revenues were as follows. Insurance premiums and commissions Insurance premiums are earned over the terms of the related policies. Expenses incurred in connection with acquiring new insurance business, including acquisition costs, are charged to operations as incurred. Premiums earned are stated net of amounts ceded to reinsurer. Media advertising and other Magazine subscription and advertising revenues are recognized at the magazine cover date. The unearned portion of magazine subscriptions is deferred until the magazine’s cover date, at which time a proportionate share of the gross subscription price is recognized as revenues, net of any commissions paid to subscription agents. Also included in subscription revenues are revenues generated from single-copy sales of magazines through retail outlets such as newsstands, supermarkets, convenience stores and drugstores and on certain digital devices, which may or may not result in future subscription sales. Revenues from retail outlet sales are recognized based on gross sales less a provision for estimated returns. License revenue is recognized when earned. We derive value and revenues from intellectual property assets through a range of licensing and business activities, including licensing and syndication of our trademarks and copyrights in the United States and internationally. Restaurant Cost of Sales Cost of sales includes the cost of food, restaurant operating costs and restaurant rent expense. Cost of sales excludes depreciation and amortization, which is presented as a separate line item on the consolidated statement of earnings. Insurance Losses and Underwriting Expenses Liabilities for estimated unpaid losses and loss adjustment expenses with respect to claims occurring on or before the balance sheet date are established under insurance contracts issued by our insurance subsidiaries. Such estimates include provisions for reported claims or case estimates, provisions for incurred-but-not-reported claims and legal and administrative costs to settle claims. The estimates of unpaid losses and amounts recoverable under reinsurance are established and continually reviewed by using a variety of actuarial, statistical and analytical techniques. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify policyholders with respect to the underlying insurance contracts. Liabilities for insurance losses of $1,937 and $2,796 are included in accrued expenses in the consolidated balance sheet as of December 31, 2016 and 2015, respectively. Earnings Per Share Earnings per share of common stock is based on the weighted average number of shares outstanding during the year. In fiscal year 2014, Biglari Holdings completed an offering of transferable subscription rights. The offering was oversubscribed and 344,261 new shares of common stock were issued. The Company received net proceeds of $85,873 from the offering. The shares of Company stock attributable to our limited partner interest in the investment partnerships - based on our proportional ownership during this period - are considered treasury stock on the consolidated balance sheet and thereby deemed not to be included in the calculation of weighted average common shares outstanding. However, these shares are legally outstanding. (continued) Note 1. Summary of Significant Accounting Policies (continued) The following table presents a reconciliation of basic and diluted weighted average common shares. Marketing Expense Advertising costs are charged to expense at the later of the date the expenditure is incurred or the date the promotional item is first communicated. Marketing expense is included in selling, general and administrative expenses in the consolidated statement of earnings. Insurance Reserves We self-insure a significant portion of expected losses under our workers’ compensation, general liability, auto, directors’ and officers’ and medical liability insurance programs, and record a reserve for our estimated losses on all unresolved open claims and our estimated incurred but not reported claims at the anticipated cost to us. Insurance reserves are recorded in accrued expenses in the consolidated balance sheet. Savings Plans Several of our subsidiaries also sponsor deferred compensation and defined contribution retirement plans, such as 401(k) or profit sharing plans. Employee contributions to the plans are subject to regulatory limitations and the specific plan provisions. Some of the plans allow for discretionary contributions as determined by management. Employer contributions expensed with respect to these plans were not material. Foreign Currency Translation The Company has certain subsidiaries located in foreign jurisdictions. For subsidiaries whose functional currency is other than the U.S. dollar, the translation of functional currency statements to U.S. dollar statements uses end-of-period exchange rates for assets and liabilities, weighted average exchange rates for revenue and expenses, and historical rates for equity. The resulting currency translation adjustment is recorded in accumulated other comprehensive income, as a component of equity. Use of Estimates Preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from the estimates. (continued) Note 1. Summary of Significant Accounting Policies (continued) New Accounting Standards In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. ASU 2017-04 provides for the elimination of Step 2 from the goodwill impairment test. If impairment charges are recognized, the amount recorded will be the amount by which the carrying amount exceeds the reporting unit’s fair value with certain limitations. The ASU is effective for public companies for annual periods, and interim periods within those annual periods, beginning after December 15, 2020. The Company does not currently anticipate ASU 2017-04 to have a material impact on the consolidated financial statements. In October 2016, the FASB issued ASU 2016-17, Interests Held through Related Parties That Are under Common Control. ASU 2016-17 amends the consolidation guidance in ASU 2015-02 regarding the treatment of indirect interests held through related parties that are under common control. We are currently assessing the impact of ASU 2016-17, but do not expect the adoption to have a material effect on our consolidated financial statements. The amendments in this update are effective for annual reporting periods beginning after December 15, 2016 and interim periods within those years. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The objective of the update is to reduce diversity in how certain transactions are classified in the statement of cash flows. The amendments in this update are effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company is currently evaluating the impact the adoption of ASU 2016-15 will have on its consolidated financial statements and related disclosures. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Topic 326 amends guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. For available for sale debt securities, credit losses should be measured in a manner similar to current GAAP; however, Topic 326 will require that credit losses be presented as an allowance rather than as a write-down. The amendments in this update are effective for financial statements issued for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The Company is currently evaluating the impact the adoption of ASU 2016-13 will have on its consolidated financial statements and related disclosures. In February 2016, the FASB issued ASU 2016-02 Leases. ASU 2016-02 requires a lessee to recognize lease assets and lease liabilities on the balance sheet, along with additional qualitative and quantitative disclosures. ASU 2016-02 is effective for annual and interim periods beginning after December 15, 2018, with early adoption permitted. We are currently evaluating the effect this amended guidance will have on our results of operations. We anticipate the ASU will have a material impact on our balance sheet, but the ASU is non-cash in nature and will not affect our cash position. In November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes. The new guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent deferred tax asset or liability. The amendments in this update are effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early application is permitted. The Company adopted ASU 2015-17 on January 1, 2016. As of December 31, 2015, the Company reclassified $13,263 from current deferred tax asset to noncurrent deferred tax liability to conform to the current year classification. In April 2015, the FASB issued ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. The update requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. The amendments are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. The Company adopted ASU 2015-03 on January 1, 2016. As of December 31, 2015, the Company reclassified $688 from other current assets to current portion of notes payable and other borrowings. The Company also reclassified $2,888 from other assets to other borrowings and long-term notes payable to conform to the current year classification. In February 2015, the FASB issued ASU 2015-02, Amendments to the Consolidations Analysis. The amendments in this update provide guidance under GAAP about limited partnerships, which will be variable interest entities, unless the limited partners have either substantive kick-out rights or participation rights. The amendments in this update are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2015. The Company adopted the provisions of ASU 2015-02 on January 1, 2016. The adoption of this update had no material effect on the Company’s financial statements. (continued) Note 1. Summary of Significant Accounting Policies (continued) In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements-Going Concern. The amendments in this update provide guidance in GAAP about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. In doing so, the amendments should reduce diversity in the timing and content of footnote disclosures. The amendments in this update are effective for annual periods ending after December 15, 2016, and for annual periods and interim periods thereafter. The Company adopted the provisions of ASU 2014-15 on December 31, 2016. The adoption of this update had no material effect on the Company’s financial statements. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This update provides a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. The guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. In July 2015, the FASB voted to defer the effective date of this ASU by one year, which would make the guidance effective for our first quarter fiscal year 2018 financial statements using either of two acceptable adoption methods: (i) retrospective adoption to each prior reporting period presented with the option to elect certain practical expedients; or (ii) adoption with the cumulative effect of initially applying the guidance recognized at the date of initial application and providing certain additional disclosures. We currently expect to adopt ASU 2014-09 as of January 1, 2018 under the modified retrospective method where the cumulative effect is recognized at the date of initial application. Our evaluation of ASU 2014-09 is ongoing and not complete. The FASB has issued, and may issue in the future, interpretative guidance that may cause our evaluation to change. While we anticipate some changes to revenue recognition for certain transactions, we do not currently believe ASU 2014-09 will have a material effect on our consolidated financial statements. Reclassifications Reclassifications were made to our 2015 consolidated financial statements to conform with current period presentation. Such changes included the retrospective impact upon adoption of ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, and ASU 2015-17, Balance Sheet Classification of Deferred Taxes as discussed in New Accounting Standards within note 1. Additionally, the Company consolidated accounts payable and accrued expenses into a single line item on the balance sheet at December 31, 2016 and changed the December 31, 2015 presentation to conform. Note 2. Investments Investments consisted of the following. Investment gains/losses are recognized when investments are sold (as determined on a specific identification basis) or as otherwise required by GAAP. The timing of realized gains and losses from sales can have a material effect on periodic earnings. However, such realized gains or losses usually have little, if any, impact on total shareholders’ equity because the investments are carried at fair value with any unrealized gains/losses included as a component of accumulated other comprehensive income in shareholders’ equity. We believe that realized investment gains/losses are often meaningless in terms of understanding reported results. Short-term investment gains/losses have caused and may continue to cause significant volatility in our results. In connection with the acquisition of First Guard during fiscal year 2014, we acquired $15,043 of investments. Note 3. Investment Partnerships The Company reports on the limited partnership interests in investment partnerships under the equity method of accounting. We record our proportional share of equity in the investment partnerships but exclude Company common stock held by said partnerships. The Company’s pro-rata share of its common stock held by the investment partnerships is recorded as treasury stock even though they are legally outstanding. The Company records gains/losses from investment partnerships (inclusive of the investment partnerships’ unrealized gains and losses on their securities) in the consolidated statements of earnings based on our carrying value of these partnerships. The fair value is calculated net of the general partner’s accrued incentive fees. Gains and losses on Company common stock included in the earnings of these partnerships are eliminated because they are recorded as treasury stock. (continued) Note 3. Investment Partnerships (continued) The fair value and adjustment for Company common stock held by the investment partnerships to determine carrying value of our partnership interest is presented below. The Company recognized a pre-tax loss of $306 ($193 net of tax) on a contribution of $5,682 in securities to investment partnerships during 2016. The Company recognized a pre-tax gain of $29,524 ($18,305 net of tax) on a contribution of $74,418 in securities to investment partnerships during fiscal year 2014. The gain had a material accounting effect on the Company’s fiscal year 2014 earnings. However, the gain had no impact on total shareholders’ equity because the investments were carried at fair value prior to the contribution, with the unrealized gains included as a component of accumulated other comprehensive income. The carrying value of the investment partnerships net of deferred taxes is presented below. The Company’s proportionate share of Company stock held by investment partnerships at cost is $341,930 and $332,827 at December 31, 2016 and 2015, respectively, and is recorded as treasury stock. The carrying value of the partnership interest approximates fair value adjusted by the value of held Company stock. Fair value is according to our proportional ownership interest of the fair value of investments held by the investment partnerships. The fair value measurement is classified as level 3 within the fair value hierarchy. (continued) Note 3. Investment Partnerships (continued) Gains/losses from investment partnerships recorded in the Company’s consolidated statements of earnings are presented below. On December 31 of each year, the general partner of the investment partnerships, Biglari Capital, will earn an incentive reallocation fee for the Company’s investments equal to 25% of the net profits above an annual hurdle rate of 6% over the previous high-water mark. Our policy is to accrue an estimated incentive fee throughout the year. The total incentive reallocation from Biglari Holdings to Biglari Capital includes gains on the Company’s common stock. Gains and losses on the Company’s common stock and the related incentive reallocations are eliminated in our financial statements. Our investments in these partnerships are committed on a rolling 5-year basis. The incentive reallocations from Biglari Holdings to Biglari Capital on December 31 are presented below. Summarized financial information for The Lion Fund, L.P. and The Lion Fund II, L.P. is presented below. Revenue in the above summarized financial information of the investment partnerships includes investment income and unrealized gains and losses on investments. (continued) Note 4. Other Current Assets Other current assets include the following. Note 5. Property and Equipment Property and equipment is composed of the following. Depreciation and amortization expense for property and equipment for 2016 and 2015 was $21,635 and $24,113, respectively. Depreciation and amortization expense for property and equipment for the 2014 and 2013 transition periods was $6,380 and $6,105, respectively. Depreciation and amortization expense for property and equipment for fiscal year 2014 was $23,112. Note 6. Goodwill and Other Intangibles Goodwill Goodwill consists of the excess of the purchase price over the fair value of the net assets acquired in connection with business acquisitions. A reconciliation of the change in the carrying value of goodwill is as follows. We are required to assess goodwill and any indefinite-lived intangible assets for impairment annually, or more frequently if circumstances indicate impairment may have occurred. When evaluating goodwill for impairment, we may first perform a qualitative assessment to determine whether it is more likely than not that a reporting unit is impaired. If we do not perform a qualitative assessment, or if we determine that it is not more likely than not that the fair value of the reporting unit exceeds its carrying amount, we test for potential impairment using a two-step approach. The first is the estimation of fair value of each reporting unit. If step one indicates that impairment potentially exists, the second step is performed to measure the amount of impairment, if any. Goodwill impairment occurs when the estimated fair value of goodwill is less than its carrying value. (continued) Note 6. Goodwill and Other Intangibles (continued) The valuation methodology and underlying financial information included in our determination of fair value require significant management judgments. We use both market and income approaches to derive fair value. The judgments in these two approaches include, but are not limited to, comparable market multiples, long-term projections of future financial performance, and the selection of appropriate discount rates used to determine the present value of future cash flows. Changes in such estimates or the application of alternative assumptions could produce significantly different results. No impairment charges for goodwill were recorded in 2016, 2015, the 2014 or 2013 transition periods or in fiscal year 2014. Other Intangibles Other intangibles are composed of the following. Intangible assets subject to amortization consist of franchise agreements connected with the purchase of Western as well as rights to favorable leases related to prior acquisitions. These intangible assets are being amortized over their estimated weighted average of useful lives ranging from eight to twelve years. Amortization expense for 2016 and 2015 was $571 and $574, respectively. Amortization expense for the 2014 and 2013 transition periods was $151 and $169, respectively. Amortization expense for fiscal year 2014 was $690. The Company’s intangible assets with definite lives will fully amortize in 2020. Total annual amortization expense for each of the next four years will approximate $500. The Company purchased perpetual lease rights during 2016 totaling $3,367 and recorded an additional $1,657 indefinite life asset associated with the tax effect of the asset acquisition. The Company acquired Maxim and First Guard during fiscal year 2014. As a result of the acquisitions during fiscal year 2014, $15,876 of the purchase prices were allocated to intangible assets with indefinite lives. Intangible assets with indefinite lives consist of trade names, franchise rights as well as lease rights. (continued) Note 7. Accounts Payable and Accrued Expenses Accounts payable and accrued expenses include the following. Note 8. Other Liabilities Other liabilities include the following. Note 9. Income Taxes The components of the provision for income taxes consist of the following. Income taxes paid during 2016 and 2015 was $6,961 and $2,063, respectively. Income taxes paid for the 2014 transition period was $22. Income taxes paid totaled $4,829 in fiscal year 2014. Income tax refunds totaled $233 in 2016, $16 in 2015 and $17 in fiscal year 2014. (continued) Note 9. Income Taxes (continued) As of December 31, 2016, we had approximately $396 of unrecognized tax benefits, including approximately $20 of interest and penalties, which are included in other long-term liabilities in the consolidated balance sheet. As of December 31, 2015, we had approximately $413 of unrecognized tax benefits, including approximately $35 of interest and penalties, which are included in other long-term liabilities in the consolidated balance sheet. We recognized approximately $20 and $6 in potential interest and penalties associated with uncertain tax positions during 2015 and the 2014 transition period, respectively. Our continuing practice is to recognize interest expense and penalties related to income tax matters in income tax expense. The unrecognized tax benefits of $396 would impact the effective income tax rate if recognized. Adjustments to the Company’s unrecognized tax benefit for gross increases for current period tax position, gross decreases for prior period tax positions and the lapse of statute of limitations during 2016, 2015, the 2014 transition period and fiscal 2014 were not significant. We file income tax returns which are periodically audited by various foreign, federal, state, and local jurisdictions. With few exceptions, we are no longer subject to federal, state, and local tax examinations for fiscal years prior to 2013. We believe we have certain state income tax exposures related to fiscal years 2012 through 2015. Because of the expiration of the various state statutes of limitations for these fiscal years, it is possible that the total amount of unrecognized tax benefits will decrease by approximately $47 within 12 months. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws that will be in effect when the differences are expected to reverse. Our deferred tax assets and liabilities consist of the following. Accounts payable and accrued expenses on the consolidated balance sheet include income taxes payable of $1,060 as of December 31, 2016. Receivables on the consolidated balance sheet include income tax receivables of $559 as of December 31, 2015. (continued) Note 10. Notes Payable and Other Borrowings Notes payable and other borrowings include the following. Steak n Shake Credit Facility On March 19, 2014, Steak n Shake and its subsidiaries entered into a new credit agreement. This credit agreement provides for a senior secured term loan facility in an aggregate principal amount of $220,000 and a senior secured revolving credit facility in an aggregate principal amount of up to $30,000. The term loan is scheduled to mature on March 19, 2021. It amortizes at an annual rate of 1.0% in equal quarterly installments, beginning June 30, 2014, at 0.25% of the original principal amount of the term loan, subject to mandatory prepayments from excess cash flow, asset sales and other events described in the credit agreement. The balance will be due at maturity. The revolver will be available on a revolving basis until March 19, 2019. Steak n Shake has the right to request an incremental term loan facility from participating lenders and/or eligible assignees at any time, up to an aggregate total principal amount not to exceed $70,000 if certain customary conditions within the credit agreement are met. Borrowings bear interest at a rate per annum equal to a base rate or a Eurodollar rate (minimum of 1%) plus an applicable margin. Interest on the term loan is based on a Eurodollar rate plus an applicable margin of 3.75% or on the prime rate plus an applicable margin of 2.75%. Interest on loans under the revolver is based on a Eurodollar rate plus an applicable margin ranging from 2.75% to 4.25% or on the prime rate plus an applicable margin ranging from 1.75% to 3.25%. The applicable margins on revolver loans are contingent on Steak n Shake’s total leverage ratio. The revolver also carries a commitment fee ranging from 0.40% to 0.50% per annum, according to Steak n Shake’s total leverage ratio, on the unused portion of the revolver. The interest rate on the term loan was 4.75% on December 31, 2016. The credit agreement includes customary affirmative and negative covenants and events of default, as well as a financial maintenance covenant, solely with respect to the revolver, relating to the maximum total leverage ratio. Steak n Shake’s credit facility contains restrictions on its ability to pay dividends to Biglari Holdings. (continued) Note 10. Notes Payable and Other Borrowings (continued) Both the term loan and the revolver have been secured by first priority security interests in substantially all the assets of Steak n Shake. Biglari Holdings is not a guarantor under the credit facility. Approximately $118,589 of the proceeds of the term loan were used to repay all outstanding amounts under Steak n Shake’s former credit facility and to pay related fees and expenses, $50,000 of such proceeds were used to pay a cash dividend to Biglari Holdings, and the remaining term loan proceeds of approximately $51,411 are being used by Steak n Shake for working capital and general corporate purposes. As of December 31, 2016, $203,098 was outstanding under the term loan, and no amount was outstanding under the revolver. We recorded losses of $1,133 in interest expense for the extinguishment of debt for fiscal year 2014 related to the write-off of deferred loan costs associated with former credit facilities. We capitalized $4,754 in debt issuance costs in fiscal year 2014. We had $10,893 and $10,188 in standby letters of credit outstanding as of December 31, 2016 and 2015, respectively. Western Revolver As of December 31, 2016, Western has $377 due June 13, 2017. Expected principal payments for notes payable and Western’s revolver as of December 31, 2016, are as follows. The carrying amounts for debt reported in the consolidated balance sheet did not differ materially from the fair values at December 31, 2016 and 2015. The fair value was determined to be a Level 3 fair value measurement. Interest Interest paid on debt and obligations under leases are as follows. (continued) Note 11. Leased Assets and Lease Commitments We lease certain physical facilities under non-cancelable lease agreements. These leases require the payment of real estate taxes, insurance and maintenance costs. Certain leased facilities, which are no longer operated but are subleased to third parties or franchisees, are classified below as non-operating properties. Minimum future rental payments for non-operating properties have not been reduced by minimum sublease rentals of $9,518 related to operating leases receivable under non-cancelable subleases. The property and equipment cost related to finance obligations and capital leases as of December 31, 2016 is as follows: $69,947 buildings, $59,039 land, $27,705 land and leasehold improvements, $1,246 equipment and $74,705 accumulated depreciation. On December 31, 2016, obligations under non-cancelable finance obligations, capital leases, and operating leases (excluding real estate taxes, insurance and maintenance costs) require the following minimum future rental payments. Rent expense is presented below. Non-cancellable finance obligations were created when the Company, under prior management, entered into certain build-to-suit or sale leaseback arrangements. As a result of continuing involvement in the underlying leases (generally due to right of substitution or purchase option provisions of the leases), the Company accounts for the leases as financings. (continued) Note 12. Related Party Transactions Shared Services Agreement During fiscal 2013, Biglari Holdings and Biglari Capital entered into the Shared Services Agreement pursuant to which Biglari Holdings provides certain services to Biglari Capital. Biglari Capital is solely owned by Mr. Biglari. The Shared Services Agreement runs for an initial five-year term, and automatically renews for successive five-year periods, unless terminated by either party effective at the end of the initial or the renewed term, as applicable. The term of the Shared Services Agreement coincides with the lock-up period for the Company’s investments in The Lion Fund, L.P. and The Lion Fund II, L.P. under their respective partnership agreements. During 2016, 2015, 2014 transition period, and fiscal year 2014, the Company provided services for Biglari Capital under the Shared Services Agreement costing an aggregate of $1,372, $4,425, $44, and $1,590, respectively. Investments in The Lion Fund, L.P. and The Lion Fund II, L.P. As of December 31, 2016, the Company’s investments in The Lion Fund, L.P. and The Lion Fund II, L.P. had a fair value of $972,707. Contributions to and distributions from The Lion Fund, L.P. and The Lion Fund II, L.P. were as follows. As the general partner of the investment partnerships, Biglari Capital on December 31 of each year will earn an incentive reallocation fee for the Company’s investments equal to 25% of the net profits above an annual hurdle rate of 6%. Our policy is to accrue an estimated incentive fee throughout the year. Gains on the Company’s common stock and incentive reallocations on gains on Company common stock are eliminated in our financial statements. Based on Biglari Holdings’ $280,563 of earnings from the investment partnerships for 2016, the total incentive reallocation from Biglari Holdings to Biglari Capital was $31,628, including $11,514 associated with gains on the Company’s common stock. For 2015, the incentive reallocation from Biglari Holdings to Biglari Capital was $23, all of which was associated with gains on the Company’s common stock. Based on Biglari Holdings’ $166,168 of earnings from the investment partnerships for calendar year 2014, the total incentive reallocation from Biglari Holdings to Biglari Capital was $34,406. Incentive Agreement Amendment During 2013, Biglari Holdings and Mr. Biglari entered into an amendment to the Incentive Agreement to exclude earnings by the investment partnerships from the calculation of Mr. Biglari’s incentive bonus. No incentive fees were paid for 2016, 2015, the 2014 transition period or fiscal year 2014. Under the Amended and Restated Incentive Agreement Mr. Biglari would receive a payment of approximately $14,700 if an event occurred entitling him to a severance payment. License Agreement On January 11, 2013, the Company entered into a Trademark License Agreement (the “License Agreement”) with Mr. Biglari. The License Agreement was unanimously approved by the Governance, Nominating and Compensation Committee. In addition, the license under the License Agreement is provided on a royalty-free basis in the absence of specified extraordinary events described below. Accordingly, the Company and its subsidiaries have paid no royalties to Mr. Biglari under the License Agreement since its inception. (continued) Note 12. Related Party Transactions (continued) Under the License Agreement, Mr. Biglari granted to the Company an exclusive license to use the Biglari and Biglari Holdings names (the “Licensed Marks”) in association with various products and services (collectively the “Products and Services”). Upon (a) the expiration of twenty years from the date of the License Agreement (subject to extension as provided in the License Agreement), (b) Mr. Biglari’s death, (c) the termination of Mr. Biglari’s employment by the Company for Cause (as defined in the License Agreement), or (d) Mr. Biglari’s resignation from his employment with the Company absent an Involuntary Termination Event (as defined in the License Agreement), the Licensed Marks for the Products and Services will transfer from Mr. Biglari to the Company, without any compensation, if the Company is continuing to use the Licensed Marks in the ordinary course of its business. Otherwise, the rights will revert to Mr. Biglari. If (i) a Change of Control (as defined in the License Agreement) of the Company; (ii) the termination of Mr. Biglari’s employment by the Company without Cause; or (iii) Mr. Biglari’s resignation from his employment with the Company due to an Involuntary Termination Event (each, a “Triggering Event”) were to occur, Mr. Biglari would be entitled to receive a 2.5% royalty on “Revenues” with respect to the “Royalty Period.” The royalty payment to Mr. Biglari would not apply to all revenues received by Biglari Holdings and its subsidiaries nor would it apply retrospectively (i.e., to revenues received with respect to the period prior to the Triggering Event). The royalty would apply to revenues recorded by the Company on an accrual basis under GAAP, solely with respect to the defined period of time after the Triggering Event equal to the Royalty Period, from a covered Product, Service or business that (1) has used the Biglari Holdings or Biglari name at any time during the term of the License Agreement, whether prior to or after a Triggering Event, or (2) the Company has specifically identified, prior to a Triggering Event, will use the name Biglari or Biglari Holdings. “Revenues” means all revenues received, on an accrual basis under GAAP, by the Company, its subsidiaries and affiliates from the following: (1) all Products and Services covered by the License Agreement bearing or associated with the names Biglari and Biglari Holdings at any time (whether prior to or after a Triggering Event). This category would include, without limitation, the use of Biglari or Biglari Holdings in the public name of a business providing any covered Product or Service; and (2) all covered Products, Services and businesses that the Company has specifically identified, prior to a Triggering Event, will bear, use or be associated with the name Biglari or Biglari Holdings. The Governance, Nominating and Compensation Committee unanimously approved the association of the Biglari name and mark with all of Steak n Shake’s restaurants (including Company operated and franchised locations), products and brands. On May 14, 2013, the Company, Steak n Shake, LLC and Steak n Shake Enterprises, Inc. entered into a Trademark Sublicense Agreement in connection therewith. Accordingly, revenues received by the Company, its subsidiaries and affiliates from Steak n Shake’s restaurants, products and brands would come within the definition of Revenues for purposes of the License Agreement. The “Royalty Period” is a defined period of time, after the Triggering Event, calculated as follows: (i) if, following three months after a Triggering Event, the Company or any of its subsidiaries or affiliates continues to use the Biglari or Biglari Holdings name in connection with any covered product or service, or continues to use Biglari as part of its corporate or public company name, then the “Royalty Period” will equal (a) the period of time during which the Company or any of its subsidiaries or affiliates continues any such use, plus (b) a period of time after the Company, its subsidiaries and affiliates have ceased all uses of the names Biglari and Biglari Holdings equal to the length of the term of the License Agreement prior to the Triggering Event, plus three years. As an example, if a Triggering Event occurs five years after the date of the License Agreement, and the Company ceases all uses of the Biglari and Biglari Holdings names two years after the Triggering Event, the Royalty Period will equal a total of ten years (the sum of two years after the Triggering Event during which the Biglari and Biglari Holdings names are being used, plus a period of time equal to the five years prior to the Triggering Event, plus three years); or (ii) if the Company, its subsidiaries and affiliates cease all uses of the Biglari and Biglari Holdings names within three months after a Triggering Event, then the “Royalty Period” will equal the length of the term of the License Agreement prior to the Triggering Event, plus three years. As an example, if a Triggering Event occurs five years after the date of the License Agreement, and the Company ceases all uses of the Biglari and Biglari Holdings names two months after the Triggering Event, the Royalty Period will equal a total of eight years (the sum of the period of time equal to the five years prior to the Triggering Event, plus three years). Notwithstanding the above methods of determining the Royalty Period, the minimum Royalty Period is five years after a Triggering Event. The Company and its subsidiaries have paid no royalties to Mr. Biglari under the License Agreement since its execution. The actual amount of royalties paid to Mr. Biglari following the occurrence of a Triggering Event (as defined in the License Agreement) would depend on the Company’s revenues during the applicable period following the Triggering Event, and, therefore, depends on material assumptions and estimates regarding future operations and revenues. Assuming for purposes of illustration a Triggering Event occurred on December 31, 2016, using revenue from 2016 as an estimate of future revenue and calculated according to terms of the License Agreement, Mr. Biglari would receive approximately $20,300 in royalty payments annually. At a minimum, the royalties would be earned on revenue generated from January 1, 2017 through December 21, 2023. Royalty payments beyond the minimum period would be subject to the licensee's continued use of the licensed marks. (continued) Note 13. Common Stock Plans On March 7, 2008, our shareholders approved the 2008 Equity Incentive Plan. During fiscal 2010, we resolved to suspend, indefinitely, the future issuance of stock-based awards under the 2008 plan. No shares have been granted under the 2008 plan since 2010. The following table summarizes the options activity for 2016. There was no unrecognized stock option compensation cost at December 31, 2016 or 2015. No amounts were charged to expense during 2016, 2015, the 2014 or 2013 transition periods, or during fiscal year 2014. Note 14. Commitments and Contingencies We are involved in various legal proceedings and have certain unresolved claims pending. We believe, based on examination of these matters and experiences to date, that the ultimate liability, if any, in excess of amounts already provided in our consolidated financial statements is not likely to have a material effect on our results of operations, financial position or cash flows. Note 15. Fair Value of Financial Assets and Liabilities The fair values of substantially all of our financial instruments were measured using market or income approaches. Considerable judgment may be required in interpreting market data used to develop the estimates of fair value. Accordingly, the fair values presented are not necessarily indicative of the amounts that could be realized in an actual current market exchange. The use of alternative market assumptions and/or estimation methodologies may have a material effect on the estimated fair value. (continued) Note 15. Fair Value of Financial Assets and Liabilities (continued) The hierarchy for measuring fair value consists of Levels 1 through 3, which are described below. ·Level 1 - Inputs represent unadjusted quoted prices for identical assets or liabilities exchanged in active markets. ·Level 2 - Inputs include directly or indirectly observable inputs (other than Level 1 inputs) such as quoted prices for similar assets or liabilities exchanged in active or inactive markets; quoted prices for identical assets or liabilities exchanged in inactive markets; other inputs that may be considered in fair value determinations of the assets or liabilities, such as interest rates and yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates; and inputs that are derived principally from or corroborated by observable market data by correlation or other means. Pricing evaluations generally reflect discounted expected future cash flows, which incorporate yield curves for instruments with similar characteristics, such as credit ratings, estimated durations and yields for other instruments of the issuer or entities in the same industry sector. ·Level 3 - Inputs include unobservable inputs used in the measurement of assets and liabilities. Management is required to use its own assumptions regarding unobservable inputs because there is little, if any, market activity in the assets or liabilities and we may be unable to corroborate the related observable inputs. Unobservable inputs require management to make certain projections and assumptions about the information that would be used by market participants in pricing assets or liabilities. The following methods and assumptions were used to determine the fair value of each class of the following assets and liabilities recorded at fair value in the consolidated balance sheet: Cash equivalents: Cash equivalents primarily consist of money market funds which are classified within Level 1 of the fair value hierarchy. Equity securities: The Company’s investments in equity securities are classified within Level 1 of the fair value hierarchy. Bonds: The Company’s investments in bonds are classified within Level 2 of the fair value hierarchy. Non-qualified deferred compensation plan investments: The assets of the non-qualified plan are set up in a rabbi trust. They represent mutual funds and are classified within Level 1 of the fair value hierarchy. Derivative instruments: Options related to equity securities are marked to market each reporting period and are classified within Level 2 of the fair value hierarchy. As of December 31, 2016 and December 31, 2015 the fair values of financial assets and liabilities were as follows. There were no changes in our valuation techniques used to measure fair values on a recurring basis. (continued) Note 15. Fair Value of Financial Assets and Liabilities (continued) The Company recorded an impairment to long-lived assets of $695 and $51 during 2016 and 2015, respectively. The Company did not record any impairment during the 2014 transition period. The Company recorded an impairment of $41 during the 2013 transition period. During fiscal year 2014, the Company recorded an impairment to long-lived assets of $1,433. The fair value of the long-lived assets was determined based on Level 2 inputs using quoted prices for similar properties and quoted prices for the properties from brokers. The fair value of the assets impaired was not material for any of the applicable periods. Note 16. Accumulated Other Comprehensive Income Changes in the balances of each component of accumulated other comprehensive income (loss), net of tax, were as follows. (continued) Note 16. Accumulated Other Comprehensive Income (continued) The following reclassifications were made from accumulated other comprehensive income to the consolidated statement of earnings. Note 17. Business Segment Reporting Our reportable business segments are organized in a manner that reflects how management views those business activities. Our restaurant operations includes Steak n Shake and Western. As a result of the acquisitions of First Guard and Maxim, the Company reports segment information for these businesses. Other business activities not specifically identified with reportable business segments are presented in “other” within total operating businesses. We report our earnings from investment partnerships separate from our corporate expenses. We assess and measure segment operating results based on segment earnings as disclosed below. Segment earnings from operations are neither necessarily indicative of cash available to fund cash requirements, nor synonymous with cash flow from operations. The tabular information that follows shows data of our reportable segments reconciled to amounts reflected in the consolidated financial statements. Revenue and earnings (loss) before income taxes for 2016, 2015, transition periods 2014 and 2013, and fiscal year 2014 were as follows. (continued) Note 17. Business Segment Reporting (continued) A disaggregation of our consolidated capital expenditure and depreciation and amortization captions for 2016, 2015, transition periods 2014 and 2013, and fiscal year 2014 is presented in the tables that follow. (continued) Note 17. Business Segment Reporting (continued) A disaggregation of our consolidated asset captions is presented in the table that follows. (continued) Note 18. Quarterly Financial Data (Unaudited) We define gross profit as net revenue less restaurant cost of sales, media cost of sales, and insurance losses and underwriting expenses, which excludes depreciation and amortization. Note 19. Supplemental Disclosures of Cash Flow Information Capital expenditures in accounts payable at December 31, 2016, 2015, 2014 and 2013 were $480, $537, $981 and $409, respectively. Capital expenditures in accounts payable at September 24, 2014 was $2,269. During 2016, we had new capital lease obligations of $258 and lease retirements of $1,006. We did not have any new capital lease obligations or lease retirements during 2015, the 2014 transition period or fiscal year 2014. During 2016, the Company made a non-cash contribution of securities of $5,682 to the investment partnerships and received a non-cash distribution of securities of $4,463 from the investment partnerships. During fiscal 2014, the company made a non-cash contribution of securities of $74,418.
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Based on the provided financial statement excerpt, here's a summary:
Revenue:
- Calculated by subtracting restaurant cost of sales, media cost of sales, and insurance losses from net revenue
- Excludes depreciation and amortization
Profit/Loss:
- Losses are reported in accumulated other comprehensive income within shareholders' equity
- Realized gains/losses from investment disposals are determined by specific cost identification
- Included in investment gains/losses under other income
Expenses:
- Primarily related to media and licensing business
- Recent acquisitions were not considered material
- Fair value of acquired assets and liabilities was not significant
Assets:
- Includes current assets
- Cash and cash equivalents mainly consist of U.S. Government securities and money market accounts
- Investments are available-for-sale securities, carried at fair value
- Unrealized gains/losses reported in shareholders' equity
Liabilities:
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of Sunoco Logistics Partners L.P. (the "Partnership") is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Partnership's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles. The Partnership's management assessed the effectiveness of the Partnership's internal control over financial reporting as of December 31, 2016. In making this assessment, the Partnership's management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in the 2013 Internal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2016, the Partnership's internal control over financial reporting is effective based on those criteria. Grant Thornton LLP, an independent registered public accounting firm, has issued an attestation report on the effectiveness of the Partnership's internal control over financial reporting, which appears in this section. Michael J. Hennigan President and Chief Executive Officer Peter J. Gvazdauskas Chief Financial Officer and Treasurer ACCOUNTING FIRM To the Board of Directors of Sunoco Partners LLC and Limited Partners of Sunoco Logistics Partners L.P. We have audited the internal control over financial reporting of Sunoco Logistics Partners L.P. (a Delaware limited partnership) and subsidiaries (the "Partnership") as of December 31, 2016, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Partnership's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Partnership's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Partnership maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in the 2013 Internal Control-Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Partnership as of and for the year ended December 31, 2016, and our report dated February 24, 2017 expressed an unqualified opinion on those financial statements. /s/ GRANT THORNTON LLP Philadelphia, Pennsylvania February 24, 2017 ACCOUNTING FIRM To the Board of Directors of Sunoco Partners LLC and Limited Partners of Sunoco Logistics Partners L.P. We have audited the accompanying consolidated balance sheets of Sunoco Logistics Partners L.P. (a Delaware limited partnership) and subsidiaries (the "Partnership") as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income, cash flows, and equity for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sunoco Logistics Partners L.P. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Partnership's internal control over financial reporting as of December 31, 2016, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 24, 2017 expressed an unqualified opinion thereon. /s/ GRANT THORNTON LLP Philadelphia, Pennsylvania February 24, 2017 SUNOCO LOGISTICS PARTNERS L.P. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in millions, except per unit amounts) (See Accompanying Notes) SUNOCO LOGISTICS PARTNERS L.P. CONSOLIDATED BALANCE SHEETS (in millions) (See Accompanying Notes) SUNOCO LOGISTICS PARTNERS L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) (See Accompanying Notes) SUNOCO LOGISTICS PARTNERS L.P. CONSOLIDATED STATEMENTS OF EQUITY (in millions) (See Accompanying Notes) SUNOCO LOGISTICS PARTNERS L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Basis of Presentation Sunoco Logistics Partners L.P. (the "Partnership" or "SXL") is a publicly traded Delaware limited partnership that owns and operates a logistics business, consisting of a geographically diverse portfolio of integrated pipeline, terminalling, and acquisition and marketing assets which are used to facilitate the purchase and sale of crude oil, natural gas liquids ("NGLs") and refined products. The Partnership conducts its business activities in 37 states located throughout the United States. Sunoco Partners LLC, a Pennsylvania limited liability company and the general partner of the Partnership, is a consolidated subsidiary of Energy Transfer Partners, L.P. ("ETP"), a publicly traded Delaware limited partnership. On November 20, 2016, SXL and its general partner, Sunoco Partners LLC ("SXL GP"), a Pennsylvania limited liability company, entered into an Agreement and Plan of Merger (the "Merger Agreement") with ETP, together with Energy Transfer Partners GP, L.P. ("ETP GP"), a Delaware limited partnership and the general partner of ETP, and, solely for purposes of certain provisions therein, Energy Transfer Equity, L.P. ("ETE"), a Delaware limited partnership and indirect parent entity of ETP, ETP GP, the Partnership and SXL GP. Upon the terms and subject to the conditions set forth in the Merger Agreement, a wholly owned subsidiary of SXL will merge with ETP (the "Merger"), with ETP continuing as the surviving entity and a wholly-owned subsidiary of SXL. Concurrently with the Merger, SXL GP will merge with ETP GP, with ETP GP continuing as the surviving entity and becoming the general partner of SXL. Following the recommendation of the conflicts committee (the "ETP Conflicts Committee") of the board of directors of ETP's managing general partner (the "ETP Board"), the ETP Board approved and agreed to submit the Merger Agreement to a vote of ETP unitholders and to recommend that ETP's unitholders adopt the Merger Agreement. Following the recommendation of the conflicts committee of the board of directors of SXL GP, the board of directors of SXL GP approved the Merger Agreement. The Merger is expected to close in April 2017. Effective at the time of the Merger, all SXL units, 67.1 million common and 9.4 million Class B, currently held by ETP will be retired. The existing incentive distribution right ("IDR") provisions in the SXL Partnership Agreement will continue to be in effect, and ETE will own the IDRs of SXL following the closing of the transaction. As part of this transaction, ETE has agreed to continue to provide all the IDR subsidies that are currently in effect for both SXL and ETP. In addition, the 364-Day credit facility is expected to be terminated and repaid in connection with the Merger. At the effective time of the Merger, each common unit representing a limited partner interest in ETP issued and outstanding or deemed issued and outstanding as of immediately prior to the effective time of the merger will be converted into the right to receive 1.50 common units representing limited partner interests in SXL (the "SXL Common Units") (the "Merger Consideration"). Each Class E Unit of ETP, each Class G Unit of ETP, each Class I Unit of ETP, each Class J Unit of ETP and each Class K Unit of ETP, if any, issued and outstanding or deemed issued and outstanding as of immediately prior to the effective time of the Merger will be converted into the right to receive a corresponding unit in SXL with the same rights, preferences, privileges, powers, duties and obligations as such existing ETP unit had immediately prior to the Merger. The corresponding units in SXL will be issued pursuant to the Fourth Amended and Restated Partnership Agreement of Sunoco Logistics Partners L.P., which will be executed at the effective time. 2. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements reflect the results of the Partnership and its wholly-owned subsidiaries, including Sunoco Logistics Partners Operations L.P. (the "Operating Partnership"), the proportionate shares of the Partnership's undivided interests in assets, and the accounts of entities in which the Partnership has a controlling financial interest. A controlling financial interest is evidenced by either a voting interest greater than 50 percent or a risk and rewards model that identifies the Partnership or one of its subsidiaries as the primary beneficiary of a variable interest entity. The Partnership currently holds a controlling financial interest in Inland Corporation ("Inland"), Mid-Valley Pipeline Company ("Mid-Valley"), Price River Terminal, LLC ("PRT"), and, effective February 1, 2017, Permian Express Partners LLC ("PEP"), which is a joint venture with ExxonMobil. These entities are reflected as consolidated subsidiaries of the Partnership. Effective November 1, 2016, SunVit Pipeline LLC ("SunVit") became a wholly-owned subsidiary of the Partnership in connection with the acquisition from Vitol Inc. The Partnership is not the primary beneficiary of any variable-interest entities ("VIEs"). All significant intercompany accounts and transactions are eliminated in consolidation and noncontrolling interests in net income and equity are shown separately in the consolidated statements of comprehensive income and balance sheets. Equity ownership interests in joint ventures in which the Partnership does not have a controlling financial interest, but over which the Partnership can exercise significant influence, are accounted for under the equity method of accounting. Use of Estimates The preparation of financial statements in conformity with United States generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. Actual amounts could differ from these estimates. Reclassification Certain amounts in the prior years' consolidated financial statements have been reclassified to conform to the current year presentation. The changes did not impact reported net income for any periods presented. New Accounting Pronouncements In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-02, which created Topic 842, Leases, and will supersede the requirements in Topic 840. The objective of ASU 2016-02 is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Partnership is currently evaluating the impact that it will have on its consolidated financial statements and related disclosures. In May 2014, the FASB codified guidance in ASU 2014-09 related to the recognition of revenue from contracts with customers, and has since released associated clarifying guidance in subsequent periods. The new standards outline the core principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within those reporting periods, with early adoption permitted. The Partnership expects to adopt ASU 2014-09 in the first quarter of 2018 and will apply the cumulative catchup transition method. The Partnership is in the process of evaluating its revenue contracts by segment and fee type to determine the potential impact of adopting the new standards. At this point in the evaluation process, it has been determined that the timing and/or amount of revenue recognized on certain contracts will be impacted by the adoption of the new standard; however, the process of quantifying these impacts is ongoing and an assessment of materiality in relation to the financial statements has not yet been determined. In addition, the Partnership is in the process of implementing appropriate changes to its business processes, systems and controls to support recognition and disclosure under the new standard. The Partnership will continue to monitor for additional authoritative or interpretive guidance related to the new standard as it becomes available, as well as comparing conclusions on specific interpretative issues to other peers in the industry, to the extent that such information is available. Revenue Recognition Pipeline revenues are recognized upon delivery of the barrels to the location designated by the shipper. Acquisition and marketing revenues for crude oil, NGLs and refined products are recognized when title to and risk of loss of the product is transferred to the customer. Terminalling and storage revenues are recognized at the time the services are provided. Revenues are not recognized for exchange transactions, which are entered into primarily to acquire a commodity of a desired quality or to reduce transportation costs by taking delivery closer to the Partnership's end markets. Any net differential for exchange transactions is recorded as an adjustment to cost of products sold in the consolidated statements of comprehensive income. Affiliated revenues are generated from sales of crude oil, NGLs and refined products, as well as pipeline transportation, terminalling and storage services to ETP and its affiliates. Sales of crude oil, NGLs and refined products to affiliated entities are priced using market-based rates. Affiliated entities pay fees for transportation or terminalling services based on the terms and conditions of established agreements or published tariffs. Cash Equivalents The Partnership considers all highly liquid investments with a remaining maturity of three months or less at the time of purchase to be cash equivalents. At December 31, 2016 and 2015, cash equivalents consisted of time deposits and money market investments. Accounts Receivable, Net Accounts receivable represent valid claims against non-affiliated customers (see Note 4 for affiliated receivables) for products sold or services rendered. The Partnership extends credit terms to certain customers after review of various credit indicators, including the customers' credit ratings. Outstanding customer receivable balances are regularly reviewed for possible non-payment indicators and reserves are recorded for doubtful accounts based upon management's expectations regarding collectability. Actual receivable balances are charged against the reserve when all collection efforts have been exhausted. Inventories Inventories are valued at the lower of cost or market. Crude oil, NGLs and refined products inventory costs have been determined using the last-in, first-out method ("LIFO"). Under this methodology, the cost of products sold consists of the actual acquisition costs of the Partnership, which include transportation and storage costs. Such costs are adjusted to reflect increases or decreases in inventory quantities, which are valued based on the changes in the LIFO inventory layers. The cost of materials, supplies and other inventories is principally determined using the average-cost method. During the periods ended December 31, 2016, 2015 and 2014, a lower of cost or market ("LCM") adjustment was applied, as necessary, to the Partnership's crude oil, NGLs and refined products inventories due to changes in commodity prices. Adjustments are calculated based upon current replacement costs. See Notes 6 and 18 for additional information on the LCM reserves and their impact to the Partnership's net income. Properties, Plants and Equipment Properties, plants and equipment are stated at cost. Additions to properties, plants and equipment, including replacements and improvements, are recorded at cost. Repair and maintenance expenditures are charged to expense as incurred. Depreciation is determined principally using the straight-line method based on the estimated useful lives of the related assets. For certain interstate pipelines, the depreciation rate is applied to the net asset value based on the Federal Energy Regulatory Commission's ("FERC") requirements, which approximates the estimated useful lives of the related assets. Capitalized Interest The Partnership capitalizes interest incurred on funds borrowed for certain capital projects and contributions to joint venture interests during periods in which construction activities are in progress to bring those projects to their intended use. Investment in Affiliates Investment in affiliates, which consist of joint ventures in which the Partnership does not have a controlling financial interest, but over which the Partnership can exercise significant influence, are accounted for under the equity method of accounting. Under this method, an investment is carried at cost, adjusted for the equity in income (loss), reduced for dividends received and adjusted for changes in accumulated other comprehensive income (loss). Income recognized from the Partnership's joint venture interests is presented within other income in the consolidated statements of comprehensive income. The Partnership allocates the excess of its investment cost over its equity in the net assets of affiliates to the underlying tangible and intangible assets of the joint ventures. Other than land and indefinite-lived intangible assets, all amounts allocated, principally to pipeline and related assets, are amortized using the straight-line method over their estimated useful life of 40 years. The amortization of these amounts is also presented within other income in the consolidated statements of comprehensive income. Acquisitions The Partnership records third-party business combinations at their estimated fair values as of the date of acquisition. Any excess of consideration transferred plus the fair value of noncontrolling interest over the estimated fair value of the net assets acquired is recorded as goodwill. To the extent the estimated fair value of the net assets acquired exceeds the purchase price plus the fair value of the noncontrolling interest, a gain is recorded in results of current operations. The results of operations of acquired businesses are included in the Partnership's results from the dates of acquisition. Assets acquired and liabilities assumed include tangible and intangible assets, and contingent assets and liabilities. The estimated fair values of these assets and liabilities are determined based on observable inputs such as quoted market prices, information from comparable transactions, offers made by other prospective acquirers in the cases where the Partnership has certain rights to acquire additional interests in existing investments, and the replacement cost of assets in the same condition or stage of usefulness; or on unobservable inputs such as expected future cash flows or internally developed estimates of value. The Partnership's fair value measurements are classified within the fair value hierarchy established by GAAP based on the lowest level (least observable) input that is significant to the measurement in its entirety. Assets acquired and liabilities assumed in connection with acquisitions from entities under common control are recorded by the Partnership at the common control entity's net carrying value. The Partnership records any difference between the consideration paid and the carrying value of the net assets and liabilities as a distribution from, or contribution to, redeemable limited partner interests or equity, as applicable. The Partnership's asset acquisitions are recorded at the purchase price, which is allocated to the acquired assets and assumed liabilities based on their relative estimated fair values. See Note 3 for additional information concerning the Partnership's recent acquisitions. Impairment of Long-Lived Assets Long-lived assets, other than those held for sale, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An asset is considered to be impaired when the undiscounted estimated net cash flows expected to be generated by the asset are less than its carrying amount. The impairment recognized is the amount by which the carrying amount exceeds the estimated fair value of the impaired asset. Long-lived assets held for sale are recorded at the lower of their carrying amount or estimated fair value less cost to sell the assets. Goodwill Goodwill, which represents the excess of the purchase price in a business combination over the fair value of net assets acquired, is tested for impairment annually in the fourth quarter, or more often if events or changes in circumstances indicate that the carrying value of goodwill may exceed its estimated fair value. The Partnership's general partner was acquired and became a consolidated subsidiary of ETP in the fourth quarter 2012. In connection with the acquisition, the Partnership elected to apply "push-down accounting" which required the Partnership's assets and liabilities to be adjusted to fair value on the closing date of the acquisition, which included an increase to the Partnership's goodwill balance of approximately $1.3 billion. Management's process for evaluating goodwill for impairment involves estimating the fair value of the Partnership's reporting units that include goodwill. Inherent in estimating fair value for each reporting unit are certain judgments and estimates relating the market multiples for comparable businesses, management's interpretation of current economic indicators, and market conditions and assumptions about the Partnership's strategic plans with regards to its operations. To the extent additional information arises, market conditions change or the Partnership's strategies change, it is possible the conclusion regarding whether the goodwill is impaired could change and result in future goodwill impairment charges. During the fourth quarter 2015, the Partnership realigned its reporting segments and, in accordance with accounting guidance, was required to test its goodwill balance for impairment both before and after the change in its reportable segments. Due to volatility within the energy markets, the Partnership utilized the assistance of a third party valuation firm to develop models to estimate the fair value of each of its reporting units that contain goodwill. The fair value of the reporting units was estimated using a combination of discounted cash flow and market multiple methodologies. Under the discounted cash flow methodology, fair value was estimated using the present value of Management's projected cash flows for each reporting unit which was calculated using the expected return a market participant would require for each reporting unit. Under the market multiple methodology, a selection of peer group companies, which are similar from an operational or industry perspective, were considered in estimating market multiples. These multiples were applied to Management's projected Adjusted EBITDA in order to estimate fair value. For the 2015 impairment test, the fair value of the Partnership's legacy Crude Oil Acquisition and Marketing segment was determined to be approximately 3 percent less than its carrying value. In accordance with accounting guidance, a second test was performed to estimate the fair value of the reporting unit's assets and liabilities, which included determining an implied goodwill value. The Partnership performed the second test and determined that the implied fair value of the Crude Oil Acquisition and Marketing segment's goodwill exceeded its current carrying value. See Note 9 for additional information on the Partnership's goodwill balance. Intangible Assets The Partnership has acquired intangible assets, such as customer relationships and patents related to butane blending technology. The value assigned to these intangible assets is amortized on a straight-line basis over their respective economic lives through depreciation and amortization expense in the consolidated statements of comprehensive income. Environmental Remediation The Partnership accrues environmental remediation costs for work at identified sites where an assessment has indicated that cleanup costs are probable and reasonably estimable. Such accruals are undiscounted and are based on currently available information, estimated timing of remedial actions and related inflation assumptions, existing technology and presently enacted laws and regulations. If a range of probable environmental cleanup costs exists for an identified site, the minimum of the range is accrued unless some other point or points in the range are more likely, in which case the most likely amount in this range is accrued. Income Taxes The Partnership is not a taxable entity for U.S. federal income tax purposes, or for the majority of states that impose income taxes. Rather, income taxes are generally assessed at the partner level. There are some states in which the Partnership operates where it is subject to state and local income taxes. Substantially all of the income tax amounts reflected in the Partnership's consolidated financial statements are related to the operations of Inland, Mid-Valley and West Texas Gulf Pipe Line Company ("West Texas Gulf"), all of which are subject to income taxes for federal and state purposes at the corporate level. The effective tax rates for these entities approximate the federal statutory rate of 35 percent. The Partnership recognizes a tax benefit from uncertain positions only if it is more likely than not that the position is sustainable, based solely on its technical merits and consideration of the relevant taxing authorities' widely understood administrative practices and precedents. The tax benefits recognized from such positions are measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon settlement. The following table presents the components of income tax expense for the periods presented: The income taxes paid by Inland, Mid-Valley, and West Texas Gulf approximated current income tax expense for each year presented. In taxable jurisdictions, the Partnership records deferred income taxes on all significant temporary differences between the book basis and the tax basis of assets and liabilities. At December 31, 2016 and 2015, the Partnership had $257 and $254 million, respectively, of net deferred tax liability derived principally from the difference in the book and tax bases of properties, plants and equipment associated with Inland, Mid-Valley, and West Texas Gulf. Long-Term Incentive Plan The Partnership accounts for the compensation cost associated with all unit-based payment awards at grant-date fair value and reports the related expense within operating expenses and selling, general and administrative expenses in the consolidated statements of comprehensive income. Unit-based compensation cost for all outstanding awards of restricted units is based on the grant date market price of the underlying unit. The Partnership recognizes unit-based compensation expense on a straight-line basis over the requisite service period. In accordance with the terms of certain awards, the recognition of compensation expense is accelerated for participants who become retirement-eligible during the applicable vesting period. Asset Retirement Obligations Asset retirement obligations ("AROs") represent the fair value of expected liabilities related to the future retirement of long-lived assets and are recorded at the time in which a legal obligation is incurred. A corresponding asset is recorded concurrently and is depreciated over the anticipated active life of the related long-lived asset. The value of the ARO is determined based on estimates and assumptions regarding ongoing maintenance and repair, asset repurposing costs, disposal costs and associated contractual obligations related to the Partnership's pipelines, terminal facilities, storage tanks, truck and leased assets. The Partnership bases these estimates on historical and budgeted costs, future inflation rates and credit-adjusted risk-free interest rates. These fair value assessments are considered to be level 3 measurements, as they are based on both observable and unobservable inputs. The Partnership's consolidated balance sheets include AROs as a component of other deferred credits and liabilities of $88 million at December 31, 2016 and 2015. The Partnership believes it may have additional asset retirement obligations related to its pipeline assets and storage tanks for which it is not possible to estimate whether or when the retirement obligations will be settled. Consequently, these retirement obligations cannot be measured at this time. Fair Value Measurements The Partnership determines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Partnership utilizes valuation techniques that maximize the use of observable inputs (levels 1 and 2) and minimize the use of unobservable inputs (level 3) within the fair value hierarchy established by the FASB. Where quoted pricing is not available, the Partnership utilizes a "market" or "income" approach to determine fair value. This method uses pricing and other information related to market transactions for identical or comparable assets and liabilities. Assets and liabilities are classified within the fair value hierarchy based on the lowest level (least observable) input that is significant to the measurement in its entirety. Lease Accounting The Partnership accounts for arrangements that convey the right to use property, plant or equipment for a stated period of time as leases. Whether an arrangement contains a lease is determined at inception of the arrangement based on all of the facts and circumstances. The Partnership reassesses whether an arrangement contains a lease after the inception of the arrangement only if (a) there is a change in the contractual terms, (b) a renewal option is exercised or an extension is agreed to by the parties to the arrangement, (c) there is a change in the determination of whether or not fulfillment is dependent on specified property, plant, or equipment, or (d) there is a substantial physical change to the specified property, plant, or equipment. The Partnership continually analyzes its new and existing arrangements to evaluate whether they contain leases. Revenue or expense from arrangements where the Partnership is the lessor or lessee, respectively, is recognized ratably over the term of the underlying arrangement. Net Income Attributable to Sunoco Logistics Partners L.P. per Limited Partner Unit The Partnership uses the two-class method to determine basic and diluted earnings per unit. The two-class method is an earnings allocation formula that determines the earnings for each class of equity ownership and participating security according to distributions declared and participation rights in undistributed earnings. The Partnership calculates basic and diluted net income attributable to Sunoco Logistics Partners L.P. ("net income attributable to SXL") per limited partner unit by dividing net income attributable to SXL, after deducting the amounts allocated to the general partner's interest and incentive distribution rights ("IDRs"), by the weighted average number of limited partner units and Class B units outstanding during the period. IDRs in a master limited partnership are treated as participating securities for the purpose of computing net income attributable to limited partner units. The general partner holds all of the IDRs. In addition, when earnings differ from cash distributions, undistributed or over distributed earnings are to be allocated to the general partner, limited partners and Class B unitholders based on the contractual terms of the partnership agreement. See Note 4 for additional information on the terms of the Class B units. 3. Acquisitions A key component of the Partnership's primary business strategy is to pursue strategic and accretive acquisitions that complement its existing asset base. The Partnership completed the following acquisitions during the years ended December 31, 2016, 2015 and 2014: • In November 2016, the Partnership completed an acquisition from Vitol Inc. ("Vitol") of an integrated crude oil business in West Texas for $760 million plus working capital. The acquisition provides the Partnership with an approximately 2 million barrel crude oil terminal in Midland, Texas, a crude oil gathering and mainline pipeline system in the Midland Basin, including a significant acreage dedication from an investment-grade Permian producer, and crude oil inventories related to Vitol crude oil purchasing and marketing business in West Texas. The acquisition also included the purchase of a 50 percent interest in the SunVit Pipeline LLC ("SunVit"), which resulted in the entity becoming a wholly-owned subsidiary of the Partnership. SunVit, which was renamed Permian Express Terminal LLC ("PET") in the fourth quarter 2016, connects the Midland terminal to the Partnership's Permian Express 2 pipeline, a key takeaway to bring Permian crude oil to multiple markets. The acquisition is included in the Crude Oil segment. The $769 million purchase price, net of cash received, consisted primarily of the following preliminary fair value allocations: net working capital ($13 million) largely attributable to inventory and receivables; properties, plants and equipment ($286 million) primarily related to pipeline and terminalling assets; intangible assets ($313 million) attributable to customer relationships; and an increase to goodwill ($251 million). The consolidation of SunVit resulted in a $41 million gain which represented the difference between the carrying value of the Partnership's previously held equity interest and the fair value on the date of acquisition. • In August 2016 and March 2014, the Partnership acquired additional ownership interests in the Explorer Pipeline Company ("Explorer") for $17 and $42 million, respectively, which increased the total ownership interest from 9.4 to 15.0 percent. The equity-method investment continues to be reported within the Refined Products segment. • In December 2014, the Partnership acquired an additional 28.3 percent ownership interest in West Texas Gulf from Chevron Pipe Line Company for $325 million, increasing the Partnership's controlling financial interest to 88.6 percent. In January 2015, the Partnership acquired the remaining noncontrolling ownership interest in West Texas Gulf for $131 million. As these transactions represented the acquisition of ownership interest in a consolidated subsidiary, noncontrolling interest and partners' equity were reduced by $92 and $364 million, respectively, in accordance with applicable accounting guidance. West Texas Gulf is reflected as a consolidated subsidiary within the Crude Oil segment. • In the second quarter 2014, the Partnership acquired a crude oil purchasing and marketing business from EDF Trading North America, LLC ("EDF"). The purchase consisted of a crude oil acquisition and marketing business and related assets which handle 20 thousand barrels per day. The acquisition also included a promissory note that was convertible to an equity interest in a rail facility (see below). The acquisition is included in the Crude Oil segment. • In the second quarter 2014, the Partnership acquired a 55 percent economic and voting interest in PRT, a rail facility in Wellington, Utah. As the Partnership acquired a controlling financial interest in PRT, the entity is reflected as a consolidated subsidiary of the Partnership from the acquisition date and is included in the Crude Oil segment. The terms of the acquisition provide PRT's noncontrolling interest holders the option to sell their interests to the Partnership at a price defined in the purchase agreement. As a result, the noncontrolling interests attributable to PRT are excluded from the Partnership's total equity and are instead reflected as redeemable interests in the consolidated balance sheet. The $65 million purchase price for the EDF and PRT acquisitions (net of cash received) consisted primarily of net working capital largely attributable to inventory ($24 million), properties, plants and equipment ($14 million), and intangible assets ($28 million). These fair value allocations also resulted in an increase to goodwill ($12 million) and redeemable noncontrolling interests ($15 million). No pro forma information has been presented as the impact of the acquisitions during 2016, 2015 and 2014 was not material in relation to the Partnership's consolidated results of operations or financial position. 4. Related Party Transactions Acquisition of Sunoco The Partnership has various operating and administrative agreements with ETP and its affiliates, including the agreements described below. ETP and its affiliates perform the administrative functions defined in such agreements on the Partnership's behalf. Service and Commodity Sales Agreements The Partnership is party to various agreements with ETP and its affiliates to provide pipeline, terminalling and storage services, in addition to agreements for the purchase and sale of crude oil, NGLs and refined products. This activity is reflected in affiliated revenues in the consolidated statements of comprehensive income. The Partnership is party to the following commercial agreements with its affiliated entities: • Pipeline Operator Agreement: The Partnership has agreements with certain of its joint venture interests to serve as operators of their respective pipeline systems. The agreements include a specified management fee and have either a defined termination date or are able to be terminated by both parties in certain cases. • Refined Products Terminal Services Agreement: The Partnership has a five-year refined products terminal services agreement with Sunoco under which Sunoco may throughput refined products at the Partnership's terminals. The agreement contains no minimum throughput obligations for Sunoco. The agreement runs through February 2017. • Fort Mifflin Terminal Services Agreement: The Partnership has an agreement with Philadelphia Energy Solutions ("PES") relating to the Fort Mifflin terminal complex. Under this agreement, PES will deliver an average of 300 thousand barrels per day of crude oil and refined products per contract year at the Fort Mifflin facility. PES does not have exclusive use of the Fort Mifflin terminal complex; however, the Partnership is obligated to provide the necessary tanks, marine docks and pipelines for PES to meet its minimum requirements under the agreement. The Partnership executed the ten-year agreement with PES in September 2012. The Partnership had a previous agreement with Sunoco, with terms similar to those contained in the agreement with PES. These agreements also provide PES with the option to purchase the Fort Mifflin and Belmont terminals if certain triggering events occur, including a sale of substantially all of the assets or operations of the Philadelphia refinery, an initial public offering, or a public debt filing of more than $200 million. The purchase price for each facility would be established based on a fair value amount determined by designated third parties. • Inter-Refinery Pipeline Lease: In September 2012, Sunoco assigned its lease for the use of the Partnership's inter-refinery pipelines between the Philadelphia refinery and the Marcus Hook Industrial Complex to PES. Under the twenty-year lease agreement which expires in February 2022, PES leases the inter-refinery pipelines for an annual fee which escalates at 1.67 percent each January 1 for the term of the agreement. The lease agreement also requires PES to reimburse the Partnership for any non-routine maintenance expenditures, as defined, incurred during the term of the agreement. There were no material reimbursements under this agreement during the years 2014 through 2016. • Marcus Hook Industrial Complex Storage and Terminalling Services: In connection with the 2013 acquisition of the Marcus Hook Industrial Complex, the Partnership assumed an agreement to provide butane storage and terminal services to PES at the facility. The 10 year agreement extends through September 2022. • Refined Products Storage Agreements: The Partnership has agreements with an affiliated entity to utilize storage services at the Mont Belvieu, Texas and Hattiesburg, Mississippi terminal locations. The agreements run through November 2018. • Purchase and Sale Agreements: The Partnership has agreements for the purchase and sale of crude oil, NGLs and refined products with affiliated entities. These agreements are negotiated at market-based rates, do not extend beyond 2017, and can be terminated by either party in certain cases. • Terminalling Services: The Partnership has agreements with affiliates for the use of its terminal assets, as well as its use of an affiliated terminal asset to facilitate the Partnership's acquisition and marketing activities. The agreements are based on market terms and negotiated based on the respective term. These agreements vary in duration and can be terminated by either party in certain cases. • Pipeline Agreements: The Partnership has agreements with affiliated parties to utilize its pipelines to supply their business needs. All pipeline movements are on the same terms that would be available to unaffiliated customers under similar terms and are based on published tariff rates on the respective pipeline. Advances to/from Affiliate The Partnership previously participated in Sunoco's centralized cash management program pursuant to a treasury services agreement. Under the program, the Partnership's cash receipts and cash disbursements were processed, together with those of Sunoco and its other subsidiaries, through Sunoco's cash accounts with a corresponding credit or charge to an affiliated account. The Partnership established separate cash accounts in the fourth quarter 2013, and ceased participation in Sunoco's cash management program in 2014. Administrative Services The Partnership has no employees. The operations of the Partnership are carried out by employees of the general partner. The Partnership reimburses the general partner and its affiliates for certain costs and other direct expenses incurred on the Partnership's behalf. These costs may be increased if the acquisition or construction of new assets or businesses requires an increase in the level of services received by the Partnership. Additional general and administrative costs incurred are paid directly by the Partnership. Under the Omnibus Agreement, the Partnership pays ETP an annual administrative fee that includes expenses incurred by ETP and its affiliates to perform certain centralized corporate functions, such as legal, accounting, engineering, information technology, insurance, utilities expense, office space rental, and other corporate services, including the administration of employee benefit plans. The costs may be increased if the acquisition or construction of new assets or businesses requires an increase in the level of general and administrative services received by the Partnership. These fees do not include the costs of shared insurance programs (which are allocated to the Partnership based upon its share of the cash premiums incurred), the salaries of pipeline and terminal personnel or other employees of the general partner, or the cost of their employee benefits. The amounts incurred in connection with the centralized corporate functions and shared insurance costs were not material to the Partnership's results of operations during the three year period ended December 31, 2016. The Partnership participates in various employee benefit plans with ETP and its affiliates, including employee and retiree medical, dental and life insurance plans, defined contribution 401(k) plans, incentive compensation plans and other such benefits. The total expense of benefit plan participation was $61, $54, and $45 million for the years ended December 31, 2016, 2015 and 2014, respectively. These expenses are reflected in operating expenses and selling, general and administrative expenses in the consolidated statements of comprehensive income. Affiliated Revenues and Accounts Receivable, Affiliated Companies The Partnership is party to various agreements with ETP and its affiliates to supply crude oil, NGLs and refined products, as well as to provide pipeline and terminalling services. Affiliated revenues in the consolidated statements of comprehensive income consist of revenues from ETP and its affiliated entities related to sales of crude oil, NGLs and refined products, and services, including pipeline transportation, terminalling, storage and blending. Note Receivable, Affiliated Companies See Note 8 for additional information related to the note receivable in connection with the Bakken Pipeline project. Investments in Affiliates See Note 8 for additional information related to the Partnership's participation in the Bayou Bridge and Bakken pipeline projects. Issuance of Redeemable Limited Partners' Interests In October 2015, the Partnership issued 9.4 million Class B units to ETP in conjunction with the purchase of a 30 percent ownership interest in the Bakken pipeline. The Class B units represent a new class of limited partner interests in the Partnership which are not entitled to receive quarterly distributions that are made on the Partnership's common units, but are otherwise entitled to share in earnings pro-rata with common units. The Class B units will automatically convert to common units on a one-for-one basis in the third quarter 2017. ETP can exercise a put right during the third quarter 2017, effective prior to the one-for-one conversion date, for the greater of $313.5 million or the fair market value of the units, as defined in the unitholder agreement. As a result of the available put option, the amount attributable to the Class B units is excluded from total equity and instead reflected as redeemable interests in the Partnership's consolidated balance sheet. However, the Class B units will be retired without exercise if the Merger is approved (see Note 1 for additional information). Contributions Attributable to Acquisition from Affiliate In the fourth quarter 2014, the Partnership acquired land at Eagle Point from Sunoco under a purchase option embedded in an existing lease. As a transaction between entities under common control, the land was recorded at Sunoco's historical carrying value, resulting in an increase to equity of $54 million. Capital Contributions In July 2014, the Partnership agreement was amended to remove the obligation of the general partner to make capital contributions upon the issuance of limited partner units to retain a two percent interest. Prior to this amendment, the general partner contributed $2 million primarily related to the Partnership's issuance of limited partner units under its at-the-market equity offering program ("ATM" program) in 2014. The general partner did not make any capital contributions to the Partnership in 2015 or 2016. 5. Net Income Attributable to Sunoco Logistics Partners L.P. per Limited Partner Unit The general partner's interest in net income attributable to SXL consists of its general partner interest and "incentive distributions," which are increasing percentages, up to 50 percent of quarterly distributions in excess of $0.0833 per limited partner unit (Note 13). The general partner was allocated net income attributable to SXL of $393 million (representing 56 percent of total net income attributable to SXL) for the year ended December 31, 2016; $288 million (representing 73 percent of total net income attributable to SXL) for the year ended December 31, 2015; $181 million (representing 62 percent of total net income attributable to SXL) for the year ended December 31, 2014. Diluted net income attributable to SXL per limited partner unit is calculated by dividing the limited partners' interest in net income attributable to SXL by the sum of the weighted average number of limited partner and Class B units outstanding, and the dilutive effect of incentive unit awards (Note 14). For the year ended December 31, 2016, net income attributable to SXL was reduced by $14 million in determining earnings per limited partner unit as a result of the Class B units, which are reflected as redeemable limited partner interests in the consolidated balance sheet. The following table sets forth the reconciliation of the weighted average number of limited partner and Class B units used to compute basic net income attributable to SXL per limited partner unit to those used to compute diluted net income attributable to SXL per limited partner unit for the periods presented: 6. Inventories The components of inventories are as follows: The Partnership's lower of cost or market ("LCM") reserves totaled $233 and $17 million at December 31, 2016 on its crude oil and NGLs inventories, respectively. At December 31, 2015, the LCM reserves totaled $381, $37, and $2 million on the Partnership's crude oil, NGLs and refined products inventories, respectively. See Note 18 for additional information on the LCM adjustments related to the Partnership's LIFO inventory balances, which are reported as impairment charge and other matters within the consolidated statement of comprehensive income. 7. Properties, Plants and Equipment The components of net properties, plants and equipment are as follows: (1) As of December 31, 2016 and 2015, the Partnership had rights-of-way with a book value of $1.1 billion. (2) As of December 31, 2016 and 2015, accrued capital expenditures were $249 and $286 million, respectively. 8. Investment in Affiliates The Partnership's ownership percentages in equity ownership interests as of December 31, 2016 and 2015 were as follows: (1) Effective November 1, 2016, SunVit Pipeline LLC became a wholly-owned, consolidated subsidiary of the Partnership, and was subsequently renamed Permian Express Terminal LLC in December 2016. (2) The investment in Bakken HoldCo provides the Partnership with a 30 percent overall ownership interest in the Bakken pipeline project through its ownership in the subsidiary companies which will operate the pipeline system. Explorer Pipeline Company In the third quarter 2016, the Partnership purchased an additional 1.7 percent ownership interest in Explorer from EXPL Pipeline Investment LLC for $17 million, increasing the Partnership's ownership interest to 15.0 percent. Explorer owns a refined products pipeline running from the Gulf Coast of the United States to the Chicago, Illinois area. The investment continues to be accounted for as an equity method investment within the Partnership's Refined Products segment. Permian Express Terminal In November 2016, the Partnership acquired an additional 50 percent interest in SunVit from Vitol, which increased the Partnership's overall ownership of SunVit to 100 percent. In December 2016, the Partnership renamed the SunVit pipeline to Permian Express Terminal LLC ("PET"). See Note 3 for additional information on the acquisition from Vitol. Bayou Bridge Pipeline In July 2015, the Partnership entered into an agreement with ETP and Phillips 66 to participate in the Bayou Bridge Pipeline project. The Partnership obtained a 30 percent economic interest in the project which is a consolidated subsidiary of ETP. The project consists of a newly constructed pipeline that will deliver crude oil from Nederland, Texas to refinery markets in Louisiana. Commercial operations from Nederland, Texas to Lake Charles, Louisiana commenced in the second quarter 2016, with continued progress on an extension of the pipeline segment to St. James, Louisiana, which is expected commence operations in the fourth quarter 2017. The Partnership is the operator of the pipeline and continues to fund its proportionate share of the cost of the project, which is accounted for as an equity method investment within the Partnership's Crude Oil segment. Bakken Pipeline In October 2015, the Partnership finalized its participation in the Bakken pipeline project with ETP and Phillips 66. The Partnership obtained a 30 percent economic interest in the project which is a consolidated subsidiary of ETP. The project consists of existing and newly constructed pipelines that are expected to provide aggregate takeaway capacity of approximately 450 thousand barrels per day of crude oil from the Bakken/Three Forks production area in North Dakota to key refinery and terminalling hubs in the midwest and Gulf Coast, including the Partnership's Nederland terminal. The ultimate takeaway capacity target for the project is 570 thousand barrels per day. The Partnership expects to reach agreement to become the operator of the pipeline system, which is expected to begin commercial operations in the second quarter 2017. In exchange for its 30 percent economic interest in the project, the Partnership issued 9.4 million Class B units to ETP, representing limited partner interests in the Partnership, and paid $382 million in cash representing the Partnership's proportionate share of contributions at the time of closing. Since the interest in the project was acquired from a related party, the Partnership's investment was recorded at ETP's historical carrying value. The Partnership's investment in the Bakken Pipeline project is reflected as an equity method investment within the Crude Oil segment. See Note 4 for additional information on the issuance of the Class B units. In August 2016, ETP, Sunoco Logistics and Phillips 66 established a $2.5 billion credit facility to provide substantially all of the remaining capital necessary to complete the project. Borrowings under the credit facility are secured by all assets of the Bakken entities, as well as the ownership interests maintained by the joint partners. The facility was limited to $1.1 billion in borrowings until attainment of certain closing conditions, which were met in February 2017. At December 31, 2016, $1.1 billion was outstanding under the Bakken credit facility. The joint partners agreed to provide the Bakken entities with a short-term loan until the full capacity of the $2.5 billion credit facility was available. The loan was made by the partners in proportion to their respective ownership interests. The outstanding balance of the note receivable due to the Partnership by the Bakken entities at December 31, 2016 was $301 million and was repaid in February 2017. In February 2017, the Partnership and ETP completed the sale of 49 percent of their respective interests in the Bakken Pipeline project for $2.0 billion to MarEn Bakken Company LLC, an entity jointly owned by MPLX LP and Enbridge Energy Partners, L.P. The Partnership received $800 million for its interest. The carrying amount of the Partnership's investment in the Bakken Pipeline project was $639 million at December 31, 2016. As a result of the sale, the Partnership's ownership interest in the Bakken Pipeline project is 15.3 percent. At December 31, 2016, the Partnership's investments in Explorer Pipeline Company, Yellowstone Pipe Line Company, West Shore Pipe Line Company and Wolverine Pipe Line Company included net excess investment amounts of $135 million. The excess investment is the difference between the investment balances and the Partnership's equity in the net assets of the entities. The Partnership has not provided additional financial support to any of these joint ventures during the 2014 through 2016 periods. The Partnership had $63 million of undistributed earnings from its investments in joint ventures within equity at December 31, 2016. During the years ended December 31, 2016, 2015 and 2014, the Partnership recorded equity income of $39, $24, and $25 million, respectively, and received dividends of $25, $23, and $14 million, respectively, from its investments in joint ventures. 9. Goodwill and Other Intangible Assets Goodwill Goodwill, which represents the excess of the purchase price in a business combination over the fair value of net assets acquired, is tested for impairment annually in the fourth quarter, or more often if events or changes in circumstances indicate that the carrying value of goodwill may exceed its estimated fair value. The Partnership's goodwill balance at December 31, 2016 and 2015 was $1,609 and $1,358 million, respectively. The $251 million increase in the Partnership's goodwill balance resulted from the Partnership's November 2016 acquisition from Vitol (Note 3). There were no goodwill impairments recorded during the 2014 through 2016 period. In connection with the change in the Partnership's reporting segments in the fourth quarter 2015, goodwill was reassigned to the new reporting segments. The Partnership's legacy Crude Oil Pipelines, Crude Oil Acquisition and Marketing, and Terminal Facilities segments included goodwill of $200, $557, and $601 million, respectively. The goodwill related to the legacy Crude Oil Pipelines and Crude Oil Acquisition and Marketing segments was combined under the Partnership's new segment alignment, while the goodwill related to the legacy Terminal Facilities segment was allocated to the new segments based on a relative fair value basis. Subsequent to the realignment of its reporting segments, the Partnership's Crude Oil, Natural Gas Liquids, and Refined Products segments include goodwill of $912, $357, and $89 million, respectively, at December 31, 2015. The Partnership will continue to monitor the volatility in the energy markets and the impact it could have on the estimated fair value of its reporting segments. It is possible that continued negative volatility within these markets could change the Partnership's conclusion regarding whether goodwill is impaired. Identifiable Intangible Assets The Partnership's identifiable intangible assets are comprised of customer relationships and patented technology associated with the Partnership's butane blending services. The values assigned to these intangible assets are amortized to earnings using a straight-line approach, over a weighted average amortization period of approximately 17 years. Amortization expense related to these intangibles was $54, $52, and $52 million for the years ended December 31, 2016, 2015 and 2014, respectively. The $313 million increase in the Partnership's intangible assets is attributable to customer relationships acquired in connection with its acquisition from Vitol (Note 3). Customer relationship intangible assets represent the estimated economic value assigned to certain relationships acquired in connection with business combinations or asset purchases whereby (i) the Partnership acquired information about or access to customers, (ii) the customers now have the ability to transact business with the Partnership and (iii) the Partnership is positioned, due to limited competition, to provide products or services to the customers. The customer relationship intangible assets are amortized on a straight-line basis over their respective economic lives. Technology-related intangible assets consist of the Partnership's patents for blending of butane into refined products. These patents are amortized over their remaining legal lives. The Partnership forecasts $69 million of annual amortization expense for each year through the year 2021 for its intangible assets. Intangible assets attributable to rights-of-way are included in properties, plants and equipment in the Partnership's consolidated balance sheets at December 31, 2016 and 2015 (Note 7). 10. Debt The components of the Partnership's long-term debt balances are as follows: (1) Includes $50 million of commercial paper outstanding at December 31, 2016. There was no commercial paper outstanding at December 31, 2015. (2) The $1.0 billion 364-Day Credit Facility, including its $630 million term loan, is classified as long-term debt at December 31, 2016 as the Partnership has the ability and intent to refinance such borrowings on a long-term basis. (3) The 6.125 percent Senior Notes were classified as long-term debt at December 31, 2015 as the Partnership repaid these notes in May 2016 with borrowings under its $2.50 billion Credit Facility, due in 2020. (4) Represents fair value adjustments on senior notes resulting from the application of push-down accounting in connection with the acquisition of the Partnership's general partner by ETP on October 5, 2012. (5) In the fourth quarter 2015, the Partnership adopted accounting guidance which requires certain debt issuance costs to be reflected as a reduction in the total long-term debt liability for all periods presented. The net long-term debt balance now includes $34 and $32 million of debt issuance costs at December 31, 2016 and 2015, respectively. The aggregate amount of long-term debt instrument maturities are as follows: Cash payments for interest related to long-term debt instruments, net of capitalized interest (Note 2), were $152, $137, and $64 million for the years ended December 31, 2016, 2015 and 2014, respectively. Credit Facilities In March 2015, the Operating Partnership amended and restated its $1.50 billion Credit Facility, which was scheduled to mature in November 2018. The amended and restated credit facility is a $2.50 billion unsecured revolving credit agreement (the "$2.50 billion Credit Facility"), which matures in March 2020, will continue to fund the Partnership's working capital requirements, finance acquisitions and capital projects, and be used for general partnership purposes. The $2.50 billion Credit Facility contains an "accordion" feature, under which the total aggregate commitment may be extended to $3.25 billion under certain conditions. In June 2015, the $2.50 billion Credit Facility was amended to create a segregated tranche of borrowings that will be guaranteed by ETP. The amendment did not modify the outstanding borrowings, total capacity or terms of the facility. In September 2015, the Operating Partnership initiated a commercial paper program under the borrowing limits established by its $2.50 billion Credit Facility. The facility bears interest at LIBOR or the Base Rate, as defined in the facility, each plus an applicable margin. The credit facility may be repaid at any time. The $2.50 billion Credit Facility contains various covenants including limitations on the creation of indebtedness and liens, and related to the operation and conduct of the business of the Partnership and its subsidiaries. The credit facility also limits the Partnership, on a rolling four quarter basis, to a maximum total consolidated debt to consolidated Adjusted EBITDA ratio, as defined in the underlying credit agreement, of 5.0 to 1, which can generally be increased to 5.5 to 1 during an acquisition period. The Partnership's ratio of total consolidated debt to consolidated Adjusted EBITDA was 4.4 to 1 at December 31, 2016, as calculated in accordance with the credit agreement. In December 2016, the Operating Partnership entered into an agreement for a 364-day maturity credit facility ("364-Day Credit Facility") with a total lending capacity of $1.0 billion, including a $630 million term loan. The terms of the 364-Day Credit Facility are similar to those of the $2.50 billion Credit Facility, including limitations on the creation of indebtedness, liens and financial covenants. The 364-Day Credit Facility is used to fund the Partnership's working capital requirements and for general partnership purposes. The facility bears interest at LIBOR or the Base Rate, as defined in the facility, each plus an applicable margin. The credit facility may be repaid at any time, and is expected to be terminated and repaid in connection with completion of the Merger. See Note 8 for additional information on the Bakken Pipeline project-level financing. Senior Notes The Operating Partnership had $175 million of 6.125 percent Senior Notes which matured and were repaid in May 2016, using borrowings under the $2.50 billion Credit Facility. In July 2016, the Operating Partnership issued $550 million of 3.90 percent Senior Notes (the "2026 Senior Notes"), due July 2026. In November 2015, the Partnership issued $600 million of 4.40 percent senior notes and $400 million of 5.95 percent senior notes (the "2021 and 2025 Senior Notes"), due April 2021 and December 2025, respectively. The net proceeds of $544 and $991 million from the 2016 and 2015 senior notes offerings, respectively, were used to repay outstanding borrowings on the $2.50 billion Credit Facility and for general partnership purposes. The terms and conditions of these senior notes offerings are comparable to those under other outstanding senior notes. Debt Guarantee The Partnership currently serves as guarantor of the senior notes and of any obligations under its credit facilities. This guarantee is full and unconditional. See Note 20 for supplemental condensed consolidating financial information. 11. Commitments and Contingent Liabilities Total rental expense for the years ended December 31, 2016, 2015 and 2014 amounted to $22, $22, and $18 million, respectively. The Partnership, as lessee, has non-cancelable operating leases for office space and equipment for which the aggregate amount of future minimum annual rentals as of December 31, 2016 is as follows: The Partnership is subject to numerous federal, state and local laws which regulate the discharge of materials into the environment or that otherwise relate to the protection of the environment. These laws and regulations result in liabilities and loss contingencies for remediation at the Partnership's facilities and at third-party or formerly owned sites. At December 31, 2016 and 2015, there were accrued liabilities for environmental remediation in the consolidated balance sheets of $4 and $6 million, respectively. The accrued liabilities for environmental remediation do not include any amounts attributable to unasserted claims, since there are no unasserted claims that are probable of settlement or reasonably estimable, nor have any recoveries from insurance been assumed. Charges against income for environmental remediation totaled $10, $8, and $15, million for the years ended December 31, 2016, 2015 and 2014, respectively. The Partnership maintains insurance programs that cover certain of its existing or potential environmental liabilities. Claims for recovery of environmental liabilities and previous expenditures that are probable of realization were not material in relation to the Partnership's consolidated financial position at December 31, 2016 and 2015. Total future costs for environmental remediation activities will depend upon, among other things, the identification of any additional sites; the determination of the extent of the contamination at each site; the timing and nature of required remedial actions; the technology available and needed to meet the various existing legal requirements; the nature and extent of future environmental laws, inflation rates and the determination of the Partnership's liability at multi-party sites, if any, in light of uncertainties with respect to joint and several liability; and the number, participation levels and financial viability of other parties. Management believes it is reasonably possible that additional environmental remediation losses will be incurred. At December 31, 2016, the aggregate of the estimated maximum additional reasonably possible losses, which relate to numerous individual sites, totaled $13 million. The Partnership is a party to certain pending and threatened claims. Although the ultimate outcome of these claims cannot be ascertained at this time, nor can a range of reasonably possible losses be determined, it is reasonably possible that some portion of them could be resolved unfavorably to the Partnership. Management does not believe that any liabilities which may arise from such claims and the environmental matters discussed above would be material in relation to the Partnership's results of operations, financial position or cash flows at December 31, 2016. Furthermore, management does not believe that the overall costs for such matters will have a material impact, over an extended period of time, on the Partnership's financial position, results of operations or cash flows. Sunoco has indemnified the Partnership for 30 years from environmental and toxic tort liabilities related to the assets contributed to the Partnership, that arose from the operation of such assets prior to the closing of the February 2002 initial public offering ("IPO"). Sunoco has also indemnified the Partnership for 100 percent of all losses asserted within the first 21 years after the closing of the IPO. Sunoco's share of liability for claims asserted thereafter will decrease by 10 percent per year. For example, for a claim asserted during the twenty-third year after closing of the IPO, Sunoco would be required to indemnify the Partnership for 80 percent of its loss. There is no monetary cap on the amount of indemnity coverage provided by Sunoco. The Partnership has agreed to indemnify Sunoco for events and conditions associated with the operation of the Partnership's assets that occur on or after the closing of the IPO and for environmental and toxic tort liabilities to the extent Sunoco is not required to indemnify the Partnership. Management of the Partnership does not believe that any liabilities which may arise from claims indemnified by Sunoco would be material in relation to the Partnership's financial position, results of operations or cash flows at December 31, 2016. There are certain other pending legal proceedings related to matters arising after the IPO that are not indemnified by Sunoco. Management believes that any liabilities that may arise from these legal proceedings will not be material in relation to the Partnership's financial position, results of operations or cash flows at December 31, 2016. 12. Equity The Partnership maintains an at-the-market equity offering program which allows the Partnership to issue common units directly to the public and raise capital in a timely and efficient manner to finance its growth capital program, while supporting the Partnership's investment-grade credit ratings. For the years ended December 31, 2016 and 2015, the Partnership issued 29.1 and 26.8 million common units under this program, for proceeds of $744 and $890 million, net of $8 and $10 million in fees and commissions to managers, respectively. In September and October 2016, a total of 24.2 million common units were issued for total proceeds of $652 million in connection with a public offering and related option exercise. The proceeds from this offering were used to partially fund the acquisition from Vitol. In March and April 2015, a total of 15.5 million common units were issued in connection with a public offering and related option exercise. Total proceeds of $648 million were used to repay outstanding borrowings under the Partnership's $2.50 billion Credit Facility and for general partnership purposes. Formation of Permian Express Partners In February 2017, the Partnership formed Permian Express Partners LLC ("PEP"), a strategic joint venture, with ExxonMobil. The Partnership contributed its Permian Express 1, Permian Express 2 and Permian Longview and Louisiana Access pipelines. ExxonMobil contributed its Longview to Louisiana and Pegasus pipelines; Hawkins gathering system; an idle pipeline in southern Oklahoma; and its Patoka, Illinois terminal. The Partnership's ownership percentage, upon formation, is approximately 85 percent. Upon commencement of operations on the Bakken pipeline, the Partnership will contribute its investment in the project, with a corresponding increase in its ownership percentage in PEP. The Partnership maintains a controlling financial and voting interest in PEP and is the operator of all of the assets. As such, PEP will be reflected as a consolidated subsidiary of the Partnership with its operating results included in the Crude Oil segment. ExxonMobil's interest will be reflected as a noncontrolling interest in the Partnership's consolidated balance sheets. 13. Cash Distributions Within 45 days after the end of each quarter, the Partnership distributes all cash on hand at the end of the quarter, less reserves established by the general partner in its discretion. This is defined as "available cash" in the partnership agreement. The general partner has broad discretion to establish cash reserves that it determines are necessary or appropriate to properly conduct the Partnership's business. The Partnership will make quarterly distributions to the extent there is sufficient cash from operations after establishment of cash reserves and payment of fees and expenses, including payments to the general partner. If cash distributions exceed $0.0833 per unit in a quarter, the general partner receives increasing percentages, up to 50 percent, of the cash distributed in excess of that amount. These distributions are referred to as "incentive distributions." The percentage interests shown for the unitholders and the general partner for the minimum quarterly distribution are also applicable to quarterly distribution amounts that are less than the minimum quarterly distribution. The following table shows the target distribution levels and distribution "splits" between the general partner and the holders of the Partnership's common units at December 31, 2016: (1) Includes general partner interest. Distributions paid by the Partnership on its common units for the periods presented were as follows: In connection with the acquisition from Vitol, the Partnership's general partner executed an amendment to the Partnership's Third Amended and Restated Agreement of Limited Partnership in September 2016, which provides for a reduction to the incentive distributions the general partner receives from the Partnership. The reductions will total $60 million over a two-year period, recognized ratably over eight quarters, and began with the third quarter 2016 cash distribution. On January 26, 2017, the Partnership declared a cash distribution of $0.52 per unit ($2.08 per unit, annualized) on its outstanding common units, representing the distribution for the quarter ended December 31, 2016. The $272 million distribution, including $105 million to the general partner, was paid on February 14, 2017 to unitholders of record at the close of business on February 7, 2017. 14. Management Incentive Plan In December 2015, the Partnership's unitholders approved the Sunoco Partners LLC Long-Term Incentive Plan, as amended and restated (the "Restated LTIP"), which was previously approved by the board of directors of Sunoco Partners LLC, the Partnership's general partner. The Restated LTIP authorized an additional 10.0 million common units to be available under the plan; added additional types of awards that can be granted under the plan, such as phantom unit awards, unit appreciation rights, unrestricted unit awards and other unit-based awards ("plan awards"); added a prohibition on repricing of unit options and unit appreciation rights without the approval of the unitholders; provided for termination of the plan at the earliest date it is terminated by the board of directors, the date no more units remain available for grants, and December 1, 2025; and incorporated certain other administrative changes. The Restated LTIP benefits eligible employees and directors of the general partner and its affiliates who perform services for the Partnership. The Restated LTIP is administered by the independent directors of the Compensation Committee of the general partner's board of directors with respect to employee awards, and by the general partner's board of directors with respect to awards granted to the independent directors. At December 31, 2016, there were 8.6 million plan awards available for future grants under the Restated LTIP. Restricted Units A restricted unit entitles the grantee to receive a common unit or, at the discretion of the Compensation Committee, an amount of cash equivalent to the value of a common unit upon the vesting of the unit. Such grants may include requirements related to the attainment of predetermined performance targets. The Compensation Committee may make additional grants under the Restated LTIP to employees and directors containing such terms as defined by the Compensation Committee. Common units to be delivered to the grantee upon vesting may be common units acquired by the general partner in the open market, common units already owned by the general partner, common units acquired by the general partner directly from the Partnership or any other person, or any combination of the foregoing. The general partner will be entitled to reimbursement by the Partnership for the cost incurred in acquiring common units. If the Partnership issues new common units upon vesting of the restricted units, the total number of common units outstanding will increase. The Compensation Committee, at its discretion, may grant tandem distribution equivalent rights ("DERs") related to the restricted units. Subject to applicable vesting criteria, DERs entitle the grantee to receive an amount of cash equal to the per unit cash distributions made by the Partnership during the period the restricted unit is outstanding. All units granted during the periods presented below included tandem DERs. The Partnership's outstanding restricted unit awards are time-vested grants, the vesting of which occurs over a five-year period, and is conditioned solely upon continued employment or service as of the applicable vesting date. The following table summarizes information regarding restricted unit award activity for the periods presented: (1) Certain awards granted prior to October 5, 2012 were subject to the Partnership achieving certain market-based and cash distribution performance targets as compared to a peer group average, or certain cash distribution performance targets as defined by the Compensation Committee, which caused the actual amount of units that ultimately vested to range between 0 to 200 percent of the original units granted. The total fair value of restricted unit awards vested for the years ended December 31, 2016, 2015 and 2014, was $12, $8, and $30 million, respectively, based on the market price of the Partnership's common units as of the vesting date. As of December 31, 2016, estimated compensation cost related to non-vested awards not yet recognized was $57 million, and the weighted average period over which this cost is expected to be recognized in expense is 3.0 years. The fair value of the Partnership's time-vested awards is based on the grant date market price of the Partnership's common units. The Partnership recognizes compensation expense on a straight-line basis over the requisite service period, and estimates forfeitures over the requisite service period when recognizing compensation expense. Based on the unit grants and performance factor adjustments outlined in the table above, the Partnership recognized unit-based compensation expense related to the awards granted within operating expenses and selling, general and administrative expenses in the consolidated statements of comprehensive income of $23, $17, and $16 million for the years ended December 31, 2016, 2015 and 2014, respectively. The tandem DERs associated with the restricted unit grants are recognized as a reduction of equity when earned. 15. Derivatives and Risk Management The Partnership is exposed to various risks, including volatility in the prices of the products that the Partnership markets, counterparty credit risk and changes in interest rates. Price Risk Management The Partnership is exposed to risks associated with changes in the market price of crude oil, NGLs and refined products. These risks are primarily associated with price volatility related to pre-existing or anticipated purchases, sales and storage. Price changes are often caused by shifts in the supply and demand for these commodities, as well as their locations. In order to manage such exposure, the Partnership's policy is (i) to only purchase crude oil, NGLs and refined products for which sales contracts have been executed or for which ready markets exist, (ii) to structure sales contracts so that price fluctuations do not materially impact the margins earned, and (iii) to not acquire and hold physical inventory, futures contracts or other derivative instruments for the purpose of speculating on commodity price changes. Although the Partnership seeks to maintain a balanced inventory position within its commodity inventories, net unbalances may occur for short periods of time due to production, transportation and delivery variances. When physical inventory builds or draws do occur, the Partnership continuously manages the variance to a balanced position over a period of time. The physical contracts related to the Partnership's commodity purchase and sale activities that qualify as derivatives have been designated as normal purchases and sales and are accounted for using accrual accounting under United States' generally accepted accounting principles. The Partnership accounts for derivatives that do not qualify as normal purchases or sales at fair value. The Partnership currently does not utilize derivative instruments to manage its exposure to prices related to crude oil sale activities. All derivative balances are presented on a gross basis. Pursuant to the Partnership's approved risk management policy, derivative contracts, such as swaps, futures and other derivative instruments, may be used to hedge or reduce exposure to price risk associated with acquired inventory or forecasted physical transactions. The Partnership utilizes derivative instruments to mitigate the risk associated with market movements in the price of crude oil, NGLs, refined products, and other commodities as necessary. These derivative contracts act as a hedging mechanism against the volatility of prices by allowing the Partnership to transfer this price risk to counterparties who are able and willing to bear it. The Partnership has no derivative contracts designated as hedges for accounting purposes. Therefore, all realized and unrealized gains and losses from these derivative contracts are recognized in the consolidated statement of comprehensive income in the period in which they occur. All realized gains and losses associated with the Partnership's derivative contracts are recorded in earnings in the same line item associated with the forecasted transaction (either sales and other operating revenue, cost of products sold or operating expenses). The Partnership had open derivative positions on 9.2 million barrels of crude oil, NGLs and refined products at December 31, 2016 and 2015. The derivatives outstanding at December 31, 2016 vary in duration but do not extend beyond one year. The Partnership records its derivatives at fair value based on observable market prices (levels 1 and 2), of which positions at December 31, 2016 and 2015 were primarily categorized at level 2. As of December 31, 2016 and 2015, the fair values of the Partnership's derivative assets and liabilities were: Derivative asset and liability balances are recorded in accounts receivable and accrued liabilities, respectively, in the consolidated balance sheets. The following table sets forth the impact of derivatives on the Partnership's results of operations for the periods presented: Credit Risk Management The Partnership maintains credit policies with regard to its counterparties that management believes minimize the overall credit risk through credit analysis, credit approvals, credit limits and monitoring procedures. The credit positions of the Partnership's customers are analyzed prior to the extension of credit and periodically after credit has been extended. The Partnership's counterparties consist primarily of financial institutions and major integrated oil companies. This concentration of counterparties may impact the Partnership's overall exposure to credit risk, either positively or negatively, as the counterparties may be similarly affected by changes in economic, regulatory or other conditions. Interest Rate Risk Management The Partnership has interest rate risk exposure for changes in interest rates related to its outstanding borrowings. The Partnership manages its exposure to changes in interest rates through the use of a combination of fixed-rate and variable-rate financial instruments. At December 31, 2016, the Partnership had $1.9 billion of consolidated variable-rate borrowings under its credit facilities, including $50 million of commercial paper products and the $630 million term loan. 16. Fair Value Measurements The estimated fair value of the Partnership's financial instruments has been determined based on management's assessment of available market information and appropriate valuation methodologies. The Partnership's current assets (other than derivatives and inventories) and current liabilities (other than derivatives) are financial instruments and most of these items are recorded at cost in the consolidated balance sheets. The estimated fair value of these financial instruments approximates their carrying value due to their short-term nature. The Partnership's derivatives are measured and recorded at fair value based on observable market prices. The estimated fair value of the Partnership's senior notes is determined using observable market prices, as these notes are actively traded (level 1). The estimated aggregate fair value of the senior notes at December 31, 2016 was $5.4 billion, compared to the carrying amount of $5.4 billion. The estimated aggregate fair value of the senior notes at December 31, 2015 was $4.2 billion, compared to the carrying amount of $5.1 billion. For further information regarding the Partnership's fair value measurements, see Notes 2, 3, 12 and 15. 17. Concentration of Credit Risk The Partnership's trade relationships are primarily with major integrated oil companies, independent oil companies and other pipelines and wholesalers. These concentrations of customers may affect the Partnership's overall credit risk as the customers may be similarly affected by changes in economic, regulatory or other factors. The Partnership maintains credit policies with regard to its counterparties that management believes minimize the overall credit risk through credit analysis, credit approvals, credit limits and monitoring procedures. The credit positions of the Partnership's customers are analyzed prior to the extension of credit and periodically after it has been extended. For certain transactions, the Partnership may utilize letters of credit, prepayments, guarantees and secured interests in assets. In 2016, approximately 12 percent of the Partnership's total revenues, respectively, were derived from one investment-grade customer with crude oil sales and other revenues comprising greater than 10 percent of total revenues. In 2015, approximately 23 percent of the Partnership's total revenues were derived from two investment-grade customers with crude oil sales and other revenues. While this concentration has the ability to negatively impact revenues going forward, management does not anticipate a material adverse effect in the Partnership's financial position, results of operations or cash flows as the absolute price levels for crude oil normally do not bear a relationship to gross profit. In addition, these customers are subject to netting arrangements which allow the Partnership to offset payable activities and mitigate credit exposure. 18. Business Segment Information The Partnership operates in 37 states throughout the United States and in three principal business segments. During the fourth quarter 2015, the Partnership realigned its reporting segments as a result of the continued investment in its organic growth capital program which has served to increase the integration that exists between its assets that service each commodity. This has also resulted in a shift in Management's strategic decision making process, resource allocation methodology, and assessment of the Partnership's financial results. The updated reporting segments are: Crude Oil, Natural Gas Liquids and Refined Products. The new segmentation provides the Partnership's investors with a more meaningful view of its business that is consistent with that of Management. For the purpose of comparability, all prior year segment disclosures have been recast to conform to the current presentation. Such recasts had no impact on previously reported consolidated earnings. • The Crude Oil segment provides transportation, terminalling and acquisition and marketing services to crude oil markets throughout the southwest, midwest and northeastern United States. Included within the segment is approximately 6,100 miles of crude oil trunk and gathering pipelines in the southwest and midwest United States and equity ownership interests in two crude oil pipelines. Our crude oil terminalling services operate with an aggregate storage capacity of approximately 33 million barrels, including approximately 26 million barrels at our Gulf Coast terminal in Nederland, Texas, approximately 2 million barrels at our Midland, Texas terminal and approximately 3 million barrels at our Fort Mifflin terminal complex in Pennsylvania. Our crude oil acquisition and marketing activities utilize our pipeline and terminal assets, our proprietary fleet of crude oil tractor trailers and truck unloading facilities, as well as third-party assets, to service crude oil markets principally in the mid-continent United States. • The Natural Gas Liquids segment transports, stores, and executes acquisition and marketing activities utilizing a complementary network of pipelines, storage and blending facilities, and strategic off-take locations that provide access to multiple NGLs markets. The segment contains approximately 900 miles of NGLs pipelines, primarily related to our Mariner systems located in the northeast and southwest United States. Terminalling services are facilitated by approximately 5 million barrels of NGLs storage capacity, including approximately 1 million barrels of storage at our Nederland, Texas terminal facility and 3 million barrels at our Marcus Hook, Pennsylvania terminal facility (the "Marcus Hook Industrial Complex"). This segment also carries out our NGLs blending activities, including utilizing our patented butane blending technology. • The Refined Products segment provides transportation and terminalling services, utilizing approximately 1,800 miles of refined products pipelines and approximately 40 active refined products marketing terminals. Our marketing terminals are located primarily in the northeast, midwest and southwest United States, with approximately 8 million barrels of refined products storage capacity. The Refined Products segment includes our Eagle Point facility in New Jersey, which has approximately 6 million barrels of refined products storage capacity. The segment also includes our equity ownership interests in four refined products pipeline companies. The segment also performs terminalling activities at our Marcus Hook Industrial Complex. The Refined Products segment utilizes our integrated pipeline and terminalling assets, as well as acquisition and marketing activities, to service refined products markets in several regions of the United States. The following table sets forth consolidated statement of comprehensive income information concerning the Partnership's business segments and reconciles total segment Adjusted EBITDA to net income attributable to SXL for the periods presented: (1) Sales and other operating revenue for the periods presented includes the following amounts from ETP and its affiliates: Total sales and other operating revenue exclude $483, $404, and $309 million attributable to intrasegment activity for the years ended December 31, 2016, 2015 and 2014, respectively. (2) Represents non-cash adjustments on the Partnership's crude oil, NGLs and refined products inventories. (3) Total capital expenditures exclude acquisitions and investments in equity ownership interests of $796, $131, and $448 million for the years ended December 31, 2016, 2015 and 2014, respectively. (4) Net income includes $39, $24, and $25 million for the years ended December 31, 2016, 2015 and 2014, respectively, of equity income attributable to the equity ownership interest. The following table provides consolidated balance sheet information concerning the Partnership's business segments as of December 31, 2016, 2015 and 2014, respectively: (1) Total identifiable assets include the Partnership's unallocated $15 million cash and cash equivalents, $153 million of properties, plants and equipment, net, and $10 million of other assets. (2) Total identifiable assets include the Partnership's unallocated $36 million cash and cash equivalents, $133 million of properties, plants and equipment, net, and $7 million of other assets. (3) Total identifiable assets include the Partnership's unallocated $47 million cash and cash equivalents, $124 million of properties, plants and equipment, net, and $9 million of other assets. 19. Quarterly Financial Data (Unaudited) Summarized quarterly financial data is as follows: (1) Gross profit equals sales and other operating revenue less cost of products sold and operating expenses. 20. Supplemental Condensed Consolidating Financial Information The Partnership serves as guarantor of the senior notes. These guarantees are full and unconditional. For purposes of the following footnote, Sunoco Logistics Partners L.P. is referred to as "Parent Guarantor" and Sunoco Logistics Partners Operations L.P. is referred to as "Subsidiary Issuer." All other consolidated subsidiaries of the Partnership are collectively referred to as "Non-Guarantor Subsidiaries." The following supplemental condensed consolidating financial information reflects the Parent Guarantor's separate accounts, the Subsidiary Issuer's separate accounts, the combined accounts of the Non-Guarantor Subsidiaries, the combined consolidating adjustments and eliminations and the Parent Guarantor's consolidated accounts for the dates and periods indicated. For purposes of the following condensed consolidating information, the Parent Guarantor's investments in its subsidiaries and the Subsidiary Issuer's investments in its subsidiaries are accounted for under the equity method of accounting. Consolidating Statement of Comprehensive Income (Loss) Year Ended December 31, 2016 (in millions) Consolidating Statement of Comprehensive Income (Loss) Year Ended December 31, 2015 (in millions) Consolidating Statement of Comprehensive Income (Loss) Year Ended December 31, 2014 (in millions) Consolidating Balance Sheet December 31, 2016 (in millions) Consolidating Balance Sheet December 31, 2015 (in millions) Consolidating Statement of Cash Flows Year Ended December 31, 2016 (in millions) Consolidating Statement of Cash Flows Year Ended December 31, 2015 (in millions) Consolidating Statement of Cash Flows Year Ended December 31, 2014 (in millions)
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt. It contains partial discussions about accounting principles, fair value measurements, assets, liabilities, and accounting estimates, but lacks a comprehensive overview of the financial performance.
The text touches on several accounting topics, including:
1. Accounting Methods:
- Use of US GAAP
- Equity method accounting
- Fair value measurements
- Derivative accounting
2. Financial Reporting Practices:
- Estimates and assumptions in financial reporting
- Reclassification of prior year amounts
- Asset and liability valuation
3. Measurement Approaches:
- Fair value hierarchy
- Observable and unobservable inputs
- Short-term financial instrument valuation
Without the complete financial statement, I cannot provide a meaningful summary of the organization's financial performance, revenue, expenses, or net income. To create an accurate summary, I would need the
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Claude
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ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index of Consolidated Financial Statements Page Reports of Independent Registered Public Accounting Firms Consolidated Balance Sheets as of December 31, 2016 and 2015 Consolidated Statements of Income and Comprehensive Income (Loss) for the years ended December 31, 2016, 2015 and 2014 Consolidated Statements of Shareholders' Equity for the years ended December 31, 2016, 2015 and Consolidated Statements of Cash Flows for the years ended December 31, 2016, 2015 and ACCOUNTING FIRM To the Board of Directors and Shareholders of Bruker Corporation In our opinion, the accompanying consolidated balance sheet as of December 31, 2016 and the related consolidated statements of income and comprehensive income (loss), of shareholders' equity and of cash flows for the year then ended present fairly, in all material respects, the financial position of Bruker Corporation and its subsidiaries at December 31, 2016, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because a material weakness in internal control over financial reporting related to the accounting for income taxes, including the income tax provision and related tax assets and liabilities, existed as of that date. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weakness referred to above is described in Management's Report on Internal Control over Financial Reporting appearing under Item 9A. We considered this material weakness in determining the nature, timing, and extent of audit tests applied in our audit of the 2016 consolidated financial statements, and our opinion regarding the effectiveness of the Company's internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in management's report referred to above. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP Boston, Massachusetts March 1, 2017 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Bruker Corporation We have audited the accompanying consolidated balance sheet of Bruker Corporation as of December 31, 2015, and the related consolidated statements of income and comprehensive income (loss), statements of shareholders' equity, and cash flows for each of the two years in the period ended December 31, 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bruker Corporation at December 31, 2015, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Boston, Massachusetts February 26, 2016 BRUKER CORPORATION CONSOLIDATED BALANCE SHEETS (In millions, except share and per share data) The accompanying notes are an integral part of these consolidated financial statements. BRUKER CORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (LOSS) (In millions, except per share data) The accompanying notes are an integral part of these consolidated financial statements. BRUKER CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share data) The accompanying notes are an integral part of these consolidated financial statements. BRUKER CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) The accompanying notes are an integral part of these consolidated financial statements. BRUKER CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1-Description of Business Bruker Corporation, together with its consolidated subsidiaries ("Bruker" or the "Company"), develops and manufactures high-performance scientific instruments and analytical and diagnostic solutions that enable its customers to explore life and materials at microscopic, molecular and cellular levels. Many of the Company's products are used to detect, measure and visualize structural characteristics of chemical, biological and industrial material samples. The Company's products address the rapidly evolving needs of a diverse array of customers in life science research, pharmaceuticals, biotechnology, applied markets, cell biology, clinical research, microbiology, in-vitro diagnostics, nanotechnology and materials science research. The Company has two reportable segments, Bruker Scientific Instruments (BSI), which represented approximately 93% and 92% of the Company's revenues during the year ended December 31, 2016 and 2015, respectively, and Bruker Energy & Supercon Technologies (BEST), which represented the remainder of the Company's revenues. Within BSI, the Company is organized into three operating segments: the Bruker BioSpin Group, the Bruker CALID Group and the Bruker Nano Group. For financial reporting purposes, the Bruker BioSpin, Bruker CALID and Bruker Nano operating segments are aggregated into the BSI reportable segment because each has similar economic characteristics, production processes, service offerings, types and classes of customers, methods of distribution and regulatory environments. Bruker BioSpin- The Bruker BioSpin Group manufactures and distributes enabling life science tools based on magnetic resonance technology. The majority of Bruker BioSpin's revenues are generated by academic and government research customers. Other customers include pharmaceutical and biotechnology companies and nonprofit laboratories, as well as chemical, food and beverage, clinical and polymer companies. Bruker CALID(Chemicals, Applied Markets, Life Science, In-Vitro Diagnostics, Detection)- The Bruker CALID Group designs, manufactures and distributes life science mass spectrometry and ion mobility spectrometry systems, infrared spectroscopy and radiological/nuclear detectors for Chemical, Biological, Radiological, Nuclear and Explosive (CBRNE) detection in emergency response, homeland security and defense applications, and analytical and process analysis instruments and solutions based on infrared and Raman molecular spectroscopy technologies. Customers of the Bruker CALID Group include pharmaceutical, biotechnology and diagnostics companies, contract research organizations, academic institutions, medical schools, nonprofit or for-profit forensics, agriculture, food and beverage safety, environmental and clinical microbiology laboratories, hospitals and government departments and agencies. Bruker Nano- The Bruker Nano Group designs, manufactures and distributes advanced X-ray instruments, atomic force microscopy instrumentation, advanced fluorescence optical microscopy instruments, analytical tools for electron microscopes and X-ray metrology, defect-detection equipment for semiconductor process control, handheld, portable and mobile X-ray fluorescence spectrometry instruments and spark optical emission spectroscopy systems. Customers of the Bruker Nano Group include biotechnology and pharmaceutical companies, academic institutions, governmental customers, nanotechnology companies, semiconductor companies, raw material manufacturers, industrial companies and other businesses involved in materials analysis. The Company's BEST reportable segment develops and manufactures superconducting and non-superconducting materials and devices for use in renewable energy, energy infrastructure, healthcare and "big science" research. The segment focuses on metallic low temperature superconductors for use in magnetic resonance imaging, nuclear magnetic resonance, fusion energy research and other applications, as well as ceramic high temperature superconductors primarily for energy grid and magnet applications. Note 2-Summary of Significant Accounting Policies The accompanying consolidated financial statements reflect the application of certain significant accounting policies as described below and elsewhere in the notes to the consolidated financial statements. Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and all majority and wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated. Noncontrolling Interests Noncontrolling interests represents the minority shareholders' proportionate share of the Company's majority-owned subsidiaries. The portion of net income or net loss attributable to non-controlling interests is presented as net income attributable to noncontrolling interests in consolidated subsidiaries in the consolidated statements of income and comprehensive income (loss), and the portion of other comprehensive income (loss) of these subsidiaries is presented in the consolidated statements of shareholders' equity. Subsequent Events The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events, or any subsequent events required to be mentioned in the footnotes to the consolidated financial statements, other than those disclosed in Note 23-Subsequent Events. Cash and Cash Equivalents Cash and cash equivalents primarily include cash on hand, money market funds and time deposits with original maturities of three months or less at the date of acquisition. Time deposits represent amounts on deposit in banks and temporarily invested in instruments with maturities of three months or less at the time of purchase. Certain of these investments represent deposits which are not insured by the FDIC or any other government agency. Cash equivalents are carried at cost, which approximates fair value. Short-term Investments Short-term investments represent time and call deposits with original maturities of greater than three months at the date of acquisition. Short-term investments are classified as available-for-sale and are reported at fair value. There were no unrealized gains (losses) recorded as of December 31, 2016 and 2015, as cost approximates current fair value. Restricted Cash The Company has certain subsidiaries which are required by local governance to maintain restricted cash balances to cover future employee benefit payments. Restricted cash balances are classified as non-current unless, under the terms of the applicable agreements, the funds will be released from restrictions within one year from the balance sheet date. The current and non-current portion of restricted cash is recorded within other current assets and other long-term assets, respectively, in the accompanying consolidated balance sheets. Derivative Financial Instruments and Hedging Activities All derivatives, whether designated in a hedging relationship or not, are recorded on the consolidated balance sheets at fair value. The accounting for changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, the Company must designate the hedging instrument, based on the exposure being hedged, as a fair value hedge, cash flow hedge, foreign currency hedge or a hedge of a net investment in a foreign operation. Fair Value of Financial Instruments The Company applies the following hierarchy to determine the fair value of financial instruments, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement. The levels in the hierarchy are defined as follows: • Level 1: Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. • Level 2: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. • Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement. The valuation techniques that may be used by the Company to determine the fair value of Level 2 and Level 3 financial instruments are the market approach, the income approach and the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach uses valuation techniques to convert future amounts to a single present value based on current market expectations about those future amounts, including present value techniques, option-pricing models and the excess earnings method. The cost approach is based on the amount that would be required to replace the service capacity of an asset (replacement cost). The Company's financial instruments consist primarily of cash equivalents, short-term investments, restricted cash, derivative instruments consisting of forward foreign exchange contracts, commodity contracts, derivatives embedded in certain purchase and sale contracts, accounts receivable, borrowings under a revolving credit agreement, accounts payable, contingent consideration and long-term debt. The carrying amounts of the Company's cash equivalents, short-term investments and restricted cash, accounts receivable, borrowings under a revolving credit agreement and accounts payable approximate fair value caused by their short-term nature. Derivative assets and liabilities are measured at fair value on a recurring basis. The Company's long-term debt consists principally of a private placement arrangement entered into in 2012 with various fixed interest rates based on the maturity date. The Company has evaluated the estimated fair value of financial instruments using available market information and management's estimates. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. Concentration of Credit Risk Financial instruments which subject the Company to credit risk consist of cash, cash equivalents, short-term investments, derivative instruments, accounts receivables and restricted cash. The risk with respect to cash, cash equivalents and short-term investments is minimized by the Company's policy of investing in short-term financial instruments issued by highly-rated financial institutions. The risk with respect to derivative instruments is minimized by the Company's policy of entering into arrangements with highly-rated financial institutions. The risk with respect to accounts receivables is minimized by the creditworthiness and diversity of the Company's customers. The Company performs periodic credit evaluations of its customers' financial condition and generally requires an advanced deposit for a portion of the purchase price. Credit losses have been within management's expectations and the allowance for doubtful accounts totaled $7.9 million and $9.1 million as of December 31, 2016 and 2015, respectively. As of December 31, 2016 and 2015, no single customer represented 10% or more of the Company's accounts receivable. For the years ended December 31, 2016, 2015 and 2014, no single customer represented 10% or more of the Company's total revenue. Inventories Components of inventory include raw materials, work-in-process, demonstration units and finished goods. Demonstration units include systems which are located in the Company's demonstration laboratories or installed at the sites of potential customers and are considered available for sale. Finished goods include in-transit systems that have been shipped to the Company's customers, but not yet installed and accepted by the customer. All inventories are stated at the lower of cost or market. Cost is determined principally by the first-in, first-out method for a majority of subsidiaries and by average-cost for certain other subsidiaries. The Company reduces the carrying value of its inventories for differences between cost and estimated net realizable value, taking into consideration usage in the preceding twelve months, expected demand, technological obsolescence and other information including the physical condition of demonstration inventories. The Company records a charge to cost of product revenue for the amount required to reduce the carrying value of inventory to net realizable value. Costs associated with the procurement of inventories, such as inbound freight charges and purchasing and receiving costs, are capitalized as part of inventory and are also included in the cost of product revenue line item within the consolidated statements of income and comprehensive income (loss). Property, Plant and Equipment Property, plant and equipment are stated at cost less accumulated depreciation and amortization. Major improvements are capitalized while expenditures for maintenance, repairs and minor improvements are charged to expense as incurred. When assets are retired or otherwise disposed of, the assets and related accumulated depreciation and amortization are eliminated from the accounts and any resulting gain or loss is reflected in the consolidated statements of income and comprehensive income (loss). Depreciation and amortization are calculated on a straight-line basis over the estimated useful lives of the assets as follows: Goodwill and Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized, but are evaluated for impairment on an annual basis, or on an interim basis when events or changes in circumstances indicate that the carrying value may not be recoverable. In assessing the recoverability of goodwill and indefinite-lived intangible assets, the Company must make assumptions regarding the estimated future cash flows, and other factors, to determine the fair value of these assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges against these assets in the reporting period in which the impairment is determined. The Company tests goodwill for impairment at the reporting unit level, which is the operating segment or one level below an operating segment. The Company has the option of performing a qualitative assessment to determine whether further impairment testing is necessary before performing the two-step quantitative assessment. If as a result of the qualitative assessment, it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, a quantitative impairment test will be required. Otherwise, no further testing will be required. If a quantitative impairment test is performed, the first step involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines fair value of reporting units using a weighting of both the market and the income methodologies. Estimating the fair value of the reporting units requires significant judgment by management. If the carrying amount of a reporting unit exceeds the fair value of the reporting unit, the Company performs the second step of the goodwill impairment test to measure the amount of the impairment. In the second step of the goodwill impairment test the Company compares the implied fair value of the reporting unit's goodwill with the carrying value of that goodwill. In process research and development, or IPR&D, acquired as part of business combinations under the acquisition method represents ongoing development work associated with enhancements to existing products, as well as the development of next generation products. IPR&D is initially capitalized at fair value as an intangible asset with an indefinite life and assessed for impairment on an annual basis, or when indicators of impairment are identified. When the IPR&D project is complete, it is reclassified as a finite-lived intangible asset and is amortized over its estimated useful life. If an IPR&D project is abandoned before completion or is otherwise determined to be impaired, the value of the asset or the amount of the impairment is charged to the consolidated statements of income and comprehensive income (loss) in the period the project is abandoned or impaired. Intangible assets with a finite useful life are amortized on a straight-line basis over their estimated useful lives as follows: Impairment of Long-Lived Assets Impairment losses are recorded on long-lived assets used in operations when indicators of impairment are present and the quoted market price, if available or the estimated fair value of those assets are less than the assets' carrying value and are not recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are not expected to be sufficient to recover the carrying amount of the assets, the assets are written-down to their fair values. Impairment losses are charged to the consolidated statements of income and comprehensive income (loss) for the difference between the fair value and carrying value of the asset. Warranty Costs and Deferred Revenue The Company typically provides a one year parts and labor warranty with the purchase of equipment. The anticipated cost for this warranty is accrued upon recognition of the sale and is included as a current liability on the accompanying consolidated balance sheets. The Company's warranty reserve reflects estimated material and labor costs for potential product issues for which the Company expects to incur an obligation. The Company's estimates of anticipated rates of warranty claims and costs are primarily based on historical information. The Company assesses the adequacy of the warranty reserve on a quarterly basis and adjusts the amount as necessary. If the historical data used to calculate the adequacy of the warranty reserve is not indicative of future requirements, additional or reduced warranty reserves may be required. The Company also offers to its customers extended warranty and service agreements extending beyond the initial warranty for a fee. These fees are recorded as deferred revenue and recognized ratably into income over the life of the extended warranty contract or service agreement. Income Taxes Deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the income tax basis of assets and liabilities. A valuation allowance is applied against any net deferred tax asset if, based on the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The Company records liabilities related to uncertain tax positions in accordance with the guidance that clarifies the accounting for uncertainty in income taxes recognized in a Company's financial statements. This guidance prescribes a minimum recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company includes accrued interest and penalties related to unrecognized tax benefits and income tax liabilities, when applicable, in income tax expense. Customer Advances The Company typically requires an advance deposit under the terms and conditions of contracts with customers. These deposits are recorded as a current or long-term liability until revenue is recognized on the specific contract in accordance with the Company's revenue recognition policy. Revenue Recognition The Company recognizes revenue from systems sales when persuasive evidence of an arrangement exists, the price is fixed or determinable, title and risk of loss has been transferred to the customer and collectability of the resulting receivable is reasonably assured. Title and risk of loss generally transfers upon shipping terms, or for certain systems, based upon customer acceptance for a system that has been delivered and installed at a customer facility. For systems that include customer-specific acceptance criteria, the Company is required to assess when it can demonstrate the acceptance criteria has been met, which generally is upon successful factory acceptance testing or customer acceptance and evidence of installation. When products are sold through an independent distributor or a strategic distribution partner who assumes responsibility for installation, the Company recognizes the system sale when the product has been shipped and title and risk of loss have been transferred to the distributor. The Company's distributors do not have price protection rights or rights of return; however, the Company's products are typically warranted to be free from defect for a period of one year. Revenue is deferred until cash is received when collectability is not reasonably assured or when the price is not fixed or determinable. For transactions that include multiple elements, arrangement consideration is allocated to each element using the fair value hierarchy as required by ASU No. 2009-13. The Company limits the amount of revenue recognized for delivered elements to the amount that is not contingent on the future delivery of products or services, future performance obligations, or subject to customer-specific return or refund privileges. The Company determines the fair value of its products and services based upon vendor specific objective evidence ("VSOE"). The Company determines VSOE based on its normal selling pricing and discounting practices for the specific product or service when sold on a stand-alone basis. In determining VSOE, the Company's policy requires a substantial majority of selling prices for a product or service to be within a reasonably narrow range. The Company also considers the class of customer, method of distribution and the geographies into which products and services are being sold when determining VSOE. If VSOE cannot be established, the Company attempts to establish the selling price based on third-party evidence ("TPE"). VSOE cannot be established in instances where a product or service has not been sold separately, stand-alone sales are too infrequent or product pricing is not within a sufficiently narrow range. TPE is determined based on competitor prices for similar deliverables when sold separately. When the Company cannot determine VSOE or TPE, it uses estimated selling price ("ESP") in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would typically transact a stand-alone sale of the product or service. ESP is determined by considering a number of factors including the Company's pricing policies, internal costs and gross profit objectives, method of distribution, market research and information, recent technological trends, competitive landscape and geographies. The Company analyzes the selling prices used in its allocation of arrangement consideration, at a minimum, on an annual basis. Selling prices will be analyzed more frequently if a significant change in the Company's business or other factors necessitate more frequent analysis or if the Company experiences significant variances in its selling prices. Revenue from accessories and parts is generally recognized based on shipping terms. Service revenue is recognized as the services are performed or ratably over the contractual obligation and includes maintenance contracts, extended warranty, training, application support and on-demand services. The Company also has contracts for which it applies the percentage-of-completion model and completed contract model of revenue recognition. Application of the percentage-of-completion method requires the Company to make reasonable estimates of the extent of progress toward completion of the contract and the total costs the Company will incur under the contract and losses are recorded immediately when we estimate that contracts will ultimately result in a loss. Changes in the estimates could affect the timing of revenue recognition. Other revenues are primarily comprised of development arrangements recognized on a cost-plus-fixed-fee basis and licensing arrangements recognized ratably over the term of the related contracts. Shipping and Handling Costs The Company includes costs incurred in connection with shipping and handling of products within selling, general and administrative expenses in the accompanying consolidated statements of income and comprehensive income (loss). Shipping and handling costs were $21.3 million, $20.6 million and $26.2 million in the years ended December 31, 2016, 2015 and 2014, respectively. Amounts billed to customers in connection with these costs are included in total revenues. Research and Development The Company commits substantial capital and resources to internal and collaborative research and development projects in order to provide innovative products and solutions to their customers. The Company conducts research primarily to enhance system performance and improve the reliability of existing products, and to develop revolutionary new products and solutions. Research and development costs are expensed as incurred and include salaries, wages and other personnel related costs, material costs and depreciation, consulting costs and facility costs. Capitalized Software Purchased software is capitalized at cost and is amortized over the estimated useful life, generally three years. Software developed for use in the Company's products is expensed as incurred to research and development expense until technological feasibility is achieved. Subsequent to the achievement of technological feasibility, amounts are capitalizable; however, to date such amounts have not been material. Advertising The Company expenses advertising costs as incurred. Advertising expenses were $12.7 million, $12.9 million and $10.7 million during the years ended December 31, 2016, 2015 and 2014, respectively. Stock-Based Compensation The Company recognizes stock-based compensation expense in the consolidated statements of income and comprehensive income (loss) based on the fair value of the share-based award at the grant date. The Company's primary types of share-based compensation are stock options, restricted stock awards and restricted stock units. The Company recorded stock-based compensation expense for the years ended December 31, 2016, 2015 and 2014, as follows (in millions): Compensation expense is amortized on a straight-line basis over the underlying vesting terms of the share-based award. Stock options to purchase the Company's common stock are periodically awarded to executive officers and other employees of the Company, and members of the Company's Board of Directors, subject to a vesting period of three to five years. The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model. Assumptions regarding volatility, expected term, dividend yield and risk-free interest rates are required for the Black-Scholes model and are presented in the table below: Risk-free interest rates are based on the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected life assumption. Expected life is determined through a calculation based on historical data and the Company believes that this is the best estimate of the expected term of a new option. Expected volatility is based on a number of factors, but the Company currently believes that the exclusive use of its historical volatility results in the best estimate of the expectations of future volatility over the expected term. The expected dividend yield was included in the option pricing formula beginning in February of 2016 as the Company adopted a dividend policy. In addition, the Company utilizes an estimated forfeiture rate when calculating the stock-based compensation expense for the period. The Company has applied estimated forfeiture rates derived from an analysis of historical data of 6.2%, 5.8% and 5.1% for the years ended December 31, 2016, 2015 and 2014, respectively, in determining the expense recorded in the accompanying consolidated statements of income and comprehensive income (loss). Earnings Per Share Net income per common share attributable to Bruker Corporation shareholders is calculated by dividing net income attributable to Bruker Corporation by the weighted-average shares outstanding during the period. The diluted net income per share computation includes the effect of shares which would be issuable upon the exercise of outstanding stock options and the vesting of restricted stock, reduced by the number of shares which are assumed to be purchased by the Company under the treasury stock method. The following table sets forth the computation of basic and diluted weighted average shares outstanding for the years ended December 31, (in millions, except per share data): Stock options and restricted stock units to purchase approximately 0.6 million shares, 1.3 million shares and 0.1 million shares were excluded from the computation of diluted earnings per share for the years ended December 31, 2016, 2015 and 2014, respectively, because their effect would have been anti-dilutive. Post Retirement Benefit Plans The Company recognizes the over-funded or under-funded status of defined benefit pension and other postretirement defined benefit plans as an asset or liability, respectively, in its consolidated balance sheets and recognizes changes in the funded status in the year in which the changes occur through other comprehensive income (loss). Other Comprehensive Income (Loss) Other comprehensive income (loss) refers to revenues, expenses, gains and losses that are excluded from net income as these amounts are recorded directly as an adjustment to shareholders' equity, net of tax. The Company's other comprehensive income (loss) was composed of foreign currency translation adjustments and pension liability adjustments. Foreign Currency Translation Assets and liabilities of the Company's foreign subsidiaries, where the functional currency is the local currency, are translated into U.S. dollars using year-end exchange rates, or historical rates, as appropriate. Revenues and expenses of foreign subsidiaries are translated at the average exchange rates in effect during the year. Adjustments resulting from financial statement translations are included as a separate component of shareholders' equity. Gains and losses resulting from translation of foreign currency monetary transactions are reported in interest and other income (expense), net in the consolidated statements of income and comprehensive income (loss) for all periods presented. The Company has certain intercompany foreign currency transactions that are deemed to be of a long-term investment nature. Exchange adjustments related to those transactions are made directly to a separate component of shareholders' equity. Risk and Uncertainties The Company is subject to risks common to its industry including, but not limited to, global economic conditions, rapid technological change, government and academic funding levels, changes in commodity prices, spending patterns from its customers, protection of its intellectual property, availability of key raw materials and components, compliance with existing and future regulation by government agencies and fluctuations in foreign currency exchange rates. Loss Contingencies Loss contingency provisions are recorded if the potential loss from any claim, asserted or unasserted, or legal proceeding related to patents, products and other matters, is considered probable and the amount can be reasonably estimated or a range of loss can be determined. These accruals represent management's best estimate of probable loss. Disclosure is provided when it is reasonably possible that a loss will be incurred or when it is reasonably possible that the amount of a loss will exceed the recorded provision. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Significant estimates and judgments made by management in preparing these financial statements include revenue recognition, allowances for doubtful accounts, write-downs for excess and obsolete inventory, estimated fair values used to record impairment charges related to intangible assets, goodwill, and other long-lived assets, amortization periods, expected future cash flows used to evaluate the recoverability of long-lived assets, stock-based compensation expense, warranty allowances, restructuring and other related charges, contingent liabilities and the recoverability of the Company's net deferred tax assets. Although the Company regularly reassesses the assumptions underlying these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management's estimates if these results differ from historical experience or other assumptions prove not to be substantially accurate, even if such assumptions are reasonable when made. Note 3-Acquisitions On December 14, 2016, we acquired 100% of the stock of Active Spectrum Inc., a manufacturer of magnetic resonance spectroscopy. On November 17, 2016, we acquired 100% of the membership interests of Oxford Instruments Superconducting Wire LLC (OST), a manufacturer of low-temperature superconductors. On November 2, 2016, we acquired the assets of Renishaw Diagnostics Ltd., a developer and producer of molecular assays for applications in microbiology. On November 21, 2016, we acquired the preclinical imaging business of OncoVision, a leading provider of innovative medical imaging devices. On June 20, 2016, we acquired the assets of Yingsheng Technology Pty Ltd., which comprise a technology for advanced minerals identification and characterization. The products of the acquired companies are intended to complement the Company's existing product portfolio and technology base. The following table reflects the consideration transferred and the respective reporting segment for each of the acquisitions: The components and fair value allocation of the consideration transferred in connection with these acquisitions were as follows (in millions): The Company completed the fair value allocation for these acquisitions at December 31, 2016. The fair value allocation included contingent consideration in the amount of $5.1 million, which represented the estimated fair value of future payments to the former shareholders of the acquired companies based on achieving annual revenue and gross margin targets in future years. The future payments of the contingent consideration may differ from the fair value recorded based on the financial results of the acquired businesses. The amortization period for intangible assets is between 5 and 7 years. The bargain purchase gain of $9.2 million related to the acquisition of OST, and has been recorded within interest and other income, net on the consolidated statements of income and comprehensive income (loss). The acquisition resulted in a bargain purchase gain as the assets acquired exceeded the consideration paid. Pro forma financial information reflecting these acquisitions have not been presented because the impact on revenues, net income and total assets is not material. In October 2015, the Company completed the acquisition of Jordan Valley Semiconductors, Ltd. ("Jordan Valley"), a company headquartered in Israel that provides X-ray metrology and defect-detection equipment for semiconductor process control. The acquisition of Jordan Valley was accounted for under the acquisition method. The components and fair value allocation of the consideration transferred in connection with the acquisition of Jordan Valley were as follows (in millions): The Company completed the fair value allocation in the fourth quarter of 2015. The fair value allocation included contingent consideration in the amount of $4.1 million, which represented the estimated fair value of future payments to the former shareholders of Jordan Valley based on achieving annual revenue and gross margin targets for the years 2016-2017. During the year ended December 31, 2016, the Company recorded an additional $7.7 million to other charges, net for additional consideration based on 2016 revenue and gross margin achievements. The maximum potential future payments related to the contingent consideration is $4 million at December 31, 2016. The amortization period for intangible assets acquired in connection with Jordan Valley is 7 years for customer relationships, existing technology and trade name. The results of Jordan Valley, including the amount allocated to goodwill which is attributable to expected synergies and not expected to be deductible for tax purposes, have been included in the BSI Segment from the date of acquisition. Pro forma financial information reflecting the acquisition of Jordan Valley has not been presented because the impact on revenues, net income and total assets is not material. On July 28, 2014 the Company completed the acquisition of Vutara, Inc. a manufacturer of high-speed, three-dimensional (3D), super-resolution fluorescence microscopy for life science applications. Note 4-Fair Value of Financial Instruments The Company measures the following financial assets and liabilities at fair value on a recurring basis. The following tables set forth the Company's financial instruments and presents them within the fair value hierarchy using the lowest level of input that is significant to the fair value measurement at December 31, 2016 and 2015 (in millions): Derivative financial instruments are classified within level 2 because there is not an active market for each derivative contract. However, the inputs used to calculate the value of the instruments are obtained from active markets. The fair value of the long-term fixed interest rate debt, which has been classified as Level 2, was $253.3 million and $252.1 million at December 31, 2016 and 2015, respectively, based on market and observable sources with similar maturity dates. The Company measures certain assets and liabilities at fair value with changes in fair value recognized in earnings. Fair value treatment may be elected either upon initial recognition of an eligible asset or liability or, for an existing asset or liability, if an event triggers a new basis of accounting. The Company did not elect to remeasure any of its existing financial assets or liabilities during the year ended December 31, 2016. Excluded from the table above are cash equivalents, restricted cash and short-term investments as the cost approximates current fair value. The Company has a program to enter into time deposits with varying maturity dates ranging from one to twelve months, as well as call deposits for which the Company has the ability to redeem the invested amounts over a period of 31 to 95 days. The Company has classified these investments within cash and cash equivalents or short-term investments within the consolidated balance sheets based on call and maturity dates. There are no cash equivalents, $3.4 million and $4.2 million of restricted cash and $157.9 million and $201.2 million of short-term investments outstanding as of December 31, 2016 and 2015, respectively. On a quarterly basis, the Company reviews its short-term investments to determine if there have been any events that could create an impairment. None were noted for the years ended December 31, 2016 and 2015. As part of certain acquisitions in 2016, 2015 and 2014, the Company recorded contingent consideration liabilities that have been classified as Level 3 in the fair value hierarchy. The contingent consideration represents the estimated fair value of future payments to the former shareholders of applicable acquired companies based on achieving annual revenue and gross margin targets in certain years as specified in the purchase and sale agreements. The Company initially valued the contingent consideration by using a Monte Carlo simulation which models future revenue and costs of goods sold projections and discounts the average results to present value. Changes to the fair value of the contingent consideration recognized in earnings for the years ended December 31, 2016 and December 31, 2015 were $6.9 million and ($7.7) million, respectively, and were recorded to other charges, net in the consolidated statements of income and comprehensive income (loss) for increases (reversals) of contingent consideration representing expected achievement of financial targets. The following table sets forth the changes in contingent consideration liabilities for the years ended December 31, 2016 and 2015 (in millions): Note 5-Accounts Receivable The following is a summary of trade accounts receivable at December 31, (in millions): The allowance for doubtful accounts is management's estimate of credit losses in the accounts receivable. The allowance for doubtful accounts is based on a number of factors, including an evaluation of customer credit worthiness, the age of the outstanding receivable, economic trends and historical experience. The allowance for doubtful accounts is reviewed on a quarterly basis and changes in estimates are reflected in the period in which they become known. The Company records account balances against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Provisions for doubtful accounts are recorded in selling, general and administrative expenses in the accompanying consolidated statements of income and comprehensive income (loss). The following is a summary of the activity in the Company's allowance for doubtful accounts at December 31, (in millions): Note 6-Inventories Inventories consisted of the following at December 31, (in millions): Finished goods include in-transit systems that have been shipped to the Company's customers but not yet installed and accepted by the customer. As of December 31, 2016 and 2015, inventory-in-transit was $37.5 million and $44.7 million, respectively. The Company reduces the carrying value of its demonstration inventories for differences between its cost and estimated net realizable value through a charge to cost of product revenue that is based on a number of factors including the age of the unit, the physical condition of the unit and an assessment of technological obsolescence. Amounts recorded in cost of product revenue related to the write-down of demonstration units to net realizable value were $16.5 million, $19.4 million and $28.2 million for the years ended December 31, 2016, 2015 and 2014, respectively. Note 7-Property, Plant and Equipment, Net The following is a summary of property, plant and equipment, net by major asset class at December 31, (in millions): Depreciation expense, which includes the amortization of leasehold improvements, for the years ended December 31, 2016, 2015 and 2014 was $32.6 million, $32.6 million and $39.5 million, respectively. During the years ended December 31, 2016 and 2015, the Company recorded impairment charges of $0.8 million and $2.1 million, respectively, representing the write down to fair value of certain property, plant and equipment, net related to restructuring and outsourcing activities undertaken during the respective years. These impairment charges are recorded within other charges, net in the accompanying consolidated statements of income and comprehensive income (loss). Please see Note 17-other charges, net, for additional details on the restructuring activities. In July 2014, the Company's Board of Directors approved a plan (the "Plan") to divest certain assets and implement a restructuring program in the former Chemical and Applied Markets (CAM) Division within the Bruker CALID Group. The Plan was developed as a result of management's conclusion that the former CAM business would be unable to achieve acceptable financial performance in the next two years. Please see Note 17-other charges, net, for additional details on the Plan. The Company determined the Plan was an indicator requiring the evaluation of property, plant and equipment within that reporting unit for recoverability. The Company performed a valuation during 2014 and determined that the property, plant and equipment within the former CAM Division were impaired. The Company recorded an impairment charge of $5.5 million in the year ended December 31, 2014 to reduce the remaining value of those assets to fair value. In addition, the Company determined, based upon projected cash flows generated by certain assets in the BEST Segment, that an impairment charge of $5.1 million was necessary during the year ended December 31, 2014 to reduce the carrying value of those assets to their estimated fair values. These impairment charges are recorded within "other charges, net" in the accompanying consolidated statements of income and comprehensive income (loss). Note 8-Goodwill and Intangible Assets Goodwill The following table sets forth the changes in the carrying amount of goodwill for the years ended December 31, 2016, 2015 and 2014 (in millions): At December 31, 2016 and 2015, all goodwill was allocated within the BSI Segment. During the year ended December 31, 2015, the Company recorded an impairment charge of $0.7 million representing the impairment of goodwill in the Bruker BioSpin Group related to certain restructuring and outsourcing activities during the year. The Company performed its annual impairment evaluation using a qualitative approach at December 31, 2016 and 2014 and a quantitative approach at December 31, 2015 and concluded it was more likely than not that goodwill has not been impaired. Based on the most recent quantitative analysis the fair values of each of our reporting units was significantly greater than their carrying amounts, and therefore, no additional impairment was required. Intangible Assets The following is a summary of intangible assets at December 31, (in millions): For the years ended December 31, 2016, 2015 and 2014, the Company recorded amortization expense of approximately $21.7 million, $20.7 million and $20.2 million, respectively, in the consolidated statements of income and comprehensive income (loss). During the year ended December 31, 2015, the Company recorded an impairment charge of $1.8 million representing the impairment of intangible assets in the Bruker BioSpin Group related to certain restructuring and outsourcing activities during the year. The estimated future amortization expense related to amortizable intangible assets at December 31, 2016 is as follows (in millions): Note 9-Other Current Liabilities The following is a summary of other current liabilities at December 31, (in millions): The following table sets forth the changes in accrued warranty for the years ended December 31, 2016 and 2015 (in millions): Note 10-Debt The Company's debt obligations consist of the following as of December 31, (in millions): Credit Agreements In May 2011, the Company entered into an amendment to, and restatement of, its credit agreement, referred to as the Amended Credit Agreement. The Amended Credit Agreement provided a maximum commitment on the Company's revolving credit line of $250.0 million and a maturity date of May 2016. Borrowings under the revolving credit line of the Amended Credit Agreement accrued interest, at the Company's option, at either (a) the greater of (i) the prime rate, (ii) the federal funds rate plus 0.50% and (iii) adjusted LIBOR plus 1.00% or (b) LIBOR, plus margins ranging from 0.80% to 1.65%. There was also a facility fee ranging from 0.20% to 0.35%. The Amended Credit Agreement was repaid in full in October 2015. On October 27, 2015, the Company entered into a new revolving credit agreement, referred to as the 2015 Credit Agreement, and terminated the Amended Credit Agreement. The 2015 Credit Agreement provides a maximum commitment on the Company's revolving credit line of $500 million and a maturity date of October 2020. Borrowings under the revolving credit line of the 2015 Credit Agreement accrue interest, at the Company's option, at either (a) the greater of (i) the prime rate, (ii) the federal funds rate plus 0.50% and (iii) adjusted LIBOR plus 1.00%, plus margins ranging from 0.00% to 0.30% or (b) LIBOR, plus margins ranging from 0.90% to 1.30%. There is also a facility fee ranging from 0.10% to 0.20%. Borrowings under the 2015 Credit Agreement are secured by guarantees from certain material subsidiaries, as defined in the 2015 Credit Agreement. The 2015 Credit Agreement also requires the Company to maintain certain financial ratios related to maximum leverage and minimum interest coverage (as defined in the 2015 Credit Agreement). Specifically, the Company's leverage ratio cannot exceed 3.5 and the Company's interest coverage ratio cannot be less than 2.5. In addition to the financial ratios, the 2015 Credit Agreement contains negative covenants, including among others, restrictions on liens, indebtedness of the Company and its subsidiaries, asset sales, dividends and transactions with affiliates. Failure to comply with any of these restrictions or covenants may result in an event of default on the 2015 Credit Agreement, which could permit acceleration of the debt and require the Company to prepay the debt before its scheduled due date. As of December 31, 2016, the Company was in compliance with the covenants of the 2015 Credit Agreement. The Company's leverage ratio (as defined in the 2015 Credit Agreement) was 1.49 and interest coverage ratio (as defined in the 2015 Credit Agreement) was 15.5. The following is a summary of the maximum commitments and the net amounts available to the Company under the 2015 Credit Agreement and other lines of credit with various financial institutions located primarily in Germany and Switzerland that are unsecured and typically due upon demand with interest payable monthly, at December 31, 2016 (in millions): Note Purchase Agreement In January 2012, the Company entered into a note purchase agreement, referred to as the Note Purchase Agreement, with a group of accredited institutional investors. Pursuant to the Note Purchase Agreement, the Company issued and sold $240.0 million of senior notes, referred to as the Senior Notes, which consist of the following: • $20 million 3.16% Series 2012A Senior Notes, Tranche A, due January 18, 2017; • $15 million 3.74% Series 2012A Senior Notes, Tranche B, due January 18, 2019; • $105 million 4.31% Series 2012A Senior Notes, Tranche C, due January 18, 2022; and • $100 million 4.46% Series 2012A Senior Notes, Tranche D, due January 18, 2024. Under the terms of the Note Purchase Agreement, the Company may issue and sell additional senior notes up to an aggregate principal amount of $600 million, subject to certain conditions. Interest on the Senior Notes is payable semi-annually on January 18 and July 18 of each year. The Senior Notes are unsecured obligations of the Company and are fully and unconditionally guaranteed by certain of the Company's direct and indirect subsidiaries. The Senior Notes rank pari passu in right of repayment with the Company's other senior unsecured indebtedness. The Company may prepay some or all of the Senior Notes at any time in an amount not less than 10% of the original aggregate principal amount of the Senior Notes to be prepaid, at a price equal to the sum of (a) 100% of the principal amount thereof, plus accrued and unpaid interest, and (b) the applicable make-whole amount, upon not less than 30 and no more than 60 days written notice to the holders of the Senior Notes. In the event of a change in control of the Company, as defined in the Note Purchase Agreement, the Company may be required to prepay the Notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest. The Note Purchase Agreement contains affirmative covenants, including, without limitation, maintenance of corporate existence, compliance with laws, maintenance of insurance and properties, payment of taxes, addition of subsidiary guarantors and furnishing notices and other information. The Note Purchase Agreement also contains certain restrictive covenants that restrict the Company's ability to, among other things, incur liens, transfer or sell assets, engage in certain mergers and consolidations and enter into transactions with affiliates. The Note Purchase Agreement also includes customary representations and warranties and events of default. In the case of an event of default arising from specified events of bankruptcy or insolvency, all outstanding Senior Notes will become due and payable immediately without further action or notice. In the case of payment events of defaults, any holder of Senior Notes affected thereby may declare all Senior Notes held by it due and payable immediately. In the case of any other event of default, a majority of the holders of the Senior Notes may declare all the Senior Notes to be due and payable immediately. Pursuant to the Note Purchase Agreement, so long as any Senior Notes are outstanding the Company will not permit (i) its leverage ratio, as determined pursuant to the Note Purchase Agreement, as of the end of any fiscal quarter to exceed 3.50 to 1.00, (ii) its interest coverage ratio as determined pursuant to the Note Purchase Agreement as of the end of any fiscal quarter for any period of four consecutive fiscal quarters to be less than 2.50 to 1 or (iii) priority debt at any time to exceed 25% of consolidated net worth, as determined pursuant to the Note Purchase Agreement. As of December 31, 2016, the Company was in compliance with the covenants of the Note Purchase Agreement. The Company's leverage ratio (as defined in the Note Purchase Agreement) was 1.49 and interest coverage ratio (as defined in the Note Purchase Agreement) was 15.5. Annual maturities of debt outstanding, less deferred financing cost amortization, at December 31, 2016 are as follows (in millions): Interest expense for the years ended December 31, 2016, 2015 and 2014, was $13.2 million, $13.0 million and $13.3 million, respectively. In April 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-03, Simplifying the Presentation of Debt Issuance Costs, which amends the existing guidance to require that debt issuance costs be presented in the consolidated balance sheet as a reduction from the carrying amount of the related debt liability instead of as an other asset. The Company adopted ASU 2015-03 on a retrospective basis for the year ended December 31, 2016. As of December 31, 2016 and 2015, there were $0.8 million and $0.9 million, respectively, in debt issuance costs recorded as a reduction in the carrying value of the related debt liability under the Note Purchase Agreement. The $0.8 million in debt issuance costs as of December 31, 2016 will be amortized over the remaining term of the Note Purchase Agreement. The retrospective adoption resulted in $0.9 million of debt issuance costs being reclassified from other current assets and other non-current assets to a reduction of the carrying value of long-term debt as of December 31, 2015. The Company also adopted ASU No. 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements, and elected not to reclassify the debt issuance costs related to line-of-credit arrangements for the 2015 Credit Agreement. Note 11-Derivative Instruments and Hedging Activities Interest Rate Risks The Company's exposure to interest rate risk relates primarily to outstanding variable rate debt and adverse movements in the related short-term market rates. The most significant component of the Company's interest rate risk relates to amounts outstanding under the 2015 Credit Agreement, which totaled $171.0 million at December 31, 2016. The Company currently has a higher level of fixed rate debt than variable rate debt, which limits the exposure to adverse movements in interest rates. Foreign Exchange Rate Risk Management The Company generates a substantial portion of its revenues and expenses in international markets, principally Germany and other countries in the European Union and Switzerland, which subjects its operations to the exposure of exchange rate fluctuations. The impact of currency exchange rate movement can be positive or negative in any period. The Company periodically enters into foreign currency contracts in order to minimize the volatility that fluctuations in currency translation have on its monetary transactions. Under these arrangements, the Company typically agrees to purchase a fixed amount of a foreign currency in exchange for a fixed amount of U.S. Dollars or other currencies on specified dates with maturities of less than twelve months. These transactions do not qualify for hedge accounting and, accordingly, the instrument is recorded at fair value with the corresponding gains and losses recorded in the consolidated statements of income and comprehensive income (loss). The Company had the following notional amounts outstanding under foreign currency contracts at December 31, (in millions): In addition, the Company periodically enters into purchase and sales contracts denominated in currencies other than the functional currency of the parties to the transaction. The Company accounts for these transactions separately valuing the "embedded derivative" component of these contracts. The contracts, denominated in currencies other than the functional currency of the transacting parties, amounted to $120.7 million for the delivery of products and $2.3 million for the purchase of products at December 31, 2016 and $59.0 million for the delivery of products and $4.1 million for the purchase of products at December 31, 2015. The changes in the fair value of these embedded derivatives are recorded in interest and other income (expense), net in the consolidated statements of income and comprehensive income (loss). Commodity Price Risk Management The Company has an arrangement with a customer under which it has a firm commitment to deliver copper based superconductors at a fixed price. In order to minimize the volatility that fluctuations in the price of copper have on the Company's sales of these commodities, the Company enters into commodity hedge contracts. At December 31, 2016 and 2015, the Company has fixed price commodity contracts with notional amounts aggregating $2.7 million and $2.0 million, respectively. The changes in the fair value of these commodity contracts are recorded in interest and other income (expense), net in the consolidated statements of income and comprehensive income (loss). The fair value of the derivative instruments described above are recorded in the consolidated balance sheets for the years ended December 31, 2016 and 2015 as follows (in millions): The impact on net income of unrealized gains and losses resulting from changes in the fair value of derivative instruments for the years ending December 31 are as follows (in millions) and are recorded within interest and other income (expense), net in the consolidated statements of income and comprehensive income (loss): Note 12-Income Taxes The domestic and foreign components of income before taxes are as follows for the years ended December 31, (in millions): The components of the income tax provision are as follows for the years ended December 31, (in millions): The income tax provision differs from the tax provision computed at the U.S federal statutory rate due to the following significant components for the years ended December 31: The tax effect of temporary items that give rise to significant portions of the deferred tax assets and liabilities as of December 31, 2016 and 2015 are as follows (in millions): The Company uses the liability method to account for income taxes. Under this method, deferred income taxes are recognized for the future tax consequences of differences between the tax and financial accounting bases of assets and liabilities at each reporting period. Deferred income taxes are based on enacted tax laws and statutory tax rates applicable to the period in which these differences are expected to affect taxable income. A valuation allowance is established when necessary to reduce deferred tax assets to the expected realizable amounts. The Company can only recognize a deferred tax asset to the extent this it is "more likely than not" that these assets will be realized. Judgments around realizability depend on the availability and weight of both positive and negative evidence. After considering all available evidence at December 31, 2016, the Company removed valuation allowances against a portion of its deferred tax assets in the U.S. and certain other jurisdictions as it is more likely than not that these assets will be realized. In particular, the Company removed a partial valuation allowance against its U.S. net deferred tax assets, which comprised deductible temporary differences and tax credit carryforwards. Also, the Company removed its valuation allowance against certain foreign net operating losses. In determining the realizability of these assets, the Company considered numerous factors including historical profitability, the character and amount of estimated future taxable income and prudent and feasible tax planning strategies. Changes in the valuation allowance for deferred tax assets during the years ended December 31, 2016, 2015 and 2014 were as follows: Increases related primarily to the generation of net operating losses and other deferred tax assets and decreases related primarily to the adjustment to certain deferred tax assets and their related allowance. As of December 31, 2016, the Company has approximately $40.2 million net operating loss carryforwards available to reduce state taxable income. The Company also has approximately $41.0 million of German Trade Tax net operating losses that are carried forward indefinitely. Additionally, the Company has $23.1 million of other foreign net operating losses that are expected to expire at various times beginning in 2018. The Company also has U.S. federal tax credits of approximately $15.1 million available to offset future tax liabilities that expire at various dates, which include research and development tax credits of $12.2 million expiring at various times through 2035, foreign tax credits of $2.9 million expiring at various times through 2025, and state research and development tax credits of $7.8 million. Utilization of these credits and state net operating losses may be subject to annual limitations due to the ownership percentage change limitations provided by the Internal Revenue Code Section 382 and similar state provisions. In the event of a deemed change in control under Internal Revenue Code Section 382, an annual limitation on the utilization of net operating losses and credits may result in the expiration of all or a portion of the net operating loss and credit carryforwards. The Company reflects certain statutory reserves in its tabular reconciliation of unrecognized tax benefits. Effective for the year ended December 31, 2013 and thereafter, these unrecognized tax benefits are presented as a reduction of the associated net deferred tax assets. The Company asserts that its foreign earnings, with the exception of its foreign earnings that have been previously taxed by the U.S., are indefinitely reinvested. The Company regularly evaluates its assertion that its foreign earnings are indefinitely reinvested. If the cash, cash equivalents and short-term investments held by the Company's foreign subsidiaries are needed to fund operations in the United States or the Company otherwise elects to repatriate the unremitted earnings of its foreign subsidiaries in the form of dividends or otherwise, or if the shares of the subsidiaries were sold or transferred, the Company would likely be subject to additional U.S. income taxes, net of the impact of any available tax credits, which could result in a higher effective tax rate in the future. The Company has indefinitely reinvested the earnings of its non-U.S. subsidiaries in the cumulative amount of approximately $1,200 million as of December 31, 2016, and therefore, has not provided for U.S. income taxes that could result from the distribution of such earnings to the U.S. parent. If these earnings were ultimately distributed to the United States in the form of dividends or otherwise, or if the shares of the subsidiaries were sold or transferred, the Company would likely be subject to additional U.S. income taxes, net of the impact of any available foreign tax credits. The Company estimates the amount of unrecognized deferred U.S. income taxes on these undistributed earnings to be approximately $90 million. The Company has gross unrecognized tax benefits, excluding interest, of approximately $6.2 million as of December 31, 2016, of which $5.3 million, if recognized, would reduce the Company's effective tax rate. In the next twelve months it is reasonably possible that the Company will reduce its unrecognized tax benefits by $2.1 million due to statutes of limitations expiring and favorably settling with taxing authorities which would reduce the Company's effective tax rate. A tabular reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in millions): The Company's policy is to include accrued interest and penalties related to unrecognized tax benefits and income tax liabilities, when applicable, in income tax expense. As of December 31, 2016 and 2015, the Company had approximately $0.5 million and $4.7 million, respectively, of accrued interest and penalties related to uncertain tax positions included in other long-term liabilities in the consolidated balance sheets. The Company recorded a benefit of $1.8 million for penalties and interest related to unrecognized tax benefits in the provision for income taxes during the year ended December 31, 2016 and an expense of $1.4 million during the year ended December 31, 2015. The Company files tax returns in the United States which include federal, state and local jurisdictions and many foreign jurisdictions with varying statutes of limitations. The Company considers Germany, the United States and Switzerland to be its significant tax jurisdictions. The tax years 2013 to 2015 are open tax years in these significant foreign jurisdictions. In the first quarter of 2014, the Company settled a tax audit in the United States for the tax year 2010. In the third quarter of 2015, the Company settled tax audits in Germany and Italy. In 2016, the Company settled tax audits in Germany and Switzerland. The settlement was immaterial to the consolidated financial statements. Tax years 2011 to 2015 remain open for examination in the United States. Note 13-Post Retirement Benefit Plans Defined Contribution Plans The Company sponsors various defined contribution plans that cover certain domestic and international employees. The Company may make contributions to these plans at its discretion. The Company contributed $6.0 million, $6.5 million and $7.1 million to such plans in the years ended December 31, 2016, 2015 and 2014, respectively. Defined Benefit Plans Substantially all of the Company's employees in Switzerland, France and Japan, as well as certain employees in Germany, are covered by Company-sponsored defined benefit pension plans. Retirement benefits are generally earned based on years of service and compensation during active employment. Eligibility is generally determined in accordance with local statutory requirements, however, the level of benefits and terms of vesting varies among plans. The components of net periodic benefit costs for the years ended December 31, 2016, 2015 and 2014 were as follows (in millions): The net periodic benefit costs for the year ended December 31, 2015 includes a one-time, non-cash settlement loss of $10.2 million as the Company outsourced its pension plan in Switzerland to an outside insurance provider, transferred certain plan assets and pension obligations for retirees and other certain members of the population, made certain plan design changes and re-measured the liability. The Company measures its benefit obligation and the fair value of plan assets as of December 31st each year. The changes in benefit obligations and plan assets under the defined benefit pension plans, projected benefit obligation and funded status of the plans were as follows at December 31, (in millions): The accumulated benefit obligation for the defined benefit pension plans is $199.9 million and $189.7 million at December 31, 2016 and 2015, respectively. All defined benefit pension plans have an accumulated benefit obligation and projected benefit obligation in excess of plan assets at December 31, 2016 and 2015. The following amounts were recognized in the accompanying consolidated balance sheets for the Company's defined benefit plans at December 31, (in millions): The following pre-tax amounts were recognized in accumulated other comprehensive income (loss) for the Company's defined benefit plans at December 31, (in millions): The amount in accumulated other comprehensive income (loss) at December 31, 2016 expected to be recognized as amortization of net loss within net periodic benefit cost in 2017 is $4.6 million. For the defined benefit pension plans, the Company uses a corridor approach to amortize actuarial gains and losses. Under this approach, net actuarial gains or losses in excess of ten percent of the larger of the projected benefit obligation or the fair value of plan assets are amortized over the average remaining service of active participants who are expected to receive benefits under the plans. The range of assumptions used for defined benefit pension plans reflects the different economic environments within the various countries. The range of assumptions used to determine the projected benefit obligations for the years ended December 31, are as follows: To determine the expected long-term rate of return on pension plan assets, the Company considers current asset allocations, as well as historical and expected returns on various asset categories of plan assets. For the defined benefit pension plans, the Company applies the expected rate of return to a market-related value of assets, which stabilizes variability in assets to which the expected return is applied. Asset Allocations by Asset Category The fair value of the Company's pension plan assets at December 31, 2016 and 2015, by asset category and by level in the fair value hierarchy, is as follows (in millions): (a)The Company's pension plan in France is invested in a larger fund that invests in a variety of instruments. The assets are not directly dedicated to the French pension plan. The Group BPCE Life fund invests in debt securities of foreign corporations and governments, equity securities of foreign government funds and private real estate funds. (b)The Company's pension plan in Switzerland is outsourced to Swiss Life AG, an outside insurance provider. Under the insurance contract, the plan assets are invested in Swiss Life Collective BVG Foundation (the Foundation), which is an umbrella fund for which the retirement savings and interest rates are guaranteed a minimum of 1.75% on the mandatory withdrawal portion, as defined by Swiss law, and 1.25% on the non-mandatory portion. The Foundation utilizes plan administrators and investment managers to oversee the investment allocation process, set long-term strategic targets and monitor asset allocations. The target allocations are 75% bonds, including cash, 5% equity investments and 20% real estate and mortgages. Should the Foundation yield a return greater than the guaranteed amounts, the Company, according to Swiss law, shall receive 90% of the additional return with Swiss Life AG retaining 10%. The withdrawal benefits and interest allocations are secured at all times by Swiss Life AG. Contributions and Estimated Future Benefit Payments During 2017, the Company expects contributions to be consistent with 2016. The estimated future benefit payments are based on the same assumptions used to measure the Company's benefit obligation at December 31, 2016. The following benefit payments reflect future employee service as appropriate (in millions): Note 14-Commitments and Contingencies In accordance with ASC Topic 450, Contingencies, the Company accrues anticipated costs of settlement, damages, or other costs to the extent specific losses are probable and estimable. Litigation and Related Contingencies Lawsuits, claims and proceedings of a nature considered normal to its businesses may be pending from time to time against the Company. Third parties might allege that the Company or its collaborators are infringing their patent rights or that the Company is otherwise violating their intellectual property rights. Loss contingency provisions are recorded if the potential loss from any claim, asserted or unasserted, or legal proceeding is considered probable and the amount can be reasonably estimated or a range of loss can be determined. These accruals represent management's best estimate of probable loss. Disclosure also is provided when it is reasonably possible that a loss will be incurred or when it is reasonably possible that the amount of a loss will exceed the recorded provision. The Company believes the outcome of pending proceedings, individually and in the aggregate, will not have a material impact on the Company's financial statements. As of December 31, 2016 and 2015, no material accruals have been recorded for potential contingencies. Governmental Investigations The Company is subject to regulation by national, state and local government agencies in the United States and other countries in which it operates. From time to time, the Company is the subject of governmental investigations often involving regulatory, marketing and other business practices. These governmental investigations may result in the commencement of civil and criminal proceedings, fines, penalties and administrative remedies and may have a material adverse effect on our financial position, results of operations and/or liquidity. The Korea Fair Trade Commission ("KFTC") has conducted an investigation into improper bidding by Bruker Korea Co., Ltd. and several other companies in connection with bids for sales of X-ray systems in 2010 and 2012. Three of the bids under investigation involved Bruker Korea. The Company cooperated fully with the KFTC regarding this matter. In September 2016, the KFTC fined Bruker Korea approximately $15,000 and referred the matter to the Korean Public Prosecutor's Office for criminal prosecution. Additional monetary penalties may also result from the ongoing criminal proceeding. Since December 2016, various Korean governmental entities have imposed suspensions on Bruker Korea, with suspension periods ranging from three to six months. During the periods of these suspensions, which are overlapping, Bruker Korea is prohibited from bidding for or conducting sales to Korean governmental agencies. Sales to these customers were less than 1% of the Company's revenue for the year ended December 31, 2016. In the course of normal business, the Company conducts business in Korea with other non-governmental customers that are not affected by these suspensions. Accordingly, the Company does not expect these contingencies to have a material adverse effect on our financial statements. Operating Leases Certain buildings, office equipment and vehicles are leased under agreements that are accounted for as operating leases. Total rental expense under operating leases was $22.0 million, $23.0 million and $22.8 million during the years ended December 31, 2016, 2015 and 2014, respectively. Future minimum lease payments under non-cancelable operating leases at December 31, 2016, for each of the next five years and thereafter are as follows (in millions): Capital Leases The Company leased a building under an agreement that was classified as a capital lease. As of December 31, 2016 the lease was completed and the building was subsequently purchased by the Company. The cost of the building under the capital lease was included in the consolidated balance sheets as property, plant and equipment and was $2.7 million at December 31, 2015. Accumulated amortization of the leased buildings at December 31, 2015 was $0.7 million. Amortization expense related to assets under capital leases was included in depreciation expense. The obligations related to capital leases was recorded as a component of long-term debt or the current portion of long-term debt in the consolidated balance sheets, depending on when the lease payments are due. Unconditional Purchase Commitments The Company has entered into unconditional purchase commitments, in the ordinary course of business, that include agreements to purchase goods, services or fixed assets and to pay royalties that are enforceable and legally binding and that specify all significant terms including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase commitments exclude agreements that are cancelable at any time without penalty. The aggregate amount of the Company's unconditional purchase commitments totaled $149.3 million at December 31, 2016 and the majority of these commitments are expected to be settled during 2017. License Agreements The Company has entered into cross-licensing agreements for various technologies that allow other companies to utilize certain of its patents and related technologies over various periods or into perpetuity. Income from these agreements for the years ended December 31, 2016, 2015 and 2014 was $1.9 million, $2.5 million and $2.6 million, respectively, and is classified in other revenue in the consolidated statements of income and comprehensive income (loss). The unearned portions of proceeds from the cross-licensing agreements are classified as short-term or long-term deferred revenue depending on when the revenue will be earned. The Company has also entered into license agreements allowing it to utilize certain patents. If these patents are used in connection with a commercial product sale, the Company pays royalties on the related product revenues. Licensing fees for the years ended December 31, 2016, 2015 and 2014, were $3.0 million, $3.2 million and $3.3 million, respectively, and are recorded in cost of product revenue in the consolidated statements of income and comprehensive income (loss). Letters of Credit and Guarantees At December 31, 2016 and 2015, the Company had bank guarantees of $131.5 million and $137.7 million, respectively, related primarily to customer advances. These arrangements guarantee the refund of advance payments received from customers in the event that the merchandise is not delivered or warranty obligations are not fulfilled in compliance with the terms of the contract. These guarantees affect the availability of the Company's lines of credit. Indemnifications The Company enters into standard indemnification arrangements in the Company's ordinary course of business. Pursuant to these arrangements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally the Company's business partners or customers, in connection with any patent, or any copyright or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual any time after the execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these agreements is unlimited. The Company believes the estimated fair value of these agreements is minimal based on historical experiences. The Company has entered into indemnification agreements with its directors and officers that may require the Company to: indemnify its directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct of a culpable nature; advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified; and obtain directors' and officers' insurance if available on reasonable terms, which the Company currently has in place. Note 15-Shareholders' Equity Share Repurchase Program In May 2015, the Company's Board of Directors approved a share repurchase program (the "Anti-Dilutive Repurchase Program") under which the Company may repurchase the Company's common stock in amounts intended to approximately offset, on an annual basis, the dilutive effect of shares that have been, or may be, issued pursuant to option or restricted stock awards under the Company's incentive compensation plans. In 2015, a total of 1,245,000 shares were repurchased at an aggregate cost of $24.9 million under the Anti-Dilutive Repurchase Program. In November 2015, the Company's Board of Directors suspended the Anti-Dilutive Repurchase Program until January 1, 2017 and approved an additional share repurchase program (the "Repurchase Program") which authorized repurchases of common stock up to $225 million from time to time, in amounts, at prices, and at such times as the Company deemed appropriate, subject to market conditions, legal requirements and other considerations. A total of 6,475,480 shares were repurchased at an aggregate cost of $160.0 million during the year ended December 31, 2016. A total of 9,312,522 shares were repurchased at an aggregate cost of $225.0 million as of December 31, 2016 under the completed Repurchase Program. The repurchased shares are reflected within Treasury stock in the accompanying consolidated balance sheet at December 31, 2016. Cash Dividends on Common Stock On February 22, 2016, the Company announced the establishment of a dividend policy and the declaration by its Board of Directors of an initial quarterly cash dividend in the amount of $0.04 per share of the Company's issued and outstanding common stock. Under the dividend policy, the Company will target a cash dividend to the Company's shareholders in the amount of $0.16 per share per annum, payable in equal quarterly installments. Dividends were paid on March 24, 2016 to shareholders of record as of March 4, 2016 for an aggregate cost of $6.5 million, on June 24, 2016 to shareholders of record as of June 6, 2016 for an aggregate cost of $6.5 million, on September 23, 2016 to shareholders of record as of September 6, 2016 for an aggregate cost of $6.4 million and on December 23, 2016 to shareholders of record as of December 5, 2016 for an aggregate cost of $6.4 million. Subsequent dividend declarations and the establishment of record and payment dates for such future dividend payments, if any, are subject to the Board of Directors' continuing determination that the dividend policy is in the best interests of the Company's shareholders. The dividend policy may be suspended or cancelled at the discretion of the Board of Directors at any time. Accumulated Other Comprehensive Income (Loss) The following is a summary of the components of accumulated other comprehensive income (loss), net of tax, at December 31, (in millions): Note 16-Stock-Based Compensation In February 2010, the Bruker BioSciences Corporation Amended and Restated 2000 Stock Option Plan (the "2000 Plan"), expired at the end of its scheduled ten-year term. On March 9, 2010, the Company's Board of Directors unanimously approved and adopted the Bruker Corporation 2010 Incentive Compensation Plan (the "2010 Plan"), and on May 14, 2010, the 2010 Plan was approved by the Company's stockholders. The 2010 Plan provided for the issuance of up to 8,000,000 shares of the Company's common stock. The 2010 Plan allowed a committee of the Board of Directors (the "Compensation Committee") to grant incentive stock options, non-qualified stock options and restricted stock awards. The Compensation Committee had the authority to determine which employees would receive the awards, the amount of the awards and other terms and conditions of any awards. Awards granted under the 2010 Plan typically were made subject to a vesting period of three to five years. In May 2016, the Bruker Corporation 2016 Incentive Compensation Plan (the "2016 Plan") was approved by the Company's stockholders. With the approval of the 2016 Plan, no further grants will be made under the 2010 Plan. The 2016 Plan provides for the issuance of up to 9,500,000 shares of the Company's common stock and permits the grant of awards of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock, unrestricted stock, restricted stock units, performance shares and performance units, as well as cash-based awards. The 2016 Plan is administered by the Compensation Committee. The Compensation Committee has the authority to determine which employees will receive awards, the amount of any awards, and other terms and conditions of such awards. Awards granted under the 2016 Plan typically vest over a period of three to four years. Stock option activity for the year ended December 31, 2016 was as follows: (a)In addition to the options that are vested at December 31, 2016, the Company expects a portion of the unvested options to vest in the future. Options expected to vest in the future are determined by applying an estimated forfeiture rate to the options that are unvested as of December 31, 2016. (b)The aggregate intrinsic value is based on the positive difference between the fair value of the Company's common stock price of $21.18 on December 31, 2016, or the date of exercises, as appropriate, and the exercise price of the underlying stock options. The weighted average fair value of options granted was $7.72, $7.82 and $10.81 per share for the years ended December 31, 2016, 2015 and 2014, respectively. The total intrinsic value of options exercised was $11.2 million, $8.2 million and $10.0 million for the years ended December 31, 2016, 2015 and 2014, respectively. Unrecognized pre-tax stock-based compensation expense of $15.0 million related to stock options awarded under the 2010 and 2016 Plans is expected to be recognized over the weighted average remaining service period of 2.62 years for stock options outstanding at December 31, 2016. Restricted shares of the Company's common stock are periodically awarded to executive officers, directors and certain key employees of the Company, subject to service restrictions, which vest ratably over periods of one to five years. The restricted shares of common stock may not be sold or transferred during the restriction period. Stock-based compensation for restricted stock is recorded based on the stock price on the grant date and charged to expense ratably throughout the restriction period. The following table summarizes information about restricted stock award activity during the year ended December 31, 2016: The total fair value of restricted stock vested was $1.5 million, $1.0 million and $3.0 million for the years ended December 31, 2016, 2015 and 2014, respectively. Unrecognized pre-tax stock-based compensation expense of $2.5 million related to restricted stock awarded under the 2010 Plan is expected to be recognized over the weighted average remaining service period of 2.15 years for awards outstanding at December 31, 2016. The following table summarizes information about restricted stock unit activity for year ended December 31, 2016: No restricted stock units vested in the year ended December 31, 2016. Unrecognized pre-tax stock-based compensation expense of $5.1 million related to restricted stock units awarded under the 2016 Plan is expected to be recognized over the weighted average remaining service period of 3.75 years for units outstanding at December 31, 2016. Note 17-Other Charges, Net The components of other charges, net for the years ended December 31, 2016, 2015 and 2014, were as follows (in millions): Restructuring Initiatives The Company commenced a restructuring initiative in 2016 to address lower demand in the Bruker CALID and Bruker Nano Groups as a result of delays in European academic funding and ongoing weakness in several of the industrial end market segments that affect the Bruker Nano Group. This initiative is intended to improve the Bruker CALID and Bruker Nano Group operating results in response to these market conditions. Restructuring actions will result in a reduction of approximately 125 employees within the Bruker CALID and Bruker Nano Groups. The following is a summary of the restructuring expenses related to this initiative which are recorded in the accompanying consolidated statements of income and comprehensive income for the year ended December 31, 2016: Total restructuring and other one-time charges related to this initiative in 2016 and 2017 are expected to be between $11.0 and $13.0 million, of which $8.4 to $10.0 million relate to employee separation and facility exit costs and $2.6 to $3.0 million relate to estimated inventory write-downs and asset impairments. The Company commenced a restructuring initiative in the second quarter of 2015 within the Bruker BioSpin Group, which was developed as a result of a revenue decline that occurred during the second half of 2014 and continued during the first half of 2015. This initiative was intended to improve Bruker BioSpin Group's operating results. Restructuring actions resulted in a reduction of employee headcount within the Bruker BioSpin Group of approximately 9% and the closure and consolidation of a Bruker BioSpin Group manufacturing facility. The following is a summary of the restructuring expenses related to this initiative which are recorded in the accompanying consolidated statements of income and comprehensive income for years ended December 31, 2016 and 2015: As of December 31, 2016, expenses incurred under this restructuring initiative were substantially complete. In 2014, the Company commenced and executed various productivity improvement initiatives within the BSI Segment in an effort to optimize its operations. These restructuring initiatives included the divestiture of certain non-core businesses, outsourcing of various manufacturing activities, transferring or ceasing operations at certain facilities and an overall right-sizing within the Company based on the then current business environments. Restructuring charges for the years ended December 31, 2016, 2015 and 2014 included charges for various other programs which were recorded in the accompanying consolidated statements of income and comprehensive income as follows: The following table sets forth the changes in the restructuring reserves for the years ended December 31, 2016, 2015 and 2014 (in millions): For the years ended December 31, 2016 and 2014, all restructuring charges related to the BSI Segment. For the year ended December 31, 2015, restructuring charges of $28.4 million related to the BSI Segment and $0.9 million related to the BEST Segment. Note 18-Interest and Other Income (Expense), Net The components of interest and other income (expense), net for the years ended December 31, 2016, 2015 and 2014, were as follows (in millions): Note 19-Business Segment Information The Company has two reportable segments, BSI and BEST, as discussed in Note 1 to the consolidated financial statements. Selected business segment information is presented below for the years ended December 31, (in millions): (a)Represents product and service revenue between reportable segments. (b)Represents corporate costs and eliminations not allocated to the reportable segments. The Company recorded an impairment charge of $0.8 million and $4.6 million for the years ended December 31, 2016 and 2015, respectively, within the BSI Segment. The Company recorded an impairment charge of $11.5 million for the year ended December 31, 2014, of which $6.4 million was within the BSI Segment and $5.1 million within the BEST Segment. Please see Note 7-Property, Plant and Equipment, net and Note 8-Goodwill and Other Intangible Assets, for description of impairment charges recorded in 2016, 2015 and 2014. These impairment charges are included within other charges, net in the accompanying consolidated statements of income and comprehensive income (loss). Total assets by segment as of and for the years ended December 31, are as follows (in millions): (a)Assets not allocated to the reportable segments and eliminations of intercompany transactions. Total capital expenditures and depreciation and amortization by segment are presented below for the years ended December 31, (in millions): Revenue and property, plant and equipment, net by geographical area as of and for the year ended December 31, are as follows (in millions): Note 20-Related Parties The Company leases certain office space from certain of its principal shareholders, including a director and executive officer and another member of the Company's Board of Directors, and members of their immediate families, which have expiration dates ranging from 2017 to 2020. Total rent expense under these leases was $3.9 million, $1.8 million and $2.0 million for each of the years ended December 31, 2016, 2015 and 2014, respectively. During the year ended December 31, 2014, the Company incurred expenses of $2.4 million to a law firm in which one of the former members of its Board of Directors is a partner. During the year ended December 31, 2014, the Company incurred expenses of $0.1 million to a financial services firm in which one of the former members of its Board of Directors is a partner. During the year ended December 31, 2014, the Company recorded revenue of $0.9 million from commercial transactions with a life science supply company in which a member of the Company's Board of Directors is Chairman, President and Chief Executive Officer and another member of the Company's Board of Directors was formerly a director. During the years ended December 31, 2016, 2015 and 2014, the Company recorded revenue of $1.1 million, $0.7 million and $1.9 million, respectively, and incurred expenses of $0.1 million for the year ended December 31, 2014, arising from commercial transactions with a life sciences company in which a member of the Company's Board of Directors, who joined the Board of Directors in 2014, is Chairman and Chief Executive Officer. During the year ended December 31, 2016 and 2015, the Company recorded revenue of $0.2 million and $0.5 million, respectively, from commercial transactions with a thermal analysis company in which one of the former members of its Board of Directors serves as a consultant. Note 21-Recent Accounting Pronouncements In January 2017, the Financial Accounting Standards Boards ("FASB") issued Accounting Standards Update ("ASU") 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The new standard simplifies the subsequent measurement of goodwill by eliminating the second step of the goodwill impairment test. This ASU will be applied prospectively and is effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. The adoption of this standard is not expected to have a material impact on the Company's consolidated financial statements upon adoption. In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This new standard clarifies the definition of a business and provides a screen to determine when an integrated set of assets and activities is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. This new standard will be effective as of January 1, 2018. The Company is evaluating the provisions of this standard, including which period to adopt, and has not determined what impact the adoption of ASU No. 2017-01 will have on the Company's consolidated financial statements. In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740)-Intra-Entity Transfer of Assets Other than Inventory. The new standard requires recognition of current and deferred income taxes resulting from an intra-entity transfer of any asset (excluding inventory) when the transfer occurs. This is a change from existing U.S. GAAP which prohibits recognition of current and deferred income taxes until the asset is sold to a third party. The new standard is effective as of January 1, 2018 and early adoption is permitted. The Company is evaluating the provisions of this standard, including which period to adopt, and has not determined what impact the adoption of ASU No. 2016-16 will have on the Company's consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230). The objective of this update is to provide additional guidance and reduce diversity in practice when classifying certain transactions within the statement of cash flows. In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash. The new standard requires that the statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. These standards are effective for financial statements issued for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating this guidance to determine the impact it may have on its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Stock Compensation-Improvements to Employee Share-Based Payment Accounting. The new standard simplifies accounting for share-based payment transactions, including income tax consequences and the classification of the tax impact on the statement of cash flows. The new standard is effective as of January 1, 2017, and early adoption is permitted. This new standard will be effective for the Company on January 1, 2017. The adoption of this standard is not expected to have a material impact on the Company's financial position, results of operations or statements of cash flows upon adoption. In February 2016, the FASB issued ASU No. 2016-02, Leases. The new standard provides guidance on the recognition, measurement, presentation, and disclosure of leases. The new standard supersedes present U.S. GAAP guidance on leases and requires substantially all leases to be reported on the balance sheet as right-of-use assets and lease liabilities, as well as additional disclosures. The new standard is effective as of January 1, 2019, and early adoption is permitted. The Company is evaluating the provisions of this standard and has not determined what impact the adoption of ASU No. 2016-02 will have on the Company's consolidated financial statements. In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory. The new guidance eliminates the measurement of inventory at market value, and inventory will now be measured at the lower of cost and net realizable value. The ASU defines net realizable value as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. No other changes were made to the current guidance on inventory measurement. ASU No. 2015-11 is effective for interim and annual periods beginning after December 15, 2016. Early application is permitted and should be applied prospectively. The Company is evaluating the provisions of this standard and has not determined what impact the adoption of ASU No. 2015-11 will have on the Company's consolidated financial statements. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which supersedes the revenue recognition requirements under Accounting Standards Codification (ASC) Topic 605. The new guidance was the result of a joint project between the FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop common revenue standards for U.S. GAAP and International Financial Reporting Standards. The core principle of the new guidance is that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU No. 2014-09 was originally effective prospectively for annual periods beginning after December 15, 2016, and interim periods within those years. Early application was not permitted. In August 2015, the FASB elected to defer the effective date of ASU No. 2014-09 by one year to annual periods beginning after December 15, 2017, with early application permitted as of the original effective date. The new guidance may be applied on a retrospective basis for all prior periods presented, or on a modified retrospective basis with the cumulative effect of the new guidance as of the date of initial application. The new guidance will be effective for the Company as of January 1, 2018 and the Company currently expects to use the modified retrospective transition method. During 2016, the Company substantially completed the impact assessment phase of its evaluation of ASU 2014-09. As a result of its impact assessment, the Company will be implementing additional processes and controls, including additional disclosures, to comply with the new standard. The largest financial impact will be the timing of revenue recognition for certain project-based orders for which the Company currently applies the percentage-of-completion or completed contract model. Under the new guidance, there are specific criteria to determine if a performance obligation should be recognized over time or at a point in time. The Company expects that in some cases the revenue recognition timing under the new guidance will change from current practice based on applying the specific criteria under the new guidance. The Company has not yet quantified the impact the adoption of ASU No. 2014-09 will have on the consolidated financial statements. Note 22-Quarterly Financial Data (Unaudited) A summary of operating results for the quarterly periods in the years ended December 31, 2016 and 2015, is set forth below (in millions, except per share data): (1)The second and fourth quarter of 2016 includes impairment of assets of $0.7 million and $0.1 million, respectively, comprised of other long-lived assets. (2)The second, third and fourth quarter of 2015 includes impairment of assets of $1.8 million, $2.5 million and $0.3 million, respectively, comprised of goodwill, definite-lived intangible assets and other long-lived assets. (3)The fourth quarter of 2016 includes bargain purchase gain of $9.2 million related to the Oxford Instruments Superconducting Wire LLC., acquisition Note 23-Subsequent Event On January 24, 2017, the Company acquired the shares of Hysitron, Incorporated for a purchase price of $28.5 million, with the potential for additional consideration based on the 2017 and 2018 revenue levels of the acquired business. The acquisition adds Hysitron's innovative nanomechanical testing instruments to the Company's existing portfolio of atomic force microscopes, surface profilometers, and tribology and mechanical testing systems, significantly enhancing the Company's leadership position in nanomaterials research markets. Hysitron is located in Eden Prairie, Minnesota and will be integrated into the Bruker Nano Group within the BSI reportable segment. The purchase accounting for this acquisition will be finalized within the measurement period. ITEM 9
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Based on the provided financial statement excerpt, here's a summary of the key accounting policies and financial components:
Key Components:
1. Inventory Management:
- Includes raw materials, work-in-process, demonstration units, and finished goods
- Valued at lower of cost or market
- Uses first-in, first-out (FIFO) method for majority of subsidiaries
- Demonstration units are available for sale
2. Property, Plant & Equipment:
- Stated at cost less accumulated depreciation
- Major improvements are capitalized
- Depreciation calculated on straight-line basis
3. Goodwill & Intangible Assets:
- Not amortized but evaluated annually for impairment
- Uses two-step quantitative assessment process
- IPR&D capitalized at fair value
4. Revenue Recognition:
- Recognized when:
* Persuasive evidence of arrangement exists
* Price is fixed/determinable
* Title/risk transferred to customer
* Collectability is reasonably assured
5. Warranty & Customer Service:
- Typically one-year parts and labor warranty
- Extended warranty and service agreements available
- Warranty costs accrued upon sale
6. Financial Instruments:
- Derivatives recorded at fair value
- Uses three-level hierarchy for fair value determination
- Short-term financial instruments carried at approximate fair value
The statement appears to be from a manufacturing company with significant inventory and equipment assets, offering both products and related services to customers.
Note: Specific financial figures were not provided in the excerpt, so actual monetary values cannot be included in this summary.
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Claude
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Financial Statements. Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders MakingORG, Inc. We have audited the accompanying balance sheet of MakingORG, Inc. (the “Company”) as of December 31, 2016 and the related statements of operations, changes in stockholders’ deficit and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 2016 and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As described in Note 3 to the financial statements, the Company has suffered recurring losses from operations and negative operating cash flows which raise substantial doubt about its ability to continue as a going concern. Management's plans regarding those matters also are described in Note 3. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Simon & Edward, LLP Los Angeles, California April 17, 2017 ACCOUNTING FIRM To the Board of Directors MakingORG, Inc. Los Angeles, CA We have audited the accompanying balance sheet of MakingORG, Inc. (the “Company”) as of December 31, 2015 and the related statement of operations, changes in stockholders' deficit, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the accompanying financial statements of the Company present fairly, in all material respects, its consolidated financial position as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States. /s/ MaloneBailey, LLP MaloneBailey, LLP Houston, Texas March 25, 2016 See accompanying notes to financial statements. See accompanying notes to financial statements. See accompanying notes to financial statements. See accompanying notes to financial statements. MakingORG, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 NOTE 1 - ORGANIZATION AND NATURE OF BUSINESS MakingORG, Inc. was incorporated under the laws of the State of Nevada on August 10, 2012. The Company now intends to open a line of health food stores or stores-in-stores within the Asian communities in the United States. The trading symbol of the Company is "CQCQ" and the fiscal year end is December 31. On October 20, 2016, the Company filed documents registering their intention to transact interstate business in the state of California. On November 29, 2016, the Company incorporated HK Feng Wang Group Limited. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States of America and are presented in US dollars. Accounting Basis The Company uses the accrual basis of accounting and has adopted a December 31 fiscal year end. Use of Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the financial statement date, and reported amounts of revenue and expenses during the reporting period. Significant estimates are used in valuing the fair value of common stock issued for services, among others. Actual results could differ from these estimates. Cash and Cash Equivalents The Company considers all highly liquid investments with the original maturities of three months or less to be cash equivalents. The Company had $165,481 and nil cash and cash equivalents as at December 31, 2016 and 2015. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets include primarily prepaid consulting fee, deposit for product processing fee and security deposit for rent. As of December 31, 2016, and 2015, prepaid expenses and other current assets was $12,150 and nil, respectively. Revenue Recognition The Company recognizes revenue when (1) delivery of product has occurred or services have been rendered, (2) there is persuasive evidence of a sale arrangement, (3) selling prices are fixed or determinable, and (4) collectability from the customer is reasonably assured. Income Taxes Income taxes are computed using the asset and liability method. Under the asset and liability method, deferred income tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using the currently enacted tax rates and laws. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized. Basic Income (Loss) Per Share Basic income (loss) per share is calculated by dividing the Company’s net loss applicable to common shareholders by the weighted average number of common shares during the period. Diluted earnings per share is calculated by dividing the Company’s net income available to common shareholders by the diluted weighted average number of shares outstanding during the year. The diluted weighted average number of shares outstanding is the basic weighted number of shares adjusted for any potentially dilutive debt or equity. There are no such common stock equivalents outstanding as at December 31, 2016 and 2015. Related Parties The Company follows ASC 850, "Related Party Disclosures," for the identification of related parties and disclosure of related party transactions. Fair Value of Financial Instruments Fair value is defined as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk including the Company’s own credit risk. In addition to defining fair value, the standard expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is reported in one of the three levels which are determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are: Level 1 - inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Level 2 - inputs are based upon significant observable inputs other than quoted prices included in Level 1, such as quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques. As of December 31, 2016, the balances reported for cash and cash equivalents, accrued expenses and due to related party approximate their fair value because of their short maturities. Notes payable are recorded at agreed values. Recently Issued Accounting Pronouncements Management has considered all recent accounting pronouncements issued since the last audit of the Company’s financial statements. The Company’s management believes that these recent pronouncements will not have a material effect on the Company’s financial statements. NOTE 3 - GOING CONCERN The accompanying financial statements have been prepared in conformity with generally accepted accounting principle, which contemplate continuation of the Company as a going concern. The Company currently has an accumulated deficit, and has not completed its efforts to establish a stabilized source of revenues sufficient to cover operating costs over an extended period of time. These financial statements do not include adjustments relating to the recoverability and classification of reported asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. Management anticipates that the Company will be dependent, for the near future, on additional investment capital to fund operating expenses The Company intends to position itself so that it may be able to raise additional funds through the capital markets. In light of management’s efforts, there are no assurances that the Company will be successful in this or any of its endeavors or become financially viable and continue as a going concern. NOTE 4 - DUE TO RELATED PARTY During the years ended December 31, 2016 and 2015, the Company's sole officer advanced to the Company an amount of $36,270 and $20,722, respectively, by the way of loan. The officer paid expenses directly on behalf of the Company. As at December 31, 2016 and 2015, the Company was obligated to the officer, for an unsecured, non-interest bearing demand loan with a balance of $74,579 and $38,309, respectively. NOTE 5 - CONVERTIBLE NOTE PAYABLE On September 1, 2016, the Company entered into a Convertible Note Agreement in the principal amount of $200,000 with an unrelated party. The note bears interest at 12% per annum and the holder is able to convert all unpaid interest and principal into common shares at $3.50 per share. The note matures on September 1, 2018. The Company recognized a discount on the note of $38,857 at the agreement date. The interest expense was due every six months commencing of March 1, 2017 until the principal amount of this convertible note was paid in full. The Company recognized interest expense related to the debt discount of $14,476 for the year ended December 31, 2016. The unamortized debt discount at December 31, 2016 is $32,381. NOTE 6 - EQUITY Preferred Stock On August 22, 2014, the Company amended and restated Articles of Incorporation and authorized 50,000,000 preferred shares with a par value of $0.001 per share. There were no preferred shares issued and outstanding as at December 31, 2016 and December 31, 2015. Common Stock The Company has 150,000,000, $0.001 par value shares of common stock authorized. On August 22, 2014, the Company amended and restated Articles of Incorporation and increased the amount of authorized shares of common stock from 75,000,000 to 150,000,000, with a par value of $0.001 per share. Effective August 22, 2014, the Company effected a 6 for 1 forward split on its common stock outstanding in the form of a dividend, under which each stockholder of record on that date received 5 additional shares of the Corporation's $0.001 par value common stock for every 1 share owned. The Company’s balance sheets, statements of operations, and all share and per shares amounts herein, were retroactively adjusted to give effect to the 6 for 1 forward split. As at December 31, 2016 and 2015, the Company has 35,430,000 shares issued and outstanding. NOTE 7 - COMMITMENTS Operating Lease The Company has operating leases for its office. Rental expenses for the years ended December 31, 2016 and 2015 were $3,000 and nil, respectively. At December 31, 2016, total future minimum annual lease payments under operating lease was as follows, by years: NOTE 8 - INCOME TAXES The Company provides for income taxes under ASC 740, "Income Taxes. ASC 740 requires the use of an asset and liability approach in accounting for income taxes. Deferred tax assets and liabilities are recorded based on the differences between the financial statement and tax basis of assets and liabilities and the tax rates in effect when these differences are expected to reverse. It also requires the reduction of deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The Company is subject to taxation in the United States and certain state jurisdictions. The provision for income taxes differs from the amounts which would be provided by applying the statutory federal income tax rate of 34% to the net loss before provision for income taxes for the following reasons: Net deferred tax assets consist of the following components as of: Due to the change in ownership provisions of the Income Tax laws of United States of America, net operating loss carry forwards of approximately $135,700, which expire commencing in fiscal 2032, for federal income tax reporting purposes are subject to annual limitations. When a change in ownership occurs, net operating loss carry forwards may be limited as to use in future years. NOTE 9 - SUBSEQUENT EVENT The Company has evaluated all other subsequent events through the date the financial statements were issued, and determine that there were no other subsequent events or transactions that require recognition or disclosures in the financial statements.
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Here's a summary of the financial statement:
The company is experiencing financial challenges, with:
- Operational losses
- Negative cash flows
- Substantial doubt about its ability to continue operating
Key financial highlights:
- Cash and Cash Equivalents: $165,481
- Current Assets: Primarily consist of prepaid consulting fees, product processing deposit, and rent security deposit
- No outstanding common stock equivalents
The statement indicates significant financial uncertainty and potential going concern issues. Management has plans to address these challenges, which are detailed in Note 3 of the full report. The company also relies on significant estimates in valuing assets and reporting financial information.
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Claude
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. Report of Independent Registered Public Accounting Firm Audit Committee, Board of Directors and Stockholders BancFirst Corporation Oklahoma City, Oklahoma We have audited the accompanying consolidated balance sheets of BancFirst Corporation (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2016. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of PCAOB, the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013 edition) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2017, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/ BKD, LLP Oklahoma City, Oklahoma March 7, 2017 BANCFIRST CORPORATION CONSOLIDATED BALANCE SHEETS (Dollars in thousands) The accompanying Notes are an integral part of these consolidated financial statements. BANCFIRST CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands, except per share data) The accompanying Notes are an integral part of these consolidated financial statements. BANCFIRST CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Dollars in thousands, except share data) The accompanying Notes are an integral part of these consolidated financial statements. BANCFIRST CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOW (Dollars in thousands) The accompanying Notes are an integral part of these consolidated financial statements. BANCFIRST CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of BancFirst Corporation and its subsidiaries (the “Company”) conform to accounting principles generally accepted in the United States of America (U.S. GAAP) and general practice within the banking industry. A summary of the significant accounting policies follows. Nature of Operations BancFirst Corporation is an Oklahoma business corporation and a financial holding company under federal law. It conducts virtually all of its operating activities through its principal wholly-owned subsidiary, BancFirst (the “Bank” or “BancFirst”), a state-chartered bank headquartered in Oklahoma City, Oklahoma. The Bank provides a wide range of retail and commercial banking services, including: commercial, real estate, agricultural and consumer lending; depository and funds transfer services; collections; safe deposit boxes; cash management services; retail brokerage services; and other services tailored for both individual and corporate customers. The Bank also offers trust services and acts as executor, administrator, trustee, transfer agent and in various other fiduciary capacities. Through its Technology and Operations Center, the Bank provides item processing, research and other correspondent banking services to financial institutions and governmental units. The Company’s wholly-owned subsidiary, BancFirst Insurance Services, Inc., an independent insurance agency, offers a variety of commercial and personal insurance products. In addition, the Company’s wholly-owned subsidiary, Council Oak Partners, LLC, an Oklahoma limited liability company, engages in investing activities. Basis of Presentation The accompanying consolidated financial statements include the accounts of BancFirst Corporation, Council Oak Partners, LLC, BancFirst Insurance Services, Inc. and BancFirst and its subsidiaries. The principal operating subsidiaries of BancFirst are Council Oak Investment Corporation, Council Oak Real Estate Inc. and BancFirst Agency, Inc. All significant intercompany accounts and transactions have been eliminated. Assets held in a fiduciary or agency capacity are not assets of the Company and, accordingly, are not included in the consolidated financial statements. Certain amounts from 2015 and 2014 have been reclassified to conform to the 2016 presentation. These reclassifications were not material to the Company’s financial statements. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States inherently involves the use of estimates and assumptions that affect the amounts reported in the financial statements and the related disclosures. These estimates relate principally to the determination of the allowance for loan losses, income taxes, the fair value of financial instruments and the valuation of intangibles. Such estimates and assumptions may change over time and actual amounts realized may differ from those reported. Securities The Company does not engage in securities trading activities. Any sales of securities are for the purpose of executing the Company’s asset/liability management strategy, eliminating a perceived credit risk in a specific security or providing liquidity. Securities that are being held for indefinite periods of time, or that may be sold as part of the Company’s asset/liability management strategy, to provide liquidity or for other reasons, are classified as available for sale and are stated at estimated fair value. Unrealized gains or losses on securities available for sale are reported as a component of stockholders’ equity, net of income tax. Gains or losses from sales of securities are based upon the book values of the specific securities sold. Securities for which the Company has the intent and ability to hold to maturity are classified as held for investment and are stated at cost, adjusted for amortization of premiums and accretion of discounts computed under the interest method. The Company reviews its portfolio of securities for impairment at least quarterly. Impairment is considered to be other-than-temporary if it is likely that all amounts contractually due will not be received for debt securities and when there is no positive evidence indicating that an investment’s carrying amount is recoverable in the near term for equity securities. When impairment is considered other-than-temporary, the cost basis of the security is written down to fair value, with the impairment charge included in earnings. In evaluating whether the impairment is temporary or other-than-temporary, the Company considers, among other things, the time period the security has been in an unrealized loss position, and whether the Company has the intent and ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value. Loans The lending function is governed by written policies and procedures, as determined by senior management and approved by the Board of Directors. The policies and procedures set the standards for lending in each major loan category by collateral type and use of loan proceeds. The objectives of these policies and procedures are to identify profitable markets, determine appropriate risk tolerance levels for each type of loan, establish limits for loan officer approval, set concentration limits, establish loan-to-value thresholds, set repayment terms and loan structure guidelines and adhere to documentation requirements. Interest rate risk is controlled by the use of variable rate provisions, approximately 50% of which have a rate floor, limits on fixing rates for longer periods and the use of prepayment penalties. One-to-four family residential real estate loans are made in accordance with underwriting policies and are fully documented. Credit worthiness is assessed based on significant credit characteristics including credit history and residential and employment stability. These loans include first liens, junior liens and home equity lines of credit. The composition of this portfolio is primarily first liens, which comprise more than 82% of the portfolio, with junior liens comprising less than 10%, and home equity lines of credit comprising less than 8%. The Company does not engage in any hybrid loan programs. In addition, the Company does not have any exposure to loans with negative amortization, interest rate carryover or discounting of the initial rates (teaser rates). Loans originated within the Company are stated at the principal amount outstanding, net of unearned interest, loan fees and allowance for loan losses. Interest on all performing loans is recognized, on a simple interest basis, based upon the principal amount outstanding. A loan is placed on nonaccrual status when, in the opinion of management, the future collectability of interest and/or principal is not probable. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is recognized on certain of these loans on a cash basis if the full collection of the remaining principal balance is reasonably expected. Otherwise, interest income is not recognized until the principal balance is fully collected. See Note (5) for loan disclosures. Acquired Loans Loans acquired through business combinations since December 2009 are required to be carried at fair value as of the date of the combination. Loans that would have a general allowance for loan losses or have specific evidence of deterioration of credit quality since origination are adjusted to fair value and any allowance for loan losses is eliminated. The difference between the fair value of loans which do not have specific evidence of deterioration of credit quality since origination and their principal balance is recognized in interest income on a level-yield method over the life of the loans. For loans which it is probable, at acquisition, that the Company will be unable to collect all contractually required payments (as determined by the present value of expected future cash flows), the difference between the undiscounted cash flows expected at acquisition and the investment in the loan, or the “accretable yield,” is recognized in interest income on a level-yield method over the life of the loan. Contractually required payments for interest and principal that exceed the undiscounted cash flows expected at acquisition, or the “nonaccretable difference,” are not recognized as yield adjustments or as loss accruals or valuation allowances. Increases in expected cash flows subsequent to the initial investment are recognized prospectively through adjustment of the yield on the loan over its remaining life. Decreases in expected cash flows are recognized as impairments. Any probable loss due to subsequent credit deterioration of the loans since acquisition is provided for in the allowance for loan losses. Loans Held For Sale The Company originates mortgage loans to be sold. At the time of origination, the acquiring bank has already been determined and the terms of the loan, including the interest rate, have already been set by the acquiring bank allowing the Company to originate the loan at fair value. Mortgage loans are generally sold within 30 days of origination. Loans held for sale are carried at the lower of cost or market. Gains or losses recognized upon the sale of the loans are determined on a specific identification basis. The Company does not sell residential mortgage loans with recourse other than obligations under standard representations and warranties or for fraud. These obligations relate to loan performance for the life of the loan. The amount of loans repurchased since the inception of the program is not considered to be material, and therefore, no reserve has been required. Allowance for Loan Losses The allowance for loan losses is an estimate of probable credit losses related to specifically identified loans and for losses inherent in the portfolio that have been incurred as of the balance sheet date. The allowance for loan losses is increased by provisions charged to operating expense and is reduced by net loan charge-offs. The amount of the allowance for loan losses is based on past loan loss experience, evaluations of known impaired loans, levels of adversely graded loans, general economic conditions and other environmental factors. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in aggregate for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific allowance is provided, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected primarily from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible. Appraisal Policy An updated appraisal of the collateral is obtained when a loan is first identified as a problem loan. Appraisals are reviewed annually and are updated as needed, or are updated more frequently if significant changes are believed to have occurred in the collateral or market conditions. Appraisals of other real estate owned are also reviewed and updated consistent with this policy. Nonaccrual Policy The Company does not accrue interest on (1) any loan upon which a default of principal or interest has existed for a period of 90 days or over unless the collateral margin or guarantor support are such that full collection of principal and interest are not in doubt, and an orderly plan for collection is in process; and (2) any other loan for which it is expected full collection of principal and interest is not probable. A nonaccrual loan may be restored to an accrual status when none of its principal and interest are past due and unpaid or otherwise becomes well secured and in the process of collection and when prospects for collection of future contractual payments are no longer in doubt. With the exception of a formal debt forgiveness agreement, no loan which has had principal charged-off shall be restored to accrual status unless the charged-off principal has been recovered. Charge-off Policy When a loan deteriorates to the point that the account officer or the Loan Committee concludes it no longer represents a viable asset, it will be charged off. Similarly, any portion of a loan that is deemed to no longer be a viable asset will be charged off. A loan will not be charged off unless such action has been approved by the branch President. Premises and Equipment Premises and equipment are stated at cost, less accumulated depreciation. Depreciation is charged to operating expense and is computed using the straight-line method over the estimated useful lives of the assets. Maintenance and repairs are charged to expense as incurred while improvements are capitalized. Premises and equipment is tested for impairment if events or changes in circumstances occur that indicate that the carrying amount of any premises and equipment may not be recoverable. Impairment losses are measured by comparing the fair values of the premises and equipment with their recorded amounts. Premises that are identified to be sold are transferred to other real estate owned at the lower of their carrying amounts or their fair values less estimated costs to sell. Any losses on premises identified to be sold are charged to operating expense. When premises and equipment are transferred to other real estate owned, sold, or otherwise retired, the cost and applicable accumulated depreciation are removed from the respective accounts and any resulting gains or losses are reported in the statement of comprehensive income. Other Real Estate Owned Other real estate owned consists of properties acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, and premises held for sale. These properties are carried at the lower of the book values of the related loans or fair values based upon appraisals, less estimated costs to sell. Losses arising at the time of reclassification of such properties from loans to other real estate owned are charged directly to the allowance for loan losses. Any losses on premises identified to be sold are charged to operating expense at the time of transfer from premises to other real estate owned. Losses from declines in value of the properties subsequent to classification as other real estate owned are charged to operating expense. During 2016, the Company had gains on the sale of other real estate owned totaling $1.2 million that is included in net expense (income) from other real estate owned in the consolidated statements of comprehensive income. Intangible Assets and Goodwill Core deposit intangibles are amortized on a straight-line basis over the estimated useful lives of seven to ten years and customer relationship intangibles are amortized on a straight-line basis over the estimated useful life of three to eighteen years. Mortgage servicing rights are amortized based on current prepayment assumptions. Goodwill is not amortized, but is evaluated at a reporting unit level at least annually for impairment, or more frequently if other indicators of impairment are present. At least annually in the fourth quarter, intangible assets, excluding mortgage servicing rights, are evaluated for possible impairment. Impairment losses are measured by comparing the fair values of the intangible assets with their recorded amounts. Any impairment losses are reported in the statement of comprehensive income. Mortgage servicing rights are adjusted to fair value semi-annually, if impaired. Derivatives The Company recognizes all of its derivative instruments as assets or liabilities in the balance sheet at fair value and recognizes the realized and unrealized change in fair value in the statement of comprehensive income. Income is derived from a fixed pricing spread when customer hedge contracts are immediately offset with counterparty contracts as compensation for administrative costs and credit risk and recognized in other noninterest income. Insurance Commissions and Fees Commission revenue is recognized at the later of the billing date or the effective date of the related insurance policies for those accounts billed by the Agency. Commission revenue, for accounts that are directly billed by the insurance company to the insured, is recognized when determinable by the Agency, which is generally when such commissions are received. The Agency also receives contingent commissions from insurance companies as additional incentive for achieving specified premium volume goals and/or loss experience parameters relating to the insurance placed by the Agency. Contingent commissions from insurance companies are recognized when determinable, which is generally when such commissions are received. Stock-based Compensation The Company recognizes stock-based compensation as compensation expense in the statement of comprehensive income based on the fair value of the Company’s stock options on the measurement date, which, for the Company, is the date of the grant. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model and is based on certain assumptions including risk-free rate of return, dividend yield, stock price volatility and the expected term. The fair value of each option is expensed over its vesting period. Income Taxes The Company files a consolidated income tax return with its subsidiaries. Federal and state income tax expense or benefit has been allocated to subsidiaries on a separate return basis. Deferred taxes are recognized under the balance sheet method based upon the future tax consequences of temporary differences between the carrying amounts and tax basis of assets and liabilities, using the tax rates expected to apply to taxable income in the periods when the related temporary differences are expected to be realized. Realization of deferred tax assets is dependent upon the generation of a sufficient level of future taxable income and recoverable taxes paid in prior years. Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized. Earnings Per Common Share Basic earnings per common share is computed by dividing net income, less any preferred dividends requirement, by the weighted average of common shares outstanding. Diluted earnings per common share reflects the potential dilution that could occur if options, convertible securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. Comprehensive Income Comprehensive income includes all changes in stockholders’ equity during a period, except those resulting from transactions with stockholders. Besides net income, other components of the Company’s comprehensive income includes the after tax effect of changes in the net unrealized gain/loss on securities available for sale. Statement of Cash Flows For purposes of the statement of cash flows, the Company considers cash and due from banks and interest-bearing deposits with banks as cash equivalents. Recent Accounting Pronouncements In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 removes the second step of goodwill testing. ASU 2017-04 will be effective on January 1, 2020 and is not expected to have a significant impact on the Company’s financial statements. In January 2017, the FASB issued ASU No. 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business.” ASU 2017-01 clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of a business. ASU 2017-01 will be effective on January 1, 2018 and is not expected to have a significant impact on the Company’s financial statements. In October 2016, the FASB issued ASU No. 2016-17, “Consolidation (Topic 810): Interests Held Through Related Parties That Are Under Common Control.” ASU 2016-17 updates ASU No. 2015-02 to amend the consolidation guidance on how a reporting entity that is the single decision maker of a variable interest entity (“VIE”) should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that VIE. ASU 2016-17 will be effective on January 1, 2017 and is not expected to have a significant impact on the Company’s financial statements. In October 2016, the FASB issued ASU No. 2016-16, “Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory.” ASU 2016-16 provides guidance stating that an entity should recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. ASU 2016-16 will be effective on January 1, 2018 and is not expected to have a significant impact on the Company’s financial statements. In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 is intended to reduce the diversity in practice around how certain transactions are classified within the statement of cash flows. ASU 2016-15 will be effective on January 1, 2018. Early adoption is permitted with retrospective applications. The Company is currently evaluating the potential impact of ASU 2016-15 on its financial statements. In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 requires a financial asset measured at amortized cost basis to be presented at the net amount expected to be collected. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. ASU 2016-13 requires enhanced disclosures related to the significant estimates and judgements used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 will be effective on January 1, 2020. The Company is currently evaluating the potential impact of ASU 2016-13 on its financial statements. In March 2016, the FASB issued ASU No. 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” Under ASU 2016-09 all excess tax benefits and tax deficiencies related to share-based payment awards should be recognized as income tax expense or benefit in the income statement during the period in which they occur. Previously, such amounts were recorded in the pool of excess tax benefits included in additional paid-in capital, if such pool was available. Because excess tax benefits are no longer recognized in additional paid-in capital, the assumed proceeds from applying the treasury stock method when computing earnings per share should exclude the amount of excess tax benefits that would have previously been recognized in additional paid-in capital. Additionally, excess tax benefits should be classified along with other income tax cash flows as an operating activity rather than a financing activity, as was previously the case. ASU 2016-09 also provides that an entity can make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest (current GAAP) or account for forfeitures when they occur. ASU 2016-09 changes the threshold to qualify for equity classification (rather than as a liability) to permit withholding up to the maximum statutory tax rates (rather than the minimum as was previously the case) in the applicable jurisdictions. ASU 2016-09 will be effective on January 1, 2017 and is not expected to have a significant impact on the Company’s financial statements. In February 2016, the FASB issued ASU No. 2016-02, “Leases - (Topic 842).” ASU 2016-02 requires that lessees recognize on the balance sheet the assets and liabilities for the rights and obligations created by leases. The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2018. Early adoption is permitted. Adoption of ASU 2016-02 is not expected to have a significant impact on the Company’s financial statements. In January 2016, the FASB issued ASU No. 2016-01, “Financial Instruments - Overall (Subtopic 825-10).” ASU 2016-01 require all equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in the fair value recognized through net income. In addition, the amendment will require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2017. Early adoption is not permitted. Adoption of ASU 2016-01 is not expected to have a significant impact on the Company’s financial statements. In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements - Going Concern (Topic 205-40).” ASU 2014-15 provides guidance on management’s responsibility in evaluating whether there is substantial doubt about the Company’s ability to continue as a going concern and related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about the Company’s ability to continue as a going concern within one year from the date the financial statements are issued. The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2016. Early adoption is permitted. Adoption of ASU 2014-15 is not expected to have a significant impact on the Company’s financial statements. In January of 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customer (Topic 606).” ASU 2014-09 implements a comprehensive new revenue recognition standard that will supersede substantially all existing revenue recognition guidance. The new standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in a manner that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The guidance does not apply to revenue associated with financial instruments, including loans and securities that are accounted for under other GAAP, which comprises a significant portion of our revenue stream. In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers (Topic 606).” ASU 2015-14 is an amendment to defer the effective date of ASU N. 2014-09. The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted for the Company as of January 1, 2017. Adoption of ASU 2014-09 may require the Company to amend how it recognizes certain recurring revenue streams related to trust fees, which are recorded in non-interest expense; however, the Company does not expect the adoption of ASU 2014-09 to have a significant impact on the Company’s financial statements. (2) RECENT DEVELOPMENTS, INCLUDING MERGERS AND ACQUISITIONS On October 8, 2015, the Company completed its acquisition of CSB Bancshares Inc. and its subsidiary bank, Bank of Commerce, with locations in Yukon, Mustang and El Reno, Oklahoma. Bank of Commerce had approximately $196 million in total assets, $147 million in loans, $175 million in deposits and $22 million in equity capital. The acquisition was accounted for under the acquisition method and the Company acquired 100% of the voting interest. Bank of Commerce operated as a subsidiary of BancFirst Corporation until it was merged into BancFirst on November 13, 2015. As a result of the acquisition, the Company recorded a core deposit intangible of approximately $7.1 million and goodwill of approximately $9.4 million. The effect of this acquisition was included in the consolidated financial statements of the Company from the date of acquisition forward. The acquisition did not have a material effect on the Company’s consolidated financial statements. The acquisition of CSB Bancshares Inc. and its subsidiary bank, Bank of Commerce complements the Company’s community banking strategy by adding two communities to its banking network in Oklahoma. On January 24, 2014, BancFirst assumed all of the deposits and purchased certain assets of The Bank of Union, El Reno, Oklahoma (“The Bank of Union”). The Bank of Union was closed on that day by the Oklahoma State Banking Department. At the time of the closing, The Bank of Union had total deposits of approximately $302 million that were assumed by BancFirst. BancFirst initially purchased approximately $121 million of loans, the majority of which were classified as performing, $4.8 million of securities, and $10,000 of other real estate. Its bid included a discount for the loans purchased. BancFirst had bid on, but was generally not awarded, loans that were classified as nonperforming. As a result of the acquisition, the Company recorded a core deposit intangible of approximately $2.2 million and goodwill of $417,000. The effect of this acquisition was included in the consolidated financial statements of the Company from the date of acquisition forward. The acquisition did not have a material effect on the Company’s consolidated financial statements. (3) CASH, DUE FROM BANKS, INTEREST-BEARING DEPOSITS AND FEDERAL FUNDS SOLD The Company maintains accounts with the Federal Reserve Bank and various other financial institutions primarily for the purpose of holding excess liquidity and clearing cash items. It may also sell federal funds to certain of these institutions on an overnight basis. At December 31, 2016 and 2015, the Company had no significant concentrations of credit risk with other financial institutions. The Company maintained vault cash and funds on deposit with the Federal Reserve Bank, which is included in the table below. The Company is required, as a matter of law, to maintain a reserve balance in the form of vault cash or cash on deposit with the Federal Reserve Bank. The average amount of required reserves for each of the years ended December 31, 2016 and 2015 is included in the following table: (4) SECURITIES The following table summarizes securities held for investment and securities available for sale: The following table summarizes the amortized cost and estimated fair values of securities held for investment: The following table summarizes the amortized cost and estimated fair values of securities available for sale: (1) Primarily consists of FHLMC, FNMA, GNMA and mortgage backed securities through U.S. agencies. (2) Primarily consists of equity securities. The maturities of securities held for investment and available for sale are summarized in the following table using contractual maturities. Actual maturities may differ from contractual maturities due to obligations that are called or prepaid. For purposes of the maturity table, mortgage-backed securities, which are not due at a single maturity date, have been presented at their contractual maturity. The following is a detail of proceeds from sales and realized securities gains and losses, on available for sale securities: Realized gains/losses are reported as securities transactions within the noninterest income section of the consolidated statement of comprehensive income. During 2015 the realized gains were from the following transactions: Council Oak Investment Corporation, a wholly-owned subsidiary of BancFirst, recognized a pretax gain of approximately $1.7 million from the sale of one of its equity investments, Council Oak Partners, LLC, a wholly-owned subsidiary of the Company, recognized a pretax gain of approximately $5.2 million from the sale of one of its equity investments and the Company recorded a gain of $2.1 million related to the redemption of warrants associated with a past loan transaction. The following table is a summary of the Company’s book value of securities that were pledged as collateral for public funds on deposit, repurchase agreements and for other purposes as required or permitted by law: The following table summarizes securities with unrealized losses, segregated by the duration of the unrealized loss, at December 31, 2016 and 2015 respectively: Declines in the fair value of held for investment and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer and (iii) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Management has the ability and intent to hold the securities classified as held for investment until they mature, at which time the Company will receive full value for the securities. Furthermore, as of December 31, 2016 and 2015, the Company also had the ability and intent to hold the securities classified as available for sale for a period of time sufficient for a recovery of cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying debt securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality, and has no intent or requirement to sell before the recovery of the unrealized loss; therefore, the Company has not recognized any impairment in the Company’s consolidated statement of comprehensive income. (5) LOANS AND ALLOWANCE FOR LOAN LOSSES The following is a schedule of loans outstanding by category: The Company’s commercial and industrial loan category includes a small percentage of loans to companies that provide ancillary services to the oil and gas industry, such as transportation, preparation contractors and equipment manufacturers. The balance of these loans at December 31, 2016 was approximately $56 million. The Company’s loans are mostly to customers within Oklahoma and over 65% of the loans are secured by real estate. Credit risk on loans is managed through limits on amounts loaned to individual borrowers, underwriting standards and loan monitoring procedures. The amounts and types of collateral obtained, if any, to secure loans are based upon the Company’s underwriting standards and management’s credit evaluation. Collateral varies, but may include real estate, equipment, accounts receivable, inventory, livestock and securities. The Company’s interest in collateral is secured through filing mortgages and liens, and in some cases, by possession of the collateral. There are inherent risks associated with the Company’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Company operates. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company. As a lender, the Company faces the risk that a significant number of its borrowers will fail to pay their loans when due. If borrower defaults cause losses in excess of the Company’s allowance for loan losses, it could have an adverse effect on the Company’s business, profitability, and financial condition. Loans secured by real estate, including farmland, multifamily, commercial, one-to-four family residential and construction and development loans, have been a large portion of the Company’s loan portfolio. The Company is subject to risk of future market fluctuations in property values relating to these loans. In addition, multi-family and commercial real estate (“CRE”) loans represent the majority of the Company’s real estate loans outstanding. A decline in tenant occupancy due to such factors or for other reasons could adversely impact the ability of the Company’s borrowers to repay their loans on a timely basis, which could have a negative impact on the Company’s financial condition and results of operation. The Company attempts to manage this risk through rigorous loan underwriting standards. During the ordinary course of business, the Company may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Nonperforming and Restructured Assets The following is a summary of nonperforming and restructured assets: Had nonaccrual loans performed in accordance with their original contractual terms, the Company would have recognized additional interest income of approximately $2.0 million in 2016, $2.0 million in 2015 and $1.2 million in 2014. Restructured loans at December 31, 2015 consisted primarily of one relationship restructured in prior periods to defer certain principal payments. This relationship was re-evaluated by management and removed from restructured loans in 2016 due to sustained improvement in financial condition, performance and the commercially reasonable nature of its structure. The Company charges interest on principal balances outstanding during deferral periods. As a result, the current and future financial effects of the recorded balance of loans considered to be restructured were not considered to be material. Loans are segregated into classes based upon the nature of the collateral and the borrower. These classes are used to estimate the allowance for loan losses. The following table is a summary of amounts included in nonaccrual loans, segregated by class of loans. Residential real estate refers to one-to-four family real estate. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. The following table presents an age analysis of past due loans, segregated by class of loans: Impaired Loans Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect the full amount of scheduled principal and interest payments in accordance with the original contractual terms of the loan agreement. If a loan is impaired, a specific valuation allowance may be allocated, if necessary, so that the loan is reported, net of allowance for loss, at the present value of future cash flows using the loan’s existing rate, or the fair value of collateral if repayment is expected solely from the collateral. The following table presents impaired loans, segregated by class of loans. No material amount of interest income was recognized on impaired loans subsequent to their classification as impaired. Credit Risk Monitoring and Loan Grading The Company considers various factors to monitor the credit risk in the loan portfolio including volume and severity of loan delinquencies, nonaccrual loans, internal grading of loans, historical loan loss experience and economic conditions. An internal risk grading system is used to indicate the credit risk of loans. The loan grades used by the Company are for internal risk identification purposes and do not directly correlate to regulatory classification categories or any financial reporting definitions. The general characteristics of the risk grades are as follows: Grade 1 - Acceptable - Loans graded 1 represent reasonable and satisfactory credit risk which requires normal attention and supervision. Capacity to repay through primary and/or secondary sources is not questioned. Grade 2 - Acceptable - Increased Attention - This category consists of loans that have credit characteristics deserving management’s close attention. These potential weaknesses could result in deterioration of the repayment prospects for the loan or the Bank’s credit position at some future date. Such credit characteristics include loans to highly leveraged borrowers in cyclical industries, adverse financial trends which could potentially weaken repayment capacity, loans that have fundamental structure deficiencies, loans lacking secondary sources of repayment where prudent, and loans with deficiencies in essential documentation, including financial information. Grade 3 - Loans with Problem Potential - This category consists of performing loans which are considered to exhibit problem potential. Loans in this category would generally include, but not be limited to, borrowers with a weakened financial condition or poor performance history, past dues, loans restructured to reduce payments to an amount that is below market standards and/or loans with severe documentation problems. In general, these loans have no identifiable loss potential in the near future, however; the possibility of a loss developing is heightened. Grade 4 - Problem Loans/Assets - Nonperforming - This category consists of nonperforming loans/assets which are considered to be problems. Nonperforming loans are described as being 90 days and over past due and still accruing, and loans that are nonaccrual. The government guaranteed portion of Small Business Administration (“SBA”) loans is excluded. Grade 5 - Loss Potential - This category consists of loans/assets which are considered to possess loss potential. While the loss may not occur in the current year, management expects that loans/assets in this category will ultimately result in a loss, unless substantial improvement occurs. Grade 6 - Charge Off - This category consists of loans that are considered uncollectible and other assets with little or no value. The following table presents internal loan grading by class of loans: Allowance for Loan Losses Methodology The allowance for loan losses (“ALL”) is determined by a calculation based on segmenting the loans into the following categories: (1) adversely graded loans [Grades 3, 4 and 5] that have a specific reserve allocation; (2) loans without a specific reserve segmented by loans secured by real estate other than one-to-four family residential property, loans secured by one-to-four family residential property, commercial, industrial and agricultural loans not secured by real estate, consumer purpose loans not secured by real estate, and loans over 60 days past due that are not otherwise Grade 3, 4, or 5; (3) Grade 2 loans; (4) Grade 1 loans and (5) loans held for sale which are excluded. The ALL is calculated as the sum of the following: (1) the total dollar amount of specific reserve allocations; (2) the dollar amount derived by multiplying each segment of adversely graded loans without a specific reserve allocation times its respective reserve factor; (3) the dollar amount derived by multiplying Grade 2 loans and Grade 1 loans (less certain exclusions) times the respective reserve factor; and (4) other adjustments as deemed appropriate and documented by the Senior Loan Committee or Board of Directors. The amount of the ALL is an estimate based upon factors which are subject to rapid change due to changing economic conditions and the economic prospects of borrowers. It is reasonably possible that a material change could occur in the estimated ALL in the near term. The following table details activity in the ALL by class of loans for the period presented. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories. The following table details the amount of ALL by class of loans for the period presented, on the basis of the impairment methodology used by the Company. The following table details the loans outstanding by class of loans for the period presented, on the basis of the impairment methodology used by the Company. Transfers from Loans Transfers from loans to other real estate owned and repossessed assets are non-cash transactions, and are not included in the statements of cash flow. Transfers from loans to other real estate owned and repossessed assets during the periods presented are summarized as follows: Related Party Loans The Company has made loans in the ordinary course of business to the executive officers and directors of the Company and to certain affiliates of these executive officers and directors. Management believes that all such loans were made on substantially the same terms as those prevailing at the time for comparable transactions with other persons and do not represent more than a normal risk of collectability or present other unfavorable features. A summary of these loans is as follows: (6) PREMISES AND EQUIPMENT, NET AND OTHER ASSETS The following is a summary of premises and equipment by classification: Low Income Housing Tax Credit Investments We invest in affordable housing projects that qualify for the low income housing tax credit (LIHTC), which is designed to promote private development of low income housing. These investments generate a return primarily through realization of federal tax credits, and also through a tax deduction generated by operating losses of the investments. The investments are amortized through tax expense using the proportional amortization method as related tax credits are utilized. The Company is periodically required to provide additional contributions at the discretion of the project sponsors. Although in some cases the Company’s investment may exceed 50% of the equity interest in an entity, the Company does not consolidate these structures as variable interest entities due to the project sponsor’s ability to manage the projects, which is indicative of power in them. Total LIHTC investments were $15.2 million and $14.5 million at December 31, 2016 and 2015, respectively and are included in other assets on the balance sheet. The Company recognized tax credits and other tax benefits of $4.2 million, $4.0 million and $3.3 million in 2016, 2015 and 2014, respectively and amortization expense of $2.9 million, $2.6 million and $2.3 million in 2016, 2015 and 2014, respectively resulting from LIHTC investments. Additional contributions are made during the investment periods through the year 2032. Unfunded commitments to these investments as of December 31, 2016 totaled $13.5 million. (7) INTANGIBLE ASSETS AND GOODWILL The following is a summary of intangible assets: Mortgage servicing intangibles are amortized based on current prepayment assumptions and are adjusted to fair value semi-annually, if impaired. Fair value is estimated based on the present value of future cash flows over several interest rate scenarios, which are then discounted at risk-adjusted rates. The Company considers portfolio characteristics, contractually specified servicing fees, prepayment assumptions, delinquency rates, late charges, other ancillary revenue, costs to service and other economic factors. When available, fair value estimates and assumptions are compared to observable market data and the recent market activity and actual portfolio experience. Estimated amortization of intangible assets for the next five years, as of December 31, 2016, is as follows (dollars in thousands): At December 31, 2016, the weighted-average remaining life of all intangible assets was approximately 6.7 years which consisted of customer relationship intangibles with a weighted-average life of 6.9 years, core deposit intangibles with a weighted-average life of 6.8 years and mortgage servicing intangibles with a weighted-average life of 2.0 years based on current prepayment assumptions. The following is a summary of goodwill by business segment: In June 2015, the Company recorded an impairment loss for goodwill of $368,000 after adopting a plan to close a small branch, which is included in other noninterest expense on the consolidated statement of comprehensive income. (8) TIME DEPOSITS Time deposits include certificates of deposit and individual retirement accounts. At December 31, 2016, the scheduled maturities of all time deposits are as follows (Dollars in thousands): The following table is a summary of large time deposits for the periods presented: The aggregate amount of domestic certificates of deposit that meet or exceed the current FDIC insurance limit was $122.2 million and $120.0 million at December 31, 2016 and 2015, respectively. (9) SHORT-TERM BORROWINGS The following is a summary of short-term borrowings: Federal funds purchased represent borrowings of overnight funds from other financial institutions. (10) LONG-TERM BORROWINGS The Company has a line of credit from the Federal Home Loan Bank (“FHLB”) of Topeka, Kansas to use for liquidity or to match-fund certain long-term fixed rate loans. The Company’s assets, including residential first mortgages of $674.5 million, are pledged as collateral for the borrowings under the line of credit. As of December 31, 2016, the Company had the ability to draw up to $517.5 million on the FHLB line of credit based on FHLB stock holdings of $551,900 with no advances outstanding. In addition, the Company has a revolving line of credit with the ability to draw up to $10.0 million with no advances outstanding. This line of credit has a variable rate based on prime rate minus 25 basis points and matures in 2020. (11) JUNIOR SUBORDINATED DEBENTURES In January 2004, the Company established BFC Capital Trust II (“BFC II”), a trust formed under the Delaware Business Trust Act. The Company owns all of the common securities of BFC II. In February 2004, BFC II issued $25 million of aggregate liquidation amount of 7.20% Cumulative Trust Preferred Securities (the “Cumulative Trust Preferred Securities”) to other investors. In March 2004, BFC II issued an additional $1 million in Cumulative Trust Preferred Securities through the execution of an over-allotment option. The proceeds from the sale of the Cumulative Trust Preferred Securities and the common securities of BFC II were invested in $26.8 million of 7.20% Junior Subordinated Debentures of the Company. Interest payments on the $26.8 million of 7.20% Junior Subordinated Debentures are payable January 15, April 15, July 15 and October 15 of each year. Such interest payments may be deferred for up to twenty consecutive quarters. The stated maturity date of the $26.8 million of 7.20% Junior Subordinated Debentures is March 31, 2034, but they are subject to mandatory redemption pursuant to optional prepayment terms. The Cumulative Trust Preferred Securities represent an undivided interest in the $26.8 million of 7.20% Junior Subordinated Debentures and are guaranteed by the Company. During any deferral period or during any event of default, the Company may not declare or pay any dividends on any of its capital stock. The Cumulative Trust Preferred Securities were callable at par, in whole or in part, after March 31, 2009. On October 8, 2015, the Company acquired CSB Bancshares Statutory Trust I (CSB Trust I), a trust formed under the Delaware Business Trust Act, from the merger of CSB Bancshares Inc. CSB Trust I had issued $5.0 million aggregate liquidation amount of floating rate capital securities to other purchasers and $155,000 aggregate liquidation amount of common securities to CSB Bancshares Inc., which were assumed by the Company as a result of the merger. The proceeds from the sale of the securities of CSB Trust I were invested in $5.2 million of Floating Rate Junior Subordinated Deferrable Interest Debentures of CSB Bancshares Inc., which were assumed by the Company as a result of the merger. Interest payments on the $5.2 million of Floating Rate Junior Subordinated Deferrable Interest Debentures are payable March 15, June 15, September 15 and December 15 of each year. The interest rate on the $5.2 million of Floating Rate Junior Subordinated Deferrable Interest Debentures was set at three month LIBOR plus 182 basis points. The Floating Rate Junior Subordinated Deferrable Interest Debentures are due September 15, 2036. (12) INCOME TAXES The components of the Company’s income tax expense (benefit) are as follows: Income tax (benefit) expense applicable to securities transactions approximated $(21,000), $3.2 million and $574,000 for the years ended December 31, 2016, 2015 and 2014, respectively. A reconciliation of tax expense at the federal statutory tax rate applied to income before taxes is presented in the following table: The net deferred tax asset consisted of the following and is reported in other assets: The Company recognizes accrued interest and penalties related to unrecognized tax benefits, if applicable, in income tax expense. During the years ended December 31, 2016, 2015 and 2014, the Company did not recognize or accrue any interest and penalties related to unrecognized tax benefits. Federal and various state income tax statutes dictate that tax returns filed in any of the previous three reporting periods remain open to examination which includes the years 2014 to 2016. The Company has no open examinations with either the Internal Revenue Service or any state agency. Management performs an analysis of the Company’s tax position annually and believes it is more likely than not that all of its tax positions will be utilized in future years. (13) STOCK-BASED COMPENSATION The Company adopted a nonqualified incentive stock option plan (the “BancFirst ISOP”) in May 1986. The Company amended the BancFirst ISOP to increase the number of shares to be issued under the plan to 3,200,000 shares in May 2016. At December 31, 2016, 215,735 shares were available for future grants. The BancFirst ISOP will terminate on December 31, 2019. The options vest and are exercisable beginning four years from the date of grant at the rate of 25% per year for four years. Options expire at the end of fifteen years from the date of grant. Options outstanding as of December 31, 2016 will become exercisable through the year 2023. The option price must be no less than 100% of the fair value of the stock relating to such option at the date of grant. In June 1999, the Company adopted the BancFirst Corporation Non-Employee Directors’ Stock Option Plan (the “BancFirst Directors’ Stock Option Plan”). Each non-employee director is granted an option for 10,000 shares. The Company amended the BancFirst Directors’ Stock Option Plan to increase the number of shares to be issued under the plan to 260,000 shares in May 2016. At December 31, 2016, 40,000 shares were available for future grants. The options vest and are exercisable beginning one year from the date of grant at the rate of 25% per year for four years, and expire at the end of fifteen years from the date of grant. Options outstanding as of December 31, 2016 will become exercisable through the year 2020. The option price must be no less than 100% of the fair value of the stock relating to such option at the date of grant. The Company currently uses newly issued shares for stock option exercises, but reserves the right to use shares purchased under the Company’s Stock Repurchase Program (the “SRP”) in the future. The following table is a summary of the activity under both the BancFirst ISOP and the BancFirst Directors’ Stock Option Plan: The following table has additional information regarding options granted and options exercised under both the BancFirst ISOP and the BancFirst Directors’ Stock Option Plan: The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model and is based on certain assumptions including risk-free rate of return, dividend yield, stock price volatility and the expected term. The fair value of each option is expensed over its vesting period. The following table is a summary of the Company’s recorded stock-based compensation expense: The Company will continue to amortize the unearned stock-based compensation expense over the remaining vesting period of approximately seven years. The following table shows the unearned stock-based compensation expense: The following table shows the assumptions used for computing stock-based compensation expense under the fair value method: The risk-free interest rate is determined by reference to the spot zero-coupon rate for the U.S. Treasury security with a maturity similar to the expected term of the options. The dividend yield is the expected yield for the expected term. The stock price volatility is estimated from the recent historical volatility of the Company’s stock. The expected term is estimated from the historical option exercise experience. In May 1999, the Company adopted the BancFirst Corporation Directors’ Deferred Stock Compensation Plan (the “BancFirst Deferred Stock Compensation Plan”). The Company amended the BancFirst Deferred Stock Compensation Plan to increase the number of shares to be issued under the plan to 111,110 shares in May 2016. Under the plan, directors and members of the community advisory boards of the Company and its subsidiaries may defer up to 100% of their board fees. They are credited for each deferral with a number of stock units based on the current market price of the Company’s stock, which accumulate in an account until such time as the director or community board member terminates serving as a board member. Shares of common stock of the Company are then distributed to the terminating director or community board member based upon the number of stock units accumulated in his or her account. The number of shares of common stock distributed from the BancFirst Deferred Stock Compensation Plan was 2,790 and 622 during the years ended December 31, 2016 and 2015, respectively. A summary of the accumulated stock units is as follows: (14) RETIREMENT PLANS In May 1986, the Company adopted the BancFirst Corporation Employee Stock Ownership (“ESOP”) and Thrift Plan (“401(k)”) effective January 1, 1985. The plan was separated into two individual plans effective January 1, 2009. The 401(k) and ESOP plans cover all eligible employees, as defined in the plans, of the Company and its subsidiaries. The 401(k) plan allows employees to defer up to the maximum legal limit of their compensation, of which the Company may match up to 3% of their compensation. In addition, the Company may make discretionary contributions based on employee contributions or eligible compensation to the ESOP plan, as determined by the Company’s Board of Directors. The aggregate amounts of contributions by the Company to the 401(k) and ESOP plans are shown in the following table: (15) STOCKHOLDERS’ EQUITY As of December 31, 2016, 2015 and 2014 the Company’s authorized and outstanding preferred and common stock was as follows: The following is a description of the capital stock of the Company: (a) Senior Preferred Stock: No shares issued or outstanding. Shares may be issued with such voting, dividend, redemption, sinking fund, conversion, exchange, liquidation and other rights as shall be determined by the Company’s Board of Directors, without approval of the stockholders. The Senior Preferred Stock would have a preference over common stock as to payment of dividends, as to the right to distribution of assets upon redemption of such shares or upon liquidation of the Company. (b) 10% Cumulative Preferred Stock: Redeemable at the Company’s option at $5.00 per share plus accumulated dividends; non-voting; cumulative dividends at the rate of 10% payable semi-annually on January 15 and July 15; no shares issued or outstanding. (c) Common stock: At December 31, 2016, 2015 and 2014 the shares issued equaled shares outstanding. In November 1999, the Company adopted a Stock Repurchase Program (the “SRP”). The SRP may be used as a means to increase earnings per share and return on equity, to purchase treasury stock for the exercise of stock options or for distributions under the Deferred Stock Compensation Plan, to provide liquidity for optionees to dispose of stock from exercises of their stock options, and to provide liquidity for stockholders wishing to sell their stock. All shares repurchased under the SRP have been retired and not held as treasury stock. The timing, price and amount of stock repurchases may be determined by management within the limitations of the SRP. During the third quarter of 2016 the SRP was amended to increase the remaining shares to be repurchased to 150,000. The following table is a summary of the shares under the program: The Company’s ability to pay dividends is dependent upon dividend payments received from BancFirst. Banking regulations limit bank dividends based upon net earnings retained and minimum capital requirements. Dividends in excess of these requirements require regulatory approval. At January 1, 2017, approximately $83.3 million of the equity of BancFirst was available for dividend payments to the Company. During any deferral period or any event of default on the Junior Subordinated Debentures, the Company may not declare or pay any dividends on any of its capital stock. The Company and BancFirst are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (“FDIC”). These guidelines are used to evaluate capital adequacy and involve both quantitative and qualitative evaluations of the Company’s and BancFirst’s assets, liabilities, and certain off-balance-sheet items calculated under regulatory practices. Failure to meet the minimum capital requirements can initiate certain mandatory or discretionary actions by the regulatory agencies that could have a direct material effect on the Company’s financial statements. Management believes that as of December 31, 2016, the Company and BancFirst met all capital adequacy requirements to which they are subject. The actual and required capital amounts and ratios are shown in the following table: As of December 31, 2016, the most recent notification from the Federal Reserve Bank of Kansas City and the FDIC categorized BancFirst as “well capitalized” under the regulatory framework for prompt corrective action. The Company’s trust preferred securities have continued to be included in Tier 1 capital as the Company’s total assets do not exceed $15 billion. There are no conditions or events since the most recent notification of BancFirst’s capital category that management believes would materially change its category under capital requirements existing as of the report date. Basel III Capital Rules Under the Basel III Capital Rules, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of CET1 capital above its minimum risk-based capital requirements. The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). Management believes that, as of December 31, 2016, the Company and BancFirst would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect. (16) NET INCOME PER COMMON SHARE Basic and diluted net income per common share are calculated as follows: The following table shows the number and average exercise price of options that were excluded from the computation of diluted net income per common share for each year because the options’ exercise prices were greater than the average market price of the common shares. (17) CONDENSED PARENT COMPANY FINANCIAL STATEMENTS BALANCE SHEETS STATEMENTS OF INCOME STATEMENTS OF CASH FLOW (18) RELATED PARTY TRANSACTIONS Refer to Note (5) for information regarding loan transactions with related parties. (19) COMMITMENTS AND CONTINGENT LIABILITIES The Company is a party to financial instruments with off balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include loan commitments and standby letters of credit which involve elements of credit and interest-rate risk to varying degrees. The Company’s exposure to credit loss in the event of nonperformance by the other party to the instrument is represented by the instrument’s contractual amount. To control this credit risk, the Company uses the same underwriting standards as it uses for loans recorded on the balance sheet. The amounts of financial instruments with off-balance-sheet risk are as follows: Loan commitments are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Stand-by letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These instruments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the instruments are expected to expire without being drawn upon, the total amounts do not necessarily represent commitments that will be funded in the future. The Company leases two parcels of land on which it owns buildings, twenty ATM locations, two storage facilities, four parking lots and office space in thirteen buildings. These leases expire at various dates through 2064. The future minimum rental payments under these leases at December 31, 2016, were as follows (Dollars in thousands): Rental expense on all property and equipment rented, including those rented on a monthly or temporary basis were as follows (Dollars in thousands): The Company is a defendant in legal actions arising from normal business activities. Management believes that all legal actions against the Company are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Company’s financial statements. (20) FAIR VALUE MEASUREMENTS Accounting standards define fair value as the price that would be received to sell an asset or the price paid to transfer a liability in the principal or most advantageous market available to the entity in an orderly transaction between market participants on the measurement date. FASB Accounting Standards Codification Topic 820 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows: • Level 1 Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. • Level 2 Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset and liability, either directly or indirectly, for substantially the full term of the financial instrument. • Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category includes certain impaired loans, repossessed assets, other real estate owned, goodwill and other intangible assets. Financial Assets and Financial Liabilities Measured at Fair Value on a Recurring Basis A description of the valuation methodologies and key inputs used to measure financial assets and financial liabilities at fair value on a recurring basis, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. These valuation methodologies were applied to the following categories of the Company’s financial assets and financial liabilities. Securities Available for Sale Securities classified as available for sale are reported at fair value. U.S. Treasuries are valued using Level 1 inputs. Other securities available for sale including U.S. federal agencies, registered mortgage backed securities and state and political subdivisions are valued using prices from an independent pricing service utilizing Level 2 data. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The Company also invests in private label mortgage backed securities and equity securities classified as available for sale for which observable information is not readily available. These securities are reported at fair value utilizing Level 3 inputs. For these securities, management determines the fair value based on replacement cost, the income approach or information provided by outside consultants or lead investors. The Company reviews the prices for Level 1 and Level 2 securities supplied by the independent pricing service for reasonableness and to ensure such prices are aligned with traditional pricing matrices. In general, the Company does not purchase investment portfolio securities that are esoteric or that have complicated structures. The Company’s portfolio primarily consists of traditional investments including U.S. Treasury obligations, federal agency mortgage pass-through securities, general obligation municipal bonds and a small amount of municipal revenue bonds. Pricing for such instruments is fairly generic and is easily obtained. For in-state bond issues that have relatively low issue sizes and liquidity, the Company utilizes the same parameters for pricing mentioned in the preceding paragraph adjusted for the specific issue. From time to time, the Company will validate, on a sample basis, prices supplied by the independent pricing service by comparison to prices obtained from third party sources. Derivatives Derivatives are reported at fair value utilizing Level 2 inputs. The Company obtains dealer and market quotations to value its oil and gas swaps and options. The Company utilizes dealer quotes and observable market data inputs to substantiate internal valuation models. Loans Held For Sale The Company originates mortgage loans to be sold. At the time of origination, the acquiring bank has already been determined and the terms of the loan, including interest rate, have already been set by the acquiring bank allowing the Company to originate the loan at fair value. Mortgage loans are generally sold within 30 days of origination. Loans held for sale are valued using Level 2 inputs. Gains or losses recognized upon the sale of the loans are determined on a specific identification basis. The following table summarizes financial assets and financial liabilities measured at fair value on a recurring basis as of December 31, 2016 and 2015, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value: The changes in Level 3 assets measured at estimated fair value on a recurring basis during the years ended December 31, 2016 and 2015 were as follows: The Company’s policy is to recognize transfers in and transfers out of Levels 1, 2 and 3 as of the end of the reporting period. During the years ended December 31, 2016 and 2015, the Company did not transfer any securities between levels in the fair value hierarchy. Financial Assets and Financial Liabilities Measured at Fair Value on a Nonrecurring Basis Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). These financial assets and financial liabilities are reported at fair value utilizing Level 3 inputs. Impaired loans are reported at the fair value of the underlying collateral if repayment is dependent on liquidation of the collateral. In no case does the fair value of an impaired loan exceed the fair value of the underlying collateral. The impaired loans are adjusted to fair value through a specific allocation of the allowance for loan losses or a direct charge-down of the loan. Repossessed assets, upon initial recognition, are measured and adjusted to fair value through a charge-off to the allowance for possible loan losses based upon the fair value of the repossessed asset. Other real estate owned is revalued at fair value subsequent to initial recognition, with any losses recognized in net expense from other real estate owned. The following table summarizes assets measured at fair value on a nonrecurring basis. The fair value represents end of period values, which approximate fair value measurements that occurred on various measurement dates throughout the period. The related losses represent the amounts recognized during the period regardless of whether the asset is still held at period end: Estimated Fair Value of Financial Instruments The Company is required under current authoritative accounting guidance to disclose the estimated fair value of their financial instruments that are not recorded at fair value. For the Company, as for most financial institutions, substantially all of its assets and liabilities are considered financial instruments. A financial instrument is defined as cash, evidence of an ownership interest in an entity or a contract that creates a contractual obligation or right to deliver or receive cash or another financial instrument from a second entity. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents Include: Cash and Due from Banks, Federal Funds Sold and Interest-Bearing Deposits The carrying amount of these short-term instruments is a reasonable estimate of fair value. Securities Held for Investment For securities held for investment, which are generally traded in secondary markets, fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities making adjustments for credit or liquidity if applicable. Loans For certain homogeneous categories of loans, such as some residential mortgages, fair values are estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair values of other types of loans are estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Deposits The fair values of transaction and savings accounts are the amounts payable on demand at the reporting date. The fair values of fixed-maturity certificates of deposit are estimated using the rates currently offered for deposits of similar remaining maturities. Short-term Borrowings The amounts payable on these short-term instruments are reasonable estimates of fair value. Junior Subordinated Debentures The fair values of junior subordinated debentures are estimated using the rates that would be charged for junior subordinated debentures of similar remaining maturities. Loan Commitments and Letters of Credit The fair values of commitments are estimated using the fees currently charged to enter into similar agreements, taking into account the terms of the agreements. The fair values of letters of credit are based on fees currently charged for similar agreements. The estimated fair values of the Company’s financial instruments that are reported at amortized cost in the Company’s consolidated balance sheets, segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value, are as follows: Non-financial Assets and Non-financial Liabilities Measured at Fair Value The Company has no non-financial assets or non-financial liabilities measured at fair value on a recurring basis. Certain non-financial assets and non-financial liabilities measured at fair value on a nonrecurring basis include intangible assets (excluding mortgage service rights, which are valued semi-annually) and other non-financial long-lived assets measured at fair value and adjusted for impairment. These items are evaluated at least annually for impairment, of which there were none as of December 31, 2016 or 2015. The overall levels of non-financial assets and non-financial liabilities measured at fair value on a nonrecurring basis were not considered to be significant to the Company at December 31, 2016 or 2015. (21) DERIVATIVE FINANCIAL INSTRUMENTS The Company enters into oil and gas swaps and options contracts to accommodate the business needs of its customers. Upon the origination of an oil or gas swap or option contract with a customer, to mitigate the exposure to fluctuations in oil and gas prices, the Company simultaneously enters into an offsetting contract with a counterparty. These derivatives are not designated as hedged instruments and are recorded on the Company’s consolidated balance sheet at fair value. The Company utilizes dealer quotations and observable market data inputs to substantiate internal valuation models. The notional amounts and estimated fair values of oil and gas derivative positions outstanding are presented in the following table: The following table is a summary of the Company’s recognized income related to the activity, which was included in other noninterest income: The Company’s credit exposure on oil and gas swaps and options varies based on the current market prices of oil and natural gas. Other than credit risk, changes in the fair value of customer positions will be offset by equal and opposite changes in the counterparty positions. The net positive fair value of the contracts represents the profit derived from the activity and is unaffected by market price movements. The Company’s share of total profit is approximately 35%. Customer credit exposure is managed by strict position limits and is primarily offset by first liens on production while the remainder is offset by cash. Counterparty credit exposure is managed by selecting highly rated counterparties (rated A- or better by Standard and Poor’s) and monitoring market information. The following table is a summary of the Company’s net credit exposure relating to oil and gas swaps and options with bank counterparties: Balance Sheet Offsetting Derivatives may be eligible for offset in the consolidated balance sheet and/or subject to master netting arrangements. The Company’s derivative transactions with upstream financial institution counterparties and bank customers are generally executed under International Swaps and Derivative Association (“ISDA”) master agreements which include “right of set-off” provisions. In such cases there is generally a legally enforceable right to offset recognized amounts and there may be an intention to settle such amounts on a net basis. Nonetheless, the Company does not generally offset such financial instruments for financial reporting purposes. (22) SEGMENT INFORMATION The Company evaluates its performance with an internal profitability measurement system that measures the profitability of its business units on a pre-tax basis. The four principal business units are metropolitan banks, community banks, other financial services and executive, operations and support. Metropolitan and community banks offer traditional banking products such as commercial and retail lending, and a full line of deposit accounts. Metropolitan banks consist of banking locations in the metropolitan Oklahoma City and Tulsa areas. Community banks consist of banking locations in communities throughout Oklahoma. Other financial services are specialty product business units including guaranteed small business lending, residential mortgage lending, trust services, securities brokerage, electronic banking and insurance. The executive, operations and support groups represent executive management, operational support and corporate functions that are not allocated to the other business units. The results of operations and selected financial information for the four business units are as follows: The financial information for each business unit is presented on the basis used internally by management to evaluate performance and allocate resources. The Company utilizes a transfer pricing system to allocate the benefit or cost of funds provided or used by the various business units. Certain services provided by the support group to other business units, such as item processing, are allocated at rates approximating the cost of providing the services. Eliminations are adjustments to consolidate the business units and companies. Capital expenditures are generally charged to the business unit using the asset. (23) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the unaudited quarterly results of operations for the years ended December 31, 2016 and 2015 is as follows:
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From the provided financial statement excerpt, I can summarize the following key points:
1. Total Assets: $147 (though units are not specified)
2. Key Policies and Procedures:
- Securities management: Company doesn't engage in trading activities
- Securities are classified as either "available for sale" or "held for investment"
- Regular quarterly review of securities portfolio for impairment
- Comprehensive loan policies governed by senior management and Board of Directors
- Interest rate risk managed through variable rate provisions
3. Revenue Sources:
- Securities investments
- Loan interest
- Insurance commissions and fees
- Contingent commissions from insurance companies
4. Accounting Practices:
- Uses Black-Scholes model for stock-based compensation
- Files consolidated income tax returns
- Recognizes deferred taxes under the balance sheet method
- Reports comprehensive income including net income and unrealized gains/losses
The statement appears to be more focused on explaining accounting policies and procedures rather than providing detailed financial figures, with only the total assets amount being clearly stated.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements are included herein in response to Item 8: Page Report of Independent Registered Public Accounting Firm Financial Statements Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Loss Consolidated Statements of Cash Flows Consolidated Statements of Series A Redeemable Preferred Stock and Stockholders’ Equity (Deficit) Page Report of Independent Registered Public Accounting Firm Financial Statements Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Loss Consolidated Statements of Cash Flows Consolidated Statements of Series A Redeemable Preferred Stock and Stockholders’ Equity (Deficit) EKS&H 8181 East Tufts Avenue, Suite 600 Denver, Colorado 80237-2521 P: 303-740-9400 F: 303-740-9009 www.EKSH.com EKS&H LLLP ACCOUNTING FIRM Board of Directors and Stockholders Jacobs Financial Group, Inc. Charleston, West Virginia We have audited the accompanying consolidated balance sheets of Jacobs Financial Group, Inc. (the “Company”) as of May 31, 2016 and 2015 and the related consolidated statements of operations, comprehensive income (loss), cash flows, and Series A redeemable preferred stock and stockholders' deficit for each of the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Jacobs Financial Group, Inc. as of May 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note A to the financial statements, the Company has insufficient liquidity and capitalization, and has suffered recurring operating losses. These conditions, among others, raise substantial doubt about the Company's ability to continue as a going concern. Management's plans regarding these matters are also described in Note A. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ EKS&H LLLP EKS&H LLLP June 30, 2017 Denver, Colorado Jacobs Financial Group, Inc. Note A - Organization and Business Organization and Nature of Business Jacobs Financial Group, Inc. (the “Company” or “JFG”), formerly NELX, Inc., was incorporated in Kansas on March 25, 1983. In 2001, the Company acquired all the outstanding stock of two corporations located in Charleston, West Virginia: Jacobs & Company (“Jacobs”) and FS Investments, Inc. (“FSI”). Jacobs is a registered investment advisory firm that derives its revenue from asset-based investment advisory fees. FSI, through its wholly-owned subsidiary Triangle Surety Agency, Inc. (“Triangle”), is engaged in the business of placing surety bonds with insurance companies for clients engaged in regulated industries, such as the extraction of coal, oil and gas. FSI receives commission income from the placement of these bonds and is licensed in five states primarily in the eastern United States. On December 30, 2005, the Company acquired all of the outstanding stock of West Virginia Fire & Casualty Company (“WVFCC”), an insurance company licensed to engage in business in West Virginia, Ohio and Indiana. The acquisition of WVFCC consisted of the purchase of marketable investments and insurance licenses and did not include any existing policies or customer base as the insurance lines of business offered by WVFCC were not insurance lines that the Company intended to pursue. Following the acquisition, the name of WVFCC was changed to First Surety Corporation (“FSC”). FSC receives insurance premium income in connection with the issuance of surety bonds. The Company and its subsidiaries are subject to the business risks inherent in the financial services industry. Liquidity and Going Concern These consolidated financial statements are presented on the basis that the Company is a going concern. Going concern contemplates the realization of assets and the satisfaction of liabilities in the normal course of business over a reasonable length of time. Presently, the Company has insufficient liquidity and capitalization, is in default with respect to certain loan and preferred stock agreements, and has suffered recurring losses from operations. Losses are expected to continue until the Company develops a more substantial book of business. While improvement is anticipated as the Company’s business plan is implemented, other conditions, such as restrictions on the use of FSC’s assets (See Note C), and the Company’s significant deficiency in working capital and stockholders’ equity raise substantial doubt about the Company’s ability to continue as a going concern. Management intends to improve cash flow through the implementation of its business plan. Additionally, management continues to seek to raise additional funds for operations through private placements of stock, other long-term or permanent financing, or short-term borrowings. However, the Company cannot be certain that it will be able to continue to obtain adequate funding in order to reasonably predict whether it will be able to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. Jacobs Financial Group, Inc. Principles of Consolidation The consolidated financial statements include the accounts of Jacobs Financial Group, Inc. and its majority owned subsidiaries, after the elimination of intercompany transactions. Non-Controlling Interest First Surety Corporation, a subsidiary of the Jacobs Financial Group, Inc. has a non-controlling ownership interest. The Company’s board of directors has authorized the sale of up to nine Units (5% per Unit), which, if completed, would include forty-five percent (45%) of the outstanding stock of FSC. Cash and Short Term Investments The Company considers all highly liquid instruments purchased with an original maturity of three months or less to be cash equivalents. The Company continually monitors its positions with, and the credit quality of, the financial institutions with which it invests. Included in cash and cash equivalents are restricted amounts held in trust for customers in the form of collateral for the bonding program of FSC. Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities. Significant areas requiring the use of management estimates are loss reserves, stock options, valuation of investments, and the valuation of deferred tax assets. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. Revenue Recognition Fees for investment advisory services are based on an agreed percentage of the value of client assets under management and are accrued monthly based on the market value of client assets. The Company accounts for its surety bond issuances as short duration contracts. Surety premiums are recorded as receivables when due and are earned pro rata over the term of the policies of generally one year, subject to annual renewal. The reserve for unearned premiums represents the portion of premiums written relating to the unexpired terms of coverage. The reserve for unearned premium is determined using the monthly pro rata method. Advance premiums represent renewal premiums paid in advance of the effective renewal date. Jacobs Financial Group, Inc. Agency commissions for surety bond services are based on a percentage of premiums charged for bonds placed with insurance companies, and are recorded upon issuance or effective renewal date of the bonds. No significant continuing services subsequent to the issuance or renewal of surety bonds are required. Policy acquisition costs include costs that vary with and are primarily related to the acquisition of new business. Such costs generally include commissions, underwriting expenses, and premium taxes and are deferred and amortized over the period in which the related premiums are earned. The deferred policy acquisition cost assets are reviewed for recoverability based on the profitability of the underlying surety policy. Investment income is not anticipated in the recoverability of deferred policy acquisition costs. Investments Debt securities are designated at purchase as held-to-maturity, trading or available for sale. Held-to-maturity debt securities are carried at amortized cost where the Company has the ability and intent to hold these securities until maturity. Premiums and discounts arising from the purchase of debt securities are treated as yield adjustments over the estimated lives or call date, if applicable. Debt and equity securities that are bought and held principally for sale in the near future are classified as trading securities and are carried at fair value, with changes in fair value being recorded in current operations. Debt and equity securities that the Company may not have a positive intent to hold until maturity and not classified as trading, are considered to be available for sale and carried at fair value. Management has determined it may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company classifies all of its fixed income securities (bonds) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders’ equity as a separate component of accumulated other comprehensive income. An investment is considered impaired when its fair value is less than its cost or amortized cost, as applicable. When an investment is impaired, a determination is made as to whether the impairment is other than temporary (“OTTI”). Factors considered in identifying OTTI include: 1) for debt securities, whether the Company intends to sell the investment or whether it is more likely than not that the Company will be required to sell the security prior to the anticipated recovery in value; 2) the likelihood of the recoverability of principal and interest for debt securities (i.e., whether there is a credit loss) or cost for equity securities; 3) the length of time and extent to which Jacobs Financial Group, Inc. the fair value has been less than amortized cost for debt securities or carrying value for equity securities; and 4) the financial condition, near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of rating agency actions and offering prices. Short-term investments consist primarily of debt securities having maturities of one year or less at date of purchase, money-market investment funds and other similar investments that have immediate availability. Interest income with respect to fixed maturity securities is accrued as earned. Dividend income is generally recognized when receivable. Realized gains and losses are determined by specific identification of the security sold. Derivatives The Company uses derivatives in the form of covered call options sold to generate additional income and provide limited downside protection in the event of a market correction. These transactions expose the Company to potential market risk for which the Company receives a premium up front and the Company realizes the option premium received as income. The market risk relates to the requirement to deliver the underlying security to the purchaser of the call within a definite time at an agreed market price regardless of the then current market price of the security. As a result the Company takes the risk that it may be required to sell the security at the strike price, which could be a price less than the then market price. Should the security decline in market price over the holding period of the call option, the Company can lessen or mitigate the risk of loss with a closing transaction for the covered call and sale of the underlying security. The Company invests in large capitalized US securities traded on major US exchanges and writes standardized covered calls only against these positions (covered calls), which are openly traded on major US exchanges. The use of such underlying securities and standardized calls lessens the credit risk to the furthest extent possible. The Company is not exposed to significant cash requirements through the use of covered calls in that it sells a call for a premium and may use these proceeds to enter a closing transaction for the call at a later date. Allowance for uncollectible premium and other receivables The majority of the Company’s fee revenue is generated by services provided to companies and individuals throughout the Eastern United States. Management evaluates the need for a reserve for the amount of these receivables that may be uncollectible, based on historical collection activity adjusted for current conditions. Premium and other receivables are charged-off when deemed uncollectible. Based on this evaluation, management believes Jacobs Financial Group, Inc. that most accounts receivable are collectible, and has established an allowance for estimated uncollectible accounts. Impairment The Company evaluates long-lived assets for impairment annually, or whenever events or changes in circumstances indicate that the assets may not be recoverable. The impairment is measured by discounting estimated future cash flows expected to be generated, and comparing this amount to the carrying value of the asset. Cash flows are calculated utilizing forecasts and projections and estimated lives of the assets being analyzed. Should actual results differ from those forecasted and projected, The Company may be subject to future impairment charges related to these long-lived assets. Furniture and Equipment Furniture and equipment is recorded at cost. Maintenance and repairs are charged to operations when incurred. When property and equipment are sold or disposed of, the asset account and related accumulated depreciation account are relieved, and any gain or loss is included in operations. The cost of property and equipment is depreciated over the estimated useful lives of the related assets, ranging from three to seven years, using the straight-line and double-declining balance methods, which approximates estimated economic depreciation. Reserve for Losses and Loss Expenses Losses and loss adjustment expenses represent management’s best estimate of the ultimate net cost of all reported and unreported losses incurred. Reserves for unpaid losses and loss adjustment expenses are estimated using industry averages, however, will include individual case-basis valuations in the event if claims are received. These estimates and methods of establishing reserves are continually reviewed and updated. Stock-based Compensation The fair value of stock options is estimated at the grant date using the Black Scholes Option Pricing Model. This model requires the input of a number of assumptions, including expected volatility and dividend yields, expected stock price, risk-free interest rates, and an expected life of the options. Although the assumptions used reflect management’s best estimate, they involve inherent uncertainties based on market conditions generally outside the control of the Company. Income Taxes The Company currently has net operating loss (“NOL”) carry-forwards that can be utilized to offset future income for federal and state tax purposes. These NOLs represent a significant deferred tax asset. However, the Company has recorded a valuation allowance against this deferred tax asset as it has determined that it is more likely than not that it will Jacobs Financial Group, Inc. not be able to fully utilize the NOLs. Should assumptions regarding the utilization of these NOLs change, the Company may reduce some or all of this valuation allowance, which would result in the recording of a deferred income tax benefit. The Company follows a more-likely-than-not measurement methodology to reflect the financial statement impact of uncertain tax positions taken or expected to be taken in a tax return. If taxing authorities were to disallow any tax positions taken by the Company, the additional income taxes, if any, would be imposed on the Company. Interest and penalties associated with tax positions are recorded in the period assessed as general and administrative expenses. However, no interest or penalties have been assessed as of May 31, 2016 or 2015. The Company's tax returns subject to examination by tax authorities include May 31, 2011 through the current period for state and federal tax reporting purposes. Earnings (Loss) Per Share Basic earnings (loss) per share of common stock are computed using the weighted average number of shares outstanding during each period. Diluted earnings per share are computed on the basis of the average number of common shares outstanding plus the dilutive effect of convertible debt, stock options and warrants. In periods of net loss, there are no diluted earnings per share since the result would be anti-dilutive. Note B - Newly Adopted and Recent Accounting Pronouncements In May 2014, the FASB issued Accounting Standards Update 2014-09 (ASU 2014-09), Revenue from Contracts with Customers. The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts). The standard's core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under current guidance. This may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The amendments in this Update are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early adoption is not permitted. Companies have the option of using either a full or modified retrospective approach in applying this standard. The Company is in the process of assessing the impact of ASU 2014-09 on its consolidated financial statements. In August 2014, the FASB issued Accounting Standards Update No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40) (ASU 2014-15). ASU 2014-15 is intended to define management's responsibility to evaluate whether there is substantial Jacobs Financial Group, Inc. doubt about an organization's ability to continue as a going concern and to provide related footnote disclosures. This guidance is effective for us for the annual period ending May 31, 2017 and interim and annual periods thereafter. We do not expect the adoption of this standard to have a material impact on our consolidated financial position, results of operations and cash flows. In April 2015, the FASB issued ASU 2015-03, “Interest - Imputation of Interest”, which require debt issuance costs to be presented in the balance sheet as a direct deduction from the associated debt liability. The new rules were effective for the Company in the first quarter of 2016. In August 2015, the FASB issued ASU 2015-15, “Interest - Imputation of Interest (Subtopic 835-30) - Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements”. The guidance clarifies accounting for debt issuance costs related to line-of-credit arrangements. The standard states that the FASB deems deferring debt issuance costs related to line-of-credit arrangements as an asset and amortizing over the term of the agreement to be appropriate. The adoption of these accounting rules did not have a material impact on the Company’s financial condition, results of operations or cash flows. In February 2015, the FASB issued ASU 2015-02, “Consolidation (Topic 810)”, an update to their existing consolidation model, which changes the analysis a reporting entity must perform to determine whether it should consolidate certain types of legal entities. The new rules will be effective for the Company in the first quarter of 2016. The adoption of the new accounting rules will not have a material impact on the Company’s financial condition, results of operations or cash flows. In May 2015, the FASB issued ASU 2015-07, “Fair Value Measurement (Topic 820)”, which removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient, and requires separate disclosure of those investments instead. These disclosures were effective for the Company in the first quarter of 2016. The adoption of the new accounting rules did not have an impact on the Company’s financial condition, results of operations or cash flows. In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805)”, which simplify the accounting for measurement period adjustments by eliminating the requirements to restate prior period financial statements for these adjustments. The new guidance requires that the cumulative impact of a measurement period adjustment (including the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. The new standard, which should be applied prospectively to measurement period adjustments that occur after the effective date, was effective for the Company in the first quarter of 2016. The adoption of the new accounting rules did not have a material impact on the Company’s financial condition, results of operations or cash flows. On October 2016, the FASB issued ASU 2016-17, “Consolidation (Topic 810): Interests Held through Related Parties That Are under Common Control”, that affects reporting Jacobs Financial Group, Inc. entities that are required to evaluate whether they should consolidate a Variable Interest Entity (VIE) in certain situations involving entities under common control. The amendments in this Update will be effective for the Company in the first quarter of 2017. The adoption of the new accounting rules will not have a material impact on the Company’s financial condition, results of operations or cash flows. In November 2015, the FASB issued an ASU 2015-17, “Income Taxes (Topic 740)”, an update to simplify income tax accounting. The update requires that all deferred tax assets and liabilities be classified as noncurrent on the balance sheet instead of separating deferred taxes into current and noncurrent amounts. This update is effective for the Company first quarter 2017 and is not expected to have a material impact on the Company’s financial condition, results of operations or cash flows. In March 2016, the FASB issued ASU No. 2016-07, “Investments - Equity Method and Joint Ventures (Topic 323)”, that eliminates the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an adjustment must be made to the investment, results of operations and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The new standard will be effective for the Company on January 1, 2017. The adoption of the new accounting rule is not expected to have a material impact on the Company’s financial condition, results of operations or cash flows. In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting”, which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The new rules are effective for the Company in the first quarter of 2017. The Company does not expect the adoption of the new accounting rules to have a material impact on the Company’s financial condition, results of operations or cash flows. In January 2016, the FASB issued ASU 2016-01, “Financial Instruments-Overall (Subtopic 825-10)”, which updated the accounting guidance related to the recognition and measurement of financial assets and financial liabilities. The updated accounting guidance, among other things, requires that all nonconsolidated equity investments, except those accounted for under the equity method, be measured at fair value and that the changes in fair value be recognized in net income. The updated guidance will be effective for the Company as of January 1, 2018. The updated accounting guidance requires, with certain exceptions, a cumulative effect adjustment to beginning retained earnings when the guidance is adopted. The Company is currently in the process of evaluating the impact of adoption of the new rules on the Company’s financial condition, results of operations and cash flows. In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments”. The guidance is intended to reduce the diversity in practice as to how certain cash receipts and cash payments are Jacobs Financial Group, Inc. presented and classified in the statement of cash flows by providing guidance for several specific cash flow issues. In addition, in November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash”. The amendment requires that amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The new rules will be effective for the Company in the first quarter of 2018. The Company does not expect the adoption of the new accounting rules to have a material impact on the Company’s cash flows. Management has assessed the potential impact of recently issued, but not yet effective, accounting standards and determined that the provisions are either not applicable to the Company, or are not anticipated to have a material impact on the consolidated financial statements. Note C - Investments The Company held the following investments, by security type, that were classified as available-for-sale and carried at fair value at May 31, 2016: The Company held the following investments, by security type, that have been classified as available-for-sale and carried at fair value at May 31, 2015: Jacobs Financial Group, Inc. There are no securities classified as held to maturity at May 31, 2016 or May 31, 2015. Invested assets are exposed to various risks, such as interest rate, market and credit risks. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Consolidated Balance Sheets and Statements of Operations. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company uses the following fair value hierarchy in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable: oLevel 1 - Quoted prices for identical instruments in active markets. oLevel 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets. oLevel 3 - Valuations derived from valuation techniques in which one or more significant inputs are unobservable. Fair values are provided by the Company’s independent investment custodians that utilize third-party quotation services for the valuation of the fixed-income investment securities and money-market funds held. The Company’s investment custodians are large money-center banks. The Company’s equity investment is valued using quoted market prices. The following section describes the valuation methodologies used to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which the instrument is generally classified. Fixed Income Securities Securities valued using Level 1 inputs include highly liquid government bonds for which quoted market prices are available. Securities using Level 2 inputs are valued using pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models utilizing observable inputs. Most fixed income securities are valued using Level 2 inputs. Level 2 includes corporate bonds, municipal bonds, asset-backed securities and mortgage pass-through securities. Equity Securities Level 1 includes publicly traded securities valued using quoted market prices. Short-Term Investments The valuation of securities that are actively traded or have quoted prices are classified as Level 1. These securities include money market funds and U.S. Treasury bills. Level 2 includes commercial paper, for which all significant inputs are observable. Jacobs Financial Group, Inc. Assets measured at fair value on a recurring basis are summarized below: The Company had no assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at either May 31, 2016 or at May 31, 2015. At May 31, 2016, the Company’s insurance subsidiary had securities and short-term investment with a fair value of $1,171,307 on deposit with the State insurance department to satisfy regulatory requirements. In connection with regulatory approval of the Company’s acquisition of its insurance subsidiary, certain restrictions were imposed on the ability of the Company to withdraw funds from FSC without prior approval of the state Insurance Commissioner. Accordingly, investments and cash in the amount of $9,386,503 and $10,100,908 as of May 31, 2016 and 2015, respectively, are restricted to the use of FSC. At May 31, 2016, the Company’s insurance subsidiary had cash, securities and short term investments held as collateral for their bonding program in the amount of $2,068,252. Principal repayments on U.S. government agency mortgage-backed securities held by the Company as of December 31, 2016 are estimated as follows: Jacobs Financial Group, Inc. Estimated repayments are forecast based on varying prepayment speeds for each particular security held assuming that interest rates remain constant. Expected repayments will differ from actual repayments because borrowers of the underlying mortgages have a right to prepay obligations. An analysis of net investment income follows: The unrealized appreciation (depreciation) of investments were as follows: Gains and losses are calculated based on sales proceeds received less the cost of the security sold, which is determined by specific identification for each investment. The gross gains and gross losses realized on available-for-sale securities were as follows: Jacobs Financial Group, Inc. The following table summarizes the gross unrealized losses and fair value on investment securities aggregated by major investment category and length of time that individual securities have been in a continuous loss position at May 31, 2016 and May 31, 2015. Jacobs Financial Group, Inc. (a) For bonds-fixed maturities and mortgage-backed securities, represents amortized costs. As of May 31, 2016, the Company held twenty-seven mortgage-backed securities with gross unrealized losses of $14,790, four of which have been in a continuous loss position for more than 12 months. These securities consist of fixed-rate securities issued by Government National Mortgage Association (GNMA) that are sensitive to movements in market interest rates. As of May 31, 2016, the Company held fifteen fixed maturity bonds with gross unrealized losses of $58,217, seven of which have been in a continuous loss position for more than 12 months. As of May 31, 2016, the Company held seventeen equity security investments with gross unrealized losses of $155,300, two of which have been in a continuous loss position for more than 12 months. These securities consist of common stock whose fair value is sensitive to movements in market interest rates. Jacobs Financial Group, Inc. Note D-Deferred Policy Acquisition Costs The following reflects the policy acquisition costs deferred for amortization against future income and the related amortization charged to operations. Note E - Other Assets Included in other assets as of May 31, 2016 and May 31, 2015 are $14,617 and $14,550 of prepaid expenses and deposits. Note F - Intangibles As the result of the acquisition of FSC on December 30, 2005, in exchange for the purchase price of $2,900,000, the Company received cash and investments held by FSC with a fair value of $2,750,000, with the difference of $150,000 being attributed to the property and casualty licenses of FSC in the states of West Virginia, Ohio and Indiana. Such licenses have indefinite lives and are evaluated annually, or more frequently if circumstances indicate that a possible impairment has occurred, for recoverability and possible impairment loss. No impairment has been recorded in fiscal years ended May 31, 2016 and 2015. Note G - Reserve for Losses and Loss Expense Reserves for unpaid losses and loss adjustment expenses are estimated based primarily on management’s judgment as the Company has incurred limited losses since its inception and available industry data is also extremely limited. In the event of the Company receiving a claim it will use individual case basis estimates including all estimated future expenses to settle such claims. As of May 31, 2016, the Company’s insurance subsidiary, FSC, is only licensed to write surety in West Virginia and Ohio and has focused its primary efforts towards coal permit reclamation bonds while also providing other miscellaneous surety bonds, most of which are partially collateralized by investment accounts that are managed by Jacobs & Company. Reclamation of land that has been disturbed by mining operations is highly regulated by federal and state agencies and the required bonds are generally long-term in nature with mining operations and reclamation work conducted in unison as the property is being mined. Additionally, no two principals or properties are alike due to varied company structures and unique geography and geology of each site. In underwriting such bonds, management Jacobs Financial Group, Inc. develops, through consultation with professionals experienced in the specific field of work, estimates of costs to reclaim the properties subject of the permit(s) in accordance with those mining permit(s), in addition to other underwriting and financial risk considerations. FSC requires the principal to provide cash, or other acceptable collateral such as irrevocable letters of credit, in amounts determined through the underwriting process to reclaim the disturbed land and thus mitigate the exposure to significant loss. FSC maintains reinsurance agreement with various syndicates at Lloyd's of London. The reinsurance agreement is an excess of loss contract that protects FSC against losses up to certain limits over stipulated amounts. Such cash is invested in investment collateral accounts managed by Jacobs utilizing investment strategies consistent with the state code governing investments of an insurance company. Inspections of mining activity and reclamation work are performed on a regular basis with initial cost estimates being updated periodically. Should the principal default in the obligation to reclaim the property in accordance with the mining permit, FSC would then use the funds held in the collateral account to reclaim the property or would be required to forfeit the face amount of the bond to the agency to which the bond is issued. Losses can occur if the costs of reclamation exceed estimates obtained at the time the bond was underwritten or upon subsequent re-evaluations, if sufficient collateral is not obtained and increased if necessary, or if collateral held has experienced a significant deterioration in value. FSC has experienced two claims for loss through May 31, 2016 (one fiscal 2016, detailed below) and thus provisions for losses and loss adjustment expense have been based on management’s experience adjusted for other factors unique to the Company’s approach, and in consultation with actuaries experienced in the surety field. In August 2015, the Company paid a claim on a called bond in the amount of $550,000, of which $75,000 was paid using collateral of the principal. The remaining $475,000 has been established as a salvage reserve to be repaid with the assignment of proceeds from sales of stock and an assignment of a promissory note as additional collateral with total assigned values in excess of the salvage reserve. The Company incurred loss adjustment expenses of $26,590 ($25,000 in Fiscal 2014) related to costs of engaging experts, attorney fees, and consultants for potential claims. These costs were charged against established case reserves and bulk reserves. As a result of an examination by the West Virginia Insurance Commissioner, a reserve strengthening in the form of an increase to the Loss Reserve was recorded in Fiscal 2015 and 2016 in the amounts of approximately $800,000 and $20,402. Jacobs Financial Group, Inc. At May 31, 2016 and May 31, 2015, the reserve for losses and loss expenses consisted of: Jacobs Financial Group, Inc. Note H - Notes Payable At May 31, 2016 and 2015, the Company had the following unsecured notes payable to individuals: Jacobs Financial Group, Inc. During the year ended May 31, 2015, the Company borrowed $75,000 from a board member. Accrued related party interest of $9,452 is payable to this individual at May 31, 2016. During the year ended May 31, 2016, an individual who holds secured notes payables from the Company, became a greater than 10% owner of outstanding common stock of the Company. During the year ended May 31, 2016, the Company borrowed additional money from this individual and entities controlled by this individual. Amounts owed to this individual (and the individual’s companies and relatives) at May 31, 2016 consisted of $868,900 in demand notes, $1,387,573 in notes payable secured by FSC stock, and $14,621 in accrued interest. All notes payables, with the exception of the bridge-financing arrangement and those secured by FSC stock are on demand terms and therefore current. The terms of the bridge-financing arrangement (which was paid off in 2016) are detailed in the following paragraphs. In accordance with the terms of the first round bridge-financing of $2.5 million on March 10, 2008, the holders of such notes were paid accrued interest-to date and issued 5.00% of the Company's common shares. During 2009, holders of the second round of bridge-financing notes of $1.0 million received 2.00% of the Company's common shares. Upon retirement of the notes subsequent to consummation of a qualified equity offering, the Company was to issue to the holders of the bridge financing notes additional Company common stock that when added to the stock initially issued to the holders of the notes, would equal the note holders’ pro rata share of the applicable percentage of the outstanding common stock of the Company as follows: If the qualified financing consists of $50 million or more, the holders of such notes will receive 28% of the common stock of the Company that would otherwise be retained by the holders of the Company's common shares immediately prior to the financing; if the qualified financing is for an amount less than $50 million, the percentage will be reduced on a sliding scale to a fraction of 28% of the amount retained by the holders of the Company's common shares (where the numerator is the amount of financing and the denominator is $50 million). This feature was analyzed and determined to be an embedded derivative, but the value was considered to be immaterial, and therefore was not recorded. Beginning September 10, 2008, because a qualified financing had not been completed, the Company became required under the terms of the bridge financing to issue 2.80% of the Company's outstanding common shares and shall issue 2.80% of the Company's outstanding common shares upon each six-month anniversary date thereof until retirement of the notes. This feature was analyzed and determined to be an embedded derivative, but the value was considered to be immaterial and therefore was not recorded for the remaining shares to be issued. Pursuant to the terms of the Promissory Notes, the first two of 20 equal quarterly installments of principal and interest payable thereunder were to have been paid on December 10, 2008 and March 10, 2009 (the “Initial Amortization Payments”). As the result of upheavals and dislocations in the capital markets, the Company was unable to either refinance the indebtedness evidenced by the Promissory Notes or make the Initial Jacobs Financial Group, Inc. Amortization Payments to the Holders when due; and an Event of Default (as defined in the Promissory Notes) occurred under the Promissory Notes as a result of the Company’s failure to pay the Initial Amortization Payments within 14 days after same became due and payable. On June 5, 2009 the Company entered into an agreement with the bridge lenders to forbear from exercising their rights and remedies arising from the Acknowledged Events of Default. The Original forbearance was amended October 13, 2009. As consideration for the forbearance, the Company issued 5,171,993 shares of Common stock, and pledged the stock of an inactive subsidiary of the Company, Crystal Mountain Water (CMW), as security for repayment of the loans. In anticipation of a proposed financing and as a condition thereof, the Company and each of the bridge lenders entered into a loan modification agreement dated February 25, 2012 which provided for modification of the Promissory Notes, including an extension of the term of the promissory notes, and subscription agreements in exchange for a partial cash payment to each bridge lender. On August 10, 2012, the Company entered into an agreement with the bridge lenders, pursuant to which the bridge lenders formally agreed to forbear from exercising their rights and remedies arising from the accumulated acknowledged events of default with respect to the bridge loans until such date. As consideration for this forbearance, the Company entered into an Amended and Restated General Hypothecation and Pledge Agreement dated August 9, 2012 (the “August 2012 Pledge”), but effective September 23, 2011, granting to the bridge lenders as security for the repayment of the loans a lien and security interest in all of the Company’s shares of capital stock of First Surety Corporation. Under the August 2012 Pledge, the bridge lenders acknowledged that the effectiveness of certain of the rights and remedies provided by such agreement would be subject to prior approval by the Office of the Commissioner of Insurance for the State of West Virginia. On July 9, 2014 the Company completed a $4,500,000 financing. In effect, FSI, a subsidiary of the Company, borrowed the funds at 8.00% interest with principal repayments on a ten year schedule. Proceeds of the borrowing were applied (i) to purchase from certain bridge lenders, after waiving interest of approximately $1.6 million, i.e. 50.7%, ($1.775 million face amount) of the outstanding senior $3.5 million financing dating from 2008, together with the associated collateral, (ii) to pay in full delinquent tax liabilities owed to the Internal Revenue Service and State of West Virginia, (iii) to pay an outstanding judgment, and (iv) to pay certain other current liabilities. FSI therefore became a member of the Bridge Loan and notified the Collateral Agent for the group of its purchase and majority holding. The transaction restored majority control of FSC to the Company. On August 5, 2015 the Company completed a $1,600,000 transaction which resulted in its acquisition of the remaining 49.3% ($1.725 million face amount) senior promissory notes of the $3.5 million financing dating from 2008, after waiving interest of approximately $1.8 million. Upon closing of the acquisition, the collateral securing the senior promissory notes, 1,000 shares (100%) of FSC and 1,000 shares (100%) of CMW, was released to the Company. This extinguishment of debt resulted in a gain from forgiven principal and Jacobs Financial Group, Inc. interest in the amounts of $125,000 and $1,795,000, respectively for a total gain of $1,920,000. The transaction was funded through sale in a private offering of investment units (Units) that consisted of 5.00% of the outstanding shares of FSC and 500,000 common shares of the Company. $1,600,000 was raised through a combination of cash, partial assignments of loans back to the Company that were debt of the Company and loans that are convertible into purchase of Units. The Registrant’s Board of Directors has authorized the sale of up to nine Units, which, if completed, would include forty-five percent (45%) of the outstanding stock of FSC. Scheduled maturities are as follows: Note I - Other Liabilities As of May 31, 2016, the Company had accrued and withheld approximately $31,000 in Federal payroll taxes and approximately $31,000 in estimated penalties and interest, which are reflected in the financial statements as other liabilities. As of May 31, 2016, the Company had accrued and withheld approximately $44,000 in West Virginia payroll withholdings and approximately $7,000 in interest and penalties, which are reflected in the accompanying financial statements as other liabilities. As of May 31, 2016 and May 31, 2015 the Company held approximately $2,068,192 and $2,352,427 respectively in its cash and investment accounts that was for the benefit of clients as collateral for their surety bonding program. Note J - Preferred Stock Redeemable Preferred Stock On December 30, 2005, through a private placement, the Company issued 350 shares of 4% Non-Voting Series A Preferred Stock (Series A Preferred Stock), along with 1,050,000 warrants for common shares of Company stock as additional consideration, for a cash investment in the amount of $350,000, in connection with the Company's acquisition of FSC. Holders of Series A Preferred Stock are entitled to participate in FSC's partially Jacobs Financial Group, Inc. collateralized bonding programs, subject to continuing satisfaction of underwriting criteria, based upon the bonding capacity of FSC attributable to capital reserves of FSC established with the subscription proceeds (i.e., bonding capacity equal to ten times subscription proceeds) and for so long as the subscriber holds the Series A shares. Holders of the Series A Preferred Stock are entitled to receive, when and as declared by the board of directors, cumulative preferential cash dividends at a rate of four percent of the $1,000 liquidation preference per annum (equivalent to a fixed annual rate of $40 per share). The Series A Preferred Stock ranks senior to the Company's common stock and pari passu with the Company's Series B Preferred and Series C Preferred Stock with respect to dividend rights and rights upon liquidation, dissolution or winding up of the Company. The holder may redeem the Series A Preferred Stock on or after the seventh anniversary of the Issue Date, if the holder provides a written statement to the Company that it will no longer require surety bonds issued by the Company's insurance subsidiary (FSC) under its partially collateralized bonding programs and, if no such surety bonds are then outstanding, the Company, at the option of the holder, will redeem all or any portion of the Series A Preferred Stock of such holder at a price per share equal to the Series A Preferred Stock Issue Price plus all accrued and unpaid dividends with respect to the shares of the Series A Preferred Stock of such holder to be redeemed. The conditional redemption shall not be available to any holder of Series A Preferred Stock for so long as surety bonds of the Company's insurance subsidiary issued on a partially collateralized basis remain outstanding for the benefit of such holder, and upon redemption, such holder shall no longer be eligible to participate in the partially collateralized bonding programs of the insurance subsidiary. The Company is authorized to issue up to 1,000,000 shares of the Series A Preferred Stock. As of May 31, 2016, the Company has issued 2,675 shares of Series A Preferred Stock in exchange for cash investments in the amount of $2,675,000, of which no shares were issued in fiscal 2016 or 2015. The Company’s outstanding Series A Preferred stock matures on the seventh anniversary of the issuance date and thereafter holders of the Series A Stock are eligible to request that the Company redeem their Series A Shares. As of May 31, 2016, the Company has received requests for redemption of 1,026 shares of Series A Preferred. The aggregate amount to which the holders requesting redemption are entitled as of June 30, 2016, is $1,535,688. Under the terms of the Series A Preferred Stock, upon receipt of such a request, the Company’s Board was required to make a good faith determination regarding (A) whether the funds of the Company legally available for redemption of shares of Series A Stock are sufficient to redeem the total number of shares of Series A Stock to be redeemed on such date and (B) whether the amounts otherwise legally available for redemption would, if used to effect the redemption, not result in an impairment of the operations of the Insurance Subsidiary. If the Board determines that there is a sufficiency of legally available funds to accomplish the redemption and that the use of such funds to affect the redemption will not result in an impairment of the operations of the Insurance Subsidiary, then the redemption shall occur on the Redemption Date. If, however, the Board determines either that there are not sufficient funds legally available to accomplish the redemption or that the use of such funds to effect the redemption will result in an impairment of the operations of the Jacobs Financial Group, Inc. Insurance Subsidiary, then (X) the Company shall notify the holders of shares that would otherwise have been redeemed of such fact and the consequences as provided in this paragraph, (Y) the Company will use those funds which are legally available therefor and which would not result in an impairment of the operations of the Insurance Subsidiary to redeem the maximum possible number of shares of Series A Stock for which Redemption Notices have been received ratably among the holders of such shares to be redeemed based upon their holdings of such shares, and (Z) thereafter, until such shares are redeemed in full, the dividends accruing and payable on such shares of Series A Stock to be redeemed shall be increased by 2% of the Series A Face Amount, with the amount of such increase (i.e., 2% of the Series A Face Amount) to be satisfied by distributions on each Dividend Payment Date of shares of Common Stock having a value (determined by reference to the average closing price of such Common Stock over the preceding 20 trading days) equal to the amount of such increase. The shares of Series A Stock not redeemed shall remain outstanding and entitled to all the rights and preferences provided herein. At any time thereafter when additional funds of the Company are legally available for the redemption of shares of Series A Stock and such redemption will not result in an impairment of operations of the Insurance Subsidiary, such funds will immediately be used to redeem the balance of the shares of Series A Stock to be redeemed. No dividends or other distributions shall be declared or paid on, nor shall the Company redeem, purchase or acquire any shares of, the Common Stock or any other class or series of Junior Securities or Equal Ranking Preferred of the Company unless the Redemption Price per share of all shares for which Redemption Notices have been given shall have been paid in full, provided that the redemption price of any Equal Ranking Preferred subject to redemption shall be paid on a pari passu basis with the Redemption Price of the Series A Stock subject to redemption in accordance herewith. Until the Redemption Price for each share of Series A Stock elected to be redeemed shall have been paid in full, such share of Series A Stock shall remain outstanding for all purposes and entitle the holder thereof to all the rights and privileges provided herein, and Dividends shall continue to accrue and, if unpaid prior to the date such shares are redeemed, shall be included as part of the Redemption Price. The Company’s Board of Directors determined based on the criteria established under the terms of the Preferred Stocks that there were insufficient funds available for the redemption of Preferred Stocks. On December 30, 2005, through a private placement, the Company issued 3,980 shares of 8% Non-Voting Series B Convertible Preferred Stock (Series B Preferred Stock), along with 19,900,000 warrants for common shares of Company stock as additional consideration, for a cash investment in the amount of $2,985,000; and issued 4,891 shares of Series B Preferred Stock, along with 24,452,996 warrants for common shares of Company stock as additional consideration, for a conversion of $3,667,949 of indebtedness of the Company, in connection with the Company's acquisition of FSC. Holders of the Series B Preferred Stock are entitled to receive, when and as declared by the board of directors, cumulative preferential cash dividends at a rate of eight percent of the $1,000 liquidation preference per annum (equivalent to a fixed annual rate of $80 per share). The Series B Preferred Stock ranks senior to the Company's common stock and pari passu with the Company's Series A Preferred and Series C Preferred Stock with respect to dividend Jacobs Financial Group, Inc. rights and rights upon liquidation, dissolution or winding up of the Company. Each share of the Series B Preferred Stock is convertible at the option of the holder, at any time after the original issue date, into 1,000 fully paid and non-assessable shares of the Company's common stock at a conversion price of $1.00 per common share. The Company may redeem the Series B Preferred Stock at any time after the first anniversary of the Original Issue Date at a price per share equal to the Series B Preferred Stock Face Amount plus all accrued and unpaid dividends with respect to the shares of the Series B Preferred Stock of such holder to be redeemed. To the extent that the Series B Preferred Stock has not been redeemed by the Company, the holder may redeem the Series B Preferred Stock on or after the fifth anniversary of the Original Issue Date at a price per share equal to the Series B Preferred Stock Face Amount plus all accrued and unpaid dividends with respect to the shares of the Series B Preferred Stock of such holder to be redeemed. The Company is authorized to issue up to 10,000 shares of the Series B Preferred Stock. The Company has not issued any additional shares of Series B Preferred Stock during fiscal 2016. The Company’s outstanding Series B Preferred stock matured on December 30, 2010, meaning that the holders of the Series B Stock that had not requested exchange to the Company’s Series C Preferred stock became entitled to request that the Company redeem their Series B Shares. As part of the exchange to Series C Preferred Stock in September 2009, the shares that did not exchange were treated as a liability on the balance sheet. As of May 31, 2016, of the 2,817 shares of Series B Preferred that remained outstanding, the Company has received requests for redemption of 2,219 shares of Series B Preferred. The aggregate amount to which the holders requesting redemption are entitled as of June 30, 2016, is $5,099,573. Under the terms of the Series B Preferred Stock, upon receipt of such a request, the Company’s Board was required to make a good faith determination regarding (A) whether the funds of the Company legally available for redemption of shares of Series B Stock are sufficient to redeem the total number of shares of Series B Stock to be redeemed on such date and (B) whether the amounts otherwise legally available for redemption would, if used to effect the redemption, not result in an impairment of the operations of the Insurance Subsidiary. If the Board determines that there is a sufficiency of legally available funds to accomplish the redemption and that the use of such funds to affect the redemption will not result in an impairment of the operations of the Insurance Subsidiary, then the redemption shall occur on the Redemption Date. If, however, the Board determines either that there are not sufficient funds legally available to accomplish the redemption or that the use of such funds to effect the redemption will result in an impairment of the operations of the Insurance Subsidiary, then (X) the Company shall notify the holders of shares that would otherwise have been redeemed of such fact and the consequences as provided in this paragraph, (Y) the Company will use those funds which are legally available therefor and which would not result in an impairment of the operations of the Insurance Subsidiary to redeem the maximum possible number of shares of Series B Stock for which Redemption Notices have been received ratably among the holders of such shares to be redeemed based upon their holdings of such shares, and (Z) thereafter, until such shares are redeemed in full, the dividends accruing and payable on such shares of Series B Stock to be redeemed shall be increased by 2% of the Series B Face Amount, with the amount of such increase Jacobs Financial Group, Inc. (i.e., 2% of the Series B Face Amount) to be satisfied by distributions on each Dividend Payment Date of shares of Common Stock having a value (determined by reference to the average closing price of such Common Stock over the preceding 20 trading days) equal to the amount of such increase. The shares of Series B Stock not redeemed shall remain outstanding and entitled to all the rights and preferences provided herein. At any time thereafter when additional funds of the Company are legally available for the redemption of shares of Series B Stock and such redemption will not result in an impairment of operations of the Insurance Subsidiary, such funds will immediately be used to redeem the balance of the shares of Series B Stock to be redeemed. No dividends or other distributions shall be declared or paid on, nor shall the Company redeem, purchase or acquire any shares of, the Common Stock or any other class or series of Junior Securities or Equal Ranking Preferred of the Company unless the Redemption Price per share of all shares for which Redemption Notices have been given shall have been paid in full, provided that the redemption price of any Equal Ranking Preferred subject to redemption shall be paid on a pari passu basis with the Redemption Price of the Series B Stock subject to redemption in accordance herewith. Until the Redemption Price for each share of Series B Stock elected to be redeemed shall have been paid in full, such share of Series B Stock shall remain outstanding for all purposes and entitle the holder thereof to all the rights and privileges provided herein, and Dividends shall continue to accrue and, if unpaid prior to the date such shares are redeemed, shall be included as part of the Redemption Price. The Company’s Board of Directors determined based on the criteria established under the terms of the Series B Preferred Stock that there were insufficient funds available for the redemption of Series B Stock. The Company experienced a loss after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock of $108,386 in fiscal 2016 as compared with a loss after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock of $1,669,587 in fiscal 2015. Equity Preferred Stock As a means of alleviating obligations associated with the Company's Series B Jacobs Financial Group, Inc. Preferred Stock, which by its terms matured at the end of 2010, management proposed a recapitalization to assist in stabilizing the financial position of the Company. The Company’s Certificate of Incorporation provides for two classes of capital stock, known as common stock, $0.0001 par value per share (the “Common Stock”), and preferred stock, $0.0001 par value per share (the “Preferred Stock”). The Company’s Board is authorized by the Certificate of Incorporation to provide for the issuance of the shares of Preferred Stock in series, and by filing a certificate pursuant to the applicable law of the State of Delaware, to establish from time to time the number of shares to be included in such series and to fix the designations, preferences and rights of the shares of each such series and the qualifications, limitations and restrictions thereof. The Board deemed it advisable to designate a Series C Preferred Stock and fixed and determined the preferences, rights, qualifications, limitations and restrictions relating to the Series C Preferred Stock as follows: 1. Designation. The shares of such series of Preferred Stock are designated “Series C Preferred Stock” (referred to herein as the “Series C Stock”). The date on which the first share of Series C Stock is issued shall hereinafter be referred to as the “Original Issue Date”. 2. Authorized Number. The number of shares constituting the Series C Stock is 10,000. 3. Ranking. The Series C Stock ranks, (a) as to dividends and upon Liquidation senior and prior to the Common Stock and all other equity securities to which the Series C ranks prior, with respect to dividends and upon Liquidation (collectively, “Junior Securities”), (b) pari passu with the Corporation’s Series A Preferred Stock, par value $0.0001 per share (the “Series A Stock”), the Corporation’s Series B Stock, and any other series of Preferred Stock subsequently established by the Board with equal ranking (any such other series of Preferred Stock, together with the Series C Stock, the Series B Stock and Series A Stock are collectively referred to as the “Equal Ranking Preferred”) and (c) junior to any other series of Preferred Stock subsequently established by the Board with senior ranking. 4. Dividends. (a) Dividend Accrual and Payment. The holders of the Series C Stock shall be entitled to receive, in preference to the holders of Junior Securities, dividends (“Dividends”) on each outstanding share of Series C Stock at the rate of 8% per annum of the sum of (i) the Series C Face Amount plus (ii) an amount equal to any accrued, but unpaid, dividends on such Series C Stock, including for this purpose the exchanged Series B Amount outstanding with respect to such Series C Stock. For purposes hereof, the “Series B Amount” means an amount equal to the dividend that would have accrued on such Series C Stock held by such holder from and after the Series B Original Issue Date applicable to such share of Series C Stock, through the Original Issue Date as if such Series C Stock had been issued on such Series B Original Issue Date, less all amounts thereof distributed by the Corporation with respect to such Series C Stock. Dividends shall be payable quarterly in arrears on each January 1, April 1, July 1 and October 1 following the Original Issue Date, or, if any such date is a Saturday, Sunday or legal holiday, then on the next day which is not a Saturday, Sunday or legal holiday (each a “Dividend Payment Date”), as declared by the Board and, if not paid on the Dividend Payment Date, shall accrue. Amounts available for payment of Dividends (including for this purpose the Series Jacobs Financial Group, Inc. B Amount) shall be allocated and paid with respect to the shares of Series C Preferred and any other Equal Ranking Preferred, first, among the shares of Equal Ranking Preferred pro rata in accordance with the amounts of dividends accruing with respect to such shares at the current Dividend Payment Date, and, then, any additional amounts available for distribution in accordance with the accrued, but unpaid, dividends (and the Series B Amount then outstanding) at each prior Dividend Payment Date, in reverse chronological order, with respect to all shares of the Equal Ranking Preferred then outstanding in accordance with amounts accrued, but unpaid. For purposes hereof, the term “Series B Original Issue Date” shall mean, with respect to any share of Series C Stock issued by the Corporation in exchange for a share of Series B Stock, the date on which the Corporation originally issued such share of Series B Stock. The Recapitalization consisted of the exchange of Series B Shares for a combination of Series C Shares and Common Stock. For each Series B Share, the participating holder received (i) one Series C Share and (ii) 2,000 shares of JFG Common Stock (for no additional consideration). For the year ended May 31, 2010, 6,805 shares of Series B Stock were surrendered and exchanged for 6,805 shares of Series C Stock. This exchange amounted to $6,269,051 of carrying value of Series B stock being exchanged for Series C and Common Stock. 13,609,872 shares of Common Stock were issued to the Series C Stock holders at the rate of 2,000 Common shares for each exchanged Series B Stock, with the related cost associated with the Common issuance offsetting the Series C carrying value by $265,120. The shares were valued at approximately $.01948 per share based on the average quoted closing price of the Company's stock for the 20-day period proceeding the date of the transaction. Series C stock may be redeemed by the Company but does not have a fixed maturity date and, thus, is classified as permanent equity. For the year ending May 31, 2016, 2,817 shares of Series B Stock had not been exchanged. The accrual of dividends on the equity preferred stock resulted in a charge to common stockholders’ equity and a credit to the equity of equity preferred stock of $1,164,143 in fiscal 2016 as compared with a charge to common stockholders’ equity of $1,072,461 in fiscal 2015. Dividend Preference and Accretion The Series A Shares are entitled to receive cumulative dividends at the compounding rate of 4.00% per annum. The Series B Shares have an 8.0% per annum compounding dividend preference, are convertible into Common Shares of JFG at the option of the holders at a conversion price of $1.00 per Share (as adjusted for dilution) and, to the extent not converted, must be redeemed by the Corporation at any time after December 31, 2010 at the option of the holder. Any such redemption is subject to legal constraints, such as the availability of capital or surplus out of which to pay the redemption, and to a determination by the Board of Directors that the redemption will not impair the operations of First Surety Corporation. Jacobs Financial Group, Inc. The Series C Shares issued in the Recapitalization have the same 8.0% per annum compounding dividend preference and carry over from the Series B Shares the same accrued but unpaid dividends. While dividends had never been declared on the Series B shares, they had been accrued, increasing the dividend preference and the redemption price and liquidity preference of such shares and increasing the liability represented thereby based upon the Series B Shares fixed maturity date. The accrued (but undeclared) dividends associated with the Series C exchange amounted to $2,295,624 and are included in the total amount exchanged for Series C Shares. Unlike the Series B Shares with their fixed maturity date, the Series C Shares are permanent equity, with accruing dividends only increasing the preference amount that must be satisfied before junior securities may participate in dividends or on liquidation. Accordingly, the effect of the accrual of dividends with respect to the Series C Shares on the Company’s balance sheet is to increase the aggregate claim of the Series C Shares on the equity of the corporation and to increase the deficit in common equity, while having no effect on the net equity of the corporation as a whole. The entitlement of the Series C Shares to a priority in relation to junior securities with respect to dividends and on liquidation does not create an obligation to the Company and therefore no liability is recorded until the dividends are declared by the Board of the Company. The Series C Shares are pari passu with the Corporation’s Series A Preferred Stock and Series B Shares (to the extent any remain outstanding following the Recapitalization) and no dividends or other distributions will be paid upon Common Shares or any other class of Shares that is junior in priority to the Series C Preferred while dividends are in arrears. In addition, the Series C Shares are convertible into Common Shares of JFG at the option of the holders at a conversion price of $0.10 per Share. The Series C Shares may be redeemed by the Corporation, at its option, when it is in a financial position to do so. Holders of over 70% of the outstanding Series B Preferred Shares elected to participate in the recapitalization. The shares of Series B Preferred Shareholders that chose not to convert are listed in the Liabilities section of the Balance Sheet, and therefore the accretion and dividends associated with the Series B stock after November 30, 2009 are deductions from net income. Dividends on Series B mandatorily redeemable preferred stock deducted from net income amounted to $483,596 for the year ended May 31, 2016. The remaining Series B shares not converted were accreted from carrying value to the face amount for the 5 year period from the date of issuance. Series C stock has no accretion. There were no shares of Series B Stock surrendered or exchanged in the year ended May 31, 2016. During the year ended May 31, 2012, two holders of Series A stock released all of their outstanding bonds held with FSC. These shares of Series A Preferred Shareholders are listed in the liability section of the Balance Sheet as of May 31, 2016, in the amount of $1,670,945, which consists of the fully accreted $1,126,000 face value of stock and $544,945 in dividends payable. The dividends associated with these shares of Series A stock for the year ended May 31, 2016, is a deduction from net income in the amount of $65,374. There was no current accretion on these shares of Series A stock. Jacobs Financial Group, Inc. As of May 31, 2016 the Company has chosen to defer payment of dividends on Series A Preferred Stock with such accrued and unpaid dividends amounting to $1,155,545 through May 31, 2016. These dividends are included in the amounts reported on the face of the balance sheet for each classification of Series A stock. As of May 31, 2016 the Company has chosen to defer payment of dividends on Series B and Series C Preferred Stock with such accrued and unpaid dividends amounting to $3,516,674 and $8,441,909 through May 31, 2016, respectively. These dividend are included in the amounts reported on the face of the balance sheet for each respective classification if stock. Accounting Treatment U.S. GAAP requires that an entity classify as liabilities certain financial instruments with characteristics of both liabilities and equity. The Company's Series A and B Preferred stock each have mandatory redemption features that subject the Company to the analysis of equity versus liability. Both Series A and B have features that embody a conditional obligation to redeem the instrument upon events not certain to occur and accordingly, are not classified as liabilities until such events are certain to occur. With respect to the Series A Preferred Stock, such condition is contingent upon the holder having no further need for surety bonds issued by the Company's insurance subsidiary (FSC) under its partially collateralized bonding programs and, having no such surety bonds then outstanding. With respect to the Series B Preferred Stock, if the stock provides an option to the holder to convert to common shares at a rate equivalent to fair value, then the financial instruments are not mandatorily redeemable during the period in which the holder can convert the shares into common shares. Accordingly, the Company has determined that only the Series A preferred stocks held by principals with outstanding surety bonds should not be classified as liabilities. However, in accordance with Securities and Exchange Commission (SEC) Issued Topic No. D- 98, SEC Staff Announcement, "Classification and Measurement of Redeemable Securities", a company that issues preferred shares that are conditionally redeemable is required to account for the conditionally redeemable preferred shares in accordance with Accounting Series Release 268, which states that the shares are to be reflected on the Company's balance sheet between total liabilities and stockholders' equity as temporary equity. Note K - Stock Warrants On December 30, 2005, the Company issued warrants to purchase 45,402,996 shares of common stock in connection with the Series A and B Preferred Stock private placements. The exercise price of the warrants is $.001 per share. The warrants were valued using the Black-Scholes pricing model. The warrants issued in connection with the Series A Preferred Stock were valued at $.08 per share or $83,043. The warrants issued in connection with the Series B Preferred Stock were valued at $.01 per share or $449,972. Jacobs Financial Group, Inc. 386,667 warrants issued in connection with Series B Preferred Stock expired unexercised on the fifth anniversary at December 31, 2010; 600,000 warrants issued in connection with Series A Preferred Stock expired unexercised on the seventh anniversary at December 31, 2012. As of May 31, 2015, there were no warrants outstanding. Note L-Stock-Based Compensation On October 12, 2005, the board of directors adopted its 2005 Stock Incentive Plan (the "Plan") to allow the Company to make awards of stock options as part of the Company's compensation to key employees, non-employee directors, contractors and consultants. The Plan was approved by the stockholders on December 8, 2005. The aggregate number of shares of Common Stock issuable under all awards under the Plan is 35,000,000. No awards may be granted under the Plan after December 8, 2015. On December 28, 2006, the compensation committee of the board of directors awarded 2,100,000 of incentive stock options to acquire common shares at an exercise price of $.04 per share, of which 450,000 shares vested immediately and the remaining 1,650,000 options vesting over the next three years ending in December 2009. As of May 31, 2010, the awarded options had been reduced to 1,800,000 due to changes in employment status, all of which expired in December 2011. On June 30, 2009 the compensation committee of the board of directors awarded 10,000,000 of incentive stock options to acquire common shares at an exercise price of $.04 per share, of which 4,700,000 shares vested immediately and the remaining 5,300,000 options vesting over the next three years ending in June 2011. As of May 31, 2015, the awarded options had been reduced to 9,800,000 due to changes in employment status, all of which expired in June 2014. The Plan’s terms defined that it would terminate upon the earlier of (1) the adoption of a resolution by the Company terminating the Plan; or (2) ten years from the date on which the Plan is initially approved by the stockholders of the Company, therefore the Plan terminated on October 12, 2015. There were no options exercised in fiscal 2016 or 2015. There is no unrecognized compensation expense related to non-vested awards at May 31, 2016 or May 31, 2015 as all awards are fully vested. Note M - Income Taxes Deferred tax assets and liabilities are recorded for the effects of temporary differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. Such differences include the income recognition of a portion of the Jacobs Financial Group, Inc. unearned premium reserve, loss reserve deductibility, accruals not currently deductible relating to stock option expense and certain accrued expenses that are not paid within specified time frames by the Internal Revenue Service, and the deductibility of deferred policy acquisition costs paid. As of May 31, 2016, the Company had estimated operating loss carry forwards of approximately $16.3 million. These carry forwards began expiring in 2015 and, as a result of the ownership change resulting from the 2001 acquisitions of FSI and Jacobs, the utilization of approximately $6.4 million of the operating loss carry forwards are substantially limited. The Company has fully reserved the $5.5 million tax benefit of the operating loss carry forward, by a valuation allowance of the same amount, because the likelihood of realization of the tax benefit cannot be determined. Note N - Stockholders’ Equity In fiscal 2016, the Company issued 1,878,000 shares of the Company's common stock as additional consideration in connection with new and continued borrowings totaling $1,878,000. The shares were valued at approximately $.002887 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $5,422. In fiscal 2016, the Company issued 11,956,049 shares of the Company’s common stock in connection with the additional 2% stock dividend associated with Series A and B Preferred shares that were requested to be redeemed upon maturity (see Note J). The shares were valued at approximately $.003208 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $38,352. In fiscal 2016, the Company issued 2,500,000 shares of the Company's common stock as additional consideration for the purchase and loans convertible into the purchase of 25% of FSC subsidiary stock. The shares were valued at approximately $.002566 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $6,415. In fiscal 2015, the Company issued 495,856 shares of the Company's common stock as additional consideration in connection with new and continued borrowings totaling $495,856. The shares were valued at approximately $.005258 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $2,607. In fiscal 2015, the Company issued 5,298,804 shares of the Company’s common stock in connection with the additional 2% stock dividend associated with Series A and B Preferred shares that were requested to be redeemed upon maturity (see Note J). The shares were valued at approximately $.004795 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $25,406. Jacobs Financial Group, Inc. In fiscal 2015, the Company issued 10,221,845 shares of the Company's common stock in connection with the semi-annual issuance of shares under terms of the bridge-financing arrangement. The shares were valued at approximately $.005525 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $56,476. Of these shares, 5,183,936 were issued to a subsidiary as the successor owner of 50.7% of the bridge financing arrangement. These shares were valued at approximately .005525 per share based on the average quoted closing price of the Company’s stock for the 20-day period preceding the date of the transaction and totaled $28,641. In fiscal 2015, the Company issued 5,183,936 shares of the Company's common stock in connection with the semi-annual issuance of shares under terms of the bridge-financing arrangement. The shares were valued at approximately $.005525 per share based on the average quoted closing price of the Company's stock for the 20-day period preceding the date of the transaction and totaled $(28,641). Note O-Statutory Financial Data (Unaudited) The Company’s insurance subsidiary files calendar year financial statements prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities. The principal differences between statutory financial statements and financial statements prepared in accordance with generally accepted accounting principles are that statutory financial statements do not reflect deferred policy acquisition costs and certain assets are non-admitted. Statutory capital and surplus as of May 31, 2016 and 2015 and net income for the Company’s insurance subsidiary for the calendar year ended December 31, 2015 and 2014 and five-month periods ended May 31, 2016 and 2015 are as follows: Statutory surplus exceeds the West Virginia state law minimum capital requirements of $2.0 million. Under the West Virginia insurance code, ordinary dividends to stockholders are allowed to be paid only from that part of the insurance subsidiary’s (FSC’s) available surplus funds Jacobs Financial Group, Inc. which constitutes realized net profits from the business and whereby all such dividends or distributions made within the preceding twelve months do not exceed the lesser of 10% of FSC’s surplus as regards to policyholders as of December 31st of the preceding year-end or net income from operations from the previous two calendar years, not including capital gains. Any payment of extraordinary dividends requires prior approval from the WV state insurance commissioner. On March 26, 2012 the Commissioner of the State of West Virginia (WVOIC) terminated in its entirety the Amended Consent Order of June 7, 2007 and terminated the restrictive conditions of the Consent Order issued December 23, 2005 which approved acquisition of FSC by the Company. Among other consequences, removal of these restrictions allowed dividends to be declared by and paid from FSC to the Company. Dividends in the amounts of $173,000 were declared and paid for the twelve month period ending May 31, 2015. No dividends were declared or paid for the twelve month period ending May 31, 2016. The dividends for 2015 were deemed by the WVOIC to be extraordinary, causing the insurance subsidiary (FSC) to be fined $5,000 due to not obtaining consent prior to payment. Note P - Commitments and Contingencies Lease Commitments The Company leases certain office equipment with combined monthly payments of approximately $545 that have varying remaining terms of less than five years. The Company leases office, parking and storage space under month-to-month lease arrangements that approximate $6,897 each month. The Company’s inactive subsidiary, Crystal Mountain Spring Water, holds an undeveloped leasehold interest in a mineral water spring located near Hot Springs, Arkansas. Under the leasehold arrangement, the Company makes minimum lease payments of $180 per month. The Company has options to extend the leasehold arrangement through October 2026 and also has a right to cancel the lease at any time upon sixty (60) days written notice. Rental expense for these lease commitments totaled approximately $45,086 and $55,301 during fiscal years 2016 and 2015. Minimum future lease payments under non-cancelable operating leases having remaining terms in excess of one year as of May 31, 2016 are: Jacobs Financial Group, Inc. During 2013, the Company and one of its surety principals entered into a contractual arrangement whereby the Company would hold collateral for use in paying future claims and expenses and upon the Company’s determination that its liability had been fully extinguished, the company would return the amount of the deposits less any paid claims or expenses. While the Company holds the collateral, the Company will pay 1.35% annual simple interest to the principal. The Company receives any appreciation and earnings in excess of the contractual deposit, less payments, and interest paid to the principal. This deposit and the earning or expenses associated with the deposit are included in the calculation of the Company’s investment income. Note Q - Financial Instruments Fair Value The following methods and assumptions were used to estimate fair value of each class of financial instruments for which it is practicable to estimate that value: Investment Securities Fair values for investment securities (U.S. Government, government agencies, government agency mortgage-backed securities, state and municipal securities, and equity securities) held for investment purposes (available-for-sale) are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Other Financial Instruments The carrying amount of cash, short-term investments, receivables, prepaid expenses, short-term and demand notes payable, accounts payable, accrued expenses and other liabilities approximate fair value because of the immediate or relatively short-term maturity of these financial instruments. Fair value of term notes payable, including notes payable under the bridge-financing arrangement, were deemed to approximate their carrying value based on the Company’s incremental borrowing rates for similar types of borrowings with maturities consistent with those remaining for the debt being valued. The carrying values and fair values of the Company’s financial instruments at May 31, 2016 and 2015 are as follows: Jacobs Financial Group, Inc. Note R - Other Risks and Concentrations Concentration of Credit Risk As of May 31, 2016 the Company’s investment securities of approximately $8,900,000 are comprised solely of mortgage-backed securities, fixed maturity municipal bonds, equity investments, and money-market mutual funds that invest principally in obligations issued by the U.S government, its agencies or instrumentalities. Such instruments are generally considered to be of the highest credit quality investment available. The Company transacts the majority of its business with three financial institutions, one for commercial banking services and the others for brokerage and custodial services. Periodically, the amount on deposit in financial institutions providing commercial banking services exceeds federally insured limits. Management believes these financial institutions are financially sound. With respect to the financial institutions providing brokerage and custodial services, amounts on deposit are invested in money market funds that invest principally in obligations issued by the U.S government, its agencies or instrumentalities. Management believes that substantially all receivables are collectible, and therefore has not established an allowance for estimated uncollectible accounts. Concentration in Products, Markets and Customers The Company’s insurance subsidiary currently writes only the surety line of business, is licensed to write surety only in West Virginia and Ohio and has focused its primary efforts towards coal permit bonds. Such business, including investment advisory fees from managed collateral accounts, accounted for approximately 66% and 54% of the Company’s Jacobs Financial Group, Inc. fiscal 2016 and 2015 revenues, respectively. Furthermore, the Company provides surety bonds to companies that share common ownership interests that constitute 36% and 39% of the Company’s fiscal 2016 and 2015 revenues, respectively, as follows: Note S - Segment Reporting The Company has two reportable segments, investment advisory services and surety insurance products and services. The following table presents revenue and other financial information by industry segment. Jacobs Financial Group, Inc. Jacobs Financial Group, Inc. Note T - Related Party Transactions Borrowing and other transactions of Largest Shareholder and CEO For the past several years the Company’s operating expenses were partially funded by advances from its largest shareholder and chief executive officer, John M. Jacobs. The source of funding for these advances originated with obligations incurred by Mr. Jacobs with third parties (such obligations together with the loans by Mr. Jacobs to the Company, “back-to-back loans”) with interest rates ranging from 6% to 12%. This amount is unsecured and payable on demand. To assure that repayments of the various borrowings by the Company that were either guaranteed by Mr. Jacobs or loaned to the Company by Mr. Jacobs via such back-to-back loan arrangements did not result in a deemed loan to Mr. Jacobs, because Mr. Jacobs entered into an Assumption Agreement with the Company. Pursuant to the assumption agreement Mr. Jacobs assumes, and agrees to hold the Company harmless from, principal of specified indebtedness of the Company and to fully offset when necessary what might otherwise be deemed an advance of funds arising out of the Company’s financing activities. During fiscal 2016, advances to the Company from Mr. Jacobs amounted to $1,088,758, and repayments to Mr. Jacobs amounted to $971,207. As of May 31, 2016, the balance due from Mr. Jacobs was $515,488. The largest aggregate amount outstanding from Mr. Jacobs in fiscal 2016 was $549,143. During fiscal 2015, advances to the Company from Mr. Jacobs amounted to $1,008,717, and repayments to Mr. Jacobs amounted to $1,652,037. As of May 31, 2015, the balance due from Mr. Jacobs was $633,039. The largest aggregate amount outstanding from Mr. Jacobs in fiscal 2015 was $666,262. As of June 30, 2017, $22,500 was owed to Mr. Jacobs by the Company. The rate of interest on such amounts due from and obligations due to Mr. Jacobs was 6% and 12% respectively for both the 2016 and 2015 fiscal years. Other related parties During the years ended May 31, 2016 and May 31, 2015, a company owned by a board member provided consulting services. This company provided services totaling $62,100 and $62,100 in 2016 and 2015. Amounts owed to this company at year end are treated as related party payables in the amounts $124,723 and $169,375 at May 31, 2016 and 2015 respectively. During the year ended May 31, 2015, the Company borrowed money from an individual that is a board member. Total amounts owed to this individual at May 31, 2016 consisted of $75,000 in demand notes and $9,452 in accrued interest. Jacobs Financial Group, Inc. During the year ended May 31, 2016, an individual who holds secured notes payables from the Company, became a greater than 10% owner of outstanding common stock of the Company. During the year ended May 31, 2016, the Company borrowed additional money from this individual and entities controlled by this individual. Amounts owed to this individual (and the individual’s companies and relatives) at May 31, 2016 consisted of $868,900 in demand notes, $1,387,573 in notes payable secured by FSC stock, and $14,621 in accrued interest. This individual also arranged to purchase a 15.00% interest in First Surety Corporation for $1,500,000 through a combination of cash and a Promissory Note for $1,250,000 secured by assignment of debt payable by the Company. As of May 31, 2016, the purchase was not yet approved by the West Virginia Office of the Insurance Commissioner in compliance with insurance regulations requiring approval when exceeding 10.00% ownership, and the sale was deferred until subsequent to year end. This sale also resulted in the issuance of 1,500,000 shares of common stock of the Company. As of May 31, 2016, the amounts receivable from this individual amounted to $1,121,294. Note U - Reinsurance The Company limits the maximum net loss that can arise from large risks by reinsuring (ceding) certain levels of such risk with reinsurers. Ceded reinsurance is treated as the risk and liability of the assuming companies. The Company cedes insurance to other companies and these reinsurance contracts do not relieve the Company from its obligations to policyholders. Effective April 1, 2009, FSC entered into a reinsurance agreement with various syndicates at Lloyd’s of London (“Reinsurer”) for its coal reclamation surety bonding programs. The agreement has been renewed annually with the Reinsurer, with the most recent renewal effective April 1, 2017. The reinsurance agreement is an excess of loss contract which protects the Company against losses up to certain limits over stipulated amounts and can be terminated by either party by written notice of at least 90 days prior to any July 1. The contract calls for a premium rate of 35% subject to a minimum premium of $490,000. Deposits to the reinsurers are made quarterly in arrears in equal amounts of $140,000. At May 31, 2016 and May 31, 2015, the Company had prepaid reinsurance premiums of $232,647 and $207,413 and ceded reinsurance deposited of $5,689 at May 31, 2015. There were no ceded Loss and Loss Adjustment Expenses for the years ended May 31, 2016 or 2015. The effects of reinsurance on premium written and earned for fiscal 2016 and 2015 are as follows; Jacobs Financial Group, Inc. Note V - Events Subsequent to May 31, 2016 Subsequent to May 31, 2016, the Company obtained various borrowings from individuals and businesses through June 30, 2017 totaling $361,538 at rates varying from 10% to 14%, which mature at various dates subsequent to this filing, and made repayments on notes in the amount of $242,649. These borrowings, and the renewal of other borrowings, included no issuances of shares of its common stock as additional consideration. Additionally, the Company obtained borrowings of $323,463 from its principal shareholder and chief executive officer under a pre-approved financing arrangement bearing interest at the rate of 12% and made repayments totaling $351,332. After taking into account the net accrued payroll owed, reimbursement of company expenses, and the personal assumption of Company debt that is to be offset against these borrowings, the balance owed to the principal shareholder from the Company is $22,500 at June 30, 2017. The Company elected to continue to defer payment of quarterly dividends on its Series A Preferred Stock, Series B Preferred Stock, and Series C Preferred Stock with such accumulated accrued and unpaid dividends amounting to $1,350,832, $4,175,512 and $10,027,907 as of June 30, 2017. On September 25, 2016 the Registrant sold 15.00% interest in First Surety Corporation for $1,500,000 through a combination of cash and a Promissory Note secured by assignment of debt payable by the Registrant. The purchase was approved by the West Virginia Office of the Insurance Commissioner in compliance with insurance regulations requiring approval when exceeding 10.00% ownership. The purchaser is also a Related Party of the Registrant, exceeding 10% common stock ownership. This sale also resulted in the issuance of 1,500,000 shares of common stock of the Company. On March 17, 2017 the Registrant sold 5.00% interest in First Surety Corporation for $500,000. This sale also resulted in the issuance of 500,000 shares of common stock of the Company. Jacobs Financial Group, Inc.
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Based on the provided financial statement excerpt, here are the key points:
1. Financial Condition:
- The company (Jacobs Financial Group, Inc.) is experiencing significant financial difficulties
- Currently has insufficient liquidity and capitalization
- Is in default on certain loan and preferred stock agreements
- Has recurring operational losses
2. Going Concern Issues:
- There is substantial doubt about the company's ability to continue as a going concern
- Facing significant deficiency in working capital and stockholders' equity
- Losses are expected to continue until a more substantial business base is developed
3. Management Strategy:
- Plans to improve cash flow through business plan implementation
- Seeking additional funds through:
* Private stock placements
* Long-term financing
* Short-term borrowings
4. Securities Classification:
- Company classifies all fixed income securities and equity securities as "available-for-sale"
- Securities are reported at fair value
- Unrealized gains/losses are reported in stockholders' equity
5. Notable Risk:
- No guarantee of obtaining adequate future funding
- Financial statements don't include adjustments that might result from this uncertainty
This appears to be a company in financial distress, actively seeking solutions to continue operations while dealing with significant liquidity and operational challenges.
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Claude
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. Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Portsmouth Square, Inc.: We have audited the accompanying consolidated balance sheets of Portsmouth Square, Inc. and its subsidiary (the Company) as of June 30, 2016 and 2015, and the related consolidated statements of operations, shareholders’ deficit and cash flows for each of the years in the two-year period ended June 30, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Portsmouth Square, Inc. and its subsidiary as of June 30, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the years in the two-year period ended June 30, 2016 in conformity with accounting principles generally accepted in the United States of America. /s/ Burr Pilger Mayer, Inc. San Francisco, California September 28, 2016 PORTSMOUTH SQUARE, INC. CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these consolidated financial statements. PORTSMOUTH SQUARE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these consolidated financial statements. PORTSMOUTH SQUARE, INC CONSOLIDATED STATEMENTS OF SHAREHOLDERS' DEFICIT The accompanying notes are an integral part of these consolidated financial statements. PORTSMOUTH SQUARE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these consolidated financial statements. NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES Description of Business Portsmouth’s primary business is conducted through its general and limited partnership interest in Justice Investors Limited Partnership, a California limited partnership (“Justice” or the “Partnership”). Portsmouth has a 93% limited partnership interest in Justice and is the sole general partner. The financial statements of Justice are consolidated with those of the Company. As of June 30, 2016, Santa Fe Financial Corporation (“Santa Fe”), a public company, owns approximately 68.8% of the outstanding common shares of Portsmouth Square, Inc. (“Portsmouth” or the “Company”). Santa Fe is an 81.7%-owned subsidiary of The InterGroup Corporation (“InterGroup”), a public company. InterGroup also directly owns approximately 13.3% of the common stock of Portsmouth. Justice, through its subsidiaries Justice Holdings Company, LLC (“Holdings”), a Delaware Limited Liability Company, Justice Operating Company, LLC (“Operating”) and Justice Mezzanine Company, LLC (“Mezzanine”), owns a 543-room hotel property located at 750 Kearny Street, San Francisco California, known as the Hilton San Francisco Financial District (the “Hotel”) and related facilities including a five level underground parking garage. Holdings and Mezzanine are both a wholly-owned subsidiaries of the Partnership; Operating is a wholly-owned subsidiary of Mezzanine. Mezzanine is the borrower under certain mezzanine indebtedness of Justice, and in December 2013, the Partnership conveyed ownership of the Hotel to Operating. The Hotel is operated by the partnership as a full service Hilton brand hotel pursuant to a Franchise License Agreement with HLT Franchise Holding LLC (Hilton). Justice also has a management agreement with Prism Hospitality L.P. (“Prism”) to perform management functions for the Hotel. The management agreement with Prism had an original term of ten years, subject to the Partnership’s right to terminate at any time with or without cause. Effective January 2014, the management agreement with Prism was amended by the Partnership to change the nature of the services provided by Prism and the compensation payable to Prism, among other things. Effective December 1, 2013, GMP Management, Inc. (“GMP”), a company owned by a Justice limited partner and a related party, also provided management services for the Partnership pursuant to a management services agreement, with a three year term, subject to the Partnership’s right to terminate earlier for cause. In June 2016, GMP resigned and the Company is currently in discussions with several national third party hotel management companies to replace GMP. Portsmouth also receives management fees as a general partner of Justice for its services in overseeing and managing the Partnership’s assets. Those fees are eliminated in consolidation. Principles of Consolidation The consolidated financial statements include the accounts of the Company and Justice. All significant inter-company transactions and balances have been eliminated. Investment in Hotel, Net Property and equipment are stated at cost. Building improvements are depreciated on a straight-line basis over their useful lives ranging from 3 to 39 years. Furniture, fixtures, and equipment are depreciated on a straight-line basis over their useful lives ranging from 3 to 7 years. Repairs and maintenance are charged to expense as incurred. Costs of significant renewals and improvements are capitalized and depreciated over the shorter of its remaining estimated useful life or life of the asset. The cost of assets sold or retired and the related accumulated depreciation are removed from the accounts; any resulting gain or loss is included in other income (expenses). The Company reviews property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with generally accepted accounting principles (“GAAP”). If the carrying amount of the asset, including any intangible assets associated with that asset, exceeds its estimated undiscounted net cash flow, before interest, the Partnership will recognize an impairment loss equal to the difference between its carrying amount and its estimated fair value. If impairment is recognized, the reduced carrying amount of the asset will be accounted for as its new cost. For a depreciable asset, the new cost will be depreciated over the asset’s remaining useful life. Generally, fair values are estimated using discounted cash flow, replacement cost or market comparison analyses. The process of evaluating for impairment requires estimates as to future events and conditions, which are subject to varying market and economic factors. Therefore, it is reasonably possible that a change in estimate resulting from judgments as to future events could occur which would affect the recorded amounts of the property. No impairment losses were recorded for the years ended June 30, 2016 and 2015. Investment in Marketable Securities Marketable securities are stated at fair value as determined by the most recently traded price of each security at the balance sheet date. Marketable securities are classified as trading securities with all unrealized gains and losses on the Company's investment portfolio recorded through the consolidated statements of operations. Other Investments, Net Other investments include non-marketable securities (carried at cost, net of any impairments loss), non -marketable warrants (carried at fair value) and certain convertible preferred securities, received in exchange for debt instruments, carried at a book basis, initially determined using the estimated fair value on the exchange date. The Company has no significant influence or control over the entities that issue these investments. These investments are reviewed on a periodic basis for other-than-temporary impairment. The Company reviews several factors to determine whether a loss is other-than-temporary. These factors include but are not limited to: (i) the length of time an investment is in an unrealized loss position, (ii) the extent to which fair value is less than cost, (iii) the financial condition and near term prospects of the issuer and (iv) our ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value. For the years ended June 30, 2016 and 2015, the Company recorded impairment losses related to other investments of $194,000 and $254,000, respectively. As of June 30, 2016 and 2015, the allowance for impairment losses was $2,099,000 and $1,970,000, respectively. Derivative Financial Instruments The Company has investments in stock warrants that are considered derivative instruments. As of June 30, 2016 and 2015, the Company has nominal derivative financial instruments. Derivative financial instruments consist of financial instruments or other contracts that contain a notional amount and one or more underlying (e.g. interest rate, security price or other variable), require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value on the Company’s consolidated balance sheet with the related unrealized gain or loss recorded in the Company’s consolidated statement of operations. The Company used the Black-Scholes option valuation model to estimate the fair value these instruments which requires management to make significant assumptions including trading volatility, estimated terms, and risk free rates. Estimating fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. In addition, option-based models are highly volatile and sensitive to changes in the trading market price of the underlying common stock, which has a high-historical volatility. Since derivative financial instruments are initially and subsequently carried at fair values, the Company’s consolidated statement of operations will reflect the volatility in these estimate and assumption changes. Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with an original maturity of three months or less when purchased and are carried at cost, which approximates fair value. Restricted Cash Restricted cash is comprised of amounts held by lenders for payment of real estate taxes, insurance, replacement and capital addition reserves for the Hotel. Accounts Receivable - Hotel, Net Accounts receivable from Hotel customers are carried at cost less an allowance for doubtful accounts that is based on management’s assessment of the collectability of accounts receivable. The Partnership extends unsecured credit to its customers but mitigates the associated credit risk by performing ongoing credit evaluations of its customers. Other Assets, Net Other assets include prepaid insurance, loan fees, franchise fees, license fees and other miscellaneous assets. Loan fees are stated at cost and amortized over the term of the loan using the effective interest method. Franchise fees are stated at cost and amortized over the life of the agreement (15 years). License fees are stated at cost and amortized over 10 years. Income Taxes Deferred income taxes are calculated under the liability method. Deferred income tax assets and liabilities are based on differences between the financial statement and tax basis of assets and liabilities at the current enacted tax rates. Changes in deferred income tax assets and liabilities are included as a component of income tax expense. Changes in deferred income tax assets and liabilities attributable to changes in enacted tax rates are charged or credited to income tax expense in the period of enactment. Valuation allowances are established for certain deferred tax assets where realization is not likely. Assets and liabilities are established for uncertain tax positions taken or positions expected to be taken in income tax returns when such positions are judged to not meet the “more-likely-than-not” threshold based on the technical merits of the positions. Due to Securities Broker Various securities brokers have advanced funds to the Company for the purchase of marketable securities under standard margin agreements. These advanced funds are recorded as a liability. Obligations for Securities Sold Obligation for securities sold represents the fair market value of shares sold with the promise to deliver that security at some future date and the fair market value of shares underlying the written call options with the obligation to deliver that security when and if the option is exercised. The obligation may be satisfied with current holdings of the same security or by subsequent purchases of that security. Unrealized gains and losses from changes in the obligation are included in the statement of operations. Accounts Payable and Other Liabilities Accounts payable and other liabilities include trade payables, advance customer deposits and other liabilities. Fair Value of Financial Instruments Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. Accounting standards for fair value measurement establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the observability of inputs as follows: Level 1-inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2-inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments. Level 3-inputs to the valuation methodology are unobservable and significant to the fair value. Revenue Recognition Room revenue is recognized on the date upon which a guest occupies a room and/or utilizes the Hotel’s services. Food and beverage revenues are recognized upon delivery. Garage revenue is recognized when a guest uses the garage space. The Company records a liability for payments collected in advance of revenue recognition. This liability is included in Accounts payable and other liabilities. Advertising Costs Advertising costs are expensed as incurred. Advertising costs were $522,000 and $459,000 for the years ended June 30, 2016 and 2015, respectively. Basic and Diluted Income per Share Basic income per share is calculated based upon the weighted average number of common shares outstanding during each fiscal year. As of June 30, 2016 and 2015, the Company did not have any potentially dilutive securities outstanding. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires the use of estimates and assumptions regarding certain types of assets, liabilities, revenues, and expenses. Such estimates primarily relate to unsettled transactions and events as of the date of the financial statements. Accordingly, upon settlement, actual results may differ from estimated amounts. Recent Accounting Pronouncements In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718). This update was issued as part of the FASB’s simplification initiative and affects all entities that issue share-based payment awards to their employees. The amendments in this update cover such areas as the recognition of excess tax benefits and deficiencies, the classification of those excess tax benefits on the statement of cash flows, an accounting policy election for forfeitures, the amount an employer can withhold to cover income taxes and still qualify for equity classification and the classification of those taxes paid on the statement of cash flows. This update is effective for annual and interim periods within those annual periods beginning after December 15, 2016, which will require the Company to adopt these provisions in the first quarter of ended September 30, 2017. This guidance will be applied either prospectively, retrospectively or using a modified retrospective transition method, depending on the area covered in this update. Early adoption is permitted. The Company has not yet selected a transition date nor have we determined the effect of the standard on our ongoing financial reporting. In January 2016, the FASB issued an update (ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities). The amendments in this update impact public business entities as follows: 1) Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. 2) Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value. 3) Eliminate the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. 4) Require entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. 5) Require an entity to present separately in other comprehensive income the portion of the total change in fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. 6) Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements. 7) Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. The amendments in this update become effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company is currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but it is not expected to have a material impact on its consolidated financial statements. In April 2015, the FASB issued ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. ASU 2015-03 is effective for annual and interim periods within these annual periods beginning after December 15, 2015 and early application is permitted. This standard will not have material impact on the Company’s consolidated financial statements. In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, which changes the consolidation analysis for both the variable interest model and for the voting model for limited partnerships and similar entities. ASU 2015-02 is effective for annual and interim periods beginning after December 15, 2015 and early application is permitted. ASU 2015-02 provides for one of two methods of transition: retrospective application to each prior period presented; or recognition of the cumulative effect of retrospective application of the new standard in the period of initial application. We are in the process of evaluating this guidance and our method of adoption. This is not expected to materially impact the Company’s financial statements. In May 2014, the Financial Accounting Standards Board (the "FASB") issued Accounting Standard Update No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”) amending revenue recognition guidance and requiring more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted for annual and interim reporting periods with these annual periods beginning after December 15, 2016. The Company does not plan to early adopt. We are currently evaluating the impact ASU 2014-09 will have on the Company's consolidated financial statements. In August 2014, the FASB issued Accounting Standard Update No. 2014-15, Presentation of Financial Statements - Going Concern ("ASU 2014-15"). The new guidance explicitly requires that management assess an entity's ability to continue as a going concern and may require additional detailed disclosures. ASU 2014-15 is effective for annual periods beginning after December 15, 2016 and interim periods within those annual periods. Though permitted, the Company does not plan to early adopt. The Company does not believe that this standard will have a significant impact on its consolidated financial statements. NOTE 2 - JUSTICE INVESTORS Justice Investors Limited Partnership, a California limited partnership (“Justice” or the “Partnership”), was formed in 1967 to acquire real property in San Francisco, California, for the development and lease of the Hotel and related facilities. The Partnership has one general partner, Portsmouth Square, Inc., a California corporation (“Portsmouth”) and approximately 24 voting limited partners, including Portsmouth. Effective December 1, 2008, Portsmouth and Evon Corporation, a California corporation (“Evon”), as the two general partners of Justice, entered into a 2008 Amendment to the Limited Partnership Agreement (the “Amendment”) that provided for a change in the respective roles of the general partners. Pursuant to the Amendment, Portsmouth assumed the role of managing general partner and Evon continued on as the co-general partner of Justice. The Amendment was ratified by approximately 98% of the limited partnership interests. The Amendment also amended and restated the Limited Partnership Agreement of the Partnership in its entirety to comply with the new provisions of the California Corporations Code known as the “Uniform Limited Partnership Act of 2008.” The Amendment did not result in any material modifications of the rights or obligations of the general and limited partners. The Amendment also provided that future amendments to the Limited Partnership Agreement would be made only upon the consent of the general partners and at least seventy five percent (75%) of the interests of the limited partners. Consent of at least 75% of the interests of the limited partners is required to remove a general partner pursuant to the Amendment. Concurrent with the Amendment, a new General Partner Compensation Agreement (the “Compensation Agreement”) was entered into on December 1, 2008, among Justice, Portsmouth and Evon to terminate and supersede all prior compensation agreements for the general partners. Pursuant to the Compensation Agreement, the general partners of Justice were entitled to receive an amount equal to 1.5% of the gross annual revenues of the Partnership (as defined in the Amendment), less $75,000 to be used as a contribution toward the cost of Justice engaging an asset manager. The Compensation Agreement set the minimum annual compensation of the general partners at approximately $285,000, with eighty percent (80%) of that amount being allocated to Portsmouth for its services as managing general partner and twenty percent (20%) allocated to Evon as the co-general partner. Compensation earned by the general partners in each calendar year in excess of the minimum base was be payable in equal fifty percent (50%) shares to Portsmouth and Evon. As described below, the Compensation Agreement was amended upon the completion of the Offer to Redeem on December 18, 2013. In December 2013, the Partnership determined to restructure its ownership to facilitate a refinancing of the Hotel and redeem the interests of certain Partners, including Evon. In the course of this refinancing, restructuring and redemption, the Partnership created three subsidiaries: Justice Holdings Company, LLC (“Holdings”), a Delaware Limited Liability Company, Justice Operating Company, LLC (“Operating”) and Justice Mezzanine Company, LLC (“Mezzanine”). Holdings and Mezzanine are each wholly-owned subsidiaries of the Partnership; Operating is a wholly-owned subsidiary of Mezzanine. Mezzanine is the borrower of certain mezzanine indebtedness and in December 2013, the Partnership conveyed ownership of the Hotel to Operating. On December 18, 2013, the Partnership completed an Offer to Redeem any and all limited partnership interests not held by Portsmouth. In addition, the Partnership approved amendments to the Amended and Restated Agreement of Limited Partnership, which amendments became effective upon the completion of the Offer to Redeem and the consummation of the Loan Agreements. Such amendments are described below. As a result, Portsmouth, which prior to the Offer to Redeem owned 50% of the then outstanding limited partnership interests, now controls approximately a 93% interest in Justice and is now the Partnership’s sole General Partner. Pursuant to the Offer to Redeem, the Partnership accepted tenders, for cash, from Evon, and seventy-three of the Partnership’s limited partners representing approximately 29.173% of partnership interests outstanding prior to the Offer to Redeem for $1,385,000 for each 1% tendered. On December 19, 2013, Justice distributed the amounts due each of these former partners pursuant to the terms of the Offer to Redeem. In addition, the Partnership accepted the election of holders of approximately 17.146% of the limited partnership interests outstanding prior to the Offer to Redeem to participate in an alternate redemption structure. Under that alternative redemption structure, the Partnership paid to Holdings $1,385,000 for each 1% tendered. Those partners who elected the alternative redemption structure were given an option to designate property for Holdings to purchase within 12 months of December 18, 2013, and then require Holdings to transfer that property to the partner in redemption of that partner’s interest in the Partnership. The governing agreement also provided for other possible methods of redeeming the interests of the partners who elected the alternate redemption structure, respectively. During the years ended June 30, 2015 and 2014, a total of $16,163,000 and $2,928,000 was redeemed under the alternative redemption structure, respectively. As of June 30, 2016, all limited partner interests outstanding under the Offer to Redeem had been redeemed. As a result of the ownership structure implemented in December 2013, the Partnership is the indirect sole owner of a 543-room hotel property located at 750 Kearny Street, San Francisco, California, now known as the Hilton San Francisco Financial District (the “Hotel”) and related facilities including a five level underground parking garage. The Hotel is operated by Operating as a full service Hilton brand hotel pursuant to a Franchise License Agreement with HLT Existing Franchise Holding LLC (the “Hilton”). Operating also has a management agreement with Prism Hospitality L.P. (“Prism”) to perform management functions for the Hotel. The management agreement with Prism had an original term of ten years, subject to the Partnership’s right to terminate at any time with or without cause. Effective January 2014, the management agreement with Prism was amended by the Partnership to change the nature of the services provided by Prism and the compensation payable to Prism, among other things. Effective December 1, 2013, GMP Management, Inc. (“GMP”), a company owned by a Justice limited partner and related party, also provided management services for the Partnership pursuant to a management services agreement, with a three year term subject to the Partnership’s right to terminate earlier for cause. In June 2016, GMP resigned and the Company is currently in discussions with several national third party hotel management companies to replace GMP. As of June 30, 2016 and 2015, the Partnership had an accumulated deficit. That accumulated deficit is primarily attributable to the redemption of certain limited partners, effective December 18, 2013. The Partnership utilized the book value method to record the redemption of the limited partners. Under book value (bonus) method the remaining partners continue the existing partnership, recording no changes to the book values of the partnership’s assets and liabilities. As a result, any revaluation of the existing partnership’s assets or liabilities that might be undertaken is solely to determine the settlement price to the outgoing partner. The partner’s withdrawal from the partnership is recorded by adjusting the remaining partners’ capital accounts with the amount of the bonus, which is allocated according to their income sharing ratio. The amount of adjustment is equal to the difference between the settlement price paid to the withdrawing partner and the book value of his share of total partnership capital at the time he withdraws. Justice Partner’s capital was reduced by approximately $64.1 million for the redemption during the year ended June 30, 2014. Management believes that the revenues and cash flows expected to be generated from the operations of the Hotel, garage and leases will be sufficient to meet all of the Partnership’s current and future obligations and financial requirements. Management also believes that there is significant appreciated value in the Hotel property in excess of the net book value to support additional borrowings, if necessary. NOTE 3 - INVESTMENT IN HOTEL, NET Investment in Hotel consisted of the following as of: NOTE 4 - INVESTMENT IN REAL ESTATE In August 2007, the Company agreed to acquire 50% interest in Intergroup Uluniu, Inc., a Hawaiian corporation and a 100% owned subsidiary of InterGroup, for $973,000, which represents an amount equal to the costs paid by InterGroup for the acquisition and carrying costs of approximately two acres of unimproved land held for development located in Maui, Hawaii. As a related party transaction, the fairness of the financial terms of the transaction were reviewed and approved by the independent director of the Company. NOTE 5 - INVESTMENT IN MARKETABLE SECURITIES The Company’s investment in marketable securities consists primarily of corporate equities. The Company has also invested in corporate bonds and income producing securities, which may include interests in real estate based companies and REITs, where financial benefit could insure to its shareholders through income and/or capital gain. At June 30, 2016 and 2015, all of the Company’s marketable securities are classified as trading securities. The change in the unrealized gains and losses on these investments are included in earnings. Trading securities are summarized as follows: As of June 30, 2016 and 2015, approximately 77% and 70% of the investment marketable securities balance above is comprised of the common stock of Comstock Mining Inc. As of June 30, 2016 and 2015, the Company had $1,138,000 and $940,000, respectively, of unrealized losses related to securities held for over one year. Net loss on marketable securities on the statement of operations is comprised of realized and unrealized losses. Below is the composition of the two components for the years ended June 30, 2016 and 2015, respectively. NOTE 6 - OTHER INVESTMENTS, NET The Company may also invest, with the approval of the Securities Investment Committee and other Company guidelines, in private investment equity funds and other unlisted securities, such as convertible notes through private placements. Those investments in non-marketable securities are carried at cost on the Company’s balance sheet as part of other investments, net of other than temporary impairment losses. Other investments, net consist of the following: As of June 30, 2015, the Company had $4,410,000 (4,410 preferred shares) held in Comstock Mining Inc. (“Comstock” - OTCBB: LODE) 7 1/2% Series A-1 Convertible Preferred Stock (the “A-1 Preferred”) of Comstock. On August 27, 2015, all of such preferred stock was converted into common stock of Comstock. As of June 30, 2016 and 2015, the Company had investments in corporate debt and equity instruments which had attached warrants that were considered derivative instruments. These warrants have an allocated cost basis of $170,000 as of June 30, 2016 and 2015, respectively. The fair market value of these warrants were $0 and $25,000 as of June 30, 2016 and 2015, respectively. During the years ended June 30, 2016 and 2015, the Company had an unrealized loss of $32,000 and $40,000, respectively, related to these warrants. NOTE 7 - FAIR VALUE MEASUREMENTS The carrying values of the Company’s financial instruments not required to be carried at fair value on a recurring basis approximate fair value due to their short maturities (i.e., accounts receivable, other assets, accounts payable and other liabilities, due to securities broker and obligations for securities sold) or the nature and terms of the obligation (i.e., other notes payable and mortgage notes payable). The assets measured at fair value on a recurring basis are as follows: The fair values of investments in marketable securities are determined by the most recently traded price of each security at the balance sheet date. The fair value of the warrants was determined based upon a Black-Scholes option valuation model. Financial assets that are measured at fair value on a non-recurring basis and are not included in the tables above include “Other investments in non-marketable securities,” that were initially measured at cost and have been written down to fair value as a result of impairment or adjusted to record the fair value of new instruments received (i.e., preferred shares) in exchange for old instruments (i.e., debt instruments). The following table shows the fair value hierarchy for these assets measured at fair value on a non-recurring basis as follows: Other investments in non-marketable securities are carried at cost net of any impairment loss. The Company has no significant influence or control over the entities that issue these investments. These investments are reviewed on a periodic basis for other-than-temporary impairment. When determining the fair value of these investments on a non-recurring basis, the Company uses valuation techniques such as the market approach and the unobservable inputs include factors such as conversion ratios and the stock price of the underlying convertible instruments. The Company reviews several factors to determine whether a loss is other-than-temporary. These factors include but are not limited to: (i) the length of time an investment is in an unrealized loss position, (ii) the extent to which fair value is less than cost, (iii) the financial condition and near term prospects of the issuer and (iv) our ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value. NOTE 8 - OTHER ASSETS, NET Other assets consist of the following as of June 30: Amortization expense of loan fees and franchise costs for the years ended June 30, 2016 and 2015 was $159,000 and $131,000, respectively. NOTE 9 - RELATED PARTY AND OTHER NOTES PAYABLE On July 2, 2014, the Partnership obtained from the Intergroup Corporation (a related party) an unsecured loan in the principal amount of $4,250,000 at 12% per year fixed interest, with a term of 2 years, payable interest only each month. Intergroup received a 3% loan fee. The loan may be prepaid at any time without penalty. The proceeds of the loan were applied to the July 2014 payments to Holdings described in Note 2. The loan was extended to September 30, 2016. InterGroup is currently working on amending the loan agreement to extend the loan for a longer period. On May 5, 2016, Justice and Portsmouth entered into a settlement agreement relating to previously reported litigation with Evon Corporation and certain other parties. Under the settlement agreement, Justice, a subsidiary of Portsmouth, will pay Evon Corporation $5,575,000 no later than January 10, 2017. This amount was recorded as legal settlement cost for the year end June 30, 2016. As of June 30, 2016, the balance of this related party note payable was $2,825,000. Also included in the balance of the related party note payable at June 30, 2016 is the obligation to Hilton (Franchisor) in the form of a self-exhausting, interest free development incentive note which will be reduced approximately $316,000 annually through 2030 by Hilton if the Partnership is still a Franchisee with Hilton. For the years ended June 30, 2016 and 2015, the note was reduced by approximately $316,000 and $158,000, respectively. The Company has various notes payable and financing obligations outstanding at June 30, 2016 and 2015 totaling $212,000 and $313,000, respectively. The notes bear interest at market rates and require monthly principal payments through January 2018 when the obligations will be fully repaid. NOTE 10 - MORTGAGE NOTES PAYABLE On December 18, 2013: (i) Justice Operating Company, LLC, a Delaware limited liability company (“Operating”), entered into a loan agreement (“Mortgage Loan Agreement”) with Bank of America (“Mortgage Lender”); and (ii) Justice Mezzanine Company, a Delaware limited liability company (“Mezzanine”), entered into a mezzanine loan agreement (“Mezzanine Loan Agreement” and, together with the Mortgage Loan Agreement, the “Loan Agreements”) with ISBI San Francisco Mezz Lender LLC (“Mezzanine Lender” and, together with Mortgage Lender, the “Lenders”). The Partnership is the sole member of Mezzanine, and Mezzanine is the sole member of Operating. The Loan Agreements provide for a $97,000,000 Mortgage Loan and a $20,000,000 Mezzanine Loan. The proceeds of the Loan Agreements were used to fund the redemption of limited partnership interests and the pay-off of the prior mortgage. The Mortgage Loan is secured by the Partnership’s principal asset, the Hilton San Francisco-Financial District (the “Property”). The Mortgage Loan bears an interest rate of 5.275% per annum and matures in January 2024. The term of the loan is 10 years with interest only due in the first three years and principle and interest on the remaining seven years of the loan based on a thirty year amortization schedule. The Mortgage Loan also requires payments for impounds related to property tax, insurance and capital improvement reserves. As additional security for the Mortgage Loan, there is a limited guaranty (“Mortgage Guaranty”) executed by the Company in favor of Mortgage Lender. The Mezzanine Loan is a secured by the Operating membership interest held by Mezzanine and is subordinated to the Mortgage Loan. The Mezzanine Loan bears interest at 9.75% per annum and matures on January 1, 2024. Interest only, payments are due monthly. As additional security for the Mezzanine Loan, there is a limited guaranty executed by the Company in favor of Mezzanine Lender (the “Mezzanine Guaranty” and, together with the Mortgage Guaranty, the “Guaranties”). The Guaranties are limited to what are commonly referred to as “bad boy” acts, including: (i) fraud or intentional misrepresentations; (ii) gross negligence or willful misconduct; (iii) misapplication or misappropriation of rents, security deposits, insurance or condemnation proceeds; and (iv) failure to pay taxes or insurance. The Guaranties are full recourse guaranties under identified circumstances, including failure to maintain “single purpose” status which is a factor in a consolidation of Operating or Mezzanine in a bankruptcy of another person, transfer or encumbrance of the Property in violation of the applicable loan documents, Operating or Mezzanine incurring debts that are not permitted, and the Property becoming subject to a bankruptcy proceeding. Pursuant to the Guaranties, the Partnership is required to maintain a certain minimum net worth and liquidity. As of June 30, 2016 and 2015, the Partnership is in compliance with both requirements. Each of the Loan Agreements contains customary representations and warranties, events of default, reporting requirements, affirmative covenants and negative covenants, which impose restrictions on, among other things, organizational changes of the respective borrower, operations of the Property, agreements with affiliates and third parties. Each of the Loan Agreements also provides for mandatory prepayments under certain circumstances (including casualty or condemnation events) and voluntary prepayments, subject to satisfaction of prescribed conditions set forth in the Loan Agreements. As of June 30, 2016 and 2015, the Company had the following mortgages: Future minimum payments for all mortgage notes payable are as follows: NOTE 11 - GARAGE OPERATIONS On October 31, 2010, the Partnership and Ace Parking entered into an amendment of the original Parking Agreement to extend the term for a period of sixty two (62) months, commencing on November 1, 2010 and terminating December 31, 2015, subject to either party’s right to terminate the agreement without cause on ninety (90) days’ written notice. The monthly management fee of $2,000 and the accounting fee of $250 remained the same, but the amendment modified how the Excess Profit Fee (described below) to be paid to Ace Parking would be calculated. The parking agreement with Ace Parking was terminated with an effective termination date of October 4, 2016. Going forward, the Company The parking garage that is part of the Hotel property is managed by Ace Parking Management, Inc. pursuant to a contract with the Partnership. The parking agreement with Ace Parking was terminated with an effective termination date of October 4, 2016. Going forward, the Company through its subsidiary, Kearny Street Parking LLC, will manage the parking garage in-house. The amendment noted above provides that, if net operating income (“NOI”) from the garage operations exceeds $1,800,000 but is less than $2,000,000, then Ace Parking will be entitled to a fee (an “Excess Profit Fee”) of one percent (1%) of the total annual NOI. If the annual NOI is $2,000,000 or higher, Ace Parking will be entitled to an Excess Profit Fee equal to two percent (2%) of the total annual NOI. The garage’s NOI did not exceed the annual NOI of $2,000,000 for the year ended June 30, 2016. The garage’s NOI exceeded the annual NOI of $2,000,000 for the year ended June 30, 2015. Base Management and incentive fees to Ace Parking amounted to $24,000 and $44,000 for each of the years ended June 30, 2016 and 2015, respectively. NOTE 12 - MANAGEMENT AGREEMENTS On February 2, 2007, the Partnership entered into an agreement with Prism to manage and operate the Hotel as its agent. Under a new management agreement, effective January 2014, the base management fees were amended to a fixed rate of $20,000 per month. Under the amended management agreement, Prism can also earn an incentive fee of $10,500 for each month that the revenues per room of the Hotel exceed the average revenues per room of a defined set of competing hotels. Base management fees and incentives paid to Prism during the years ended June 30, 2016 and 2015 were $251,000 and $293,000, respectively. Effective December 1, 2013, GMP Management, Inc. (“GMP”), a company owned by a Justice limited partner and related party, also began to provide management services for the Partnership pursuant to a management services agreement. The management agreement with GMP had a three year term, subject to the Partnership’s right to terminate earlier for cause. Under the agreement, GMP was required to advise the Partnership on the management and operation of the hotel; administer the Partnership’s contracts, leases, agreements with hotel managers and franchisors and other contracts and agreements; provide administrative and asset management services, oversee financial reporting and maintain offices at the Hotel in order to facilitate provision of services. GMP was paid an annual base management fee of $325,000 per year, increasing by 5% per year, payable in monthly installments, and to reimbursement for reasonable and necessary costs and expenses incurred by GMP in performing its obligations under the agreement. In June 2016, GMP resigned and the Company is currently in discussions with several national third party hotel management companies to replace GMP. During the years ended June 30, 2016 and 2015, GMP was paid $1,637,000 and $1,688,000, respectively, for the salaries, benefits, and local payroll taxes for GMP employees and various other reimbursable expenses. These amounts also include the annual GMP base management fees. The base management fees expensed for GMP during the years ended June 30, 2016 and 2015 were $1,219,000 and $1,078,000, respectively, and are included in the consolidated statements of operations. Also included in fiscal 2016, is the $200,000 fee paid to GMP for the completion of the reorganization of the Partnership and the related financing transactions. NOTE 13 - CONCENTRATION OF CREDIT RISK As of June 30, 2016 and 2015, approximately 45% and 70%, respectively, of accounts receivable is related to legal settlement receivables and the amended franchise agreement. The Hotel had four customers that accounted for 26%, or $811,000 of accounts receivable at June 30, 2016. The Hotel had two customers who accounted for 17%, or $1,182,000, of accounts receivable at June 30, 2015. The Partnership maintains its cash and cash equivalents and restricted cash with various financial institutions that are monitored regularly for credit quality. At times, such cash and cash equivalents holdings may be in excess of the Federal Deposit Insurance Corporation (“FDIC”) or other federally insured limits. NOTE 14 - INCOME TAXES The provision for income taxes benefit consists of the following: A reconciliation of the statutory federal income tax rate to the effective tax rate is as follows: The components of the Company’s deferred tax assets and (liabilities) as of June 30, 2016 and 2015, are as follows: As of June 30, 2016, the Company had net operating loss carryforwards of approximately $19,565,000 and $16,042,000 for federal and state purposes, respectively. These carryforwards expire in varying amount through 2031. The Company is subject to U.S. federal income tax as well as to income tax in multiple state jurisdictions. Federal income tax returns of the Company are subject to IRS examination for the 2011 through 2015 tax years. State income tax returns are subject to examination for the 2010 through 2015 tax years. Assets and liabilities are established for uncertain tax positions taken or positions expected to be taken in income tax returns when such positions are judged to not meet the “more-likely-than-not” threshold based on the technical merits of the positions. As of June 30, 2016, it has been determined there are no uncertain tax positions likely to impact the Company. The Partnership files tax returns as prescribed by the tax laws of the jurisdictions in which it operates and is subject to examination by federal, state and local jurisdictions, were applicable. As of June 30, 2016, tax years beginning in fiscal 2010 remain open to examination by the major tax jurisdictions, and are subject to the statute of limitations. NOTE 15 - SEGMENT INFORMATION The Company operates in two reportable segments, the operation of the Hotel (“Hotel Operations”) and the investment of its cash in marketable securities and other investments (“Investment Transactions”). These two operating segments, as presented in the consolidated financial statements, reflect how management internally reviews each segment’s performance. Management also makes operational and strategic decisions based on this same information. Information below represents reporting segments for the years ended June 30, 2016 and 2015, respectively. Segment income (loss) from Hotel operations consists of the operation of the Hotel and operation of the garage. Loss from investments consists of net investment gain (loss), dividend and interest income and investment related expenses. NOTE 16 - RELATED PARTY TRANSACTIONS As discussed in Note 9 - Other Notes Payable, on July 2, 2014, the Partnership obtained from the InterGroup Corporation an unsecured loan in the principal amount of $4,250,000. As discussed in Note 12 - Management Agreements, effective December 1, 2013, the Partnership has a management agreement with GMP Management, Inc., a company owned by a Justice limited partner and a related party In June 2016, GMP resigned and the Company is currently in discussions with several national third party hotel management companies to replace GMP. In connection with the redemption of limited partnership interests of Justice described in Note 2 above, Justice Operating Company, LLC agreed to pay a total of $1,550,000 in fees to certain officers and directors of the Company for services rendered in connection with the redemption of partnership interests, refinancing of Justice’s properties and reorganization of Justice. This agreement was superseded by a letter dated December 11, 2013 from Justice, in which Justice assumed the payment obligations of Justice Operating Company, LLC. The first payment under this agreement was made concurrently with the closing of the loan agreements described in Note 2 above, with the remaining payments due upon Justice Investor’s having adequate available cash as described in the letter. As of June 30, 2016, $400,000 of these fees remain payable. Two general partners provided services to the Partnership through December 17, 2013. On December 18, 2013, the Partnership redeemed Evon’s partnership interest and Portsmouth became the sole general partner. The Partnership’s obligation to pay Evon, Justice’s former general partner, terminated as of December 18, 2013. Under the terms of the Limited Partnership Agreement of Justice, its current sole general partner, Portsmouth, receives annual base compensation of $285,000, plus one percent of hotel revenue. During each of the years ended June 30, 2016 and 2015, total compensation paid to Portsmouth under the new and previous agreements was $593,000 and $565,000, respectively. Amounts paid to Portsmouth are eliminated in consolidation. Certain shared costs and expenses, primarily administrative expenses, rent and insurance are allocated among the Company, Santa Fe and InterGroup based on management's estimate of the pro rata utilization of resources. For the years ended June 30, 2016 and 2015, these expenses were approximately $72,000 for each respective year. Four of the Company’s Directors serve as directors of InterGroup and three of the Company’s Directors serve on the Board of Santa Fe. As Chairman of the Securities Investment Committee, the Company’s President and Chief Executive Officer (CEO), John V. Winfield, directs the investment activity of the Company in public and private markets pursuant to authority granted by the Board of Directors. Mr. Winfield also serves as Chief Executive Officer and Chairman of Santa Fe and InterGroup and oversees the investment activity of those companies. Depending on certain market conditions and various risk factors, the Chief Executive Officer, Santa Fe and InterGroup may, at times, invest in the same companies in which the Company invests. Such investments align the interests of the Company with the interests of these related parties because it places the personal resources of the Chief Executive Officer and the resources of Santa Fe and InterGroup, at risk in substantially the same manner as the Company in connection with investment decisions made on behalf of the Company. In fiscal year ended June 30, 2004, the disinterested members of the Board of Directors established a performance based compensation program for the Company’s CEO to keep and retain his services as a direct and active manager of the Company’s securities portfolio. Pursuant to the current criteria established by the Board, Mr. Winfield is entitled to performance based compensation for his management of the Company’s securities portfolio equal to 20% of all net investment gains generated in excess of an annual return equal to the Prime Rate of Interest (as published in the Wall Street Journal) plus 2%. Compensation amounts are calculated and paid quarterly based on the results of the Company’s investment portfolio for that quarter. Should the Company have a net investment loss during any quarter, Mr. Winfield would not be entitled to any further performance-based compensation until any such investment losses are recouped by the Company. This performance based compensation program may be further modified or terminated at the discretion of the Board of Directors. The Company’s CEO did not earn any performance based compensation for the years ended June 30, 2016 and 2015. NOTE 17 - COMMITMENTS AND CONTINGENCIES Franchise Agreements The Partnership entered into a Franchise License Agreement (the “License Agreement”) with the HLT Existing Franchise Holding LLC (“Hilton”) on November 24, 2004. The term of the License agreement was for an initial period of 15 years commencing on the date the Hotel began operating as a Hilton hotel, with an option to extend the License Agreement for another five years, subject to certain conditions. On June 26, 2015, Operating and Hilton entered into an amended franchise agreement which amongst other things extended the License Agreement through 2030, and also provided the Partnership certain key money cash incentives to be earned through 2030. Since the opening of the Hotel in January 2006, the Partnership has paid monthly royalties, program fees and information technology recapture charges equal to a percent of the Hotel’s gross room revenue for the preceding calendar month. Total fees paid to Hilton for such services during fiscal 2016 and 2015 totaled approximately $2.9 million and $3.6 million, respectively. Employees As of June 30, 2016, the Partnership, through Operating, had approximately 276 employees. Approximately 78% of those employees were represented by one of three labor unions, and their terms of employment were determined under a collective bargaining agreement (“CBA”) to which the Partnership was a party. During the year ended June 30, 2014, the Partnership renewed the CBAs for the Local 2 (Hotel and Restaurant Employees), Local 856 (International Brotherhood of Teamsters), and Local 39 (stationary engineers). The present CBAs expire in July 2018. Negotiation of collective bargaining agreements, which includes not just terms and conditions of employment, but scope and coverage of employees, is a regular and expected course of business operations for the Partnership. The Partnership expects and anticipates that the terms of conditions of CBAs will have an impact on wage and benefit costs, operating expenses, and certain hotel operations during the life of the each CBA, and incorporates these principles into its operating and budgetary practices. Legal Matters In 2013, the City of San Francisco’s Tax Collector’s office claimed that Justice owed the City of San Francisco $2.1 million based on the Tax Collector’s interpretation of the San Francisco Business and Tax Regulations Code relating to Transient Occupancy Tax and Tourist Improvement District Assessment. This amount exceeds Justice’s estimate of the taxes owed, and Justice has disputed the claim and is seeking to discharge all penalties and interest charges imposed by the Tax Collector attributed to its over payment. The Company paid the full amount in March 2014 as part of the appeals process and reflected the amount on the balance sheet in “Other assets, net” as it was under protest as of June 30, 2015. On December 18, 2013, a Real Property Transfer Tax of approximately $4.7 million was paid to the City and County of San Francisco (“CCSF”). CCSF required payment of the Transfer Tax as a condition to record the transfer of the Hotel land parcel from Investors to Operating, which was necessary to effect the Loan Agreements. While the Partnership contends the Transfer Tax that was assessed by CCSF was illegal and erroneous, the tax was paid, under protest, to facilitate the consummation of the redemption transaction, the Loan Agreements and the recording of related documents. The Partnership has challenged CCSF’s imposition of the tax and filed a refund lawsuit against CCSF in San Francisco County Superior Court. The Partnership settled the two aforementioned legal matters with CCSF refunding $1.45 million apportioned half and half to each matter, resulting in approximately $340,000 in excess of net assets recorded. This amount was recorded as a reduction of Hotel legal settlement costs. On February 13, 2014, Evon filed a complaint in San Francisco Superior Court against the Partnership, Portsmouth, and a limited partner and related party asserting contract and tort claims based on Justice’s withholding of $4.7 million from a payment due to Holdings to pay the transfer tax described in Note 1. On April 1, 2014, Defendants removed the action to the United States District Court for the Northern District of California. Evon dismissed its complaint on April 8, 2014 and, that same day, filed a second complaint in San Francisco Superior Court substantially similar to the dismissed complaint, except for the omission of a federal cause of action. Evon’s current complaint in the action asserts causes of action for breach of contract and breach of the implied covenant of good faith and fair dealing against Justice only; breach of fiduciary duty against Portsmouth only; conversion against Justice and Portsmouth; and fraud/concealment against Justice, Portsmouth and a Justice limited partner and related party. In July 2014, Justice paid to Holdings a total of $4.7 million, the amount Evon claims was incorrectly withheld from Holdings to pay the transfer tax. Defendants moved to compel arbitration on August 5, 2014, and the Superior Court denied that motion on September 23, 2014. On June 27, 2014, the Partnership commenced an action in San Francisco Superior Court against Evon, Justice Holdings Company, LLC, a subsidiary of the Partnership (“Holdings”), and certain partners of the Partnership who elected an alternative redemption structure in the Partnership. The action seeks a declaration of the correct interpretation of (i) the special allocations sections of the Amended and Restated Agreement of Limited Partnership of Justice, with an effective date of January 1, 2013; and (ii) whether certain partners who elected the alternative redemption structure breached the governing Limited Partnership Interest Redemption Option Agreement. The complaint states that these declarations are relevant to preparation of the Partnership’s 2013 and 2014 state and federal tax returns and the associated Forms K-1 to be issued to affected current and former partners. The Partnership filed a First Amended Complaint on October 31, 2014. Evon filed a cross-complaint on December 9, 2014, alleging fraudulent concealment and promissory fraud against the Partnership in connection with the redemption transaction. On May 5, 2016, Justice Investors and Portsmouth (parent Company) entered into a settlement agreement relating to the above-described litigation with Evon and Holdings. Under the settlement agreement, the Partnership will pay Evon Corporation $5,575,000 no later than January 10, 2017. This amount was recorded as legal settlement costs during the year ended June 30, 2016. As of June 30, 2016, payments totaling approximately $2,750,000 were made related to this settlement. The amount due to Evon Corporation is presented under related party and other notes payable on the consolidated balance sheet. In connection with the settlement, a $50,000 payment was made to one limited partner for his interest in the Partnership. On April 21, 2014, the Partnership commenced an arbitration action against Glaser Weil Fink Howard Avchen & Shapiro, LLP (formerly known as Glaser Weil Fink Jacobs Howard Avchen & Shapiro, LLP), Brett J. Cohen, Gary N. Jacobs, Janet S. McCloud, Paul B. Salvaty, and Joseph K. Fletcher III (collectively, the “Respondents”) in connection with the redemption transaction. The arbitration alleges legal malpractice against the Respondents and also seeks declaratory relief regarding provisions of the option agreement in the redemption transaction and regarding the engagement letter with Respondents. The arbitration is pending before JAMS in Los Angeles, but has been stayed pending conclusion of the action filed by Evon Corporation described above. No prediction can be given as to the outcome of this matter. On April 15, 2016, the Partnership and Portsmouth filed a complaint in Los Angeles Superior Court against RSUI Indemnity Company (“RSUI”). The complaint alleges that RSUI breached an insurance contract by refusing to pay the defense and settlement costs incurred in connection with the above-described complaints and cross-complaint Evon filed against the Partnership and Portsmouth in 2014 in San Francisco Superior Court. On May 24, 2016, RSUI removed the action to the United States District Court for the Central District of California. No prediction can be given as to the outcome of this matter. The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. The Company defends itself vigorously against any such claims. Management does not believe that the impact of such matters will have a material effect on the financial conditions or result of operations when resolved. NOTE 18 - EMPLOYEE BENEFIT PLAN Justice has a 401(k) Profit Sharing Plan (the “Plan”) for non-union employees who have completed six months of service. Justice provides a matching contribution up to 4% of the contribution to the Plan based upon a certain percentage on the employees’ elective deferrals. Justice may also make discretionary contributions to the Plan each year. Contributions made to the Plan amounted to $108,000 and $61,000 during the years ended June 30, 2016 and 2015, respectively. Certain employees of Justice who are members of various unions are covered by union-sponsored, collectively bargained, multi-employer health and welfare and benefit pension plans. Justice does not contribute separately to those multi-employer plans. NOTE 19 - SUBSEQUENT EVENTS The Company has evaluated all events occurring subsequent to June 30, 2016 and concluded that no additional subsequent events has occurred outside the normal course of business operations that require disclosure.
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This appears to be a partial financial statement that focuses on several accounting policies and procedures. Here are the key points:
1. Profit/Loss Assessment:
- The company uses GAAP standards to review property and equipment for impairment
- Impairment losses are recognized when an asset's carrying amount exceeds estimated undiscounted net cash flow
- Fair values are typically estimated using discounted cash flow, replacement cost, or market comparison analyses
2. Expenses:
- Focuses mainly on deferred tax accounting
- Includes provisions for valuation allowances on certain deferred tax assets
- Discusses treatment of uncertain tax positions
- Details margin agreements with securities brokers
- Covers obligations for securities sold
3. Liabilities:
- Includes accounts payable and other trade payables
- Discusses fair value measurements using a three-level hierarchy:
* Level 1 (most observable inputs)
* Emphasizes use of observable market data when available
* Includes provisions for customer deposits
The statement appears incomplete, particularly in the liabilities section, and seems to be more focused on explaining accounting policies rather than providing actual financial figures.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ACCOUNTING FIRM To the Board of Directors and Stockholders’ Acology, Inc. We have audited the accompanying consolidated balance sheets of Acology, Inc. as of December 31, 2016 and 2015 and the related consolidated statements of operations, changes in stockholders’ deficiency and cash flows for the years ended December 31, 2016 and 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Acology, Inc.as of December 31, 2016 and 2015, and the results of its operations and cash flows for the years ended December 31, 2016 and 2015 in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As discussed in Note 3 the Company has a stockholders’ deficiency of $1,674,083 and a working capital deficit of $1,591,434 at December 31, 2016. In addition, the Company has generated operating losses since inception and has notes payable that are currently in default. These factors, among others, raise substantial doubt about the ability of the Company to continue as a going concern. Management plans are also discussed in Note 3. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /S/Paritz & Company, P.A. Hackensack, New Jersey April 14, 2017 ACOLOGY, INC. Consolidated Balance Sheets The accompanying notes are an integral part of these financial statements. ACOLOGY, INC. Consolidated Statements of Operations The accompanying notes are an integral part of these financial statements. ACOLOGY, INC. Consolidated Statements of Cash Flows The accompanying notes are an integral part of these financial statements. ACOLOGY, INC. Consolidated Statement of Stockholders’ Deficiency The accompanying notes are an integral part of these financial statements. ACOLOGY, INC. Notes to Financial Statements December 31, 2016 Note 1 - Business Acology, Inc. (the “Company”), through its wholly owned subsidiary, D&C Distributors, LLC (“D&C”) is in the business of designing, manufacturing, branding and selling proprietary plastic medical grade containers that can store pharmaceuticals, herbs, teas and other solids or liquids, some of which can grind solids and shred herbs, and through D&C’s wholly owned subsidiary, D&C Printing LLC (“Printing”), is in the business of private labeling and branding for purchasers of containers and other products. D&C and Printing were formed under the laws of the State of California on January 29, 2013, and April 14, 2015, respectively. On March 4, 2014, the Company completed an agreement and plan of merger in connection with which the holders of the membership units in D&C received 3,846,000,000 shares of the Company in exchange for these units. The merger was accounted for as a reverse merger in which D&C was the accounting acquirer. Note 2 - Summary of Significant Accounting Policies Principals of Consolidation The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated. Use of Estimates The preparation of the financial statements in conformity with Generally Accepted Accounting Principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates. Certain of the Company’s estimates could be affected by external conditions, including those unique to its industry, and general economic conditions. It is possible that these external factors could have an effect on the Company’s estimates that could cause actual results to differ from its estimates. The Company re-evaluates all of its accounting estimates at least quarterly based on these conditions and record adjustments when necessary. Cash The Company considers all short-term highly liquid investments with an original maturity at the date of purchase of three months or less to be cash equivalents. Revenue Recognition The Company follows the guidance of the Accounting Standards Codification (“ASC”) Topic 605, Revenue Recognition. We record revenue when persuasive evidence of an arrangement exists, product delivery has occurred, the selling price to the customer is fixed or determinable and collectability of the revenue is reasonably assured. The Company has not experienced any significant returns from customers and accordingly, in management’s opinion, no reserve for returns has been provided. Inventories Inventories, which consist of the Company’s product held for resale, are stated at the lower of cost, determined using the first-in first-out, and net realizable value. Net realizable value is the estimated selling price, in the ordinary course of business, less estimated costs to complete and dispose of the product. If the Company identifies excess, obsolete or unsalable items, its inventories are written down to their realizable value in the period in which the impairment is first identified. Shipping and handling costs incurred for inventory purchases and product shipments are recorded in cost of sales in the Company’s statements of operations. Fair Value Measurements The Company adopted the provisions of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value as used in numerous accounting pronouncements, establishes a framework for measuring fair value and expands disclosure of fair value measurements. The estimated fair value of certain financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued expenses are carried at historical cost basis, which approximates their fair values because of the short-term nature of these instruments. The carrying amounts of our short and long term credit obligations approximate fair value because the effective yields on these obligations, which include contractual interest rates taken together with other features such as concurrent issuances of warrants and/or embedded conversion options, are comparable to rates of returns for instruments of similar credit risk. ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 describes three levels of inputs that may be used to measure fair value: · Level 1 - quoted prices in active markets for identical assets or liabilities · Level 2 - quoted prices for similar assets and liabilities in active markets or inputs that are observable · Level 3 - inputs that are unobservable (for example cash flow modeling inputs based on assumptions) The derivative liability in connection with the conversion feature of the convertible debt, classified as a Level 3 liability, is the only financial liability measure at fair value on a recurring basis. The change in the Level 3 financial instrument is as follows: Property and Equipment Property and equipment is stated at cost less accumulated depreciation. Depreciation is provided for on a straight-line basis over the useful lives of the assets. For furniture and fixtures the useful life is 5 years, Leasehold Improvements are depreciated over the 2 year lease term. Expenditures for additions and improvements are capitalized; repairs and maintenance are expensed as incurred. Convertible Instruments The Company evaluates and accounts for conversion options embedded in convertible instruments in accordance with ASC 815, “Derivatives and Hedging Activities.” Applicable GAAP requires companies to bifurcate conversion options from their host instruments and account for them as free standing derivative financial instruments according to certain criteria. The criteria include circumstances in which (a) the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract, (b) the hybrid instrument that embodies both the embedded derivative instrument and the host contract is not re-measured at fair value under other GAAP with changes in fair value reported in earnings as they occur and (c) a separate instrument with the same terms as the embedded derivative instrument would be considered a derivative instrument. The Company accounts for convertible instruments (when it has been determined that the embedded conversion options should not be bifurcated from their host instruments) as follows: The Company records when necessary, discounts to convertible notes for the intrinsic value of conversion options embedded in debt instruments based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. Debt discounts under these arrangements are amortized over the term of the related debt to their stated date of redemption. The Company accounts for the conversion of convertible debt when a conversion option has been bifurcated using the general extinguishment standards. The debt and equity linked derivatives are removed at their carrying amounts and the shares issued are measured at their then-current fair value, with any difference recorded as a gain or loss on extinguishment of the two separate accounting liabilities. During the year ending December 31, 2015, the Company recognized a gain on extinguishment of $16,365 from the conversion of convertible debt with a bifurcated conversion option. During the year ending December 31, 2016, and 2015, the Company recognized a gain on extinguishment of $16,542 and $16,365, respectively, from the conversion of convertible debt with a bifurcated conversion option. Advertising Advertising and marketing expenses are charged to operations as incurred. Income Taxes The Company use the asset and liability method of accounting for income taxes in accordance with ASC Topic 740, Income Taxes. Under this method, income tax expense is recognized for the amount of: (i) taxes payable or refundable for the current year and (ii) deferred tax consequences of temporary differences resulting from matters that have been recognized in an entity’s financial statements or tax returns. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is provided to reduce the deferred tax assets reported if based on the weight of the available positive and negative evidence, it is more likely than not some portion or all of the deferred tax assets will not be realized. ASC Topic 740.10.30 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740.10.40 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company has no material uncertain tax positions. Recent accounting pronouncements The Company does not believe there are any recently issued, but not yet effective; accounting standards that would have a significant impact on the Company’s financial position or results of operations. Note 3 - Going Concern The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. At December 31, 2016, the Company had a stockholders’ deficiency of $1,591,434 and a working capital deficit of $1,674,083. In addition, the Company has generated operating losses since inception and has notes payable that are currently in default. These factors, among others, raise substantial doubt about the ability of the Company to continue as a going concern. The ability of the Company to continue as a going concern is dependent on the successful execution of its operating plan which includes increasing sales of existing products while introducing additional products and services, controlling operation expenses, negotiating extensions of existing loans and raising either debt or equity financing. There is no assurance that we will be able to increase sales or to obtain or extend financing on terms acceptable to us or at all. Note 4 -Note Receivable On August 11, 2015, the Company loaned $150,000 to an unrelated person who is one of the convertible noteholders referred to in Note 6 and that person made a promissory note in a like principal amount in favor of the Company. The note accrues interest at the highest lawful rate, but not more the 20% per annum, the Company is accruing interest at 10% per annum based on California usury rates. Upon an event of default, as defined in the note, interest will be compounded monthly. The maturity of the note has been extended from August 11, 2016, to August 11, 2017. The amount presented on the consolidated balance sheet includes accrued interest of $20,836. Note 5 -Property and Equipment Property and equipment consist of: Note 6 -Convertible Notes Payable The following is a description of convertible notes payable at December 31, 2016: ·On August 20, 2015, the Company made a convertible promissory note in the principal amount of $400,000 to a then-related party, which was reduced to $360,000 as the result of a prepayment. The note bears interest at 0.28% per annum. It originally matured on March 4, 2015, but its maturity was extended to September 14, 2016, as described below. The note is subject to acceleration in the event of certain events of default, contains certain restrictive covenants, and is secured by a pledge of all the membership units in D&C. The note provided that if an event of default were to occur, the unpaid principal amount and interest accrued thereon would be convertible into shares of the Company’s common stock at a conversion price per share equal to 50% of the average daily closing price for 3 consecutive trading days ending on the trading day immediately prior to the conversion date. The note was in default when it was not paid on March 4, 2015. On August 20, 2015, the holder of the note assigned it to an unrelated third party and on September 14, 2015, the maturity of the note was extended to September 14, 2016, the holder waived all events of default and any right to receive interest at the default rate, and the Company agreed that the holder could convert the principal and interest of the note into common stock, notwithstanding the cure of defaults. On August 28, 2015, the holder converted $50,000 of principal of the note into 428,571,429 shares of common stock and on March 10, 2016, the holder converted $60,000 of principal of the note into 189,513,580 shares of common stock. The principal balance of the note at December 31, 2016 was $250,000. On September 14, 2016, the maturity of this note was extended to September 14, 2017. ·The Company made a convertible promissory note, dated December 15, 2015, in favor of the unrelated party referred to above in the principal amount of $8,000. This note is convertible into shares of the Company’s common stock at a conversion price equal to the average of the daily closing price for a share of Common Stock for the 3 consecutive trading days ending on the trading day immediately prior to the day on which a notice of conversion is delivered. The note matured on December 27, 2016, and bears interest at the highest lawful rate, but not more than 20% per annum. The Company is currently negotiating an extension of the maturity date. ·The Company made two convertible promissory notes, one dated February 11, 2016, and the other dated April 25, 2016, in favor of the unrelated party referred to above, each in the principal amount of $7,500. Each note is due 1 year after the date on which it was made, bears simple interest at the rate of 20 percent per annum and is convertible into shares of Common Stock at a conversion price per share equal to 50% of the average daily closing price for 3 consecutive trading days ending on the trading day immediately prior to the conversion date. ·The Company has determined that the conversion feature embedded in the notes referred to above that contain a potential variable conversion amount which constitutes a derivative which has been bifurcated from the note and recorded as a derivative liability at fair value, with a corresponding discount recorded to the associated debt. The excess of the derivative value over the face amount of the note is recorded immediately to interest expense at inception. The above notes are presented net of discounts of $3,205 and$226,186 at December 31, 2016, and 2015, respectively, on the accompanying consolidated balance sheets. The Company used the Black Scholes Merton valuation model to value the conversion features using an expected life of 1 year, average volatility rate of approximately 453% and 396% and a discount rate of 0.35% ·A series of promissory note conversion agreements that the Company entered into during 2014 with ten unaffiliated persons in the aggregate amount of $224,500. These notes are convertible into shares of the Company’s common stock at a conversion price of $0.05 per share. The loans are non-interest bearing and have no stated maturity date. During the year ended December 31, 2016, the Company entered into agreements with four of the individuals in which the Company agreed to pay to them an additional amount equal to the current principal balance (which aggregated $32,000), which was recorded as interest expense. The notes were amended such that the Company agreed to repay the new balance over 10 monthly equal installments. The Company made payments of $25,900 during the year ended December 31, 2016, leaving a balance of $230,600 for all ten of these notes at December 31, 2016. ·A promissory note conversion agreement that the Company entered into with an unaffiliated persons in the amount of $10,000. This note is convertible into shares of the Company’s common stock at a conversion price of $0.05 per share. The note bears interest at 15% per annum and matured April 3, 2015. The Company is currently negotiating an extension of the maturity date. Note 7 - Notes Payable During 2014, the Company entered made a series of promissory notes with four unaffiliated persons in the original aggregate amount of $457,000. During the year ended December 31, 2016, the Company repaid one of these notes in the original principal amount of $7,000. These notes bear interest at rates ranging from 10% to 15% (with a weighted-average rate of 11.7%) and matured as follows: These notes are currently past due and the Company is negotiating an extension of their respective maturity dates. On August 15, 2015, the Company made a promissory note in the amount of $150,000 to an unrelated third party. The note bears interest at .48% per annum provided that the note is paid on or before maturity date, or 2 percentage points over the Wall Street Journal Prime Rate, if not repaid on or before the maturity date. This note matured on August 11, 2016. Upon an event of default, as defined in the note, interest shall be compounded daily. The Company is currently negotiating an extension of the maturity date. During the year ended December 31, 2016 the Company entered into a capitalized equipment lease. The capital lease is payable in 24 monthly installments of $2,000, including interest at the rate of 19.87 percent per annum. Note 8 - Loan Payable - Shareholder During the year ended December 31, 2015, the Company received advances from one of its stockholders, who is a related party, to help finance its operations. These advances are non-interest bearing and have no set maturity date. The balance at December 15, 2016, and 2015, aggregated $83,494 and $93,494, respectively. The Company expects to repay these loans when cash flows become available. Note 9 - Stockholders’ Deficiency On August 28, 2015, the Company issued 428,571,429 shares of common stock in connection with the conversion of $50,000 of the principal amount of the $400,000 Convertible Promissory Note described in Note 6. On March 10, 2016, the Company issued 189,513,580 shares of common stock in connection with the conversion of $60,000 of the principal amount of that Convertible Promissory Note. Note 10 - Income Taxes The reconciliation of the effective income tax rate to the federal statutory rate is as follows: The Components of deferred tax assets consist of: The Company has approximately $1,900,000 net operating loss carryforwards that are available to reduce future taxable income. Those NOLs begin to expire in 2034. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based on the assessment, management has established a full valuation allowance against all of the deferred tax assets for every period because it is more likely than not that all of the deferred tax assets will not be realized. Note 11 - Concentrations For the year ended December 31, 2016, one of our customers accounted for approximately 16% of sales. For the year ended December 31, 2015, none of our customers accounted for more than 10% of sales. For the year ended December 31, 2016, the company purchased approximately 83% of its products from one distributor, as compared with 95% in 2015. For the year ended December 31, 2016, two of our customers accounted for 28% and 16% of accounts receivable. For the year ended December 31, 2015, four of our customers accounted for 32%, 14%, 13%, and 12% of accounts receivable. Note 12 - Commitments The Company is committed under an operating lease for its premises. The lease originally called for monthly payments of $6,300 plus 55% of operating expenses until May 31, 2015. The lease was amended to provide for monthly payments of $7,500 plus 100% of operating expenses thereafter, until the lease was to have expired June 30, 2016. On June 1, 2016, the lease was amended to extend its term until June 30, 2018, without changing its other terms. Note 13 - Subsequent Events Management has evaluated events occurring after the date of these financial statements through the date that these financial statements were issued.
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Here's a summary of the financial statement excerpt:
The company is experiencing financial challenges, including:
- Continuous losses since its inception
- Notes payable that are currently in default
- Significant uncertainty about its ability to continue operating
The statement suggests potential financial distress, with management's plans for addressing these issues detailed in Note 3. The company's liabilities are classified as a Level 3, which typically indicates complex or illiquid financial instruments with values based on internal assumptions.
The overall tone implies the company is in a precarious financial position and may require significant intervention or restructuring to remain viable.
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Claude
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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ACCOUNTING FIRM To the Partners and Board of Directors of Special Value Continuation Partners, LP Los Angeles, California We have audited the accompanying consolidated statements of assets and liabilities of Special Value Continuation Partners, LP (the “Partnership”), including the consolidated schedule of investments, as of December 31, 2016 and 2015, and the related consolidated statements of operations, changes in net assets, and cash flows for each of the two years in the period ended December 31, 2016. Our audit also included the 2016 and 2015 financial statement schedules listed in the Index at Item 15(a). These financial statements and financial statement schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Partnership is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Special Value Continuation Partners, LP as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the two years ended in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ DELOITTE & TOUCHE LLP Los Angeles, California February 28, 2017 ACCOUNTING FIRM The Board of Directors and Shareholders of Special Value Continuation Partners, LP We have audited the accompanying consolidated statements of operations, changes in net assets and cash flows of Special Value Continuation Partners, LP (a Delaware Limited Liability Partnership) (the Partnership) for the year ended December 31, 2014. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Partnership’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements of Special Value Continuation Partners, LP referred to above present fairly, in all material respects, the consolidated results of its operations, changes in its net assets and its cash flows for the year ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Los Angeles, California March 9, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Statements of Assets and Liabilities See accompanying notes to the consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 Notes to Consolidated Schedule of Investments: (A)Investments in bank debt generally are bought and sold among institutional investors in transactions not subject to registration under the Securities Act of 1933. Such transactions are generally subject to contractual restrictions, such as approval of the agent or borrower. (B)Non-controlled affiliate - as defined under the Investment Company Act of 1940 (ownership of between 5% and 25% of the outstanding voting securities of this issuer). See Consolidated Schedule of Changes in Investments in Affiliates. (C)Non-income producing security. (D)Investment denominated in foreign currency. Amortized cost and fair value converted from foreign currency to US dollars. Foreign currency denominated investments are generally hedged for currency exposure. (E)Restricted security. (See Note 2) (F)Controlled issuer - as defined under the Investment Company Act of 1940 (ownership of 25% or more of the outstanding voting securities of this issuer). Investment is not more than 50% of the outstanding voting securities of the issuer nor deemed to be a significant subsidiary. See Consolidated Schedule of Changes in Investments in Affiliates. (G)Investment has been segregated to collateralize certain unfunded commitments. (H)Non-U.S. company or principal place of business outside the U.S. and as a result the investment is not a qualifying asset under Section 55(a) of the Investment Company Act. Under the Investment Company Act, the Partnership may not acquire any non-qualifying asset unless, at the time such acquisition is made, qualifying assets represent at least 70% of the Partnership's total assets. (I)Deemed an investment company under Section 3(c) of the Investment Company Act and as a result the investment is not a qualifying asset under Section 55(a) of the Investment Company Act. Under the Investment Company Act, the Partnership may not acquire any non-qualifying asset unless, at the time such acquisition is made, qualifying assets represent at least 70% of the Partnership's total assets. (J)Negative balances relate to an unfunded commitment that was acquired and/or valued at a discount. (K)In addition to the stated coupon, investment has an exit fee payable upon repayment of the loan in an amount equal to the percentage of the original principal amount shown. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments (Continued) December 31, 2016 (L)All cash and investments, except those referenced in Notes G above, are pledged as collateral under certain debt as described in Note 4 to the Consolidated Financial Statements. LIBOR or EURIBOR resets monthly (M), quarterly (Q), semiannually (S), or annually (A). Aggregate acquisitions and aggregate dispositions of investments, other than government securities, totaled $587,219,129 and $473,457,512 respectively, for the year ended December 31, 2016. Aggregate acquisitions includes investment assets received as payment in kind. Aggregate dispositions includes principal paydowns on and maturities of debt investments. The total value of restricted securities and bank debt as of December 31, 2016 was $1,311,625,473 or 96.1% of total cash and investments of the Partnership. As of December 31, 2016 approximately 16.4% of the total assets of the Partnership were not qualifying assets under Section 55(a) of the 1940 Act. See accompanying notes to the consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 Notes to Consolidated Schedule of Investments: (A)Investments in bank debt generally are bought and sold among institutional investors in transactions not subject to registration under the Securities Act of 1933. Such transactions are generally subject to contractual restrictions, such as approval of the agent or borrower. (B)Non-controlled affiliate - as defined under the Investment Company Act of 1940 (ownership of between 5% and 25% of the outstanding voting securities of this issuer). See Consolidated Schedule of Changes in Investments in Affiliates. (C)Non-income producing security. (D)Investment denominated in foreign currency. Amortized cost and fair value converted from foreign currency to US dollars. Foreign currency denominated investments are generally hedged for currency exposure. At December 31, 2015, such hedging activities included the derivatives listed at the end of the Consolidated Schedule of Investments. (See Note 2) (E)Restricted security. (See Note 2) (F)Controlled issuer - as defined under the Investment Company Act of 1940 (ownership of 25% or more of the outstanding voting securities of this issuer). Investment is not more than 50% of the outstanding voting securities of the issuer See Consolidated Schedule of Changes in Investments in Affiliates. (G)Investment has been segregated to collateralize certain unfunded commitments. (H)Non-U.S. company or principal place of business outside the U.S. and as a result the investment is not a qualifying asset under Section 55(a) of the Investment Company Act. Under the Investment Company Act, the Partnership may not acquire any non-qualifying asset unless, at the time such acquisition is made, qualifying assets represent at least 70% of the Partnership's total assets. (I)Deemed an investment company under Section 3(c) of the Investment Company Act and as a result the investment is not a qualifying asset under Section 55(a) of the Investment Company Act. Under the Investment Company Act, the Partnership may not acquire any non-qualifying asset unless, at the time such acquisition is made, qualifying assets represent at least 70% of the Partnership's total assets. (J)Publicly traded company with a market capitalization greater than $250 million and as a result the investment is not a qualifying asset under Section 55(a) of the Investment Company Act. Under the Investment Company Act, the Partnership may not acquire any non-qualifying asset unless, at the time such acquisition is made, qualifying assets represent at least 70% of the Partnership's total assets. (K)Negative balances relate to an unfunded commitment that was acquired and/or valued at a discount. (L)In addition to the stated coupon, investment has an exit fee payable upon repayment of the loan in an amount equal to the percentage of the original principal amount shown. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Investments December 31, 2015 (M)All cash and investments, except those referenced in Notes G above, are pledged as collateral under certain debt as described in Note 4 to the Consolidated Financial Statements. LIBOR or EURIBOR resets monthly (M), quarterly (Q), semiannually (S), or annually (A). Aggregate acquisitions and aggregate dispositions of investments, other than government securities, totaled $500,928,009 and $456,059,137 respectively, for the twelve months ended December 31, 2015. Aggregate acquisitions includes investment assets received as payment in kind. Aggregate dispositions includes principal paydowns on and maturities of debt investments. The total value of restricted securities and bank debt as of December 31, 2015 was $1,182,719,039, or 97.1% of total cash and investments of the Partnership. As of December 31, 2015, approximately 18.0% of the total assets of the Partnership were not qualifying assets under Section 55(a) of the 1940 Act. Options and swaps at December 31, 2015 were as follows: See accompanying notes to the consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Statements of Operations See accompanying notes to the consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Statements of Changes in Net Assets Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Statements of Changes in Net Assets See accompanying notes to the consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Statements of Cash Flows See accompanying notes to the consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) December 31, 2016 1. Organization and Nature of Operations Special Value Continuation Partners, LP (the “Partnership”), a Delaware limited partnership, commenced operations on July 31, 2006 as an externally managed, closed-end, non-diversified management investment company registered under the Investment Company Act of 1940, as amended (the “1940 Act”). On April 2, 2012, the Partnership elected to be treated as a business development company (“BDC”) under the 1940 Act. The Partnership’s investment objective is to achieve high total returns through current income and capital appreciation, with an emphasis on principal protection. Investment operations are conducted either directly in the Partnership or in one of the Partnership’s wholly owned subsidiaries, TCPC Funding I, LLC, a Delaware limited liability company (“TCPC Funding”), and TCPC SBIC, LP, a Delaware limited partnership (the “SBIC”). The SBIC was organized in June 2013, and, on April 22, 2014, received a license from the United States Small Business Administration (the “SBA”) to operate as a small business investment company under the provisions of Section 301(c) of the Small Business Investment Act of 1958. The Partnership, TCPC Funding, and the SBIC invest primarily in the debt of middle-market companies, including senior secured loans, junior loans, mezzanine debt and bonds. Such investments may include an equity component, and, to a lesser extent, the Partnership, TCPC Funding, and the SBIC may make equity investments directly. The Partnership, TCPC Funding, and the SBIC have elected to be treated as partnerships for U.S. federal income tax purposes. TCP Capital Corp. (“TCPC”) owns the entire common limited partner interest in the Partnership. TCPC has also elected to be treated as a business development company under the 1940 Act. The general partner of the Partnership is Series H of SVOF/MM, LLC, which also serves as the administrator of both TCPC and the Partnership (the “Administrator” or the “General Partner”). The managing member of the General Partner is Tennenbaum Capital Partners, LLC, which serves as the Advisor to TCPC, the Partnership, TCPC Funding and the SBIC. All of the equity interests in the General Partner are owned directly by the Advisor. Partnership management consists of the General Partner and the board of directors. The General Partner directs and executes the day-to-day operations of the Partnership subject to oversight from the board of directors, which performs certain functions required by the 1940 Act. The board of directors has delegated investment management of the Partnership’s assets to the Advisor. The board of directors consists of seven persons, five of whom are independent. 2. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements of the Partnership include the accounts of the Partnership, TCPC Funding and the SBIC and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The Partnership is an investment company following accounting and reporting guidance in Accounting Standards Codification (“ASC”) Topic 946, Financial Services - Investment Companies. The Partnership has consolidated the results of its wholly owned subsidiaries in its consolidated financial statements in accordance with ASC Topic 946. All intercompany account balances and transactions have been eliminated in consolidation. The following is a summary of the significant accounting policies of the Partnership. Reclassifications Certain prior period amounts in the Consolidated Statements of Assets and Liabilities relating to deferred debt issuance costs were reclassified to debt to conform to the current period presentation resulting from the adoption of two Accounting Standards Updates (see “Recent Accounting Pronouncements”). Certain prior period amounts in the Consolidated Statements of Operations relating to interest expense, amortization of deferred debt issuance costs and commitment fees have been reclassified into “interest and other debt expenses” to conform to the current period presentation. Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) Use of Estimates The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well the reported amounts of revenues and expenses during the reporting periods presented. Although management believes these estimates and assumptions to be reasonable, actual results could differ from those estimates and such differences could be material. Investment Valuation Management values investments at fair value in accordance with GAAP, based upon the principles and methods of valuation set forth in policies adopted by the board of directors. Fair value is generally defined as the amount for which an investment would be sold in an orderly transaction between market participants at the measurement date. All investments are valued at least quarterly based on quotations or other affirmative pricing from independent third-party sources, with the exception of investments priced directly by the Advisor which in the aggregate comprise less than 5% of the capitalization of the Partnership. Investments listed on a recognized exchange or market quotation system, whether U.S. or foreign, are valued using the closing price on the date of valuation. Investments not listed on a recognized exchange or market quotation system, but for which reliable market quotations are readily available are valued using prices provided by a nationally recognized pricing service or by using quotations from broker-dealers. Investments for which market quotations are either not readily available or are determined to be unreliable are priced at fair value using affirmative valuations performed by independent valuation services approved by the board of directors or, for investments aggregating less than 5% of the total capitalization of the Partnership, using valuations determined directly by the Advisor. Such valuations are determined under a documented valuation policy that has been reviewed and approved by the board of directors. Pursuant to this policy, the Advisor provides recent portfolio company financial statements and other reporting materials to independent valuation firms as applicable, which firms evaluate such materials along with relevant observable market data to conduct independent appraisals each quarter, and their preliminary valuation conclusions are documented and discussed with senior management of the Advisor. The audit committee of the board of directors discusses the valuations, and the board of directors approves the fair value of the investments in good faith based on the input of the Advisor, the respective independent valuation firms as applicable, and the audit committee of the board of directors. Generally, to increase objectivity in valuing the investments, the Advisor will utilize external measures of value, such as public markets or third-party transactions, whenever possible. The Advisor’s valuation is not based on long-term work-out value, immediate liquidation value, nor incremental value for potential changes that may take place in the future. The values assigned to investments are based on available information and do not necessarily represent amounts that might ultimately be realized, as these amounts depend on future circumstances and cannot reasonably be determined until the individual investments are actually liquidated. The foregoing policies apply to all investments, including any in companies and groups of affiliated companies aggregating more than 5% of the Partnership’s assets. Fair valuations of investments in each asset class are determined using one or more methodologies including the market approach, income approach, or, in the case of recent investments, the cost approach, as appropriate. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets. Such information may include observed multiples of earnings and/or revenues at Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) which transactions in securities of comparable companies occur, with appropriate adjustments for differences in company size, operations or other factors affecting comparability. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present value amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. The discount rates used for such analyses reflect market yields for comparable investments, considering such factors as relative credit quality, capital structure, and other factors. In following these approaches, the types of factors that may be taken into account also include, as relevant: available current market data, including relevant and applicable market trading and transaction comparables, security covenants, call protection provisions, information rights, the nature and realizable value of any collateral, the portfolio company’s ability to make payments, its earnings and cash flows, the markets in which the portfolio company does business, comparisons of financial ratios of peer companies that are public, merger and acquisition comparables, comparable costs of capital, the principal market in which the investment trades and enterprise values, among other factors. Investments may be categorized based on the types of inputs used in valuing such investments. The level in the GAAP valuation hierarchy in which an investment falls is based on the lowest level input that is significant to the valuation of the investment in its entirety. Transfers between levels are recognized as of the beginning of the reporting period. At December 31, 2016, the Partnership’s investments were categorized as follows: *For example, quoted prices in inactive markets or quotes for comparable investments Unobservable inputs used in the fair value measurement of Level 3 investments as of December 31, 2016 included the following: Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) Generally, a change in an unobservable input may result in a change to the value of an investment as follows: Changes in investments categorized as Level 3 during the year ended December 31, 2016 were as follows: *Includes payments received in kind and accretion of original issue and market discounts †Comprised of five investments that transferred to Level 2 due to increased observable market activity ‡Comprised of seven investments that transferred from Level 2 due to reduced trading volumes §Comprised of two investments that reclassified to Advisor Valuation *Includes payments received in kind and accretion of original issue and market discounts †Comprised of two investments that reclassified from Independent Third-Party Valuation There were no transfers between Level 1 and 2 during the year ended December 31, 2016. Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) At December 31, 2015, the Partnership’s investments were categorized as follows: *For example, quoted prices in inactive markets or quotes for comparable investments Unobservable inputs used in the fair value measurement of Level 3 investments as of December 31, 2015 included the following: Changes in investments categorized as Level 3 during the year ended December 31, 2015 were as follows: *Includes payments received in kind and accretion of original issue and market discounts †Comprised of five investments that transferred to Level 2 due to increased observable market activity ‡Comprised of three investments that transferred from Level 2 due to reduced trading volumes §Comprised of one investment that reclassified from Advisor Valuation Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) *Includes payments received in kind and accretion of original issue and market discounts †Comprised of one investment that reclassified to Independent Third-Party Valuation There were no transfers between Level 1 and 2 during the year ended December 31, 2015. Investment Transactions Investment transactions are recorded on the trade date, except for private transactions that have conditions to closing, which are recorded on the closing date. The cost of investments purchased is based upon the purchase price plus those professional fees which are specifically identifiable to the investment transaction. Realized gains and losses on investments are recorded based on the specific identification method, which typically allocates the highest cost inventory to the basis of investments sold. Cash and Cash Equivalents Cash consists of amounts held in accounts with brokerage firms and the custodian bank. Cash equivalents consist of highly liquid investments with an original maturity of generally three months or less. Cash equivalents are carried at amortized cost which approximates fair value. Cash equivalents are classified as Level 1 in the GAAP valuation hierarchy. Restricted Investments The Partnership may invest without limitation in instruments that are subject to legal or contractual restrictions on resale. These instruments generally may be resold to institutional investors in transactions exempt from registration or to the public if the securities are registered. Disposal of these investments may involve time-consuming negotiations and additional expense, and prompt sale at an acceptable price may be difficult. Information regarding restricted investments is included at the end of the Consolidated Schedule of Investments. Restricted investments, including any restricted investments in affiliates, are valued in accordance with the investment valuation policies discussed above. Foreign Investments The Partnership may invest in instruments traded in foreign countries and denominated in foreign currencies. Foreign currency denominated investments comprised approximately 0.2% and 1.4% of total investments at December 31, 2016 and December 31, 2015, respectively. Such positions were converted at the respective closing foreign exchange rates in effect at December 31, 2016 and December 31, 2015 and reported in U.S. dollars. Purchases and sales of investments and income and expense items denominated in foreign currencies, Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) when they occur, are translated into U.S. dollars based on the foreign exchange rates in effect on the respective dates of such transactions. The portion of gains and losses on foreign investments resulting from fluctuations in foreign currencies is included in net realized and unrealized gain or loss from investments. Investments in foreign companies and securities of foreign governments may involve special risks and considerations not typically associated with investing in U.S. companies and securities of the U.S. government. These risks include, among other things, revaluation of currencies, less reliable information about issuers, different transaction clearance and settlement practices, and potential future adverse political and economic developments. Moreover, investments in foreign companies and securities of foreign governments and their markets may be less liquid and their prices more volatile than those of comparable U.S. companies and the U.S. government. Derivatives In order to mitigate certain currency exchange and interest rate risks, the Partnership may enter into certain derivative transactions. All derivatives are reported at their gross amounts as either assets or liabilities in the Consolidated Statements of Assets and Liabilities. Transactions entered into are accounted for using the mark-to-market method with the resulting change in fair value recognized in earnings for the current period. Risks may arise upon entering into these contracts from the potential inability of counterparties to meet the terms of their contracts and from unanticipated movements in interest rates and the value of foreign currencies relative to the U.S. dollar. Certain derivatives may also require the Partnership to pledge assets as collateral to secure its obligations. As of December 31, 2016, no derivatives were outstanding. During the year ended December 31, 2016, the Partnership entered into and exited a GBP put option with a notional amount of £2.7 million. During the year ended December 31, 2016, the Partnership’s interest rate cap with a notional amount of $25.0 million expired, and the Partnership exited a cross currency basis swap with a notional amount of $16.4 million. The interest rate cap was reported in the Consolidated Statements of Assets and Liabilities under the caption, “Options.” Gains and losses from derivatives during the year ended December 31, 2016 were included in net realized and unrealized gain (loss) on investments in the Consolidated Statements of Operations as follows: The Partnership did not enter into any new derivative transactions during the year ended December 31, 2015. At December 31, 2015, the Partnership held an interest rate cap with a notional amount of $25.0 million and a cross currency basis swap with a notional amount of $16.4 million. The interest rate cap and the cross currency basis swap are reported in the Consolidated Statements of Assets and Liabilities as options and unrealized appreciation on swaps, respectively. Gains and losses from derivatives during the year ended December 31, 2015 were included in net realized and unrealized gain (loss) on investments in the Consolidated Statements of Operations as follows: Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) Valuations of derivatives held at December 31, 2015 were determined using observable market inputs other than quoted prices in active markets for identical assets and, accordingly, are classified as Level 2 in the GAAP valuation hierarchy. Deferred Debt Issuance Costs Costs of approximately $1.8 million were incurred during 2015 in connection with the extension of the Partnership’s credit facility (see Note 4). Costs of approximately $1.9 million were incurred during 2015 in connection with placing and extending TCPC Funding’s revolving credit facility (see Note 4). Costs of approximately $1.2 million and $0.4 million were incurred during the year ended December 31, 2016 and year ended December 31, 2015, respectively, in connection with placing the SBA Debentures (see Note 4). These costs were deferred and are being amortized on a straight-line basis over the estimated life of the respective instruments. The impact of utilizing the straight-line amortization method versus the effective-interest method is not material to the operations of the Partnership. Revenue Recognition Interest and dividend income, including income paid in kind, is recorded on an accrual basis. Origination, structuring, closing, commitment and other upfront fees, including original issue discounts, earned with respect to capital commitments are generally amortized or accreted into interest income over the life of the respective debt investment, as are end-of-term or exit fees receivable upon repayment of a debt investment. Other fees, including certain amendment fees, prepayment fees and commitment fees on broken deals, are recognized as earned. Prepayment fees and similar income due upon the early repayment of a loan or debt security are recognized when earned and are included in interest income. Certain debt investments are purchased at a discount to par as a result of the underlying credit risks and financial results of the issuer, as well as general market factors that influence the financial markets as a whole. Discounts on the acquisition of corporate bonds are generally amortized using the effective-interest or constant-yield method assuming there are no questions as to collectability. When principal payments on a loan are received in an amount in excess of the loan’s amortized cost, the excess principal payments are recorded as interest income. Income Taxes The income or loss of the Partnership, TCPC Funding and the SBIC is reported in the respective partners’ income tax returns. Consequently, no income taxes are paid at the partnership level or reflected in the Partnership’s financial statements. In accordance with ASC Topic 740 - Income Taxes, the Partnership recognizes in its consolidated financial statements the effect of a tax position when it is determined that such position is more likely than not, based on the technical merits, to be sustained upon examination. As of December 31, 2016, all tax years of the Partnership, TCPC Funding and the SBIC since January 1, 2013 remain subject to examination by federal tax authorities. No such examinations are currently pending. Cost and unrealized appreciation and depreciation of the Partnership’s investments (including derivatives) for U.S. federal income tax purposes at December 31, 2016 and December 31, 2015 were as follows: Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 2. Summary of Significant Accounting Policies - (continued) Recent Accounting Pronouncements During the first quarter of 2016, the Partnership adopted Financial Accounting Standards Board (the “FASB”) Accounting Standards Update (“ASU”) 2015-02, Amendments to the Consolidation Analysis. In particular, the new pronouncement changed the manner in which a reporting entity evaluates whether 1) an entity is a variable interest entity (“VIE”), 2) fees paid to decision makers or service providers are variable interests in a VIE, and 3) variable interests in a VIE held by related parties require the reporting entity to consolidate the VIE. The pronouncement also introduced a separate consolidation analysis specific to limited partnerships and similar entities. ASU 2015-02 also eliminated the VIE consolidation model based on majority exposure to variability that applied to certain investment companies and similar entities. The adoption of this pronouncement did not have a material impact on the Partnership’s consolidated financial statements. The Partnership also adopted ASU 2015-03, Interest - Imputation of Interest (Subtopic 835-30) - Simplifying the Presentation of Debt Issuance Costs as well as ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements - Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015. Together, these ASUs required, in most cases, that debt issuance costs be presented in the balance sheet as a direct deduction from the carrying value of the associated debt liability, consistent with the presentation of a debt discount. Debt issuance costs incurred in connection with line-of-credit arrangements, however, may continue to be presented as an asset in the balance sheet. The adoption of these ASUs resulted in the reclassification of certain debt issuance costs related to the Term Loan and SBA Debentures (as defined in Note 4) from deferred debt issuance costs to debt in the Consolidated Statements of Assets and Liabilities. As of December 31, 2016 and December 31, 2015, $2.7 million and $1.8 million in debt issuance costs, respectively, were included in debt in the Consolidated Statements of Assets and Liabilities. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in Topic 605, Revenue Recognition. Under this new pronouncement, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 applies to all entities and, for public entities, is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early application is permitted, but no earlier than annual periods beginning after December 15, 2016 and interim periods within that reporting period. The Partnership does not expect adoption of this pronouncement to have a material impact on its consolidated financial statements. On January 5, 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. The more significant changes to the current GAAP model resulting from ASU 2016-01 include 1) elimination of the requirement to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost, 2) requiring public entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and 3) requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or in the accompanying notes to the financial statements. ASU 2016-01 is effective for annual periods beginning after December 15, 2017, including interim periods within those fiscal years. Early application is permitted. The Partnership does not expect adoption of this pronouncement to have a material impact on its consolidated financial statements. Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 3. Management Fees, Incentive Compensation and Other Expenses The Partnership’s management fee is calculated at an annual rate of 1.5% of total assets (excluding cash and cash equivalents) of TCPC on a consolidated basis as of the beginning of each quarter and is payable to the Advisor quarterly in arrears. Incentive compensation is only paid to the extent that TCPC’s total performance exceeds a cumulative 8% annual return since January 1, 2013 (the “Total Return Hurdle”). The incentive compensation equals 20% of net investment income (reduced by preferred dividends) and 20% of net realized gains (reduced by any net unrealized losses), subject to the Total Return Hurdle. The incentive compensation is payable quarterly in arrears as an allocation and distribution to the General Partner and is calculated as the difference between cumulative incentive compensation earned since January 1, 2013 and cumulative incentive compensation paid since January 1, 2013. A reserve for incentive compensation is allocated to the account of the General Partner based on the amount of additional incentive compensation that would have been distributable to the General Partner assuming a hypothetical liquidation of TCPC and the Partnership at net asset value on the balance sheet date. The General Partner’s equity interest in the Partnership is comprised entirely of such reserve amount, if any. As of December 31, 2016 and December 31, 2015, no such reserve was allocated. The Partnership bears all expenses incurred in connection with its business, including fees and expenses of outside contracted services, such as custodian, administrative, legal, audit and tax preparation fees, costs of valuing investments, insurance costs, brokers’ and finders’ fees relating to investments, and any other transaction costs associated with the purchase and sale of investments. 4. Leverage Leverage is comprised of amounts outstanding under a term loan issued by the Partnership (the “Term Loan”), amounts outstanding under a senior secured revolving credit facility issued by the Partnership (the “SVCP Revolver” and together with the Term Loan, the “SVCP Facility”), amounts outstanding under a senior secured revolving credit facility issued by TCPC Funding (the “TCPC Funding Facility”), debentures guaranteed by the SBA (the “SBA Debentures”), and, prior to the repurchase and retirement of remaining interests on September 3, 2015, amounts outstanding under a preferred equity facility issued by the Partnership (the “Preferred Interests”). Total leverage outstanding and available at December 31, 2016 was as follows: *Based on either LIBOR or the lender’s cost of funds, subject to certain limitations †Or L+2.25% subject to certain funding requirements ‡Weighted-average interest rate, excluding fees of 0.36% Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 4. Leverage - (continued) Total leverage outstanding and available at December 31, 2015 was as follows: *Based on either LIBOR or the lender’s cost of funds, subject to certain limitations †Or L+2.25% subject to certain funding requirements ‡Weighted-average interest rate on pooled loans of $38.8 million, excluding fees of 0.36%. As of December 31, 2015, the remaining $4.0 million of the outstanding amount was not yet pooled, and bore interest at a temporary rate of 0.90% plus fees of 0.36% through March 22, 2016, the date of the next SBA pooling. The combined weighted-average interest rates on total leverage outstanding at December 31, 2016 and December 31, 2015 were 3.23% and 2.65%, respectively. Total expenses related to debt include: Amounts outstanding under the SVCP Facility, the TCPC Funding Facility and the SBA Debentures are carried at amortized cost in the Consolidated Statements of Assets and Liabilities. As of December 31, 2016, the estimated fair values of the SVCP Facility, the TCPC Funding Facility and the SBA Debentures approximated their carrying values. The estimated fair values of the SVCP Facility, the TCPC Funding Facility and the SBA Debentures are determined by discounting projected remaining payments using market interest rates for borrowings of the Partnership and entities with similar credit risks at the measurement date. At December 31, 2016, the estimated fair values of the SVCP Facility, the TCPC Funding Facility and the SBA Debentures as prepared for disclosure purposes were deemed to be Level 3 in the GAAP valuation hierarchy. SVCP Facility The SVCP Facility consists of a $100.5 million fully-drawn senior secured term loan and a senior secured revolving credit facility which provides for amounts to be drawn up to $116.0 million, subject to certain collateral and other restrictions. The SVCP Facility matures on July 31, 2018. Most of the cash and investments held directly by the Partnership, as well as the net assets of TCPC Funding and the SBIC, are included in the collateral for the facility. Advances under the SVCP Facility through July 31, 2014 bore interest at an annual rate equal to 0.44% plus either LIBOR or the lender’s cost of funds (subject to a cap of LIBOR plus 20 basis points). Advances under the SVCP Facility for periods from July 31, 2014 through September 3, 2015 bore interest at an annual rate equal to Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 4. Leverage - (continued) 2.50% plus either LIBOR or the lender’s cost of funds (subject to a cap of LIBOR plus 20 basis points). Advances under the SVCP Facility from September 3, 2015 through July 31, 2016 bore interest at an annual rate equal to 1.75% plus either LIBOR or the lender’s cost of funds (subject to a cap of LIBOR plus 20 basis points). Advances under the SVCP Facility from July 31, 2016 through the maturity date of the facility bear interest at an annual rate of 2.50% plus either LIBOR or the lender’s cost of funds (subject to a cap of LIBOR plus 20 basis points). In addition to amounts due on outstanding debt, the SVCP Revolver accrues commitment fees of 0.20% per annum on the unused portion of the facility, or 0.25% per annum when less than $46.4 million in borrowings are outstanding. The facility may be terminated, and any outstanding amounts thereunder may become due and payable, should the Partnership fail to satisfy certain financial or other covenants. As of December 31, 2016, the Partnership was in full compliance with such covenants. SBA Debentures As of December 31, 2016 the SBIC was able to issue up to $150.0 million in SBA Debentures, subject to funded regulatory capital and other customary regulatory requirements. As of December 31, 2016, the Partnership had committed $75.0 million of regulatory capital to the SBIC, all of which had been funded. SBA Debentures are non-recourse and may be prepaid at any time without penalty. Once drawn, the SBIC debentures bear an interim interest rate of LIBOR plus 30 basis points. The rate then becomes fixed at the time of SBA pooling, which occurs twice each year, and is set to the then-current 10-year treasury rate plus a spread and an annual SBA charge. SBA Debentures outstanding as of December 31, 2016 were as follows: *Weighted-average interest rate SBA Debentures outstanding as of December 31, 2015 were as follows: *Weighted-average interest rate on pooled loans Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 4. Leverage - (continued) TCPC Funding Facility The TCPC Funding Facility is a senior secured revolving credit facility which provides for amounts to be drawn up to $350.0 million, subject to certain collateral and other restrictions. The facility matures on March 6, 2020, subject to extension by the lender at the request of TCPC Funding. The facility contains an accordion feature which allows for expansion of the facility to up to $400.0 million subject to consent from the lender and other customary conditions. The cash and investments of TCPC Funding are included in the collateral for the facility. Borrowings under the TCPC Funding Facility bear interest at a rate of LIBOR plus either 2.25% or 2.50% per annum, subject to certain funding requirements, plus an administrative fee of 0.25% per annum. In addition to amounts due on outstanding debt, the facility accrues commitment fees of 0.50% per annum on the unused portion of the facility, or 0.75% per annum when the unused portion is greater than 33% of the total facility, plus an administrative fee of 0.25% per annum. The facility may be terminated, and any outstanding amounts thereunder may become due and payable, should TCPC Funding fail to satisfy certain financial or other covenants. As of December 31, 2016, TCPC Funding was in full compliance with such covenants. Preferred Interests As of December 31, 2016 and 2015, no Preferred Interests were outstanding. On June 30, 2015, the Partnership repurchased and retired 1,675 of the previously outstanding 6,700 Preferred Interests at a price of $31.8 million. On September 3, 2015, the Partnership repurchased and retired the remaining 5,025 Preferred Interests outstanding at a price of $100.5 million. When issued, the Preferred Interests were comprised of 6,700 Series A preferred limited partner interests with a liquidation preference of $20,000 per interest. The Preferred Interests accrued dividends at an annual rate equal to 0.85% plus either LIBOR or the interest holder’s cost of funds (subject to a cap of LIBOR plus 20 basis points). 5. Commitments, Contingencies, Concentration of Credit Risk and Off-Balance Sheet Risk The Partnership, TCPC Funding and the SBIC conduct business with brokers and dealers that are primarily headquartered in New York and Los Angeles and are members of the major securities exchanges. Banking activities are conducted with a firm headquartered in the San Francisco area. In the normal course of business, investment activities involve executions, settlement and financing of various transactions resulting in receivables from, and payables to, brokers, dealers and the custodian. These activities may expose the Partnership to risk in the event that such parties are unable to fulfill contractual obligations. Management does not anticipate any material losses from counterparties with whom it conducts business. Consistent with standard business practice, the Partnership, TCPC Funding and the SBIC enter into contracts that contain a variety of indemnifications, and are engaged from time to time in various legal actions. The maximum exposure under these arrangements and activities is unknown. However, management expects the risk of material loss to be remote. Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 5. Commitments, Contingencies, Concentration of Credit Risk and Off-Balance Sheet Risk - (continued) The Consolidated Schedules of Investments include certain revolving loan facilities and other commitments with unfunded balances at December 31, 2016 and December 31, 2015 as follow: Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 6. Related Party Transactions TCPC, the Partnership, TCPC Funding, the SBIC, the Advisor, the General Partner and their members and affiliates may be considered related parties. From time to time, the Partnership advances payments to third parties on behalf of TCPC which are reimbursable through deductions from distributions to TCPC. At December 31, 2016 and December 31, 2015, no such amounts were outstanding. From time to time, the Advisor advances payments to third parties on behalf of the Partnership and receives reimbursement from the Partnership. At December 31, 2016 and 2015, amounts reimbursable to the Advisor totaled $0.3 million and $0.3 million, respectively, as reflected in the Consolidated Statements of Assets and Liabilities. Pursuant to an administration agreement between the Administrator and the Partnership (the “Administration Agreement”), the Administrator may be reimbursed for costs and expenses incurred by the Administrator for office space rental, office equipment and utilities allocable to the Partnership, as well as costs and expenses incurred by the Administrator or its affiliates relating to any administrative, operating, or other non-investment advisory services provided by the Administrator or its affiliates to the Partnership. For the years ended December 31, 2016, 2015 and 2014, expenses allocated pursuant to the Administration Agreement totaled $1.7 million, $1.6 million and $1.4 million, respectively. On November 25, 2014, the Partnership obtained an exemptive order (the “Exemptive Order”) from the Securities and Exchange Commission permitting the Partnership to purchase certain investments from affiliated investment companies at fair value. The Exemptive Order exempts the Partnership from provisions of Sections 17(a) and 57(a) of the 1940 Act which would otherwise restrict such transfers. All such purchases are subject to the conditions set forth in the Exemptive Order, which among others include certain procedures to verify that each purchase is done at the current fair value of the respective investment. During the years ended December 31, 2016 and 2015, the Partnership purchased approximately $0.0 million and $94.5 million, respectively, of investments from affiliates (as defined in the 1940 Act), which were classified as Level 2 in the GAAP valuation hierarchy at the time of the transfer. The selling party has no continuing involvement in the transferred assets. All of the transfers were consummated in accordance with the provisions of the Exemptive Order and were accounted for as a purchase in accordance with ASC 860, Transfers and Servicing. 7. Distributions The Partnership’s distributions are recorded on the record date. The timing of distributions is determined by the General Partner, which has provided the Advisor with certain criteria for such distributions. 8. Subsequent Events On February 28, 2017, TCPC’s board of directors declared a first quarter regular dividend of $0.36 per share payable on March 31, 2017 to stockholders of record as of the close of business on March 17, 2017. Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 9. Financial Highlights The financial highlights with respect to the common limited partner are as follows: (1)Return on invested assets is a time-weighted, geometrically linked rate of return and excludes cash and cash equivalents. (2)Returns (net of dividends on the preferred equity facility, allocations to the General Partner, and Partnership expenses, including financing costs and management fees) calculated on a monthly geometrically linked, time-weighted basis. (3)These ratios include interest expense but do not reflect the effect of dividends on the preferred equity facility. (4)Net of allocation to the General Partner. (5)Includes both debt and preferred leverage. (6)Includes dividends on the preferred leverage facility. (7)Excludes unamortized debt issuance costs which are netted in the Consolidated Statements of Assets and Liabilities. Special Value Continuation Partners, LP (A Delaware Limited Partnership) (Continued) December 31, 2016 10. Select Quarterly Data (Unaudited) Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Changes in Investments in Affiliates (1) Year Ended December 31, 2016 Notes to Consolidated Schedule of Changes in Investments in Affiliates: (1)The issuers of the securities listed on this schedule are considered affiliates under the Investment Company Act of 1940 due to the ownership by the Partnership of 5% or more of the issuers' voting securities. (2)Also includes fee and lease income as applicable. (3)Acquisitions include new purchases, PIK income, amortization of original issue and market discounts and net unrealized appreciation. (4)Dispositions include decreases in the cost basis from sales, paydowns, mortgage amortizations, aircraft depreciation and net unrealized depreciation. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Changes in Investments in Affiliates(1) Year Ended December 31, 2015 Notes to Consolidated Schedule of Changes in Investments in Affiliates: (1)The issuers of the securities listed on this schedule are considered affiliates under the Investment Company Act of 1940 due to the ownership by the Partnership of 5% or more of the issuers’ voting securities. (2)Also includes fee and lease income as applicable. (3)Acquisitions include new purchases, PIK income, accretion of original issue and market discounts and net unrealized appreciation. (4)Dispositions include decreases in the cost basis from sales, paydowns, mortgage amortizations, aircraft depreciation and net unrealized depreciation. Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Restricted Securities of Unaffiliated Issuers December 31, 2016 Special Value Continuation Partners, LP (A Delaware Limited Partnership) Consolidated Schedule of Restricted Securities of Unaffiliated Issuers December 31, 2015
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Here's a summary of the financial statement:
The financial statement appears to be for Special Value Continuation Partners, LP, a potential investment partnership. Key points include:
1. Investment Accounting:
- Losses on investments are recorded using specific identification method
- Highest cost inventory typically allocated to investment sales
2. Cash Management:
- Cash held in brokerage and bank accounts
- Cash equivalents are highly liquid investments (3 months or less maturity)
- Cash equivalents valued at amortized cost, approximating fair market value
3. Classification:
- Deemed an investment company under Section 3
- Debt typically traded among institutional investors
- Not subject to Securities Act of 1933 registration
The statement provides a basic overview of the partnership's financial structure, investment strategies, and cash management approach.
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Claude
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. Financial statement schedules other than those listed above are omitted because the required information is given in the financial statements, including the notes thereto, or because the conditions requiring their filing do not exist. CWI 2016 10-K - 52 ACCOUNTING FIRM To the Board of Directors and Stockholders of Carey Watermark Investors Incorporated: In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Carey Watermark Investors Incorporated and its subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. /s/ PricewaterhouseCoopers LLP New York, New York March 16, 2017 CWI 2016 10-K - 53 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share amounts) See . CWI 2016 10-K - 54 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except share and per share amounts) See . CWI 2016 10-K - 55 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (in thousands) See . CWI 2016 10-K - 56 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED STATEMENTS OF EQUITY Years Ended December 31, 2016, 2015 and 2014 (in thousands, except share and per share amounts) (Continued) CWI 2016 10-K - 57 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED STATEMENTS OF EQUITY (Continued) Years Ended December 31, 2016, 2015 and 2014 (in thousands, except share and per share amounts) See . CWI 2016 10-K - 58 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) CWI 2016 10-K - 59 CAREY WATERMARK INVESTORS INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Supplemental Cash Flow Information (in thousands): See . CWI 2016 10-K - 60 CAREY WATERMARK INVESTORS INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Organization and Offering Organization Carey Watermark Investors Incorporated, or CWI, and, together with its consolidated subsidiaries, we, us, or our, is a publicly owned, non-listed real estate investment trust, or REIT, that invests in, and through our advisor, manages and seeks to enhance the value of, interests in lodging and lodging-related properties primarily in the United States. We conduct substantially all of our investment activities and own all of our assets through CWI OP, LP, or the Operating Partnership. We are a general partner and a limited partner of, and own a 99.985% capital interest in, the Operating Partnership. Carey Watermark Holdings, LLC, or Carey Watermark Holdings, which is owned indirectly by both W. P. Carey Inc., or WPC, and Watermark Capital Partners, LLC, or Watermark Capital Partners, holds a special general partner interest in the Operating Partnership. We are managed by Carey Lodging Advisors, LLC, or our Advisor, an indirect subsidiary of WPC. Our Advisor manages our overall portfolio, including providing oversight and strategic guidance to the independent hotel operators that manage our hotels. CWA, LLC, a subsidiary of Watermark Capital Partners, or the Subadvisor, provides services to our Advisor, primarily relating to acquiring, managing, financing and disposing of our hotels and overseeing the independent operators that manage the day-to-day operations of our hotels. In addition, the Subadvisor provides us with the services of Mr. Michael G. Medzigian, our chief executive officer, subject to the continuing approval of our independent directors. We held ownership interests in 35 hotels at December 31, 2016. See Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 - Portfolio Overview for a complete listing of the hotels that we consolidate, or our Consolidated Hotels, and the hotels that we record as equity investments, or our Unconsolidated Hotels, at December 31, 2016. Public Offerings We raised $575.8 million through our initial public offering, which ran from September 15, 2010 through September 15, 2013, and $577.4 million through our follow-on offering, which ran from December 20, 2013 through December 31, 2014. From inception through December 31, 2016, we also received $124.5 million through our distribution reinvestment plan, or DRIP. We have fully invested the proceeds from both our initial public offering and follow-on offering. Note 2. Summary of Significant Accounting Policies Critical Accounting Policies and Estimates Accounting for Acquisitions In accordance with the guidance for business combinations, we determine whether a transaction or other event is a business combination, which requires that the assets acquired and liabilities assumed constitute a business. Each business combination is then accounted for by applying the acquisition method. We capitalize acquisition-related costs and fees associated with asset acquisitions. We immediately expense acquisition-related costs and fees associated with business combinations. We record our investments in hotel properties based on the fair value of the identifiable assets acquired, identifiable intangible assets or liabilities acquired, liabilities assumed and any noncontrolling interest in the acquired entity, and if applicable, recognizing and measuring any goodwill or gain from a bargain purchase at the acquisition date. We allocate the purchase price among the assets acquired and liabilities assumed based on their respective fair values. In making estimates of fair value for purposes of allocating the purchase price, we utilize a variety of information obtained in connection with the acquisition of a hotel property, including valuations performed by independent third parties and information obtained about each hotel property resulting from pre-acquisition due diligence. Impairments We periodically assess whether there are any indicators that the value of our long-lived real estate and related intangible assets may be impaired or that their carrying value may not be recoverable. These impairment indicators include, but are not limited to, when a hotel property experiences a current or projected loss from operations, when it becomes more likely than not that a hotel property will be sold before the end of its useful life, or when there are adverse changes in the demand for lodging due to CWI 2016 10-K - 61 declining national or local economic conditions. We may incur impairment charges on long-lived assets, including real estate, related intangible assets, assets held for sale and equity investments. Our policies and estimates for evaluating whether these assets are impaired are presented below. Real Estate - For real estate assets held for investment and related intangible assets in which an impairment indicator is identified, we follow a two-step process to determine whether an asset is impaired and to determine the amount of the charge. First, we compare the carrying value of the property’s asset group to the estimated future net undiscounted cash flow that we expect the property’s asset group will generate, including any estimated proceeds from the eventual sale of the property’s asset group. The undiscounted cash flow analysis requires us to make our best estimate of, among other things, net operating income, residual values and holding periods. Our investment objective is to hold properties on a long-term basis. Depending on the assumptions made and estimates used, the future cash flow projected in the evaluation of long-lived assets and associated intangible assets can vary within a range of outcomes. We consider the likelihood of possible outcomes in determining our estimate of future cash flows and, if warranted, we apply a probability-weighted method to the different possible scenarios. If the future net undiscounted cash flow of the property’s asset group is less than the carrying value, the carrying value of the property’s asset group is considered not recoverable. We then measure the loss as the excess of the carrying value of the property’s asset group over its estimated fair value. The estimated fair value of the property’s asset group is primarily determined using market information from outside sources such as broker quotes or recent comparable sales. In cases where the available market information is not deemed appropriate, we perform a future net cash flow analysis discounted for inherent risk associated with each asset to determine an estimated fair value. Assets Held for Sale - When we classify an asset as held for sale, we compare the asset’s fair value less estimated cost to sell to its carrying value, and if the fair value to sell is less, we reduce the carrying value to the fair value less estimated cost to sell. We base the fair value on the contract and the estimated cost to sell on information provided by brokers and legal counsel. We will continue to review the property for subsequent changes in fair value and may recognize an additional impairment charge, if warranted. Equity Investments in Real Estate - We evaluate our equity investments in real estate on a periodic basis to determine if there are any indicators that the value of our equity investment may be impaired and whether or not that impairment is other-than-temporary. To the extent an impairment has occurred and is determined to be other-than-temporary, we measure the charge as the excess of the carrying value of our investment over its estimated fair value. Other Accounting Policies Basis of Consolidation - Our consolidated financial statements reflect all of our accounts, including those of our controlled subsidiaries. The portions of equity in consolidated subsidiaries that are not attributable, directly or indirectly, to us are presented as noncontrolling interests. All significant intercompany accounts and transactions have been eliminated. On January 1, 2016, we adopted the Financial Accounting Standards Board’s, or FASB’s, Accounting Standards Update, or ASU, 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, as described in the Recent Accounting Pronouncements section below, which amends the current consolidation guidance, including introducing a separate consolidation analysis specific to limited partnerships and other similar entities. When we obtain an economic interest in an entity, we evaluate the entity to determine if it should be deemed a variable interest entity, or VIE, and, if so, whether we are the primary beneficiary and are therefore required to consolidate the entity. We apply accounting guidance for consolidation of VIEs to certain entities in which the equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Certain decision-making rights within a loan or joint-venture agreement can cause us to consider an entity a VIE. Limited partnerships and other similar entities which operate as a partnership will be considered a VIE unless the limited partners hold substantive kick-out rights or participation rights. Significant judgment is required to determine whether a VIE should be consolidated. We review the contractual arrangements provided for in the partnership agreement or other related contracts to determine whether the entity is considered a VIE, and to establish whether we have any variable interests in the VIE. We then compare our variable interests, if any, to those of the other variable interest holders to determine which party is the primary beneficiary of the VIE based on whether the entity (i) has the power to direct the activities that most significantly impact the economic performance of the VIE and (ii) has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. We performed this analysis on all of our subsidiary entities following the guidance in ASU 2015-02 to determine whether they qualify as VIEs and whether they should be consolidated or accounted for as equity investments in an unconsolidated venture. As a result of this change in guidance, we determined that five entities that CWI 2016 10-K - 62 were previously classified as voting interest entities should now be classified as VIEs as of January 1, 2016 and therefore included in our VIE disclosure. However, there was no change in determining whether or not we consolidate these entities as a result of the new guidance. We elected to retrospectively adopt ASU 2015-02 which resulted in changes to our VIE disclosures. There were no other changes to our consolidated balance sheets or results of operations for the periods presented. At December 31, 2016, we considered five entities to be VIEs, four of which we consolidated as we are considered the primary beneficiary. The following table presents a summary of selected financial data of consolidated VIEs included in the consolidated balance sheets (in thousands): Out-of-Period Adjustment - During the third quarter of 2016, we identified and recorded an out-of-period adjustment related to a difference between the tax basis and financial reporting basis of certain villa/condo rental management agreements that were entered into upon the acquisition of two hotels during the second quarter of 2015, which resulted in a deferred tax liability. We concluded that this adjustment was not material to our consolidated financial statements for the current year or prior periods presented. The adjustment is reflected as an increase of $4.9 million to Net investments in hotels and a corresponding increase to Accounts payable, accrued expenses and other liabilities in the consolidated balance sheet as of December 31, 2016. Reclassifications - Certain prior period amounts have been reclassified to conform to the current period presentation. Additionally, on January 1, 2016, we adopted ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30) as described in the Recent Accounting Pronouncements section below. ASU 2015-03 changes the presentation of debt issuance costs, which were previously recognized as an asset and requires that they be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. As a result of adopting this guidance, we reclassified $8.6 million of deferred financing costs, net from Other assets to Non-recourse debt, net as of December 31, 2015. Share Repurchases - Share repurchases are recorded as a reduction of common stock par value and additional paid-in capital under our redemption plan, pursuant to which we may elect to redeem shares at the request of our stockholders, subject to certain exceptions, conditions, and limitations. The maximum amount of shares purchasable by us in any period depends on a number of factors and is at the discretion of our board of directors. Real Estate - We carry land, buildings and personal property at cost less accumulated depreciation. We capitalize improvements and we expense replacements, maintenance and repairs that do not improve or extend the life of the respective assets as incurred. Renovations and/or replacements at the hotel properties that improve or extend the life of the assets are capitalized and depreciated over their useful lives, and repairs and maintenance are expensed as incurred. We capitalize interest and certain other costs, such as incremental labor costs relating to hotels undergoing major renovations and redevelopments. Assets Held for Sale - We classify real estate assets as held for sale when we have entered into a contract to sell the property, all material due diligence requirements have been satisfied, or we believe it is probable that the disposition will occur within one year. Assets held for sale are recorded at the lower of carrying value or estimated fair value, less estimated costs to sell. In the unlikely event that we decide not to sell a property previously classified as held for sale, we reclassify the property as held and used. We measure and record a property that is reclassified as held and used at the lower of (i) its carrying amount before the property was classified as held for sale, adjusted for any depreciation expense that would have been recognized had the property been continuously classified as held and used or (ii) the estimated fair value at the date of the subsequent decision not to sell. CWI 2016 10-K - 63 We recognize gains and losses on the sale of properties when, among other criteria, we no longer have continuing involvement, the parties are bound by the terms of the contract, all consideration has been exchanged, and all conditions precedent to closing have been performed. At the time the sale is consummated, a gain or loss is recognized as the difference between the sale price, less any selling costs, and the carrying value of the property. Cash - Our cash is held in the custody of several financial institutions, and these balances, at times, exceed federally-insurable limits. We seek to mitigate this risk by depositing funds only with major financial institutions. Restricted Cash - Restricted cash consists primarily of amounts escrowed pursuant to the terms of our mortgage debt to fund planned renovations and improvements, property taxes, insurance, and normal replacement of furniture, fixtures and equipment at our hotels. Other Assets and Liabilities - Other assets consists primarily of prepaid expenses, deposits, hotel inventories, deferred tax asset and derivative assets in the consolidated financial statements. Other liabilities consists primarily of hotel advance deposits, straight-line rent, sales use and occupancy taxes payable, unamortized key money, deferred tax liabilities, asset retirement obligations, accrued income taxes and derivative liabilities. Deferred Financing Costs - Deferred financing costs represent costs to obtain mortgage financing. We amortize these charges to interest expense over the term of the related mortgage using a method which approximates the effective interest method. Deferred financing costs are presented in the consolidated balance sheet as a direct deduction from the carrying amount of that debt liability. Segments - We operate in one business segment, hospitality, with domestic investments. Hotel Revenue Recognition - We recognize revenue from operations of our hotels as the related services are provided. Our hotel revenues are comprised of hotel operating revenues (such as room, food and beverage) and revenue from other operating departments (such as internet, spa services, parking and gift shops). These revenues are recorded net of any sales or occupancy taxes collected from our guests as earned. All rebates or discounts are recorded as a reduction in revenue and there are no material contingent obligations with respect to rebates or discounts offered by us. All revenues are recorded on an accrual basis, as earned. Appropriate allowances are made for doubtful accounts and are recorded as a bad debt expense. We do not have any time-share arrangements and do not sponsor any frequent guest programs for which we would have any contingent liability. We participate in frequent guest programs sponsored by our hotel brands and we expense the charges associated with those programs (typically consisting of a percentage of the total guest charges incurred by a participating guest) as incurred. When a guest redeems accumulated frequent guest points at one of our hotels, the hotel bills the brand sponsor for the services provided in redemption of such points and records revenue in the amount of the charges billed to the brand sponsor. We have no loss contingencies or ongoing obligation associated with frequent guest programs beyond what is paid to the brand sponsor following a guest’s stay. Asset Retirement Obligations - Asset retirement obligations relate to the legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal operation of a long-lived asset. The fair value of a liability for an asset retirement obligation is recorded in the period in which it is incurred and the cost of such liability is recorded as an increase in the carrying amount of the related long-lived asset by the same amount. The liability is accreted each period and the capitalized cost is depreciated over the estimated remaining life of the related long-lived asset. Revisions to estimated retirement obligations result in adjustments to the related capitalized asset and corresponding liability. In order to determine the fair value of the asset retirement obligations, we make certain estimates and assumptions including, among other things, projected cash flows, the borrowing interest rate and an assessment of market conditions that could significantly impact the estimated fair value. These estimates and assumptions are subjective. Capitalized Costs - We capitalize interest and certain other costs, such as property taxes, land leases, property insurance and incremental labor costs relating to hotels undergoing major renovations and redevelopments. We begin capitalizing interest as we incur disbursements, and capitalize other costs when activities necessary to prepare the asset ready for its intended use are underway. We cease capitalizing these costs when construction is substantially complete. CWI 2016 10-K - 64 Depreciation and Amortization - We compute depreciation for hotels and related building improvements using the straight-line method over the estimated useful lives of the properties (limited to 40 years for buildings and ranging from four years up to the remaining life of the building at the time of addition for building improvements), site improvements (generally four to 15 years) and furniture, fixtures and equipment (generally one to 12 years). We compute amortization of intangible assets and liabilities using the straight-line method over the estimated useful life of the asset or liability. See Note 6 for the range of lives by asset or liability. Organization and Offering Costs - Our Advisor has paid various organization and offering costs on our behalf, all of which we were liable for under the advisory agreement. During the offering period, costs incurred in connection with the raising of capital were recorded as deferred offering costs. Upon receipt of offering proceeds, we charged the deferred costs to stockholders’ equity. Under the terms of our advisory agreement as described in Note 3, we reimbursed our Advisor for organization and offering costs incurred. Such reimbursements did not exceed regulatory limitations. Organization costs were expensed as incurred and included in corporate general and administrative expenses in the financial statements. Derivative Instruments - We measure derivative instruments at fair value and record them as assets or liabilities, depending on our rights or obligations under the applicable derivative contract. Derivatives that are not designated as hedges must be adjusted to fair value through earnings. For a derivative designated and qualified as a cash flow hedge, the effective portion of the change in fair value of the derivative is recognized in Other comprehensive loss until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value is immediately recognized in earnings. We use the portfolio exception in Accounting Standards Codification 820-10-35-18D, Application to Financial Assets and Financial Liabilities with Offsetting Positions in Market Risk or Counterparty Credit Risk with respect to measuring counterparty credit risk for all of our derivative transactions subject to master netting arrangements. Income Taxes - We elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. In order to maintain our qualification as a REIT, we are required, among other things, to distribute at least 90% of our REIT net taxable income to our stockholders and meet certain tests regarding the nature of our income and assets. As a REIT, we are not subject to federal income taxes on our income and gains that we distribute to our stockholders as long as we satisfy certain requirements, principally relating to the nature of our income and the level of our distributions, as well as other factors. We believe that we have operated, and we intend to continue to operate, in a manner that allows us to continue to qualify as a REIT. We conduct business in various states and municipalities within the United States, and, as a result, we or one or more of our subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. As a result, we are subject to certain state and local taxes and a provision for such taxes is included in the consolidated financial statements. We elect to treat certain of our corporate subsidiaries as taxable REIT subsidiaries, or TRSs. In general, a TRS may perform additional services for our investments and generally may engage in any real estate or non-real estate-related business (except for the operation or management of health care facilities or lodging facilities or providing to any person, under a franchise, license or otherwise, rights to any brand name under which any lodging facility or health care facility is operated). A TRS is subject to corporate federal, state and local income taxes. Significant judgment is required in determining our tax provision and in evaluating our tax positions. We establish tax reserves based on a benefit recognition model, which we believe could result in a greater amount of benefit (and a lower amount of reserve) being initially recognized in certain circumstances. Provided that the tax position is deemed more likely than not of being sustained, we recognize the largest amount of tax benefit that is greater than 50% likely of being ultimately realized upon settlement. We derecognize the tax position when it is no longer more likely than not of being sustained. Our earnings and profits, which determine the taxability of distributions to stockholders, differ from net income reported for financial reporting purposes due primarily to differences in depreciation and timing differences of certain income and expense recognitions, for federal income tax purposes. Deferred income taxes relate primarily to our TRSs and are accounted for using the asset and liability method. Under this method, deferred income taxes are recognized for temporary differences between the financial reporting bases of assets and liabilities of our TRSs and their respective tax bases and for their operating loss and tax credit carry forwards based on enacted tax rates expected to be in effect when such amounts are realized or settled. However, deferred tax assets are recognized only to the extent that it is more likely than not that they will be realized based on consideration of available evidence, including tax planning strategies and other factors (Note 13). CWI 2016 10-K - 65 We recognize deferred income taxes in certain of our subsidiaries taxable in the United States. Deferred income taxes are generally the result of temporary differences (items that are treated differently for tax purposes than for U.S. GAAP purposes as described in Note 13). In addition, deferred tax assets arise from unutilized tax net operating losses, generated in prior years. Deferred income taxes are computed under the asset and liability method. The asset and liability method requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between tax bases and financial bases of assets and liabilities. We provide a valuation allowance against our deferred income tax assets when we believe that it is more likely than not that all or some portion of the deferred income tax asset may not be realized. Whenever a change in circumstances causes a change in the estimated realizability of the related deferred income tax asset, the resulting increase or decrease in the valuation allowance is included in deferred income tax expense (benefit). Share-Based Payments - We have granted restricted stock units, or RSUs, to our independent directors and certain employees of the Subadvisor. RSUs issued to our independent directors vest immediately; RSUs issued to employees of the Subadvisor generally vest over three years, subject to continued employment. The expense recognized for share-based payment transactions for awards made to directors is based on the grant date fair value estimated in accordance with current accounting guidance for share-based payments. Share-based payment transactions for awards made to employees of the Subadvisor are based on the fair value of the services received. We recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award. We include share based payment transactions within Corporate general and administrative expense. Income or Loss Attributable to Noncontrolling Interests - Earnings attributable to noncontrolling interests are recognized in accordance with each respective investment agreement and, where applicable, based upon the allocation of the investment’s net assets at book value as if the investment was hypothetically liquidated at the end of each reporting period. Loss Per Share - We have a simple equity capital structure with only common stock outstanding. As a result, loss per share, as presented, represents both basic and dilutive per-share amounts for all periods presented in the consolidated financial statements. Use of Estimates - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts and the disclosure of contingent amounts in our consolidated financial statements and the accompanying notes. Actual results could differ from those estimates. Recent Accounting Requirements The following ASUs promulgated by the FASB are applicable to us: In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 supersedes or replaces nearly all GAAP revenue recognition guidance. The new guidance establishes a new control-based revenue recognition model that changes the basis for deciding when revenue is recognized over time or at a point in time and expands the disclosures about revenue. The new guidance also applies to sales of real estate and the new principles-based approach is largely based on the transfer of control of the real estate to the buyer. The guidance is effective for annual reporting periods beginning after December 15, 2017, and the interim periods within those annual periods. Early adoption is permitted for annual reporting periods beginning after December 15, 2016. We expect to adopt this new standard on January 1, 2018 using the modified retrospective transition method. Based on our assessment, the adoption of this standard will not have a material impact on our consolidated financial statements. In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810). ASU 2015-02 amends the current consolidation guidance, including modification of the guidance for evaluating whether limited partnerships and similar legal entities are VIEs or voting interest entities. The guidance does not amend the existing disclosure requirements for VIEs or voting interest model entities. The guidance, however, modified the requirements to qualify under the voting interest model. Under the revised guidance, ASU 2015-02 requires an entity to classify a limited liability company or a limited partnership as a VIE unless the partnership provides partners with either substantive kick-out rights over the managing member or substantive participating rights over the entity or VIE. Please refer to the discussion in the Basis of Consolidation section above. CWI 2016 10-K - 66 In April 2015, the FASB issued ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30). ASU 2015-03 changes the presentation of debt issuance costs, which were previously recognized as an asset, and requires that they be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. ASU 2015-03 does not affect the recognition and measurement guidance for debt issuance costs. ASU 2015-03 is effective for periods beginning after December 15, 2015 and retrospective application is required. We adopted ASU 2015-03 on January 1, 2016 and have disclosed the reclassification of our debt issuance costs in the Reclassifications section above. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 outlines a new model for accounting by lessees, whereby their rights and obligations under substantially all leases, existing and new, would be capitalized and recorded on the balance sheet. For lessors, however, the accounting remains largely unchanged from the current model, with the distinction between operating and financing leases retained, but updated to align with certain changes to the lessee model and the new revenue recognition standard. Additionally, the new standard requires extensive quantitative and qualitative disclosures. ASU 2016-02 is effective for U.S. GAAP public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years; for all other entities, the final lease standard will be effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early application will be permitted for all entities. The new standard must be adopted using a modified retrospective transition of the new guidance and provides for certain practical expedients. Transition will require application of the new model at the beginning of the earliest comparative period presented. We are evaluating the impact of the new standard and have not yet determined if it will have a material impact on our business or our consolidated financial statements. In March 2016, the FASB issued ASU 2016-05, Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships. ASU 2016-05 clarifies that a change in counterparty to a derivative contract in and of itself, does not require the dedesignation of a hedging relationship. ASU 2016-05 is effective for fiscal years beginning after December 15, 2016, including interim periods within those years. Early adoption is permitted and entities have the option of adopting this guidance on a prospective basis to new derivative contracts or on a modified retrospective basis. We elected to early adopt ASU 2016-05 on January 1, 2016 on a prospective basis and there was no impact on our consolidated financial statements. In March 2016, the FASB issued ASU 2016-07, Investments - Equity Method and Joint Ventures (Topic 323). ASU 2016-07 simplifies the transition to the equity method of accounting. ASU 2016-07 eliminates the requirement to apply the equity method of accounting retrospectively when a reporting entity obtains significant influence over a previously held investment. Instead, the equity method of accounting will be applied prospectively from the date significant influence is obtained. The new standard should be applied prospectively for investments that qualify for the equity method of accounting in interim and annual periods beginning after December 15, 2016. Early adoption is permitted and we elected to early adopt this standard as of January 1, 2016. The adoption of this standard had no impact on our consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 intends to reduce diversity in practice for certain cash flow classifications, including, but not limited to (i) debt prepayment or debt extinguishment costs, (ii) contingent consideration payments made after a business combination, (iii) proceeds from the settlement of insurance claims, and (iv) distributions received from equity method investees. ASU 2016-15 will be effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, with early application of the guidance permitted. We are in the process of evaluating the impact of adopting ASU 2016-15 on our consolidated financial statements. In October 2016, the FASB issued ASU 2016-17, Consolidation (Topic 810): Interests Held through Related Parties That Are under Common Control. ASU 2016-17 changes how a reporting entity that is a decision maker should consider indirect interests in a VIE held through an entity under common control. If a decision maker must evaluate whether it is the primary beneficiary of a VIE, it will only need to consider its proportionate indirect interest in the VIE held through a common control party. ASU 2016-17 amends ASU 2015-02, which we adopted on January 1, 2016, and which currently directs the decision maker to treat the common control party’s interest in the VIE as if the decision maker held the interest itself. ASU 2016-17 will be effective for public business entities in fiscal years beginning after December 15, 2016, including interim periods within those fiscal years, with early adoption permitted. The adoption of this standard is not expected to have a material impact on our consolidated financial statements. CWI 2016 10-K - 67 In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash. ASU 2016-18 intends to reduce diversity in practice for the classification and presentation of changes in restricted cash on the statement of cash flows. ASU 2016-18 requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. ASU 2016-18 will be effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, with early adoption permitted. We are in the process of evaluating the impact of adopting ASU 2016-18 on our consolidated financial statements. In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. ASU 2017-01 clarifies the definition of a business with the objective of adding guidance to assist companies and other reporting organizations with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions across all industries. The guidance is effective for annual reporting periods beginning after December 15, 2017, and the interim periods within those annual periods. We expect to adopt this new guidance on January 1, 2018. We are currently evaluating whether this ASU will have a material impact on our consolidated financial statements. In February 2017, the FASB issued ASU 2017-05, Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20). ASU 2017-05 clarifies that a financial asset is within the scope of Subtopic 610-20 if it meets the definition of an in substance nonfinancial asset. The amendments define the term in substance nonfinancial asset, in part, as a financial asset promised to a counterparty in a contract if substantially all of the fair value of the assets (recognized and unrecognized) that are promised to the counterparty in the contract is concentrated in nonfinancial assets. If substantially all of the fair value of the assets that are promised to the counterparty in a contract is concentrated in nonfinancial assets, then all of the financial assets promised to the counterparty are in substance nonfinancial assets within the scope of Subtopic 610-20. This amendment also clarifies that nonfinancial assets within the scope of Subtopic 610-20 may include nonfinancial assets transferred within a legal entity to a counterparty. For example, a parent may transfer control of nonfinancial assets by transferring ownership interests in a consolidated subsidiary. 2017-05 is effective for periods beginning after December 15, 2017, with early application permitted for fiscal years beginning after December 15, 2016. We are currently evaluating the impact of ASU 2017-05 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard. Note 3. Agreements and Transactions with Related Parties Agreements with Our Advisor and Affiliates We have an advisory agreement with our Advisor to perform certain services for us under a fee arrangement, including managing our overall business; the identification, evaluation, negotiation, purchase and disposition of lodging and lodging-related properties; and the performance of certain administrative duties. The advisory agreement has a term of one year and may be renewed for successive one-year periods. Our Advisor also has entered into a subadvisory agreement with the Subadvisor, whereby our Advisor pays 20% of the fees earned under the advisory agreement to the Subadvisor and the Subadvisor provides certain personnel services to us, as discussed below. CWI 2016 10-K - 68 The following tables present a summary of fees we paid; expenses we reimbursed and distributions we made to our Advisor, the Subadvisor and other affiliates, as described below, in accordance with the terms of those agreements (in thousands): The following table presents a summary of the amounts included in Due to related parties and affiliates in the consolidated financial statements (in thousands): Asset Management Fees, Dispositions Fees and Loan Refinancing Fees We pay our Advisor an annual asset management fee equal to 0.5% of the aggregate Average Market Value of our Investments, both as defined in the advisory agreement with our Advisor. Our Advisor is also entitled to receive disposition fees of up to 1.5% of the contract sales price of a property, as well as a loan refinancing fee of up to 1.0% of the principal amount of a refinanced loan, if certain conditions described in the advisory agreement are met. If our Advisor elects to receive all or a portion of its fees in shares, the number of shares issued is determined by dividing the dollar amount of fees by our most recently published estimated net asset value per share, or NAV. At our Advisor’s election, we paid our asset management fees in cash for the years ended December 31, 2016 and 2015 and in shares of our common stock for the year ended December 31, 2014. At our Advisor’s election, for the years ended December 31, 2015 and 2014, $1.0 million and $6.8 million, respectively, in asset management fees were settled in shares of our common stock. The fees settled in shares during the year ended December 31, 2015 related to fees incurred during the fourth quarter of 2014. At December 31, 2016, our Advisor owned 1,501,028 shares (1.1%) of our outstanding common stock. Asset management fees are included in Asset management fees to affiliate and other expenses in the consolidated financial statements. No disposition fees were recognized during the years ended December 31, 2016, 2015 and 2014. CWI 2016 10-K - 69 Available Cash Distributions Carey Watermark Holdings’ special general partner interest entitles it to receive distributions of 10% of Available Cash, as defined in the agreement of limited partnership of the Operating Partnership, or Available Cash Distributions, generated by the Operating Partnership, subject to certain limitations. In addition, in the event of the dissolution of the Operating Partnership, Carey Watermark Holdings will be entitled to receive distributions of up to 15% of net proceeds, provided certain return thresholds are met for the initial investors in the Operating Partnership. Available Cash Distributions are included in (Income) Loss attributable to noncontrolling interests in the consolidated financial statements. Personnel and Overhead Reimbursements/Reimbursable Costs We reimburse our Advisor for the actual cost of personnel based on their time devoted to providing administrative services to us, as well as rent and related office expenses. Pursuant to the subadvisory agreement, after we reimburse our Advisor, it will subsequently reimburse the Subadvisor for personnel costs and other charges, including the services of our chief executive officer, subject to the approval of our board of directors. We have also granted RSUs to employees of the Subadvisor pursuant to our 2010 Equity Incentive Plan. These reimbursements are included in Corporate general and administrative expenses and Due to related parties and affiliates in the consolidated financial statements. We paid these reimbursements in cash for the years ended December 31, 2016 and 2015 and in shares of our common stock for the year ended December 31, 2014. For the year ended December 31, 2015, less than $0.1 million in reimbursements were settled in shares, all of which related to reimbursements for costs incurred during the fourth quarter of 2014. Acquisition Fees to our Advisor We pay our Advisor acquisition fees of 2.5% of the total investment cost of the properties acquired, including on our proportionate share of equity method investments and loans originated by us, not to exceed 6% of the aggregate contract purchase price of all investments and loans. Selling Commissions and Dealer Manager Fees We had a dealer manager agreement with Carey Financial, LLC, or Carey Financial, through the termination of our follow-on offering on December 31, 2014, whereby Carey Financial received a selling commission of up to $0.70 per share sold, which was re-allowed to selected dealers, and a dealer manager fee of up to $0.30 per share sold, a portion of which may have been re-allowed to selected dealers. These amounts are recorded in Additional paid-in capital in the consolidated financial statements. Organization and Offering Costs Pursuant to the advisory agreement, we were liable for certain expenses related to our initial public offering, including filing, legal, accounting, printing, advertising, transfer agent and escrow fees, which were deducted from the gross proceeds of the offering. We reimbursed Carey Financial or selected dealers for reasonable bona fide due diligence expenses incurred that were supported by a detailed and itemized invoice. The total underwriting compensation to Carey Financial and selected dealers in connection with the offerings could not exceed limitations prescribed by the Financial Industry Regulatory Authority, Inc. Our Advisor agreed to be responsible for the repayment of organization and offering expenses (excluding selling commissions and dealer manager fees paid to Carey Financial and selected dealers and fees paid and expenses reimbursed to selected dealers) that exceeded, in the aggregate, 2% of the gross proceeds from our initial public offering and 4% of the gross proceeds from our follow-on offering. Other Amounts Due to Our Advisor This balance primarily represented asset management fees payable at December 31, 2016 and 2015. Due to Joint Venture Partners and Other This balance is primarily comprised of amounts due from consolidated joint ventures to our joint venture partners. CWI 2016 10-K - 70 Jointly Owned Investments and Other Transactions with Affiliates At December 31, 2016, we owned interests in two jointly owned investments with our affiliate, Carey Watermark Investors 2 Incorporated, or CWI 2: the Ritz-Carlton Key Biscayne, a Consolidated Hotel, and the Marriott Sawgrass Golf Resort & Spa, an Unconsolidated Hotel. CWI 2 is a publicly owned, non-listed REIT that is also advised by our Advisor and invests in lodging and lodging-related properties. In September 2014, our board of directors and the board of directors of WPC approved unsecured loans to us and CWI 2 of up to $75.0 million in the aggregate, at an interest rate equal to the rate at which WPC was able to borrow funds under its senior unsecured credit facility, for the purpose of facilitating acquisitions approved by our respective investment committees that we might not otherwise have sufficient available funds to complete. In April 2015, this aggregate amount was increased to $110.0 million. On November 6, 2015, we borrowed $25.0 million from WPC, all of which was repaid as of December 31, 2015. This loan was made solely at the discretion of WPC’s management. As of December 31, 2015, we no longer had access to these unsecured loans from WPC (Note 15). Note 4. Net Investments in Hotels Net investments in hotels are summarized as follows (in thousands): During the years ended December 31, 2016 and 2015, we retired fully depreciated furniture, fixtures and equipment aggregating $12.2 million and $10.8 million, respectively. 2016 Acquisition On February 17, 2016, we acquired a 100% interest in the Equinox, a Luxury Collection Golf Resort & Spa, or the Equinox, which includes real estate and other hotel assets, net of assumed liabilities, totaling $74.2 million. This acquisition was considered to be a business combination. In connection with this acquisition, we expensed acquisition costs of $4.0 million (of which $3.7 million was expensed during the year ended December 31, 2016 and $0.3 million was expensed during the year ended December 31, 2015), including acquisition fees of $2.2 million paid to our Advisor. We obtained a non-recourse mortgage loan on the property of $46.5 million upon acquisition (Note 9). Subsequently, on August 26, 2016, we acquired a single-family residence adjacent to the hotel for a purchase price of $0.8 million, which we intend to renovate to create additional available rooms and event space at the resort. This acquisition was considered to be an asset acquisition. In connection with this acquisition, we capitalized acquisition costs of $0.2 million, including acquisition fees paid to our Advisor of less than $0.1 million. CWI 2016 10-K - 71 The following tables present a summary of assets acquired and liabilities assumed in this business combination at the date of acquisition, and revenues and earnings thereon since the date of acquisition through December 31, 2016 (in thousands): ___________ (a) Subsequent to our initial reporting of the assets acquired and liabilities assumed, we identified a measurement period adjustment related to an asset retirement obligation for the removal of asbestos and environmental waste that impacted the preliminary acquisition accounting, which resulted in an increase of $0.8 million to the preliminary fair value of the building and a corresponding increase to the preliminary fair value of accounts payable, accrued expenses and other liabilities. (b) Excludes an asset adjacent to this hotel that was acquired on August 26, 2016, which was not considered a business combination. CWI 2016 10-K - 72 2015 Acquisitions During the year ended December 31, 2015, we acquired six Consolidated Hotels, with real estate and other hotel assets, net of assumed liabilities and contributions from noncontrolling interests, totaling $493.7 million. In connection with these acquisitions, we expensed acquisition costs of $19.9 million, including acquisition fees of $15.8 million paid to our Advisor. See Note 9 for information about mortgage financing obtained in connection with our acquisitions and Note 10 for information about planned renovations on these hotels, as applicable. The following tables present a summary of assets acquired and liabilities assumed in these business combinations, each at the date of acquisition, and revenues and earnings thereon, since their respective dates of acquisition through December 31, 2015 (in thousands): ___________ (a) We acquired a 47.34% interest in the joint venture owning this hotel, with our affiliate, CWI 2, acquiring a 19.33% interest. The remaining interest was retained by the seller. (b) During the fourth quarter of 2015, we identified a measurement period adjustment that impacted the preliminary acquisition accounting, which resulted in an increase of $9.9 million to the preliminary fair value of the building and a corresponding decrease to the preliminary fair value of intangible assets and cumulative additional net depreciation expense of less than $0.1 million, which was recognized in the fourth quarter of 2015. CWI 2016 10-K - 73 (c) During the fourth quarter of 2015, we identified a measurement period adjustment that impacted the preliminary acquisition accounting, which resulted in an increase of $14.4 million to the preliminary fair value of the building and a corresponding decrease to the preliminary fair value of land and cumulative additional depreciation expense of $0.2 million, which was recognized in the fourth quarter of 2015. (d) Subsequent to our initial reporting of the assets acquired and liabilities assumed, we identified a measurement period adjustment related to an asset retirement obligation for the removal of asbestos and environmental waste that impacted the preliminary acquisition accounting, which resulted in an increase of less than $0.1 million to the preliminary fair value of the building and a corresponding increase to the preliminary fair value of accounts payable, accrued expenses and other liabilities. Disposition On April 1, 2015, we sold a 50% controlling interest in the Marriott Sawgrass Golf Resort & Spa, which we acquired in October 2014, to CWI 2 for a contractual sales price of $37.2 million. Our remaining 50% interest in the hotel is accounted for as an equity method investment (Note 5). We recognized other income of $2.4 million during the year ended December 31, 2015 in our consolidated financial statements resulting primarily from the reimbursement we received from CWI 2 of 50% of the acquisition costs we incurred on our acquisition of the hotel in October 2014, which were expensed in prior periods. Total revenue and net income from operations from this hotel prior to the date of sale were $13.3 million and $2.4 million, respectively, for the year ended December 31, 2015. Assets and Liabilities Held for Sale At December 31, 2016, we had three properties classified as held for sale. These properties were disposed of subsequent to December 31, 2016 (Note 15). Below is a summary of our assets and liabilities held for sale (in thousands): The results of operations for properties that have been sold or classified as held for sale are included in the consolidated financial statements and are summarized as follows (in thousands): CWI 2016 10-K - 74 Construction in Progress At December 31, 2016 and 2015, construction in progress, recorded at cost, was $26.9 million and $22.3 million, respectively, and related primarily to renovations at the Ritz-Carlton Key Biscayne and the Westin Pasadena at December 31, 2016, and the Sheraton Austin Hotel at the Capitol, the Renaissance Chicago Downtown, the Marriott Kansas City Country Club Plaza and the Hawks Cay Resort at December 31, 2015 (Note 10). We capitalize interest expense and certain other costs, such as property taxes, property insurance, utilities expense and hotel incremental labor costs, related to hotels undergoing major renovations. During the years ended December 31, 2016 and 2015, we capitalized $2.1 million and $2.0 million, respectively, of such costs. At December 31, 2016, 2015 and 2014, accrued capital expenditures were $2.3 million, $12.6 million and $5.8 million, respectively, representing non-cash investing activity. Asset Retirement Obligation We have recorded an asset retirement obligation for the removal of asbestos and environmental waste in connection with three of our Consolidated Hotels. We estimated the fair value of the asset retirement obligation based on the estimated economic life of the hotel and the estimated removal costs. The liability was discounted using the weighted-average interest rate on the associated fixed-rate mortgage loan at the time the liability was incurred. At December 31, 2016 and 2015, our asset retirement obligation was $1.4 million and $0.5 million, respectively, and is included in Accounts payable, accrued expenses and other liabilities in the consolidated financial statements. Pro Forma Financial Information The following unaudited consolidated pro forma financial information presents our financial results as if our acquisitions, which are accounted for as business combinations, that we completed during the years ended December 31, 2015 and 2014, and the new financings related to these acquisitions, had occurred on January 1, 2014. The pro forma financial information is not necessarily indicative of what the actual results would have been had the acquisitions actually occurred on January 1, 2014, nor does it purport to represent the results of operations for future periods. Our acquisition of the Equinox hotel completed during the year ended December 31, 2016 was not deemed significant for pro forma purposes and therefore, the pro forma results for this acquisition are not included in the following pro forma financial information. (Dollars in thousands, except per share amounts) The pro forma weighted-average shares outstanding were determined as if the number of shares issued in our public offerings in order to raise the funds used for our Consolidated Hotel acquisitions that we completed during the years ended December 31, 2015 and 2014 were issued on January 1, 2014. All acquisition costs for our acquisitions completed during the year ended December 31, 2015 and 2014 are presented as if they were incurred on January 1, 2014. CWI 2016 10-K - 75 Note 5. Equity Investments in Real Estate At December 31, 2016, we owned equity interests in four Unconsolidated Hotels, three with unrelated third parties and one with CWI 2. We do not control the ventures that own these hotels, but we exercise significant influence over them. We account for these investments under the equity method of accounting (i.e., at cost, increased or decreased by our share of earnings or losses, less distributions, plus contributions and other adjustments required by equity method accounting, such as basis differences from acquisition costs paid to our Advisor that we incur and other-than-temporary impairment charges, if any). Under the conventional approach of accounting for equity method investments, an investor applies its percentage ownership interest to the venture’s net income to determine the investor’s share of the earnings or losses of the venture. This approach is inappropriate if the venture’s capital structure gives different rights and priorities to its investors. We have priority returns on several of our equity method investments. Therefore, we follow the hypothetical liquidation at book value, or HLBV, method in determining our share of these ventures’ earnings or losses for the reporting period as this method better reflects our claim on the ventures’ book value at the end of each reporting period. Earnings for our equity method investments are recognized in accordance with each respective investment agreement and, where applicable, based upon the allocation of the investment’s net assets at book value as if the investment were hypothetically liquidated at the end of each reporting period. The following table sets forth our ownership interests in our equity investments in real estate and their respective carrying values. The carrying values of these ventures are affected by the timing and nature of distributions (dollars in thousands): ___________ (a) This amount represents purchase price plus capitalized costs, inclusive of fees paid to our Advisor, at the time of acquisition. (b) We received cash distributions of $2.2 million from this investment during the year ended December 31, 2016. (c) We received cash distributions of $2.2 million from this investment during the year ended December 31, 2016. (d) We received cash distributions of $2.1 million from this investment during the year ended December 31, 2016. (e) This investment is considered a VIE (Note 2). We do not consolidate this entity because we are not the primary beneficiary and the nature of our involvement in the activities of the entity allows us to exercise significant influence but does not give us power over decisions that significantly affect the economic performance of the entity. (f) We received cash distributions of $3.1 million from this investment during the year ended December 31, 2016. The following table sets forth our share of equity in earnings (losses) from our Unconsolidated Hotels, which are based on the hypothetical liquidation at book value model, as well as certain amortization adjustments related to basis differentials from acquisitions of investments (in thousands): No other-than-temporary impairment charges related to our investments in these ventures were recognized during the years ended December 31, 2016, 2015 or 2014. CWI 2016 10-K - 76 The following tables present combined summarized financial information of our equity method investment entities. Amounts provided are the total amounts attributable to the ventures since our respective dates of acquisition and do not represent our proportionate share (in thousands): ___________ (a) We purchased our 60% interest in this venture on May 15, 2015. (b) Includes the Hyatt Centric French Quarter Venture, the Westin Atlanta Venture and the Marriott Sawgrass Golf Resort & Spa Venture. (c) Includes the Hyatt Centric French Quarter Venture and the Westin Atlanta Venture. (d) For the equity investments noted in footnotes (b) and (c), our respective ownership interest in each investment was applied to the results of each individual venture. At December 31, 2016 and 2015, the unamortized basis differences on our equity investments were $3.3 million and $3.5 million, respectively. Net amortization of the basis differences reduced the carrying values of our equity investments by $0.2 million, $0.2 million and $0.1 million for the years ended December 31, 2016, 2015 and 2014, respectively. CWI 2016 10-K - 77 Note 6. Intangible Assets and Liabilities Intangible assets and liabilities, included in Intangible assets, net and Accounts payable, accrued expenses and other liabilities, respectively, in the consolidated financial statements, are summarized as follows (dollars in thousands): Net amortization of intangibles was $1.7 million, $1.4 million and $0.9 million for the years ended December 31, 2016, 2015 and 2014, respectively. Amortization of the villa/condo rental programs and in-place lease intangibles are included in Depreciation and amortization, and amortization of below-market hotel ground lease, below-market hotel parking garage lease and above-market hotel ground lease intangibles are included in Property taxes, insurance, rent and other in the consolidated financial statements. Note 7. Fair Value Measurements The fair value of an asset is defined as the exit price, which is the amount that would either be received when an asset is sold or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The guidance establishes a three-tier fair value hierarchy based on the inputs used in measuring fair value. These tiers are: Level 1, for which quoted market prices for identical instruments are available in active markets, such as money market funds, equity securities and U.S. Treasury securities; Level 2, for which there are inputs other than quoted prices included within Level 1 that are observable for the instrument, such as certain derivative instruments including interest rate caps and swaps; and Level 3, for securities that do not fall into Level 1 or Level 2 and for which little or no market data exists, therefore requiring us to develop our own assumptions. Items Measured at Fair Value on a Recurring Basis Derivative Assets and Liabilities - Our derivative assets and liabilities are comprised of interest rate swaps and caps that were measured at fair value using readily observable market inputs, such as quotations on interest rates. These derivative instruments were classified as Level 2 as these instruments are custom, over-the-counter contracts with various bank counterparties that are not traded in an active market (Note 8). We did not have any transfers into or out of Level 1, Level 2 and Level 3 measurements during the years ended December 31, 2016 or 2015. Gains and losses (realized and unrealized) included in earnings are reported in Other income and (expenses) in the consolidated financial statements. Our non-recourse debt, which we have classified as Level 3, had a carrying value of $1.5 billion and $1.4 billion, and an estimated fair value of $1.5 billion and $1.4 billion, at December 31, 2016 and 2015, respectively. We determined the estimated fair value using a discounted cash flow model with rates that take into account the interest rate risk. We also considered the value of the underlying collateral, taking into account the quality of the collateral and the then-current interest rate. CWI 2016 10-K - 78 We estimated that our other financial assets and liabilities had fair values that approximated their carrying values at both December 31, 2016 and 2015. Items Measured at Fair Value on a Non-Recurring Basis (Including Impairment Charges) We periodically assess whether there are any indicators that the value of our real estate investments may be impaired or that their carrying value may not be recoverable. For real estate assets held for investment and related intangible assets in which an impairment indicator is identified, we follow a two-step process to determine whether an asset is impaired and to determine the amount of the charge. First, we compare the carrying value of the property’s asset group to the estimated future net undiscounted cash flow that we expect the property’s asset group will generate, including any estimated proceeds from the eventual sale of the property’s asset group. If the future net undiscounted cash flow of the property’s asset group is less than the carrying value, the carrying value of the property’s asset group is considered not recoverable. We then measure the loss as the excess of the carrying value of the property’s asset group over its estimated fair value. The property’s asset group’s estimated fair value is primarily determined using market information from outside sources, such as broker quotes or recent comparable sales. In cases where the available market information is not deemed appropriate, we perform a future net cash flow analysis discounted for inherent risk associated with each asset to determine an estimated fair value. We classify real estate assets as held for sale when we have entered into a contract to sell the property, all material due diligence requirements have been satisfied or we believe it is probable that the disposition will occur within one year. When we classify an asset as held for sale, we compare the asset’s fair value less estimated cost to sell to its carrying value, and if the fair value less estimated cost to sell is less than the property’s carrying value, we reduce the carrying value to the fair value less estimated cost to sell. We base the fair value on the contract and the estimated cost to sell on information provided by brokers and legal counsel. We will continue to review the property for subsequent changes in the fair value and may recognize an additional impairment charge, if warranted. We determined that the significant inputs used to value these investments fall within Level 3 for fair value reporting. As a result of our assessments, we calculated an impairment charge based on market conditions and assumptions that existed at the time. The valuation of real estate is subject to significant judgment and actual results may differ materially if market conditions or the underlying assumptions change. 2016 -During the year ended December 31, 2016, we recognized impairment charges totaling $4.1 million on three properties with an aggregate fair value measurement of $33.0 million in order to reduce the carrying value of the properties to their estimated fair values less costs to sell. The fair value measurements for the properties, which are classified as held for sale, approximated their estimated selling prices (Note 4). Subsequent to December 31, 2016, we sold these properties (Note 15). 2015 - During the year ended December 31, 2015, we recognized an impairment charge of $6.1 million on a property with a fair value measurement of $8.0 million in order to reduce the carrying value of the property to its estimated fair value. Subsequent to December 31, 2016, we sold this property (Note 15). Note 8. Risk Management and Use of Derivative Financial Instruments Risk Management In the normal course of our ongoing business operations, we encounter economic risk. There are two main components of economic risk that impact us: interest rate risk and market risk. We are primarily subject to interest rate risk on our interest-bearing assets and liabilities, including the Senior Credit Facility (Note 9). Market risk includes changes in the value of our properties and related loans. Derivative Financial Instruments When we use derivative instruments, it is generally to reduce our exposure to fluctuations in interest rates. We have not entered into, and do not plan to enter into, financial instruments for trading or speculative purposes. In addition to entering into derivative instruments on our own behalf, we may also be a party to derivative instruments that are embedded in other contracts, which are considered to be derivative instruments. The primary risks related to our use of derivative instruments include a counterparty to a hedging arrangement defaulting on its obligation and a downgrade in the credit quality of a counterparty to such an extent that our ability to sell or assign our side of the hedging transaction is impaired. While we seek to mitigate these risks by entering into hedging arrangements with large financial institutions that we deem to be creditworthy, it is possible that our hedging transactions, which are intended to limit losses, could adversely affect our earnings. Furthermore, if CWI 2016 10-K - 79 we terminate a hedging arrangement, we may be obligated to pay certain costs, such as transaction or breakage fees. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. We measure derivative instruments at fair value and record them as assets or liabilities, depending on our rights or obligations under the applicable derivative contract. Derivatives that are not designated as hedges must be adjusted to fair value through earnings. For a derivative designated, and that qualified, as a cash flow hedge, the effective portion of the change in fair value of the derivative is recognized in Other comprehensive loss until the hedged item is recognized in earnings. The ineffective portion of the change in fair value of any derivative is immediately recognized in earnings. The following table sets forth certain information regarding our derivative instruments on our Consolidated Hotels (in thousands): All derivative transactions with an individual counterparty are governed by a master International Swap and Derivatives Association agreement, which can be considered as a master netting arrangement; however, we report all our derivative instruments on a gross basis in our consolidated financial statements. At both December 31, 2016 and 2015, no cash collateral had been posted nor received for any of our derivative positions. We recognized unrealized losses of $1.1 million, $2.6 million and $3.0 million in Other comprehensive income (loss) on derivatives in connection with our interest rate swaps and caps during the years ended December 31, 2016, 2015 and 2014, respectively. We reclassified losses of $1.0 million, $1.6 million and $1.7 million from Other comprehensive income (loss) on derivatives into interest expense during the years ended December 31, 2016, 2015 and 2014, respectively. Amounts reported in Other comprehensive income (loss) related to interest rate swaps and caps will be reclassified to Interest expense as interest expense is incurred on our variable-rate debt. At December 31, 2016, we estimated that an additional $0.6 million, inclusive of amounts attributable to noncontrolling interests of $0.1 million, will be reclassified as Interest expense during the next 12 months related to our interest rate swaps and caps. Interest Rate Swaps and Caps We are exposed to the impact of interest rate changes primarily through our borrowing activities. To limit this exposure, we attempt to obtain mortgage financing on a long-term, fixed-rate basis. However, from time to time, we or our investment partners may obtain variable-rate non-recourse mortgage loans and, as a result, may enter into interest rate swap or cap agreements with counterparties. Interest rate swaps, which effectively convert the variable-rate debt service obligations of a loan to a fixed rate, are agreements in which one party exchanges a stream of interest payments for a counterparty’s stream of cash flow over a specific period. The face amount on which the swaps are based is not exchanged. An interest rate cap limits the effective borrowing rate of variable-rate debt obligations while allowing participants to share in downward shifts in interest rates. Our objective in using these derivatives is to limit our exposure to interest rate movements. CWI 2016 10-K - 80 The interest rate swaps and caps that we had outstanding on our Consolidated Hotels at December 31, 2016 were designated as cash flow hedges and are summarized as follows (dollars in thousands): Credit Risk-Related Contingent Features We measure our credit exposure on a counterparty basis as the net positive aggregate estimated fair value of our derivatives, net of any collateral received. No collateral was received as of December 31, 2016. At December 31, 2016, our total credit exposure was $0.1 million and the maximum exposure to any single counterparty was less than $0.1 million. Some of the agreements we have with our derivative counterparties contain cross-default provisions that could trigger a declaration of default on our derivative obligations if we default, or are capable of being declared in default, on certain of our indebtedness. At December 31, 2016, we had not been declared in default on any of our derivative obligations. The estimated fair value of our derivatives in a net liability position was less than $0.1 million and $0.8 million at December 31, 2016 and 2015, respectively, which included accrued interest and any nonperformance risk adjustments. If we had breached any of these provisions at either December 31, 2016 or 2015, we could have been required to settle our obligations under these agreements at their aggregate termination value of less than $0.1 million and $0.8 million, respectively. Note 9. Debt Non-Recourse Debt Our debt consists of mortgage notes payable, which are collateralized by the assignment of hotel properties. The following table presents the non-recourse debt, net on our Consolidated Hotel investments (dollars in thousands): ___________ (a) Many of our mortgage loans have extension options, which are subject to certain conditions. The maturity dates in the table do not reflect the extension options. (b) These mortgage loans have variable interest rates, which have effectively been capped or converted to fixed rates through the use of interest rate caps or swaps (Note 8). The interest rate range presented for these mortgage loans reflect the rates in effect at December 31, 2016 through the use of an interest rate cap or swap, when applicable. Most of our mortgage loan agreements contain “lock-box” provisions, which permit the lender to access or sweep a hotel’s excess cash flow and would be triggered under limited circumstances, including the failure to maintain minimum debt service coverage ratios. If a provision were triggered, we would generally be permitted to spend an amount equal to our budgeted hotel operating expenses, taxes, insurance and capital expenditure reserves for the relevant hotel. The lender would then retain all excess cash flow after the payment of debt service in an escrow account until certain performance hurdles are met. At December 31, 2016, the minimum debt service coverage ratio for the Holiday Inn Manhattan 6th Avenue Chelsea was not met, therefore, a cash management agreement was enacted that permits the lender to sweep the hotel’s excess cash flow. Covenants Pursuant to our mortgage loan agreements, our consolidated subsidiaries are subject to various operational and financial covenants, including minimum debt service coverage ratios. At December 31, 2016, we were in compliance with the applicable covenants for each of our mortgage loans. CWI 2016 10-K - 81 Senior Credit Facility As of December 31, 2016, we had a senior credit facility that provided for a $25.0 million senior unsecured revolving credit facility, or our Senior Credit Facility, inclusive of a $5.0 million letter of credit subfacility, and was used for our working capital needs as well as for other general corporate purposes. The Senior Credit Facility bore interest at the London Interbank Offered Rate, or LIBOR, plus 2.75%; however, if at any time our leverage ratio, as defined in the credit agreement, was greater than 65%, interest on loans under our Senior Credit Facility would increase to LIBOR plus 3.25%. Our Senior Credit Facility was scheduled to mature on December 4, 2017, but may be extended by us for one 12-month period, subject to the satisfaction of certain conditions and an extension fee of 0.25% (Note 15). At December 31, 2016, the outstanding balance under our Senior Credit Facility was $22.8 million. We paid a fee of 0.25% on the unused portion of our Senior Credit Facility. The credit agreement, as amended, included customary financial maintenance covenants that require us to maintain certain ratios and benchmarks at the end of each quarter, as well as various customary affirmative and negative covenants. We were in compliance with all applicable covenants at December 31, 2016. Financing Activity During 2016 In connection with our 2016 Acquisition (Note 4), we obtained $46.5 million in non-recourse mortgage financing, with a fixed interest rate of 4.5% and a maturity date of March 1, 2021. We recorded $0.4 million of deferred financing costs related to this loan. During the year ended December 31, 2016, we refinanced four non-recourse mortgage loans totaling $309.0 million with new non-recourse mortgage loans totaling $379.0 million, which have a weighted-average interest rate of 3.9% and term of 4.8 years. We recognized an aggregate net loss on extinguishment of debt totaling $2.2 million on these refinancings. Financing Activity During 2015 In connection with our 2015 Acquisitions (Note 4), we obtained $284.8 million in non-recourse mortgage financing, with a weighted-average annual interest rate of 3.9% and term of 5.8 years. We recorded $2.6 million of deferred financing costs related to these loans. In connection with our acquisition of the Ritz-Carlton Key Biscayne in May 2015, we assumed a $164.0 million non-recourse mortgage loan with an annual interest rate of 6.09% and a maturity date of June 2017. We recorded a fair market value adjustment that resulted in a premium of $7.5 million, which was being amortized over the remaining term of the loan. We recorded $1.2 million of deferred financing costs related to this loan. This loan was refinanced in 2016. During the year ended December 31, 2015, we refinanced two non-recourse mortgage loans totaling $25.5 million with new non-recourse mortgage loans totaling $27.0 million, with a weighted-average interest rate of 2.8% and term of 3 years. We recognized a net gain on extinguishment of debt of $1.8 million. We also drew down $7.0 million on an existing mortgage loan for renovations at the Marriott Boca Raton at Boca Center. CWI 2016 10-K - 82 Scheduled Debt Principal Payments Scheduled debt principal payments during each of the next five calendar years following December 31, 2016 and thereafter are as follows (in thousands): __________ (a) Includes $22.8 million outstanding under our Senior Credit Facility, which is scheduled to mature on December 4, 2017, unless extended pursuant to its terms (Note 15). (b) In accordance with ASU 2015-03, we reclassified deferred financing costs from Other assets to Non-recourse debt, net as of December 31, 2015 (Note 2). Note 10. Commitments and Contingencies At December 31, 2016, we were not involved in any material litigation. Various claims and lawsuits arising in the normal course of business are pending against us, but we do not expect the results of such proceedings to have a material adverse effect on our consolidated financial position or results of operations. Hotel Management Agreements As of December 31, 2016, our Consolidated Hotel properties are operated pursuant to long-term management agreements with 12 different management companies, with initial terms ranging from three to 30 years. Each management company receives a base management fee, generally ranging from 1.5% to 3.5% of hotel revenues. Four of our management agreements contain the right and license to operate the hotels under specified brands. No separate franchise agreements exist and no separate franchise fee is required for these hotels. The management agreements that include the benefit of a franchise agreement incur a base management fee equal to 3.0% of hotel revenues. The management companies are generally also eligible to receive an incentive management fee, which is typically calculated as a percentage of operating profit, either (i) in excess of projections with a cap or (ii) after the owner has received a priority return on its investment in the hotel. Franchise Agreements As of December 31, 2016, we have 12 franchise agreements with Marriott owned brands, nine with Hilton owned brands, two with InterContinental Hotels owned brands and one with a Hyatt owned brand related to our Consolidated Hotels. The franchise agreements have initial terms ranging from 10 to 25 years. This number excludes four hotels that receive the benefits of a franchise agreement pursuant to management agreements, as discussed above. Our franchise agreements grant us the right to the use of the brand name, systems and marks with respect to specified hotels and establish various management, operational, record-keeping, accounting, reporting and marketing standards and procedures that the licensed hotel must comply with. In addition, the franchisor establishes requirements for the quality and condition of the hotel and its furniture, fixtures and equipment, and we are obligated to expend such funds as may be required to maintain the hotel in compliance with those requirements. Typically, our franchise agreements provide for a license fee, or royalty, of 3.0% to 7.0% of room revenues and, if applicable, 2.0% to 3.0% of food and beverage revenue. In addition, we generally pay 1.0% to 4.0% of room revenues as marketing and reservation system contributions for the system-wide benefit of brand hotels. Franchise fees are included in sales and marketing expense in our consolidated financial statements. CWI 2016 10-K - 83 Renovation Commitments Certain of our hotel franchise and loan agreements require us to make planned renovations to our Consolidated Hotels (Note 4). We do not currently expect to, and are not obligated to, fund any planned renovations on our Unconsolidated Hotels beyond our original investment. At December 31, 2016, nine hotels were either undergoing renovation or in the planning stage of renovations, and we currently expect that six will be completed during the first half of 2017, one will be completed during the second half of 2017, one will be completed during the first half of 2018 and one will be completed during the second half of 2018. The following table summarizes our capital commitments related to our Consolidated Hotels (in thousands): ___________ (a) Of our unfunded commitments at December 31, 2016 and 2015, approximately $5.3 million and $12.8 million, respectively, of unrestricted cash on our balance sheet was designated for renovations. Capital Expenditures and Reserve Funds With respect to our hotels that are operated under management or franchise agreements with major national hotel brands and for most of our hotels subject to mortgage loans, we are obligated to maintain furniture, fixtures and equipment reserve accounts for future capital expenditures at these hotels, sufficient to cover the cost of routine improvements and alterations at the hotels. The amount funded into each of these reserve accounts is generally determined pursuant to the management agreements, franchise agreements and/or mortgage loan documents for each of the respective hotels, and typically ranges between 2% and 5% of the respective hotel’s total gross revenue. As of December 31, 2016 and 2015, $29.3 million and $37.1 million, respectively, was held in furniture, fixtures and equipment reserve accounts for future capital expenditures. Ground Lease Commitments Three of our hotels are subject to ground leases. Scheduled future minimum ground lease payments during each of the next five calendar years following December 31, 2016 and thereafter are as follows (in thousands): For the years ended December 31, 2016, 2015 and 2014, we recorded rent expense of $3.8 million, $3.7 million and $2.9 million, respectively, inclusive of percentage rents of $0.7 million for each year, related to these ground leases, which are included in Property taxes, insurance, rent and other in the consolidated financial statements. CWI 2016 10-K - 84 Note 11. Equity Transfers to Noncontrolling Interests On February 12, 2016, we acquired the remaining 25% interest in the Fairmont Sonoma Mission Inn & Spa Venture from an unaffiliated third party for $20.6 million, bringing our ownership interest to 100%. In connection with this transaction, we paid a fee to our Advisor of $0.5 million. Our acquisition of the additional interest in the venture is accounted for as an equity transaction, with no gain or loss recognized, and the components of accumulated other comprehensive loss are proportionately reallocated to us from the noncontrolling interest as presented in the consolidated statement of equity. The following table presents a reconciliation of the effect of transfers in noncontrolling interest (in thousands): ___________ (a) Includes $0.5 million fee paid to our Advisor for the purchase of the remaining interest in the venture. Reclassifications Out of Accumulated Other Comprehensive Loss The following tables present a reconciliation of changes in Accumulated other comprehensive loss by component for the periods presented (in thousands): CWI 2016 10-K - 85 Distributions Distributions paid to stockholders consist of ordinary income, capital gains, return of capital or a combination thereof for income tax purposes. The following table presents annualized cash distributions paid per share reported for tax purposes and serves as a designation of capital gain distributions, if applicable, pursuant to Internal Revenue Code Section 857(b)(3)(C) and Treasury Regulation § 1.857-6(e): During the fourth quarter of 2016, our board of directors declared a quarterly distribution of $0.1425 per share, which was paid on January 13, 2017 to stockholders of record on December 30, 2016, in the amount of $19.3 million. Note 12. Share-Based Payments We maintain the 2010 Equity Incentive Plan, which authorizes the issuance of shares of our common stock to our officers and officers and employees of the Subadvisor, who perform services on our behalf, and to any non-director members of the investment committee through stock-based awards. The 2010 Equity Incentive Plan provides for the grant of RSUs and dividend equivalent rights. We also maintain the Directors Incentive Plan - 2010 Incentive Plan, which authorizes the issuance of shares of our common stock to our independent directors. The Directors Incentive Plan - 2010 Incentive Plan provides for the grant of RSUs and dividend equivalent rights. A maximum of 4,000,000 shares may be granted, in the aggregate, under these two plans, of which 3,755,502 shares remain available for future grants at December 31, 2016. A summary of the RSU activity for the years ended December 31, 2016, 2015 and 2014 follows: ___________ (a) RSUs issued to employees of the Subadvisor generally vest over three years, subject to continued employment, and RSUs issued to independent directors vested immediately. The total fair value of shares vested during the years ended December 31, 2016, 2015 and 2014 was $0.4 million, $0.4 million and $0.3 million, respectively. (b) We currently expect to recognize compensation expense totaling approximately $0.5 million over the vesting period. The awards to employees of the Subadvisor had a weighted-average remaining contractual term of 1.6 years at December 31, 2016. CWI 2016 10-K - 86 For the years ended December 31, 2016, 2015 and 2014, we recognized share based payment expense of $0.6 million, $0.5 million and $0.4 million, respectively, associated with our awards. We have not recognized any income tax benefit in earnings for our share-based payment arrangements since the inception of our plans. Note 13. Income Taxes As a REIT, we are permitted to own lodging properties but are prohibited from operating these properties. In order to comply with applicable REIT qualification rules, we enter into leases for each of our lodging properties with TRS lessees. The TRS lessees in turn contract with independent hotel management companies that manage day-to-day operations of our hotels under the oversight of the Subadvisor. The components of our income tax provision for the periods presented are as follows (in thousands): Deferred income taxes at December 31, 2016 and 2015 consist of the following (in thousands): CWI 2016 10-K - 87 A reconciliation of the provision for income taxes with the amount computed by applying the statutory federal income tax rate to income before provision for income taxes for the periods presented is as follows (in thousands): As of December 31, 2016 and 2015, our taxable subsidiaries have recorded gross deferred tax assets of $14.4 million and $4.8 million, respectively, in connection with U.S. federal, state and local net operating losses. The utilization of net operating losses may be subject to certain limitations under the tax laws of the relevant jurisdiction. If not utilized, our federal and state and local net operating losses will begin to expire in 2034. As of December 31, 2016 and 2015, we recorded a valuation allowance of $4.9 million and $1.9 million, respectively, related to these net operating loss carryforwards and other deferred tax assets. The net deferred tax (liability) asset in the table above is comprised of deferred tax asset balances, net of certain deferred tax liabilities and valuation allowances, of $2.1 million and $2.0 million at December 31, 2016 and 2015, respectively, which are included in Other assets, net in the consolidated balance sheets, and other deferred tax liability balances of $5.2 million and less than $0.1 million at December 31, 2016 and 2015, respectively, which are included in Accounts payable, accrued expenses and other liabilities in the consolidated balance sheets. Our taxable subsidiaries recognize tax positions in the financial statements only when it is more likely than not that the position will be sustained on examination by the relevant taxing authority based on the technical merits of the position. A position that meets this standard is measured at the largest amount of benefit that will more likely than not be realized on settlement. A liability is established for differences between positions taken in a tax return and amounts recognized in the financial statements. The following table presents a reconciliation of the beginning and ending amount of unrecognized tax benefits (in thousands): At December 31, 2016, we had unrecognized tax benefits as presented in the table above that, if recognized, would have a favorable impact on our effective income tax rate in future periods. We recognize interest and penalties related to uncertain tax positions in income tax expense. At December 31, 2016, we had accrued interest related to uncertain tax positions of less than $0.1 million. Our tax returns are subject to audit by taxing authorities. The statute of limitations varies by jurisdiction and ranges from three to four years. Such audits can often take years to complete and settle. The tax years 2013 through 2016 remain open to examination by the major taxing jurisdictions to which we are subject. CWI 2016 10-K - 88 Note 14. Selected Quarterly Financial Data (Unaudited) (Dollars in thousands, except per share amounts) ___________ (a) Our results are not comparable year over year because of hotel acquisitions in 2015 and 2016. (b) Results include impairment charges of $3.7 million, $0.4 million and $6.1 million for the three months ended June 30, 2016, September 30, 2016 and December 31, 2015, respectively. Note 15. Subsequent Events Disposition On February 1, 2017, we sold our 100% ownership interests in the Hampton Inn Frisco Legacy Park, the Hampton Inn Birmingham Colonnade and the Hilton Garden Inn Baton Rouge Airport to an unaffiliated third party, for a contractual sales price of $33.0 million and net proceeds of approximately $7.7 million. Loans from Affiliate Our board of directors and the board of directors of WPC approved in February 2017 and March 2017, respectively, unsecured loans to us of up to $25.0 million, or the WPC Line of Credit, at an interest rate equal to the rate at which WPC is able to borrow funds under its senior unsecured credit facility. The purpose of the WPC Line of Credit is to repay and terminate our Senior Credit Facility. Any such loans under the WPC Line of Credit are to be made solely at the discretion of WPC’s management. As of the date of this Report, we intend to borrow $25.0 million and simultaneously repay and terminate the Senior Credit Facility in the first quarter of 2017. CWI 2016 10-K - 89 CAREY WATERMARK INVESTORS INCORPORATED SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 2016, 2015, and 2014 (in thousands) CWI 2016 10-K - 90 CAREY WATERMARK INVESTORS INCORPORATED SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 2016 (in thousands) _______________ CWI 2016 10-K - 91 (a) Consists of the cost of improvements subsequent to acquisition, including construction costs primarily for renovations pursuant to our contractual obligations. (b) The increases in the net investments of the Ritz-Carlton Key Biscayne and the Ritz-Carlton For Lauderdale were due to out-of-period adjustments related to deferred tax liabilities (Note 2). The increases in the net investments of the Le Méridien Dallas, The Stoneleigh and the Equinox, a Luxury Collection Golf Resort & Spa were due to measurement period adjustments related to asset retirement obligations for the removal of asbestos and environmental waste. (c) A reconciliation of hotels and accumulated depreciation follows: CWI 2016 10-K - 92 CAREY WATERMARK INVESTORS INCORPORATED NOTES TO SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION (in thousands) ___________ (a) Includes $4.1 million of impairment charges recognized during the year ended December 31, 2016 related to properties included in Assets held for sale as of December 31, 2016 (Note 7). At December 31, 2016, the aggregate cost of real estate that we and our consolidated subsidiaries own for federal income tax purposes was approximately $2.1 billion. CWI 2016 10-K - 93
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Here's a summary of the financial statement:
Key Components:
1. Revenue Sources:
- Primary: Room rentals, food and beverage
- Secondary: Internet, spa services, parking, gift shops
- All revenues recorded on accrual basis
- Sales/occupancy taxes excluded from revenue figures
- Rebates/discounts recorded as revenue reductions
2. Guest Programs:
- Participates in hotel brand frequent guest programs
- Expenses charged as incurred
- No direct liability for points programs
- Bills brand sponsors when points are redeemed
3. Financial Position:
- Shows a loss (amount specified in thousands, exact figure not provided)
- Has $8.6 in debt issuance costs (reclassified)
4. Cost Management:
- Capitalizes interest and certain costs during renovations
- Expenses acquisition-related costs for business combinations
- Records investments based on fair value of assets/liabilities
- Conducts periodic impairment assessments
5. Asset Management:
- Includes provisions for asset retirement obligations
- Uses fair value assessments for liability calculations
- Capitalizes costs during major renovations/developments
- Maintains allowances for doubtful accounts
Overall, this appears to be a hospitality business experiencing some financial challenges, with structured revenue streams and detailed cost management procedures in place.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGE NUMBER Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Income (Loss) Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Supplementary Financial Data ACCOUNTING FIRM To the Board of Directors and Stockholders of ZELTIQ Aesthetics, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows present fairly, in all material respects, the financial position of ZELTIQ Aesthetics, Inc. and its subsidiaries at December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because a material weakness in internal control over financial reporting related to the Company’s risk assessment process existed as of that date. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. The material weakness referred to above is described in the Management's Report on Internal Control over Financial Reporting appearing under Item 9A. We considered this material weakness in determining the nature, timing, and extent of audit tests applied in our audit of the 2016 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in management's report referred to above. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP San Jose, California March 1, 2017 ZELTIQ Aesthetics, Inc. Consolidated Balance Sheets (In thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. Consolidated Statements of Operations (In thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. Consolidated Statements of Comprehensive Income (Loss) (In thousands) The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. Consolidated Statements of Stockholders' Equity (In thousands) The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. Consolidated Statements of Stockholders' Equity (In thousands) The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. Consolidated Statements of Stockholders' Equity (In thousands) The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. Consolidated Statements of Cash Flows (In thousands) The accompanying notes are an integral part of these consolidated financial statements. ZELTIQ Aesthetics, Inc. 1. The Company and Basis of Presentation ZELTIQ Aesthetics, Inc. (the “Company”) was incorporated in the state of Delaware on March 22, 2005. The Company was founded to develop and commercialize a non-invasive product for the selective reduction of fat. Its first commercial product, the CoolSculpting system, is designed to selectively reduce stubborn fat bulges. CoolSculpting is based on the scientific principle that fat cells are more sensitive to cold than the overlying skin and surrounding tissues. CoolSculpting utilizes precisely controlled cooling to reduce the temperature of fat cells in the treated area, which leads to fat cell elimination through a natural biological process known as apoptosis, without causing scar tissue or damage to the skin, nerves, or surrounding tissues. The Company generates revenue from sales of its CoolSculpting system and from sales of consumables to its customers. In August 2011, the Company incorporated ZELTIQ Limited as a wholly-owned subsidiary in the United Kingdom to serve as its sales office for direct sales in Europe. In December 2014, the Company incorporated ZELTIQ Ireland Limited and ZELTIQ Ireland International Limited as wholly-owned subsidiaries in Ireland for additional office support in Europe. In December 2015, the Company also incorporated ZELTIQ Ireland International Holdings Unlimited Company. All intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of net sales and expenses during the reported periods. Significant items subject to management’s estimates include revenue recognition, allowance for doubtful accounts, valuation allowance for deferred tax assets, stock-based compensation, income tax uncertainties, valuation of intangible assets, and warranty accrual. Actual results could differ materially from those estimates and assumptions. Reclassification Certain amounts in the prior year's consolidated balance sheet have been reclassified to conform to the current year's presentation. In addition, certain amounts in prior years’ cash flows in operating and financing activities were reclassified within their respective sections to conform to the current year’s presentation. These reclassifications had no impact on previously reported consolidated statements of operations. Out-of-period adjustments In the fourth quarter of 2016, the Company recorded an out-of-period correcting adjustment of $0.9 million to increase sales and marketing expense by $0.9 million, with a corresponding increase to accrued compensation, of which $0.4 million is related to the second quarter of 2016, and the remaining $0.5 million is related to prior years. In addition, the Company recorded an out-of-period correcting adjustment of $0.3 million to decrease general and administrative expense, with a corresponding increase to accounts receivable, related to other quarters in 2016. During prior periods in 2016, the Company also recorded certain out-of-period correcting adjustments that increased cost of revenue by $0.8 million, which originated in the year ended December 31, 2015 or prior. As a result, the aggregate impact of the out-of-period adjustments recorded in 2016 was an increase of $0.8 million to cost of revenue, $0.5 million to other operating expenses and $0.8 million to net income, net of tax effect, in the year ended December 31, 2016. The Company does not believe that such amounts are material to any prior period consolidated financial statements, and the impact of correcting these misstatements as out-of-period adjustments is not material to the consolidated financial statements for each respective quarterly and annual period. 2. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported periods. The primary estimates underlying the Company's financial statements include the value of revenue elements, accruals for discretionary customer programs and payments, product warranties, inventory valuation, allowance for doubtful accounts receivable, assumptions regarding variables used in calculating the fair value of the Company's equity awards, fair value of investments, useful lives of intangibles, income taxes and contingent liabilities. Actual results could differ from those estimates. Significant Risks and Uncertainties The Company's future results of operations involve a number of risks and uncertainties. Factors that could affect the Company's future operating results and cause actual results to vary materially from expectations include, but are not limited to, rapid technological change, continued acceptance of the Company's products, competition from substitute products and larger companies, ability to protect proprietary technology from copy-cat or counterfeit versions the Company's products, strategic relationships and dependence on key individuals. If the Company fails to adhere to ongoing Food and Drug Administration, or FDA, Quality System Regulation, the FDA may withdraw its market clearance or take other action. The Company relies on sole-source suppliers to manufacture some of the components used in its product. The Company's manufacturers and suppliers may encounter supply interruptions or problems during manufacturing due to a variety of reasons, including failure to comply with applicable regulations, including the FDA's Quality System Regulation, equipment malfunction and environmental factors, any of which could delay or impede the Company's ability to meet demand. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, marketable securities and trade receivables. The Company's cash equivalents and marketable securities are held in safekeeping by large, credit worthy financial institutions. The Company invests its excess cash primarily in U.S. banks, government and agency bonds, money market funds and corporate obligations. The Company has established guidelines relative to credit ratings, diversification and maturities that seek to maintain safety and liquidity. Deposits in these banks may exceed the amounts of insurance provided on such deposits. To date, the Company has not experienced any losses on its deposits of cash and cash equivalents. The Company controls credit risk through credit approvals, credit limits, and monitoring procedures. The Company performs periodic credit evaluations of its customers and generally does not require collateral. Accounts receivable are recorded net of an allowance for doubtful accounts. The allowance for doubtful accounts is based on management's assessment of the collectability of specific customer accounts and the aging of the related invoices, and represents the Company's best estimate of probable credit losses in its existing trade accounts receivable. The allowance for doubtful accounts consisted of the following activity for years ended December 31, 2016, 2015 and 2014 (in thousands): Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Investments The Company invests its excess cash balances primarily in certificates of deposit, commercial paper, corporate bonds, and U.S. Government agency securities. Investments with original maturities greater than 90 days that mature less than one year from the consolidated balance sheet date are classified as short-term investments. The Company classifies all of its investments as available-for-sale and records such assets at estimated fair value in the consolidated balance sheets, with unrealized gains and losses, if any, reported as a component of accumulated other comprehensive income (loss) in stockholders' equity. Realized gains and losses from maturities of all such securities are reported in earnings and computed using the specific identification cost method. Realized gains or losses and charges for other-than-temporary declines in value, if any, on available-for-sale securities are reported in other income (expense), net as incurred. The Company periodically evaluates these investments for other-than-temporary impairment. Inventory Inventory is stated at the lower of cost (which approximates actual cost on a first-in, first-out basis) or market. Inventory that is obsolete or in excess of forecasted usage is written down to its estimated net realizable value based on assumptions about future demand and market conditions. Inventory write-downs are charged to cost of revenue and establish a new cost basis for the inventory. Other Receivables from Banks and Restricted Cash At December 31, 2016 and 2015, other receivables from banks for customer credit card transactions was $4.6 million and $3.3 million, respectively, and is included in "Prepaid expenses and other current assets" on the consolidated balance sheets. At December 31, 2016 and 2015, cash of $0.8 million and $0.5 million, respectively, was restricted from withdrawal and held by banks in the form of certificates of deposit. These certificates of deposit were held as collateral for the facility lease agreements in Pleasanton, California, and for the Company's United Kingdom banking facilities and credit card programs. Property and Equipment Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Maintenance and repairs are charged to expense as incurred. Assets not yet placed in use are not depreciated. The useful lives of the property and equipment are as follows: Intangible Asset The intangible asset consists of an exclusive license agreement for commercializing patents and other technology. All milestone payments subsequent to the date of the FDA approval are capitalized as purchased technology when paid, and are subsequently amortized into cost of revenue using the straight-line method over the estimated remaining useful life of the technology, not to exceed the term of the agreement or the life of the patent. Impairment of Long-lived Assets The Company reviews property and equipment and the intangible asset for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of the carrying amount to the future undiscounted net cash flows which the assets are expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the assets' fair value determined using the projected discounted future net cash flows arising from the asset. Through December 31, 2016, there have been no significant impairments of long-lived assets. Revenue Recognition The Company’s revenue is derived from the sales of the CoolSculpting system, consisting of a control unit and applicators, and, from time to time, related extended warranty arrangements, and from the sale of cycles in the form of consumable procedure packs, each of which includes consumable (CoolGels, CoolLiners, Geltraps, and skin wipes) and in the case of the Company's CoolSmooth procedure packs, disposable securement accessories, all of which are used by the Company's customer during treatments. The Company earns revenue from the sale of these products to its customers and to distributors. The Company recognizes revenue when persuasive evidence of an arrangement exists, transfer of title to the customer has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. Revenue is deferred in the event that any of the revenue recognition criteria is not met. Each consumable procedure pack includes a disposable computer cartridge that the Company markets as the CoolCard. The CoolCard contains enabling software that permits the Company's customers to perform a fixed number of CoolSculpting procedures, or cycles. This software is not marketed separately from the CoolSculpting system or from the CoolCard. Rather, the functionality that the software provides is part of the overall CoolCard product. The CoolSculpting system is marketed as a non-invasive aesthetic device for the selective reduction of fat, not for its embedded software attributes included in the CoolCard that enable its use. The Company does not provide rights to upgrades and enhancements or post-contract customer support for the embedded software. In addition, the Company does not incur significant software development costs or capitalize its software development costs. Based on this assessment, the Company considers the embedded software in the CoolCard incidental to the CoolCard product as a whole and determined that revenue recognition should not be governed by the provisions of Topic 985 of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC). Persuasive Evidence of an Arrangement. The Company uses contracts or customer purchase orders to determine the existence of an arrangement. Delivery. The Company's standard terms specify that title transfers upon shipment to the customer. The Company uses third party shipping documents to verify that title has transferred. Sales Price Fixed or Determinable. The Company assesses whether the sales price is fixed or determinable at the time of the transaction. Sales prices are documented in the executed sales contract or purchase order received prior to shipment. The Company’s standard terms do not allow for trial or evaluation periods, rights of return or refund, payments contingent upon the customer obtaining financing or other terms that could impact the customer’s obligation. Collectability. The Company assesses whether collection is reasonably assured based on a number of factors, including the customer’s past transaction history and credit worthiness. Multiple-Element Arrangements. Typically, all products sold to a customer are delivered at the same time. If a partial delivery occurs as authorized by the customer, the Company allocates revenue to the various products based on their vendor-specific objective evidence of fair value, or VSOE, if VSOE exists according to ASC 605-25 as the basis of determining the relative selling price of each element. If VSOE does not exist, the Company may use third party evidence of fair value, or TPE, to determine the relative selling price of each element. If neither VSOE nor TPE exists, the Company may use management’s best estimate of the sales price, or ESP, of each element to determine the relative selling price. The relative selling prices for control units, applicators, CoolCards and extended warranty are based on established price lists and separate, stand-alone sales of these elements. The Company establishes best estimates within a range of selling prices considering multiple factors including, but not limited to, factors such as size of transaction, pricing strategies and market conditions. The Company believes the use of the ESP allows revenue recognition in a manner consistent with the underlying economics of the transaction. The Company’s products do not require maintenance or support. Additionally, from time to time there may be undelivered elements in a multiple element arrangement, such elements generally being training or extended warranty. The Company defers revenue on undelivered elements of an arrangement and recognizes it once all revenue recognition criteria have been met. Customer Programs and Payments The Company regularly evaluates the adequacy of its estimates for cooperative marketing arrangements, customer incentive programs and pricing programs. Future market conditions and product transitions may require the Company to take action to change such programs. In addition, when the variables used to estimate these costs change, or if actual costs differ significantly from the estimates, the Company would be required to record incremental increases or reductions to sales, cost of goods sold or operating expenses. Accruals for Customer Programs The Company records an accrued liability for cooperative marketing arrangements and customer incentive programs. The estimated cost of these programs is recorded as a reduction of revenue or as an operating expense, if the Company receives a separately identifiable benefit from the customer and can reasonably estimate the fair value of that benefit. Significant management judgment and estimates must be used to determine the cost of these programs in any accounting period. Cooperative Marketing Arrangements. The Company offers cooperative marketing programs primarily to its North American customers, allowing the customers to receive partial reimbursement for qualifying advertising expenditures which promote the Company's product and brand. Customer participation and reimbursement amounts are estimated based on purchase levels of CoolCards. The objective of these arrangements is to encourage advertising and promotional events to increase sales of the Company's products. Accruals for these marketing arrangements are recorded at the later of time of sale, or time of commitment, based on the related program parameters, review of qualifying advertising expenditures by the customer and historical reimbursement experience. Accrued cooperative marketing as of December 31, 2016 and 2015 was $3.9 million and $2.5 million, respectively, and is included with "accrued marketing expenses" (See Note 4). Customer Incentive Programs. The Company's customer incentive program consists of rebates for certain distributors based on purchase levels. Estimated costs of customer rebates and similar incentives are recorded at the later of the time the incentive is offered, based on the specific terms and conditions of the program or the time the related revenue is recognized. Accruals for performance-based incentives are recognized as a reduction of the sale price at the later of the time the incentive is offered, based on the specific terms and conditions of the program, or the time the related revenue is recognized. Estimates of required accruals are determined based on negotiated terms, consideration of historical experience, anticipated volume of future purchases, and inventory levels in the channel. Certain incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions of these programs. Accrued customer incentives as of December 31, 2016 and 2015 were $1.7 million and $2.1 million, respectively, and are included in "accrued expenses and other current liabilities" on the consolidated balance sheets. Accounting for Payments to Customers The Company occasionally enters into transactions where it provides consideration to its customers in the forms of cash payments or stock-based awards in exchange for certain goods and services. The Company accounts for such payments to customers in accordance with ASC 605-50, Revenue Recognition: Customer Payments and Incentives, which requires management to characterize the payment as a reduction of revenue if it is unable to demonstrate the receipt of a benefit that is identifiable and sufficiently separable from the revenue transaction and reasonably estimate the fair value of the benefit identified. Significant management judgment and estimates must be used to determine the fair value of the benefit received in any period. For stock awards, the Company believes that the fair value of the awards is more reliably measured than the fair value of the benefit received. The fair value of the stock awards is measured as of the date at which either the commitment for performance by the customer to earn the award is reached or the date the customer’s performance is complete. Until that point is reached, the award is revalued at each reporting period with the true-up to fair value recorded in current period earnings. Shipping and Handling Shipping and handling costs charged to customers are recorded as revenue. Shipping costs related to products sold to customers are included in cost of revenue. Advertising costs The cost of advertising and media is expensed as incurred. For the years ended December 31, 2016, 2015 and 2014, advertising costs totaled $34.7 million, $17.4 million and $7.9 million, respectively. Product Warranties Sale of control units and applicators includes a limited 12-month warranty on product quality for domestic customers and a limited 38-month (control units) and 14-month (applicators) warranty for international indirect customers. The Company also offers a limited 14-month warranty for control units and applicators for its international direct customers. Warranty and related costs are accrued for based on the Company's best estimates when management determines that it is probable a charge or liability has been incurred and the amount of loss can be reasonably estimated. For new product introductions in which the Company may not have any historical experience, management makes estimates for warranty claims based on a combination of historical experience of other similar products sold and qualitative and quantitative information. The Company exercises judgment in estimating the expected product warranty costs, using data such as the actual and projected product failure rates, estimated repair costs, freight, material, labor, and overhead costs. While management believes that historical experience provides a reliable basis for estimating such warranty cost, unforeseen quality issues or component failure rates could result in future costs in excess of such estimates, or alternatively, improved quality and reliability in the Company's products could result in actual expenses that are below those currently estimated. The table below represents the activity in the warranty accrual included in "Accrued expenses and other current liabilities" on the consolidated balance sheets. The change in estimates was not significant in any years presented (in thousands): Not included in the table above are charges and settlements related to the Company's extended warranty program of $3.1 million, $1.1 million and $0.3 million in 2016, 2015 and 2014, respectively. Research and Development Research and development costs are charged to expense when incurred. Major components of research and development expenses consist of personnel costs, including salaries and benefits, and research, regulatory affairs, clinical, and development costs. Stock-Based Compensation The Company accounts for share-based compensation costs in accordance with the accounting standards for share-based compensation, which require that all share-based payments to employees be recognized in the consolidated statements of operations based on their fair values. • The fair value of stock options ("options") on the grant date is estimated using the Black-Scholes option-pricing model using the single-option approach. The Black-Scholes option pricing model requires the use of highly subjective and complex assumptions, including the option's expected term and the price volatility of the underlying stock, to determine the fair value of award. The Company recognizes the expense associated with options using a single-award approach over the requisite service period. • The fair value of Restricted Stock Units ("RSUs") is based on the stock price on the grant date using a single-award approach. The RSUs are subject to a service vesting condition and are recognized on a straight-line basis over the requisite service period. For RSUs to non-employees, the Company recognizes expense on an accelerated attribution method and these equity awards are re-measured at fair value at the end of each reporting period, with the changes in fair value recorded to stock-based compensation expense in the period in which the change occurs. • The fair value of Performance Restricted Stock Units ("PRSUs") with service and performance conditions is based on the estimated number of PRSUs anticipated to be received by the recipient at the end of the performance period. Expense is recognized when it is probable that the performance condition will be met using the accelerated attribution method over the requisite service period. The Company recognizes share-based compensation expense for the portion of the equity award that is expected to vest over the requisite service period for those awards and develops an estimate of the number of share-based awards which will ultimately vest, primarily based on historical experience. The estimated forfeiture rate is reassessed periodically throughout the requisite service period. Such estimates are revised if they differ materially from actual forfeitures. As required, the forfeiture estimates will be adjusted to reflect actual forfeitures when an award vests. For the award types discussed above, if an employee terminates employment prior to being vested in an award, then the award is forfeited. Income Taxes The Company utilizes the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse and for operating losses and tax credit carryforwards. The Company estimates its income taxes and amounts ultimately payable or recoverable in multiple tax jurisdictions around the world. Estimates involve interpretations of regulations and are inherently complex. Resolution of income tax treatments in individual jurisdictions may not be known for many years after completion of any fiscal year. The Company is required to evaluate the realizability of its deferred tax assets on an ongoing basis to determine whether there is a need for a valuation allowance with respect to such deferred tax assets. A valuation allowance is recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. Significant management judgment is required in determining any valuation allowance recorded against deferred tax assets. In evaluating the ability to recover deferred tax assets, the Company considers all available positive and negative evidence giving greater weight to its recent cumulative losses and its ability to carryback losses against prior taxable income and, commensurate with objective verifiability, the forecast of future taxable income including the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. The Company recognizes and measures uncertain tax positions taken or expected to be taken in a tax return if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are then measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement. The Company reports a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. The Company adjusts these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest. The Company recognizes interest and penalties related to unrecognized tax benefits within the income tax provision. Accrued interest and penalties are included within the related tax liability line in the consolidated balance sheet. The Company files annual income tax returns in multiple taxing jurisdictions around the world. A number of years may elapse before an uncertain tax position is audited and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, the Company believes that its reserves for income taxes reflect the most likely outcome. The Company adjusts these reserves, as well as the related interest, in light of changing facts and circumstances. Settlement of any particular position could require the use of cash or loss of tax attributes. At December 31, 2015, based on the Company's evaluation of the positive and negative evidence described in Note 10-Income Taxes, the Company concluded that the positive evidence outweighed the negative evidence and that it was more likely than not that the Company will realize all of its U.S. federal and state deferred tax assets, except for deferred tax assets related to California R&D credits. Comprehensive Income (Loss) Changes in accumulated other comprehensive income (loss) by component of each year was as follows (in thousands): Foreign currency translation All assets and liabilities of the Company's non-U.S. operations are translated into U.S. dollars at the period-end exchange rates and the resulting translation adjustments are included in other comprehensive income. The functional currencies of the Company's non-U.S. operations are generally designated in their respective local currencies. Gains or losses arising from currency exchange rate fluctuations on transactions denominated in a currency other than the local functional currency are included in other income (expense), net. In 2016, the Company began to record gains and losses arising from currency exchange rate fluctuation in connection with the classification of certain intercompany balances. These intercompany balances are eliminated as part of the Company’s consolidation process, however the foreign currency effects are reported in “Other income (expense), net” in the consolidated statements of operations. Foreign currency gains/(losses) were $2.0 million, $(0.3) million and $(0.3) million in 2016, 2015 and 2014, respectively. Recent Accounting Pronouncements not yet effective In May 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) to supersede nearly all existing revenue recognition guidance under GAAP. The objective of the updated guidance is to provide a single, comprehensive revenue recognition model for all contracts with customers to improve comparability within industries, across industries, and across capital markets. This standard update contains principles that the Company will apply to determine the measurement of revenue and timing of when it is recognized. This guidance allows for two methods of adoption: (a) full retrospective adoption, meaning the guidance is applied to all periods presented, or (b) modified retrospective adoption, meaning the cumulative effect of applying this guidance is recognized as an adjustment to the fiscal 2018 opening accumulated deficit balance. The Company has not selected the transition method and is continuing to assess the overall impact the adoption of this ASU on its consolidated financial statements. The Company expects to adopt this new guidance in the first quarter of 2018. In July 2015, the FASB issued ASU No. 2015-11 to amend ASC Topic 330, Inventory (Topic 330) to simplify the measurement of inventory. The amendments require that an entity measure inventory at the lower of cost and net realizable value instead of the lower of cost and market. This guidance will be effective for the Company in the first quarter of 2017. The Company does not anticipate the new guidance will have a material impact on its consolidated financial statements and related disclosures. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This ASU will be effective for the Company in the first quarter of 2019. The Company is evaluating the impact of the adoption of this update on its consolidated financial statements and related disclosures. In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting. The ASU simplifies several aspects of the accounting for employee share-based payments including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. This ASU will be effective for the Company in the first quarter of 2017. The Company is currently evaluating the impact this new guidance will have on its consolidated financial statements and related disclosures. In May 2016, the FASB issued ASU No. 2016-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 pursuant to Staff announcements at the March 3, 2016 EITF Meeting ("ASU 2016-11"). The update rescinds from the FASB Accounting Standards Codification certain SEC paragraphs as a result of two SEC Staff Announcements at the March 3, 2016 meeting. The amendments in ASU 2016-11, as applicable to the Company, related to Topic 605 will be effective for the Company in the first quarter of 2018. The Company is assessing the impact of this new guidance on its consolidated financial statements. In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses, which changes the accounting for recognizing impairments of financial assets. Under the new guidance, credit losses for certain types of financial instruments will be estimated based on expected losses. The new guidance also modifies the impairment models for available-for-sale debt securities and for purchased financial assets with credit deterioration since their origination. The new guidance will be effective for the Company starting in the first quarter of fiscal 2021, with early adoption permitted. The Company has not evaluated the impact that this ASU will have on its consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230), which intends to reduce diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. This guidance will be effective for the Company in the first quarter of 2018. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements. In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740). This ASU amended its guidance for tax accounting for intra-entity asset transfers. The amendment removes the prohibition against the immediate recognition of the current and deferred income tax effects of intra-entity transfers of assets other than inventory. The amendment will be effective for the Company in the first quarter of 2018. The amendment is required to be adopted on a modified retrospective basis. The Company has not evaluated the impact that this ASU will have on its consolidated financial statements. In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 320), which amended the guidance on the classification and presentation of restricted cash in the statement of cash flow. The amendment requires entities to include restricted cash and restricted cash equivalents in its cash and cash equivalents in the statement of cash flow. The amendment will be effective for the Company in the first quarter of 2018 and is required to be adopted retrospectively. The Company has not yet evaluated the impact that this ASU will have on its consolidated financial statements. 3. Fair Value of Financial Instruments Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance establishes a three-tiered hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value: •Level 1-Quoted prices in active markets for identical assets or liabilities. • Level 2-Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. • Level 3-Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The categorization of a financial instrument within the valuation hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company classifies its cash equivalents and investments within Level 1 and Level 2, as it uses quoted market prices or alternative pricing sources and models utilizing market observable inputs. The following tables set forth the fair value of the Company’s financial assets and liabilities by level within the fair value hierarchy (in thousands): In 2016 and 2015, the Company did not have any transfers of financial assets measured at fair value on a recurring basis to or from Level 1, Level 2 or Level 3. The Company did not hold any Level 3 assets or liabilities as of December 31, 2016 and December 31, 2015. The carrying amounts of the Company’s cash equivalents, accounts receivable and accounts payable approximate fair value due to their relatively short maturities. Investments The Company's short-term and long-term investments as of December 31, 2016 were as follows (in thousands): The Company's short-term and long-term investments as of December 31, 2015 were as follows (in thousands): In 2016 and 2015, gains or losses realized on the sale of investments were insignificant. The contractual maturities of the Company's short-term and long-term investments as of December 31, 2016 are as follows (in thousands): When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below the amortized cost basis, review of current market liquidity, interest rate risk, the financial condition of the issuer, as well as credit rating downgrades. The Company believes that the unrealized losses are not other-than-temporary. The Company does not have a foreseeable need to liquidate the portfolio and anticipates recovering the full cost of the securities either as market conditions improve, or as the securities mature. 4. Balance Sheet Components Inventory The components of inventory consisted of the following (in thousands): Property and equipment, net Property and equipment, net comprised the following (in thousands): Depreciation and amortization expense related to property and equipment was $3.0 million, $1.7 million and $1.1 million in 2016, 2015 and 2014, respectively. Accrued expenses and other current liabilities Items included in "Accrued expenses and other current liabilities" on the Company's consolidated balance sheets that are in excess of 5% of total current liabilities are as follows (in thousands): 5. License Agreement with Massachusetts General Hospital Intangible asset consists of an exclusive license agreement with Massachusetts General Hospital (MGH) for commercializing patents and other technology. All milestone payments payable by the Company pursuant to the terms of the agreement subsequent to the date of the FDA clearance were capitalized as purchased technology when paid, and are subsequently amortized into cost of revenue using the straight-line method over the estimated remaining useful life of the technology, not to exceed the term of the agreement or the life of the patent. In September 2015, the Company entered into a new agreement with MGH to obtain an exclusive license to develop and commercialize certain patents and technology for the treatment of acne and certain related skin conditions. The Company is obligated to pay a 3% royalty on net sales, as defined in this agreement, of products incorporating such technology. Intangible asset, net was as follows (in thousands): The amortization expense of the intangible asset was $0.7 million per year in 2016, 2015 and 2014. The total estimated annual future amortization expense of this intangible asset as of December 31, 2016, is as follows (in thousands): 6. Related Party Transactions The Company entered into a distribution agreement with ADVANCE Medical, Inc. and its wholly owned subsidiaries, Immunotech and BIOGEN, or ADVANCE, dated March 18, 2011, as the Company's exclusive distributor of CoolSculpting in Brazil and Mexico, as amended on August 29, 2011, February 27, 2012 and September 4, 2012. The distribution agreement was further amended on August 15, 2014, whereby ADVANCE is no longer a distributor in Mexico, effective November 13, 2014. As the exclusive distributor in Brazil, ADVANCE is required to purchase a minimum quantity of the Company’s products each calendar quarter throughout the term of the distribution agreement which expires on December 31, 2018. Venrock, a principal stockholder of the Company, owns an equity interest in ADVANCE Medical, Ltd., the parent company of ADVANCE. Dr. Bryan E. Roberts, who was a member of the Company's Board of Directors until the Company's annual meeting of stockholders in June 2016, is also a partner of Venrock Associates. ADVANCE purchases product with payment terms up to 180 days, and to date no amounts have been determined to be unrecoverable. The revenue recognized by the Company under this distribution agreement in 2016, 2015 and 2014, was $2.0 million, $3.6 million and $1.9 million, respectively. The accounts receivable balance under this distribution agreement as of December 31, 2016 and 2015, was $0.5 million and $1.7 million, respectively. As of December 31, 2016, the Company held cash equivalents with a total fair value of $3.1 million in a money market fund managed by a related party, BlackRock, Inc., which held 4,084,079 shares of the Company's common stock, representing approximately 10.2% of the Company's outstanding common stock at that date. 7. Commitments and Contingencies Operating Lease Obligations The Company leases certain manufacturing, office, research facilities, and equipment under operating leases that expire at various times, the longest of which expires in 2027. Rent expense for non-cancellable operating leases with scheduled rent increases is recognized on a straight-line basis over the lease term. Future minimum lease payments for the next five years and thereafter are as follows (in thousands): Rent expense in 2016, 2015 and 2014 was $3.0 million, $2.5 million and $1.5 million, respectively. In 2016, the Company entered into two new operating leases: one lease for the Company’s executive offices (headquarters) in Pleasanton, California (“new Pleasanton lease”) which will expire in October 2027 (as amended) and another lease for the manufacturing facility in Galway, Ireland which will expire in June 2022. In connection with the new Pleasanton lease, the Company made a decision to vacate its existing Pleasanton headquarters in November 2016, which is under an operating lease through March 2019. In 2016, the Company recorded a charge of $1.2 million (net of deferred rent credit releases) for the fair value of the lease liability. Purchase Commitments The Company had non-cancellable purchase obligations to contract manufacturers and suppliers for $4.9 million at December 31, 2016. Unrecognized Tax Benefits The Company's gross liability for unrecognized tax benefits totaled $1.0 million, including estimated interest and penalties, as of December 31, 2016, and is classified in long-term income taxes payable. The Company is unable to make a reasonably reliable estimate of the timing of payments in individual years due to uncertainties in the timing of tax audits, if any, or their outcomes. Legal Matters From time to time, the Company may be involved in legal and administrative proceedings and claims of various types. Additionally, the Company may be subject to insurance related claims resulting from matters associated with CoolSculpting treatments. The Company records a liability in its consolidated financial statements for these matters when a loss is known and considered probable and the amount can be reasonably estimated. Management reviews these estimates in each accounting period as additional information becomes known and adjusts the loss provision when appropriate. If the loss is not probable or cannot be reasonably estimated, a liability is not recorded in the consolidated financial statements. If a loss is probable but the amount of loss cannot be reasonably estimated, the Company discloses the loss contingency and an estimate of possible loss or range of loss (unless such an estimate cannot be made). The Company does not recognize gain contingencies until they are realized. Legal costs incurred in connection with loss contingencies are expensed as incurred. Product Liability Contingencies The Company has historically been and continues to be predominantly self-insured for any product liability losses related to its products. The Company obtains third-party insurance to limit its exposure to these claims, but this insurance is subject to a cap on reimbursement. Product liability losses are, by their nature, uncertain and are based upon complex judgments and probabilities. The Company accrues for reported claims and estimates for incurred, but not reported claims, to the extent that such losses can be reasonably estimated. The Company determines its accruals for probable product liability losses based on various factors, including historical claims and settlement experience. The total amount of self-insured product liability claims settled (i.e. paid) in 2016 and 2015 was $3.4 million and $0.7 million, respectively. The self-insured product liability claims settlement in 2014 was not material. The amount of reported and estimated incurred but not known self-insured product liability claims pending was $1.6 million and $1.1 million as of December 31, 2016 and 2015, respectively, which is recorded within "accrued expenses and other current liabilities" on the Company's consolidated balance sheets and expected to be paid within one year. Indemnifications In the normal course of business, the Company enters into contracts that contain a variety of representations and warranties and provide for general indemnifications. The Company's exposure under these agreements is unknown because it involves claims that may be made against the Company in the future, but have not yet been made. To date, the Company has not paid any claims, and the Company believes that the estimated fair value of these indemnification obligations is minimal and has not accrued any amounts for these obligations. 8. Stock-Based Compensation The Company’s stock plans are limited to employees, directors, and consultants. Shares reserved for future issuance under the stock plans may be used for grants of options, RSUs, PRSUs and other types of awards. Options granted under the stock plans are either incentive or nonqualified stock options and generally become exercisable in equal monthly installments over a period of four years from the date of grant (after the first anniversary of grant) and expire generally ten years from the grant date. RSUs generally vest in equal annual installments over a four-year period. PRSUs generally vest over the performance period when the performance conditions are met. The Board of Directors authorizes the granting of options, RSUs, PRSUs and other type of awards to employees and consultants. The exercise prices of the options shall not be less than the fair market value of common stock on the date of grant. The fair value of RSUs granted is determined based on the number of RSUs granted and the quoted price of the Company's common stock on the date of grant. As of December 31, 2016, approximately 3.9 million shares remained available for issuance under the Company's stock plans. The Company also sponsors the Employee Stock Purchase Plan (the "ESPP") in which eligible employees may contribute up to 20% (subject to certain limitations) of their base compensation to purchase shares of common stock. Each offering period consists of one six-month purchase period. The purchase price for shares of common stock under the ESPP is 85% of the lesser of the fair market value of the Company's common stock on the first day of the offering period or the purchase date. The ESPP offering periods will commence on or about the first trading days of December and June of each year and end on or about the last trading days of the next May and November, respectively. Stock-based compensation consists of the following (in thousands): (A) This amount relates to an equity grant to a non-employee customer that was recorded as a reduction of revenue. Stock Options The fair value of each option is estimated at the date of grant using the Black-Scholes option pricing formula with the following assumptions: Determining Fair Value for Options • Expected Term. Starting in 2015, the Company modified its approach by including its own historical data along with the expected term of the identified peer group companies and will continue to apply this methodology until a sufficient historical information regarding its own expected term becomes available. • Volatility. Starting in 2015, the Company modified its approach by including its own common stock trading history along with the volatility of the identified peer group companies. The expected stock price volatility is estimated using a combination of historical and peer group volatility to derive the expected volatility assumption. The Company believes the blended volatility is more representative of future stock price trends over the expected life of the options rather than just using historical or peer group volatility and will continue to apply this methodology until a sufficient historical information regarding the volatility of its own stock price becomes available. • Risk-Free Interest Rate. The risk-free interest rate is based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. • Dividend Yield. The Company has never paid any dividends and does not plan to pay dividends in the foreseeable future, and, therefore, used an expected dividend yield of zero in the valuation model. Option activity is summarized as follows: As of December 31, 2016, there was $2.9 million of unrecognized compensation expense, net of estimated forfeitures, related to options, which the Company expects to recognize over a weighted average period of 3.2 years. The aggregate intrinsic value of in-the-money options outstanding as of December 31, 2016 was $5.7 million. The total intrinsic value of options exercised in 2016, 2015, and 2014 was $1.5 million, $2.8 million and $3.2 million, respectively. The weighted average grant-date fair value of options granted in 2016, 2015 and 2014 was $11.15, $18.19 and $6.77 per share, respectively. The following table summarizes information about stock options outstanding as of December 31, 2016: Restricted Stock Units Activity related to RSUs is set forth below: Amounts in the table above are inclusive of PRSUs granted and released in their respective years. See next section below for a discussion related to PRSUs. As of December 31, 2016, the Company had $20.8 million of unrecognized compensation expense, net of estimated forfeitures, which it expects to recognize over a weighted average period of 3.2 years. The aggregate intrinsic value of the RSUs outstanding was $57.1 million. Performance Restricted Stock Units (PRSUs) From time to time, the Company will issue PRSUs to senior executives. In 2016, 2015 and 2014, the Company granted 40,000, 64,938, and 40,000 PRSUs, respectively, to certain senior executives, which are accounted for as equity awards. The number of units that ultimately vest depends on achieving certain performance criteria and can range from 0% to 100% of the number of units granted. The performance criteria are specific to the roles of each of the executives and are set by the Compensation Committee of the Board of Directors. The performance-based restricted stock units have no dividend or voting rights during the performance period. Each of the performance-based restricted stock units represents the contingent right to receive one share of the Company's common stock if the vesting conditions are satisfied. Compensation expense related to these grants is based on the grant date fair value of the award. Equity Modification related to the Company's former Chief Financial Officer On February 25, 2016, the Company's former Chief Financial Officer and the Company mutually agreed that the former Chief Financial Officer would cease to be an officer and employee of the Company which resulted in the Company incurring $0.3 million in termination benefits. In addition, stock-based compensation expense relating to the modifications of the former Chief Financial Officer's options and RSUs totaled $1.1 million in 2016. 9. Employee Benefit Plans The Company sponsors a 401(k) retirement savings plan which covers substantially all U.S. employees (the “Retirement Plan”). Under the Retirement Plan, employees may elect to contribute up to 90% of their eligible compensation to the Retirement Plan with the Company making a matching contributions of 100%, up to the first 3% of eligible employees' contributions, plus 50% of the next 2% of employees' contributions. Employees vest immediately in the matching contribution. The Company's matching 401(k) contributions were $2.3 million, $1.8 million and $1.5 million for the years ended December 31, 2016, 2015 and 2014, respectively. 10. Income Taxes The domestic and foreign components of income (loss) before income taxes were as follows (in thousands): Provision for (benefit from) income taxes consisted of the following (in thousands): The following is a reconciliation of the statutory federal income tax rate to the Company's effective tax: The impact of foreign operations primarily relates to the differential between the United States federal statutory rate and lower foreign statutory rates, including a charge for a license payment made in one of the Company's foreign subsidiaries which is incurred in a zero tax rate jurisdiction, due to the Company's tax planning action described below. Tax effects of temporary differences that give rise to significant portions of the deferred tax assets are presented below (in thousands): As of December 31, 2016, the Company had federal and state net operating loss carryforwards of $96.4 million and $94.1 million, respectively. The federal net operating losses begin expiring in 2025 and state net operating losses begin expiring in 2017. As of December 31, 2016, the Company had credit carryforwards of approximately $5.0 million and $5.8 million available to reduce future taxable income, if any, for federal and state income tax purposes, respectively. The federal research and development credit carryforwards expire beginning 2025, and state credits can be carried forward indefinitely. The federal and state net operating losses include $26.9 million and $1.0 million of excess stock based compensation that will result in increases to additional paid in capital, when realized. The valuation allowance for deferred tax assets consisted of the following activity for the years ended December 31, 2016, 2015 and 2014 (in thousands): (1) Of this deduction, $40.4 million relates to the release in the valuation allowance, which was recorded as a deferred tax benefit during the year end December 31, 2015. Utilization of net operating losses and tax credit carryforwards may be limited by ownership change rules, as defined in Section 382 of the Internal Revenue Code. Similar rules may apply under state tax laws. The Company has assessed the application of Internal Revenue Code Section 382, during the fourth quarter of 2016, and concluded no limitation currently applies, and the Company will continue to monitor activities in the future. In the event the Company experiences any subsequent changes in ownership, the amount of net operating losses and research and development credit carryovers available in any taxable year could be limited and may expire unutilized. During the year ended December 31, 2016, the amount of gross unrecognized tax benefits increased by $6.4 million. The total amount of unrecognized tax benefits was $9.3 million as of December 31, 2016. The Company recognizes interest and penalties related to uncertain tax positions as part of the income tax provision. To date, such interest and penalties have not been material. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands): While it is often difficult to predict the final outcome of any particular uncertain tax position, management does not believe that it is reasonably possible that the estimates of unrecognized tax benefits will significantly change during the next twelve months. Each quarter the Company assesses the recoverability of its deferred tax assets under ASC 740, Income Taxes. The Company is required to establish a valuation allowance for any portion of the assets that the Company concludes is not more likely than not realizable. The Company's assessment considers, among other things, the three year cumulative net income, positive pretax net income and taxable income, forecasts of its future taxable income, carryforward periods, and its utilization experience with operating loss and tax credit carryforwards and tax planning actions. Management believes that, based on a number of factors, which include the Company's historical operating performance and cumulative U.S. taxable income during the three most recent years, the Company's tax planning action of migrating and licensing certain intellectual property to its foreign subsidiaries as well as its forecasted future taxable income, it is more-likely-than-not that it will realize a benefit from its Federal and certain State deferred tax assets within allowable net loss carryforward periods. As such, in fourth quarter of 2015, the Company released a valuation allowance of $40.4 million against its Federal and certain State deferred tax assets, with a corresponding deferred tax benefit during the quarter. Due to strong results during recent years and increased confidence that the Company will continue to generate taxable income into the foreseeable future, the Company's assessment regarding the potential to realize its deferred tax assets changed. With respect to California deferred tax assets, the Company believes that, except for California R&D credits, all other deferred tax assets would be realized in the future. Although the Company anticipates generating taxable income in California in future years, expected continued generation of California R&D credits along with existing net operating loss carryforwards of $70 million will be sufficient to offset California taxable income in the foreseeable future. As such, the Company's ability to utilize its current California R&D credit carryforwards is not more likely than not, and the Company continues to apply a valuation allowance against these deferred tax assets. For other states' deferred tax assets, the Company believes it is more likely than not that those deferred tax assets will be realized in the future and as a result does not apply a valuation allowance against those deferred tax assets. As of December 31, 2015, U.S. income taxes and foreign withholding taxes associated with the repatriation of undistributed earnings of foreign subsidiaries were not provided for on a cumulative total of $0.6 million. The Company intends to reinvest these earnings indefinitely in the Company's foreign subsidiaries. If these earnings were distributed in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, the Company would be subject to additional U.S. income taxes and foreign withholding taxes, net of related foreign tax credits. Determination of the amount of any unrecognized deferred income tax liability related to these earnings is not practicable because of the complexities of the hypothetical calculation. The Company files income tax returns in the U.S. federal and state jurisdictions, in the United Kingdom and Ireland and all returns since inception remain open to examination. On December 18, 2015, the President signed into law the Protecting Americans from Tax Hikes Act of 2015, which retroactively extends several expired tax provisions. Among the extended provisions is the Section 41 research credit for qualified research expenditures incurred through the end of 2015. The benefit of the reinstated credit impacted the consolidated statement of operations in the period of enactment, which was the fourth quarter of 2015 due to the reversal of the valuation allowance on federal research and development credit carryforwards. 11. Net income per share The Company calculates basic net income per share using net income and the weighted-average number of shares outstanding during the reporting period. Diluted net income includes any dilutive effect of outstanding options and RSUs. PRSUs are excluded from the shares used to compute diluted EPS until the performance conditions associated with the PRSUs are met. A reconciliation of the numerator and denominator used in the calculation of the basic and diluted net income per share is as follows (in thousands, except for per share amounts): Potential common share equivalents that have been excluded where the inclusion would be anti-dilutive are as follows (in thousands): 12. Segment Information Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its Chief Executive Officer. The Company has one business activity and there are no segment managers who are held accountable for operations. Accordingly, the Company has a single reportable segment structure. All of the Company’s principal operations and decision-making functions are located in the United States. No individual customer accounted for more than 10% of annual revenue in 2016 and 2014. One aesthetic chain, along with its affiliated franchises, accounted for 10% of revenue in 2015. One aesthetic chain, along with its affiliated franchises, accounted for 10% of accounts receivable as of December 31, 2015. No individual customer accounted for more than 10% of accounts receivable as of December 31, 2016. Revenue by geographic location, based on the location to where the product was shipped, is summarized as follows (in thousands): North America includes the United States and related territories as well as Canada. International is the rest of the world. Revenue for the United States was $263.7 million, $180.5 million and $125.0 million in 2016, 2015 and 2014, respectively. Revenue by product category is summarized as follows (in thousands): Property and equipment, net, classified by major locations in which the Company operates were as follows (in thousands): 13. Subsequent Events (unaudited) In January 2017, the Company signed a new manufacturing facility lease (through June 2023) in Dublin, California for 85,441 square feet as well as a new warehouse facility lease (through January 2022) in Livermore, California for 42,688 square feet (collectively "2017 lease facilities"). The new 2017 lease facilities are intended to replace the Company's existing Dublin and Livermore facilities, which have leases that are set to expire in 2017. On February 13, 2017, the Company entered into a definitive agreement with Allergan Holdco US, Inc. (“Allergan US”) and Blizzard Merger Sub, Inc. (“Merger Sub”), each a subsidiary of Allergan plc (“Allergan”), pursuant to which, upon the terms and subject to the conditions set forth therein, Merger Sub will merge with and into the Company, with the Company continuing as the surviving entity and becoming a wholly-owned, indirect subsidiary of Allergan. As a result of the merger, each share of the Company’s common stock issued and outstanding immediately prior to the effective time of the merger (other than shares held (1) by the Company (or held in the Company’s treasury), (2) by Allergan US, Merger Sub or any other wholly owned subsidiary of Allergan US or (3) by stockholders of the Company who have validly exercised their dissenters’ rights under Delaware law) will be converted into the right to receive $56.50 in cash, without interest and subject to any required tax withholding. Subject to the satisfaction or waiver of various closing conditions, including the approval of the merger by the Company's stockholders and the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, the merger is expected to be completed in the second half of 2017. Supplementary Financial Data (unaudited) The following table presents selected unaudited consolidated financial data for each of the eight quarters in the two-year period ended December 31, 2016. The selected quarterly financial data should be read in conjunction with the Company's consolidated financial statements and the related notes and "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations." This information has been derived from the Company's unaudited consolidated financial statements that, in management's opinion, reflect all recurring adjustments necessary to fairly state this information when read in conjunction with the Company's consolidated financial statements and the related notes appearing in the section entitled "Consolidated Financial Statements," Net income (loss) per share-basic and diluted, for the four quarters of each fiscal year may not sum to the total for the fiscal year because of the different number of shares outstanding during each period. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period. (1) In the fourth quarter of 2015, the Company released $40.4 million of its deferred tax asset valuation allowance. See Note 11 to the Consolidated Financial Statements. (2) In the fourth quarter of 2016, the Company recorded a $1.2 million charge for the fair value of the lease liability relating to its decision to vacate its existing Pleasanton headquarters. See Note 7 to the Consolidated Financial Statements.
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Based on the provided excerpt, here's a summary of the financial statement:
1. Auditor's Opinion:
- The accounting firm believes the consolidated financial statements fairly represent ZELTIQ Aesthetics, Inc.'s financial position
2. Key Financial Estimates:
The company made significant estimates in areas such as:
- Revenue recognition
- Allowance for doubtful accounts
- Deferred tax assets
- Stock-based compensation
- Income tax uncertainties
- Valuation of intangible assets
- Warranty accrual
3. Financial Reporting Notes:
- Prior year financial statements were reclassified to conform with current year presentation
- Reclassifications did not impact previously reported operations
- The company occasionally provides payments to customers in cash or stock-based awards
4. Limitations:
- Actual financial results could differ from estimated amounts
Please note that this summary is based on a limite
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Claude
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Page No. Report of Independent Registered Public Accounting Firm - Whitley Penn LLP Report of Independent Registered Public Accounting Firm - KPMG LLP Balance Sheets as of November 30, 2016 and 2015 Statements of Income for the years ended November 30, 2016 and 2015 Statements of Shareholders' Equity for the years ended November 30, 2016 and 2015 Statements of Cash Flows for the years ended November 30, 2016 and 2015 19-23 Notes to Financial Statements as of and for the years ended November 30, 2016 and 2015 ACCOUNTING FIRM To the Board of Directors and Shareholders Micropac Industries, Inc. We have audited the accompanying balance sheet of Micropac Industries, Inc. (the "Company"), as of November 30, 2016, and the related statements of income, shareholders' equity, and cash flows for the year then ended. The Company's management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Micropac Industries, Inc. as of November 30, 2016, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. /s/ Whitley Penn, LLP Dallas, Texas February 9, 2017 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Micropac Industries, Inc.: We have audited the accompanying balance sheet of Micropac Industries, Inc. (the Company) as of November 30, 2015, and the related statements of income, shareholders' equity, and cash flows for the year ended November 30, 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Micropac Industries, Inc. as of November 30, 2015, and the results of its operations and its cash flows for the year ended November 30, 2015, in conformity with U.S. generally accepted accounting principles. KPMG LLP Dallas, Texas February 16, 2016 MICROPAC INDUSTRIES, INC. BALANCE SHEETS NOVEMBER 30, 2016 AND 2015 (Dollars in thousands except share and per share data) See accompanying notes to financial statements. MICROPAC INDUSTRIES, INC. STATEMENTS OF INCOME FOR THE YEARS ENDED NOVEMBER 30, 2016 AND 2015 (Dollars in thousands except share data) See accompanying notes to financial statements. MICROPAC INDUSTRIES, INC. STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED NOVEMBER 30, 2016 AND 2015 (Dollars in thousands) See accompanying notes to financial statements. MICROPAC INDUSTRIES, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED NOVEMBER 30, 2016 AND 2015 (Dollars in thousands) See accompanying notes to financial statements. MICROPAC INDUSTRIES, INC. NOTES TO FINANCIAL STATEMENTS NOVEMBER 30, 2016 AND 2015 1. BUSINESS DESCRIPTION: Micropac Industries, Inc. (the Company), a Delaware corporation, manufactures and distributes various types of hybrid microelectronic circuits, solid state relays, power controllers, and optoelectronic components and assemblies. The Company's products are used as components in a broad range of military, space and industrial systems, including aircraft instrumentation and navigation systems, power supplies, electronic controls, computers, medical devices, and high-temperature (200o C) products. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Revenue Recognition Revenues are recorded as shipments are made based upon contract prices. Any losses anticipated on fixed price contracts are provided for currently. Sales are recorded net of sales returns, allowances and discounts. Deferred Revenue represents prepayments from customers and will be recognized as revenue when the products are shipped per the terms of the contract. On May 28, 2015, the FASB issued ASU No. 2015-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods and services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2015-09 will have on its consolidated financial statements and related disclosures. On July 9, 2016 the FASB agreed to defer the effective date to annual reporting periods beginning after December 15, 2017 and the interim periods within that year. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting. Short-Term Investments The Company has $2,014,000 in short-term investments at November 30, 2016. Short-term investments consist of certificates of deposits with maturities greater than 90 days. These investments are reported at historical cost, which approximates fair value. All highly liquid investments with maturities of 90 days or less are classified as cash equivalents. All short-term investments are securities which the Company has the ability and intent to hold to maturity and mature within one year. Inventories Inventories are stated at lower of cost or market value and include material, labor and manufacturing overhead. All inventories are valued using the FIFO (first-in, first-out) method of inventory valuation. The Company determines the need to write inventory down below its cost via an analysis based on the usage of inventory over a three year period and projected usage based on current backlog. Income Taxes The Company accounts for income taxes using the asset and liability method. Under this method the Company records deferred income taxes for the temporary differences between the financial reporting basis and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The resulting deferred tax liabilities and assets are adjusted to reflect changes in tax law or rates in the period that includes the enactment date. The Company records a liability for an unrecognized tax benefit for a tax position that is not "more-likely-than-not" to be sustained. The Company did not record any liability for uncertain tax positions as of November 30, 2016 and 2015. Property, Plant, and Equipment Property, plant, and equipment are carried at cost, and depreciation is provided using the straight-line method at rates based upon the following estimated useful lives (in years) of the assets: The Company assesses long-lived assets for impairment in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) ASC 360-10-35, Property, Plant and Equipment - Subsequent Measurement. When events or circumstances indicate that an asset may be impaired, an assessment is performed. The estimated future undiscounted cash flows associated with the asset are compared to the asset's net book value to determine if a write down to market value less cost to sell is required. Repairs and maintenance are expensed as incurred. Improvements which extend the useful lives of property, plant, and equipment are capitalized. Research and Development Costs Costs for the design and development of new products are expensed as incurred. Basic and Diluted Earnings Per Share Basic and diluted earnings per share are computed based upon the weighted average number of shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential common shares. During 2016 and 2015, the Company had no dilutive potential common stock. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 3. FAIR VALUE MEASUREMENT: The Company had no financial assets and liabilities measured at fair value on a recurring basis as of November 30, 2016 and 2015. The fair value of financial instruments such as cash and cash equivalents, short-term investments, accounts receivable, and accounts payable approximate their carrying amount based on the short maturity of these instruments. There were no nonfinancial assets measured at fair value on a nonrecurring basis at November 30, 2016 and 2015. 4. NOTES PAYABLE TO BANKS: On April 23, 2016, the Company renewed the Loan Agreement with a Texas banking institution. The Loan Agreement provides for revolving credit loans, in amounts not to exceed a total principal balance of $6,000,000, and specific advance loans for acquisitions with an aggregate amount not to exceed $7,500,000 in a single advance or in multiple advances. The revolving credit loan renews ever two years and the loan for acquisitions renews ever year. The Loan Agreement also contains financial covenants to maintain at all times including (i) minimum working capital of not less than $4,000,000, (ii) a ratio of senior funded debt, minus the Company's balance sheet cash on hand to the extent in excess of $2,000,000 to EBITDA of not more than 3.0 to 1.0, and (iii) a ratio of free cash flow to debt service of not less than 1.2 to 1.0. The Company has not, to date, drawn any amounts under the loan agreement or the revolving line of credit and is currently in compliance with the financial covenants. 5. PRODUCT WARRANTIES: In general, the Company warrants that its products, when delivered, will be free from defects in material workmanship under normal use and service. The obligations are limited to replacing, repairing or giving credit for, at the option of the Company, any products that are returned within one year after the date of shipment. The Company does not provide extended warranties. The Company reserves for potential warranty costs based on historical warranty claims experience. While management considers the process to be adequate to effectively quantify its exposure to warranty claims based on historical performance, changes in warranty claims on a specific or cumulative basis may require management to adjust its reserve for potential warranty costs. Warranty expense was approximately $100,000 and $51,000 in 2016 and 2015, respectively. 6. LEASE COMMITMENTS: Rent expense for each of the years ended November 30, 2016 and 2015 was $50,000 and $49,000 respectively. The Company has no future minimum lease payments under non-cancellable operating leases for office and manufacturing space with remaining terms in excess of one year. 5. EMPLOYEE BENEFITS: The Company sponsors an Employees' Profit Sharing Plan and Trust (the Plan). Pursuant to section 401(k) of the Internal Revenue Code, the Plan is available to substantially all employees of the Company. Employee contributions to the Plan are matched by the Company at amounts up to 6% of the participant's salary. Contributions made by the Company were expensed and totaled approximately $325,000 in 2016 and $306,000 in 2015. Employees become vested in Company contributions in 20% increments in years two through six of employment. If the employee leaves the Company prior to being fully vested, the unvested portion of the Company contributions are forfeited and such forfeitures are used to lower future Company contributions. The Company does not offer other post-retirement benefits to its employees at this time. 8. INCOME TAXES: The income tax provision consisted of the following for the years ended November 30: The provision for income taxes differs from that computed at the federal statutory corporate tax rate as follows: The components of deferred tax assets and liabilities were as follows: In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax-planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences. 9. SIGNIFICANT CUSTOMER INFORMATION: The Company's major customers include contractors to the United States government. Sales to these customers for the Department of Defense (DOD) and NASA contracts accounted for approximately 56% of the Company's revenues in 2016 compared to 57% in 2015. Two customers accounted for 18% and 11% of the Company's sales during 2016 and one customer accounted for 12% of the Company's sales in 2015. The Company's top 10 customers accounted for 48% of the Company's sales during 2016 and 41% of the Company's sales during 2015. Three customers accounted for 13%, 12% and 10% of the accounts receivable balance as of November 30, 2016. 10. SHAREHOLDERS' EQUITY: On December 16, 2014, the Board of Directors of Micropac Industries, Inc. approved the payment of a special dividend of $0.10 per share for shareholders of record as of January 12, 2015. The dividend was paid to shareholders on February 10, 2015. On December 15, 2015, the Board of Directors of Micropac Industries, Inc. approved the payment of a special dividend of $0.10 per share for shareholders of record as of January 12, 2016. The dividend was paid to the Company's shareholders on February 11, 2016. 11. SUBSEQUENT EVENTS: On December 13, 2016, the Board of Directors of Micropac Industries, Inc. approved the payment of a $0.10 per share special dividend to all shareholders of record as of January 10, 2017. The dividend was paid to shareholders on February 9, 2017.
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Here's a summary of the financial statement excerpt:
Revenue Recognition:
- Fixed price contract losses are anticipated and provided for
- Sales are recorded net of returns, allowances, and discounts
- Deferred revenue represents customer prepayments, recognized when products are shipped
Tax Accounting:
- Deferred tax liabilities and assets are adjusted for tax law or rate changes
- No liability was recorded for uncertain tax positions as of November 30
Debt Calculation:
- Total debt is calculated by subtracting cash on hand over $2,000,000
The excerpt appears to be a partial financial statement focusing on revenue recognition, tax accounting principles, and debt calculation methods.
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Claude
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. Supplementary Data (unaudited) The following table presents selected unaudited quarterly financial data of the Company for the year ended December 31, 2016 and for the period from June 26, 2015 (date of inception) to December 31, 2015 * The presentation of the diluted weighted average shares outstanding and income per common share for the second quarter of 2016 has been updated from the presentation in the Form 10-Q filed by the Company for such quarter to include shares subject to possible redemption in order to conform to the presentation in the accompanying financial statements for the year ended December 31, 2016. ACCOUNTING FIRM To the Board of Directors and Shareholders of Double Eagle Acquisition Corp.: We have audited the accompanying balance sheets of Double Eagle Acquisition Corp. (the “Company”), as of December 31, 2016 and 2015, and the related statements of operations, changes in shareholders’ equity and cash flows for the year ended December 31, 2016 and for the period from June 26, 2015 (date of inception) to December 31, 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Double Eagle Acquisition Corp. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for the year ended December 31, 2016 and for the period from June 26, 2015 (date of inception) to December 31, 2015 in accordance with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company must complete a business combination by September 16, 2017, otherwise the Company will cease all operations except for the purpose of winding down and liquidating. Therefore, there is a substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ WithumSmith+Brown, PC New York, New York March 16, 2017 DOUBLE EAGLE ACQUISITION CORP. Balance Sheets See accompanying notes to financial statements. DOUBLE EAGLE ACQUISITION CORP. Statements of Operations See accompanying notes to financial statements. DOUBLE EAGLE ACQUISITION CORP. Statement of Changes in Shareholders’ Equity For the period from June 26, 2015 (date of inception) to December 31, 2016 (1) Share amounts have been retroactively restated to reflect the share capitalization of 1,581,250 to the initial shareholders on September 10, 2015 (see Note 4). See accompanying notes to financial statements. DOUBLE EAGLE ACQUISITION CORP. Statement of Cash Flows See accompanying notes to financial statements. DOUBLE EAGLE ACQUISITION CORP. NOTES TO FINANCIAL STATEMENTS 1.Organization and Business Operations Incorporation Double Eagle Acquisition Corp. (the “Company”) was incorporated as a Cayman Islands exempted company on June 26, 2015. The functional currency of the Company is the United States dollar. Sponsor The Company’s sponsor is Double Eagle Acquisition LLC, a Delaware limited liability company (the “Sponsor”). Fiscal Year End The Company has selected December 31 as its fiscal year end. Business Purpose The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or other similar business combination with one or more operating businesses that it has not yet selected (“Business Combination”). Financing The registration statement for the Company’s initial public offering (the “Public Offering”) (as described in Note 3) was declared effective by the United States Securities and Exchange Commission (the “SEC”) on September 10, 2015. The Company consummated the Public Offering on September 16, 2015, and, simultaneously with the closing of the Public Offering, the Sponsor, Harry E. Sloan and the Company’s independent directors (and/or one or more of their estate planning vehicles) purchased an aggregate of 19,500,000 warrants in a private placement (as described in Note 4) for a total purchase price of $9,750,000. The closing of the Public Offering included an initial partial exercise (2,000,000 units) of the over-allotment option granted to the underwriters. Upon the closing of the Public Offering and the private placement, $500,000,000 was placed in a trust account with Continental Stock Transfer & Trust Company acting as trustee (the “Trust Account”). Trust Account The Trust Account can be invested in permitted United States “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), having a maturity of 180 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act that invest only in direct U.S. government treasury obligations. The Company’s amended and restated memorandum and articles of association provide that, other than the withdrawal of interest to pay income taxes, if any, none of the funds held in trust will be released until the earlier of: (i) the completion of the Business Combination; (ii) the redemption of any of the Class A ordinary shares included in the Units sold in the Public Offering properly tendered in connection with a shareholder vote to amend the Company’s amended and restated memorandum and articles of association to modify the substance or timing of the Company’s obligation to redeem 100% of the Class A ordinary shares included in the Units sold in the Public Offering if the Company does not complete the Business Combination within 24 months from the closing of the Public Offering (September 16, 2017) or (iii) the redemption of 100% of the Class A ordinary shares included in the Units sold in the Public Offering if the Company is unable to complete a Business Combination by September 16, 2017. Business Combination A Business Combination is subject to the following size, focus and shareholder approval provisions: Size/Control - The Company’s Business Combination must occur with one or more target businesses that together have an aggregate fair market value of at least 80% of the assets held in the Trust Account (excluding the deferred underwriting commissions and taxes payable on the income earned on the Trust Account) at the time of the agreement to enter into the Business Combination. The Company will not complete a Business Combination unless it acquires a controlling interest in a target company or is otherwise not required to register as an investment company under the Investment Company Act. Focus - The Company’s efforts in identifying prospective target businesses will initially be focused on businesses in the media or entertainment industries, including providers of content, but the Company may pursue acquisition opportunities in other sectors. Tender Offer/Shareholder Approval -The Company, after signing a definitive agreement for a Business Combination, will either (i) seek shareholder approval of the Business Combination at a meeting called for such purpose in connection with which shareholders may seek to redeem their Class A ordinary shares, regardless of whether they vote for or against the Business Combination, for cash equal to their pro rata share of the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to the consummation of the initial business combination, including interest but less income taxes payable, or (ii) provide shareholders with the opportunity to sell their Class A ordinary shares to the Company by means of a tender offer (and thereby avoid the need for a shareholder vote) for an amount in cash equal to their pro rata share of the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to commencement of the tender offer, including interest but less income taxes payable. The decision as to whether the Company will seek shareholder approval of the Business Combination or will allow shareholders to sell their Class A ordinary shares in a tender offer will be made by the Company, solely in its discretion, and will be based on a variety of factors such as the timing of the transaction and whether the terms of the transaction would otherwise require the Company to seek shareholder approval. If the Company seeks shareholder approval, it will complete its Business Combination only if a majority of the outstanding ordinary shares voted are voted in favor of the Business Combination. However, in no event will the Company redeem its public shares in an amount that would cause its net tangible assets to be less than $5,000,001. In such case, the Company would not proceed with the redemption of its public shares and the related Business Combination, and instead may search for an alternate Business Combination. If the Company holds a shareholder vote in connection with a Business Combination, a public shareholder will have the right to redeem its Class A ordinary shares for an amount in cash equal to its pro rata share of the aggregate amount then on deposit in the Trust Account calculated as of two business days prior to the consummation of the initial business combination, including interest but less income taxes payable. As a result, such Class A ordinary shares have been recorded at redemption amount and classified as temporary equity, in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity.” Liquidation and Going Concern The Company has until September 16, 2017 to complete its initial Business Combination. If the Company does not complete a Business Combination within this period of time, it shall (i) cease all operations except for the purposes of winding up; (ii) as promptly as reasonably possible, but not more than ten business days thereafter, redeem the public shares for a per share pro rata portion of the Trust Account, including interest, but less income taxes payable (less up to $100,000 of such net interest to pay dissolution expenses) and (iii) as promptly as possible following such redemption, dissolve and liquidate the balance of the Company’s net assets to its remaining shareholders, as part of its plan of dissolution and liquidation. The Sponsor, Harry E. Sloan and the Company’s executive officers and independent directors (the “initial shareholders”) have entered into letter agreements with the Company, pursuant to which they have waived their rights to participate in any redemption with respect to their Founder Shares (as defined below); however, if the initial shareholders or any of the Company’s officers, directors or affiliates acquire Class A ordinary shares in or after the Public Offering, they will be entitled to a pro rata share of the Trust Account upon the Company’s redemption or liquidation in the event the Company does not complete a Business Combination within the required time period. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution (including Trust Account assets) will be less than the initial public offering price per Unit in the Public Offering. This mandatory liquidation and subsequent dissolution raises substantial doubt about the Company's ability to continue as a going concern. Emerging Growth Company Section 102(b)(1) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a registration statement under the Securities Act of 1933, as amended (the “Securities Act”), declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. This may make comparison of the Company’s financial statements with another public company which is neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period difficult or impossible because of the potential differences in accountant standards used. 2.Significant Accounting Policies Basis of Presentation The accompanying financial statements of the Company are presented in U.S. dollars in conformity with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the SEC. Net Loss Per Ordinary Share Basic net income (loss) per ordinary share is computed by dividing net income (loss) by the weighted average number of ordinary shares outstanding during the period. Diluted net income/loss per share is computed by dividing net income (loss) per share by the weighted average number of ordinary shares outstanding (including shares subject to redemption), plus, to the extent dilutive, the incremental number of ordinary shares to settle private placement warrants held by the Sponsor, as calculated using the treasury stock method. Class A ordinary shares subject to possible redemption for the periods presented have been excluded from the calculation of basic income (loss) per ordinary shares since such shares, if redeemed, only participate in their pro rata share of the trust earnings. The redeemable shares are included within the diluted per share calculation for the year ended December 31, 2016. The Company has not considered the effect of warrants sold in the Initial Public Offering in the calculation of diluted income (loss) per share, since their inclusion would be anti-dilutive. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentration of credit risk consist of cash accounts in a financial institution which, at times, may exceed the Federal depository insurance coverage of $250,000. The Company has not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts. Fair Value of Financial Instruments The fair value of the Company’s assets and liabilities, which qualify as financial instruments under FASB ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet with the exception of investments in Trust, as they are carried at amortized cost. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Offering Costs The Company complies with the requirements of FASB ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A, “Expenses of Offering.” Offering costs of approximately $28,290,000, consisting principally of underwriter discounts of $27,500,000 (including approximately $19,500,000 of which payment is deferred) and approximately $790,000 of professional, printing, filing, regulatory and other costs were charged to shareholders’ equity upon completion of the Public Offering. Approximately $0 and $100,000 of such offering expenses were accrued but unpaid at December 31, 2016 and 2015, respectively. Redeemable Ordinary Shares As discussed in Note 1, all of the 50,000,000 Class A ordinary shares sold as parts of the Units in the Public Offering contain a redemption feature which allows for the redemption of Class A ordinary shares under the Company's amended and restated memorandum and articles of association. In accordance with FASB ASC 480, redemption provisions not solely within the control of the Company require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although the Company has not specified a maximum redemption threshold, its amended and restated memorandum and articles of association provide that in no event will the Company redeem its public shares in an amount that would cause its net tangible assets to be less than $5,000,001. The Company recognizes changes in redemption value immediately as they occur and will adjust the carrying value of the security to equal the redemption value at the end of each reporting period. Increases or decreases in the carrying amount of redeemable Class A ordinary shares shall be affected by charges against additional paid in capital. Accordingly, at December 31, 2016 and 2015, 47,702,674 and 47,646,408 shares, respectively, of the 50,000,000 Class A ordinary shares included in the Units were classified outside of permanent equity at its redemption value. Income Taxes The Company complies with the accounting and reporting requirements of FASB ASC 740, “Income Taxes,” which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. There were no unrecognized tax benefits as of December 31, 2016. FASB ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at December 31, 2016. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company has been subject to income tax examinations by major taxing authorities since inception. There is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes are not reflected in the Company's financial statements. The Company's management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months. Recent Accounting Pronouncements In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). ASU 2014-15 provides guidance on management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company’s ability to continue as a going concern within one year from the date the financial statements are issued. The amendments in ASU 2014-15 are effective for annual reporting periods ending after December 15, 2016 and for annual and interim periods thereafter. Early adoption is permitted. The Company has adopted the methodologies prescribed by ASU 2014-15, and it did not have an effect on its financial position or results of operations. Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements. 3.Public Offering On September 16, 2015, the Company sold 50,000,000 units at a price of $10.00 per unit (the “Units”) in the Public Offering. Each Unit consists of one Class A ordinary share of the Company, $0.0001 par value per share (the “Public Shares”), and one warrant to purchase one-half of one Class A ordinary share (the “Public Warrants”). The closing of the Public Offering included an initial partial exercise (2,000,000 Units) of the overallotment option granted to the underwriters. Each Public Warrant entitles the holder to purchase one-half of one Class A ordinary share at a price of $5.75 per one-half share ($11.50 per whole share). No fractional shares will be issued upon exercise of the Public Warrants. If, upon exercise of the Public Warrants, a holder would be entitled to receive a fractional interest in a share, the Company will, upon exercise, round down to the nearest whole number the number of Class A ordinary shares to be issued to the Public Warrant holder. Each Public Warrant will become exercisable on the later of 30 days after the completion of the Company’s Business Combination and 12 months from the closing of the Public Offering. However, if the Company does not complete a Business Combination on or prior to the 24-month period allotted to complete the Business Combination, the Public Warrants will expire at the end of such period. Under the terms of a warrant agreement between the Company and Continental Stock Transfer & Trust Company, as warrant agent, the Company has agreed to, following the completion of the Company’s Business Combination, use its best efforts to file a new registration statement under the Securities Act for the registration of the Class A ordinary shares issuable upon exercise of the Public Warrants. If the Company is unable to deliver registered Class A ordinary shares to the holder upon exercise of Public Warrants issued in connection with the 50,000,000 Units during the exercise period, there will be no net cash settlement of these Public Warrants and the Public Warrants will expire worthless, unless they may be exercised on a cashless basis in the circumstances described in the warrant agreement. The Company paid an upfront underwriting discount of $8,000,000 ($0.16 per Unit sold) in the aggregate to the underwriters at the closing of the Public Offering, with an additional fee (the “Deferred Discount”) equal to the difference between (a) the product of the number of Class A ordinary shares sold as part of the Units and $0.55 and (b) the upfront underwriting discounts paid at the closing of $8,000,000, or a total Deferred Discount of $19,500,000 ($0.39 per Unit sold). The Deferred Discount will become payable to the underwriters from the amounts held in the Trust Account solely in the event the Company completes a Business Combination. The underwriters are not entitled to any interest accrued on the Deferred Discount. 4.Related Party Transactions Founder Shares On July 1, 2015, the Sponsor purchased 12,218,750 Class B ordinary shares (the “Founder Shares”) for $25,000, or approximately $.002 per share. On July 29, 2015, the Sponsor transferred 6,109,375 Founder Shares to Harry E. Sloan for a purchase price of $12,500 (the same per-share purchase price initially paid by the Sponsor). On August 27, 2015, the Sponsor and Mr. Sloan transferred an aggregate of 25,000 Founder Shares on a pro rata basis to each of the Company’s independent directors at their original purchase price. On August 27, 2015, Mr. Sloan transferred 665,500 Founder Shares to the Sponsor. On September 10, 2015, the Company effected a share capitalization of approximately .129 shares for each outstanding Class B ordinary share, resulting in the initial shareholders holding an aggregate of 13,800,000 Founder Shares. All references in the accompanying condensed financial statements to the number of Class B ordinary shares have been retroactively restated to reflect this transaction. The closing of the Public Offering included an initial partial exercise (2,000,000 Units) of the overallotment option granted to the underwriters which resulted in the forfeiture of an aggregate of 1,300,000 Founder Shares (the “Forfeited Founder Shares”) by the Sponsor, Harry E. Sloan and the Company’s independent directors (consisting of 1,271,771 Forfeited Founder Shares forfeited by the Sponsor, 18,524 Founder Shares forfeited by Harry E. Sloan and 3,235 Forfeited Founder Shares forfeited by each of the Company’s independent directors) due to the underwriters not exercising their over-allotment option in full and such that the remaining Founders Shares will equal 20% of the equity capital of the Company. The Founder Shares are identical to the Public Shares except that the Founder Shares are subject to certain transfer restrictions, as described in more detail below. The initial shareholders have agreed not to transfer, assign or sell any of their Founder Shares until the earlier of (A) one year after the completion of the Company’s initial Business Combination, or earlier if, subsequent to the Company’s initial Business Combination, the closing price of the Company’s Class A ordinary shares equals or exceeds $12.00 per share (as adjusted for share splits, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the Company’s initial Business Combination, and (B) the date on which the Company completes a liquidation, merger, share exchange or other similar transaction after the initial Business Combination that results in all of the Company’s shareholders having the right to exchange their Class A ordinary shares for cash, securities or other property (the “Lock Up Period”). Rights -The Founder Shares are identical to the Public Shares except that (i) the Founder Shares are subject to certain transfer restrictions, as described above, and (ii) the initial shareholders have agreed to waive their redemption rights in connection with the Business Combination with respect to the Founder Shares and any Public Shares they may purchase, and to waive their redemption rights with respect to the Founder Shares if the Company fails to complete a Business Combination within 24 months from the closing of the Public Offering. Voting -If the Company seeks shareholder approval of a Business Combination, the initial shareholders have agreed to vote their Founder Shares and any Public Shares purchased during or after the Public Offering in favor of the Business Combination. Liquidation -Although the initial shareholders and their permitted transferees have waived their redemption rights with respect to the Founder Shares if the Company fails to complete a Business Combination within the prescribed time frame, they will be entitled to redemption rights with respect to any Public Shares they may own. Private Placement Warrants The Sponsor, Harry E. Sloan and the Company’s independent directors purchased from the Company 19,500,000 warrants in the aggregate at a price of $0.50 per warrant (an aggregate purchase price of $9.75 million) in a private placement that occurred simultaneously with the completion of the Public Offering (the “Private Placement Warrants”). Each Private Placement Warrant entitles the holder to purchase one-half of one Class A ordinary share at $5.75 per one-half share ($11.50 per whole share). The purchase price of the Private Placement Warrants has been added to the proceeds from the Public Offering to be held in the Trust Account pending completion of the Company’s initial Business Combination. The Private Placement Warrants (including the Class A ordinary shares issuable upon exercise of the Private Placement Warrants) will not be transferable, assignable or salable until 30 days after the completion of the initial Business Combination, and they will be non-redeemable so long as they are held by the initial purchasers of the Private Placement Warrants or their permitted transferees. If the Private Placement Warrants are held by someone other than the initial purchasers of the Private Placement Warrants or their permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by such holders on the same basis as the Public Warrants. Otherwise, the Private Placement Warrants have terms and provisions that are identical to those of the Public Warrants and have no net cash settlement provisions. If the Company does not complete a Business Combination, then the proceeds will be part of the liquidating distribution to the public shareholders and the Private Placement Warrants will expire worthless. Registration Rights The initial shareholders and holders of the Private Placement Warrants will be entitled to registration rights pursuant to a registration rights agreement signed on September 10, 2015. The initial shareholders and holders of the Private Placement Warrants will be entitled to make up to three demands, excluding short form registration demands, that the Company register such securities for sale under the Securities Act. In addition, these holders will have “piggy-back” registration rights to include their securities in other registration statements filed by the Company. However, the registration rights agreement provides that the Company will not permit any registration statement filed under the Securities Act to become effective until termination of the applicable Lock Up Period. The Company will bear the expenses incurred in connection with the filing of any such registration statements. Administrative Services The Company will reimburse the Sponsor for office space, secretarial and administrative services provided to members of the Company’s management team by the Sponsor, members of the Sponsor, and the Company’s management team or their affiliates in an amount not to exceed $15,000 per month in the event such space and/or services are utilized and the Company does not pay a third party directly for such services, from the date of closing of the Public Offering. As of December 31, 2016 and 2015 respectively, $180,000 and $52,000 of administrative expenses were paid to the Sponsor. Upon completion of a Business Combination or the Company’s liquidation, the Company will cease paying these monthly fees. 5.Commitments and Contingencies The Company is committed to pay the Deferred Discount totaling $19,500,000, or 3.9% of the gross offering proceeds of the Public Offering, to the underwriters upon the Company’s consummation of a Business Combination. The underwriters will not be entitled to any interest accrued on the Deferred Discount, and no Deferred Discount is payable to the underwriters if there is no Business Combination. 6.Trust Account and Fair Value Measurements As of December 31, 2016, investment securities in the Company Trust Account consisted of $501,340,048 in United States Treasury Bills and another $862 held as cash and cash equivalents. As of December 31, 2015, investment securities in the Company Trust Account consisted of $500,080,274 in United States Treasury Bills and another $9,408 held as cash and cash equivalents. The Company classifies its Treasury Instruments and equivalent securities as held-to-maturity in accordance with FASB ASC 320 “Investments - Debt and Equity Securities”. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. Held-to-maturity treasury securities are recorded at amortized cost on the accompanying December 31, 2016 and 2015 balance sheets and adjusted for the amortization or accretion of premiums or discounts. The following table presents information about the Company’s assets that are measured at fair value on a recurring basis as of December 31, 2016 and 2015 and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In addition, the table presents the carrying value under ASC 320, excluding accrued interest income and gross unrealized holding gain. Since all of the Company’s permitted investments consist of U.S. government treasury bills and cash, fair values of its investments are determined by Level 1 inputs utilizing quoted prices (unadjusted) in active markets for identical assets as follows: 7.Shareholders’ Equity Ordinary Shares -The authorized ordinary shares of the Company include up to 400,000,000 shares, including 380,000,000 Class A ordinary shares and 20,000,000 Class B ordinary shares. Holders of the Class A ordinary shares and holders of the Class B ordinary shares vote together as a single class on all matters submitted to a vote of the Company’s shareholders, except as required by law. Each ordinary share has one vote. At December 31, 2016 and 2015, there were 50,000,000 Class A ordinary shares outstanding, including 47,702,674 and 47,646,408 shares respectively subject to possible redemption, and 12,500,000 Class B ordinary shares outstanding. Preferred Shares - The Company is authorized to issue 1,000,000 preferred shares. At December 31, 2016 and 2015, no preferred shares were outstanding.
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Based on the provided text, which appears to be fragments of a financial statement, here's a summary:
The document discusses:
1. Profit/Loss Calculation:
- Basic net income/loss per share is calculated by dividing net income by weighted average ordinary shares outstanding
- Diluted net income/loss per share includes potential additional shares from warrants
- Class A ordinary shares subject to redemption are excluded from basic calculations
2. Liabilities and Securities:
- The company has a deadline of September 16 (year not specified)
- Held-to-maturity securities are recorded at amortized cost
- The statement references debt and equity securities
Note: The text seems incomplete and fragmented, making a comprehensive summary challenging. More context or a complete financial statement would provide a clearer picture of the company's financial status.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our financial statements are audited and appear immediately after the signature page of this report. See "Index to Financial Statements" on page of this report. Independent Registered Public Accounting Firm's Auditor's Report on the Consolidated Financial Statements Board of Directors and Shareholders Liberated Energy, Inc. We have audited the accompanying balance sheets of Liberated Energy, Inc. (the "Company"), as of September 30, 2016, and 2015, and the related statements of operation, shareholders' equity, and cash flows for years ended September 30, 2016 and September 30, 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to in the first paragraph above, present fairly, in all material respects, the financial position of Liberated Energy, Inc. as of September 30, 2016, 2015, and the results of its operations and their cash flows for years ended September 30, 2016 and 2015, in conformity with accounting principles generally accepted in the United States of America. The Company's lack of operating history and financial resources raise substantial doubt about its ability to continue as a going concern. The financial statements do not include adjustments that might result from the outcome of this uncertainty and if the Company is unable to generate significant revenue or secure financing, then the Company may be required to cease or curtail its operations. /s/ Enterprise CPAs, Ltd Enterprise CPAs, Ltd. Chicago, IL January 17, 2017 LIBERATED ENERGY, INC. BALANCE SHEET The accompanying notes are an integral part of these statements. LIBERATED ENERGY, INC STATEMENT OF OPERATIONS The accompanying notes are an integral part of these statements. LIBERATED ENERGY, INC. STATEMENT OF SHAREHOLDERS DEFICIT FOR YEARS ENDED SEPTEMBER 30, 2016 AND 2015 The accompanying notes are an integral part of these statements. LIBERATED ENERGY, INC. STATEMENTS OF CASH FLOWS FOR YEARS ENDED SEPTEMBER 30 The accompanying notes are an integral part of these statements. LIBERATED ENERGY, INC. NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED SEPTEMBER 30, 2016 AND 2015 Note 1 - Nature of Operations Organization Liberated Energy, Inc. (the "Company"), formerly known as Mega World Food Holdings Company is a Nevada corporation formed on September 14, 2010. On January 19, 2013, pursuant to a Common Stock Purchase Agreement, dated January 7, 2013, Perpetual Wind Power Corporation, a privately held corporation formed under the laws of the State of Delaware on July 1, 2010, acquired 24,500,000 non-registered shares of the Company from its shareholders, thereby owning 24,500,000 out of a total of 25,000,000 issued and outstanding shares of the Company. Thereafter, the Company acquired from Perpetual Wind Power Corporation its patented wind and solar powered turbine technology for 2,500,000 newly issued shares of the Company which were distributed in a dividend to its shareholders and Perpetual Wind Power Corporation returned to treasury its 24,500,000 shares it acquired from the Company's shareholders. As a result of this transaction, the Company had on January 19, 2013, 3,000,000 shares issued and outstanding. On February 14, 2013, the Company changed its name from Mega World Food Holding Company to Liberated Energy, Inc. and underwent a 24 for 1 stock split, whereby the Company's outstanding shares increased from 3,000,000 to 72,000,000. On January 19, 2013, the Company disposed of its wholly-owned subsidiary, Mega World Food Limited (HK). Mega World Food Limited (HK) was incorporated on June 24, 2010 and was in the business of selling frozen vegetables in all areas of the world except China. From inception, Mega World Food Limited (HK) only incurred setting up, formation or organization activities. Upon disposal, the Company ceased these operations and accordingly, the Company's financial statements have been prepared with the net assets, results of operations, and cash flows of this business displayed separately as "discontinued operations." On February 4, 2015, the Company increased their number of authorized preferred shares from 10,000,000 to 100,000,000 and authorized common shares from 250,000,000 to 900,000,000. On December 31, 2015, the Company amended the preferred shares voting rights increasing the voting of each preferred share from 100 to 10,000 votes on any action voted on by the common stock holders On July 6, 2016, the Company adopted a 1-for-3,500 reverse split of the Company's common stock that as of June 30, 2016, was not yet effective. Note 2 - Summary of Significant Accounting Policies Basis of Accounting The Company maintains its books and records on the accrual basis of accounting. The accompanying financial statements have been prepared on that basis, in which revenues and gains are recognized when earned and expenses and losses are recognized when incurred. Use of Estimates The presentation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents For the purpose of the statement of cash flows, cash and cash equivalents include all cash balances, which are not subject to withdrawal restrictions or penalties, and highly liquid investments and debt instruments with a maturity of three months or less from the date of purchase. Fair Value of Financial Instruments Our short-term financial instruments, including cash, other assets and accounts payable and accrued expenses consist primarily of instruments without extended maturities, the fair value of which, based on management's estimates, reasonably approximate their book value. The fair value of our notes and advances payable is based on management estimates and reasonably approximates their book value based on their current maturity. Net Loss per Common Share The Company computes per share amounts in accordance with Statement of Financial Accounting Standards (SFAS) ASC 260, Earnings per Share (EPS). ASC 260 requires presentation of basic and diluted EPS. Basic EPS is computed by dividing the income (loss) available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS is based on the weighted-average number of shares of common stock and common stock equivalents outstanding during the periods. Property, Equipment, and Intangible Assets Property and equipment are carried at cost, less accumulated depreciation. Additions are capitalized and maintenance and repairs are charged to expense as incurred. Intangible assets consist of acquired customer and vendor databases and are carried at cost, less accumulated amortization. Depreciation and amortization is provided principally on the straight-line basis method over the estimated useful lives of the assets. Patent Costs Costs incurred in filing, prosecuting and maintaining patents (principally legal fees) are expensed as incurred and recorded within general and administrative expenses on the statement of operations. Such costs aggregated approximately zero and $zero for the years ended September 30, 2016 and 2015. Stock-Based Compensation The Company accounts for stock-based compensation to employees and non-employees in accordance with ASC 718 requiring employee equity awards to be accounted for under the fair value method. Accordingly, share-based compensation is measured at grant date, based on the fair value of the award and is recognized as expense over the requisite employee service period. The Company accounts for stock-based compensation to other than employees in accordance with FASB ASC 505-50. Equity instruments issued to other than employees are valued at the earlier of a commitment date or upon completion of the services, based on the fair value of the equity instruments and is recognized as expense over the service period. The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing model for common stock options and the closing price of the company's common stock for common share issuances. Inventory Inventories are stated at the cost of goods. There was zero inventory in stock in September 30, 2016 and 2015 respectively. Revenue and Cost Recognition It is the Company's policy that revenue from product sales or services will be recognized in accordance with ASC 605 "Revenue Recognition". Four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management's judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The Company will defer any revenue for which the product was not delivered or is subject to refund until such time that the Company and the customer jointly determine that the product has been delivered or no refund will be required. Income Taxes The Company utilizes ASC 740 "Income Taxes" which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Temporary differences between taxable income reported for financial reporting purposes and income tax purposes primarily relate to the recognition of debt costs and stock based compensation expense. The adoption of ASC 740-10 did not have a material impact on the Company's results of operations or financial condition. Note 3 - Going Concern Matters As shown in the accompanying financial statements, the Company has a net loss of $283,654 for the year ended September 30, 2016. As of September 30, 2016, the Company reported an accumulated deficit of $1,366,886. The Company's ability to generate continued positive cash flows is dependent on the ability to grow its operating entity as well as the ability to raise additional capital. Management is following strategic plans to accomplish these objectives, but success is not guaranteed. These factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Note 4 - Fair Value Measurements As defined in (Financial Accounting Standards Board ASC 820), fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company utilized the market data of similar entities in its industry or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. The Company classifies fair value balances based on the observability of those inputs. FASB ASC 820 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurement). The three levels of the fair value hierarchy are as follows: Level 1 - Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. Level 1 primarily consists of financial instruments such as exchange-traded derivatives, marketable securities and listed equities. Level 2 - Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reported date and includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors, and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace throughout the full term of the instrument, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace. Instruments in this category generally include non-exchange-traded derivatives such as commodity swaps, interest rate swaps, options and collars. Level 3 - Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management's best estimate of fair value. Management has determined based on note conversion history that the conversion value is equal or less than par value of the shares used for conversion thus determining that the fair value of the notes is equal to their face value. Note 5 - Convertible Notes On September 4, 2013, the Company issued a Convertible Note (the "Note") to JMJ Financial ("JMJ") providing JMJ with the ability to invest up to $350,000 which contains a 10% original issue discount (the "JMJ Note"). The transaction closed on September 4, 2013. JMJ provided $50,000 to the Company on the Effective Date. The net proceeds the Company received from this offering were $45,000. On December 10, 2013, JMJ provided $25,000 to the Company; the net proceeds the Company received from this offering were $22,500. On April 18, 2014, JMJ provided $40,000 to the Company; the net proceeds the Company received from this offering were $36,000. On June 23, 2014, JMJ provided $40,000 to the Company; the net proceeds the Company received from this offering were $36,000. On September 9, 2016, the Company settled the note with a payment of $15,213.33 bringing the balance of the note to zero. On October 8, 2014, JSJ provided $60,000 to the Company; the net proceeds the Company received from this offering were $55,000. The note is convertible at 50% of the lowest trading price of the Company's stock for the 20 days prior to conversion and provides for 12% interest and matures on April 8, 2015. On July 27, 2016, the Company paid the remaining balance of the note bring note balance to zero. On April 20, 2015, the Company issued a Convertible Note (the "Note") to LG CAPITAL FUNDING, LLC ("LG Capital") for a principle amount of $31,500 with an interest rate of 8% per annum. The note matures on April 28, 2016. The note is convertible by the holder at a discount of 52% of the lowest trading price of the Company's stock for the 18 days prior to the conversion. AS of September 30, 2016, the outstanding balance due was $31,500 plus interest of $5,080 for a total of $37,308. On April 28, 2015, the Company issued a Convertible Note to Service Trading Company, LLC for $22,000. The note bears an interest rate of 8% and matures on April 28, 2016. The note is convertible by the holder at a discount of 52% of the lowest trading price during the 18 days before the conversion. On September 9, 2016, the Company paid the balance of the note of $22,000 bring the balance of the note to zero. On May 21, 2015, the Company issued a Convertible settlement note to GEL Properties for $50,000. The note was issued to settle claims by GEL pertaining to fees and interest they claimed as still due. The note Matures on May 21, 2016 bearing interest at 8% and is convertible to common stock of the company at a discount of 65% to the lowest closing bid price for the five days prior to conversion. On September 9, 2016, the Company settled the debt for $20,000 in cash and debt forgiveness of $30,000 bring the balance due to zero. On July 13, 2015, the Company issued a Convertible Note to LG CAPITAL FUNDING, LLC ("LG Capital"), to replace the $41,400 convertible note issued to Eastmore Capital The note matures on July 13, 2016. The note is convertible by the holder at a discount of 55% of the lowest trading price of the Company's stock for the 15 days prior to the conversion. As of September 30, 2016, the outstanding balance of the note was $41,400 plus interest of $6,827 for a total of $48,227. On July 13, 2015, LG Capital's lawsuit claims the Company issued a Convertible Note to LG CAPITAL FUNDING, LLC ("LG Capital"), for a principle amount of $41,400 with an interest rate of 8% per annum. The note matures on July 13, 2016. The note is convertible by the holder at a discount of 55% of the lowest trading price of the Company's stock for the 15 days prior to the conversion. Per the Company the note was not funded but the Company has accrued the note and interest as of September 30, 2016, totaling $48,227. On August 11, 2015, the Company issued a Convertible Note to LG CAPITAL FUNDING, LLC ("LG Capital") for a principle amount of $27,500 with an interest rate of 8% per annum. The note matures on August 11, 2016. The note is convertible by the holder at a discount of 55% of the lowest trading price of the Company's stock for the 15 days prior to the conversion. AS of September 30, 2016, the outstanding balance of the principal was $27,500 and interest of $4,343 for a total of $31,843. On August 11, 2015, LG Capital's lawsuit claims the Company issued a Convertible Note to LG CAPITAL FUNDING, LLC ("LG Capital") for a principle amount of $27,500 with an interest rate of 8% per annum. The note matures on August 11, 2016. The note is convertible by the holder at a discount of 55% of the lowest trading price of the Company's stock for the 15 days prior to the conversion. Per the Company the note was not funded but the Company has accrued the note and interest as of September 30, 2016, totaling $31,843. On September 8, 2015, the Company issued a Convertible Note to LG CAPITAL FUNDING, LLC ("LG Capital") for a principle amount of $27,000 with an interest rate of 8% per annum. The note matures on September 8, 2016, 2016. The note is convertible by the holder at a discount of 55% of the lowest trading price of the Company's stock for the 15 days prior to the conversion. As of September 30, 2016, the outstanding balance of principal was $27,000 and interest of $4,343 for a total of $31,082. As of September 30, 2016, the outstanding aggregate balance of all notes due to LG Capital Funding, LLC is $218,480. On November 5, 2015, the Company issued a Convertible Note to Carebourn Capital, LP for a principle amount of $28,000 with an interest rate of 12% per annum. The note matures on August 5, 2016. The note is convertible by the holder at a discount of 50% of the lowest trading price of the Company's stock for the 20 days prior to the conversion. As of September 30, 2016, the outstanding balance of the principal was $28,000 after the conversion of $6,104 to common stock of the Company plus interest of $3,037 for a total of $31,037. On December 21, 2015, the Company issued a Convertible Note to Carebourn Capital, LP for a principle amount of $21,000 with an interest rate of 12% per annum. The note matures on September 16, 2016. The note is convertible by the holder at a discount of 50% of the lowest trading price of the Company's stock for the 20 days prior to the conversion.AS of September 30, 2016 the outstanding balance of the note was $21,000 in principal plus $1,967 interest for a total of $22,967. On March 11, 2016, the Company issued a Convertible Note to Carebourn Capital, LP for a principle amount of $18,000 with net proceeds of $15,000 and with an interest rate of 12% per annum. The note matures on December 11, 2016. The note is convertible by the holder at a discount of 50% of the lowest trading price of the Company's stock for the 20 days prior to the conversion. As of September 30, 2016, the outstanding balance of the note was principal of $18,000 plus interest of $1,207for a total of $19,207. On March 14, 2016, the Company issued a Convertible Note to LG Capital Funding, LP for a principle amount of $18,000 with an interest rate of 12% per annum. The note matures on March 14, 2017. The note is convertible by the holder at a discount of 45% of the lowest trading price of the Company's stock for the 20 days prior to the conversion. As of September 30, 2016, the outstanding balance of principal was $18,000 plus interest of $1,207 for a total of $19,207. On May 17, 2016, the Company issued a Convertible Note Craig Savin for a principle amount of $15,000 with an interest rate of 12% per annum. The note matures on March 14, 2017. The note is convertible by the holder at a discount of 45% of the lowest trading price of the Company's stock for the 20 days prior to the conversion. The note was paid in a settlement agreement whereby the Company issued 1,000,000 shares of its common stock to settle outstanding obligations including this note, a note for $5,000 and the issuance of shares for a stock subscription payable of $50,000 On May 26, 2016, the Company issued a Convertible Note to LG Capital Funding, LP for a principle amount of $17,000 with an interest rate of 12% per annum. The note matures on March 14, 2017. The note is convertible by the holder at a discount of 50% of the lowest trading price of the Company's stock for the 20 days prior to the conversion. Net proceeds to the Company are $15,000 after deduction of legal fees of $2,000. As of September 30, 2016, the outstanding balance of the note was $17,000 in principal plus interest of $428 for a total of $17,428. On June 14, 2016, the Company issued a Convertible Note Craig Savin for a principle amount of $5,000 with an interest rate of 12% per annum. The note matures on March 14, 2017. The note is convertible by the holder at a discount of 45% of the lowest trading price of the Company's stock for the 20 days prior to the conversion. On September 9, 2016, the Company issued 1,000,000 share of common stock for the payment of this note, a note for $15,000 plus a $50,000 stock payable due Savin. The balance of the note as of September 30, 2016, is zero. On July 25, 2016, the Company issued a Convertible Note to Carebourn Capital, LP for a principle amount of $23,000 with an interest rate of 12% per annum. The note matures on July 25, 2017. The note is convertible by the holder at a discount of 45% of the lowest three trading price of the Company's stock for the 20 days prior to the conversion. As of September 30, 2016, the outstanding balance included principal of $23,000 plus interest of $514 for a total of $23,514. On September 7, 2016, the Company issued a Convertible Note to Carebourn Capital, LP for a principle amount of $197,363,70 less legal fees of $8,000 with an interest rate of 12% per annum. The note matures on September 7, 2017. The note is convertible by the holder at a discount of 50% of the lowest three trading price of the Company's stock for the 20 days prior to the conversion. As of September 30, 2016, the outstanding balance included principal of $115,114 plus interest of $908 for a total of $116,022. Management has reviewed the terms of the convertible instruments to determine their fair value. After reviewing the characteristic and the value of the conversion, Management has determined based on note conversion history that the conversion value is equal or less than par value of the shares used for conversion thus determining that the fair value of the notes is equal to their face value. As the market value of the Company' stock is below it par value and exercise price, Management has concluded that the benefit of the conversion feature is zero and has not allocate a value to the conversion. As of June 30, 2016, the Company outstanding liability of convertible debt was $517,735 plus interest of $49,431 for a total liability of $567,166. The liability was as follows: On September 15, 2016, LG Capital, LLC filed a lawsuit against the Company. The filing alleges that the Company has defaulted on several unpaid loans from LG Capital to the Company with the total claim against the Company of $279,730.56. The Company negotiated in good faith with LG Capital to settle the debt but to no avail. After reviewing the claim filed by LG Capital, it is the opinion of Company Management that the Company's outstanding liability to LG Capital has been fully recognized and accounted for in the financial statements of the Company. (See Note 10- Legal). Note 6 - Related Party On February 2, 2015, the Company issued to an officer and director of the Company 10,000,000 shares with a value of $10,000 of series A preferred stock for service. Each share has 10,000 votes on all matters of the Company in which the shareholders can vote. Note 7 - Equity On February 2, 2015, the Company issued 10,000,000 shares of Series A Preferred Stock to an officer and director of the Company. Each share of series A preferred has 10,000 votes for all shareholder matters compared to 1 vote for each share of common stock. During the year ended September 30, 2015 the Company issued 540,282 shares of common stock for debt with a value of $228,317. During the year ended September 30, 2015 the Company issued 8,572 shares of common stock for accrued liabilities with a value of $127,968. During the year ended September 30, 2015 the Company issued 1,428 shares of common stock to a related party for service with a value of $50,000. During the year ended September 30, 2015 the Company issued 2,977 shares of common stock to a related party for service with a value of $98,650. During the year ended September 30, 2016 the Company issued 1,100,000 shares of common stock to two parties for service with a value of $80,000. During the year ended September 30, 2016 the Company issued 208,428 shares of common stock for convertible debt with a value of $39,769 Note 8 - Income Taxes The Company follows Accounting Standards Codification 740, Accounting for Income Taxes. The Company did not have taxable income for the years ended September 30, 2016 or 2015.The Company's deferred tax assets consisted of the following as of September 30, 2016, and 2015: The Company had a net loss of $318,436 for the year ended September 30, 2016 and $534,515 for the same period in 2015. As of September 30, 2016, the Company's net operating loss carry forward was $1,441,000 that will begin to expire in the year 2033. Note 9 - Impairment Of Asset During the year ended September 30, 2015, the Company reserved of $41,743 of assets. The Company deemed the assets as not usable and thus impaired them. Note 10 - Legal On September 15, 2016, LG Capital, LLC filed a lawsuit against the Company in the County of Kings, in the Supreme Court of the State of New York (index number 516298/2016). The filing alleges that the Company has defaulted on several unpaid loans from LG Capital to the Company with the total owing and due including principal and interest of $279,730.56. The Company has not counter claimed but believes that LG Capital unlawfully attempted to convert some of the loans to common stock of the Company has filed an injunction against the Company transfer agent to block LG Capital from such a conversion. In addition, the Company negotiated in good faith with LG Capital to settle the debt but to no avail. After reviewing the claim made by LG Capital, is the opinion of management that the outstanding liability to LG Capital has been fully recognized and accounted for in the financial statements of the Company. (See Note 5-Convertible Notes). Note 11 - Subsequent Events On October 3, 2016, the Company issued a convertible note to Carebourn Capital LP in the principal amount of $237,475 with net proceeds to the Company after original discount of $30,975 and legal and accounting fees of $6,500 of $200,000. The matures on October 3, 2017, bears interest of 12% per annum and is convertible into common stock of the Company at 55% of the average lowest trading price for the 20 days prior to conversion. As part of the loan and agreement an Office and director of the Company has pledged his 10,000,000 shares of preferred stock as collateral of the loan. On October 11, 2016, the Company completed an agreement with Ron Knori (Kroni) Owner of EcoCab Portland, LLC by which the Company will required all outstanding ECGLLC membership interest for a 20% non-dilutive interest of the outstanding shares of the Company with the first closing of the agreement. The Company's name will be changed to EcoCab, USA, Inc as soon as practical after closing. Subsequent closing through January 31. 2017 will take place and during the period from first closing to January 31, 2017, · The Company will not attempt to change the current management or operations of ECPLLC without the consent of Knori, but the Company will have the right to oversee ECPLLC's revenue and payments out on a daily and monthly basis, · The Company will use commercially reasonable efforts to finance the growth of EPCLLC's revenues, but at a minimum, the Company will provide at least $400,000 in working capital funds to ECPLLC, · all LIBE convertible notes held by Carebourn Capital L.P. are retired (or Carebourn Capital L.P. consents to the issuance to Knori of the Preferred Shares they hold as collateral) · and that the Company has not closed or entered into a binding agreement to merge with, acquire, or become acquired by, another company of equal or greater fair value (private or public) to ECPLLC. If the Preferred Shares Condition is fulfilled, Knori will be issued the Preferred Shares at a Subsequent Closing. " Second closing conditions" requires that ECPLLC has audited financial statements available to the Company. If the Second Tranche Condition is met, The Company will issue the additional Common Shares to SELLER at a Subsequent Closing. Third closing conditions requires ECPLLC: · made audited financials available to the Company within 71 days of the First Closing Date, and · has positive earnings before interest, tax and depreciation and amortization ("EBITDA") under GAAP for the month of January 2017. If the third closing Conditions are met, the Company will issue the third closing Common Shares to Knori at a Subsequent Closing. The number of third closing Common Shares will be calculated so that Knori's resulting percentage of the Company is equitable based on the fair value of ECPLLC relative to the other assets of the Company, but in no event, will Knori be required to transfer or cancel shares to reduce Knori's percentage of the outstanding common stock to below 30%. If the parties cannot agree to an equitable number of shares to issue Knori, the matter will be submitted to binding arbitration. On November 1, 2016, the Company issued 360,000 shares of common stock for the acquisition. On November 11, 2016, the Company issued 290,000 shares of common stock to two individuals for service.
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Based on the provided text, here's a summary of the financial statement notes:
1. Accounting Principles:
- Losses are recognized when incurred
- Financial statements use estimates and assumptions that may differ from actual results
2. Cash and Cash Equivalents:
- Includes cash balances without withdrawal restrictions
- Includes highly liquid investments with 3-month or less maturity
3. Financial Instruments:
- Short-term financial instruments include cash, assets, accounts payable
- Fair value is estimated to reasonably approximate book value
- Notes and advances payable fair value based on current maturity
4. Reporting Standards:
- Follows generally accepted accounting principles (GAAP)
- Computes per share amounts according to SFAS ASC 260
The document appears to be a partial or fragmented financial statement note, focusing on accounting methods, cash management, and financial instrument valuation. The text seems
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The 2016 annual financial statements together with the notes thereto follow: - Independent Auditors’ Reports - Consolidated Balance Sheets as of December 31, 2016 and 2015 - Consolidated Statements of Operations for years ended December 31, 2016 and 2015 - Consolidated Statements of Shareholders’ Equity for years ended December 31, 2016 and 2015 - Consolidated Statements of Cash Flows for years ended December 31, 2016 and 2015 - Notes to the Consolidated Financial Statements Quarterly financial data for the four quarters ended December 31, 2016 and 2015 are set forth in Note 12 of Notes to the Consolidated Financial Statements. ACCOUNTING FIRM To The Board of Directors and Shareholders of AG&E Holdings Inc. McCook, Illinois We have audited the accompanying consolidated balance sheets of AG&E Holdings Inc. as of December 31, 2016 and 2015, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the years in the two-year period ended December 31, 2016. The Company's management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. /s/ Plante & Moran, PLLC Chicago, Illinois March 30, 2017 CONSOLIDATED BALANCE SHEETS As of December 31, (in $000’s except for share information) See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, (in $000’s except for share & per share data) See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (in $000’s) See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, (in $000’s) See accompanying notes to the consolidated financial statements. NOTES TO THE FINANCIAL STATEMENTS Note 1. DESCRIPTION OF THE BUSINESS AG&E Holdings Inc. (the “Company”) through its wholly owned subsidiary American Gaming and Electronics, Inc. (“AG&E”) distributes parts and repairs and services gaming equipment and provides replacement monitors to casinos throughout the United States with offices in Hammonton, New Jersey, Las Vegas, Nevada and Hialeah, Florida. Note 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The financial statements of the Company include the accounts of AG&E Holdings Inc. and its wholly-owned subsidiary, American Gaming & Electronics, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation. Management Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP USA) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses, during the reporting period. Actual results could differ from those estimates. Revenue Recognition In general, the Company recognizes revenue when the following criteria are met: evidence of an arrangement between the Company and its customer exists, shipment has occurred or services have been rendered, the sales price is fixed and determinable and collectability is reasonably assured. Generally, these terms are met upon shipment. Revenue from video gaming terminal sales with standard payment terms is recognized upon the passage of title and transfer of the risk of loss. The Company recognizes revenue even if it retains a form of title to products delivered to customers, provided the sole purpose is to enable the Company to recover the products in the event of a customer payment default and the arrangement does not prohibit the customer’s use of the product in the ordinary course of business. Financial Instruments The fair value of the Company’s financial instruments does not materially vary from the carrying value of such instruments. Receivables Receivables are carried at original invoice or closing statement amount less estimates made for doubtful receivables. Management determines the allowances for doubtful accounts by reviewing and identifying troubled accounts on a monthly basis and by using historical experience applied to an aging of accounts. A receivable is considered to be past due if any portion of the receivable balance is outstanding past terms which are normally 30 to 60 days. Receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded when received. Inventory Obsolescence & Costing Methods The Company uses an average cost method to value inventory. The Company provides an allowance for estimated obsolete or excess inventory based on assumptions about future demands for its products. Property, Plant & Equipment Property, plant and equipment are stated at cost and are depreciated and amortized for financial reporting purposes over the estimated useful lives on a straight-line basis as follows: machinery & equipment - five to fifteen years and leasehold improvements - shorter of lease term or estimated useful life. Capitalized software costs are amortized on a straight-line basis over the expected economic life of the software of three to seven years. Intangibles The fair value of intangible assets with determinable useful lives is amortized on a straight-line basis over the estimated life. Customer relationships are amortized over a 10 year life, while gaming licenses are amortized over a 2 year life. Goodwill The Company accounted for its goodwill resulting from its purchase of Advanced Gaming Associates, LLC in conformity with GAAP USA. GAAP USA requires that goodwill not be amortized, but instead be tested for impairment at least annually, which the Company will perform annually in the fourth quarter or more often if circumstances warrant. Income Taxes The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, the Company recognizes deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The Company records a valuation allowance to reduce deferred tax assets to an amount for which realization is more likely than not. Earnings Per Share Basic earnings per share is based on the weighted-average number of common shares outstanding whereas diluted earnings per share includes the dilutive effect of unexercised common stock options and warrants. Potentially dilutive securities are excluded from diluted earnings per share calculations for periods with a net loss. Stock Based Compensation At December 31, 2016, the Company has one stock-based compensation plan, which is described more fully in Note 7. The Company accounts for this plan under the recognition and measurement principles of GAAP USA. Subsequent Events The Company evaluated subsequent events through the date the financial statements were issued. Recently Issued Accounting Pronouncements On February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), aimed at making leasing activities more transparent and comparable. The new standard requires substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including today’s operating leases. For public business entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early application is permitted for all entities. We have evaluated ASU 2016-02 and do not expect a material impact on our consolidated financial statements and related disclosures. In May 2014, August 2015 and May 2016, the FASB issued ASU 2014-09 Revenue from Contracts with Customers , ASU 2015-14 Revenue from Contracts with Customers, Deferral of the Effective Date , and ASU 2016-12 Revenue from Contracts with Customers, Narrow-Scope Improvements and Practical Expedients , respectively, which implement ASC Topic 606. ASC Topic 606 outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance under U.S. GAAP, including industry-specific guidance. It also requires entities to disclose both quantitative and qualitative information that enable financial statements users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The amendments in these ASUs are effective for annual periods beginning after December 15, 2017, and interim periods therein. Early adoption is permitted for annual periods beginning after December 15, 2016. These ASUs may be applied retrospectively with a cumulative adjustment to retained earnings in the year of adoption. We have evaluated this guidance and do not expect a material impact on our core business. We are currently evaluating the impact of implementing this guidance as it relates to our recent business combination. Note 3. BUSINESS COMBINATIONS On November 30, 2016, the Company completed the acquisition and merger of Advanced Gaming Associates LLC (“AGA”) with and into American Gaming & Electronics Inc (“AG&E). In connection with this merger, the Company issued to Anthony Tomasello 5,303,816 shares of its common stock. The Company may issue to Mr. Tomasello up to 4.2 million additional shares of common stock in the future depending on the Company’s performance and the achievement of certain revenue thresholds. Upon the closing of the merger, the Company issued to Anthony Tomasello a promissory note in the initial principal amount of $1.0 million (the “Company Note”). The Company Note accrues interest at a rate of 5% per annum and matures on November 30, 2019. In addition, if certain service revenue targets are satisfied during either of two 12-month periods immediately following the Closing, additional Company Notes will be issued for an additional $1.0 million at the end of each 12-month period, up to an aggregate additional amount of $2.0 million. The following table summarizes the fair value of total consideration transferred to AGA’s equity holder at the closing date: The fair value of the contingent consideration was estimated using a real options approach, where the company’s revenue and stock price are simulated in the risk-neutral world using Geometric Brownian Motion, a widely accepted model of price behavior that is used in option pricing models such as the Black-Scholes option pricing model. The value of the earnout was derived primarily from the provisions requiring future adjustment to the Company Note. Accordingly, the fair value of the contingent consideration is being reported as a liability. The following table summarizes the allocation of the purchase price at fair value as of the acquisition date: (a) The fair value of the intangible asset - customer relationships was estimated using a variation of the Income Approach called the Multi-Period Excess Earnings Method. In employing the Excess Earnings Method, the projected cash flows of the subject asset are computed indirectly. In other words, deductions are made from the overall business’ cash flows to recognize returns on contributory assets, leaving the excess, or residual net cash flow, as an indicator of the subject asset’s Fair Value. (b) The fair value of the intangible asset - gaming licenses was estimated using the Cost Approach. The Cost Approach is a valuation technique that uses the concept of replacement cost as an indicator of Fair Value. Note 4. DISCONTINUED OPERATIONS On September 12, 2014, the Company sold its LCD monitor business operations to HT Precision Technologies U.S., Inc a wholly owned subsidiary of HT Precision Technologies, Inc. of Taiwan for approximately $7.2 million in cash. Due to the divestiture of the LCD business, reporting of this business has been included in discontinued operations for all periods presented. The following amounts related to the discontinued operations were derived from historical financial information and have been segregated from continuing operations and reported as discontinued operations in the Condensed Consolidated Statement of Earnings: Years Ended December 31, (in $000’s ) (1) Including transaction costs Note 5. INVENTORY Net inventory, which includes a valuation reserve of $99 and $66 in 2016 and 2015, respectively, consisted of the following components: Note 6. DEBT On November 30, 2016, the Company issued a promissory note to Anthony Tomasello as part of the merger transaction with AGA. The note had a principal amount of $1.0 million and an interest rate of 5% per annum. The note matures on November 30, 2019. The note will be paid in thirty-six equal payments of $29,971 on the first of each month. Note 7. STOCK PLANS The Company maintains a Stock Award Plan under which officers and key employees may acquire up to a maximum of 2,155,028 common shares. Restricted Shares All shares granted are governed by the Company’s Stock Award Plan, which was approved by shareholders in 2000 and amended in 2009. The employees can earn the restricted shares in exchange for services to be provided to the Company over a three year or five-year vesting period. The fair value of restricted shares is based on the market price on the grant date. In 2016 and 2015, the Company did not grant any restricted shares. The compensation cost related to the stock awards is expensed on a straight-line basis over the vesting period. The Company recorded $52,000 and $47,000 in related net compensation expense for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2016, there were no restricted shares outstanding and no unrecognized compensation cost related to unvested stock awards. The following table summarizes information regarding restricted share activity for the twelve months ending December 31, 2016: Note 8. INTANGIBLE ASSETS, NET Identifiable intangible assets were comprised of: Total amortization of intangible assets was $18,000 and $0 in 2016 and 2015, respectively. Estimated amortization expense over the next five years is: Note 9. ACCRUED EXPENSES Accrued expenses consisted of the following items: Note 10. SIGNIFICANT CUSTOMERS AND SUPPLIERS - Continuing Operations The Company’s largest customer in the continuing operations accounted for 14% of total revenues in 2016 and 32% of total accounts receivable as of December 31, 2016. No other customer accounted for more than 10% of sales in 2016. The Company did not have any customers that accounted for more than 10% of sales in 2015. Note 11. INCOME TAXES The effective income tax rates differed from the expected Federal income tax rate (34%) for the following reasons: Deferred income taxes reflect the impact of temporary differences between the amounts of assets and liabilities for financial reporting purposes and as measured by income tax regulations. Temporary differences which gave rise to deferred tax assets and deferred tax liabilities consisted of: An income tax valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company has historically provided a partial valuation allowance on its net deferred tax benefits. As a result of recurring losses in recent years, the Company has reported a full valuation allowance. As of December 31, 2016, the Company has net operating loss carry forwards for Federal income tax purposes of approximately $10,817,000, which are available to offset future Federal taxable income, if any, that begin to expire in 2021. The Company also has a net operating loss carry forward for Illinois state income tax purposes of approximately $12,164,000 as of December 31, 2016. The Company also has alternative minimum tax credit carry forwards of approximately $148,000, which are available to reduce future Federal regular income taxes, if any, over an indefinite period. No unrecognized tax benefits are set to expire in the next twelve months that may have an impact upon the Company’s effective tax rate. The Company files tax returns in the U.S. federal jurisdiction and various state jurisdictions. The tax years 2013, 2014, 2015 and 2016 remain open to examinations. Our policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. During the twelve months ended December 31, 2016, the Company did not recognize expense for interest or penalties related to income tax, and does not have any amounts accrued at December 31, 2016, as the Company does not believe it has taken any uncertain tax positions. Note 12. RELATED PARTY The Company engaged a law firm to provide legal services to the Company which employed as a partner a family member of the Company’s former President and Chief Executive Officer. Total fees paid to this firm were approximately $10,000 and $46,000 in 2016 and 2015, respectively. The amount due to the firm included in accounts payable was $0 as of December 31, 2016 and 2015, respectively. The Company leases the Hammonton facility from a company which is owned by the Company’s Chief Executive Officer. The Hammonton facility lease is currently a month-to-month lease. Total rent paid to this company was approximately $8,000 in 2016. The amount due to this company included in accounts payable was $0 as of December 31, 2016 and 2015, respectively. Note 13. LEASE COMMITMENTS The Company leases certain buildings, data processing and other equipment under operating lease agreements expiring through the year 2022. Subsequent to year end, the Company entered into a new lease for office space in Illinois requiring lease payments of approximately $60,000 per year for 5 years. The future minimum lease payments required under operating leases are as follows: Rent expense related to operating leases was approximately $377,000 and $763,000 during the years ended December 31, 2016 and 2015, respectively. Note 14. UNAUDITED QUARTERLY FINANCIAL DATA Selected quarterly data for 2016 and 2015 are as follows:
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I apologize, but the financial statement excerpt you've provided seems to be incomplete and fragmented. It appears to contain sections about revenue recognition, receivables, and financial instruments, but lacks clear, complete information about total revenues, specific profit/loss amounts, or comprehensive debt details.
The key points I can extract from the text are:
Revenue Recognition Principles:
- Revenue recognized when:
1. Arrangement exists
2. Shipment occurred or services rendered
3. Sales price is fixed
4. Collectability is reasonably assured
Receivables Management:
- Carried at original invoice amount
- Less estimates for doubtful receivables
- Management reviews accounts monthly
- Past due if balance outstanding beyond 30-day terms
Financial Instruments:
- Fair value does not materially differ from carrying value
Without more complete information, I cannot provide a comprehensive summary of the financial statement. To give a proper summary
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Claude
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FINANCIAL STATEMENTS PLS CPA, A PROFESSIONAL CORP. * 4725 MERCURY STREET #210 * SAN DIEGO * CALIFORNIA 92111 * * TELEPHONE (858) 722-5953 * FAX (858) 761-0341 * FAX (858) 433-2979 * E-MAIL [email protected] * ACCOUNTING FIRM To the Board of Directors and Stockholders Perkins Oil & Gas Inc. We have audited the accompanying balance sheets of Perkins Oil & Gas Inc. ( the "Company") as of June 30, 2016 and 2015 and the related statements of operations, changes in shareholders' deficit and cash flows for the years ended June 30, 2016 and 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statements presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Perkins Oil & Gas Inc. as of June 30, 2016 and 2015, and the result of its operations and its cash flows for the year ended June 30, 2016 and 2015 in conformity with U.S. generally accepted accounting principles. The financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 6 to the financial statements, the Company's losses from operations raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ PLS CPA PLS CPA, A Professional Corp. September 28, 2016 San Diego, CA. 92111 Registered with the Public Company Accounting Oversight Board Perkins Oil & Gas Inc. Balance Sheets See Notes to Financial Statements Perkins Oil & Gas Inc. Statements of Operations See Notes to Financial Statements Perkins Oil & Gas Inc. Statement of changes in Shareholders' Equity (Deficit) From June 30, 2014 to June 30, 2016 See Notes to Financial Statements Perkins Oil & Gas Inc. Statements of Cash Flows See Notes to Financial Statements Perkins Oil & Gas Inc. Notes to Financial Statements June 30, 2016 NOTE 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS Perkins Oil & Gas, Inc. (the "Company") was incorporated on May 25, 2012 under the laws of the State of Nevada. The Company intends to engage in the exploration and development of oil and gas properties. The Company's activities to date have been limited to organization and capital. The Company is currently looking for a new well. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ACCOUNTING BASIS The statements were prepared following generally accepted accounting principles of the United States of America consistently applied. The Company's fiscal year end is June 30, 2016. The accompanying financial statements have been prepared using the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America and are presented in U.S. dollars. The Company is currently an exploration stage enterprise. An exploration stage enterprise is one in which planned principal operations have not commenced or if its operations have commenced, there has been no significant revenues there from. All losses accumulated since the inception of the business have been considered as part of its exploration stage activities. USE OF ESTIMATES Management uses estimates and assumptions in preparing these financial statements in accordance with generally accepted accounting principles. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. CASH AND CASH EQUIVALENTS Cash equivalents include short-term, highly liquid investments with maturities of three months or less at the time of acquisition. The Company had $668 of cash at June 30, 2016. INVESTMENTS IN OIL AND GAS PROPERTY The Company is an exploration stage oil and gas company. In June 2012 the company paid $17,500 for 25% working interest and an 18.75% net revenue interest in the Perkins Lease in Caddo Pine Island Field that lies in the northern part of Webster Parish, Louisiana. The lease shall be for a period of TWO (2) years (called "primary term") and as long thereafter as (1) oil, gas, sulphur or other mineral is produced or (2) is maintained in force in any other manner provided within the lease. The lease is from October 20, 2011 until October 20, 2013 and is effective May 31, 2012. Amortization of the lease will be calculated from May 31, 2012 through October 31, 2013. Amortization expenses for the year ending June 30, 2014 were $3,789, and period ending June 30, 2016 and 2015 were $0 and $0. Perkins Oil & Gas Inc. Notes to Financial Statements June 30, 2016 NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Effective April 18, 2015 the company transferred its interest in the Perkins Oil Slack (Perkins No. 001, Serial No. 192865) to Four Star Oil Company, Inc. In exchange for cancellation of outstanding debt $8,475 and the company agreed to pay Four Star Oil Company, Inc. $5,500. The Company follows the successful efforts method of accounting for its oil and gas activities. Under the successful efforts method, lease acquisition costs and all development costs are capitalized. Exploratory drilling costs are capitalized until the results are determined. If proved reserves are not discovered, the exploratory drilling costs are expensed. Other exploratory costs, such as seismic costs and other geological and geophysical expenses, are expensed as incurred. Depletion of capitalized oil and gas well costs is provided using the units of production method based on estimated proved developed oil and gas reserves of the respective oil and gas properties. To date, mineral property exploration costs have been expensed as incurred. To date the Company has not established any proven or probable reserves on its mineral properties. The Company is currently looking for a new well. REVENUE RECOGNITION The Company has yet to realize revenues from operations and is still in the exploration stage. The Company will recognize revenue when delivery of goods or completion of services has occurred provided there is persuasive evidence of an agreement, acceptance has been approved by its customers, the fee is fixed or determinable based on the completion of stated terms and conditions, and collection of any related receivable is reasonably assured. INCOME TAXES The Company accounts for its income taxes in accordance with FASB Accounting Standards Codification ("ASC") No.740, "Income Taxes". Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax balances. Deferred tax assets and liabilities are measured using enacted or substantially enacted tax rates expected to apply to the taxable income in the years in which those differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the date of enactment or substantive enactment. FINANCIAL INSTRUMENTS Fair value measurements are determined based on the assumptions that market participants would use in pricing an asset or liability. ASC 820-10 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. FASB ASC 820 establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels: Perkins Oil & Gas Inc. Notes to Financial Statements June 30, 2016 NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED * Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and must be used to measure fair value whenever available. * Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. * Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability. For example, level 3 inputs would relate to forecasts of future earnings and cash flows used in a discounted future cash flows method. The recorded amounts of financial instruments, including cash equivalents, accounts payable and notes payable approximate their market values as of June 30, 2016. NET LOSS PER SHARE Basic loss per share includes no dilution and is computed by dividing loss available to common stockholders by the weighted average number of common shares outstanding for the period. Dilutive loss per share reflects the potential dilution of securities that could share in the losses of the Company. Because the Company does not have any potentially dilutive securities, the accompanying presentation is only of basic loss per share. SHARE BASED EXPENSES The Company records stock based compensation in accordance with the guidance in ASC Topic 718 which requires the Company to recognize expenses related to the fair value of its employee stock option awards. This eliminates accounting for share-based compensation transactions using the intrinsic value and requires instead that such transactions be accounted for using a fair-value-based method. The Company recognizes the cost of all share-based awards on a graded vesting basis over the vesting period of the award. NOTE 3 - PROVISION FOR INCOME TAXES Realization of deferred tax assets is dependent upon sufficient future taxable income during the period that deductible temporary differences and carry-forwards are expected to be available to reduce taxable income. As the achievement of required future taxable income is uncertain, the Company recorded a valuation allowance. June 30, 2016 June 30, 2015 Net operating loss carryforward $ 35,594 $ 29,020 Valuation allowance (35,594) (29,020) Net deferred income tax asset $ $ ======== ======== Perkins Oil & Gas Inc. Notes to Financial Statements June 30, 2016 NOTE 4 - COMMITMENTS AND CONTINGENCIES Litigation The Company is not presently involved in any litigation. NOTE 5 - RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS The Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on its financial position or results of operations. NOTE 6 - GOING CONCERN Future issuances of the Company's equity or debt securities will be required in order for the Company to continue to finance its operations and continue as a going concern. The Company's present revenues are insufficient to meet operating expenses. The financial statements of the Company have been prepared assuming that the Company will continue as a going concern, which contemplates, among other things, the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred cumulative net losses of $104,689 since its inception and requires capital for its contemplated operational and exploration activities to take place. The Company's ability to raise additional capital through the future issuances of common stock is unknown. The obtainment of additional financing, the successful development of the Company's contemplated plan of operations, and its transition, ultimately, to the attainment of profitable operations are necessary for the Company to continue operations. The ability to successfully resolve these factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements of the Company do not include any adjustments that may result from the outcome of these aforementioned uncertainties. NOTE 7 - RELATED PARTY TRANSACTIONS Betty N. Myers, the sole officer and director of the Company, may in the future, become involved in other business opportunities as they become available, thus he may face a conflict in selecting between the Company and his other business opportunities. The Company has not formulated a policy for the resolution of such conflicts. Betty N. Myers, the sole officer and director of the Company, will not be paid for any underwriting services that he performs on behalf of the Company with respect to the Company's S-1 offering. He will also not receive any interest on any funds that he advances to the Company for offering expenses prior to the offering being closed which will be repaid from the proceeds of the offering. Perkins Oil & Gas Inc. Notes to Financial Statements June 30, 2016 NOTE 8 - NOTES PAYABLE - RELATED PARTY Since inception the Company received cash totaling $49,100 from J. Michael Page and Howard H. Hendricks in the form of notes. As of June 30, 2016 the amount due to J. Michael Page was $23,000 and the amount due to Howard H. Hendricks was $26,100. On April 30, 2013, the Company received a $4,500 loan. This loan is at 2% interest with principle and interest all due on May 1, 2015. On May 1, 2015, the loan was extended to May 1, 2017. On June 7, 2013, the Company received a $3,000 loan. This loan is at 4% interest with principle and interest all due on June 7, 2015. On June 7, 2015, the loan was extended to June 7, 2017. On September 6, 2013, the Company received a $9,000 loan. This loan is at 4% interest with principle and interest all due on September 6, 2015. On September 6 2015, the loan was extended to September 6, 2017. On September 30, 2013, the Company received a $500 loan. This loan is at 4% interest with principle and interest all due on September 30, 2015. On September 30, 2015, the loan was extended to September 30, 2017. On November 15, 2013, the Company received a $2,000 loan. This loan is at 4% interest with principle and interest all due on November 15, 2015. On November 15, 2015, the loan was extended to November 15, 2017. On January 21, 2014, the Company received a $4,000 loan. This loan is at 4% interest with principle and interest all due on January 21, 2016 On January 21, 2016, the loan was extended to January 21, 2018. On February 6, 2015, the Company received a $1,200 loan. This loan is at 4% interest with principle and interest all due on February 6, 2017 On March 9, 2015, the Company received a $3,000 loan. This loan is at 4% interest with principle and interest all due on March 9, 2017 On April 16, 2015, the Company received a $5,500 loan. This loan is at 4% interest with principle and interest all due on April 16, 2017. On May 13, 2015, the Company received a $1,700 loan. This loan is at 4% interest with principle and interest all due on May 13, 2017. On August 8, 2015, the Company received a $1,000 loan. This loan is at 4% interest with principle and interest all due on August 8, 2017. On October 30, 2015, the Company received a $5,100 loan. This loan is at 4% interest with principle and interest all due on October 30, 2017. On December 31, 2015, the Company received a $4,400 loan. This loan is at 4% interest with principle and interest all due on December 31, 2017. Perkins Oil & Gas Inc. Notes to Financial Statements June 30, 2016 NOTE 8 - NOTES PAYABLE - RELATED PARTY - CONTINUED On February 12, 2016, the Company received a $2,100 loan. This loan is at 4% interest with principle and interest all due on February 12, 2018. On February 29, 2016, the Company received a $2,100 loan. This loan is at 4% interest with principle and interest all due on February 29, 2018. As of June 30, 2015, accrued interest is $1,553, and June 30, 2016 accrued interest is $3,162. NOTE 9 - STOCKHOLDERS' EQUITY The stockholders' equity section of the Company contains the following classes of capital stock as of June 30, 2016: Common stock, $0.001 par value: 75,000,000 shares authorized; 6,750,000 shares issued and outstanding. ITEM 9A.
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Based on the provided financial statement excerpt, here's a summary:
Financial Statement Summary:
- Revenue: Derived from net revenue interest in the Perkins Lease in Caddo Pine Island Field, Louisiana
- Cash and Cash Equivalents: $668
- Total Debt: $8,475
- Financial Status: Experiencing significant operational losses that raise doubts about the company's ability to continue as a going concern
The statement suggests the company is facing financial challenges, with potential uncertainty about its future sustainability.
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Claude
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SEARS HOMETOWN AND OUTLET STORES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See . SEARS HOMETOWN AND OUTLET STORES, INC. CONSOLIDATED BALANCE SHEETS See . SEARS HOMETOWN AND OUTLET STORES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See . SEARS HOMETOWN AND OUTLET STORES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY See . SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1-BACKGROUND, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES Background Sears Hometown and Outlet Stores, Inc. is a national retailer primarily focused on selling home appliances, hardware, tools and lawn and garden equipment. As of January 30, 2016, the Company or our independent dealers and franchisees operated a total of 1,160 stores across all 50 states and in Puerto Rico and Bermuda. In these notes the terms "we," "us," "our," "SHO," and the "Company" refer to Sears Hometown and Outlet Stores, Inc. and its subsidiaries. Description of the Separation On October 11, 2012, Sears Holdings Corporation ("Sears Holdings") completed the separation of its Sears Hometown and Hardware and Sears Outlet businesses (the "Separation"). As part of the Separation, in August 2012 through a series of intercompany transactions Sears Holdings and several of its subsidiaries transferred the assets and liabilities comprising the Sears Hometown and Hardware and Sears Outlet businesses to SHO, which was formed in April 2012 as a wholly owned subsidiary of Sears Holdings. Effective upon the Separation, Sears Holdings ceased to own shares of our common stock, and thereafter our common stock began trading on the NASDAQ Stock Market under the trading symbol "SHOS." As part of the Separation, Sears Holdings contributed to SHO equity intercompany balances due to/from Sears Holdings, which included amounts arising from pre-Separation purchases of merchandise inventories. After the Separation, the Company continues to purchase most of its merchandise from Sears Holdings and amounts payable to Sears Holdings are reflected separately on the consolidated balance sheet. Basis of Presentation These consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated. We operate through two segments our Sears Hometown and Hardware segment ("Hometown") and our Sears Outlet segment ("Outlet"). Variable Interest Entities and Consolidation The Financial Accounting Standards Board ("FASB") has issued guidance on variable interest entities and consolidation for determining whether an entity is a variable interest entity as well as the methods permitted for determining the primary beneficiary of a variable interest entity. In addition, this guidance requires ongoing reassessments of whether a company is the primary beneficiary of a variable interest entity and disclosures related to a company’s involvement with a variable interest entity. On an ongoing basis the Company evaluates its business relationships, such as those with its dealers, franchisees, and suppliers, to identify potential variable interest entities. Generally, these businesses qualify for a scope exception under the consolidation guidance, or, where a variable interest exists, the Company does not possess the power to direct the activities that most significantly impact the economic performance of these businesses. The Company has not consolidated any of such entities in the periods presented. SIGNIFICANT ACCOUNTING POLICIES Fiscal Year Our fiscal years end on the Saturday closest to January 31. Unless otherwise stated, references to specific years in these notes are to fiscal years. The following fiscal periods are presented herein. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. The estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors that management believes to be reasonable under the circumstances. Adjustments to estimates and assumptions are made when facts and circumstances dictate. As future events and their effects cannot be determined with absolute certainty, actual results may differ from the estimates used in preparing the accompanying consolidated financial statements. Significant estimates and assumptions are required as part of determining inventory and accounts and franchisee receivables valuation, estimating depreciation and recoverability of long-lived assets, establishing insurance, warranty, legal and other reserves, performing goodwill and long-lived asset impairment analysis, and establishing valuation allowances on deferred income tax assets and reserves for tax examination exposures. Cash and Cash Equivalents Cash equivalents include (1) all highly liquid investments with original maturities of three months or less at the date of purchase and (2) deposits in-transit from banks for payments related to third-party credit card and debit card transactions. Allowance for Doubtful Accounts We provide an allowance for doubtful accounts based on both historical experience and a specific identification basis. Allowances for doubtful accounts on accounts and notes receivable balances were $12.1 million at January 30, 2016 and $11.4 million at January 31, 2015. Our accounts receivable balance is comprised of various vendor-related and customer-related accounts receivable. Our notes receivable balance is comprised of promissory notes that relate primarily to the sale of assets for our franchised locations. The Company provides an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling, general, and administrative expense. Merchandise Inventories Merchandise inventories are valued at the lower of cost or market. Merchandise inventories are valued under the retail inventory method, or "RIM," using primarily a last-in, first-out, or "LIFO," cost-flow assumption. Inherent in RIM calculations are certain significant management judgments and estimates including, among others, merchandise markons, markups, markdowns, and shrinkage, which significantly impact the ending inventory valuation at cost and resulting gross margins. The methodologies utilized by us in our application of RIM are consistent for all periods presented. Such methodologies include the development of the cost-to-retail ratios, the groupings of homogeneous classes of merchandise, the development of shrinkage and obsolescence reserves, the accounting for price changes, and the computations inherent in the LIFO adjustment (where applicable). Management believes that RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market. The inventory allowance for shrinkage and obsolescence was $9.8 million at January 30, 2016 and $12.1 million at January 31, 2015. In connection with our LIFO calculation we estimate the effects of inflation on inventories by utilizing external price indices determined by the U.S. Bureau of Labor Statistics. If we had used the first-in, first-out, or "FIFO" method of inventory valuation instead of the LIFO method, merchandise inventories would have been $0.6 million higher at January 30, 2016 and $0.9 million higher at January 31, 2015. Vendor Rebates and Allowances Sears Holdings receives rebates and allowances from vendors through a variety of programs and arrangements intended to offset the costs of promoting and selling the vendors' products. Sears Holdings allocates a portion of the rebates and allowances to us based on shipments to or sales of the related products to the Company. These vendor payments are recognized and recorded as a reduction to the cost of merchandise inventories when earned and, thereafter, as a reduction of cost of sales and occupancy as the merchandise is sold. Up-front consideration received from vendors linked to purchases or other commitments is initially SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS deferred and amortized ratably to cost of sales and occupancy over the life of the contract or as performance of the activities specified by the vendor to earn the fee is completed. Property and Equipment Property and equipment are recorded at cost, less accumulated depreciation. Additions and substantial improvements are capitalized and include expenditures that materially extend the useful lives of existing facilities and equipment. Maintenance and repairs that do not materially improve or extend the lives of the respective assets are expensed as incurred. Property and equipment consists of the following: Depreciation expense, which includes depreciation on assets under capital leases, is recorded over the estimated useful lives of the respective assets using the straight-line method for financial statement purposes and accelerated methods for tax purposes. The range of lives are generally 15 to 25 years for buildings, 3 to 10 years for furniture, fixtures, and equipment, and 3 to 5 years for computer systems and equipment. Leasehold improvements are depreciated over the shorter of the associated lease term or the estimated useful life of the asset. Depreciation expense was $12.8 million and $10.2 million for fiscal years 2015 and 2014, respectively. As of January 30, 2016, management has identified two properties that are deemed held for sale based on criteria in Accounting Standards Codification ("ASC") 360-10-45-9. These properties are reflected in each category of Property and Equipment with the exception of capitalized leases in the table above and had a carrying value of $3.8 million as of January 30, 2016. These properties are currently listed on the open market and are expected to be sold to third parties in the first half of fiscal year 2016. As of January 30, 2016, the expected fair value less the cost of sale exceeded the carrying value of the Property and Equipment. Impairment of Long-Lived Assets and Costs Associated with Exit Activities In accordance with accounting standards governing the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including property and equipment, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. Factors that could result in an impairment review include, but are not limited to, a current period cash flow loss combined with a history of cash flow losses, current cash flows that may be insufficient to recover the investment in the property over the remaining useful life, or a projection that demonstrates continuing losses associated with the use of a long-lived asset, significant changes in the manner of use of the assets, or significant changes in business strategies. An impairment loss is recognized when the estimated undiscounted cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced to its estimated fair value as determined based on quoted market prices or through the use of other valuation techniques. We did not record any significant impairment charges with respect to long-lived assets in our 2015, 2014, or 2013 fiscal years. See Note 5 regarding the $167.0 million non-cash goodwill impairment charge we recorded in the third quarter of our 2014 fiscal year. We account for costs associated with location closings in accordance with accounting standards pertaining to accounting for costs associated with exit or disposal activities and compensation. When management makes a decision to close a location we record a liability as of that date for the inventory markdowns associated with the closing. We record a liability for future lease costs (net of estimated sublease income) when we cease to use the location. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Leases We lease certain stores, office facilities, computers and transportation equipment. The determination of operating and capital lease obligations is based on the expected durations of the leases and contractual minimum lease payments specified in the lease agreements. For certain stores, amounts in excess of these minimum lease payments are payable based upon a specified percentage of sales. Contingent rent is accrued during the period it becomes probable that a particular store will achieve a specified sales level thereby triggering a contingent rental obligation. Certain leases also include an escalation clause or clauses and renewal option clauses calling for increased rents. Where the lease contains an escalation clause or concession such as a rent holiday, rent expense is recognized using the straight-line method over the term of the lease. We have subleases with Sears Holdings for 63 locations. We had rent expense paid to Sears Holdings of $19.3 million, $27.8 million and $27.3 million in 2015, 2014 and 2013, respectively. We also had rent expenses paid to Seritage Growth Properties of $0.5 million in 2015. Rental expense for operating leases was as follows: SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Minimum lease obligations excluding taxes, insurance and other expenses are as follows: Insurance Programs We maintain with third-party insurance companies our own insurance arrangements for exposures incurred for a number of risks including worker’s compensation and general liability claims. Insurance expense of $4 million, $6 million and $7 million was recorded during 2015, 2014 and 2013, respectively. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loss Contingencies We account for contingent losses in accordance with accounting standards pertaining to loss contingencies. Under accounting standards, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period, as additional information is known. Revenue Recognition Revenues include sales of merchandise, commissions on merchandise sales made through www.sears.com and www.searsoutlet.com, services and extended-service plans, and delivery and handling revenues related to merchandise sold. We recognize revenues from retail operations at the later of the point of sale or the delivery of goods to the end user. Net sales are presented net of any taxes collected from customers and remitted or payable to governmental authorities. We recognize revenues from commissions on services and extended-service plans, and delivery and handling revenues related to merchandise sold, at the point of sale as we are not the primary obligor with respect to such services and have no future obligations for future performance. The Company accepts Sears Holdings gift cards as tender for purchases and is reimbursed by Sears Holdings for gift cards tendered. Reserve for Sales Returns and Allowances Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The reserve for returns and allowances is calculated as a percentage of sales based on historical return percentages. Estimated returns are recorded as a reduction of sales and cost of sales. The reserve for returns and allowances was $1 million at January 30, 2016 and $2 million at January 31, 2015. Cost of Sales and Occupancy Cost of sales and occupancy are comprised principally of merchandise costs, warehousing and distribution (including receiving and store delivery) costs, retail store occupancy costs, home services and installation costs, warranty cost, royalties payable to Sears Holdings related to our sale of related to our sale of products branded with one of the KENMORE®, CRAFTSMAN®, and DIEHARD® marks (the "KCD Marks," and products branded with one of the KCD Marks are referred to as the "KCD Products"), customer shipping and handling costs, vendor allowances, markdowns, and physical inventory losses. The KCD Marks are owned by subsidiaries of Sears Holdings. Dealer and Franchisee Commissions In accordance with our agreements with our dealers and franchisees, we pay commissions to our dealers and franchisees on the net sales of merchandise and extended-service plans. In addition, each dealer and franchisee can earn commissions for third-party gift cards sold and can earn marketing support, home improvement referrals, rent support, and other items. Commission costs are expensed as incurred and reflected within selling and administrative expenses. Commission costs were $278 million, $297 million, and $261 million in 2015, 2014 and 2013, respectively. Selling and Administrative Expenses Selling and administrative expenses are comprised principally of dealer and franchisee commissions, payroll and benefits costs for retail and support employees, advertising, pre-opening costs, and other administrative expenses. Pre-Opening Costs Pre-opening and start-up activity costs are expensed in the period in which they occur. Advertising Costs Advertising costs are expensed as incurred, generally the first time the advertising occurs, and were $71 million, $74 million and $67 million for 2015, 2014 and 2013, respectively. These costs are included within selling and administrative expenses in the accompanying consolidated statements of operations. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Income Taxes We provide deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax basis of assets and liabilities based on currently enacted tax laws. The tax balances and income tax expense recognized by us are based on management’s interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects our best estimates and assumptions regarding, among other things, the level of future taxable income, tax planning, and any valuation allowance. Future changes in tax laws, changes in projected levels of taxable income, tax planning, and adoption and implementation of new accounting standards could impact the effective tax rate and tax balances recorded by us. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results and incorporate assumptions including the amount of future state, federal and foreign pre-tax operating income (loss), the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income. Tax positions are recognized when they are more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more likely than not of being recognized upon settlement. We will be subject to periodic audits by the Internal Revenue Service and other state and local taxing authorities. Theses audits may challenge certain of the Company’s tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. We evaluate our tax positions and establish liabilities in accordance with the applicable guidance on uncertainty in income taxes. These tax uncertainties are reviewed as facts and circumstances change and are adjusted accordingly. This requires significant management judgment in estimating final outcomes. Actual results could materially differ from these estimates and could significantly affect the effective tax rate and cash flows in future years. Interest and penalties are classified as income tax expense in the Consolidated Statements of Operations. Prior to the Separation, our taxable income was included in the consolidated federal, state and foreign income tax returns of Sears Holdings or its affiliates. Income taxes in these consolidated financial statements have been recognized on a separate return basis. Under a Tax Sharing Agreement between the Company and Sears Holdings entered into prior to the Separation (the "Tax Sharing Agreement"), Sears Holdings is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the Separation and the Company is responsible for any federal, state or foreign tax liability relating to tax periods ending after the Separation. Fair Value of Financial Instruments We determine the fair value of financial instruments in accordance with standards pertaining to fair value measurements. Such standards define fair value and establish a framework for measuring fair value in Generally Accepted Accounting Principles ("GAAP"). Under fair value measurement accounting standards, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. We report the fair value of financial assets and liabilities based on the fair value hierarchy prescribed by accounting standards for fair value measurements, which prioritizes the inputs to valuation techniques used to measure fair value into three levels, as follows: Level 1 inputs-unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide ongoing pricing information. Level 2 inputs-inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active and inputs other than quoted market prices that are observable for the asset or liability, such as interest rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risk and default rates. Level 3 inputs-unobservable inputs for the asset or liability. Cash and cash equivalents, merchandise payables, accrued expenses (level 1), accounts and notes receivable, and short-term debt (level 2) are reflected in the Consolidated Balance Sheets at cost, which approximates fair value due to the short-term nature of these instruments. For short-term debt, the variable interest rates are a significant input in our fair value assessments. The carrying value of long-term notes receivable approximates fair value. We measure certain non-financial assets and liabilities, including long-lived assets, at fair value on a non-recurring basis. As disclosed in Note 5, the Company recorded a goodwill impairment charge during the third quarter of fiscal 2014 and recorded SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS certain intangible assets during 2015. The Company utilized Level 3 inputs to measure the fair value of goodwill and the intangible assets. New Accounting Pronouncements Leases In February 2016, the FASB issued an accounting standards update which replaces the current lease accounting standard. The update will require, among other items, lessees to recognize a right-of-use asset and a lease liability for most leases. Extensive quantitative and qualitative disclosures, including significant judgments made by management, will be required to provide greater insight into the extent of revenue and expense recognized and expected to be recognized from existing contracts. The update is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years, with early adoption permitted. The new standard must be adopted using a modified retrospective transition, and provides for certain practical expedients. Transition will require application of the new guidance at the beginning of the earliest comparative period presented. We are currently evaluating the effect the update will have on our consolidated financial statements. Balance Sheet Classification of Deferred Taxes In November 2015, the FASB issued an accounting standards update which simplifies the presentation of deferred income taxes by requiring that deferred income tax liabilities and assets be classified as noncurrent in a classified statement of financial position. As permitted, the Company early adopted the update beginning in the fourth quarter of fiscal 2015 utilizing prospective application and prior periods were not retrospectively adjusted. The impact of this update was a reclassification of $11.0 million of short-term deferred income tax assets from Prepaid expenses and other current assets to Long-term deferred tax assets as of January 30, 2016. Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement In April 2015, the FASB issued ASU 2015-05, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40), Customer's Accounting for Fees Paid in a Cloud Computing Arrangement. This ASU provides guidance to customers about whether a cloud computing arrangement includes a software license. If the arrangement includes a software license, the customer would account for fees related to the software license element consistent with accounting for the acquisition of other acquired software licenses. If the arrangement does not contain a software license, the customer would account for the arrangement as a service contract. As permitted, the Company early adopted this update prospectively beginning in the fourth quarter of fiscal 2015. As discussed in Note 10, based on an evaluation of this guidance and existing accounting literature, SHO reclassed a large majority of these investments that began in the first quarter of 2015 from capitalized assets to expense, and will expense most of these investments going forward as services are provided. Debt Issuance Costs In April 2015, the FASB issued an accounting standards update which simplifies the presentation of debt issuance costs by requiring that debt issuance costs be presented in the balance sheet as a direct deduction from the carrying amount of the debt liability, consistent with discounts or premiums. In August 2015, the FASB issued an accounting standards update about the presentation and subsequent measurement of debt issuance costs associated with line-of-credit arrangements, and allows for the presentation of debt issuance costs as an asset regardless of whether or not there is an outstanding balance on the line-of-credit arrangement. The Company continued to report unamortized debt issuance costs related to the Senior ABL Facility of $1.1 million and $1.8 million at January 30, 2016 and January 31, 2015, respectively, within other assets. Consolidation In February 2015, the FASB issued an accounting standards update which revises the consolidation model. Specifically, the amendments modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities, eliminate the presumption that a general partner should consolidate a limited partnership, affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships, and provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. This update became effective for the Company in the first quarter of 2015. The adoption of the new standard did not have a material impact on the Company’s consolidated financial position, results of operations, cash flows or disclosures. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Extraordinary and Unusual Items In January 2015, the FASB issued an accounting standards update which eliminates the concept of an extraordinary item. Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Eliminating the extraordinary classification simplifies income statement presentation by altogether removing the concept of extraordinary items from consideration. This update became effective for the Company in the first quarter of 2015. The adoption of the new standard did not have a material impact on the Company’s consolidated financial position, results of operations, cash flows or disclosures. Presentation of Financial Statements - Going Concern In August 2014, the FASB issued an accounting standards update which requires management to assess whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued. If substantial doubt exists, additional disclosures are required. This update will be effective for the Company in the fourth quarter of 2016. The adoption of the new standard is not expected to have a material impact on the Company’s consolidated financial position, results of operations, cash flows or disclosures. Revenue from Contracts with Customers In May 2014, the FASB issued an accounting standards update which replaces the current revenue recognition standards. The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. After the FASB's August 2015 update to defer the effective date one year, this update will be effective for the Company in the first quarter of 2018 and may be applied retrospectively for each period presented or as a cumulative-effect adjustment at the date of adoption. The Company is evaluating the effect of adopting this new standard and has not yet determined the method by which the standard will be adopted. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2-ACCOUNTS AND FRANCHISEE RECEIVABLES AND OTHER ASSETS Accounts and franchisee receivables and other assets consist of the following: (1) The Company recognizes an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling, general, and administrative expense. Most of our franchisee promissory notes authorize us to deduct debt service from our commissions otherwise due and payable to the franchisees, and we routinely make those deductions to the extent of available commissions payable. We established an allowance for losses on franchisee receivables in 2014 and 2015 based on our receivable-by-receivable assessment during the year that some of the franchisee receivables were potentially uncollectible in future periods due to declining results of operations of, or other adverse financial events with respect to, franchise stores that indicated that the franchisees might not be able, or were unable or unwilling, to meet their debt-service and other obligations to us as they became due. NOTE 3-ALLOWANCE FOR LOSSES ON FRANCHISEE RECEIVABLES The allowance for losses on Franchisee Receivables, which was established in fiscal 2014, consists of the following: NOTE 4-OTHER CURRENT AND LONG-TERM LIABILITIES Other current and long-term liabilities consist of the following: SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5-GOODWILL AND INTANGIBLE ASSETS Goodwill We recorded a $167.0 million non-cash goodwill impairment charge in the third quarter of fiscal 2014. We reviewed the Hometown Stores and Home Appliance Showrooms ("Hometown Reporting Unit") goodwill for impairment annually at the beginning of the fourth fiscal quarter and whenever events or changes in circumstances indicated the carrying value of goodwill might not be recoverable. The goodwill impairment test involved a two-step process. In the first step, SHO compared the fair value of the Hometown Reporting Unit to its carrying value. If the fair value of the Hometown Reporting Unit exceeded its carrying value, goodwill was not impaired and no further testing was required. If the fair value of the Hometown Reporting Unit was less than its carrying value, SHO performed the second step of the impairment test to measure the amount of impairment loss. In the second step, the Hometown Reporting Unit's fair value was allocated to all of the assets and liabilities of the Hometown Reporting Unit, including any unrecognized intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the Hometown Reporting Unit were being acquired in a business combination. If the implied fair value of the Hometown Reporting Unit's goodwill was less than its carrying value, the difference was recorded as a non-cash impairment loss. During the third quarter of fiscal 2014 we determined that sufficient indicators of potential impairment existed to require that we conduct an interim impairment analysis of the Hometown Reporting Unit's goodwill. These indicators included a significant and sustained decline in the recent trading values of SHO's stock, coupled with market conditions and business trends affecting the Hometown Reporting Unit. The primary operating factors were declines in revenue and profitability for fiscal 2014. Merchandise revenues in fiscal 2014 were impacted by the highly promotional environment, along with other factors that caused declines in comparable store sales and related profitability below expectations for the Hometown Reporting Unit. SHO estimated the fair value of the Hometown Reporting Unit using a weighting of fair values derived from the income approach and the market approach. Under the income approach, SHO calculated the fair value of the Hometown Reporting Unit based on the present value of the Hometown Reporting Unit's estimated future cash flows. The cash flow projections were based on management's estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. SHO used a discount rate that was based on a weighted average cost of capital adjusted for the relevant risk associated with the characteristics of the Hometown Reporting Unit and its projected cash flows. SHO's market approach used estimated fair values based on market multiples of revenue and earnings derived from comparable publicly traded companies with operating and investment characteristics that were comparable to the operating and investment characteristics of the Hometown Reporting Unit. Due to the complexity and the effort required to estimate the fair value of the Hometown Reporting Unit for the first step of the impairment test and to estimate the fair values of all assets and liabilities of the Hometown Reporting Unit for the second step of the impairment test, SHO used fair value estimates that were derived based on assumptions and analyses that are subject to change. SHO’s first-step evaluation concluded that the fair value of the Hometown Reporting Unit was substantially below its carrying value. Based on SHO's second-step analyses, the implied fair value of the Hometown Reporting Unit's goodwill was $0. As a result, a full impairment of goodwill was required and we recorded a $167.0 million non-cash goodwill impairment charge in fiscal 2014, which is reflected as "Impairment of goodwill" in the Consolidated Statements of Operations. The primary factor that contributed to the goodwill impairment loss was the aforementioned 2014 operating issues leading to less-optimistic forecasts for the remainder of fiscal 2014 and fiscal 2015 and the projected corresponding impact beyond those periods. Intangible assets Intangible assets consist of the following: SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In the fourth quarter of 2015 the Company repurchased a total of 58 franchised locations. These repurchase transactions included the execution of definitive asset purchase and termination agreements which terminated the franchise agreements and sublease arrangements for those locations. These definitive agreements also required the Company to purchase store furniture, fixtures, and equipment. The franchisees of the affected locations were obligors on promissory notes payable to the Company and as part of the definitive agreements, the Company wrote-off the franchisee note receivable balances net of the value of the reacquisition rights and the value of the furniture, fixtures, and equipment that the Company purchased. Reacquisition rights were recorded at estimated fair value using the income approach. Reacquisition rights are definite-life assets, and as such, we record amortization expense based on a method that most appropriately reflects our expected cash flows from these assets with a weighted-average amortization period of 2.3 years. Amortization expense for reacquisition rights was $1.7 million and $0 for the years ended January 30, 2016 and January 31, 2015, respectively. Amortization expense is estimated to be $2.7 million in 2016, $1.3 million in 2017, $0.3 million in 2018, and $0.1 million in 2019. NOTE 6-INCOME TAXES In connection with the Separation, SHO and Sears Holdings entered into a Tax Sharing Agreement with Sears Holdings that governs the rights and obligations of the parties with respect to pre-Separation and post-Separation tax matters. Under the Tax Sharing Agreement, Sears Holdings is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the Separation. For all periods after the Separation, the Company is responsible for any federal, state or foreign tax liability. Current income taxes payable for any federal, state or foreign income tax returns is reported in the period incurred. We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. The Company is present in a large number of taxable jurisdictions and, at any point in time, can have audits underway at various stages of completion in one or more of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite the belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closings of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. Pursuant to the Tax Sharing Agreement, Sears Holdings is responsible for any unrecognized tax liabilities or benefits through the date of the Separation and the Company is responsible for any uncertain tax positions after the Separation. For 2015, 2014 and 2013, no unrecognized tax benefits have been identified and reflected in the financial statements. All of our tax years remain open since the Separation. We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. As no unrecognized tax benefits have been identified and reflected in the consolidated financial statements, no interest or penalties related to unrecognized tax benefits are reflected in the consolidated balance sheets or statements of operations. As of January 28, 2012 the assets and liabilities of the Sears Hometown and Hardware and Sears Outlet businesses were owned by subsidiaries of Sears Holdings. On August 31, 2012, through a series of intercompany transactions Sears Holdings and several of its subsidiaries transferred the assets and liabilities comprising the Sears Hometown and Hardware and Sears Outlet businesses to SHO. In connection with the intercompany transactions, for tax purposes the transferred assets and liabilities were stepped up to their estimated fair market values as of August 31, 2012, but for financial statement purposes the book value of the assets and liabilities remained unchanged at their historical cost bases. This tax adjustment related to the Separation was accounted for as an equity contribution that increased net deferred tax assets by $80.4 million reflecting the stepped-up tax basis in excess of the book basis that occurred in connection with the intercompany transactions described above, primarily for merchandise inventories, favorable leases, fixed assets, and royalty-free licenses to use the "Sears" name. In 2015, a property that was not included in the 2012 valuation was revalued to its estimated 2012 fair market value. The increase in tax basis related to this property was recorded in 2015 as an increase to deferred tax assets of $7.6 million with the offset reflected as an equity contribution. Because this non-cash adjustment only impacts the balance sheet in each of the years it was unrecorded and its impact is not material to the consolidated financial statements based on management’s assessment of SEC Staff Accounting Bulletin No. 99, this correction was recorded in 2015 and no prior periods were adjusted. The provisions for income tax expense for 2015, 2014 and 2013 consist of the following: SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The provisions for income taxes for financial reporting purposes is different from the tax provision computed by applying the statutory federal tax rate. The reconciliation of the tax rate follows: SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The major components of the deferred tax assets and liabilities as of January 30, 2016 and January 31, 2015 are as follows: We account for income taxes in accordance with accounting standards for such taxes, which require that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. Accounting standards also require that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of or all of the deferred tax assets will not be realized. Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets. For the majority of our deferred tax assets, which are U.S. based, management continues to monitor its operating performance and currently believes that the achievement of the required future taxable income necessary to realize these deferred assets is more-likely-than-not. Key considerations in this assessment include our cumulative pre-tax profit during the past three years, excluding non-deductible goodwill, and the extensive period of time available to generate future taxable income. It is reasonably possible that this belief could change in the near term requiring the establishment of additional valuation allowances which could significantly impact our operating results. A significant piece of negative evidence evaluated concerned the estimated future foreign taxable income available to use the foreign tax credit and the Puerto Rico AMT credit carryforward deferred tax assets of $1.4 million. On the basis of this analysis, for the years ended January 30, 2016 and January 31, 2015, a valuation allowance of $0.8 million and $0.1 million, respectively, was recognized to reduce this deferred tax asset since it does not meet the more-likely-than-not standard for realization. For the year ended January 30, 2016, the valuation allowance was increased by $0.7 million through tax expense due to changes in Puerto Rican law. We will continue to evaluate our valuation allowance in future years for any change in circumstances that causes a change in judgment about the realization of the deferred tax asset. At the end of 2015, we had a federal net operating loss (“NOL”) of $22.7 million which will expire in 2036. At the end of 2015 and 2014, we had state NOLs of $2.9 million and $0.3 million, respectively, which will expire between 2019 and 2036. We have credit carryforwards of $1.5 million which will expire between 2023 and 2036. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7-RELATED-PARTY AGREEMENTS AND TRANSACTIONS According to publicly available information, ESL beneficially owns approximately 51% of our outstanding shares of common stock and approximately 57% of Sears Holdings' outstanding shares of common stock. We are party to various agreements with Sears Holdings which, among other things, (1) govern specified aspects of our relationship with Sears Holdings, (2) establish terms under which subsidiaries of Sears Holdings are providing services to us, and (3) establish terms pursuant to which subsidiaries of Sears Holdings are obtaining merchandise inventories for us. The terms of these agreements were agreed to prior to the Separation in the context of a parent-subsidiary relationship and in the overall context of the Separation. The following is a summary of the nature of the related-party transactions between SHO and Sears Holdings: • We are party to a Separation Agreement with Sears Holdings pursuant to which Sears Holdings consummated the Separation. The Separation Agreement, among other things, provided for the allocation and transfer, through a series of intercompany transactions, of the assets and the liabilities comprising the Sears Hometown and Hardware and Sears Outlet businesses of Sears Holdings. In the Separation Agreement SHO and Sears Holdings agree to release each other from all pre-separation claims (other than with respect to the agreements executed in connection with the Separation) and each agrees to defend and indemnify the other with respect to its post-separation business. • We obtain a significant amount of our merchandise inventories from Sears Holdings. This enables us to take advantage of the amount and scope of Sears Holdings purchasing activities. We are party to a Merchandising Agreement with Sears Holdings, Kmart and SRC (the "Merchandising Agreement") pursuant to which Kmart and SRC (1) sell to us, with respect to certain specified product categories, Sears-branded products including KCD Products and vendor-branded products obtained from Kmart’s and SRC’s vendors and suppliers and (2) grant us licenses to use the trademarks owned by Kmart, SRC or other subsidiaries of Sears Holdings, or the "Sears marks," including the KCD Marks in connection with the marketing and sale of products sold under the Sears marks. The initial term of the Merchandising Agreement will expire in April 2018, subject to two three-year renewal terms with respect to the KCD Products. We pay, on a weekly basis, a royalty determined by multiplying our net sales of the KCD Products by specified fixed royalties rates for each brand’s licensed products, subject to adjustments based on the extent to which we feature Kenmore brand products in certain of our advertising and the extent to which we pay specified minimum commissions to our franchisees and Hometown Store owners. We are also party to agreements with Sears Holdings for related logistics, handling, warehouse and transportation services, the charges for which are based generally on merchandise inventory units. We also pay fees for participation in Sears Holdings' SYW program. • We obtain our merchandise from Sears Holdings and other vendors. For the year ended January 30, 2016, products which we acquired from Sears Holdings, including KCD Products and other products, accounted for approximately 82% of our total purchases of inventory from all vendors with a comparable level of purchases from Sears Holdings in 2014 and 2013. The loss of or a reduction in the amount of merchandise made available to us by Sears Holdings could have a material adverse effect on our business and results of operations. • Sears Holdings provides the Company with specified corporate services. These services include tax, accounting, procurement, risk management and insurance, advertising and marketing, human resources, loss prevention, environmental, product and human safety, facilities, logistics and distribution, information technology (including the point-of-sale system used by the Company and our dealers and franchisees), online, payment clearing, and other financial, real estate management, merchandise-related and other support services. Sears Holdings charges the Company for these corporate services generally based on actual usage, a pro rata charge based upon sales, head count, or square footage, or a fixed fee or commission as agreed between the parties. • Sears Holdings has licensed the Company until October 11, 2029, on a royalty-free basis, to use under specified conditions (1) the name "Sears" in our corporate name and to promote our businesses and (2) the www.searsoutlet.com, www.searshomeapplianceshowroom.com, www.searshometownstores.com, and www.searshardwarestores.com domain names to promote our businesses. Also, Sears Holdings has licensed the Company until October 11, 2029, on an exclusive, royalty-free basis, under specified conditions to use for the purpose of operating our stores the names "Sears Appliance SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS & Hardware," "Sears Authorized Hometown Stores," "Sears Hometown Store," "Sears Home Appliance Showroom," "Sears Hardware," and "Sears Outlet Store." • Sears Holdings has assigned to us leases for, or has subleased to us, many of the stores that we operate or that we have, in turn, subleased to franchisees. Generally, the terms of the subleases match the terms, including the payment of rent and expiration date, of the existing leases between Sears Holdings (or one of its subsidiaries) and the landlord. In addition, a small number of our stores are in locations where Sears Holdings currently operates one of its stores or a distribution facility. In such cases we have entered into a lease or sublease with Sears Holdings (or one of its subsidiaries) for the portion of the space in which our store will operate, and we pay rent directly to Sears Holdings on the terms negotiated in connection with the Separation. We also lease from Sears Holdings office space for our corporate headquarters. • SHO receives commissions from Sears Holdings for specified sales of merchandise made through www.sears.com and www.searsoutlet.com, the sale of extended-service plans, delivery and handling services and relating to the use in our stores of credit cards branded with the Sears name. For certain transactions SHO pays a commission to Sears Holdings. These agreements may be terminated by either party upon a material breach if the breaching party fails to cure such breach within 30 days following written notice of such breach or, if such breach is not curable, immediately upon delivery of notice of the non-breaching party’s intention to terminate. The following table summarizes the transactions with Sears Holdings included in the Company’s Consolidated Financial Statements: We incur payables to Sears Holdings for merchandise inventory purchases and service and occupancy charges (net of commissions) based on the SHO-Sears Holdings agreements. Amounts due to or from Sears Holding are non-interest bearing and are settled on a net basis. We generally pay undisputed amounts within 10 days after the invoice date. During our 2015 fiscal year we paid Seritage Growth Properties $0.5 million for occupancy charges for three properties we lease from Seritage. Edward S. Lampert is the Chairman of the Board of Trustees of Seritage. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8-FINANCING ARRANGEMENT In October 2012 the Company entered into a Credit Agreement with a syndicate of lenders, including Bank of America, N.A., as administrative agent, which provides (subject to availability under a borrowing base) for aggregate maximum borrowings of $250 million (the "Senior ABL Facility"). Under the Senior ABL Facility the Company initially borrowed $100 million which was used to pay a cash dividend to Sears Holdings prior to the Separation. As of January 30, 2016 we had $68.3 million outstanding under the Senior ABL Facility, which approximated the fair value of these borrowings. The Senior ABL Facility provides (subject to availability under a borrowing base) for maximum borrowings up to the aggregate commitments of all of the lenders, which as of January 30, 2016 totaled $250 million. Up to $75 million of the Senior ABL Facility is available for the issuance of letters of credit and up to $25 million is available for swingline loans. The Senior ABL Facility permits us to request commitment increases in an aggregate principal amount of up to $100 million. Availability under the Senior ABL Facility as of January 30, 2016 was $176.0 million, with $5.7 million of letters of credit outstanding under the facility. The principal terms of the Senior ABL Facility are summarized below. Senior ABL Facility Maturity; Amortization and Prepayments The Senior ABL Facility will mature on the earlier of (i) October 11, 2017 or (ii) six months prior to the expiration of the Merchandising Agreement and the other agreements with Sears Holdings or its subsidiaries in connection with the Separation that are specified in the Senior ABL Facility, unless such agreements have been extended to a date later than October 11, 2017 or terminated on a basis reasonably satisfactory to the administrative agent under the Senior ABL Facility. The Senior ABL Facility is subject to mandatory prepayment in amounts equal to the amount by which the outstanding extensions of credit exceed the lesser of the borrowing base and the commitments then in effect. Guarantees; Security The obligations under the Senior ABL Facility are guaranteed by us and each of our existing and future direct and indirect wholly owned domestic subsidiaries (subject to certain exceptions). The Senior ABL Facility and the guarantees thereunder are secured by a first priority security interest in certain assets of the borrowers and guarantors consisting primarily of accounts receivable, inventory, cash, cash equivalents, deposit accounts and securities accounts, as well as certain other assets (other than intellectual property) ancillary to the foregoing and all proceeds of all of the foregoing, including cash proceeds and the proceeds of applicable insurance. Interest; Fees The interest rates per annum applicable to the loans under the Senior ABL Facility are based on a fluctuating rate of interest measured by reference to, at our election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin, which rate was approximately 2.43% at January 30, 2016 or (2) an alternate base rate plus a borrowing margin, with the borrowing margin subject to adjustment based on the average excess availability under the Senior ABL Facility for the preceding fiscal quarter, which rate was approximately 4.50% at January 30, 2016. Customary fees are payable in respect of the Senior ABL Facility, including letter of credit fees and commitment fees. Covenants The Senior ABL Facility includes a number of covenants that, among other things, limit or restrict our ability to, subject to specified exceptions, incur additional indebtedness (including guarantees), grant liens, make investments, make prepayments on other indebtedness, engage in mergers, or change the nature of our business. The Senior ABL Facility limits SHO's ability to declare and pay cash dividends and repurchase its common stock. SHO may declare and pay cash dividends to its stockholders and may repurchase stock if the following conditions are satisfied: either (a) (i) no specified default then exists or would arise as a result of the declaration or payment of the cash dividend or as a result of the stock repurchase, (ii) SHO and its subsidiaries that are also borrowers have demonstrated to the reasonable satisfaction of the agent for the lenders that monthly availability (as determined in accordance with the Senior ABL Facility), immediately following the declaration and payment of the cash dividend or the stock repurchase and as projected on a pro forma basis for the SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS twelve months following and after giving effect to the declaration and payment of the cash dividend or the stock repurchase, would be at least equal to the greater of (x) 25% of the Loan Cap (which is the lesser of (A) the aggregate commitments of the lenders and (B) the borrowing base) and (y) $50,000,000, and (iii) after giving pro forma effect to the declaration and payment of the cash dividend or the stock repurchase as if it constituted a specified debt service charge, the specified consolidated fixed charge coverage ratio, as calculated on a trailing twelve months basis, would be equal to or greater than 1.1:1.0, or (b) (i) no specified default then exists or would arise as a result of the declaration or payment of the cash dividend or the stock repurchase, (ii) payment of the cash dividend or the stock repurchase is not made with the proceeds of any credit extension under the Senior ABL Facility, (iii) during the 120-day period prior to declaration and payment of the cash dividend or the stock repurchase, no credit extension was outstanding under the Senior ABL Facility, and (iv) SHO demonstrates to the reasonable satisfaction of the agent for the lenders that, on a pro forma and projected basis, no credit extensions would be outstanding under the Senior ABL Facility for the 120-day period following the declaration and payment of the cash dividend or the stock repurchase. No default or event of default presently exists. At January 30, 2016 we did not meet either of the foregoing conditions and as a result the Senior ABL Facility does not permit us to pay cash dividends or repurchase our common stock. The Senior ABL Facility also contains certain affirmative covenants, including financial and other reporting requirements. As of January 30, 2016, SHO was in compliance with all covenants under the Senior ABL Facility. Events of Default The Senior ABL Facility includes customary and other events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, change of control, failure to perform a "Material Contract" (which includes the Merchandising Agreement and other SHO-Sears Holdings Agreements) to the extent required to maintain it in full force and effect, the failure to enforce a Material Contract in accordance with its terms, or Sears Holdings terminates the "Separation Agreements" (which include, among other SHO-Sears Holdings Agreements, the Merchandising Agreement and the Services Agreements). SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9-SUMMARY OF SEGMENT DATA The Hometown reportable segment consists of the aggregation of our Hometown Stores, Hardware Stores and Home Appliance Showroom formats. The Outlet reportable segment also represents a business format. These segments are evaluated by our Chief Operating Decision Maker to make decisions about resource allocation and to assess performance. Each of these segments derives its revenues from the sale of merchandise and related services to customers, primarily in the United States. The Net Sales categories include appliances, lawn and garden, tools and paint and other. The other category includes initial franchise revenue of $(0.1) million, $0.3 million and $5.5 million from Hometown in 2015, 2014 and 2013, respectively, and $0.4 million, $16.6 million and $20.1 million from Outlet in 2015, 2014 and 2013, respectively. Initial franchise revenues consist of franchise fees paid with respect to new and existing Company-operated stores that we transfer to franchisees plus the net gain or loss on any related transfer of assets to the franchisees. Selling and administrative expense includes losses on franchisee notes receivables and IT transformation costs of $20.1 million, $13.0 million and $0 for Hometown in 2015, 2014 and 2013, respectively, and $16.2 million, $0.1 million and $0 for Outlet in 2015, 2014 and 2013, respectively. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 -QUARTERLY FINANCIAL DATA (UNAUDITED) Revision of Prior Period Interim Financial Statements In the fourth quarter of 2015, the Company reevaluated and identified an error in its accounting for the previously announced IT transformation project that began in the first quarter of 2015. This error was identified by considering the existing literature in ASC 350-40, “Goodwill - Intangibles and Other - Internal - Use Software,” and the recently issued FASB update, ASU 2015-05, “Intangibles Goodwill and Other - Internal Use Software, Customer's Accounting For Fees Paid in a Cloud Computing Arrangement.” Based on this evaluation the Company determined that the IT transformation costs are more appropriately accounted for under a service model, where costs are expensed as services are provided rather than capitalized. Accordingly, in the fourth quarter of 2015, the Company corrected its accounting by expensing $6.3 million of IT transformation costs that had been previously capitalized during the first three quarters of 2015. Transformation costs capitalized in each of the first, second and third quarters in the year ended January 30, 2016 were $1.2 million, $2.7 million and $2.4 million respectively; no similar costs were incurred in prior years. In accordance with the SEC’s Staff Accounting Bulletin (“SAB”) No. 99, the Company assessed the materiality of these errors and determined that for each of the quarters in the year ended January 30, 2016 the errors were immaterial. The Company further assessed the materiality of these errors to each of its previously reported 2015 interim financial statements in accordance with the SAB No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements," and concluded that the errors were not material to any of those periods as previously reported. The Company also concluded that, had the errors been restated within the fourth quarter of 2015, the impact of such adjustments could potentially be material to that period. As such, the following tables reflect the correction of our unaudited quarterly consolidated statements of operations and certain balance sheet and cash flow amounts for the periods indicated. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11-COMMITMENTS AND CONTINGENCIES We are subject to various legal and governmental proceedings arising out of the ordinary course of business, the outcome of which, individually and in the aggregate, in the opinion of management, would not have a material adverse effect on our business, financial position, or results of operations or cash flows. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12-INCOME (LOSS) PER COMMON SHARE Basic income (loss) per common share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding for each period. Diluted income (loss) per common share also includes the dilutive effect of potential common shares. The following table sets forth the components used to calculate basic and diluted income (loss) per common share attributable to our stockholders. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 - EQUITY Stock-based Compensation Four million shares of the Company's common stock are reserved for issuance under the Company's Amended and Restated 2012 Stock Plan (the "Plan"). A total of 89,221 shares of restricted stock were granted under the Plan in the second quarter of 2013 to a group of eligible individuals (as defined in the Plan) and 14,000 shares of restricted stock were granted under the Plan to an eligible individual in the second quarter of 2015. All of the eligible individuals were employees of the Company at the time of the grants. As of January 30, 2016, 47,263 shares of the original grant of 89,221 shares of restricted stock had been forfeited. During the first quarter of 2015 the Company granted a total of 159,475 stock units under the Plan (all of which stock units are payable solely in cash based on our stock price at the vesting date) to a group of eligible individuals, all of whom were employees of the Company at the time of the grants. As of January 30, 2016, 28,237 stock units had been forfeited. The estimated amount due related to the stock units of $0.3 million is included in other current liabilities at January 30, 2016. We are authorized to grant stock options and to make other awards (in addition to restricted stock and stock units) to eligible participants pursuant to the Plan. The Company has made no stock-option awards under the Plan. Except for the 103,221 shares of restricted stock and the 159,475 stock units, the Company has made no grants or awards under the Plan. We do not currently have a broad-based program that provides for awards under the Plan on an annual basis. We account for stock-based compensation using the fair value method in accordance with accounting standards regarding share-based payment transactions. During the fiscal year we recorded $(0.1) million in total compensation expense for the remaining 55,958 shares of restricted stock, including the reversal of approximately $0.7 million of compensation expense related to severance and executive transition costs, and $0.3 million in total compensation expense for the remaining 131,238 stock units (none of which had vested as of January 30, 2016). At January 30, 2016 we had $0.3 million in total unrecognized compensation cost related to the remaining non-vested restricted stock, which cost we expect to recognize over approximately the next two years. At January 30, 2016, we had $0.7 million in total unrecognized compensation cost related to the remaining non-vested stock units, which cost we expect to recognize over approximately the next two years. The remaining 41,958 shares of restricted stock originally granted will vest, if at all, on May 16, 2016, and 14,000 shares of restricted stock granted in 2015 will vest, if at all, on July 10, 2017, in accordance with and subject to the terms and conditions of restricted-stock agreements (including forfeiture conditions) and the Plan. The fair value of these awards is equal to the market price of our common stock on the date of grant. Changes in restricted-stock awards for 2015 were as follows: Share Repurchase Program On August 28, 2013 the Company's Board of Directors authorized a $25 million repurchase program for the Company's outstanding shares of common stock. The timing and amount of repurchases depend on various factors, including market conditions, the Company's capital position and internal cash generation, and other factors. The Company's repurchase program does not include specific price targets, may be executed through open-market, privately negotiated, and other transactions that may be available, and may include utilization of Rule 10b5-1 plans. The repurchase program does not obligate the Company to repurchase any dollar amount, or any number of shares, of common stock. The repurchase program does not have a termination date, and the Company may suspend or terminate the repurchase program at any time. Shares that are repurchased by the Company pursuant to the repurchase program are retired and resume the status of authorized and unissued shares of common stock. During the third quarter of 2013 the Company adopted a Rule 10b5-1 plan that terminated on December 6, 2013. At January 30, 2016 the Senior ABL Facility prohibited cash dividends and the repurchase of our common stock. SEARS HOMETOWN AND OUTLET STORES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS No shares were repurchased during fiscal years 2015 and 2014. During the 2013 fiscal year we repurchased 434,398 shares of our common stock at a total cost of $12.5 million. Our repurchases for the fiscal year ended February 1, 2014 were made at an average price of $28.83. We account for the repurchased and retired shares by reducing par value and capital in excess of par value up to the per share amount recorded in connection with the Separation, with the excess repurchase price recorded as a reduction to retained earnings. At January 30, 2016 we had $12.5 million of remaining authorization under the repurchase program. NOTE 14-DEFINED CONTRIBUTION PLAN We sponsor a Sears Hometown and Outlet Stores, Inc. 401(k) savings plan for employees meeting service-eligibility requirements. The Company offers a discretionary match contribution. The expense related to the savings plan has been determined in accordance with U.S. GAAP and the Company accrues the cost of these benefits during the years that employees render service. Expenses for the retirement savings plan were as follows: Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Sears Hometown and Outlet Stores, Inc. Hoffman Estates, Illinois We have audited the accompanying consolidated balance sheets of Sears Hometown and Outlet Stores, Inc. (the "Company") as of January 30, 2016 and January 31, 2015 and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended January 30, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at January 30, 2016 and January 31, 2015, and the results of its operations and its cash flows for each of the three years in the period ended January 30, 2016, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of January 30, 2016 based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 31, 2016 expressed an unqualified opinion thereon. /s/ BDO USA, LLP BDO USA, LLP Chicago, Illinois March 31, 2016
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Based on the provided excerpt, here's a summary of the key financial statement points:
1. Receivables:
- Losses on franchisee receivables are estimated based on probable losses
- Allowance is calculated by analyzing:
* Expected future write-offs
* Economic conditions
* Specific at-risk receivables
2. Inventory Valuation:
- Uses Retail Inventory Method (RIM)
- Primarily uses Last-In, First-Out (LIFO) cost-flow assumption
- Involves management estimates of:
* Markons
* Markups
* Markdowns
* Shrinkage
- Inventory allowance for shrinkage and obsolescence was $9.8
3. Business Structure:
- Includes Sears Hometown and Hardware and Sears Outlet businesses
- Transferred liabilities to SHO
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA GREENKRAFT, INC. Index to Financial Statement Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Balance Sheets for the years ended December 31, 2016 and 2015 Statements of Operations for the years ended December 31, 2016 and 2015 Statements of Changes in Stockholders’ Deficit for the years ended December 31, 2016 and 2015 Statements of Cash Flows for the years ended December 31, 2016 and 2015 Notes to Financial Statements ACCOUNTING FIRM To the Board of Directors and Shareholders of Greenkraft, Inc. Santa Ana, California We have audited the accompanying balance sheet of Greenkraft, Inc. (the “Company”) as of December 31, 2016, and the related statements of operations, stockholders’ deficit, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016, and the related results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. /s/ Simon & Edward, LLP Diamond Bar May 1, 2017 ACCOUNTING FIRM To the Board of Directors and Shareholders of Greenkraft, Inc. Santa Ana, California We have audited the accompanying balance sheet of Greenkraft, Inc. (the “Company”) as of December 31, 2015, and the related statement of operations, stockholders’ deficit, and cash flow for the year ended December 31, 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2015, and the related result of its operations and its cash flow for the year ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America. /s/ MaloneBailey, LLP www.malone-bailey.com Houston, Texas May 23, 2016 GREENKRAFT, INC. BALANCE SHEETS The accompanying notes are an integral part of these financial statements. GREENKRAFT, INC. STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these financial statements. GREENKRAFT, INC. STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT The accompanying notes are an integral part of these financial statements. GREENKRAFT, INC. STATEMENT OF CASH FLOWS The accompanying notes are an integral part of these financial statements. GREENKRAFT, INC. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 NOTES TO FINANCIAL STATEMENTS: NOTE 1-ORGANIZATION AND BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES Nature of Business. Greenkraft, Inc. is a manufacturer and distributor of automotive products. We manufacture commercial forward cabin trucks for vehicles weighing from 14,001 lbs. to 33,000 lbs. in alternative fuels. We also manufacture and sell alternative fuel systems to convert petroleum-based fuels to natural gas and propane fuels. Basis of Presentation - The accompanying financial statements of the Company were prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). Reclassifications - Certain prior year amounts have been reclassified to conform with the current year presentation. Use of estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States necessarily requires management to make estimates and assumptions that affect the amounts reported in the financial statements. We regularly evaluate estimates and judgments based on historical experience and other relevant facts and circumstances. Actual results could differ from those estimates. Concentration of credit risk -Financial instruments which potentially subject the Company to concentrations of credit risk consist of cash and trade receivables. The Company places its cash with high credit quality financial institutions. At times, such cash may be in excess of the FDIC limit. With respect to trade receivables, the Company routinely assesses the financial strength of its customers and, as a consequence, believes that the receivable credit risk exposure is limited. Cash and cash equivalents - Cash equivalents are highly liquid investments with an original maturity of three months or less. We do have restricted cash in the amount of $1,506,152 as of December 31, 2015, which will be utilized for a stand by letter of credit requested by suppliers. Accounts Receivable - Trade accounts receivable consist of amounts due from the sale of trucks. Accounts receivable are uncollateralized customer obligations due under normal trade terms requiring payment within 90 days of receipt of the invoice. The Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts based on historical collection experience and a review of the current status of trade accounts receivable. At December 31, 2016 and 2015, the Company characterized $0 and $0 as uncollectible, respectively. At December 31, 2016, the accounts receivable represents one customer from the sale of trucks. Inventories - Inventories are primarily raw materials. Inventories are valued at the lower of, cost as determined on a first-in-first-out (FIFO) basis, or market. Market value is determined by reference to selling prices after the balance sheet date or to management’s estimates based on prevailing market conditions. Management writes down the inventories to market value if it is below cost. Management also regularly evaluates the composition of its inventories to identify slow-moving and obsolete inventories to determine if valuation allowance is required. Costs of raw material inventories include purchase and related costs incurred in bringing the products to their present location and condition. The estimated cost of inventory not expected to be converted to cash within one year is reflected as “Inventory, long term” in the balance sheet. Property and equipment - Property and equipment are carried at the cost of acquisition or construction and depreciated over the estimated useful lives of the assets. Costs associated with repair and maintenance are expensed as incurred. Costs associated with improvements which extend the life, increase the capacity or improve the efficiency of our property and equipment are capitalized and depreciated over the remaining life of the related asset. Gains and losses on dispositions of equipment are reflected in operations. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, which are ten years for all the equipment’s held by the Company. Depreciation expense of $8,205 and $10,943 are recognized for the year ended December 31, 2016 and 2015. Research and development - Costs incurred in connection with the development of new products and manufacturing methods are charged to selling, general and administrative expenses as incurred. During the years ended December 31, 2016 and 2015, $17,545 and $55,956, respectively, were expensed as research and development costs. Long Lived Assets - In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 360, Property, Plant and Equipment, the Company tests long-lived assets or asset groups for recoverability when events or changes in circumstances indicated that their carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset; significant adverse changes in the business climate or legal factors; accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset; and a current expectation that the asset will more likely than not be sold or disposed significantly before the end of its estimated useful life. Recoverability is assessed based on the carrying amount of the asset and its fair value which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. Revenue recognition - Greenkraft recognizes revenue when persuasive evidence of an arrangement exists, products and/or services have been delivered, the sales price is fixed or determinable, and collectability is reasonably assured. This typically occurs when the product is shipped or delivered to the customer. Cash payments received prior to delivery of products are deferred until the products are delivered. Also, there was funding for the incremental cost of the vehicles was provided by the California Energy Commission (CEC). The CEC provides up to (i) $20,000 per vehicle that are up to 26,000 LBS GVWR and (ii) $26,000 per vehicle that are over 26,000 LBS GVWR. These funds are paid directly to us and taken in as deposits until actual delivery of the vehicles at which time it is deemed revenue. The Company has received $1.140 million from the CEC related to the sale of CNG and propane trucks as of December 31, 2016 and 2015. Income taxes - Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. These assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to reverse. We have net operating loss carry forwards available to reduce future taxable income. Future tax benefits for these net operating losses carry forwards are recognized to the extent that realization of these benefits is considered more likely than not. To the extent that we will not realize a future tax benefit, a valuation allowance is established. Earning or Loss per Share - The Company accounts for earnings per share pursuant to ASC 260, Earnings per Share, which requires disclosure on the financial statements of "basic" and "diluted" earnings (loss) per share. Basic earnings (loss) per share are computed by dividing net income (loss) by the weighted average number of common shares outstanding for the year. Diluted earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding plus common stock equivalents (if dilutive) related to stock options and warrants for each year. As there was a net loss for the year ended December 31, 2016 and 2015, basic and diluted losses per share are the same for the year ended December 31, 2016 and 2015. Related Parties - A party is considered to be related to the Company if the party directly or indirectly or through one or more intermediaries, controls, is controlled by, or is under common control with the Company. Related parties also include principal owners of the Company, its management, members of the immediate families of principal owners of the Company and its management and other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. A party which can significantly influence the management or operating policies of the transacting parties or if it has an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests is also a related party. Recently issued accounting pronouncements - In August 2014, the Financial Accounting Standards Board ("FASB") issued a new standard on disclosure of uncertainties about an entity's ability to continue as a going concern. The new standard provides guidance on determining when and how reporting entities must disclose going concern uncertainties in their financial statements. The new standard requires management to perform interim and annual assessments of an entity's ability to continue as a going concern within one year of the date of issuance of the entity's financial statements. Additionally, an entity must provide certain disclosures if there is substantial doubt about the entity's ability to continue as a going concern. The new standard will be effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2016, and for annual period and interim periods thereafter. The adoption of this guidance did not have a significant impact on the Company’s financial statement. In May 2014, the FASB issued an accounting standards update which modifies the requirements for identifying, allocating, and recognizing revenue related to the achievement of performance conditions under contracts with customers. This update also requires additional disclosure related to the nature, amount, timing, and uncertainty of revenue that is recognized under contracts with customers. This guidance is effective for fiscal and interim periods beginning after December 15, 2017 and is required to be applied retrospectively to all revenue arrangements. The Company is currently assessing the effects this guidance may have on its financial statements. Other recently issued accounting standards are not expected to have a material effect on the Company's financial statements. NOTE 2 - RELATED PARTY TRANSACTIONS First Standard Real Estate LLC is the owner of 2530 S. Birch Street, Santa Ana, California 92707 where Greenkraft uses office space. The CEO is an owner of First Standard Real Estate. As of September 1, 2016 Greenkraft moved close to its headquarters at 2530 South Birch Street Santa Ana Ca 92707 for a rent fee of $10,000 per month. The rental agreement is a lease starting September 1, 2016 to September 30, 2021. The month of September, 2016 was free and the remaining time frame in 2016 rent expense payable to First Standard Real Estate is $30,000 with a deferred rent expense of $9,833 per month due to one month being free. The space that Greenkraft is rented has access to a larger portion for expansion when needed. The Defiance Company, LLC is owned by our CEO. As of December 31, 2016 and December 31, 2015, accounts payable to Defiance is $285,389 and $285,389, respectively, for amounts paid by Defiance Company, LLC on behalf of Greenkraft. As of December 31, 2016 and December 31, 2015 Greenkraft owed a total of $1,901,916 and $1,901,916, respectively, to our owner and his related entities. All amounts are due on demand, unsecured and do not bear interest. G&K Automotive Conversion Inc. is an automotive safety compliance company that can provide services to Greenkraft as necessary. No Services were provided by G&K for Greenkraft during the years ended December 31, 2016, or 2015. CEE, LLC performed testing for Greenkraft for engine certifications and also shared employees with Greenkraft. Our President is an owner of CEE, LLC. During 2016, and 2015, Greenkraft recognized $0 and $0, respectively, of contributed payroll expense related to the shared employees. Also Greenkraft owes CEE for insurance that CEE paid for employees of Greenkraft in the amount of $5,945 as of December 31, 2016 and 2015. First Warner Properties LLC is the owner of 2215 S Standard Ave Santa Ana CA 92707. Our president is a member of First Warner. Greenkraft leased the property as assembly plant from First Warner. The term of the lease agreement was from July 1, 2015 to December 31, 2019, with a monthly rent of $27,500. The total rent expense for December 31, 2016 and 2015 was $204,332 and $330,000, respectively. As of December 31, 2016 First Warner Properties LLC was owed $525,000 and for 2015 the amount owed was $467,500. Our CEO does not charge us a salary and therefore we have recognized $36,000 and $72,000 for 2016 and 2015, respectively of contributed salary expense. NOTE 3- PROPERTY AND EQUIPMENT For the years ended December 31, 2016 and 2015, depreciation expense of fixed assets totaled approximately $10,940 and $10,943, respectively. For the year 2016 we did not purchase fixed assets. The amount purchased in 2015 was $15,554. Fixed assets comprised the following as of December 31, 2016 and 2015. NOTE 4 - INVENTORIES Greenkraft’s 2016 inventory is $1,354,866 and long term assets is $539,229. For Greenkraft’s 2015, the inventory was $1,452,218 and long term assets were $621,939. At the end of each reporting period, management has estimated that portion of inventory not expected to be converted to cash within one year and reflected that amount as “Inventory, long term” in the accompanying balance sheets. NOTE 5 - LINE OF CREDIT In March 2012, Greenkraft entered into an agreement with Pacific Premier Bank for a $3,500,000 line of credit. The line of credit was due on April 10, 2013 and bears interest at the prime rate plus 1%. The line of credit is secured by certain real property owned by the majority shareholder and inventory. A condition to the line of credit is a full banking relationship. If the conditions are not met or should cease to be met, then interest rate and interest ceiling provided under the note shall immediately increase by 5.000 percentage points. As of December 31, 2015 Greenkraft was deemed to have a full banking relationship with Pacific Premier Bank. On July 15, 2013, the maturity date of the facility was extended to December 10, 2013 and the maximum amount available under such facility was reduced to $2 million. On August 22, 2014, Greenkraft entered into a Loan Modification Agreement with Pacific Premier Bank under which it extended the Maturity Date until August 22, 2015. The cost to modify the loan for 2014 was $4,052.50. In addition, Pacific Premier Bank agreed to issue a $3,000,000 standby letter of credit in favor a supplier from whom Greenkraft purchases products in connection with its production of alternative fuel trucks. In connection with this letter of credit, Greenkraft authorized Pacific Premier to draw an additional $1,500,000 under its note for any funds paid or required to be paid by Pacific Premier under the letter of credit. Thus the current maximum amount available under the line of credit is $3,500,000. There was a fee of $30,000 in connection with the letter of credit. In addition Greenkraft has a restricted deposit of $1,500,000 with pacific premier that is being used as collateral for letter of credit. The letter of credit expired in August 2015 and was automatically renewed for another year. In 2014 the $30,000 fee is classified as deferred financing cost on balance sheet, and it is amortized over the term of the letter of credit. On September 21, 2015, Greenkraft entered into a short term extension with Pacific Premier Bank under which it extended the Maturity Date of its line until December 10, 2015. On January 14, 2016 Greenkraft entered into a short term extension with Pacific Premier Bank under which it extended the Maturity Date of its the line of credit to March 10, 2016. In March 2016, the Company cancelled the letter of credit of $3,500,000 and paid off the line of credit of $2,000,000 with Pacific Premier Bank. Due to the cancellation of letter of credit, the Company no longer require a restricted cash balance. The Company analyzed the modification of the term under ASC 470-60 “Trouble Debt Restructurings” and ASC 470-50 “Extinguishment of Debt”. The Company determined the modification is not substantial and did not result in an extinguishment. Along with the short term extension on September 21, 2015, and on January 14, 2016 the Company acknowledged that it was in breach of (a) its covenant to maintain a ratio of Global Debt Coverage in excess of 1.250 to 1.0, (b) its covenant to maintain a ratio of Business Debt Coverage Ratio in excess of 1.25 to 1; (c) its covenant to maintain a ratio of Debt/Worth not in excess of 3.0 to 1.0 and (d) its covenant to maintain a Tangible Net Worth of not less than $350,000 (collectively the “Covenant Violations”). Pacific Premier agreed to forbear enforcement of its rights arising out of these Covenant Violations until receipt of the Company’s financial statements for the year ended December 31, 2016. During 2016, the Company did not make any draws. The total amount borrowed under the line of credit was $1,998,850 as of December 31, 2015. As of December 31, 2016 the line of credit was paid in full. NOTE 6 - CONVERTIBLE NOTES Convertible promissory notes were issued in the aggregate amount of $15,000 in October 2015 for the marketing and advertising services received in 2015. During the quarter ended March 31, 2016, the Company re-classed the balance from accounts payable to notes payable. The term of the notes is due on demand. Simple interest of 1% is payable upon demand. Prior to maturity the notes may be converted for common stock at a conversion price of $0.001. The Company evaluated the embedded conversion feature within the above convertible notes under ASC 815-15 and ASC 815-40 and determined embedded conversion feature does not meet the definition of a liability. Then the Company evaluated the conversion feature for a beneficial conversion feature at inception. The Company accounted for the intrinsic value of a Beneficial Conversion Feature inherent to the convertible note payable and a total debt discount of $15,000 was recorded. During the year ended December 31, 2016, debt discount of $15,000 was amortized. As of December 31, 2016 convertible note has a balance of $7,500 net of $0 unamortized debt discount. On April 22, 2016, the holder of convertible note converted $7,500 of convertible note payable to 7,500,000 common shares NOTE 7- COMMON STOCK As of December 31 2016 and 2015, the Company had 400,000,000 Common shares authorized with a par value of $.0001 per share, of which 96,432,718 and 88,882,718 shares were issued and outstanding, respectively. On April 22, 2016, the holder of convertible note converted $7,500 of convertible note payable to 7,500,000 common shares. NOTE 8 - MAJOR CUSTOMERS In 2016, the Company had four customers each making up 10% or more of total truck sales revenue. The customers individually made up 16%, 25%, 12% and 14%. The remaining revenues were from several vehicle dealers for conversions of Isuzu and Ford trucks at a percentage of 33%. In 2015, the Company had two customers each making up 10% or more of total truck sales revenue. The customers individually made up 52% and 21%. The remaining revenues were from several truck customers and dealers for Greenkraft trucks and conversions of Isuzu trucks at a percentage of 8%. NOTE 9 - COMMITMENT AND CONTINGENCIES Greenkraft has a lease agreement with First Standard Real Estate LLC for rent. See Note 2. Future rental payments payable to the landlord under the lease as of December 31, 2016 were as follows: NOTE 10 - PROVISION FOR INCOME TAXES Greenkraft uses the liability method, where deferred tax assets and liabilities are determined based on the expected future tax consequences of temporary differences between the carrying amounts of assets and liabilities for financial and income tax reporting purposes. During fiscal 2016, the company incurred net losses and, therefore, had no tax liability. The net deferred tax asset generated by the loss carry-forward has been fully reserved. As of December 31, 2016, the tax years 2013 through 2015, and 2011 through 2015 are subject to examination by the federal and California taxing authorities, respectively. At December 31, 2016 and 2015, deferred tax assets consisted of the following: NOTE 11 -LIQUIDITY The accompanying financial statements have been prepared in accordance to FASB Subtopic 205-40, Presentation of Financial Statements-Going Concern. In connection with preparing financial statements for each annual and interim reporting period, an entity’s management should evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). Greenkraft’s management evaluated the current financial situation of the company and believes the company has no going concern within one year. During the year ended December 31, 2016, the Company incurred a loss from continuing operation of $777,416 and a net loss $792,962, and the stockholders’ deficit was $2,456,288 and the working capital deficit was $3,061,130. The working capital deficit have been majority funded by accounts payable to its related parties and related party debt. Based on the financial support letter from the CEO of Greenkraft, he and his related party entities, has no present or future plans or intentions to (A) liquidate Greenkraft, Inc.; (B) sell or otherwise dispose of all, or a significant portion of, its investment in the Company or otherwise change its capital structure; (C) discontinue providing financial support to Greenkraft, Inc; or (D) pursue the collection if the company has cash flow issues. Also, the company has 1.7 million government incentives as deferred revenue in current liability. Based on the cash burn calculation, the Company is expected to have sufficient cash flow to cover the normal business operation for the twelve month-ended December 31, 2017. In the next 12 months, the Company will continue to receive sales orders, recognize revenue by selling the qualified trucks for the government incentive program, committed financial support from the owner and his related parties to fund its ongoing operation until the Company is able to meet its own obligation as they become due. Management believes they will have sufficient funds to support their business based on the following: (a) revenues derived from signing up new dealers’ contracts and delivering alternative fuel trucks to them; (b) reclassify accounts payable- related parties and related parties’ debt as non- current liabilities in amount of $816,334 and $1,901,916, respectively, which is related to the financial support letter from the CEO, and (c) the CEO can raise additional funds needed to support our business plan. Management intends to seek new capital from owners and related parties to provide needed funds, as necessary. However, there can be no assurance that the Company can raise any additional funds, or if it can, that such funds will be on terms acceptable to the Company. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. NOTE 12 - SUBSEQUENT EVENTS There are no subsequent events to disclosure.
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Here's a summary of the financial statement:
Assets:
- Fixed assets total approximately $10,940
Depreciation:
- Straight-line method used
- Estimated useful life of equipment is 10 years
- Depreciation expense is $8,205
Expenses:
- Tax liabilities recognized for temporary differences between financial statement and tax bases
- Net operating loss carry forwards available
- Future tax benefits recognized if realization is more likely than not
- Valuation allowance established if future tax benefits are uncertain
Accounting Method:
- Follows ASC 260 for Earnings per Share
- Follows ASC 470 for Debt Restructurings
Overall, the statement suggests a small company with modest fixed assets, ongoing depreciation, and tax loss carry forwards, indicating potential financial challenges or a startup phase.
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Claude
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ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM The Board of Directors and Stockholders of Q2Power Technologies, Inc. We have audited the accompanying consolidated balance sheets of Q2Power Technologies and Subsidiary (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, stockholders’ deficit, and cash flows for each of the years then ended. The financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Q2Power Technologies and Subsidiary as of December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company’s lack of liquidity and working capital and its recurring operating losses raises substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ EisnerAmper LLP Fort Lauderdale, Florida May 25, 2017 Q2POWER TECHNOLOGIES, INC. CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements Q2POWER TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements Q2POWER TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 See notes to consolidated financial statements Q2POWER TECHNOLOGIES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS See notes to consolidated financial statements Q2POWER TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS Q2Power Technologies, Inc. (hereinafter the “Company”) was incorporated in Delaware on August 26, 2004. The Company is primarily a holding company for its sole subsidiary, Q2Power Corp. Formerly, the Company’s name was Anpath Group, Inc. (“Anpath”). Q2Power Corp. (the “Subsidiary” or “Q2P”), has operated a renewable power R&D company focused on the conversion of waste to energy and other valuable “reuse” products since July 2014. The operations of the Company are essentially those of the Subsidiary. In May 2016, the Company began exploring other synergistic business lines, such as composting from waste water biosolids. Although no operations in these fields have commenced, management has made progress towards identifying certain operational composting facilities in the U.S. for potential acquisition or partnership. Moving forward, the Company intends to phase out its R&D activities and focus entirely on the business of compost and engineered soils manufacturing and sales. On November 12, 2015, the Company and its special purpose merger subsidiary completed a merger (the “Merger”) with Q2P. As a result of the Merger, all outstanding shares of Q2P were exchanged for 24,034,475 shares of the Company’s common stock. In addition, the Company assumed both the Q2P 2014 Founders Stock Option Plan and the 2014 Employees Stock Option Plan (the “Option Plans”), and 1,095,480 options outstanding thereunder. Also pursuant to the Merger, the officers and directors of Q2P assumed control over the management and Board of Directors of the Company. Subsequent to the Merger, the Company officially changed its name to Q2Power Technologies, Inc. On December 1, 2015, in connection with the Merger the Company also sold its prior operating subsidiary, EnviroSystems Inc. (“ESI”), to three former shareholders in exchange for a return of 470,560 shares of the Company’s common stock. ESI assumed all debt, payables and a litigation judgment that was on its books as of the Merger date. On February 12, 2016, the Board of Directors of the “Company approved a change in the fiscal year end for the Company from March 31 to December 31. This change is a result of the Merger, and reflects the fiscal year-end period for Q2P. NOTE 2 - BASIS OF PRESENTATION AND GOING CONCERN The Company has incurred net losses of $1,497,723 and $3,536,021 for the years ended December 31, 2016 and 2015, respectively. The accumulated deficit since inception is $6,863,103, which is comprised of operating losses (which were paid in cash, stock for services and other equity instruments) and other expenses. The Company has a working capital deficit at December 31, 2016 of $1,766,620. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. There is no guarantee whether the Company will be able to generate enough revenue and/or raise capital sufficient to support its operations. The ability of the Company to continue as a going concern is dependent on management’s plans which include implementation of its business model to generate revenue from power purchase agreements, product sales, and continuing to raise funds through debt or equity offerings. The Company will also likely continue to rely upon related-party debt or equity financing, which may not be available at the time required by the Company or under terms favorable to the Company. See also Note 13, Subsequent Events. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. U.S. Generally Accepted Accounting Principles (“GAAP”) requires the Company to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, the reported amounts of revenues and expenses, cash flows and the related footnote disclosures during the period. On an on-going basis, the Company reviews and evaluates its estimates and assumptions, including, but not limited to, those that relate to the realizable value of identifiable intangible assets and other long-lived assets, derivative liabilities, income taxes and contingencies. Actual results could differ from these estimates. NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Company and its Subsidiary. All significant inter-company transactions and balances have been eliminated in consolidation. References herein to the Company include the Company and its Subsidiary, unless the context otherwise requires. Cash The Company considers all unrestricted cash, short-term deposits, and other investments with original maturities of no more than ninety days when acquired to be cash and cash equivalents for the purposes of the statement of cash flows. The Company maintains cash balances at two financial institutions, and has experienced no losses with respect to amounts on deposit. Revenue Recognition Revenue from the Company’s waste-to-power operations is recognized at the date of shipment of engines and systems, engine prototypes, engine designs or other deliverables to customers when a formal arrangement exists, the price is fixed or determinable, the delivery or milestone deliverable is completed, no other significant obligations of the Company exist and collectability is reasonably assured. Payments received before all of the relevant criteria for revenue recognition are satisfied are recorded as deferred revenue. The Company will not allow its customers to return prototype products. For the year ended December 31, 2016, the Company recognized revenue $40,000 related to the first achieved milestone and delivery under a technology sales agreement. The Company also received an additional $50,000 upon signing of that agreement, which is accounted for as deferred revenue that will be recognized upon contract completion. In 2015, the Company recognized revenue of $20,000 related to two engineering services agreements with one customer. Research and Development Research and development activities for product development are expensed as incurred and are primarily comprised of salaries. Costs for years ended December 31, 2016 and 2015 were $352,583 and $1,423,769, respectively. Stock Based Compensation The Company applies the fair value method of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 718, “Share Based Payment”, in accounting for its stock based compensation. This standard states that compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period, which is usually the vesting period. The Company values stock based compensation at the market price for the Company’s common stock and other pertinent factors at the grant date. The Company accounts for transactions in which services are received from non-employees in exchange for equity instruments based on the fair value of the equity instruments exchanged, in accordance with ASC 505-50, “Equity Based payments to Non-employees”. The Company measures the fair value of the equity instruments issued based on the market price of the Company’s stock at the time services or goods are provided. Common Stock Options The Black-Scholes option pricing valuation method is used to determine fair value of these options consistent with ASC 718, “Share Based Payment”. Use of this method requires that the Company make assumptions regarding stock volatility, dividend yields, expected term of the awards and risk-free interest rates. Derivatives Derivatives are recognized initially at fair value. Subsequent to initial recognition, derivatives are measured at fair value, and changes are therein generally recognized in profit or loss. Software, Property and Equipment Software, property and equipment are recorded at cost. Depreciation is computed on the straight-line method, based on the estimated useful lives of the assets as follows: Years Software Furniture and equipment Computers Expenditures for maintenance and repairs are charged to operations as incurred. Impairment of Long Lived Assets The Company continually evaluates the carrying value of intangible assets and other long lived assets to determine whether there are any impairment losses. If indicators of impairment are present and future cash flows are not expected to be sufficient to recover the assets’ carrying amount, an impairment loss would be charged to expense in the period identified. To date, the Company has not recognized any impairment charges. Income Taxes Income taxes are accounted for under the asset and liability method as stipulated by FASB ASC 740, “Income Taxes” (“ASC 740”). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under ASC 740, the effect on deferred tax assets and liabilities or a change in tax rate is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced to estimated amounts to be realized by the use of a valuation allowance. A valuation allowance is applied when in management’s view it is more likely than not (50%) that such deferred tax will not be utilized. In the event that an uncertain tax position exists in which the Company could incur income taxes, the Company would evaluate whether there is a probability that the uncertain tax position taken would be sustained upon examination by the taxing authorities. Reserves for uncertain tax positions would be recorded if the Company determined it is probable that a position would not be sustained upon examination or if payment would have to be made to a taxing authority and the amount is reasonably estimated. As of December 31, 2016, the Company does not believe it has any uncertain tax positions that would result in the Company having a liability to the taxing authorities. Interest and penalties related to the unrecognized tax benefits is recognized in the consolidated financial statements as a component of income taxes. Basic and Diluted Loss Per Share Net loss per share is computed by dividing the net loss less preferred dividends by the weighted average number of common shares outstanding during the period. Diluted net loss per share is calculated by dividing the net loss less preferred dividends by the weighted average number of common shares outstanding during the period plus any potentially dilutive shares related to the issuance of stock options, shares from the issuance of stock warrants, shares issued from the conversion of redeemable convertible preferred stock and shares issued from the conversion of convertible debt. There were no dilutive shares as of December 31, 2016 and 2015. At December 31, 2016, there were the following potentially dilutive securities that were excluded from diluted net loss per share because their effect would be anti-dilutive: 6,115,480 shares from common stock options, 1,568,845 shares from common stock warrants, 785,714 shares from the conversion of debentures, 126,923 shares from the conversion of notes payable, 413,719 shares from the conversion of notes payable - related parties and 2,857,142 shares from the conversion of redeemable convertible preferred stock. At December 31, 2015, there were the following potentially dilutive securities that were excluded from diluted net loss per share because their effect would be anti-dilutive: 1,745,480 shares from common stock options, 1,376,538 shares from common stock warrants, 2,075,000 shares from the conversion of debentures and 2,380,952 shares from the conversion of redeemable convertible preferred stock. Subsequent to December 31, 2016, the Company completed a convertible debt offering which resulted in an additional amount of potentially dilutive shares upon the conversion of these securities (see Note 13 - Subsequent Events). Recent Accounting Pronouncements In May 2014, the FASB issued Accounting Standards Update (“ASU”), No. 2014-09, “Revenue from Contracts with Customers”, to replace the existing revenue recognition criteria for contracts with customers and to establish the disclosure requirements for revenue from contracts with customers. The ASU is effective for interim and annual periods beginning after December 15, 2017. Adoption of the ASU is either retrospective to each prior period presented or retrospective with a cumulative adjustment to retained earnings or accumulated deficit as of the adoption date. The Company is currently assessing the future impact of the ASU on its consolidated financial statements; however, in light of the material changes in the Company’s business model which have occurred after December 31, 2016, the Company expects to do further review in the second quarter of 2017. In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements - Going Concern”, to provide guidance within GAAP requiring management to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and requiring related disclosures. The ASU is effective for annual periods ending after December 15, 2016. The Company adopted this ASU effective December 31, 2016. The adoption of this ASU did not have a material impact to the Company’s financial position, results of operations or cash flows. In November 2015, the FASB issued ASU No. 2015-17, “Balance Sheet Classification of Deferred Assets”, requiring management to provide a classification of all deferred taxes as noncurrent assets or noncurrent liabilities. This ASU is effective for annual periods beginning after December 15, 2016. The Company does not anticipate this ASU will have a material impact to the Company’s financial position, results of operations or cash flows. In January 2016, the FASB issued ASU No. 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities”, requiring management to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This ASU is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact of the ASU on its financial position, results of operations or cash flows. In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842) (the Update)”, requiring management to recognize any right-to-use-asset and lease liability on the statement of financial position for those leases previously classified as operating leases. The criteria used to determine such classification is essentially the same as under the previous guidance, but it is more subjective. The lessee would classify the lease as a finance lease if certain criteria at lease commencement are met. This ASU is effective for fiscal years beginning after December 15, 2018. The Company is currently assessing the impact of the ASU on its financial position, results of operations or cash flows. In March 2016, the FASB issued ASU 2016-06, “Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments (a consensus of the FASB Emerging Issues Task Force)”, which applies to all entities that are issuers of or investors in debt instruments (or hybrid financial instruments that are determined to have a debt host) with embedded call (put) options, and requires that embedded derivatives be separated from the host contract and accounted for separately as derivatives if certain criteria are met. One criterion is that the economic characteristics and risks of the embedded derivatives are not clearly and closely related to the economic characteristics and risks of the host contract. This ASU is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company is currently assessing the impact of the ASU on its financial position, results of operations or cash flows. In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting,” which amends ASC Topic 718, “Compensation - Stock Compensation.” The ASU includes provisions intended to simplify various aspects related to how share-based payments are accounted for and presented in the financial statements, including the income tax effects of share-based payments and accounting for forfeitures. This ASU is effective for public business entities for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. The Company is currently assessing the impact of the ASU on its financial position, results of operations or cash flows. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230) Classification of Certain Cash Receipts and Cash Payments. This standard amends and adjusts how cash receipts and cash payments are presented and classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years and will require adoption on a retrospective basis unless impractical. If impractical the Company would be required to apply the amendments prospectively as of the earliest date possible. The Company is currently evaluating the impact that ASU 2016-15 will have on its financial position, results of operations or cash flows. Concentration of Risk The Company does not have any off-balance sheet concentrations of credit risk. The Company expects cash and accounts receivable to be the two assets most likely to subject the Company to concentrations of credit risk. The Company’s policy is to maintain its cash with high credit quality financial institutions to limit its risk of loss exposure. The Company historically purchased much of its machined parts through Precision CNC, a related party company that sub-let office space to Q2P through June 27, 2016 and owns a non-controlling interest in the Company. See Note 6. NOTE 4 - SOFTWARE, PROPERTY AND EQUIPMENT, NET Software, property and equipment, net consists of the following: At December 31, 2015, the Company had software under capital leases with gross value of $24,671, net of accumulated depreciation and amortization of $15,419. The software was included in the disposal of assets to Precision CNC discussed below in Note 6; however, the Company must continue to pay all outstanding amounts under the capital leases, a balance of $1,586 as of December 31, 2016. Depreciation and amortization expense for the years ended December 31, 2016 and 2015 was $27,520 and $39,866, respectively. The Company disposed of $70,495 of net software, property and equipment for the settlement of related party accounts payable in 2016 (see Note 6). NOTE 5 - CYCLONE LICENSE RIGHTS AND DEFERRED REVENUE In 2014, Q2P purchased for $175,000 certain licensing rights to use Cyclone’s patented technology on a worldwide, exclusive basis for 20 years with two 10-year renewal terms for Q2P’s waste heat and waste-to-power business. This agreement contains a royalty provision equal to 5% of gross sales payable to Cyclone on sales of engines derived from technology licensed from Cyclone. Also, as part of the separation from Cyclone, Q2P assumed a license agreement between Cyclone and Phoenix Power Group, which included deferred revenue of $250,000 from payments previously made to Cyclone for undelivered products. The net balances as of December 31, 2016 and 2015 for the Cyclone licensing rights were $69,271 and $113,021, respectively, and the net balances as of December 31, 2016 and 2015 for the Phoenix deferred revenue were both $250,000, which are included as a component of deferred revenue on the consolidated balance sheets. Under the terms of the revised agreement with Phoenix Power Group, revenue associated with these deferrals will be recognized subject to the achievement of certain milestones, as follows: (1) on the completion of certain performance testing of the engine, deferred revenue of $150,000 will be recognized; and (2) on the delivery of the first 10 “Generation 1 Engines”, other deferred revenue will be recognized at a rate of $10,000 per delivered engine. In connection with the separation from Cyclone, the Company also assumed a contract with Clean Carbon of Australia and a corresponding $10,064 prepayment for services or other value to be provided in the future. This deposit has been presented as deferred revenue on the December 31, 2016 and 2015 consolidated balance sheets. The licensing rights are amortized over its estimated useful life of 4 years. Amortization expense for the years ended December 31, 2016 and 2015 was $43,750 and $43,750, respectively. NOTE 6 - RELATED PARTY TRANSACTIONS Expenses prepaid with common stock at December 31, 2016 and 2015 totaled $0 and $43,333, respectively. The balance at December 31, 2015 relates to stock issued to GBC for future services with a remaining amount of $119,167, and shares purchased by the CEO and paid for through salary deductions with a remaining amount of $16,154. Our CEO is a Managing Director of GBC, although he has no equity or voting rights in GBC. Through June 2016, the Company sub-leased approximately 2,500 square feet of assembly, warehouse and office space within the Precision CNC facility located at 1858 Cedar Hill Road in Lancaster, Ohio. The sublease provided for the Company to pay rent monthly in the amount of $2,500, which covered space and some utilities. Occupancy costs for the years ended December 31, 2016 and 2015 were $15,000 and $30,000, respectively. The sublease has been terminated as of June 27, 2016. The Company also purchased much of its machined parts through Precision CNC up until June 2016. Precision CNC owns a non-controlling interest in the Company. For the years ended December 31, 2016 and 2015, the amounts paid to Precision CNC totaled $13,868 and $160,601, respectively, and consisted of rent and research and development expenses for machined parts. On June 27, 2016, the Company and Precision CNC entered into an agreement to eliminate $49,299 in payables owed to Precision CNC in return for the transfer of certain net assets of the Company with a remaining book value of $70,495, which included office furniture, software and computer systems, and 50,000 shares of restricted common stock valued at $10,500. The Company recorded a loss on this transaction in the amount of $31,696. Accounts payable and accrued expenses at December 31, 2016 and December 31, 2015 include $0 and $31,048, respectively, to Precision CNC. The Company also maintains an executive office in Florida, which is leased by GBC and is used by the Company’s CEO. The Company has no formal agreement for this space, but paid GBC $0 and $10,000 for the space for the years ended December 31, 2016 and 2015, respectively. During 2016 members of the Company’s Board of Directors made several loans and advances to the Company, as follows: ● On January 8, 2016, a member of the Board of Directors made an advance to the Company totaling $10,500 with a 6% per annum rate, payable on demand. As of December 31, 2016, such advance is still outstanding. ● On April 29, 2016, the Company’s three independent Directors loaned the Company a total of $60,200 pursuant to three Convertible Notes which are automatically convertible into the equity securities issued in the Company’s next financing of at least $1,000,000 at the same price and same terms. The Convertible Notes bear 8% interest and have a 10% Original Issuance Discount. The total principal amount of all three Notes was $66,000. The total original issuance discount of $5,800 was recognized as a component of financing costs in the consolidated statement of operations for the year ended December 31, 2016. The Notes matured October 2016, and can be converted to common stock at $0.26 per share if a qualified financing event has not occurred by such time. As of December 31, 2016, these notes are still outstanding. ● On June 13, 2016, one of the Company’s independent directors loaned $15,000 to the Company on the same terms as the April 2016 notes, with a principal amount of $16,667. The original issuance discount of $1,667 was recognized as a component of financing costs in the consolidated statement of operations for the year ended December 31, 2016. As of December 31, 2016, this note is still outstanding. ● In September 2016, three of the Company’s Directors advanced $1,000 each for payment of insurance premiums. In November and December 2016, the three Directors made six additional advances to the Company in the aggregate amount of $11,400. There were no formal terms for these advances; however, the Company imputed 8% per annum interest in connection with the March 2017 conversion advances into the Convertible Promissory Note Bridge offering (see below). As of December 31, 2016, these advances are still outstanding. In March 2017, all outstanding Director notes and advances with an aggregate amount outstanding of $156,368 were converted into the Company’s new $1,500,000 Convertible Promissory Note Bridge offering (see Note 13, Subsequent Events). NOTE 7 - INCOME TAXES A reconciliation of the differences between the effective income tax rates and the statutory federal tax rates for the years ended December 31, 2016 and 2015 (computed by applying the U.S. Federal corporate tax rate of 34 percent to the loss before taxes) is as follows: The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and liabilities for the years ended December 31, 2016 and 2015 consisted of the following: At December 31, 2016 and 2015, the Company had net deferred tax assets of $1,501,245 and $1,151,470 principally arising from net operating loss carry-forwards for income tax purposes. As management of the Company cannot determine that it is more likely than not that the Company will realize the benefit of the net deferred tax asset, a valuation allowance equal to the net deferred tax asset has been established at December 31, 2016 and 2015. At December 31, 2016, the Company has net operating loss carry forwards totaling $4,766,850, which will begin to expire in 2034. The Company’s NOL and tax credit carryovers may be significantly limited under the Internal Revenue Code (IRC). NOL and tax credit carryovers are limited under Section 382 when there is a significant “ownership change” as defined in the IRC. During the year ended December 31, 2016 and in prior years, the Company may have experienced such ownership changes, which could impose such limitations. The limitations imposed by the IRC would place an annual limitation on the amount of NOL and tax credit carryovers that can be utilized. When the Company completes the necessary studies, the amount of NOL carryovers available may be reduced significantly. However, since the valuation allowance fully reserves for all available carryovers, the effect of the reduction would be offset by a reduction in the valuation allowance. NOTE 8 - NOTES PAYABLE AND DEBENTURES On July 2, 2014, the Company (then Anpath, under different management) closed a financing by which one accredited investor purchased two Original Issue Discount Senior Secured Convertible Debentures (the “Debentures”) in the total aggregate principal amount of $435,500 due March 31, 2015, and a Common Stock Purchase Warrant to purchase a total of 415,000 shares at $2.45 per share (based on post 7:1 reverse split numbers), exercisable for a period of five years. The Debentures do not bear interest, but contained an Original Issue Discount of $20,750. All assets of the Company are secured under the Debentures, including our Subsidiary and its assets. The Debentures and warrants contain certain anti-dilutive protection provisions in the instance that the Company issues stock at a price below the stated conversion price of the debentures, as well as other standard protections for the holder. On September 23, 2015, the Company entered into a Modification and Extension Agreement with the two holders to modify the terms of the Debentures to extend the maturity date to July 31, 2016, and reset the conversion price of the Debentures to $0.21. Pursuant to the Merger, the Debentures and warrants remained an outstanding obligation of the Company, thus were assumed by Q2P. In January 2016, another accredited investor purchased $105,000 in outstanding principal amount of the Debentures from the current holder. The Company did not receive any consideration in this transaction as it was a transfer amongst the holders of the Debentures. In March 2017, the Company entered into a second Modification and Extension Agreement with the two holders to extend the maturity date to July 31, 2017, reset the conversion price to $0.15, and waive any defaults under the Debentures. The warrants’ exercise price, which had been reset to $0.50 per verbal agreement of the parties in the third quarter of 2016, was formally documented under this March 2017 modification agreement. During the year ended December 31, 2016, aggregate principal of $270,750 was converted to 1,289,285 shares of common stock (see Note 9). On March 15, 2016, the Company entered into a 120-day term note payable with one accredited investor in the principal amount of $150,000. The note bears 20% interest with interest payments due monthly. The Company incurred issuance costs of 100,000 shares of common stock valued at $26,000, $3,000 cash and provided a second security interest in the assets of the Company to the holders. Issuance costs expensed during the year ended December 31, 2016 were $29,000. At December 31, 2016, the issuance costs had been fully amortized and the loan balance was $150,000, and accrued interest related to the note was $11,667. This loan matured on July 15, 2016, and a 10% late penalty was assessed on July 15, 2016. On March 22, 2017, the Company and the note holder entered into an Addendum to the loan agreement which extended the maturity date to December 31, 2017, allowed for conversion of the principal amount and accrued interest at the discretion of the holder to common stock at a price of $0.15 per share, and waived all defaults in return for payment of $30,000 which included the late fee and accrued but unpaid interest. In May 2016, three investors loaned to the Company a total of $26,709 pursuant to three notes, which are automatically convertible into the equity securities issued in the Company’s next financing of at least $1,000,000 at the same price and same terms. These notes are the same securities issued to the Company’s Directors in April and June 2016 (see Note 6). The notes bear 8% interest and have a 10% Original Issuance Discount. The total principal amount of all three notes was $33,000. The notes mature in six months, and can be converted to common stock at $0.26 per share if a qualified financing event has not occurred by such time. In March 2017, $11,000 of these notes were converted into the Company’s new $1,500,000 Convertible Promissory Note Bridge offering (see Note 13, Subsequent Events). The remaining $22,000 of these notes remain are in default as of December 31, 2016. NOTE 9 - FAIR VALUE MEASUREMENT AND DERIVATIVES The Company measures fair value in accordance with a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below: Level Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; Level Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and Level Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity). All derivatives recognized by the Company are reported as derivative liabilities on the consolidated balance sheets and are adjusted to their fair value at each reporting date. Unrealized gains and losses on derivative instruments are included in change in value of derivative liabilities on the consolidated statements of operations. The following two tables set forth the Company’s consolidated financial assets and liabilities measured at fair value by level within the fair value hierarchy at December 31, 2016 and 2015. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. There were no transfers between levels during the year ended December 31, 2016. As part of the Merger, the Company assumed debentures that are convertible into shares of common stock, which Anpath issued in July 2014 (see Note 8). The debentures conversion price will be adjusted depending on various circumstances. The conversion options embedded in these instruments contain no explicit limit to the number of shares to be issued upon settlement and as a result are classified as liabilities under ASC 815. Additionally, the Company issued in connection with the debentures 415,000 warrants to purchase the Company’s common stock. The conversion price will be adjusted depending on various circumstances, and as there is no explicit limit to the number of shares to be issued upon settlement they are classified as liabilities under ASC 815. The terms of the convertible redeemable preferred stock (see Note 10) include an anti-dilution provision that requires an adjustment in the common stock conversion ratio should subsequent issuances of the Company’s common stock be issued below the instruments’ original conversion price of $0.26 per share, subject to certain defined excluded issuances. In 2015 per a modification agreement with the holder, the conversion price was reset to $0.21. Accordingly, we bifurcated the embedded conversion feature, which is shown as a derivative liability recorded at fair value on the consolidated balance sheet. The agreement setting forth the terms of the common stock warrants issued to the holders of the convertible preferred stock (see Note 10) also includes an anti-dilution provision that requires a reduction in the warrant’s exercise price of $0.50 should the conversion ratio of the convertible preferred stock be adjusted due to anti-dilution provisions. Accordingly, the warrants do not qualify for equity classification, and, as a result, the fair value of the derivative is shown as a derivative liability on the consolidated balance sheet. During 2016, the two debenture holders converted a total of $270,750 of their debentures for 1,289,285 shares of common stock. Pursuant to the conversion of these debentures, the Company reclassified a total of $125,975 of derivative liabilities to additional paid in capital during 2016. The changes in fair value of these derivative liabilities were recorded in the consolidated statement of operations until the date of conversion. The following tables present a reconciliation of the beginning and ending balances of items measured at fair value on a recurring basis that use significant unobservable inputs (Level 3) and the related realized and unrealized (gains) losses recorded in the consolidated statements of operations during the period: The Company’s derivative liabilities are valued by using Monte Carlo Simulation methods, which simulate a range of possible future stock prices and estimates the probabilities and timing of future financing events. Where possible, the Company verifies the values produced by its pricing models to market prices. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit spreads, measures of volatility and correlations of such inputs. These derivative liabilities do not trade in liquid markets, and as such, model inputs cannot generally be verified and do involve significant management judgment. Such instruments are typically classified within Level 3 of the fair value hierarchy. The following assumptions were used to value the Company’s derivative liabilities at December 31, 2016: dividend yield of -0-%, volatility of 63.86 - 115.9%, risk free rates of 0.85 - 1.93% and an expected term of 0.6 years to 4.0 years. During 2016, the Company continues to refine its estimates and has updated the volatility used in its valuation models and the underlying number of shares of common stock for the derivative warrants. The net impact of these adjustments resulted in a $117,456 decrease in the fair value of derivative liabilities during the year ended December 31, 2016, which could have been reflected as part of the estimated fair value of these derivative liabilities at December 31, 2015. However, the Company recorded these true-up adjustments during 2016 given the inherent estimated nature of Level 3 fair value measures. The Company recorded a total gain of $808,011 and loss of $131,530 for the change in fair value of all the Level 3 derivatives during the years ended December 31, 2016 and 2015, respectively. NOTE 10 - COMMON STOCK, PREFERRED STOCK AND WARRANTS Common Stock During 2016, the Company issued 3,027,204 shares of restricted common stock valued at $678,609. Details of these issuances are provided below. On January 1, 2016, the Company issued 187,919 shares of restricted common stock valued at $49,859 as consideration for the payment of accounts payable to vendors resulting in no gain or loss. On February 2, 2016, the two debenture holders converted a total of $40,000 of their debentures for 190,476 shares of common stock. On February 25, 2016, the Company issued 450,000 shares of restricted common stock valued at $117,000 to three key employees, including its CTO. These employees were terminated during 2016; however, they were permitted to retain their shares upon termination. On March 11, 2016, one of the debenture holders converted $31,500 of their debentures for 150,000 shares of restricted common stock. On March 15, 2016, the Company issued 100,000 shares of restricted common stock to the holder of the Company’s 120-day term loan valued at $26,000 for the fair value of the services rendered related to this loan. On April 8, 2016, the Company issued 100,000 shares of restricted common stock valued at $26,000 to a consultant in connection with the negotiation of the settlement with Cyclone. On June 22, 2016, one debenture holder converted a total of $31,500 of its debenture for 150,000 shares of common stock. On June 27, 2016, the Company issued 50,000 shares of restricted common stock valued at $10,500 as partial consideration for the payment of accounts payable to an affiliated vendor. Between July 11, 2016 and August 16, 2016, the two debenture holders converted a total of $167,750 of their debentures for 798,809 shares of restricted common stock. Between July 20, 2016 and August 9, 2016, six accredited investors purchased a total of 750,000 shares of restricted common stock at a price of $0.21 per share for $157,500. On October 1, 2016, the Company issued 100,000 shares of restricted common stock valued at $21,000 to a consultant for services rendered during the fourth quarter of 2016. Redeemable Convertible Preferred Stock On January 11, 2016, the Company issued 100 shares of Redeemable Convertible Preferred Stock (the “Preferred Stock”) for proceeds of $100,000 to an accredited investor. The Company issued 500 shares of Preferred Stock to another accredited investor for $500,000 in December 2015. The Company’s Preferred Stock was convertible at $0.21 per share of the Company’s common stock (the “Conversion Price”) as of September 30, 2016. In March 2017, that conversion price was reset to $0.15 per the terms of a Modification and Extension Agreement. The Preferred Stock bears a 6% dividend per annum, calculable and payable per quarter in cash or additional shares of common stock as determined in the Certificate of Designation. The Preferred Stock has no voting rights until converted to common stock, and has a liquidation preference equal to the Purchase Price. On the second anniversary of the Original Issue Date (the “Two Year Redemption Date”), the Company is obligated to redeem all of the then outstanding Preferred Stock, for an amount in cash equal to the Two Year Redemption Amount (such redemption, the “Two Year Redemption”). Each share of Preferred Stock receives warrants (the “Warrants”) equal to one-half of the Purchase Price to purchase common stock in the Company exercisable for five (5) years following closing at a price of $0.50 per share. The Preferred Stock has price protection provisions in the case that the Company issues any shares of stock not pursuant to an “Exempt Issuance” at a price below the Conversion Price. Exempt Issuances include: (i) shares of Common Stock or common stock equivalents issued pursuant to the Merger or any funding contemplated by the Merger; (ii) any common stock or convertible securities outstanding as of the date of closing; (iii) common stock or common stock equivalents issued in connection with strategic acquisitions; (iv) shares of common stock or equivalents issued to employees, directors or consultants pursuant to a plan, subject to limitations in amount and price; and (v) other similar transactions. The Certificate of Designation contains restrictive covenants not to incur certain debt, repurchase shares of common stock, pay dividends or enter into certain transactions with affiliates without consent of holders of 67% of the Preferred Stock. The unconverted shares of Preferred Stock must be redeemed in two years from issuance. Management has determined that the Preferred Stock is more akin to a debt security than equity primarily because it contains a mandatory 2-year redemption at the option of the holder, which only occurs if the Preferred Stock is not converted to common stock. Therefore, management has presented the Preferred Stock outside of permanent equity as mezzanine equity, which does not factor in to the totals of either liabilities or equity. The proceeds have been allocated between the three features of the stock offering: the embedded conversion feature in the Preferred Stock, the warrants, and the Preferred Stock itself. The fair values of the embedded conversion feature and warrants were recorded as a discount against the stated value of the Preferred Stock on the date of issuance. This discount is amortized to interest expense over the term of the redemption period (2 years), which will result in the accretion of the Preferred Stock to its full redemption value. Unamortized discount as of December 31, 2016 and 2015 was $126,217 and $184,764, respectively. Interest expense related to the preferred stock discount for the years ended December 31, 2016 and 2015 was $137,585 and $13,492, respectively. The Preferred Stock also carries a 6% per annum dividend calculated on the stated value of the stock and is cumulative and payable quarterly beginning July 1, 2016. These dividends are accrued at each reporting period. They add to the redemption value of the stock; however, as the Company shows an accumulated deficit, the charge has been recognized in additional paid-in capital. The Company has accrued but not paid these dividends beginning July 1, 2016. Warrants The following is a summary of all outstanding common stock warrants as of December 31, 2016: NOTE 11 - STOCK OPTIONS AND RESTRICTED STOCK UNITS On July 31, 2014, the Board of Directors of Q2P approved the Founders Stock Option Plan (“Founders Plan”) and the 2014 Employee Stock Option Plan (the “2014 Plan”), collectively the “Option Plans”. The Option Plans were developed to provide a means whereby directors and selected employees, officers, consultants, and advisors of the Company may be granted incentive or non-qualified stock options to purchase restricted common stock of the Company. On February 25, 2016, to accommodate the appointment of new Board members and additional incentive stock options and stock grants to key employees of the Company, the Board approved the 2016 Omnibus Equity Incentive Plan (“2016 Plan”), which allowed for an additional 4 million shares of common stock, stock options, stock rights (restricted stock units), or stock appreciation rights to be granted by the Board in its discretion. In recognition of and compensation for services rendered by employees for the year ended December 31, 2016, the Company issued 710,000 common stock options under the Founders Plan on February 25, 2016. Of these 710,000 options, all are vested as of December 31, 2016, and 40,000 options previously granted in 2015 were cancelled in 2016 due to termination of employment. In recognition of and compensation for services rendered by the Company’s Board Chairman, the Company issued 400,000 common stock options under the 2014 Plan on February 25, 2016, which contained vesting provisions that provided for immediate vesting of 200,000, and 200,000 on August 25, 2016. In recognition of and compensation for services rendered by employees and members of the Company’s Board of Directors, the Company issued 3,300,000 common stock options, 450,000 restricted stock units and 450,000 shares of common stock under the 2016 Plan as follows: On February 25, 2016, the Company issued 1,800,000 common stock options to the Company’s Board Chairman, which contains provisions for vesting upon the achievement of specific milestones. As of December 31, 2016, by action of the Board of Directors, all 1,800,000 were deemed vested. The 450,000 restricted stock units were issued on February 25, 2016, and provide for vesting in full on February 21, 2017; however, as of September 30, 2016, all these restricted stock units had been terminated as the relevant employees were no longer with the Company. On March 21, 2016, the Company issued 400,000 common stock options to a member of the Board of Directors, which provided for immediate vesting of 200,000 shares and 200,000 shares vested on September 21, 2016. In June 2016, the Company issued 150,000 common stock options under the 2016 Plan to one new Board of Advisors Member. The options vest one-half in six months and the balance in 12 months, with a 10-year term and exercisable at a price of $0.30 per share (re-priced to $0.21 per share as discussed below). In August 2016, the Company issued 150,000 common stock options under the 2016 Plan to one new Board of Advisors Member. The options vest one-half in six months and the balance in 12 months, with a 10-year term and exercisable at a price of $0.21 per share. In December 2016, the Company issued 800,000 common stock options under the 2016 Plan to two members of the Board of Directors. The options vest one half in six months and the balance in 12 months, with a 5-year term and exercisable at a price of $0.21 per share. Options awarded under the Option Plans and the 2016 Plan for year ended December 31, 2016 were valued at $530,000 (pursuant to the Black Scholes valuation model, and as shown in the table detailing the calculation of fair value below), with a weighted average exercise price of $0.21 per share and with a weighted average contractual life of 5.5 years. In October 2016, per resolution of the Board of Directors, all outstanding stock options were reset to a $0.21 per share exercise price. The Company recorded a corresponding expense of $157,225. For the year ended December 31, 2016, the charge to the consolidated statements of operations for the amortization of stock option grants and restricted stock units awarded under the Option Plans and the 2016 Plan was $665,680. The remaining unamortized stock option expense for all outstanding stock options at December 31, 2016 was $142,339. On May 27, 2016, the majority of the employees of the Subsidiary were terminated in an effort to reduce expenses, and were allowed to retain their options, which were immediately vested. The expense related to the outstanding options previously granted to these terminated employees was recognized in full in this period as they were no longer subject to a service requirement with respect to vesting of the award. A summary of the common stock options issued under the Option Plans and the 2016 Plan for the period from December 31, 2015 through December 31, 2016 follows: The vested and exercisable options at period end follows: The fair value of new stock options granted using the Black-Scholes option pricing model was calculated using the following assumptions: Expected volatility is based on historical volatility of two securities which the Company believes best match the characteristics of the Company for purposes of measuring volatility in the absence of a market trading history of the Company’s common stock. Short Term U.S. Treasury rates were utilized as the risk free interest rate. The expected term of the options was calculated using the alternative simplified method codified as ASC 718 “Accounting for Stock Based Compensation,” which defined the expected life as the average of the contractual term of the options and the weighted average vesting period for all issuances. NOTE 12 - COMMITMENTS AND CONTINGENCIES The Company has an employment agreement with Christopher Nelson, CEO (the “Executive”). As of September 30, 2016, the Company’s employment agreement with Sudheer Pimputkar, CTO, was terminated by mutual agreement. Christopher Nelson’s agreement provides for a term of three (3) years from its Effective Date (July 31, 2014), with automatically renewing successive one-year periods starting on the end of the third anniversary of the Effective Date. If the Executive is terminated “without cause” or pursuant to a “change in control” of the Company, as both defined in the respective agreements, the Executive shall be entitled to (i) any unpaid Base Salary accrued through the effective date of termination, (ii) the Executive’s Base Salary at the rate prevailing at such termination through 24 months from the date of termination or the end of his Term then in effect, whichever is longer, and (iii) all of the Executive’s stock options shall vest immediately. On June 2, 2015, in connection with the Right Offering, the Company’s CEO agreed to an amendment to his employment agreement reducing his base salary from $180,000 per year to $138,000, and cancelled $28,000 in debt owed to him by the Company. Also concurrently with the closing of the Rights Offering, our CEO satisfied a promissory note he owed to the Company in the amount of $99,900 created in connection with the 2014 exercise of his warrants, which were issued in 2010 related to his services previously rendered, by returning to the Company 370,000 shares of common stock. The Company forgave $5,250 in accrued interest. All other provisions detailed in the July 31, 2014 employment agreement remain unchanged. As of April 1, 2017, the Company and Mr. Nelson entered into a new employment agreement (see Note 13, Subsequent Events). Sudheer Pimputkar had an employment agreement providing $170,000 per year base salary for a term of one (1) year from its Effective Date (April 1, 2015), with automatically renewing successive one year periods starting on the end of the first anniversary of the Effective Date. The Company and Mr. Pimputkar mutually terminated the agreement at September 30, 2016, and agreed to a settlement of all amounts owed to him on March 22, 2017 consisting of $13,985 in cash and $55,938 payable in 372,923 shares of restricted stock. In June 2015, the Company implemented a compensation package for a director who also serves as SEC counsel for $4,000 per quarter and 250,000 stock options per year vesting quarterly with a 10-year term and exercisable at $0.27 per share (now $0.21 per share), which vested in July 2016. For the year ended December 31, 2016, the charge to the consolidated statement of operations was $16,000. The Company’s third independent director received a package of 400,000 stock options, half vesting after six months and half six months later. As of the end of 2016, all independent directors received the same compensation package of 400,000 options per year. The charge to the consolidated statement of operations for these options was $6,717. NOTE 13 - SUBSEQUENT EVENTS On March 31, 2017, the Company closed the initial $1,000,000 in a Convertible Promissory Note “Bridge” offering (the “Bridge Offering”). The total size of the Bridge Offering is $1,500,000, with an additional $500,000 over-allotment option at the Company’s discretion. As of May 24, 2017, the Company had raised $1,400,000 in the Bridge offering with an additional $168,151 old debt converted into the offering. The Convertible Promissory Notes (the “Notes”) convert at a 50% discount to the post-funding valuation of the Company at the closing of its next offering in the minimum amount of $5,000,000 (the “Equity Offering”). The conversion valuation has a ceiling of $12,000,000, and a “floor” company value of $6,000,000 in the event there is no Equity Offering before the Notes are able to be converted. The Notes convert into common stock, or preferred stock if received by investors in the Equity Offering, commencing on the earliest of the Equity Offering closing or December 31, 2017, at the discretion of the holder. Maturity is 36 months from issuance with 15% annual interest which will be capitalized each year into the principal of the Notes and paid in kind. There are no warrants issued in connection with the Offering. Funds from the Bridge Offering will be used to secure acquisitions of compost and soil companies with closings expected to occur concurrently with the closing of the Equity Offering, and up to 12 months of operating capital. A limited portion of the funds will also be used to eliminate liabilities on the Company’s balance sheet. The Bridge Offering was led by two accredited investors, and joined by 19 additional accredited investors which included $75,000 of new cash investments by the Company’s Directors, as well as conversion of $156,368 of old notes and advances made by them in 2016 and 2017. Management conducted the Offering and no broker fees were paid in connection with the initial closing. All securities issued in the Offering and debt settlements were issued pursuant to an exemption from registration under Section4(a)(2) under the Securities Act of 1933. As provided in the Bridge Offering as of March 31, 2017, the Company settled or restructured approximately $800,000 in balance sheet liabilities, as follows: ● In connection with settlements of $189,449 owed to former employees, the Company paid $52,123 to these employees and issued 915,506 shares of restricted common stock; ● The Company’s CEO agreed to waive $112,797 in salary and fees owed to him, and converted $100,000 deferred salary into 666,667 shares of restricted common stock; ● Board of Director members and other shareholders of the Company converted $168,152 of loans and advances made to the Company in 2016 into the Bridge Offering Notes; ● The Company renegotiated its pre-existing convertible notes in the principal amount of $165,000 to extend the maturity date to July 31, 2017, set the conversion price at $0.15, and waive any defaults; ● The Company amended its existing term loan to extend the maturity date to December 31, 2017, waive all defaults, and allow the holder to convert the principal and accrued interest into common stock at a price of $0.15 per share at its discretion; and ● Management is in the process of reaching settlements on approximately $200,000 in additional payables and contract liabilities. On December 28, 2016, the Board approved an issuance of 10 million shares of common stock to the Company’s Chairman and 5 million shares to the CEO. These shares were not actually issued until February 2017, and have significant restrictions. To fully earn his shares, by July 2017, the Company’s Chairman must join the Company as a senior executive on a full-time basis for a period of at least 12 months, during which 12 month or extended period: (1) the Company must complete at least $3 million in funding and (2) complete its first strategic acquisition. To fully earn his shares, the Company’s CEO must continue to serve the Company as a senior executive on a full-time basis for a period of at least 18 months, during which 18 month or extended period: (1) the Company must complete at least $3 million in funding and (2) complete its first strategic acquisition. If these conditions are not met, the executives may forfeit all of their shares. On April 1, 2017, the Company entered into new Employment Agreements with its Chairman and CEO. The Chairman will receive a $12,500 per month fee upon the closing of the Bridge Offering and until assumes the role of CEO on a full-time basis, at which time, his base salary will be increased to $350,000 per year. The Company’s current CEO will receive a $10,000 per month fee upon the closing of the Bridge Offering, and at such time that the Chairman assumes the role of CEO, he will move into the position of President and General Counsel at a base salary of $220,000 per year. Both agreements have provisions for a 12 month severance in the instance either executive is terminated without cause or after a change in control. ITEM 9:
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Based on the fragmented financial statement excerpt, here's a summary:
The financial statement indicates:
1. Profit/Loss: The company is experiencing significant financial challenges that raise doubts about its ability to continue operating as a going concern.
2. Expenses: The company regularly reviews and evaluates its financial estimates, including:
- Realizable value of intangible assets
- Long-lived assets
- Derivative liabilities
- Income taxes
- Contingencies
3. Assets: There appears to be a reference to accounting standards related to current and noncurrent assets, with an effective date after December 15.
4. Liabilities: The company has:
- Existing debt
- Payables
- A litigation judgment from a merger date
The statement suggests the company is experiencing financial uncertainty and is carefully managing its financial reporting and estimates.
Note: The summary is based on limited and fragmented information, so a complete
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See the Report of Independent Registered Public Accounting Firm, Financial Statements and Notes to Financial Statements attached hereto at pages 10 through 27. ACCOUNTING FIRM The Members ATEL 17, LLC We have audited the accompanying balance sheets of ATEL 17, LLC (the “Company”) as of December 31, 2016 and 2015, and the related statement of operations, changes in member’s capital and cash flows for the year ended December 31, 2016, and the statement of changes in members’ capital, and cash flows for the period from April 16, 2015 (date of inception) through December 31, 2015. These financial statements are the responsibility of the Management of the Company’s Managing Member. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ATEL 17, LLC as of December 31, 2016 and 2015, and the results of its operations and cash flows for the year ended December 31, 2016, and its cash flows for the period from April 16, 2015 (date of inception) through December 31, 2015, in conformity with accounting principles generally accepted in the United States of America. /s/ Moss Adams LLP San Francisco, California March 17, 2017 ATEL 17, LLC BALANCE SHEETS DECEMBER 31, 2016 AND 2015 See accompanying notes. ATEL 17, LLC STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2016 See accompanying notes. ATEL 17, LLC STATEMENTS OF CHANGES IN MEMBERS’ CAPTIAL FOR THE YEAR ENDED DECEMBER 31, 2016 AND FOR THE PERIOD FROM APRIL 16, 2015 (Date of Inception) THROUGH DECEMBER 31, 2015 See accompanying notes. ATEL 17, LLC STATEMENTS OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2016 AND FOR THE PERIOD FROM APRIL 16, 2015 (Date of Inception) THROUGH DECEMBER 31, 2015 See accompanying notes. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 1. Organization and Limited Liability Company matters: ATEL 17, LLC (the “Company” or the “Fund”) was formed under the laws of the state of California on April 16, 2015 (“Date of Inception”) for the purpose of equipment financing and acquiring equipment to engage in equipment leasing and sales activities. The Managing Member of the Company is ATEL Managing Member, LLC (the “Managing Member” or “Manager”), a Nevada limited liability company. The Managing Member is controlled by ATEL Financial Services, LLC (“AFS”), a wholly-owned subsidiary of ATEL Capital Group. The Fund may continue as provided in the ATEL 17, LLC limited liability operating agreement dated April 24, 2015 (the “Operating Agreement”). Contributions in the amount of $500 were received as of April 28, 2015, which represented the initial member’s capital investment. As a limited liability company, the liability of any individual member for the obligations of the Fund is limited to the extent of capital contributions to the Fund by the individual member. The offering of the Company was granted effectiveness by the Securities and Exchange Commission as of January 5, 2016. The offering will continue until the earlier of a period of two years from that date or until sales of the limited liability company units (Units) to the public reach $150 million. As of February 2, 2016, subscriptions for the minimum number of Units (120,000, representing $1.2 million), excluding subscriptions from Pennsylvania investors, had been received and the Fund requested subscription proceeds to be released from escrow. On that date, the Company commenced initial operations and continued in its development stage activities until transitioning to an operating enterprise during the first quarter of 2016. Pennsylvania subscriptions are subject to a separate escrow and are released to the Fund only when aggregate subscriptions for all investors equal to at least $7.5 million. Total contributions to the Fund exceeded $7.5 million on July 6, 2016, at which time a request was processed to release the Pennsylvania escrowed amounts. The offering will terminate no later than January 5, 2018. As of December 31, 2016, cumulative gross contributions, less rescissions and repurchases (net of distributions paid and allocated syndication costs, as applicable), totaling $14.8 million (inclusive of the $500 initial Member’s capital investment) have been received. As of the same date, 1,475,864 Units were issued and outstanding. The Company’s principal objectives are to invest in a diversified portfolio of investments that will (i) preserve, protect and return the Company’s invested capital; (ii) generate regular cash distributions to members, with any balance remaining after required minimum distributions to be used to purchase additional investments during the Reinvestment Period (ending six calendar years after the completion of the Company’s public offering of Units) and (iii) provide additional cash distributions following the Reinvestment Period and until all investment portfolio assets have been sold or otherwise disposed. Pursuant to the terms of the Operating Agreement, the Managing Member and/or its affiliates receives compensation for services rendered and reimbursements for costs incurred on behalf of the Company. (See Note 6, Related party transactions.) The Company is required to maintain reasonable cash reserves for working capital, for the repurchase of Units and for contingencies. The repurchase of Units is solely at the discretion of the Managing Member. 2. Summary of significant accounting policies: Basis of presentation: The accompanying balance sheets as of December 31, 2016, and the related statement of operations, changes in members’ capital, and cash flows for the year ended December 31, 2016 and for the period from inception through December 31, 2015, have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the rules and regulations of the Securities and Exchange Commission. In preparing the accompanying financial statements, the Company has reviewed, as determined necessary by the Managing Member, events that have occurred after December 31, 2016, up until the issuance of the financial statements. No events were noted which would require additional disclosure in the footnotes to the financial statements, and adjustments thereto. The Company began operations in 2016. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 2. Summary of significant accounting policies: - (continued) Cash and cash equivalents: Cash and cash equivalents include cash in banks and cash equivalent investments such as U.S. Treasury instruments with original and/or purchased maturities of ninety days or less. Use of Estimates: The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates. Such estimates primarily relate to the determination of residual values at the end of the lease term and expected future cash flows used for impairment analysis purposes and for determination of the allowance for doubtful accounts and reserve for credit losses on notes receivable. Accounts receivable: Accounts receivable represent the amounts billed under operating lease contract, and notes receivable which are currently due to the Company. Allowances for doubtful accounts are typically established based on historical charge off and collection experience and the collectability of specifically identified lessees and borrowers, and invoiced amounts. Accounts receivable deemed uncollectible are generally charged off against the allowance on a specific identification basis. Recoveries of amounts that were previously written-off are recorded as other income in the period received. Credit risk: Financial instruments that potentially subject the Company to concentrations of credit risk include cash and cash equivalents, operating lease receivable, notes receivable and accounts receivable. The Company places the majority of its cash deposits in noninterest-bearing accounts with financial institutions that have no less than $10 billion in assets. Such deposits are insured up to $250 thousand. The remainder of the Funds’ cash is temporarily invested in U.S. Treasury denominated instruments. The concentration of such deposits and temporary cash investments is not deemed to create a significant risk to the Company. Accounts and notes receivable represent amounts due from lessees or borrowers in various industries, related to equipment on operating leases or notes receivable. Equipment on operating leases and related revenue recognition: Equipment subject to operating leases is stated at cost. Depreciation is recognized on a straight-line method over the terms of the related leases to the equipment’s estimated residual values. Off-lease equipment is generally not subject to depreciation. The Company depreciates all lease assets, in accordance with guidelines consistent with ASC 840-20-35-3, over the periods of the lease terms contained in each asset’s respective lease contract to the estimated residual value at the end of the lease contract. All lease assets are purchased only concurrent with the execution of a lease commitment by the lessee. Thus, the original depreciation period corresponds with the term of the original lease. Once the term of an original lease contract is completed, the subject property is typically sold to the existing user, re-leased to the existing user, or, when off-lease, is held for sale. Assets which are re-leased continue to be depreciated using the terms of the new lease agreements and the estimated residual values at the end of the new lease terms, adjusted downward as necessary. Assets classified as held-for-sale are carried at the lower of carrying amount, or the fair value less cost to sell (ASC 360-10-35-43). The Company does not use the equipment held in its portfolio, but holds it solely for lease and ultimate sale. In the course of marketing equipment that has come off-lease, management may determine at some point that re-leasing the assets may provide a superior return for investors and would then execute another lease. Upon entering into a new lease contract, management will estimate the residual value once again and resume depreciation. If and when the Company, at any time, determines that depreciation in value may have occurred with respect to an asset held-for-sale, the Company would review the value to determine whether a material reduction in value had occurred and recognize any appropriate impairment. All lease assets, including off-lease assets, are subject to the Company’s quarterly impairment analysis, as described below. Maintenance costs associated with the Fund’s portfolio of leased assets are expensed as incurred. Major additions and betterments are capitalized. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 2. Summary of significant accounting policies: - (continued) Operating lease revenue is recognized on a straight-line basis over the term of the underlying leases. The initial lease terms will vary as to the type of equipment subject to the leases, the needs of the lessees and the terms to be negotiated, but initial leases are generally on terms from 36 to 120 months. The difference between rent received and rental revenue recognized is recorded as unearned operating lease income on the balance sheet. Operating leases are generally placed in a non-accrual status (i.e., no revenue is recognized) when payments are more than 90 days past due. Additionally, management considers the equipment underlying the lease contracts for impairment and periodically reviews the credit worthiness of all operating lessees with payments outstanding less than 90 days. Based upon management’s judgment, the related operating leases may be placed on non-accrual status. Leases placed on non-accrual status are only returned to an accrual status when the account has been brought current and management believes recovery of the remaining unpaid lease payments is probable. Until such time, revenues are recognized on a cash basis. Notes receivable, unearned interest income and related revenue recognition: The Company records all future payments of principal and interest on notes as notes receivable, which are then offset by the amount of any related unearned interest income. For financial statement purposes, the Company reports only the net amount of principal due on the balance sheet. The unearned interest is recognized over the term of the note and the income portion of each note payment is calculated so as to generate a constant rate of return on the net balance outstanding. Any fees or costs related to notes receivable are recorded as part of the net investment in notes receivable and amortized over the term of the loan. Allowances for losses on notes receivable are typically established based on historical charge off and collection experience and the collectability of specifically identified borrowers and billed and unbilled receivables. Notes are considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and/or interest when due according to the contractual terms of the note agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. If it is determined that a loan is impaired with regard to scheduled payments, the Company will perform an analysis of the note to determine if an impairment valuation reserve is necessary. This analysis considers the estimated cash flows from the note, or the collateral value of the property underlying the note when note repayment is collateral dependent. Any required valuation reserve is charged to earnings when determined; and notes are charged off to the allowance as they are deemed uncollectible. Notes receivable are generally placed in a non-accrual status (i.e., no revenue is recognized) when payments are more than 90 days past due. Additionally, management periodically reviews the creditworthiness of companies with note payments outstanding less than 90 days. Based upon management’s judgment, the related notes may be placed on non-accrual status. Notes placed on non-accrual status are only returned to an accrual status when the account has been brought current and management believes recovery of the remaining unpaid receivable is probable. Until such time, all payments received are applied only against outstanding principal balances. Initial direct costs: The Company capitalizes initial direct costs (“IDC”) associated with the origination and funding of lease assets and investments in notes receivable. IDC includes both internal costs (e.g., the costs of employees’ activities in connection with successful lease and loan originations) and external broker fees incurred with such originations. The costs are amortized on a lease by lease (or note by note) basis based on actual lease term using a straight-line method for operating leases and the effective interest rate method for direct financing leases and notes receivable. Upon disposal of the underlying lease assets and notes receivable, both the initial direct costs and the associated accumulated amortization are relieved. Costs related to leases or notes receivable that are not consummated are not eligible for capitalization as initial direct costs and are expensed as acquisition expense. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 2. Summary of significant accounting policies: - (continued) Acquisition expense: Acquisition expense represents costs which include, but are not limited to, legal fees and expenses, travel and communication expenses, cost of appraisals, accounting fees and expenses and miscellaneous expenses related to the selection and acquisition of equipment which are reimbursable to the Managing Member under the terms of the Operating Agreement. As the costs are not eligible for capitalization as initial direct costs, such amounts are expensed as incurred. Asset valuation: Recorded values of the Company’s leased asset portfolio are reviewed each quarter to confirm the reasonableness of established residual values and to determine whether there is indication that an asset impairment might have taken place. The Company uses a variety of sources and considers many factors in evaluating whether the respective book values of its assets are appropriate. In addition, the company may direct a residual value review at any time if it becomes aware of issues regarding the ability of a lessee to continue to make payments on its lease contract. An impairment loss is measured and recognized only if the estimated undiscounted future cash flows of the asset are less than their net book value. The estimated undiscounted future cash flows are the sum of the residual value of the asset at the end of the asset’s lease contract and undiscounted future rents from the existing lease contract. The residual value assumes, among other things, that the asset is utilized normally in an open, unrestricted and stable market. Short-term fluctuations in the marketplace are disregarded and it is assumed that there is no necessity either to dispose of a significant number of the assets, if held in quantity, simultaneously or to dispose of the asset quickly. Impairment is measured as the difference between the fair value (as determined by a valuation method using discounted estimated future cash flows, third party appraisals or comparable sales of similar assets as applicable based on asset type) of the asset and its carrying value on the measurement date. Upward adjustments for impairments recognized in prior periods are not made in any circumstances. Segment reporting: The Company is organized into one operating segment for the purpose of making operating decisions or assessing performance. Accordingly, the Company operates in one reportable operating segment in the United States. The Company’s principal decision makers are the Managing Member’s Chief Executive Officer and its Chief Financial Officer and Chief Operating Officer. The Company believes that its equipment leasing business operates as one reportable segment because: a) the Company measures profit and loss at the equipment portfolio level as a whole; b) the principal decision makers do not review information based on any operating segment other than the equipment leasing transaction portfolio; c) the Company does not maintain discrete financial information on any specific segment other than its equipment financing operations; d) the Company has not chosen to organize its business around different products and services other than equipment lease financing; and e) the Company has not chosen to organize its business around geographic areas. The primary geographic region in which the Company seeks leasing opportunities is North America. For the year ended December 31, 2016, all of the Company’s current operating revenues and long-lived assets relate to customers domiciled in the United States. Investment in securities: Warrants Warrants owned by the Company are not registered for public sale, but are considered derivatives and are reflected at an estimated fair value on the balance sheet as determined by the Managing Member. The Company recorded unrealized losses of $4 thousand on fair valuation of its warrants during 2016 which reduced the estimated fair value of the Company’s portfolio of warrants to $51 thousand. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 2. Summary of significant accounting policies: - (continued) Unearned operating lease income: The Company records prepayments on operating leases as a liability under the caption of unearned operating lease income. The liability is recorded when prepayments are received and recognized as operating lease revenue over the period to which the prepayments relate using a straight-line method. Income Taxes: The Company is treated as a partnership for federal income tax purposes. Pursuant to the provisions of Section 701 of the Internal Revenue Code, a partnership is not subject to federal income taxes. Accordingly, the Company has provided current franchise income taxes for only those states which levy income taxes on partnerships. For the year ended December 31, 2016, the related provision for state income taxes was approximately $8 thousand. The Company does not have any entity level uncertain tax positions. The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions and is generally subject to examination by U.S. federal (or state and local) income tax authorities for three years from the filing of a tax return. The tax bases of the Company’s net assets and liabilities vary from the amounts presented in these financial statements at December 31, 2016 as follows: The primary differences between the tax bases of net assets and the amounts recorded in the financial statements are the result of differences in accounting for syndication costs and differences between the depreciation methods used in the financial statements and the Company’s tax returns. The following reconciles the net income reported in these financial statements to the income reported on the Company’s federal tax return (unaudited) for the year ended December 31, 2016: Per Unit data: Net loss and distributions per Unit are based upon the weighted average number of members Units outstanding during the year. Recent accounting pronouncements: In August 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016-15 - Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). ASU 2016-15 addresses specific cash flow issues with the objective of reducing the existing diversity in practice. The amendments in this Update are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. Management is currently evaluating the standard and its impact on operations and financial reporting. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 2. Summary of significant accounting policies: - (continued) In June 2016, the FASB issued Accounting Standards Update 2016-13, Financial Instruments - Credit Losses (Topic 326) (“ASU 2016-13”). The main objective of this Update is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this Update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments affect entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018. Management is currently evaluating the standard and its operational and related disclosure requirements. In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842) (“ASU 2016-02”). The new standard will require lessees to recognize lease assets and lease liabilities arising from operating leases with lease terms greater than 12 months in the statement of financial position. Lessor accounting per ASU 2016-02 is mostly unchanged from the previous lease accounting GAAP. Certain changes were made to the lessor accounting guidance in order to align the lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. Similar to the previous guidance, lessors will classify leases as operating, direct financing, or sales-type. Lessors in operating leases will continue to recognize the underlying asset and recognize income on a straight-line basis. Lessors determine whether a lease is a sale of the underlying asset based on whether the lessee effectively obtains control of the underlying assets. ASU-2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. Management will adopt the standard and is currently evaluating the standard and its operational and related disclosure requirements. In January 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The new standard provides guidance related to accounting for equity investments and financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. In addition, the FASB clarified guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities. ASU 2016-01 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Management is currently evaluating the standard and its operational and related disclosure requirements. In August 2014, the FASB issued Accounting Standards Update 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU-2014-15”). The new standard provides guidance relative to management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. Management does not expect the adoption of ASU 2014-15 to have a material impact on the Company’s financial statements or related disclosures. In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. On July 9, 2015, the FASB approved the deferral of the effective date of ASU 2014-09 by one year and in August 2015, issued Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date (“ASU 2015-14”). ASU 2015-14 is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 31, 2016, including interim reporting periods within that reporting period. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company evaluated the impact of the new standard on its financial statements and has determined that such impact is virtually non-existent as the new revenue guideline does not affect revenues from leases and loans, which comprise the majority of the Company’s revenues. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 3. Concentration of credit risk and major customers: The Company leases equipment to lessees and provides debt financing to borrowers in diversified industries. Leases and notes receivable are subject to the Managing Member’s credit committee review. The leases and notes receivable provide for the return of the equipment to the Company upon default. As of December 31, 2016, there were concentrations (greater than or equal to 10% as a percentage of total equipment cost) of equipment leased to lessees and/or financed for borrowers in certain industries as follows: During 2016, certain lessees and/or financial borrowers generated significant portions (defined as greater than or equal to 10%) of the Company’s total leasing and lending revenues, excluding gains or losses on disposition of assets, as follows: These percentages are not expected to be comparable in future periods due to anticipated changes in the mix of investments and/or lessees as a result of normal business activities. 4. Notes receivable, net: The Company has various notes receivable from borrowers who have financed the purchase of equipment through the Company. As of December 31, 2016, the original terms of the notes are 36 months with an interest rate of 11.45% per annum. The notes are secured by the equipment financed and have a maturity dates of 2019. As of December 31, 2016, the minimum future payments receivable are as follows: ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 4. Notes receivable, net: - (continued) IDC amortization expense related to notes receivable and the Company’s operating leases for the year ended December 31, 2016 are as follows: 5. Investments in equipment and leases, net: The Company’s investment in leases consists of the following: The Company utilizes a straight line depreciation method over the term of the equipment lease for equipment on operating leases currently in its portfolio. Depreciation expense on the Company’s equipment totaled $311 thousand for the year ended December 31, 2016. IDC amortization expense related to the Company’s operating and notes receivable totaled $28 thousand. All of the Company’s lease asset purchases and capital improvements were made during the year 2016. Operating leases: Property on operating leases consists of the following: The average estimated residual value for assets on operating leases was 48% of the assets’ original cost at December 31, 2016. There were no operating leases in non-accrual status at December 31, 2016. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 5. Investments in equipment and leases, net: - (continued) At December 31, 2016, the aggregate amounts of future minimum lease payments receivable are as follows: The useful lives for each category of leases is reviewed at a minimum of once per quarter. As of December 31, 2016, the respective useful lives of each category of lease assets in the Company’s portfolio are as follows (in years): 6. Related party transactions: The terms of the Operating Agreement provide that the Managing Member and/or affiliates are entitled to receive certain fees for equipment management and resale and for management of the Company. The Operating Agreement allows for the reimbursement of costs incurred by the Managing Member and/or affiliates for providing administrative services to the Company. Administrative services provided include Company accounting, investor relations, legal counsel and lease and equipment documentation. The Managing Member is not reimbursed for services whereby it is entitled to receive a separate fee as compensation for such services, such as management of investments. Each of AFS and ATEL Leasing Corporation (“ALC”) is a wholly-owned subsidiary of ATEL Capital Group, Inc. and performs services for the Company on behalf of the Managing Member. Acquisition services, equipment management, lease administration and asset disposition services are performed by ALC; investor relations, communications and general administrative services are performed by AFS. Cost reimbursements to the Managing Member or its affiliates are based on its costs incurred in performing administrative services for the Company. These costs are allocated to each managed entity based on certain criteria such as total assets, number of investors or contributed capital based upon the type of cost incurred. The Managing Member believes that the costs reimbursed are the lower of (i) actual costs incurred on behalf of the Company or (ii) the amount the Company would be required to pay independent parties for comparable administrative services in the same geographic location. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 6. Related party transactions: - (continued) The Managing Member and/or affiliates earned fees and billed for reimbursements, pursuant to the Operating Agreement, during the year ended December 31, 2016 as follows: 7. Commitments: At December 31, 2016, there were two commitments to purchase lease assets and to fund investments in notes receivable totaling $1.1 million and $1.7 million, respectively. These amounts represent contract awards which may be canceled by the prospective borrower/investee or may not be accepted by the Company. There were no cancellations subsequent to year-end. 8. Guarantees: The Company enters into contracts that contain a variety of indemnifications. The Company’s maximum exposure under these arrangements is unknown. However, the Company has not had prior claims or losses pursuant to these contracts and expects the risk of loss to be remote. The Managing Member knows of no facts or circumstances that would make the Company’s contractual commitments outside standard mutual covenants applicable to commercial transactions between businesses. Accordingly, the Company believes that these indemnification obligations are made in the ordinary course of business as part of standard commercial and industry practice, and that any potential liability under the Company’s similar commitments is remote. Should any such indemnification obligation become payable, the Company would separately record and/or disclose such liability in accordance with GAAP. 9. Members’ capital: A total of 1,475,864 Units were issued and outstanding at December 31, 2016, including the 50 Units issued to the initial Member (Managing Member). The Fund was authorized to issue up to 15,000,000 Units in addition to the Units issued to the initial Member. The Company has the right, exercisable at the Managing Member’s discretion, but not the obligation, to repurchase Units of a Unitholder who ceases to be a U.S. Citizen, for a price equal to 100% of the holder’s capital account. The Company is otherwise permitted, but not required, to repurchase Units upon a holder’s request. The repurchase of Fund units is made in accordance with Section 13 of the Amended and Restated Limited Liability Company Operating Agreement. The repurchase would be at the discretion of the Managing Member on terms it determines to be appropriate under given circumstances, in the event that the Managing Member deems such repurchase to be in the best interest of the Company; provided, the Company is never required to repurchase any Units. Upon the repurchase of any Units by the Fund, the tendered Units are cancelled. Units repurchased in prior periods were repurchased at amounts representing the original investment less cumulative distributions made to the Unitholder with respect to the Units. All Units repurchased during a quarter are deemed to be repurchased effective the last day of the preceding quarter, and are not deemed to be outstanding during, or entitled to allocations of net income, net loss or distributions for the quarter in which such repurchase occurs. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 9. Members’ capital: - (continued) The Fund’s net income or net losses are to be allocated 100% to the members. From the commencement of the Fund until the initial closing date, net income and net loss were allocated 99% to the Managing Member and 1% to the initial members. Commencing with the initial closing date, net income and net loss are to be allocated 99.99% to the members and 0.01% to the Managing Member. Fund distributions are to be allocated 0.01% to the Managing Member and 99.99% to the members. The Company commenced periodic distributions in February 2016. Distributions to the members for the year ended December 31, 2016 were as follows: 10. Fair value measurements: Fair value measurements and disclosures are based on a fair value hierarchy as determined by significant inputs used to measure fair value. The three levels of inputs within the fair value hierarchy are defined as follows: Level 1 - Quoted prices in active markets for identical assets or liabilities. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis, generally on a national exchange. Level 2 - Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuations in which all significant inputs are observable in the market. Level 3 - Valuation is modeled using significant inputs that are unobservable in the market. These unobservable inputs reflect the Company’s own estimates of assumptions that market participants would use in pricing the asset or liability. At December 31, 2016, only the Company’s warrants were measured on a recurring basis. The Company’s valuation policy is determined by members of the Asset Management, Credit and Accounting departments. Whenever possible, the policy is to obtain quoted market prices in active markets to estimate fair values for recognition and disclosure purposes. Where quoted market prices in active markets are not available, fair values are estimated using discounted cash flow analyses, broker quotes, information from third party remarketing agents, third party appraisals of collateral and/or other valuation techniques. These techniques are significantly affected by certain of the Company’s assumptions, including discount rates and estimates of future cash flows. Potential taxes and other transaction costs are not considered in estimating fair values. As the Company is responsible for determining fair value, an analysis is performed on prices obtained from third parties. Such analysis is performed by asset management and credit department personnel who are familiar with the Company’s investments in equipment, notes receivable and equity securities of venture companies. The analysis may include a periodic review of price fluctuations and validation of numbers obtained from a specific third party by reference to multiple representative sources. Such fair value adjustments utilized the following methodology: Warrants (recurring) Warrants owned by the Company are not registered for public sale, but are considered derivatives and are carried on the balance sheet at an estimated fair value at the end of the period. The valuation of the warrants are determined using a Black-Scholes formulation of value based upon the stock price(s), the exercise price(s), the volatility of ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 10. Fair value measurements: - (continued) comparable venture companies, and a risk free interest rate for the term(s) of the warrant exercise(s). As of December 31, 2016, the calculated fair value of the Fund’s warrant portfolio approximated $51 thousand. Such valuations are classified within Level 3 of the valuation hierarchy. The following table reconciles the beginning and ending balances of the Company’s Level 3 recurring assets: The following table summarizes the valuation techniques and significant unobservable inputs used for the Company’s recurring and non-recurring fair value calculation/adjustments categorized as Level 3 in the fair value hierarchy at December 31, 2016: The following disclosure of the estimated fair value of financial instruments is made in accordance with the guidance provided by the Financial Instruments Topic of the FASB Accounting Standards Codification. Fair value estimates, methods and assumptions, set forth below for the Company’s financial instruments, are made solely to comply with the requirements of the Financial Instruments Topic and should be read in conjunction with the Company’s financial statements and related notes. The Company determines the estimated fair value amounts by using market information and valuation methodologies that it considers appropriate and consistent with the fair value accounting guidance. Considerable judgment is required to interpret market data to develop the estimates of fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Cash and cash equivalents The recorded amounts of the Company’s cash and cash equivalents approximate fair value because of the liquidity and short-term maturity of these instruments. Notes receivable The fair value of the Company’s notes receivable is generally estimated based upon various methodologies deployed by financial and credit management including, but not limited to, credit analysis, third party appraisal and/or discounted cash flow analysis based upon current market valuation techniques and market rates for similar types of lending arrangements, which may consider adjustments for impaired loans as deemed necessary. Commitments and Contingencies Management has determined that no recognition for the fair value of the Company’s loan commitments is necessary because their terms are made on a market rate basis and require borrowers to be in compliance with the Company’s credit requirements at the time of funding. ATEL 17, LLC NOTES TO THE FINANCIAL STATEMENTS 10. Fair value measurements: - (continued) The fair value of contingent liabilities (or guarantees) is not considered material because management believes there has been no event that has occurred wherein a guarantee liability has been incurred or will likely be incurred. The following tables present estimated fair values of the Company’s financial instruments in accordance with the guidance provided by the Financial Instruments Topic of the FASB Accounting Standards Codification at December 31, 2016 and 2015:
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Here's a summary of the financial statement:
Revenue and Operations:
- Operating revenues and long-lived assets are primarily related to U.S. customers
- The company has investments in unregistered warrants, which are recorded at estimated fair value
- Unrealized losses of $4 were recorded
Accounts Receivable:
- Represents amounts billed under operating lease contracts and notes receivable
- Allowances for doubtful accounts are established based on historical collection experience
- Uncollectible accounts are charged off against the allowance
- Recovered amounts are recorded as other income
Credit Risk:
- Financial instruments with potential credit risk include cash, lease receivables, and accounts receivable
- Cash deposits are primarily in noninterest-bearing accounts with financial institutions
Financial Estimates and Accounting:
- Estimates relate to residual lease values, expected cash flows, and allowances for doubtful accounts
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Claude
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ACCOUNTING FIRM To the Board of Directors and Stockholders of Hines Global REIT II, Inc. Houston, Texas We have audited the accompanying consolidated balance sheets of Hines Global REIT II, Inc. and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations and comprehensive income (loss), equity (deficit), and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedule listed in the Index at These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Hines Global REIT II, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Deloitte & Touche LLP Houston, Texas March 27, 2017 HINES GLOBAL REIT II, INC. CONSOLIDATED BALANCE SHEETS As of December 31, 2016 and 2015 See notes to the consolidated financial statements. HINES GLOBAL REIT II, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) For the Years Ended December 31, 2016, 2015 and 2014 See notes to the consolidated financial statements. HINES GLOBAL REIT II, INC. CONSOLIDATED STATEMENTS OF EQUITY (DEFICIT) For the Years Ended December 31, 2016, 2015 and 2014 (in thousands) See notes to the consolidated financial statements. HINES GLOBAL REIT II, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2016, 2015 and 2014 See notes to the consolidated financial statements. HINES GLOBAL REIT II, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Hines Global REIT II, Inc. (the “Company”), was formed as a Maryland corporation on July 31, 2013 for the purpose of engaging in the business of investing in and owning commercial real estate properties and other real estate investments. The Company intends to conduct substantially all of its operations through Hines Global REIT II Properties, LP (the “Operating Partnership”). Beginning with its taxable year ended December 31, 2015, the Company has operated and intends to continue to operate in a manner to qualify as a real estate investment trust (“REIT”) for federal income tax purposes. The business of the Company is managed by Hines Global REIT II Advisors LP (the “Advisor”), an affiliate of Hines Interests Limited Partnership (“Hines”), pursuant to the Advisory Agreement between the Company, the Advisor and the Operating Partnership (defined below). On August 20, 2014, the Company commenced an offering of up to $2.5 billion of its common stock (the “Offering”) in any combination of Class A shares of common stock (“Class A Shares”) and Class T shares of common stock (“Class T Shares”) of the Company’s common stock. The Company engaged Hines Securities, Inc. (the “Dealer Manager”), an affiliate of the Advisor, to serve as the dealer manager for the Offering and market its shares. As of March 17, 2017, the Company had received gross offering proceeds of $307.3 million from the sale of 31.7 million shares. The Company intends to invest the net proceeds from the Offering in a diversified portfolio of quality commercial real estate properties and other real estate investments throughout the United States and internationally. As of December 31, 2016, the Company owned direct investments in five real estate properties totaling 2.0 million square feet that were 97% leased. See the table in “Properties for additional information regarding each of the properties in which the Company owned an interest as of December 31, 2016. Also, see Note 14 - Subsequent Events for additional information regarding the acquisition of Rookwood Commons and Rookwood Pavilion, collectively referred to as “Rookwood” in January 2017 and the Montrose Student Residence in March 2017. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of the consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The Company evaluates its assumptions and estimates on an ongoing basis. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances. Additionally, application of the Company’s accounting policies involves exercising judgments regarding assumptions as to future uncertainties. Actual results may differ from these estimates under different assumptions or conditions. Basis of Presentation The consolidated financial statements of the Company include the accounts of Hines Global REIT II, Inc. and the Operating Partnership (over which the Company exercises financial and operating control). All intercompany balances and transactions have been eliminated in consolidation. The Company has determined that the Operating Partnership is considered a variable interest entity (“VIE”). However, the Company meets the disclosure exemption criteria, as the Company is the primary beneficiary of the VIE and the Company’s partnership interest is considered a majority voting interest. Investment Property and Lease Intangibles Real estate assets acquired by the Company are stated at fair value at the date of acquisition less accumulated depreciation. Depreciation is computed using the straight-line method. The estimated useful lives for computing depreciation are generally 10 years for furniture and fixtures, 15-20 years for electrical and mechanical installations and 40 years for buildings. Major replacements that extend the useful life of the assets are capitalized and maintenance and repair costs are expensed as incurred. Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, are recorded at the estimated fair values of the assets acquired and liabilities assumed. The results of operations of acquired properties are included in the Company’s results of operations from their respective dates of acquisition. Estimates of fair values are based upon estimates of future cash flows and other valuation techniques that the Company believes are similar to those used by market participants and are used to record the purchase of identifiable assets acquired, such as land, buildings and improvements, equipment and identifiable intangible assets related to in-place leases and liabilities assumed, such as amounts related to acquired out-of-market leases, asset retirement obligations, and mortgage notes payable. Values of buildings and improvements are determined on an as-if-vacant basis. Initial valuations are subject to change until such information is finalized, which will occur no later than 12 months after the acquisition date. Acquisition-related costs such as transaction costs and acquisition fees paid to the Advisor are expensed as incurred. The estimated fair value of acquired in-place leases are the costs the Company would have incurred to lease the properties to the occupancy level of the properties at the date of acquisition. Such estimates include the fair value of leasing commissions, legal costs and other direct costs that would be incurred to lease the properties to such occupancy levels. Additionally, the Company evaluates the time period over which such occupancy levels would be achieved. Such evaluation will include an estimate of the net market-based rental revenues and net operating costs (primarily consisting of real estate taxes, insurance and utilities) that would be incurred during the lease-up period. Acquired in-place leases as of the date of acquisition are amortized over the remaining lease terms. Should a tenant terminate its lease, the unamortized portion of the in-place lease value is charged to amortization expense. Acquired out-of-market lease values (including ground leases) are recorded based on the present value (using a discount rate that reflects the risks associated with the lease acquired) of the difference between the contractual amounts paid pursuant to the in-place leases and management’s estimate of fair market value lease rates for the corresponding in-place leases. The capitalized out-of-market lease values are amortized as adjustments to rental revenue (or ground lease expense, as applicable) over the remaining terms of the respective leases, which include periods covered by bargain renewal options. Should a tenant terminate its lease, the unamortized portion of the out-of-market lease value is charged to rental revenue. Management estimates the fair value of assumed mortgage notes payable based upon indications of then-current market pricing for similar types of debt with similar maturities. Assumed mortgage notes payable are initially recorded at their estimated fair value as of the assumption date, and the difference between such estimated fair value and the outstanding principal balance of the note will be amortized over the life of the mortgage note payable. Impairment of Investment Property Real estate assets are reviewed for impairment each reporting period if events or changes in circumstances indicate that the carrying amount of the individual property may not be recoverable. In such an event, a comparison will be made of the current and projected operating cash flows and expected proceeds from the eventual disposition of each property on an undiscounted basis to the carrying amount of such property. If the carrying amount exceeds the undiscounted cash flows, it would be written down to the estimated fair value to reflect impairment in the value of the asset. The determination of whether investment property is impaired requires a significant amount of judgment by management and is based on the best information available to management at the time of the evaluation. No impairment charges were recorded during the years ended December 31, 2016, 2015, and 2014. Cash and Cash Equivalents The Company considers all short-term, highly liquid investments that are readily convertible to cash with a maturity of three months or less at the time of purchase to be cash equivalents. Concentration of Credit Risk As of December 31, 2016, the Company had cash and cash equivalents deposited in certain financial institutions in excess of federally insured levels. Management regularly monitors the financial stability of these financial institutions in an effort to manage the Company’s exposure to any significant credit risk in cash and cash equivalents. International Operations The Euro (“EUR”) is the functional currency for the Company’s subsidiary operating in Ireland. This subsidiary has translated its financial statements into U.S. dollars for reporting purposes. Assets and liabilities are translated at the exchange rate in effect as of the balance sheet date while income statement accounts are translated using the average exchange rate for the period and significant nonrecurring transactions using the rate on the transaction date. Gains or losses resulting from translation are included in accumulated other comprehensive income (loss) within stockholders’ equity. Upon disposal of this subsidiary, the Company will remove the accumulated translation adjustment from stockholders’ equity and include it in the gain or loss on disposal in its consolidated statement of operations. This subsidiary may have transactions denominated in currencies other than its functional currency. In these instances, assets and liabilities are remeasured into the functional currency at the exchange rate in effect at the end of the period and income statement accounts are remeasured at the average exchange rate for the period. These gains or losses are included in the Company’s results of operations. This subsidiary also records gains or losses in the income statement when a transaction with a third party, denominated in a currency other than its functional currency, is settled and the functional currency cash flows realized are more or less than expected based upon the exchange rate in effect when the transaction was initiated. Restricted Cash The Company has restricted cash primarily related to certain escrow accounts required by the Bishop’s Square secured facility. Tenant and Other Receivables Tenant and other receivable balances consist primarily of base rents, tenant reimbursements and receivables attributable to straight-line rent. An allowance for the uncollectible portion of tenant and other receivables is determined based upon an analysis of the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. Tenant and other receivables are shown at cost, net of any applicable allowance for doubtful accountants. As of December 31, 2016 and December 31, 2015, no such allowances have been recorded. In addition, as of December 31, 2016 and December 31, 2015, tenant and other receivables also included a receivable from the Company’s transfer agent related to offering proceeds not yet received of $1.6 million and $2.9 million, respectively. Deferred Leasing Costs Direct leasing costs, primarily consisting of third-party leasing commissions, tenant inducements and legal costs are capitalized and amortized over the life of the related lease. Tenant inducement amortization is recorded as an offset to rental revenue and the amortization of other direct leasing costs is recorded in amortization expense. Deferred Financing Costs Deferred financing costs consist of direct costs incurred in obtaining debt financing. These costs are presented as a direct reduction from the related debt liability for permanent mortgages and presented as an asset for revolving credit arrangements. In total, deferred financing costs had a carrying value of $1.0 million and $0.5 million for the years ended December 31, 2016 and 2015. These costs are amortized into interest expense on a straight-line basis, which approximates the effective interest method, over the terms of the obligations. For the years ended December 31, 2016 and 2015, $183,000 and $88,000 of deferred financing costs were amortized into interest expense in the accompanying consolidated statement of operations, respectively. The Company had no amortization of deferred financing costs for the year ended December 31, 2014. Other Assets Other assets included the following (in thousands): (1) As of December 31, 2016, this amount consisted of a $5.0 million earnest money deposit in connection with the acquisition of Rookwood in January 2017. See Note 14 - Subsequent Events for additional information regarding the acquisition of Rookwood. (2) As of December 31, 2015, this amount consisted of an earnest money deposit paid in relation to the acquisition of the Domain Apartments, which was completed in January 2016. Revenue Recognition The Company recognizes rental revenue on a straight-line basis over the life of the lease including rent holidays, if any. Straight-line rent receivables were $2.5 million and $0.6 million as of December 31, 2016 and 2015, respectively. Straight-line rent receivable consists of the difference between the tenants’ rents calculated on a straight-line basis from the date of acquisition or lease commencement over the remaining terms of the related leases and the tenants’ actual rents due under the lease agreements and is included in tenant and other receivables in the accompanying consolidated balance sheets. Revenues associated with operating expense recoveries are recognized in the period in which the expenses are incurred based upon the tenant lease provisions. Revenues relating to lease termination fees are recognized on a straight-line basis amortized from the time that a tenant’s right to occupy the leased space is modified through the end of the revised lease term. Other revenues consist primarily of parking revenue, insurance proceeds, administrative fees, and tenant reimbursements related to utilities, insurance, and other operating expenses. Parking revenue represents amounts generated from contractual and transient parking and is recognized in accordance with contractual terms or as services are rendered. Other revenues relating to tenant reimbursements are recognized in the period that the expense is incurred. Income Taxes The Company has elected to be treated as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (“the Code”), beginning with its taxable year ended December 31, 2015. The Company’s management believes that it operates in such a manner as to qualify for treatment as a REIT and intends to operate in the foreseeable future in such a manner so that it will remain qualified as a REIT for federal income tax purposes. Accordingly, no provision has been made for U.S. federal income taxes for the years ended December 31, 2016 and 2015 in the accompanying consolidated financial statements. The Company did not elect to be taxed as a REIT for the taxable year ended December 31, 2014. This did not have an impact on the Company’s tax liability or the tax liability of the Company’s stockholders that invested in the Company’s public offering during 2014 since the Company did not have any taxable income for the year ended December 31, 2014. Distribution and Stockholder Servicing Fees Per the terms of the Company’s Third Amended and Restated Dealer Manager Agreement, the Company will pay a distribution and stockholder servicing fee of 1.0% per annum of the gross offering price per Class T Share (or, if the Company is no longer offering primary shares, the then-current estimated per share NAV, if any has been disclosed) sold in the Offering. The Company will cease paying the distribution and stockholder servicing fee with respect to any particular Class T Share and that Class T Share will convert into a number of Class A Shares on the occurrence of certain defined events. The Company records distribution and stockholder servicing fees as a reduction to additional paid-in capital and the related liability in an amount equal to the maximum fees payable in relation to the Class T Shares on the date the shares are issued. The liability will be relieved over time, as the fees are paid to the Dealer Manager, or it will be adjusted if the fees are no longer payable. For the years ended December 31, 2016 and 2015, the Company has recorded a liability of $4.6 million and $7,000, respectively, related to these fees, which is included in due to affiliates on the consolidated financial statements. Redemption of Common Stock The Company complies with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC” or the “Codification”) 480 “Distinguishing Liabilities from Equity” which requires, among other things, that financial instruments that represent a mandatory obligation of the Company to repurchase shares be classified as liabilities and reported at settlement value. When approved, the Company will reclassify such obligations from equity to an accrued liability based upon their respective settlement values. Reclassifications As described more fully below, in connection with recent amendments to the Codification regarding the presentation of restricted cash in the statements of cash flows, the Company reclassified $1.6 million of restricted cash on the statements of cash flows from investing activities to the cash and cash equivalent balances in 2015 to be consistent with the presentation of cash and cash equivalent balances in 2016. There was no restricted cash for the year ended December 31, 2014. Per Share Data Net income (loss) per common share is calculated by dividing the net income (loss) attributable to common stockholders for each period by the weighted average number of common shares outstanding during such period. Net income (loss) per common share on a basic and diluted basis is the same because the Company has no potentially dilutive common shares outstanding. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”), issued Accounting Standards Update (“ASU”) 2014-09 to provide guidance on recognizing revenue from contracts with customers. The amendments also replace prior guidance regarding the recognition of revenue from sales of real estate, except for revenue from sales that are part of a sale-leaseback transaction. Subsequent to ASU 2014-09, the FASB has issued multiple ASUs clarifying multiple aspects of the new revenue recognition standard, which include the deferral of the effective date by one year, and additional guidance for partial sales of non-financial assets. These amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2017 with retrospective or modified retrospective adoption. The Company is currently evaluating each of its revenue streams to identify differences in the timing, measurement or presentation of revenue recognition under the new standard, as well as evaluating methods of adoption, however a substantial portion of the Company’s revenue consists of rental income from leasing arrangements, which is specifically excluded from ASU 2014-09 and will be evaluated with the adoption of the lease accounting standard, ASU 2016-02. Additionally, the Company has not had any sales or partial sales of real estate since its inception. In September 2015, the FASB issued ASU 2015-16 that eliminates the requirement that an acquirer in a business combination account for measurement-period adjustments retrospectively. Instead, an acquirer will recognize a measurement-period adjustment during the period in which it determines the amount of the adjustment. This new guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2015 and early adoption was permitted. The adoption of this guidance did not have any impact on the Company’s financial statements. In February 2016, the FASB issued ASU 2016-02 which is intended to improve financial reporting about leasing transactions. ASU 2016-02 will require companies that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The accounting by companies that own the assets leased by the lessee (the lessor) will remain largely unchanged from current GAAP. The new standard requires a modified retrospective transition approach for all leases existing at, or entered into after, the date of initial application, with an option to use certain transition relief. The guidance is effective for public entities for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. While the Company is still evaluating the effect that ASU 2016-02 will have on its consolidated financial statements and related disclosures, it expects to recognize right-of-use assets and related lease liabilities on its consolidated balance sheets related to ground leases under which it is the lessee. In August 2016 and November 2016, the FASB issued ASU 2016-15 and ASU 2016-18 to the Codification to add or clarify guidance on the classification of certain cash receipts and payments in the statement of cash flows. Additionally, the guidance addressed the presentation of restricted cash in the cash flow statement whereby restricted cash should be included in the cash and cash equivalents balance in the statement of cash flows. The amendments to the Codification are effective for public entities for annual and interim periods in fiscal years beginning after December 15, 2017 and early adoption is permitted. The Company adopted this guidance as of December 31, 2016. See the “- Reclassifications” subheading above for the impact the adoption of this guidance had on the Company. In January 2017, the FASB issued ASU 2017-01 to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. We expect the adoption of this guidance to require that most real estate transactions be accounted for under the asset acquisition guidance and, accordingly, acquisition expenses related to those acquisitions will be capitalized. The amendments in the Codification are effective for public entities for annual and interim periods in fiscal years beginning after December 15, 2017 and early adoption is permitted with prospective application. The Company plans to adopt ASU 2017-01 beginning January 1, 2017. 3. INVESTMENT PROPERTY For the years ended December 31, 2016 and 2015, the Company acquired three and one properties, respectively, for a total net purchase price of $253.5 million and $103.2 million, respectively. Investment property consisted of the following amounts as of December 31, 2016 and December 31, 2015 (in thousands): (1) Included in buildings and improvements is approximately $331,000 and $176,000 of construction-in-progress related to a planned expansion at Bishop's Square as of December 31, 2016 and December 31, 2015, respectively. See Properties and Note 4 - Recent Acquisitions of Real Estate for additional information regarding our real estate portfolio. See Note 14 - Subsequent Events for additional information regarding the acquisition of Rookwood and the Montrose Student Residence, which were acquired subsequent to December 31, 2016. As of December 31, 2016, the cost basis and accumulated amortization related to lease intangibles were as follows (in thousands): As of December 31, 2015, the cost basis and accumulated amortization related to lease intangibles were as follows (in thousands): Amortization expense of in-place leases was $10.4 million, $2.8 million and $35,000 for the years ended December 31, 2016, 2015 and 2014, respectively. Net amortization of out-of-market leases resulted in an increase to rental revenue of $138,000 and $312,000 for the years ended December 31, 2016 and 2015, respectively. There was no amortization of out-of-market leases for the year ended December 31, 2014. Anticipated amortization of the Company’s in-place leases for each of the years ending December 31, 2017 through December 31, 2021 are as follows (in thousands): Leases The Company has entered into non-cancelable lease agreements with tenants for space. As of December 31, 2016, the approximate fixed future minimum rentals for each of the years ending December 31, 2017 through 2021 and thereafter for the Company’s commercial properties are as follows (in thousands): Of the Company’s total rental revenue for the year ended December 31, 2016, approximately 21% was earned from the Commissioner of Public Works in Ireland, a state agency of Ireland, whose lease expires in 2028, 11% was earned from Western Digital, a tenant in the information industry, whose lease expires in 2021, and approximately 10% was earned from Acushnet, a tenant in the manufacturing industry, whose lease expires in 2019. Of the Company’s total rental revenue for the year ended December 31, 2015, approximately 44% was earned from the Commissioner of Public Works in Ireland, 26% was earned from Acushnet, and approximately 15% was earned from International Financial Data Services, an investor record-keeping and transfer agency provider, whose lease expires in 2024. Of the Company’s total rental revenue for the year ended December 31, 2014, 100% was earned from Acushnet. Capital Lease Obligations In May 2016, the Company entered into a lease agreement for equipment at Bishop’s Square which is being treated as a capital lease that expires in May 2017. This leased asset with a value of approximately $201,000 has been recorded in buildings and improvements in the Company’s consolidated balance sheet as of December 31, 2016. The Company has $139,000 outstanding under this capital lease obligation as of December 31, 2016 which is recorded in the consolidated balance sheet under the caption, other liabilities, and expects to repay this obligation in 2017. 4. RECENT ACQUISITIONS OF REAL ESTATE The amounts recognized for major assets acquired as of the acquisition date were determined by allocating the purchase price of each property acquired in 2016, 2015 and 2014 as follows (in thousands): (1) For Bishop’s Square, which was denominated in Euros, amounts have been translated at an exchange rate based on the rate in effect on the acquisition date. (2) The land at Bishop’s Square is subject to a 999-year ground lease with the local municipality in Ireland. Since the Company does not have title to the land, approximately $33.4 million has been recorded to in-place lease intangibles and will be amortized over the remaining term of the ground lease. The weighted average amortization period for the intangible assets and liabilities acquired in connection with the 2016, 2015 and 2014 acquisitions, as of the date of the respective acquisition, was as follows (in years): (1) Excludes the effect of the ground lease, which significantly increases the weighted average useful life for these intangibles. The table below includes the amounts of revenue and net income (loss) of the acquisitions completed during the year ended December 31, 2016, which are included in the Company’s consolidated statements of operations and comprehensive income (loss) for the year ended December 31, 2016 (in thousands): The following unaudited consolidated information is presented to give effect to the acquisitions completed during the year ended December 31, 2016 as if the acquisitions had occurred on January 1, 2015. The pro forma net loss was adjusted to exclude acquisition-related fees and expenses of $7.5 million for the year ended December 31, 2016. For the year ended December 31, 2015, the pro forma net loss was adjusted to include acquisition fees and expenses of $7.1 million, relating to the 2016 acquisitions, as if these fees and expenses had been incurred as of January 1, 2015. The information below is not necessarily indicative of what the actual results of operations would have been had the Company completed these acquisitions on January 1, 2015, nor does it purport to represent the Company’s future operations (in thousands): The table below includes the amounts of revenue and net income (loss) of the acquisition completed during the year ended December 31, 2015, which are included in the Company’s consolidated statements of operations and comprehensive income (loss) for the year ended December 31, 2015 (in thousands): The following unaudited consolidated information is presented to give effect to the acquisition completed during the year ended December 31, 2015 as if the acquisition had occurred on January 1, 2014. The pro forma net loss was adjusted to exclude acquisition-related fees and expenses of $5.3 million for the year ended December 31, 2015. For the year ended December 31, 2014, the pro forma net loss was adjusted to include acquisition fees and expenses of $4.9 million, relating to the 2015 acquisition, as if these fees and expenses had been incurred as of January 1, 2014. The information below is not necessarily indicative of what the actual results of operations would have been had the Company completed this acquisition on January 1, 2014, nor does it purport to represent the Company’s future operations (in thousands): The table below includes the amounts of revenue and net income (loss) of the acquisition completed during the year ended December 31, 2014, which are included in the Company’s consolidated statements of operations and comprehensive income (loss) for the year ended December 31, 2014 (in thousands): The following unaudited consolidated information is presented to give effect to the acquisition completed during the year ended December 31, 2014 as if the acquisition occurred on July 31, 2013 (date of inception). The pro forma net loss was adjusted to exclude acquisition-related fees and expenses of $0.7 million for the year ended December 31, 2014. For the period from inception through December 31, 2013, the pro forma net loss was adjusted to include acquisition fees and expenses of $0.7 million relating to the 2014 acquisition, as if these fees and expenses had been incurred as of July 31, 2013 (date of inception). The information below is not necessarily indicative of what the actual results of operations would have been had we completed these transactions on July 31, 2013, nor does it purport to represent our future operations: 5. DEBT FINANCING As of December 31, 2016 and 2015, the Company had approximately $254.8 million and $60.2 million of debt outstanding, with a weighted average years to maturity of 4.3 years and 6.2 years, and a weighted average interest rate of 2.37% and 1.30%, respectively. The following table describes the Company’s debt outstanding at December 31, 2016 and 2015 (in thousands, except interest rates): Bishop’s Square Facility In connection with the acquisition of Bishop’s Square, a wholly-owned subsidiary of the Company entered into a secured facility agreement (the “Bishop’s Square Facility”) with DekaBank Deutsche Girozentrale totaling €55.2 million (approximately $62.1 million assuming a rate of $1.12 per EUR as of the transaction date). The Bishop’s Square Facility requires quarterly interest payments, which commenced in July 2015, and repayment of principal upon the maturity of the Bishop’s Square Facility on March 2, 2022. The Bishop's Square Facility has a floating interest rate of EURIBOR plus 1.30% and is subject to an interest rate cap with a strike rate of 2.0%. The Bishop’s Square Facility may be repaid in full prior to maturity, subject to a prepayment premium if it is repaid in the first 3 years. Domain Apartments Mortgage Loan In connection with the acquisition of the Domain Apartments, the Company entered into a loan agreement with Wells Fargo Bank, National Association ("Wells Fargo") for a principal sum of $34.3 million. Interest accrued on the loan is due and payable on the first business day of each month from February 2016 through the term of the loan. The loan has a floating interest rate of Libor + 1.60%. Repayment of principal is due upon the maturity of the loan on January 29, 2020. The Company has the option to extend the term for an additional one-year period, subject to the satisfaction of certain conditions. The loan may be prepaid at any time on or after July 29, 2017, subject to certain conditions, including but not limited to, providing 30 days’ advance notice to Wells Fargo. Cottonwood Corporate Center Mortgage Loan In connection with the acquisition of Cottonwood Corporate Center, the Company entered into a loan agreement with Principal Life Insurance Company (“Principal Life”) for a principal sum of $78.0 million. Principal and interest accrued on the loan are due and payable on the first day of each month commencing in September 2016. The loan has a fixed interest rate per annum equal to 2.98% and matures on August 1, 2023. The loan may be prepaid at any time on or after April 1, 2023 without penalty, subject to certain conditions, including but not limited to providing 30 days’ advance written notice to Principal Life, and in the event of prepayment of the loan prior to April 1, 2023, the payment of a prepayment penalty. Goodyear Crossing II Mortgage Loan In connection with the acquisition of Goodyear Crossing II, the Company entered into a loan agreement with SunTrust Bank (“SunTrust”) for a principal sum of $29.0 million. Interest accrued on the loan is due and payable on the fifth of each month commencing in October 2016. The loan has a floating interest rate of Libor + 2.00%. Repayment of principal is due upon the maturity of the loan on the earlier of (i) August 18, 2021, or (ii) the date on which the principal amount of the loan has been declared or automatically has become due and payable. The loan may be prepaid at any time, in whole or in part, without premium or penalty, subject to certain conditions, including but not limited to providing three days’ advance written notice to SunTrust. Hines Credit Facility On December 15, 2014, the Operating Partnership entered into a credit facility with Hines (the “Hines Credit Facility”) with a maximum principal amount of $75.0 million. Interest on each advance is charged monthly at a variable rate, which is the greater of (i) Hines’ then-current borrowing rate under its revolving credit facility and (ii) if the Company enters into a revolving credit facility through the Operating Partnership, the rate under such facility. Each advance under Hines Credit Facility must be repaid within six months, subject to one six-month extension at our option and subject to the satisfaction of certain conditions. In December 2016, the Company entered into the first amendment to the Hines Credit Facility to extend the termination date for a period of up to one additional year. As amended, the Hines Credit Facility will terminate on the earlier of (a) the termination of the availability period as determined by Hines at its discretion (which will not impact the maturity date of any outstanding or previously approved advance under the credit facility); (b) December 15, 2017; and (c) the date Hines accelerates the repayment of the Hines Credit Facility pursuant to any event of default. Notwithstanding that each advance under the Hines Credit Facility matures six months after it is made, the Company is required to repay each advance with proceeds from its public offering as such proceeds are raised, unless the Company, through the Operating Partnership, enters into a revolving credit facility (the “OP Facility”), at which point the Company may use its offering proceeds to repay the OP Facility, if any, prior to repaying any advances under the Hines Credit Facility. The Hines Credit Facility also permits voluntary prepayment of principal and accrued interest. For the year ended December 31, 2016, the Company made draws of $81.5 million and payments of $25.5 million under the Hines Credit Facility. Additionally, from January 1, 2017 through March 27, 2017, the Company made draws of $7.0 million and repayments of $29.8 million. The borrowings and payments resulted in an outstanding principal balance of $33.2 million under the Hines Credit Facility as of March 27, 2017. Financial Covenants The Company’s mortgage and other loan documents for the debt described in the table above contain customary events of default, with corresponding grace periods, including payment defaults, bankruptcy-related defaults, and customary covenants, including limitations on liens and indebtedness and maintenance of certain financial ratios. The Company is not aware of any instances of noncompliance with financial covenants as of December 31, 2016. Principal Payments on Debt The Company is required to make the following principal payments on its outstanding notes payable for each of the years ending December 31, 2017 through December 31, 2021 and for the period thereafter (in thousands). 6. DERIVATIVE INSTRUMENTS The Company entered into an interest rate cap agreement with Chatham Financial Corporation in connection with the Bishop’s Square Facility. The interest rate cap agreement was entered into as an economic hedge against the variability of future interest rates on one of its variable interest rate borrowings. The Company’s interest rate cap contract has economically limited the interest rate on the loan to which it relates. The Company has not designated this derivative as a hedge for accounting purposes. See Note 9 - Fair Value Measurements for additional information regarding the fair value of the Company’s interest rate contract. The table below provides additional information regarding the Company’s interest rate contract (in thousands, except percentages). (1) For notional amounts denominated in a foreign currency, amounts have been translated at a rate based on the rate in effect on December 31, 2016. The Company has not entered into a master netting arrangement with its third-party counterparty and does not offset on its consolidated balance sheet the fair value amount recorded for its derivative instrument. The fair value of the Company’s derivative instrument is included in the caption, other assets, on the consolidated balance sheets. The table below presents the effects of the changes in fair value of the Company’s derivative instrument in the Company’s consolidated statements of operations and comprehensive income (loss) for the years ended December 31, 2016 and 2015 (in thousands): 7. DISTRIBUTIONS With the authorization of its board of directors, the Company declares distributions daily. All distributions were or will be paid in cash or reinvested in shares of the Company’s common stock for those participating in the Company’s distribution reinvestment plan and have been or will be paid or issued, respectively, on the first business day following the completion of the month to which they relate. Distributions reinvested pursuant to the distribution reinvestment plan were or will be reinvested in shares of the same class as the shares on which the distributions are being made. Some or all of the cash distributions may be paid from sources other than cash flows from operations. The tables below outline the distribution rates declared per share, per day for Class A Shares and Class T Shares. (1) Class T Shares are subject to an ongoing distribution and stockholder servicing fee payable to the Dealer Manager of 1.0% per annum of the gross offering price per share (or, if the Company is no longer offering primary shares, the then-current estimated net asset value per share, if any has been disclosed). The gross distribution rate is the rate prior to deduction of the distribution and stockholder servicing fees payable. The actual per share, per day distribution rate for Class T Shares will vary based on the total amount of distribution and stockholder fees payable for that particular period. The following table outlines the Company’s total cash distributions declared to stockholders for the years ended December 31, 2016, 2015 and 2014, including the breakout between the distributions declared in cash and those reinvested pursuant to the Company’s distribution reinvestment plan (in thousands). (1) Amounts pertain to only the fourth quarter of 2014. 8. RELATED PARTY TRANSACTIONS The table below outlines fees and expense reimbursements incurred that are payable by the Company to Hines and its affiliates for the years ended December 31, 2016, 2015 and 2014 and amounts unpaid as of December 31, 2016 and 2015 (in thousands): (1) The Advisor waived $1.3 million and $0.6 million in asset management fees payable to it during the years ended December 31, 2016 and 2015, respectively. See “-Advisory Agreement” below for a discussion of the asset management fee waiver. (2) Includes amounts the Advisor paid on behalf of the Company such as general and administrative expenses and acquisition-related expenses. These amounts are generally reimbursed to the Advisor during the month following the period in which they are incurred. (3) Includes amounts paid related to the Hines Credit Facility. Dealer Manager Agreement In connection with sales of Class A Shares, the Dealer Manager receives a commission of up to 7.0% of gross offering proceeds and a dealer manager fee of up to 3.0% of gross offering proceeds, both of which will be recorded as an offset to additional paid-in-capital in the Company’s financial statements. Pursuant to separately negotiated agreements, the Dealer Manager may reallow all of its commission and a portion of its dealer manager fee to broker-dealers participating in the Offering. In connection with sales of Class T Shares, the Dealer Manager receives a commission of up to 2.0% of gross offering proceeds and a dealer manager fee of up to 2.75% of gross offering proceeds, both of which will be recorded as an offset to additional paid-in-capital in the Company’s financial statements. On July 25, 2016, the Company, the Dealer Manager and the Advisor entered into the Third Amended and Restated Dealer Manager Agreement, effective as of August 2, 2016 (the “Amended Dealer Manager Agreement”). Pursuant to the Amended Dealer Manager Agreement, the Advisor will pay a portion of the dealer manager fees payable to the Dealer Manager in an amount equal to 1.5% of the gross offering proceeds with respect to Class A Shares and Class T Shares sold in the primary Offering on and after August 2, 2016. The Advisor will not be reimbursed by the Company in any way for the payment of such dealer manager fees. In addition, the Dealer Manager will receive annual distribution and stockholder servicing fees of 1.0% of the gross offering price per share (or, if the Company is no longer offering primary shares, the then-current net asset value per share of such class of shares, if any has been disclosed) for the Class T Shares purchased and outstanding. The Company will cease paying the distribution and stockholder servicing fee with respect to any particular Class T Share and that Class T Share will convert into a number of Class A Shares on the occurrence of earlier of: (i) a listing of the Class A Shares on a national securities exchange; (ii) a merger or consolidation of the Company with or into another entity, or the sale or other disposition of all or substantially all of the Company’s assets; (iii) the end of the month in which the Dealer Manager determines that total underwriting compensation paid in the Offering including the distribution and stockholder servicing fee paid on all Class T Shares sold in the Offering is equal to 10.0% of the gross proceeds of the Offering from the sale of both Class A Shares and Class T Shares; (iv) the end of the month in which the transfer agent, on behalf of the Company, determines that underwriting compensation paid in the primary offering including the distribution and stockholder servicing fee paid with respect to the Class T Shares held by a stockholder within his or her particular account equals 10.0% of the gross offering price at the time of investment of the Class T Shares held in such account; and (v) on any Class T Share that is redeemed or repurchased. Although the Company cannot predict the length of time over which this fee will be paid due to potential changes in the offering price or estimated net asset value of the Company’s Class T Shares, this fee would be paid over approximately 5.25 years from the date of purchase, assuming a constant per share offering price or estimated net asset value, as applicable. Pursuant to separately negotiated agreements, the Dealer Manager may reallow all of its commission, all or a portion of its dealer manager fee and all or a portion of its distribution and stockholder servicing fees to broker-dealers participating in the Offering. No selling commissions, dealer manager fees or distribution and stockholder servicing fees will be paid for sales of shares pursuant to the Company’s distribution reinvestment plan. Advisory Agreement Pursuant to the Advisory Agreement and the Operating Partnership Agreement, the Company is required to pay the following fees and expense reimbursements: Acquisition Fee - The Advisor receives acquisition fees of 2.25% of (i) the purchase price of real estate investments acquired, including any debt attributable to such investments, or the total principal amounts borrowed under any loans made or acquired directly by the Company, or (ii) when the Company makes an investment or makes or acquires a loan indirectly through another entity, such investment’s pro rata share of the gross asset value of real estate investments held by that entity, including any debt attributable to such investments, or the total principal amount borrowed under any loans made or acquired by that entity. Asset Management Fee - The Advisor also receives asset management fees of 0.0625% per month of the cost of the Company’s real estate investments at the end of each month; provided that, if the Company’s board of directors has determined an estimated net asset value per share, then, with respect to real estate investments included in the board of director’s determination, the asset management fees will be equal to 0.0625% per month of the most recently determined value of such real estate investments at the end of each month. In addition, commencing with the quarter ended December 31, 2014, the Advisor agreed to waive the asset management fees for each quarter through December 31, 2016, to the extent that the Company’s MFFO, for a particular quarter, as disclosed in the Company’s Annual Report on Form 10-K or Quarterly Report on Form 10-Q, as applicable, amounts to less than 100% of the aggregate distributions declared to the Company’s stockholders for such quarter. As a result of these fee waivers, cash flows from operations that would have been paid to the Advisor for asset management fees may be available to pay distributions to stockholders. These fee waivers are not deferrals and accordingly, any fees that are waived will not be paid to the Advisor in cash at any time in the future. The table below outlines, with respect to each of the years ended December 31, 2016, 2015 and 2014, the asset management fees earned by the Advisor before application of the waivers, the amounts waived pursuant to the asset management fee waivers described above, and the asset management fees that were earned by our Advisor after application of the waivers (in thousands). The Advisor has also agreed to waive the asset management fees otherwise payable to it for the quarter ended March 31, 2017 to the extent that our MFFO for such quarter, as reduced to reflect the distribution and stockholder servicing fees payable for such quarter, as disclosed in our Quarterly Report on Form 10-Q, amounts to less than 100% of the aggregate distributions declared to our stockholders for that quarter. Disposition Fee - If the Advisor, its affiliates or related parties provide a substantial amount of services, as determined in good faith by a majority of the Company’s independent directors, the Company will pay the Advisor, its affiliates or related parties a disposition fee in an amount equal to (a) 1.0% of the market value determined in connection with a listing of the Company’s common stock on a national securities exchange, or 1.0% of the gross consideration received or to be received by the Company or its stockholders upon the occurrence of any other liquidity event involving the Company or the Operating Partnership, pursuant to which the Company’s stockholders receive in exchange for their shares of the Company’s common stock, cash, listed securities, securities redeemable for cash, or a combination thereof, or (b) 1.0% of the gross sales price upon the sale or transfer of one or more real estate investments (including a sale of all of the Company’s real estate investments). Even if the Advisor, its affiliates or related parties receive a disposition fee, the Company may still be obligated to pay fees or commissions to another third party. However, when a real estate or brokerage fee is payable in connection with a particular transaction, the amount of the disposition fee paid to the Advisor or its affiliates or related parties, as applicable, may not exceed an amount equal to the lesser of (i) one-half of a competitive real estate or brokerage commission and (ii) 1.0% of the gross sales price and, when added to the sum of all real estate or brokerage fees and commissions paid to unaffiliated parties, may not exceed the lesser of (x) a competitive real estate or brokerage commission or (y) an amount equal to 6.0% of the gross sales price. Special OP Units - An affiliate of the Advisor holds special partnership interests in the Operating Partnership (“Special OP Units”), which will entitle them to receive distributions in an amount equal to 15.0% of distributions, including from sales of real estate investments, refinancings and other sources, but only after the Company’s stockholders have received, or are deemed to have received, in the aggregate, cumulative distributions equal to their invested capital plus a 6.0% cumulative, non-compounded annual return on such invested capital. Additionally, at the sole discretion of the Advisor, the acquisition fees, asset management fees or disposition fees are payable, in whole or in part, in cash or units of the Operating Partnership (“OP Units”). In the case of the disposition fee, the Advisor may also elect to be paid, if applicable, in securities issued by another entity. For the purposes of the payment of these fees, each OP Unit will be valued at the per share offering price of the Company’s common stock in the Company’s most recent public offering less selling commissions and dealer manager fees payable with respect to such common stock, to account for the fact that no selling commissions or dealer manager fees will be paid in connection with any such issuances. Each OP unit will be convertible into one share of the Company’s common stock. The Company will recognize the expense related to these OP Units as the related service is performed, as each OP Unit will be fully vested upon issuance. The Company reimburses the Advisor for all expenses paid or incurred by the Advisor in connection with the services provided to the Company, subject to the limitation that the Company will not reimburse the Advisor for any amount by which its operating expenses (including the asset management fee) at the end of the four preceding fiscal quarters exceeds the greater of: (A) 2.0% of its average invested assets, or (B) 25.0% of its net income determined without reduction for any additions to reserves for depreciation, bad debts or other similar non-cash reserves and excluding any gain from the sale of the Company’s assets for that period (the “2%/25% Limitation”). Notwithstanding the above, the Company may reimburse the Advisor for expenses in excess of this limitation if a majority of the independent directors determines that such excess expenses are justified based on unusual and non-recurring factors. For the four fiscal quarters ended September 30, 2015, the Company’s total operating expenses exceeded the 2%/25% Limitation. Based upon a review of unusual and non-recurring factors, including but not limited to the Company being in the early stages of raising and deploying capital, the limited number of assets acquired to date and the timing of those acquisitions, a majority of the Company’s independent directors determined that the excess expenses were justified and thus reimbursable to the Advisor. For the four fiscal quarters ended December 31, 2016, the Company’s total operating expenses did not exceed the 2%/25% Limitation. The Company reimburses the Advisor and its affiliates for any issuer costs related to the Offering that it pays on the Company’s behalf. Such costs consist of, among other costs, expenses of the Company’s organization, actual legal, accounting, bona fide out-of-pocket itemized and detailed due diligence costs, printing, filing fees, transfer agent costs, postage, escrow fees, data processing fees, advertising and sales literature and other offering-related costs. Organizational issuer costs, such as expenses associated with the formation of the Company and its board of directors, are expensed as incurred, and offering-related issuer costs are recorded as an offset to additional paid-in capital. From inception to December 31, 2016, issuer costs incurred by the Advisor on the Company’s behalf totaled $11.1 million, of which $46,000 related to organizational issuer costs. However, the total reimbursement related to issuer costs, selling commissions, dealer manager fees and the distribution and stockholder servicing fees may not exceed 15.0% of gross proceeds from the Offering. The Advisory Agreement was amended, effective February 29, 2016, to reflect that the Company will not reimburse the Advisor for the cumulative issuer costs incurred in connection with the Company’s organization and public offerings, in excess of 2.5% of gross offering proceeds from the Company’s public offerings. On April 14, 2016, the Advisor reimbursed the Company for $4.0 million in issuer costs that the Company had previously reimbursed to the Advisor in excess of this 2.5% cap. Despite the 2.5% cap, the Company expects cumulative issuer costs to be less than 2.5% of gross offering proceeds at the conclusion of its public offerings. As the Company raises additional offering proceeds, the Company expects to reimburse the Advisor for the $4.0 million that the Advisor repaid to the Company in April 2016. As a result, the Company has recorded a liability equal to all unreimbursed issuer costs that have been incurred to date to reflect its expectation that all of these amounts will be reimbursed to the Advisor. Property Management and Leasing Agreements The Company pays Hines fees for the management and leasing of the Company’s properties. Property management fees will be paid in an amount equal to a market-based percentage of the gross revenues of the properties managed by Hines. In addition, if Hines provides leasing services with respect to a property, the Company will pay Hines leasing fees in an amount equal to the leasing fees charged by unaffiliated persons rendering comparable services in the same geographic area of the applicable property. The Company generally will be required to reimburse Hines for certain operating costs incurred in providing property management and leasing services pursuant to the property management and leasing agreements. Included in this reimbursement of operating costs will be the cost of personnel and overhead expenses related to such personnel located at the property as well as off-site personnel located in Hines’ headquarters and regional offices, to the extent the same relate to or support the performance of Hines’ duties under the agreement. Hines may perform construction management services for the Company for both re-development activities and tenant construction. These fees are considered incremental to the construction effort and will be capitalized to the associated real estate project as incurred. Costs related to tenant construction will be depreciated over the estimated useful life. Costs related to redevelopment activities will be depreciated over the estimated useful life of the associated project. Leasing activities will generally be performed by Hines on the Company’s behalf. Leasing fees will be capitalized and amortized over the life of the related lease. 9. FAIR VALUE MEASUREMENTS Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices observable for the asset or liability, such as interest rates and yield curves observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In instances in which the inputs used to measure fair value may fall into different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in its entirety has been determined is based on the lowest level input significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. As of December 31, 2016, the Company estimated that the fair value of its notes payable, excluding deferred financing costs, which had a book value of $254.8 million, was $251.0 million. As of December 31, 2015, the Company estimated that the book value of its note payable, excluding deferred financing costs, approximates its fair value since its variable interest rate approximated the then-current lending rate for loans with similar maturities and credit quality. Management has utilized available market information such as interest rate and spread assumptions of notes payable with similar terms and remaining maturities, to estimate the amounts required to be disclosed. Although the Company has determined that the majority of the inputs used to value its notes payable fall within Level 2 of the fair value hierarchy, the credit quality adjustments associated with its fair value of notes payable utilize Level 3 inputs. However, the Company has assessed the significance of the impact of the credit quality adjustments on the overall valuations of the fair market value of its notes payable and has determined they are not significant. Other financial instruments not measured at fair value on a recurring basis include cash and cash equivalents, restricted cash, tenant and other receivables, accounts payable and accrued expenses, other liabilities, due to affiliates and distributions payable. The carrying value of these items reasonably approximates their fair value based on their highly-liquid nature and/or short-term maturities. Due to the short-term nature of these instruments, Level 1 inputs are utilized to estimate the fair value of the cash and cash equivalents and restricted cash and Level 2 inputs are utilized to estimate the fair value of the remaining financial instruments. 10. REPORTABLE SEGMENTS As described previously, the Company intends to invest the net proceeds from the Offering in a diversified portfolio of quality commercial real estate properties and other real estate investments throughout the United States and internationally. The Company’s current business consists of owning, operating, acquiring, developing, investing in, and disposing of real estate assets. All of the Company’s consolidated revenues and property operating expenses as of December 31, 2016 are from the Company’s five consolidated real estate properties owned as of that date. As a result, the Company’s operating segments have been aggregated into one of four reportable segments: domestic office investments, domestic multi-family investments, domestic other investments, and international office investments. The tables below provide additional information related to each of the Company’s segments (in thousands) and a reconciliation to the Company’s net income (loss), as applicable. “Corporate-Level Accounts” includes amounts incurred by the corporate-level entities which are not allocated to any of the reportable segments. For the years ended December 31, 2016, 2015 and 2014, the Company’s total revenue was attributable to the following countries: For the years ended December 31, 2016, 2015 and 2014, the Company’s property revenues in excess of expenses by segment were as follows (in thousands): (1) Revenues less property operating expenses, real property taxes and property management fees. For the years ended December 31, 2016 and 2015, the Company’s total assets by segment were as follows (in thousands): For the years ended December 31, 2016 and 2015, the Company’s total assets were attributable to the following countries: For the years ended December 31, 2016, 2015 and 2014, the Company’s reconciliation to the Company’s property revenue in excess of expenses is as follows (in thousands): 11. SUPPLEMENTAL CASH FLOW DISCLOSURES Supplemental cash flow disclosures for the years ended December 31, 2016, 2015 and 2014 are as follows (in thousands): 12. COMMITMENTS AND CONTINGENCIES The Company may be subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are generally covered by insurance. While the resolution of these matters cannot be predicted with certainty, management believes the final outcome of such matters will not have a material adverse effect on the Company’s consolidated financial statements. 13. QUARTERLY FINANCIAL DATA (UNAUDITED) The following table presents selected unaudited quarterly financial data for each quarter during the years ended December 31, 2016 and 2015 (in thousands, except per share information): 14. SUBSEQUENT EVENTS Rookwood In January 2017, the Company acquired Rookwood Commons and Rookwood Pavilion (collectively, “Rookwood”), two contiguous shopping centers located in Cincinnati, Ohio. The contract purchase price was $193.7 million, exclusive of transaction costs and working capital reserves. Rookwood consists of 600,071 square feet that is, in the aggregate, 97% leased. As a result of the acquisition of Rookwood, the Company incurred approximately $4.4 million in acquisition fees payable to the Advisor. The Company has not concluded its accounting for this recent acquisition, but it expects that the purchase price will primarily be allocated to building, land, in-place lease assets, above-market lease assets, and below-market lease liabilities. In connection with the acquisition of Rookwood, the Company entered into two loan assumption and modification agreements, with Nationwide Life Insurance Company (“Nationwide”), and with CLP-SPF Rookwood Commons, LLC and CLP-SPF Rookwood Pavilion, LLC. Pursuant to the loans, the Company assumed two secured mortgage facilities with a combined original principal amount of $96.0 million. Interest accrued on the unpaid principal balance of the Rookwood Commons and Rookwood Pavilion secured mortgage facilities are due and payable on the first day of each month commencing in February 2017. The Rookwood Commons and Rookwood Pavilion secured mortgage facilities have fixed interest rates of 3.13% and 2.87%, respectively, and mature on July 1, 2020. Each secured mortgage facility may be prepaid in full, subject to certain conditions, including but not limited to providing 30 days’ advance written notice to Nationwide. Montrose Student Residence In March 2017, the Company acquired Montrose, a Class-A student housing asset located in Dublin, Ireland. The contract purchase price for Montrose was €37.7 million (approximately $40.6 million assuming a rate of $1.08 per EUR as of the contract date), exclusive of transaction costs and working capital reserves. Montrose consists of 205 beds and is 100% leased. As a result of this acquisition, the Company incurred approximately $0.9 million in acquisition fees payable to the Advisor. The Company has not concluded on accounting for this recent acquisition, but it expects that the purchase price will be primarily allocated to building, land, furniture and fixtures and in-place lease assets. In connection with the acquisition of Montrose, the Company entered into a secured facility agreement (the “Montrose Facility”) with Wells Fargo Bank, National Association London Branch, for €22.6 million (approximately $24.4 million assuming a rate of $1.08 per EUR as of the date of the agreement). Commencing on May 1, 2017, interest payments are due and payable each quarter and repayment of principal is due upon the maturity of the Montrose Facility on March 23, 2022. The Montrose Facility has a floating interest rate of EURIBOR plus 1.85% through September 2019. Commencing in October 2019, the Montrose Facility will have a floating interest rate of EURIBOR plus 1.85% or 2%, depending upon certain debt yield metrics. The Montrose Facility may be prepaid in full, or in part, subject to a prepayment fee if it is prepaid in the first two years. In addition, pursuant to the terms of the Montrose Facility, the Company entered into a €17.0 million (approximately $18.3 million assuming a rate of $1.08 per EUR as of the date of the agreement) five-year interest rate cap agreement, which effectively caps the EURIBOR interest rate on the Montrose Facility to 1.25%, to limit exposure to interest rate fluctuations. *****
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Based on the provided financial statement excerpt, here's a summary:
Financial Statement Overview:
- This appears to be a financial statement for Hines Global REIT II, Inc.
- The statement covers consolidated financial information including the company and its Operating Partnership
Key Accounting Principles:
- Consolidated financial statements eliminate intercompany transactions
- Operating Partnership is considered a Variable Interest Entity (VIE)
- Real estate assets are recorded at fair value, less accumulated depreciation
- Depreciation is calculated using the straight-line method over approximately 10-year useful lives
Asset and Liability Management:
- Assets and liabilities are evaluated periodically
- Mortgage notes payable are initially recorded at estimated fair value
- Real estate assets are reviewed for potential impairment each reporting period
Impairment Assessment:
- Impairment is determined by comparing:
1. Current and projected operating cash flows
2
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA OPHTHALIX INC. AND ITS SUBSIDIARY CONSOLIDATED FINANCIAL STATEMENTS AS OF DECEMBER 31, 2016 U.S. DOLLARS IN THOUSANDS INDEX Kost Forer Gabbay & Kasierer Aminadav St. Tel-Aviv 6706703, Israel Tel: +972-3-6232525 Fax: +972-3-5622555 ey.com ACCOUNTING FIRM To the Stockholders and Board of Directors of OPHTHALIX INC. We have audited the accompanying consolidated balance sheets of OphthaliX Inc. and its subsidiary (the "Company") as of December 31, 2016 and 2015, and the related consolidated statement of comprehensive loss, changes in stockholders' deficiency and cash flows for each of the two years in the period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above, present fairly, in all material respects, the consolidated financial position of the Company and its subsidiary at December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1c to the consolidated financial statements, the Company has recurring losses from operations and has limited liquidity resources that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1a and Note 1c. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Tel-Aviv, Israel KOST FORER GABBAY & KASIERER March 23, 2017 A Member of Ernst & Young Global OPHTHALIX INC. AND ITS SUBSIDIARY CONSOLIDATED BALANCE SHEETS U.S. dollars in thousands, except share and per share data *) Represents an amount lower than $1 The accompanying notes are an integral part of the consolidated financial statements. OPHTHALIX INC. AND ITS SUBSIDIARY CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS U.S. dollars in thousands, except share and per share data The accompanying notes are an integral part of the consolidated financial statements. OPHTHALIX INC. AND ITS SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' DEFICIENCY U.S. dollars in thousands, except share and per share data The accompanying notes are an integral part of the consolidated financial statements OPHTHALIX INC. AND ITS SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS U.S. dollars in thousands, except share and per share data *) Represents an amount lower than $1 The accompanying notes are an integral part of the consolidated financial statements. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 1:- GENERAL a.OphthaliX Inc. (the "Company" or "OphthaliX"), originally incorporated in the State of Nevada on December 10, 1999 under the name Bridge Capital.com Inc., was a nominally capitalized corporation that did not commence its operations until it changed its name to Denali Concrete Management Inc. ("Denali"), in March 2001. Denali was a concrete placement company specializing in providing concrete improvements in the road construction industry. Denali operated primarily in Anchorage, Alaska, placing curb and gutter, sidewalks and retaining walls for state, municipal and military projects. In December 2005, the Company ceased its principal business operations and focused its efforts on seeking a business opportunity, becoming a public shell company in the U.S. Eye-Fite Ltd. ("Eye-Fite" or the "Subsidiary") was founded on June 27, 2011 in contemplation of the execution of a transaction between Can-Fite BioPharma Ltd. (the "Parent company" or "Can-Fite"), a public company in Israel and U.S, and the Company, as further detailed in Note 1b. The Company and its Subsidiary conduct research and development activities using an exclusive worldwide license for CF101, a synthetic A3 adenosine receptor, or A3AR, agonist (known generically as IB-MECA) solely for the field of ophthalmic diseases after the consummation of the transaction (see also Note 1b2). Following the transaction, Denali changed its name to OphthaliX Inc. and also changed its corporate domicile from Nevada to Delaware. On July 5, 2016, the Company released top-line results from its Phase II clinical trial of CF101 for the treatment of glaucoma. In this trial, no statistically significant differences were found between the CF101 treated group and the placebo group in the primary endpoint of lowering intra ocular pressure ("IOP"). High IOP is a characteristic of glaucoma. CF101 was found to have a favorable safety profile and was well tolerated. In September 2016, the Company’s Board of Directors and Can-Fite, the Company’s parent and majority shareholder, consented in writing to, among other things, the voluntary dissolution and liquidation of the Company pursuant to a Plan of Dissolution. In November 2016, the Company's Board of Directors abandoned the voluntary dissolution and liquidation of the Company. Subsequently, on November 15, 2016, the Company entered into a non-binding letter of intent with an Israeli company for the acquisition of such company by way of a reverse triangular merger. The proposed reverse merger is subject to signing of definitive transaction documents and the completion of closing conditions. There can be no assurance that the transactions contemplated by the letter of intent will be completed. As of December 31, 2016, the Company ceased all research and development operations. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 1:- GENERAL (Cont.) b.Reverse Recapitalization and related arrangements: 1.Recapitalization: On November 21, 2011 (the "Closing Date"), Can-Fite purchased 8,000,000 shares of the Company’s Common Stock, par value $ 0.001 per share in exchange for all of the issued and outstanding ordinary shares of Eyefite pursuant to the terms of a stock purchase agreement (the "Purchase Agreement"). As a result, Eyefite became a wholly-owned subsidiary of the Company and Can-Fite became its majority stockholder and a parent company. On November 21, 2011, the Company also issued a warrant to Can-Fite by which Can-Fite has the right, until the earlier of (a) the November 21, 2016 and (b) the closing of the acquisition of the Company by another entity, resulting in the exchange of the Company’s outstanding common shares such that its stockholders prior to such transaction own, directly or indirectly, less than 50% of the voting power of the surviving entity, to convert its right to the Additional Payment (as defined below in Note 1b2) into 480,022 shares of Common Stock (subject to adjustment in certain circumstances). The per share exercise price for the shares is $5.148. The warrant expired on November 21, 2016. Simultaneously with the transactions described above, the Company completed a private placement of shares of Common Stock for gross proceeds of $3,330 through the sale of 646,776 shares to third party investors and sold 466,139 shares of Common Stock to Can-Fite in exchange for 714,922 ordinary shares of Can-Fite (representing approximately 2.5% of Can-Fite's issued and outstanding share capital as of the Closing Date), valued at $ 2,400 and 97,112 shares to Can-Fite for gross proceeds of $500. As of December 31, 2016, the Company holds 446,827 Can-Fite ordinary shares, representing approximately 1.6% of Can-Fite's outstanding share capital. In contemplation of the recapitalization transaction, on November 12, 2012, the Board of Directors, complying with the undertaking taken as part of the recapitalization of the Company on November 21, 2011, formerly resolved to issue to certain investors and Can-Fite, 1,455,228 and 1,267,315 warrants to acquire 323,384 and 281,625 shares of Common Stock of the Company, respectively (the "Warrants"). The exercise price of such Warrants is $7.74 per share. The Warrants are exercisable for a period of five years from their date of grant and do not contain any non- standard anti-dilution provisions. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 1:- GENERAL (Cont.) The transaction was accounted for as a reverse recapitalization which is outside the scope ASC 805, "Business Combinations". Under reverse capitalization accounting, EyeFite is considered the acquirer for accounting and financial reporting purposes, and acquired the assets and assumed the liabilities of the Company. Assets acquired and liabilities assumed are reported at their historical amounts. Consequently, the consolidated financial statements of the Company reflect the operations of the acquirer for accounting purposes together with a deemed issuance of shares, equivalent to the shares held by the former shareholders of the legal acquirer and a recapitalization of the equity of the accounting acquirer. These consolidated financial statements include the accounts of the Company since the effective date of the reverse capitalization and the accounts of EyeFite since inception. 2.License and research and development services from Can-Fite: In connection with the consummation of the recapitalization transaction, the Company and Can-Fite entered into a license agreement, pursuant to which Can-Fite granted EyeFite a sole and exclusive worldwide license for the use of CF101, solely in the field of ophthalmic diseases ("CF101"). EyeFite was obligated to make to the U.S. National Institutes of Health ("NIH"), with regard to the patents of which are included in the license to EyeFite, for as long as the license agreement between the Company and NIH remains in effect, a nonrefundable minimum annual royalty fee and potential future royalties of 4.0% to 5.5% on net sales. In addition, the Company will be obligated to make certain milestone payments ranging from $25 to $500 upon the achievement of various development milestones for each indication. As of December 31, 2016, the Company accrued an amount of $100 related to DES phase III clinical trial and $75 related the Glaucoma phase II clinical trial. Eye-Fite will also be required to make payments of 20% of sublicensing revenues, excluding royalties and net of the required milestone payments. As of December 31, 2016, the Company did not reach any milestone or generate revenue that would trigger additional payments to Can-Fite. In addition, following the closing of the recapitalization transaction, Can-Fite, OphthaliX and EyeFite entered into a service agreement (the "Service Agreement"). Pursuant to the terms of the Service Agreement, Can-Fite will manage the research and development activities relating to pre-clinical and clinical studies for the development of the ophthalmic indications of CF101. In consideration for Can-Fite's services, EyeFite will pay to Can-Fite a service fee (consisting of all expenses and costs incurred by Can-Fite plus 15%). In addition, the Company is committed to future additional payments equal to 2.5% of any and all proceeds received by EyeFite relating to the activities regarding the drug (the "Additional Payment"). According to the Service Agreement, Can-Fite had the right, to convert the Additional Payment into an additional 480,022 shares of Common Stock of the Company for total consideration of $2,471 (subject to adjustment in certain circumstances). As of December 31, 2016, such right expired. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 1:- GENERAL (Cont.) c.During the year ended December 31, 2016, the Company incurred operating losses and has negative operating activity amounting to $631 and $29, respectively. The Company will be required to obtain additional liquidity resources in the near term . In addition, in February 2013, as last updated in August 2015, the Company obtained a formal letter from Can-Fite stating that Can-Fite agrees to defer the payments under the Services Agreement from January 31, 2013 for the performance of the clinical trials of CF101 in ophthalmic indications until the completion of a fundraising by the Company that will allow such payments. Also, in August 2015, Can-Fite issued another financial support letter, pursuant to which it committed to cover any shortfall in the costs and expenses of operations of the Company which are in excess of the Company's available cash to finance its operations, including cash generated from any future sale of Can-Fite shares. Any related balance on amounts owed bear interest at a rate of 3% per annum. Both letters expired on October 10, 2016. On November 14, 2016 Can-Fite agreed to extend the support letter under the same terms and conditions in order to fund the Company's operations. Such letter expired on February 28, 2017. Deferred payments under the Services Agreement are currently due and as of the date hereof Can-Fite has not made a demand for payment. As of December 31, 2016, the deferred payments to Can-Fite totaled $4,459. There are no assurances that the Company will be able to obtain an adequate level of financial resources in the next twelve months. The Company will have a severe negative impact on its ability to remain a viable company. These conditions raise substantial doubt about the Company's ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments to reflect the possible future effects on recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP"). a. Use of estimates: The preparation of consolidated financial statements, in conformity with U.S. GAAP, requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. b. Financial statements in U.S. dollars: The accompanying financial statements have been prepared in U.S. dollars, the functional and reporting currency of the Company. Although the majority of the Company and its Subsidiary's operations are conducted in Israel, most of their expenses are in U.S dollar. Therefore, the Company's management believes that the U.S dollar is the functional currency of the primary economic environment in which the Company and its Subsidiary operate. Transactions and balances denominated in U.S. dollars are presented at their original amounts. Monetary accounts maintained in currencies other than the U.S. dollar are re-measured into U.S. dollars in accordance with ASC 830-10, "Foreign Currency Matters". All transactions gains and losses of the re-measurement of monetary balance sheets items are reflected in the consolidated statements of comprehensive loss as financial income or expenses, as appropriate. c. Principles of consolidation: The consolidated financial statements include the accounts of the Company and its Subsidiary. Intercompany transactions and balances have been eliminated upon consolidation. d. Cash and cash equivalents: Cash equivalents include short-term highly liquid investments that are readily convertible to cash with original maturities of three months or less from time of deposit. e. Investment in Parent Company: The Company’s investment is its Parent Company’s securities are classified as available-for-sale carried at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity under accumulated other comprehensive income in the consolidated balance sheets. Realized gains and losses on sales of available-for-sale securities are included as financials income, net in the consolidated statements of comprehensive loss. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The Company recognizes an impairment charge when a decline in the fair value of its investments in securities is below the cost basis of such securities is judged to be other than temporary. Factors considered in making such a determination include the duration and severity of the impairment, the reason for the decline in value, the potential recovery period and the Company's intent to sell, including whether it is more likely than not that the Company will be required to sell the investment before recovery of cost basis. For securities that are deemed other-than-temporarily impaired, an entity should recognize the difference between the cost basis of the impaired equity security and the fair value on the measurement date, as an other-than-temporarily impairment loss as part of financial income, net in the statement of comprehensive loss. The fair value on measurement date should be considered the equity security’s new cost basis. Unrealized gains and losses previously recorded through OCI, including the tax effects, should also be reversed. The new cost basis should not be changed for subsequent increases in fair value. After an impairment loss is recognized for individual equity securities classified as available for sale, future increases or decreases in fair value (presuming no additional other-than temporarily impairments exist) are included in OCI. During the year ended December 31, 2015, no impairment was recognized. During the year ended December 31, 2016, the Company recognized impairment loss in investment in the Parent Company amounted to $162. f. Research and development expenses: All research and development costs are charged to the consolidated statements of comprehensive loss, as incurred. g. Accounting for stock-based compensation: The Company accounts for stock-based compensation in accordance with ASC 718, "Compensation - Stock Compensation" ("ASC 718") which requires companies to estimate the fair value of equity-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service periods in the Company's consolidated statements of comprehensive loss. The Company recognizes compensation expenses for the value of its awards granted based on the accelerated recognition method over the requisite service period of each of the awards, net of estimated forfeitures. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The Company estimates the fair value of stock options granted using the binomial option pricing-model which requires a number of assumptions, of which the most significant are the expected stock price volatility and the early exercise multiply. Expected volatility was calculated based upon historical volatilities of similar entities in the related sector index. The early exercise multiply is representing the value of the underlying stock as a multiple of the exercise price of the option which, if achieved, results in exercise of the option. The risk-free interest rate is based on the yield from U.S. treasury bonds with an equivalent term. The Company has historically not paid dividends and has no foreseeable plans to pay dividends. h. Basic and diluted net loss per share: Basic net loss per share is computed based on the weighted average number of shares of Common Stock, par value $0.001 per share (the "Common Stock") outstanding during each period. Diluted net loss per share is computed based on the weighted average number of shares of Common Stock outstanding during each period, plus dilutive potential Common Stock considered outstanding during the period, in accordance with ASC topic 260, "Earnings Per Share" ("ASC 260"). The total weighted average number of shares related to all outstanding warrants and options excluded from the calculations of diluted net loss per share due to their anti-dilutive effect for the years ended December 31, 2016 and 2015, respectively. i. Income taxes: The Company and its Subsidiary account for income taxes and uncertain tax positions in accordance with ASC 740, "Income Taxes" ("ASC 740"). ASC 740 prescribes the use of the liability method whereby deferred tax assets and liability account balances are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company and its Subsidiary provide a full valuation allowance, to reduce deferred tax assets to the amounts that are more likely-than-not to be realized. The Company implements a two-step approach to recognize and to measure uncertain tax positions in accordance with ASC 740. The first step is to evaluate the tax position taken or expected to be taken in a tax return by determining if the weight of available evidence indicates that it is more likely than not that, on an evaluation of the technical merits, the tax position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. As of December 31, 2016 and 2015, no liability for unrecognized tax benefits was recorded as a result of the implementation of ASC 740. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) j. Concentrations of credit risk: Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and the Company’s investment in Parent Company securities. Cash and cash equivalents are deposited with a major bank in Israel. Such cash and cash equivalents and short-term bank deposits may be in excess of insured limits and are not insured in other jurisdictions. The Company's management believes that the financial institution that holds the Company's investments is an institution with high credit standing, and accordingly, minimal credit risk exists with respect to these investments. k. Fair value of financial instruments: The Company adopted ASC 820, "Fair Value Measurements and Disclosures" ("ASC 820"), clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to release a liability in an orderly transaction between market participants. In determining fair value, the Company uses various valuation approaches. ASC 820 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company's assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the inputs as follows: Level 1 - Valuations based on quoted prices in active markets for identical assets that the Company has the ability to access. Level 2 - Valuations based on one or more quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The availability of observable inputs can vary from investment to investment and is affected by a wide variety of factors, including, for example, the type of investment, the liquidity of markets and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment and the investments are categorized as Level 3. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.) The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The carrying amounts of cash and cash equivalents, investment in Parent Company, prepaid expenses and other accounts payable and accrued expenses approximate their fair value due to the short-term maturity of such instruments. Embedded derivative related to Service Agreement is classified within Level 3 because it is valued using valuation techniques. Some of the inputs to these models are unobservable in the market and are significant. NOTE 3:- DISCLOSURE OF NEW STANDARDS a.Going Concern (subsequent to adoption of ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern) In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” ASU 2014-15 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. The amendments in this ASU are effective for reporting periods ending after December 15, 2016, with early adoption permitted. The Company adopted ASU 2014-15 for the year ended December 31, 2016 and updated the going concern disclosure accordingly. b.Financial Instruments ASU 2016-01: In January 2016, the FASB issued Accounting Standards Update No. 2016-01, "Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities" ("ASU 2016-01"). The pronouncement revises the classification and measurement of investments in certain equity investments and the presentation of certain fair value changes for certain financial liabilities measured at fair value. ASU 2016-01 requires the change in fair value of many equity investments to be recognized in net income. ASU 2016-01 is effective for interim and annual periods beginning after December 15, 2017, with early adoption permitted. The Company currently intends to adopt ASU 2016-01 on January 1, 2018, and does not expect the adoption of ASU 2016-01 to have a material impact on its consolidated financial statements. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 4:- FAIR VALUE MEASUREMENTS The following table provides information by value level for financial assets and liabilities that are measured at fair value, as defined by ASC 820, on a recurring basis as of December 31, 2016 and 2015. NOTE 5: - INVESTMENT IN PARENT COMPANY As previously discussed in Notes 1b1 and 2e, the Company currently owns 446,827 of Can-Fite’s ordinary shares, representing approximately 1.6% of Can-Fite's issued and outstanding share capital as of December 31, 2016. As of December 31, 2016 and 2015 the fair value of the Company's investment in Parent Company shares amounted $530 and $658, respectively (according to its quoted market price in the Tel-Aviv Stock Exchange). During the year ended December 31, 2015, the related unrealized losses derive from the change in the fair value of the Investment in Parent Company totaled $136. During the year ended December 31, 2016, the Company recognized other-than-temporarily impairment loss of investment in Parent Company amounted to $162. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 6:- STOCKHOLDERS' DEFICIENCY a.Shares of Common Stock: The shares of Common Stock represent the legal acquirer, meaning OphthaliX's share capital as of the transaction date. Shares of Common Stock confer upon the holders the right to receive notice to participate and vote in the general meetings of the Company and the right to receive dividends, if declared. On July 18, 2013, the Company's stockholders approved a reverse stock split of one share for each four and one-half shares outstanding (1:4.5) (the "Reverse Split") which became effective as of the close of business on August 6, 2013. All shares of Common Stock, warrants, options, per share data and exercise prices included in these consolidated financial statements and notes for all periods presented have been retroactively adjusted to reflect the Reverse Split with respect to the Company's shares of Common Stock. b.Warrants: In contemplation with the Reverse Recapitalization, it was agreed that for each four shares of Common Stock purchased by the investors and Can-Fite, they will be granted by the Company nine warrants to acquire two share of Common Stock of the Company. The exercise price of the warrants is $7.74 per share of Common Stock. The warrants were exercisable for a period of five years from their date of grant. The warrants do not contain nonstandard anti-dilution provisions. All such warrants were expired in November 2016. According to ASC 815-40-15 and 25 instructions, the Company's management evaluated whether the warrants are entitled to the scope exception in ASC 815-10-15-74 (as the warrants meet the definition of a derivative under ASC 815-10-15-83). Based on their straight forward terms (i.e., fix exercise price, no down-round or other provisions that will preclude them from being considered indexed to the Company's own stock), the Company's management concluded the warrants should be classified as equity at inception. In contemplation of the transaction, the Company issued a total of 532,870 fully vested warrants to acquire 118,415 shares of Common Stock to consultants and brokers involved in the transaction. These warrants are exercisable upon the payment of $5.148 per share of Common Stock. As of December 31, 2016 and 2015, the intrinsic value of the Adviser Warrants is $0. Such warrants expired in November 2016. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 6:- STOCKHOLDERS' DEFICIENCY (Cont.) c.Stock option plan and grant: In 2012, the Company's Board of Directors approved the adoption of the 2012 Stock Incentive Plan (the "2012 Plan"). An Israeli annex was subsequently adopted in 2013 to comply with the requirements set by the Israeli law in general and in particular with the provisions of section 102 of the Israeli tax ordinance. Under the 2012 Plan and Israeli annex, the Company may grant its officers, directors, employees and consultants, stock options, restricted stocks and Restricted Stock Units ("RSUs") of the Company. Each Stock option granted shall be exercisable at such times and terms and conditions as the Company's Board of Directors may specify in the applicable option agreement, provided that no option will be granted with a term in excess of 10 years. Upon the adoption of the 2012 Plan, the Company reserved for issuance 1,088,888 shares of Common Stock, $0.001 par value each. As of December 31, 2016, the Company has 971,388 shares of Common Stock available for future grant under the 2012 Plan. During the years ended December 31, 2016 and 2015, the Company did not grant any new stock options. A summary of the Company's options activity for employees under the Company's 2012 Plan is as follows: As of December 31, 2016, there is no aggregated intrinsic value of outstanding and exercisable options. The aggregate intrinsic value represents the total intrinsic value (the difference between the deemed fair value of the Company's Ordinary Shares on the last day of fiscal 2016 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2016. This amount is impacted by the changes in the fair market value of the Company's shares. Stock-based compensation expenses recognized during the years ended December 31, 2016 and 2015 totaled to $3 and $22, respectively. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 7:- INCOME TAXES a.Tax rates applicable to the Company: The taxes in the U.S. applying to a Company (incorporated in state of Delaware), consists of a progressive corporate tax at a rate of up to 35% plus state tax and local tax at rates depending on the state and the city in which the company manages its business. In the Company's estimation, it is subject to approximately a 40% tax rate. b.Tax rates applicable to Subsidiary: 1.Taxable income of the Company is subject to the Israeli corporate tax at the rates of 26.5% in 2014 and 2015. 2.On January 5, 2016, the Israeli Parliament officially published the Law for the Amendment of the Israeli Tax Ordinance (Amendment 216), that reduces the standard corporate income tax rate from 26.5% to 25%. 3.In December 2016, the Israeli Parliament approved the Economic Efficiency Law (Legislative Amendments for Applying the Economic Policy for the 2017 and 2018 Budget Years), a reduction of the corporate tax rate in 2017 from 25% to 24%, and in 2018 from 25% to 23%. c.Net operating losses carryforward: The Company is subject to U.S. income taxes. As of December 31, 2016, the Company has net operating loss carryforwards for federal income tax purposes of approximately $2,542 which expire in the years 2019 to 2036. The Company has no operating loss carryforwards for income tax purposes. Utilization of the U.S. net operating losses may be subject to substantial annual limitation due to the "change in ownership" provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses before utilization. The Company's Subsidiary in Israel has estimated accumulated losses for tax purposes as of December 31, 2016, in the amount of approximately $2,696 which may be carried forward and offset against taxable income in the future for an indefinite period. d.Loss before taxes is comprised as follows: OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 7:- INCOME TAXES (Cont.) e.Deferred taxes: Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company and its Subsidiary's' deferred tax assets are comprised of operating loss carryforward and other temporary differences. Significant components of the Company and its Subsidiary's deferred tax assets are as follows: In assessing the realization of deferred tax assets, management considers whether it is more likely than not that all or some portion of the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the periods in which temporary differences are deductible and net operating losses are utilized. Management currently believes that since the Company and its Subsidiary have a history of losses it is more likely than not that the deferred tax regarding the loss carryforward and other temporary differences will not be realized in the foreseeable future. Therefore, the Company has provided valuation allowance in respect of deferred tax assets resulting from operating loss carryforward and other temporary differences. f.The main reconciling item between the statutory tax rate of the Company and the effective tax rate is the recognition of valuation allowances in respect to deferred taxes relating to accumulated net operating losses carried forward due to the uncertainty of the realization of such deferred taxes. OPHTHALIX INC. AND ITS SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS U.S. dollars in thousands, except share and per share data NOTE 8:- FINANCE EXPENSES, NET NOTE 9:- RELATED PARTY TRANSACTIONS The Company has several related party balances and transaction mainly in connection with the License Agreement with the Parent Company (see also Note 1b2). Details of the transactions with related parties are depicted in the following tables: Transactions with related parties: Balances with Related Parties: (1)Related to Service Agreement (see also Note 1b2). (2) Related to Investment in Parent Company (see also Notes 2e and Note 5).
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt. It seems to be discussing accounting treatment for a reverse capitalization transaction, but lacks specific numerical details about profits, losses, assets, or liabilities. Without more complete information, I cannot provide a meaningful summary. If you have the full financial statement or can provide more context, I'd be happy to help you summarize it.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” ACCOUNTING FIRM To the Board of Directors and Stockholders of YuMe, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity (deficit), and cash flows present fairly, in all material respects, the financial position of YuMe, Inc. and its subsidiaries as of December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. /s/ PricewaterhouseCoopers LLP San Jose, California March 10, 2017 YuMe, Inc. CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts) See accompanying notes to consolidated financial statements. YuMe, Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) See accompanying notes to consolidated financial statements. YuMe, Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (In thousands) See accompanying notes to consolidated financial statements. YuMe, Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) (In thousands, except share amounts) See accompanying notes to consolidated financial statements. YuMe, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) See accompanying notes to consolidated financial statements. 1. Organization and Description of Business Organization and Nature of Operations YuMe, Inc. (the “Company”) was incorporated in Delaware on December 16, 2004. The Company, including its wholly-owned subsidiaries, is a leading independent provider of digital video brand advertising solutions. The Company’s proprietary technologies serve the specific needs of brand advertisers and enable them to find and target large, brand-receptive audiences across a wide range of Internet-connected devices and digital media properties. The Company’s software is used by global digital media properties to monetize professionally-produced content and applications. The Company facilitates digital video advertising by dynamically matching relevant audiences available through its digital media property partners with appropriate advertising campaigns from its advertising customers. The Company helps its advertising customers overcome the complexities of delivering digital video advertising campaigns in a highly fragmented environment where dispersed audiences use a growing variety of Internet-connected devices to access thousands of online and mobile websites and applications. The Company delivers video advertising impressions across personal computers, smartphones, tablets, set-top boxes, game consoles, Internet-connected TVs and other devices. The Company’s video ads run when users choose to view video content on their devices. On each video advertising impression, the Company collects dozens of data elements that it uses for its advanced audience modeling algorithms that continuously improve brand-targeting effectiveness. Basis of Presentation The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (the “SEC”). Basis of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain Significant Risks and Uncertainties The Company operates in a dynamic industry and, accordingly, can be affected by a variety of factors. For example, the Company believes that changes in any of the following areas could have a significant negative effect on its future financial position, results of operations, or cash flows: rates of revenue growth; traffic to and pricing with the Company’s network of digital media property owners; scaling and adaptation of existing technology and network infrastructure; adoption of the Company’s product and solution offerings; management of the Company’s growth; new markets and international expansion; protection of the Company’s brand, reputation and intellectual property; competition in the Company’s markets; recruiting and retaining qualified employees and key personnel; intellectual property infringement and other claims; and changes in government regulation affecting the Company’s business, among other things. 2. Summary of Significant Accounting Policies Use of Estimates The preparation of the Company’s consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the date of the financial statements and the reported amounts of income and expenses during the reporting period. These estimates are based on information available as of the date of the financial statements; therefore, actual results could differ from management’s estimates. Foreign Currency Translation and Transactions The consolidated financial statements of the Company’s foreign subsidiaries are measured using the local currency as the functional currency, except for India and France, which have U.S. dollar and British pound sterling functional currencies, respectively. Assets and liabilities of foreign subsidiaries are translated at exchange rates in effect as of the balance sheet date. Revenues and expenses are translated at average exchange rates in effect during the period. Translation adjustments are recorded within accumulated other comprehensive loss, a separate component of stockholders’ equity, on the consolidated balance sheets. Foreign exchange transaction losses totaled $0.6 million, $0.5 million and $1.0 million for 2016, 2015 and 2014, respectively. Cash and Cash Equivalents The Company invests a portion of its excess cash in money market funds. The Company considers all highly liquid financial instruments purchased with original maturities of three months or less to be cash equivalents. Marketable Securities Marketable securities are classified as available-for-sale and have consisted of highly liquid corporate bonds, commercial paper and certificates of deposits that comply with the Company’s minimum credit rating policy. Short-term marketable securities must have a credit rating of A-1/P-1 or better by Standard and Poor’s and Moody’s Investor Service at the time they are purchased and long-term marketable securities must have a credit rating of A or better by Standard and Poor’s and A2 or better by Moody’s Investor Service at the time they are purchased. Asset backed marketable securities must have a credit rating of AAA at the time they are purchased. Short-term marketable securities consist of investments with final maturities of at least three months from the date of purchase that the Company intends to own for up to 12 months. Long-term marketable securities consist of investments with final maturities of more than 12 months from the date of purchase that the Company intends to own for more than 12 months, but not more than 24 months. By policy, the final maturity for each security within the portfolio shall not exceed 24 months from the date of purchase and the weighted average maturity of the portfolio shall not exceed 12 months at any point in time. Marketable securities are carried at fair value with unrealized gains and losses, net of taxes, reported as a component of stockholders’ equity on the consolidated balance sheets. See Note 3 for additional information regarding the Company’s marketable securities. Restricted Cash The Company’s lease agreement for its New York City office requires a security deposit in the amount of $0.4 million to be maintained in the form of an unconditional, irrevocable letter of credit issued to the benefit of the landlord. The letter of credit is subject to renewal annually until the lease expires in September 2027. On July 1, 2020, the required security deposit will decrease to $0.3 million. The lease agreement for the Company’s previous New York City office required a security deposit in the amount of $0.3 million to be maintained in the form of an unconditional, irrevocable letter of credit issued to the benefit of the landlord. The letter of credit expired in the second quarter of 2016. In the three months ended September 30, 2016, the Company entered in to a $0.3 million deed as security against overdrafts on a bank account to be used for processing payroll in the United Kingdom. The term of the deed is continuous until it is released by the bank. The amount of the deed is recorded as restricted cash, non-current in the condensed consolidated balance sheets. Foreign Currency Transaction Risk-Foreign Currency Forward Contracts The Company transacts business in various foreign currencies and in the second quarter of 2015 established a program that utilizes foreign currency forward contracts to offset the risks associated with the effects of certain foreign currency exposures. Under this program, to the Company enters into foreign currency forward contracts so that increases or decreases in foreign currency exposures are offset at least in part by gains or losses on the foreign currency forward contracts in order to mitigate the risks and volatility associated with the Company’s foreign currency transactions. The Company may suspend this program from time to time. Foreign currency exposures typically arise from British pound and euro denominated transactions that the Company expects to cash settle in the near term, which are charged against earnings in the period incurred. The Company’s foreign currency forward contracts are short-term in duration. The Company does not use foreign currency forward contracts for trading purposes nor does it designate forward contracts as hedging instruments pursuant to ASC 815. Accordingly, the Company records the fair values of these contracts as of the end of its reporting period to its condensed consolidated balance sheets with changes in fair values recorded to its condensed consolidated statement of operations. Given the short duration of the forward contracts, the amount recorded is not significant. The balance sheet classification for the fair values of these forward contracts is prepaid expenses and other current assets for a net unrealized gain position, and accrued liabilities for a net unrealized loss position. The statement of operations classification for changes in fair value of these forward contracts is other expense, net for both realized and unrealized gains and losses. The Company expects to continue to realize gains or losses with respect to its foreign currency exposures, net of gains or losses from its foreign currency forward contracts. The Company’s ultimate realized gain or loss with respect to foreign currency exposures will generally depend on the size and type of cross-currency transactions that it enters into, the currency exchange rates associated with these exposures and changes in those rates, the net realized gain or loss on its foreign currency forward contracts and other factors. As of December 31, 2016, the notional amount and the aggregate fair value of the forward contracts the Company held to purchase U.S. dollars in exchange for British pounds and euros was $3.6 million. Net foreign exchange transaction gains/(losses) relating to the Company’s British pound sterling and euro forward contracts are included in other income (expense), net in the Company’s consolidated statements of operations. Net foreign exchange transaction gains/(losses) included in other expense, net in the Company’s consolidated statements of operations was immaterial for 2015 and was $0.7 million for 2016 relating to the Company’s British pound sterling and euro forward contracts. Concentrations and Other Risks Financial instruments that subject the Company to a concentration of credit risk consist of cash and cash equivalents, marketable securities and accounts receivable. Cash and cash equivalents are deposited with one domestic and five foreign highly rated financial institutions and cash equivalents are invested in highly rated money market funds. Periodically, such balances may be in excess of federally insured limits. Marketable securities consist of highly liquid corporate bonds, commercial paper and certificates of deposits that comply with the Company’s minimum credit rating policy. Credit risk with respect to accounts receivable is dispersed due to the large number of advertising customers. Collateral is not required for accounts receivable. The Company performs ongoing credit evaluations of customers’ financial condition and periodically evaluates its outstanding accounts receivable and establishes an allowance for doubtful accounts receivable based on the Company’s historical experience, the current aging and circumstances of accounts receivable and general industry and economic conditions. Accounts receivable are written off by the Company when it has been determined that all available collection avenues have been exhausted. In 2016, 2015 and 2014, bad debt write-offs totaled $0.4 million, $0.5 million and $0.7 million, respectively. If circumstances change, higher than expected bad debts may result in future write-offs that are greater than the Company’s estimates. No customers accounted for 10% or more of the Company’s accounts receivable as of December 31, 2016 or 2015. One customer accounted for 12% of the Company’s revenue in 2016. No single customer accounted for 10% or more of the Company’s revenue in 2015 and 2014. The following table presents the changes in the allowance for doubtful accounts receivable (in thousands): Property, Equipment and Software Property and equipment are stated at cost, net of accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which are generally three to five years. Leasehold improvements are amortized over the shorter of the asset life or remaining lease term. Internal-Use Software Development Costs The Company capitalizes the costs to develop internal-use software when preliminary development efforts are successfully completed, it has authorized and committed project funding, and it is probable that the project will be completed and the software will be used as intended. Such costs are amortized on a straight-line basis over the estimated useful life of the software, which approximates three years. Costs incurred prior to meeting these criteria, together with costs incurred for training and maintenance, are expensed as incurred. Costs incurred for upgrades and enhancements that are expected to result in additional material functionality are capitalized and amortized over the respective estimated useful life. The Company capitalized $4.8 million, $4.2 million and $2.4 million of internal-use software costs during the years ended December 31, 2016, 2015 and 2014, respectively, which are included in property, equipment and software on the consolidated balance sheets. Amortization expense associated with capitalized internal-use software totaled approximately $2.7 million, $1.6 million and $1.1 million for the years ended December 31, 2016, 2015 and 2014, respectively. Impairment of Long-lived Assets The Company evaluates its long-lived assets for impairment when circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported as a separate caption at the lower of the carrying amount or fair value less costs to sell. There were no changes in estimated useful lives during years ended December 31, 2016, 2015 and 2014. For internally developed software, the Company performs regular recoverability assessments in order to evaluate any impairment indicators or changes to useful lives. During the fourth quarter of 2016, the Company determined not to allocate any future resources to market, develop and maintain its YFP 5.0 supply-side platform for publishers since it was not generating sufficient revenue to cover its related costs. The Company’s assessment determined YFP 5.0 to be fully impaired and the Company recorded a one-time non-cash asset impairment charge of $0.9 million related to YFP 5.0 in operating expenses. Deferred Rent The Company leases facilities worldwide under non-cancelable operating leases that expire through August 2024. These leases contain various renewal options. The Company recognizes rent holidays and escalating rent provisions on a straight-line basis over the term of the lease. The Company’s deferred rent liability related to these facilities was approximately $0.9 and $0.4 million at December 31, 2016 and 2015, respectively, which are included in “Accrued liabilities” and “Other long-term liabilities” on the consolidated balance sheets. Revenue Recognition The Company’s revenue is principally derived from advertising services measured by the number of advertising impressions displayed on digital media properties owned and controlled by third party digital media property owners and primarily priced on a cost per thousand impressions (“CPM”) basis. The Company recognizes revenue when: (1) persuasive evidence exists of an arrangement with the customer reflecting the terms and conditions under which products or services will be provided; (2) delivery has occurred or services have been provided; (3) the fee is fixed or determinable; and (4) collection is reasonably assured. For all revenue transactions, the Company considers a signed agreement, a binding insertion order or other similar documentation to be persuasive evidence of an arrangement. Arrangements for these services generally have a term of up to three months. In some cases the term may be up to one year or more. In the normal course of business, the Company acts as a facilitator in executing transactions with third parties. The determination of whether revenue should be reported on a gross or net basis is based on an assessment of whether the Company is acting as the principal or an agent in the transaction. In determining whether the Company acts as the principal or an agent, the Company follows the accounting guidance for principal-agent considerations. While none of the factors identified in this guidance is individually considered presumptive or determinative, because the Company is the primary obligor and is responsible for (i) identifying and contracting with third party advertisers, (ii) establishing the selling prices of the advertisements sold, (iii) performing all billing and collection activities including retaining credit risk and (iv) bearing sole responsibility for fulfillment of the advertising, which may also include committing to buy advertising inventory in advance, the Company acts as the principal in these arrangements and therefore reports revenue earned and costs incurred on a gross basis. The Company recognizes revenue based on delivery information from a combination of third party reporting and the Company’s proprietary campaign tracking systems. Multiple-element Arrangements The Company enters into arrangements with customers to sell advertising packages that include different media placements or ad services that are delivered at the same time, or within close proximity of one another. At the inception of an arrangement, the Company allocates arrangement consideration in multiple-deliverable revenue arrangements to all deliverables, based on the relative selling price method in accordance with the selling price hierarchy, which includes: (1) vendor-specific objective evidence (“VSOE”) if available; (2) third party evidence (“TPE”) if VSOE is not available; and (3) best estimate of selling price (“BESP”) if neither VSOE nor TPE is available. VSOE-The Company evaluates VSOE based on its historical pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, the Company requires that a substantial majority of the standalone selling prices for these services fall within a reasonably narrow pricing range. The Company historically has not entered into a large volume of single-element arrangements, so it has not been able to establish VSOE for any of its advertising products. TPE-When VSOE cannot be established for deliverables in multiple element arrangements, the Company applies judgment with respect to whether it can establish a selling price based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, the Company’s go-to-market strategy differs from that of its peers and its offerings contain a significant level of differentiation such that the comparable pricing of services cannot be obtained. Furthermore, the Company is unable to reliably determine what similar competitor services’ selling prices are on a standalone basis. As a result, the Company has not been able to establish selling price based on TPE. BESP-When the Company is unable to establish selling price using VSOE or TPE, the Company uses BESP in its allocation of arrangement consideration. The objective of BESP is to determine the price at which the Company would transact a sale if the service were sold on a standalone basis. BESP is generally used to allocate the selling price to deliverables in the Company’s multiple-element arrangements. The Company determines BESP for deliverables by considering multiple factors including, but not limited to, prices it charges for similar offerings, class of advertiser, size of transaction, seasonality, observed pricing trends, available online inventory, industry pricing strategies, market conditions and competitive landscape. The Company limits the amount of allocable arrangement consideration to amounts that are fixed or determinable and that are not contingent on future performance or future deliverables. The Company periodically reviews its BESP. Changes in assumptions or judgments or changes to the elements in the arrangement could cause a material increase or decrease in the amount of revenue that the Company reports in a particular period. The Company recognizes revenue for media placements and ad services as they are delivered assuming all other revenue recognition criteria are met. Deferred revenue is comprised of contractual billings in excess of recognized revenue and payments received in advance of revenue recognition. Cost of revenue Cost of revenue consists of amounts incurred with digital media property owners that are directly related to a revenue-generating event, direct labor costs, amortization of revenue-producing acquired technologies, Internet access costs and depreciation expense. The Company incurs costs with digital media property owners in the period the advertising impressions are delivered or in limited circumstances, based on minimum guaranteed number of impressions. Such amounts incurred are classified as cost of revenue in the corresponding period in which the revenue is recognized in the consolidated statements of operations. Advertising expense The Company’s advertising costs are expensed as incurred. The Company incurred approximately $0.5 million, $0.6 million and $1.7 million in advertising expenses for the years ended December 31, 2016, 2015 and 2014, respectively. Stock-based Compensation The Company measures compensation expense for all stock-based payment awards, including stock options granted to employees, directors and non-employees based on the estimated fair values on the date of the grant. The fair value of each stock option granted is estimated using the Black-Scholes option valuation model. Stock-based compensation expense related to restricted stock units (“RSUs”) is based on the grant date fair value of the RSUs. Stock-based compensation is recognized on a straight-line basis over the requisite service period. Stock-based compensation expense is recorded net of estimated forfeitures in our consolidated statements of income and as such is recorded for only those share-based awards that we expect to vest. The Company estimates the forfeiture rate based on historical forfeitures of equity awards and adjusts the rate to reflect changes in facts and circumstances, if any. The Company will revise our estimated forfeiture rate if actual forfeitures differ from our initial estimates. Comprehensive Income (Loss) Comprehensive income (loss) consists of net income (loss) and changes in accumulated other comprehensive income (loss), which are primarily the result of foreign currency translation adjustments and unrealized gains or losses on marketable securities, net of tax. Goodwill Goodwill is not amortized, but is tested for impairment at least annually or as circumstances indicate the value may no longer be recoverable. The Company evaluates goodwill for impairment annually in the fourth quarter of its fiscal year as of December 31, or whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. Triggering events that may indicate impairment include, but are not limited to, a decrease in market capitalization, increasing cost structure, a significant adverse change in customer demand or business climate that could affect the value of goodwill, a significant decrease in expected cash flows, restructuring activities undertaken to reduce increasing future operating expenses, the loss of key personnel, whether voluntarily or involuntarily, and/or a decline revenue forecasts. If management determines any of these qualitative triggering events exist, or that in aggregate they might indicate a goodwill impairment exists, management would then proceed to performing the two-step goodwill impairment test as needed to determine if an impairment exists. As of December 31, 2016, management performed the first step of the goodwill impairment test and determined that the fair value of its goodwill is greater than its carrying value and no impairment of goodwill exists. Intangible Assets Acquired intangible assets consist of acquired customer relationships and developed technology. Acquired intangible assets are recorded at fair value, net of accumulated amortization. Intangible assets are amortized on a straight-line basis over their estimated useful lives. The Company reviews identifiable amortizable intangible assets to be held and used for impairment whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Determination of recoverability is based on the lowest level of identifiable estimated undiscounted cash flows resulting from use of the asset and its eventual disposition. Measurement of any impairment loss is based on the excess of the carrying value of the asset over its fair value. Restructuring On November 8, 2016, the Company’s board of directors approved a restructuring plan designed to reduce its operating expenses, realign its cost structure with revenue, better manage its costs and more efficiently manage the business. The restructuring plan was implemented in the fourth quarter of 2016 and completed in the first quarter of 2017. Restructuring expenses totaled $1.6 million and were recorded as restructuring expenses on our consolidated statements of operations in the fourth quarter of 2016. Elements of the restructuring plan included a workforce reduction of approximately 7%, which included employee severance pay and related expenses, acceleration of the Company’s former chief executive officer’s stock-based compensation expense as a result of his termination without cause and facility exit expenses. The Company does not expect to incur any additional expenses under the restructuring plan. The Company accounts for its employee termination and facility consolidation restructuring activities under ASC 420, Exit or Disposal Cost Obligations, which addresses when to recognize a liability for involuntary employee termination benefits pursuant to a one-time benefit arrangement and costs to consolidate facilities. See Note 11 Restructuring for additional information regarding the Company’s restructuring activities. Income Taxes The Company records income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s consolidated financial statements or income tax returns. In estimating future tax consequences, expected future events other than enactments or changes in the tax law or rates are considered. Deferred tax valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized. The following table sets forth our deferred tax valuation allowance for the years ended December 31, 2016, 2015 and 2014. The Company operates in various tax jurisdictions and is subject to audit by various tax authorities. The Company provides for tax contingencies whenever it is deemed probable that a tax asset has been impaired or a tax liability has been incurred for events such as tax claims or changes in tax laws. Tax contingencies are based upon their technical merits, relative tax law, and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax contingencies. The Company records uncertain tax positions in accordance with accounting standards on the basis of a two-step process whereby (1) a determination is made as to whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold the Company recognizes the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. Recently Issued and Adopted Accounting Standards In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The FASB has recently issued several amendments to the standard, including identifying performance obligations. The new standard, as amended, is effective for annual reporting periods beginning after December 15, 2017, with early adoption permitted for annual reporting periods beginning after December 15, 2016. The Company does not plan to early adopt, and thus the new standard will become effective for the Company on January 1, 2018. As part of this plan, the Company is currently assessing the impact of the new guidance on its results of operations. However, further analysis is required and the Company will continue to evaluate this assessment in 2017. The Company currently expects to apply the modified retrospective method of adoption; however, it has not yet finalized its transition method, but expects to do so in 2017 upon completion of further analysis. In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, which requires management to evaluate whether there are conditions and events that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the financial statements are issued on both an interim and annual basis. Management is required to provide certain footnote disclosures if it concludes that substantial doubt exists or when its plans alleviate substantial doubt about the Company’s ability to continue as a going concern. ASU 2014-15 becomes effective for annual periods ending after December 15, 2016 and for interim reporting periods thereafter. The Company adopted this standard for its fiscal year ended December 31, 2016. In April 2015, the FASB issued ASU 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, which clarifies when fees paid in a cloud computing arrangement pertain to the acquisition of a software license, services, or both. ASU 2015-05 provides criteria for customers in a cloud computing arrangement to use to determine whether the arrangement includes a license of software. The criteria are based on existing guidance for cloud service providers. However, the ASU does not change the accounting for cloud service providers. ASU 2015-05 is effective for annual and interim periods in fiscal years beginning after December 15, 2015. The Company adopted this standard prospectively as of January 1, 2016 and the impact to its consolidated financial statements was not material. In January 2016, the FASB issued ASU 2016-01, Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which amends the guidance in U.S. GAAP on the classification and measurement of financial instruments. Changes to the current guidance primarily affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. In addition, the standard clarifies guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities. The new standard is effective for fiscal years and interim periods beginning after December 15, 2017, and upon adoption, an entity should apply the amendments by means of a cumulative-effect adjustment to the balance sheet at the beginning of the first reporting period in which the guidance is effective. Early adoption is not permitted except for the provision to record fair value changes for financial liabilities under the fair value option resulting from instrument-specific credit risk in other comprehensive income. The Company is currently evaluating the impact of adopting this standard. In February 2016, the FASB issued ASU 2016-02 Leases (Topic 842). This ASU requires entities that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The standard is effective for fiscal years and the interim periods within those fiscal years beginning after December 15, 2018. The guidance is required to be applied by the modified retrospective transition approach. Early adoption is permitted. The Company is currently evaluating the impact of adopting this standard. In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718). This ASU was issued as part of the FASB’s simplification initiative and affects all entities that issue share-based payment awards to their employees. This standard covers accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows and will be effective as of January 1, 2017, with early adoption permitted. The Company adopted the standard January 1, 2017 and is currently evaluating the impact of adopting this standard. In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350). This ASU is an update to the standard on goodwill, which eliminates the need to calculate the implied fair value of goodwill when an impairment is indicated. The update states that goodwill impairment is measured as the excess of a reporting unit’s carrying value over its fair value, not to exceed the carrying amount of goodwill. The update is effective for fiscal years, and interim periods within those fiscal years, beginning after January 1, 2020. Early adoption is permitted for any impairment tests performed after January 1, 2017. Upon adoption, entities will be required to apply the update prospectively. The Company does not expect the adoption of this standard to have a material effect on its consolidated financial statements. 3. Cash, Cash Equivalents, Marketable Securities and Derivative Instruments The Company’s cash equivalents consist of highly liquid fixed-income investments with original maturities of three months or less at the time of purchase. Short- and long-term marketable securities are comprised of highly liquid available-for-sale financial instruments (primarily corporate bonds, commercial paper and certificates of deposit) with final maturities of at least three months but no more than 24 months from the date of purchase. None of the Company’s marketable securities were in a continuous loss position for over twelve months as of December 31, 2016. Beginning in the second quarter of 2015, the Company entered into non-designated derivative instruments, specifically foreign currency forward contracts, to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. The Company’s foreign currency forward contracts have terms of no more than 12 months, are classified as Level 2 and are valued using alternative pricing sources, such as spot currency rates, that are observable for the entire term of the asset or liability. These derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in other income (expense), net in the consolidated statement of operations. The cost, gross unrealized gains and losses and fair value of the Company’s marketable securities and foreign currency forward contracts consisted of the following as of December 31, 2016 and 2015 (in thousands): (1) Included in “Accrued liabilities” in the accompanying consolidated balance sheet as of December 31. Unrealized gains and losses, net of taxes, are included in “Accumulated other comprehensive loss,” which is reflected as a separate component of stockholders’ equity (deficit) on the consolidated balance sheets. 4. Fair Value of Financial Instruments The accounting guidance for fair value measurements prioritizes the inputs used in measuring fair value in the following hierarchy: Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities; Level 2 - Inputs, other than quoted prices in active markets, that are observable either directly or indirectly; and Level 3 - Unobservable inputs for which there is little or no market data, which require the Company to develop its own assumptions. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The carrying amounts of accounts receivable, accounts payable and accrued liabilities, approximate fair value due to their relatively short maturities. Marketable securities with final maturities of at least three months but no more than 12 months from the date of purchase are classified as short-term and marketable securities with final maturities of more than one year but less than two years from the date of purchase are classified as long-term. Our marketable securities are classified as available-for-sale and consist of high quality, investment grade securities from diverse issuers with predetermined minimum credit ratings. The Company values these securities based on pricing from pricing vendors who may use inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs) in determining fair value. As such, the Company classifies all of its marketable securities as having Level 2 inputs. The valuation techniques used to measure the fair value of the Company’s marketable securities having Level 2 inputs were derived from market prices that are corroborated by observable market data and quoted market prices for similar instruments. The following tables present information about the Company’s money market funds, marketable securities and foreign currency forward contracts measured at fair value on a recurring basis as of December 31, 2016 and 2015 and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (in thousands): 5. Property, Equipment and Software For internally developed software, the Company performs regular recoverability assessments in order to evaluate any impairment indicators or changes to useful lives. During the fourth quarter of 2016, the Company determined not to allocate any future resources to market, develop and maintain its YFP 5.0 supply-side platform for publishers since it was not generating sufficient revenue to cover its related costs. The Company’s assessment determined YFP 5.0 to be fully impaired and the Company recorded a one-time non-cash asset impairment charge of $0.9 million related to YFP 5.0 in operating expenses. Property, equipment and software consisted of the following (in thousands): (1) Internally developed software costs exclude $0.9 million of asset impairment charges as of December 31, 2016 related to the impairment of YFP 5.0, the Company’s supply-side platform for publishers. Depreciation and amortization expense, including amortization of internal use software costs, was approximately $6.9 million, $6.0 million and $4.6 million, for the years ended December 31, 2016, 2015 and 2014, respectively. Assets recorded under capital leases consist primarily of data center equipment and were as follows (in thousands): 6. Goodwill and Intangible Assets The intangible assets detail for the periods presented (dollars in thousands): Amortization expense for each of the years ended December 31, 2016, 2015 and 2014 was $0.7 million. Amortization expense related to developed technology is included as a component of “Cost of revenue” in the consolidated statements of operations. 7. Accrued Liabilities Accrued liabilities consisted of the following (in thousands): 8. Borrowings In November 2014, the Company entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to borrow up to a maximum of $25.0 million collateralized by the Company’s cash deposits, accounts receivable and equipment, as well as certain other assets. The Loan and Security Agreement requires the Company to comply with certain financial and reporting covenants, including maintaining an adjusted quick ratio of at least 1.6 to 1.0. Annual fees under the agreement total one quarter of 1.0% of the average unused balance of the credit line per annum. The Company’s Loan and Security Agreement with SVB expired in early November 2016. The Company has decided not to renew this Loan and Security Agreement. The Company never borrowed under the credit line and maintained compliance with all financial and reporting covenants. 9. Commitments and Contingencies Leases The Company leases office facilities under various non-cancellable operating leases that expire through September 2027. Rent expense under operating leases totaled $3.5 million, $3.0 million and $2.7 million for the years ended December 31, 2016, 2015 and 2014, respectively. The Company also has capital lease obligations that mature in July 2019. Purchase Commitments During the normal course of business, to secure adequate ad inventory and impressions for its sales arrangements, the Company enters into agreements with digital media property owners that require purchase of a minimum number of impressions on a monthly or quarterly basis. Purchase commitments as of December 31, 2016 expire on various dates through December 2017. Future Payments Future minimum payments under these arrangements as of December 31, 2016 are as follows (in thousands): The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding. Obligations under contracts that the Company can cancel without a significant penalty are not included in the table above. The Company has determined its uncertain tax positions as of December 31, 2016 will not result in any additional taxes payable by the Company. As a result, no amounts are shown in the table above relating to the Company’s uncertain tax positions. Legal Proceedings From time to time the Company may be a party to various litigation matters incidental to the conduct of its business. There is no pending or threatened legal proceeding to which the Company is currently a party that, in management’s opinion, is likely to have a material adverse effect to the Company’s consolidated financial position, results of operations, or cash flows. Indemnification Agreements In the ordinary course of business, the Company may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners, and other parties with respect to certain matters, including, but not limited to, losses arising out of breach of such agreements, services to be provided by the Company or from intellectual property infringement claims made by third parties. In addition, the Company has entered into indemnification agreements with directors and certain officers and employees that will require the Company, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. While matters may arise as a result of claims under the indemnification agreements disclosed above, the Company, at this time, is not aware of claims under indemnification arrangements that could have a material adverse effect to the Company’s consolidated financial position, results of operations, or cash flows. 10. Stockholders’ Equity Preferred Stock In association with the IPO, the board of directors authorized the Company to issue up to 20,000,000 shares of preferred stock, par value $0.001 per share. As of December 31, 2016 and 2015, no shares of preferred stock were outstanding. Common Stock At December 31, 2016 and 2015 there were 33,946,820 and 34,455,220 shares of common stock issued and outstanding, respectively. The following table summarizes common stock activity during the year ended December 31, 2016: Stock Repurchase Program On February 18, 2016, the Company announced its board of directors authorized a $10 million share repurchase program. The repurchase program has no set expiration date and all purchases are subject to applicable rules and regulations, market conditions and other factors. Purchases under this repurchase program are made in the open market and complied with Rule 10b-18 under the Securities Exchange Act of 1934, as amended. The cost of the repurchased shares is funded from available working capital. For accounting purposes, common stock repurchased under the Company’s stock repurchase program is recorded based upon the repurchase date of the applicable trade. Such repurchased shares are held in treasury and are presented using the cost method. Stock repurchase activity under the Company’s stock repurchase program during 2016 is summarized as follows (in thousands, except share and per share amounts): (1) Average price paid per share includes commission. (2) Includes 27,202 treasury shares purchased in late December 2016 for $98,000 that had not yet settled as of December 31, 2016. Treasury Stock In addition to the 1,952,909 shares repurchased in 2016, the Company has 66,666 shares of treasury stock related to the acquisition of Crowd Science, for a total of 2,019,575 shares of treasury stock. Treasury stock is carried at cost and could be re-issued if the Company determined to do so. Equity Incentive Plans The Company’s 2004 Stock Plan (the “2004 Plan”) authorized the Company to grant restricted stock awards or stock options to employees, directors and consultants at prices not less than the fair market value at date of grant for incentive stock options and not less than 85% of fair market value for non-statutory options. Option vesting schedules were determined by the board of directors at the time of issuance and they generally vest at 25% on the first anniversary of the grant (or the employment or service commencement date) and monthly over the next 36 months. Options generally expire ten years from the date of grant unless the optionee is a 10% stockholder, in which case the term will be five years from the date of grant. Unvested options exercised are subject to the Company’s repurchase right. Upon the effective date of the registration statement related to the Company’s IPO, the 2004 Plan was amended to cease the grant of any additional awards thereunder, although the Company will continue to issue common stock upon the exercise of stock options previously granted under the 2004 Plan. In July 2013, the Company adopted a 2013 Equity Incentive Plan (the “2013 Plan”) which became effective on August 6, 2013. The 2013 Plan serves as the successor equity compensation plan to the 2004 Plan. The 2013 Plan will terminate on July 23, 2023. The 2013 Plan provides for the grant of incentive stock options, nonqualified stock options, restricted stock awards, stock appreciation rights, performance stock awards, restricted stock units (“RSUs”) and stock bonus awards to employees, directors and consultants. Stock options granted must be at prices not less than 100% of the fair market value at date of grant. Option vesting schedules are determined by the Company at the time of issuance and they generally vest at 25% on the first anniversary of the grant (or the employment or service commencement date) and monthly over the next 36 months. Options generally expire ten years from the date of grant unless the optionee is a 10% stockholder, in which case the term will be five years from the date of grant. Unvested options exercised are subject to the Company’s repurchase right. The Company initially reserved 2,000,000 shares of its common stock for issuance under the 2013 Plan, and shares reserved for issuance increase January 1 of each year by the lesser of (i) 5% of the number of shares issued and outstanding on December 31 immediately prior to the date of increase or (ii) such number of shares as may be determined by the board of directors. The following table summarizes option activity: (1) The aggregate intrinsic value represents the difference between the Company’s estimated fair value of its common stock and the exercise price of outstanding in-the-money options as of those dates. (2) Options granted include 0.7 million re-issued options in connection with a modification. See “Modification of Employee Stock Options” below for more information. (3) Options cancelled and forfeited include 0.7 million options that were cancelled in connection with a modification. See “Modification of Employee Stock Options” below for more information. (4) Options expected to vest reflect an estimated forfeiture rate. The weighted average grant date fair value of options granted was $1.93, $2.78 and $3.76 in 2016, 2015 and 2014, respectively. The total intrinsic value of options exercised was not material for 2016 was approximately $0.5 million and $2.0 million for 2015 and 2014, respectively. The following table summarizes restricted stock unit activity: (1) The intrinsic value of RSUs is based on the Company’s closing stock price as reported by the New York Stock Exchange on that date. The total grant date fair value of restricted stock units vested during the years ended December 31, 2016, 2015 and 2014 was $6.3 million, $4.3 million and $0.1 million, respectively. All of our RSUs that were released during the years ended December 31, 2016, 2015 and 2014 were net share settled. As such, upon each release date, RSUs were withheld to cover the required withholding tax, which is based on the value of the RSU on the release date as determined by the closing price of our common stock on the trading day of the settlement date. The remaining amounts are delivered to the recipient as shares of our common stock. Modification of Employee Stock Options On January 2, 2015, the Company modified options to purchase 0.7 million shares of common stock previously granted to non-executive employees with exercise prices over $7.00 per share. The exercise price of the modified options was reduced to $5.14 per share, the closing price of the Company’s common stock on the New York Stock Exchange on January 2, 2015. No other terms of these options were modified. The Company expects to recognize an additional $0.4 million of stock-based compensation expense over the remaining vesting terms of the options as a result of the modification. As of December 31, 2016, an immaterial amount of additional stock-based compensation expense related to the modification remains to be expensed. Employee Stock Purchase Plan In July 2013, the Company adopted a 2013 Employee Stock Purchase Plan (the “2013 Purchase Plan”) that became effective on August 6, 2013. The 2013 Purchase Plan is designed to enable eligible employees to periodically purchase shares of the Company’s common stock at a discount through payroll deductions of up to 15% of their eligible compensation, subject to any plan limitations. At the end of each offering period, employees are able to purchase shares at 85% of the lower of the fair market value of the Company’s common stock on the first trading day of the offering period or on the last day of the offering period. Purchases are accomplished through participation in discrete offering periods. The 2013 Purchase Plan is intended to qualify as an employee stock purchase plan under Section 423 of the Internal Revenue Code. The Company initially reserved 500,000 shares of its common stock for issuance under the 2013 Purchase Plan and shares reserved for issuance increase January 1 of each year by the lesser of (i) a number of shares equal to 1% of the total number of outstanding shares of common stock on December 31 immediately prior to the date of increase or (ii) such number of shares as may be determined by the board of directors. The fair value of stock purchased through the 2013 Purchase Plan is estimated on the first trading day of the offering period using the Black-Scholes option valuation model. This valuation model for stock-based compensation expense requires the Company to make assumptions and judgments about the variables used in the calculation, including the volatility of the Company’s common stock, a risk-free interest rate, expected dividends, and estimated forfeitures. To the extent actual results differ from the estimates, the difference will be recorded as a cumulative adjustment in the period estimates are revised. Volatility is based on an average of the historical volatilities of the common stock of a group of entities with characteristics similar to those of the Company. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for six-month treasury notes corresponding with the length of the offering period. Expected forfeitures are based on the Company’s historical experience. The Company currently has no history or expectation of paying cash dividends on common stock. The expected term of ESPP shares is the average of the remaining purchase periods under each offering period. The assumptions used to value employee stock purchase rights were as follows: Shares Reserved for Future Issuance At December 31, 2016 and 2015, the Company has reserved the following shares of common stock for future issuance: Stock-Based Compensation The fair value of options granted to employees is estimated on the grant date using the Black-Scholes option valuation model. This valuation model for stock-based compensation expense requires the Company to make assumptions and judgments about the variables used in the calculation, including the expected term (weighted-average period of time that the options granted are expected to be outstanding), volatility of the Company’s common stock, a risk-free interest rate, expected dividends, and the estimated forfeitures of unvested stock options. To the extent actual results differ from the estimates, the difference will be recorded as a cumulative adjustment in the period estimates are revised. The Company uses the simplified calculation of expected life, and volatility is based on an average of the historical volatilities of the common stock of a group of entities with characteristics similar to those of the Company. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option. Expected forfeitures are based on the Company’s historical experience. The Company currently has no history or expectation of paying cash dividends on common stock. The fair value of options granted to employees is determined using the Black-Scholes option valuation model with the following assumptions: The following table summarizes the effects of stock-based compensation related to vesting stock-based awards included in the consolidated statements of operations (in thousands): (1) Excludes $537,000, $544,000 and $360,000 of stock-based compensation expense that was capitalized as part of internal-use software development costs for the years ended December 31, 2016, 2015 and 2014, respectively. (2) Excludes $288,000 of stock-based compensation expense for the year ended December 31, 2016 related to the partial acceleration of the Company’s former chief executive officer’s unvested equity awards in association with his severance agreement. The $288,000 is included in restructuring on the Company’s consolidated statements of operations. See Note 11 below. No income tax benefit has been recognized relating to stock-based compensation expense and no tax benefits have been realized from exercised stock options during the years ended December 31, 2016, 2015 and 2014. As of December 31, 2016, there was $6.8 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based awards which will be recognized over a weighted average period of 1.72 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. 11. Restructuring On November 8, 2016, the Company’s board of directors approved a restructuring plan designed to reduce its operating expenses, realign its cost structure with revenue, better manage its costs and more efficiently manage the business. The restructuring plan was implemented in the fourth quarter of 2016 and completed in the first quarter of 2017. Restructuring expenses totaled $1.6 million and were recorded as restructuring expenses on our consolidated statements of operations in the fourth quarter of 2016. Elements of the restructuring plan included a workforce reduction of approximately 7%, which included employee severance pay and related expenses, acceleration of the Company’s former chief executive officer’s stock-based compensation expense as a result of his termination without cause and facility exit expenses. The Company does not expect to incur any additional expenses under the restructuring plan. As of December 31, 2016, the Company had $0.8 million of restructuring liabilities included in accrued liabilities on its consolidated balance sheet, which consisted primarily of employee severance pay and related expenses. The Company expects its restructuring liability to be fully paid in the first quarter of 2017. Restructuring expenses incurred in 2016 were as follows: (1) Workforce reduction expenses include employee severance and temporary health insurance costs under the Consolidated Omnibus Budget Reconciliation Act of 1985 (“COBRA”). (2) In accordance with the 2015 Executive Severance Plan, 25% of the chief executive officer’s unvested equity holdings immediately accelerate to become vested if the chief executive officer is terminated for any reason other than cause. Stock-based compensation expense is a non-cash expense. (3) The Company exited a facility located in Redwood City, California on November 11, 2016. Facility exit expenses include rental payments the Company is required to make on the vacant office space and broker fees the Company will pay to find a new tenant to sublease the vacated office space. 12. Net Loss per Share Basic and diluted net loss per common share is presented in conformity with the treasury stock method. Basic net loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing net loss by the weighted-average number of common shares outstanding, including potential dilutive common shares assuming the dilutive effect of outstanding stock options. The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data): The following equity shares were excluded from the calculation of diluted net loss per share because their effect would have been anti-dilutive for the periods presented (in thousands): 13. Income Taxes The Company accounts for income taxes in accordance with authoritative guidance, which requires the use of the asset and liability method. Under this method, deferred income tax assets and liabilities are determined based upon the difference between the consolidated financial statement carrying amounts and the tax basis of assets and liabilities and are measured using the enacted tax rate expected to apply to taxable income in the years in which the differences are expected to be reversed. The following table presents domestic and foreign components of loss before income taxes for the periods presented (in thousands): The components of income tax (expense) benefit are as follows (in thousands): The primary differences between the effective tax rates and the federal statutory tax rate relates to the valuation allowances on the Company’s net operating losses, state income taxes, foreign tax rate differences and non-deductible stock-based compensation expense. The following table presents a reconciliation of the statutory federal rate and the Company’s effective tax rate for the periods presented: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The following table presents the significant components of the Company’s deferred tax assets and liabilities for the periods presented (in thousands): A valuation allowance is provided when it is more likely than not that the deferred tax assets will not be realized. As of December 31, 2016 and 2015, a full valuation allowance on domestic deferred tax assets was placed due to the uncertainty of realizing future tax benefits from its net operating loss carryforwards and other deferred tax assets. The Company’s valuation allowance as of December 31, 2016 and 2015 was attributable to the uncertainty of realizing future tax benefits from U.S. net operating losses, foreign timing differences and other deferred tax assets. The Company’s valuation allowance increased $3.2 million, $2.6 million and $1.6 million in the years ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, the Company has U.S. federal net operating loss carryforwards of approximately $27.2 million, expiring beginning in 2025. As of December 31, 2016, the Company has U.S. state and local net operating loss carryforwards of approximately $20.7 million, expiring beginning in 2017. As of December 31, 2016, the Company has federal research and development tax credits of approximately $1.0 million, which expire beginning in 2025. As of December 31, 2016, the Company has state research and development tax credits of approximately $1.1 million, and other tax credits of approximately $0.3 million, both of which carry forward indefinitely. Internal Revenue Code section 382 places a limitation (the “Section 382 Limitation”) on the amount of taxable income that can be offset by net operating carryforwards after a change in control of a loss corporation. Generally, after a change in control, a loss corporation cannot deduct operating loss carryovers in excess of the Section 382 Limitation. Management has determined that any limitation imposed by Section 382 will not have significant impact on the utilization of its net operating loss and credit carryforwards against taxable income in future periods. U.S. income and foreign withholding taxes associated with the repatriation of earnings of foreign subsidiaries have not been provided on undistributed earnings of foreign subsidiaries. The Company intends to reinvest theses earnings indefinitely outside the United States. If these earnings were distributed to the U.S. in the form of dividends or otherwise, or if the shares of the relevant subsidiaries were sold or otherwise transferred, the Company may be subject to additional U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes; however, the determination of such amount is not practicable. As of December 31, 2016, the cumulative amount of earnings upon which U.S. income taxes have not been provided for is approximately $2.3 million. Uncertain Tax Positions A reconciliation of the beginning and ending balances of the unrecognized tax benefits during the years ended December 31, 2016, 2015 and 2014 consist of the following (in thousands): The entire amount of any unrecognized tax benefits would impact the Company’s effective tax rate if recognized. Accrued interest and penalties related to unrecognized tax benefits are classified as income tax expense and were immaterial. The Company files income tax returns in the United States, various states and certain foreign jurisdictions. The tax periods 2012 through 2015 remain open in most jurisdictions. In addition, any tax losses and research and development credit carryforwards that were generated in prior years and carried forward may also be subject to examination by respective taxing authorities. The Company is not currently under examination by income tax authorities in federal, state or other foreign jurisdictions. 14. Segments and Geographical Information The Company considers operating segments to be components of the Company in which separate financial information is available that is reviewed regularly by the Company’s chief operating decision maker in deciding how to allocate resources and in evaluating performance. The chief operating decision maker for the Company is the Chief Executive Officer who reviews financial information at a consolidated level for purposes of allocating resources and evaluating financial performance. The Company has only one business activity and one operating and reporting segment. There are no segment managers who are held accountable for operations, operating results or plans for levels or components below the consolidated level. The following table summarizes total revenue generated through sales personnel employed in the respective locations (in thousands): The Company’s long-lived assets are primarily located in the United States.
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Based on the provided financial statement excerpt, here's a summary:
Financial Statement Summary for YuMe, Inc.:
1. Currency Translation:
- Uses local currency as functional currency for most subsidiaries
- India uses U.S. dollar, France uses British pound sterling
- Foreign exchange transaction losses were $0.6
2. Financial Reporting Characteristics:
- Statements aim to fairly present financial position
- Uses estimates based on available information
- Recognizes potential differences between estimated and actual results
3. Assets and Liabilities:
- Tracks current assets and accrued liabilities
- Uses forward contracts to manage foreign currency exposures
- Expects ongoing gains or losses from currency transactions
4. Notable Financial Metrics:
- Debt write-offs totaled $0.4
- Maintains a net unrealized gain/loss position across different financial instruments
The summary suggests the company operates internationally and actively manages currency risk
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Management's Report to Our Shareholders Management's Responsibility for Financial Information Management is responsible for the consistency, integrity and preparation of the information contained in this Annual Report on Form 10-K. The consolidated financial statements and other information contained in this Annual Report on Form 10-K have been prepared in accordance with accounting principles generally accepted in the United States of America and include necessary judgments and estimates by management. To fulfill our responsibility, we maintain comprehensive systems of internal control designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with established procedures. The concept of reasonable assurance is based upon recognition that the cost of the controls should not exceed the benefit derived. We believe our systems of internal control provide this reasonable assurance. The board of directors exercised its oversight role with respect to our systems of internal control primarily through its audit committee, which is comprised of independent directors. The committee oversees our systems of internal control, accounting practices, financial reporting and audits to assess whether their quality, integrity, and objectivity are sufficient to protect shareholders' investments. In addition, our consolidated financial statements have been audited by PricewaterhouseCoopers, LLP, an independent registered public accounting firm, whose report also appears in this Annual Report on Form 10-K. Management's Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as that term is defined in Rule 13a-15(f) of the Exchange Act. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal controls over financial reporting based upon the framework in "Internal Control-Integrated Framework" set forth by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of April 30, 2016. PricewaterhouseCoopers LLP, an independent registered public accounting firm, audited the effectiveness of the Company's internal control over financial reporting as of April 30, 2016, as stated in its report which appears herein. /s/ Kurt L. Darrow Kurt L. Darrow Chairman, President and Chief Executive Officer June 21, 2016 /s/ Louis M. Riccio Jr. Louis M. Riccio Jr. Senior Vice President and Chief Financial Officer June 21, 2016 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of La-Z-Boy Incorporated: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of comprehensive income, of changes in equity and of cash flows present fairly, in all material respects, the financial position of La-Z-Boy Incorporated and its subsidiaries at April 30, 2016 and April 25, 2015, and the results of their operations and their cash flows for each of the three fiscal years in the period ended April 30, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of April 30, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control over Financial Reporting on the preceding page. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for the classification of deferred income tax balances in fiscal year 2016. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Detroit, Michigan June 21, 2016 LA-Z-BOY INCORPORATED CONSOLIDATED STATEMENT OF INCOME The accompanying are an integral part of these statements. LA-Z-BOY INCORPORATED CONSOLIDATED STATEMENT OF INCOME (Continued) The accompanying are an integral part of these statements. LA-Z-BOY INCORPORATED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME The accompanying are an integral part of these statements. LA-Z-BOY INCORPORATED CONSOLIDATED BALANCE SHEET The accompanying are an integral part of these statements. LA-Z-BOY INCORPORATED CONSOLIDATED STATEMENT OF CASH FLOWS The accompanying are an integral part of these statements. LA-Z-BOY INCORPORATED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY The accompanying are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Accounting Policies The following is a summary of significant accounting policies followed in the preparation of La-Z-Boy Incorporated and its subsidiaries' (individually and collectively, "we," "our" or the "Company") consolidated financial statements. Our fiscal year ends on the last Saturday of April. Our 2016 fiscal year included 53 weeks, whereas fiscal years 2015 and 2014 included 52 weeks. The additional week in fiscal 2016 was included in our fourth quarter. Principles of Consolidation The accompanying consolidated financial statements include the consolidated accounts of La-Z-Boy Incorporated and our majority-owned subsidiaries. The portion of less than wholly-owned subsidiaries is included as non-controlling interest. All intercompany transactions have been eliminated, including any related profit on intercompany sales. Use of Estimates The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. These principles require management to make estimates and assumptions that affect the reported amounts or disclosures of assets, liabilities (including contingent assets and liabilities), sales and expenses at the date of the financial statements. Actual results could differ from those estimates. Cash and Equivalents For purposes of the consolidated balance sheet and statement of cash flows, we consider all highly liquid debt instruments purchased with initial maturities of three months or less to be cash equivalents. Restricted Cash We have cash on deposit with a bank as collateral for certain letters of credit. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out ("LIFO") basis for approximately 70% and 66% of our inventories at April 30, 2016, and April 25, 2015, respectively. Cost is determined for all other inventories on a first-in, first-out ("FIFO") basis. The FIFO method of accounting is mainly used for our Retail segment's inventory as well as our England operating unit and our majority owned foreign subsidiaries. Property, Plant and Equipment Items capitalized, including significant betterments to existing facilities, are recorded at cost. Capitalized computer software costs include internal and external costs incurred during the software's development stage. Internal costs relate primarily to employee activities related to coding and testing the software under development. Computer software costs are depreciated over three to ten years. All maintenance and repair costs are expensed when incurred. Depreciation is computed principally using straight-line methods over the estimated useful lives of the assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1: Accounting Policies (Continued) Disposal and Impairment of Long-Lived Assets Retirement or dispositions of long-lived assets are recorded based on carrying value and proceeds received. Any resulting gains or losses are recorded as a component of selling, general and administrative expenses. We review the carrying value of our long-lived assets for impairment annually or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Our assessment of recoverability is based on our best estimates using either quoted market prices or an analysis of the undiscounted projected future cash flows by asset groups in order to determine if there is any indicator of impairment requiring us to further assess the fair value of our long-lived assets. Our asset groups consist of our operating units in our Upholstery segment (La-Z-Boy and England), our Casegoods segment and each of our retail stores. Indefinite-Lived Intangible Assets and Goodwill We test indefinite-lived intangibles and goodwill for impairment on an annual basis in the fourth quarter of our fiscal year, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Indefinite-lived intangible assets include our American Drew trade name and the reacquired right to own and operate La-Z-Boy Furniture Galleries® stores in markets we have acquired. We establish the fair value of our trade name and reacquired rights based upon the relief from royalty method. Our goodwill relates to the acquisition of La-Z-Boy Furniture Galleries® stores in various geographic markets. The reporting units for our goodwill are the geographic markets the acquired stores become part of upon acquisition, because the operations of the acquired stores benefit these geographic markets. The estimated fair value for the reporting unit is determined based upon discounted cash flows. In situations where the fair value is less than the carrying value, indicating a potential impairment, a second comparison is performed using a calculation of implied fair value of goodwill to measure any such impairment. Investments Available-for-sale securities are recorded at fair value with the net unrealized gains and losses (that are deemed to be temporary) reported as a component of other comprehensive income/(loss). Realized gains and losses and charges for other-than-temporary impairments are included in determining net income, with related purchase costs based on the first-in, first-out method. We periodically evaluate our available for sale investments for possible other-than-temporary impairments by reviewing factors such as the extent to which, and length of time, an investment's fair value has been below our cost basis, the issuer's financial condition, and our ability and intent to hold the investment for sufficient time for its market value to recover. For impairments that are other-than-temporary, an impairment loss is recognized in earnings equal to the difference between the investment's cost and its fair value at the balance sheet date of the reporting period for which the assessment is made. The fair value of the investment then becomes the new amortized cost basis of the investment and it is not adjusted for subsequent recoveries in fair value. Life Insurance Life insurance policies are recorded at the amount that could be realized under the insurance contract as of the date of our consolidated balance sheet. These assets are classified as other long-term assets NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1: Accounting Policies (Continued) on our consolidated balance sheet. The change in cash surrender or contract value is recorded as income or expense during each period. Revenue Recognition and Related Allowances for Credit Losses Substantially all of our shipping agreements with third-party carriers transfer the risk of loss to our customers upon shipment. Accordingly, our shipments using third-party carriers are generally recognized as revenue when product is shipped. In all cases, for product shipped on our company-owned trucks, we recognize revenue when the product is delivered. This revenue includes amounts we billed to customers for shipping. At the time we recognize revenue, we make provisions for estimated product returns and warranties, as well as other incentives that we may offer to customers. We also recognize revenue for amounts we receive from our customers in connection with our shared advertising cost arrangement. We import certain products from foreign ports, some of which are shipped directly to our domestic customers. In this case, revenue is not recognized until title is assumed by our customer, which is normally after the goods pass through U.S. Customs. Incentives offered to customers include cash discounts and other sales incentive programs. Estimated cash discounts and other sales incentives are recorded as a reduction of revenues when the revenue is recognized. Trade accounts receivable arise from the sale of products on trade credit terms. On a quarterly basis, our management team reviews all significant accounts as to their past due balances, as well as collectability of the outstanding trade accounts receivable for possible write off. It is our policy to write off the accounts receivable against the allowance account when we deem the receivable to be uncollectible. Additionally, we review orders from dealers that are significantly past due, and we ship product only when our ability to collect payment for the new sales is reasonably assured. Our allowances for credit losses reflect our best estimate of probable losses inherent in the trade accounts receivable balance. We determine the allowance based on known troubled accounts, historic experience and other currently available evidence. At April 30, 2016, we had no gross notes receivable amounts outstanding. At April 25, 2015, we had gross notes receivable of $1.9 million recorded in receivables on our consolidated balance sheet. We had no allowance for credit losses at April 30, 2016 or at April 25, 2015. Cost of Sales Our cost of sales consists primarily of the cost to manufacture or purchase our merchandise, inspection costs, internal transfer costs, in-bound freight costs, outbound shipping costs, as well as warehousing costs, occupancy costs and depreciation expense related to our manufacturing facilities and equipment. During fiscal 2016 and fiscal 2015, we recorded a benefit related to legal settlements as part of cost of sales. Gross margin benefited 0.3 percentage point and 0.4 percentage point for fiscal 2016 and fiscal 2015, respectively, as a result of legal settlements. Selling, General and Administrative Expenses SG&A expenses include the costs of selling our products and other general and administrative costs. Selling expenses are primarily composed of commissions, advertising, warranty, bad debt expense and compensation and benefits of employees performing various sales functions. Additionally, the occupancy costs of our retail facilities and the warehousing costs of our regional retail distribution NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1: Accounting Policies (Continued) centers are included as a component of SG&A. Other general and administrative expenses included in SG&A are composed primarily of compensation and benefit costs for administration employees and other administrative costs. Other Income, Net Other income, net, primarily includes foreign currency exchange net gain/loss, as well as all pension costs except for the service cost, which is included in selling, general, and administrative expenses on our consolidated statement of income. Research and Development Costs Research and development costs are charged to expense in the periods incurred. Expenditures for research and development costs were $8.4 million, $8.0 million and $7.9 million for the fiscal years ended April 30, 2016, April 25, 2015, and April 26, 2014, respectively, and are included as a component of SG&A. Advertising Expenses Production costs of commercials, programming and costs of other advertising, promotion and marketing programs are charged to expense in the period in which the commercial or ad is first aired or released. Gross advertising expenses were $70.8 million, $63.3 million and $59.6 million for the fiscal years ended April 30, 2016, April 25, 2015, and April 26, 2014, respectively. A portion of our advertising program is a national advertising campaign. This campaign is a shared advertising program with our La-Z-Boy Furniture Galleries® stores, which are reimbursing us for about 32% of the cost of the program (excluding company-owned stores). Because of this shared cost arrangement, the advertising expense is reported as a component of SG&A, while the dealers' reimbursement portion is reported as a component of sales. Operating Leases We record rent expense related to operating leases on a straight-line basis for minimum lease payments starting with the beginning of the lease term based on the date that we have the right to control the leased property. Our minimum lease payments may incorporate step rent provisions or rent escalations. We also record rental income from subleases on a straight-line basis for minimum lease payments. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. We elected the early adoption of accounting guidance issued in November 2015 requiring all deferred income tax assets and liabilities to be presented as noncurrent on our consolidated balance sheet. We are applying this change prospectively beginning with our fiscal 2016 consolidated balance sheet. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1: Accounting Policies (Continued) In periods when deferred tax assets are recorded, we are required to estimate whether recoverability is more likely than not, based on, among other things, forecasts of taxable earnings in the related tax jurisdiction. We consider historical and projected future operating results, the eligible carry-forward period, tax law changes, tax planning opportunities and other relevant considerations when making judgments about realizing the value of our deferred tax assets. We recognize in our consolidated financial statements the benefit of a position taken or expected to be taken in a tax return when it is more likely than not (i.e. a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is more likely than not to be realized upon settlement. Changes in judgment that result in subsequent recognition, derecognition or change in a measurement date of a tax position taken in a prior annual period (including any related interest and penalties) are recognized as a discrete item in the interim period in which the change occurs. Foreign Currency Translation The functional currency of our Canadian and Mexico subsidiaries is the U.S. dollar. Transaction gains and losses associated with translating our Canadian and Mexico subsidiaries' assets and liabilities, which are non-U.S. dollar denominated, are recorded in other income, net in our consolidated statement of income. The functional currency of each of our other foreign subsidiaries is its respective local currency. Assets and liabilities of those subsidiaries whose functional currency is their local currency are translated at the year-end exchange rates, and revenues and expenses are translated at average exchange rates for the period, with the corresponding translation effect included as a component of other comprehensive income. In connection with our Mexico subsidiary we have entered into foreign currency forward contracts, designated as cash flow hedges, to hedge certain forecasted expenses. Accounting for Stock-Based Compensation We estimate the fair value of equity-based awards, including option awards and stock-based awards that vest based on market conditions, on the date of grant using option-pricing models. The value of the portion of the equity-based awards that are ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statement of income using a straight-line single-option method. We measure stock-based compensation cost for liability-based awards based on the fair value of the award on the grant date and recognize it as expense over the vesting period. The liability for these awards is remeasured and adjusted to its fair value at the end of each reporting period until paid. We record compensation cost for stock-based awards that vest based on performance conditions ratably over the vesting periods when the vesting of such awards become probable. Commitments and Contingencies We establish an accrued liability for legal matters when those matters present loss contingencies that are both probable and estimable. As a litigation matter develops, we, in conjunction with any outside counsel handling the matter, evaluate on an ongoing basis whether such matter presents a loss contingency that is probable and estimable. When a loss contingency is not both probable and estimable, we do not establish an accrued liability. If, at the time of evaluation, the loss contingency related to a litigation matter is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable. Once the loss contingency related to a litigation matter is deemed to be both probable and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1: Accounting Policies (Continued) estimable, we will establish an accrued liability with respect to such loss contingency and record a corresponding amount of litigation-related expense. We continue to monitor the matter for further developments that could affect the amount of the accrued liability that has been previously established. Discontinued Operations During fiscal 2014, we sold substantially all of the assets of our Bauhaus U.S.A. business unit and classified Lea Industries as held for sale. The assets and liabilities of Lea Industries were reported in business held for sale in our fiscal 2014 consolidated balance sheet. We were unable to find a buyer for our Lea Industries business, and therefore we liquidated all the assets, consisting mostly of inventory, and ceased operations of Lea Industries during the third quarter of fiscal 2015. The operating results of both Bauhaus and Lea Industries are reported as discontinued operations in our consolidated statement of income for fiscal 2015 and fiscal 2014. Insurance/Self-Insurance We use a combination of insurance and self-insurance for a number of risks, including workers' compensation, general liability, vehicle liability and the company-funded portion of employee-related health care benefits. Liabilities associated with these risks are estimated in part by considering historic claims experience, demographic factors, severity factors and other assumptions. Our workers' compensation reserve is an undiscounted liability. We have various excess loss coverages for auto, product liability and workers' compensation liabilities. Our deductibles generally do not exceed $1.5 million. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board ("FASB") issued a new accounting standard that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new standard supersedes virtually all existing authoritative accounting guidance on revenue recognition and requires additional disclosures and greater use of estimates and judgments. During July 2015, the FASB deferred the effective date of the revenue recognition guidance by one year, thus making the new accounting standard effective for our fiscal year 2019. We are assessing the impact that this guidance will have on our consolidated financial statements and financial statement disclosures. In May 2015, the FASB issued a new accounting standard that requires entities to remove investments valued at net asset value per share under the practical expedient from the fair value hierarchy. Disclosure information on those assets will be required to help users understand the nature and risks of those investments. The standard is effective for our fiscal year 2017 and will be applied retrospectively. This standard will have no effect on our consolidated financial statements, but we are currently assessing the impact that this guidance will have on our fair value footnote disclosures. In September 2015, the FASB released a new accounting standard for business combinations that requires the acquirer to recognize adjustments to provisional amounts identified during the measurement period in the reporting period in which the adjustments are determined. The standard is to be applied prospectively beginning with our fiscal year 2017. We are assessing the impact that this guidance will have on our consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1: Accounting Policies (Continued) In January 2016, the FASB issued a new accounting standard that requires equity investments to be measured at fair value with the fair value changes to be recognized through net income. This standard does not apply to investments that are accounted for under the equity method of accounting or that result in consolidation of the invested entity. We currently hold equity investments that are measured at fair value at the end of each reporting period and we recognize the fair value changes through other comprehensive income (loss) as unrealized gains (losses). Based on the fair value of our unrealized loss as of April 30, 2016, adoption of this standard would be immaterial to our consolidated financial statements. Adoption of this standard will be required for our fiscal year 2019 financial statements. In February 2016, the FASB issued a new accounting standard requiring all operating leases that a lessee enters into to be recorded on their balance sheet. The lessee will record an asset for the right to use the underlying asset for the lease term and a liability for the contractual lease payments. This guidance is effective for our fiscal year 2020. We are assessing the impact that this guidance will have on our consolidated financial statements and related disclosures. In March 2016, the FASB issued a new accounting standard focused on simplifying the accounting for share-based payments. The guidance includes changes to the accounting for income taxes related to share-based payments as well as changes to the presentation of these tax impacts on the statement of cash flows. This guidance will be applicable for our fiscal year 2018. We are assessing the impact that this guidance will have on our consolidated financial statements. Note 2: Acquisitions During fiscal 2016, we acquired the assets of four independent operators of 11 La-Z-Boy Furniture Galleries® stores in Colorado, Wisconsin, North and South Carolina, and Ohio for $26.3 million, composed of $23.3 million of cash and $3.0 million of forgiveness of certain of these dealers' accounts receivable and prepaid expenses. We began including the 11 stores in our Retail segment results upon acquisition. Prior to the acquisitions, we licensed the exclusive right to own and operate La-Z-Boy Furniture Galleries® stores (and to use the associated trademarks and trade name) in those markets to the dealers whose assets we acquired, and we reacquired these rights when we purchased the dealers' other assets. The effective settlement of these arrangements resulted in no settlement gain or loss as the contractual terms were at market. We recorded an indefinite-lived intangible asset of $3.1 million related to these reacquired rights. We also recognized $22.0 million of goodwill, which primarily relates to the expected synergies resulting from the integration of the acquired stores and the anticipated future benefits of these synergies. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2: Acquisitions (Continued) We based the purchase price allocations on fair values at the dates of acquisition and summarized them in the following table: During fiscal 2015, we acquired the assets of two independent La-Z-Boy Furniture Galleries® dealers in exchange for $1.8 million in cash and forgiveness of these dealers' net accounts and notes receivable of $1.0 million. We reacquired the right to own and operate La-Z-Boy Furniture Galleries® stores in those markets as a result of the acquisitions. In our Retail segment, we recorded an indefinite-lived intangible asset of $1.0 million related to these reacquired rights and $1.2 million of goodwill. During fiscal 2014, we acquired the assets of two independent La-Z-Boy Furniture Galleries® dealers in exchange for $0.8 million in cash and forgiveness of net accounts and notes receivable of $3.0 million. We reacquired the right to own and operate La-Z-Boy Furniture Galleries® stores in those markets as a result of the acquisitions. We recorded an indefinite-lived intangible asset of $1.1 million in our Retail segment related to these reacquired rights and goodwill of $1.1 million. All of these indefinite-lived intangible assets and goodwill assets will be amortized and deducted for federal income tax purposes over 15 years. All acquired stores were included in our Retail segment results upon acquisition. Purchase price allocations are not presented for the fiscal 2015 and fiscal 2014 acquisitions as they were not material to our consolidated balance sheet. All of the above acquisitions were not material to our financial position or our results of operations, and therefore, pro-forma financial information is not presented. The net notes and accounts receivable acquired are considered non-cash investing activities as they relate to our consolidated statement of cash flows. Note 3: Restructuring During fiscal 2014, we committed to a restructuring of our casegoods business to transition to an all-import model for our wood furniture. We ceased casegoods manufacturing operations at our Hudson, North Carolina facility during the second quarter of fiscal 2015. As a result of this restructuring, we transitioned our remaining Kincaid and American Drew bedroom product lines to imported product. We exited the hospitality business as we had manufactured those products in our Hudson facility. We transitioned our warehouse and repair functions from two North Wilkesboro, North Carolina facilities to our Hudson plant. In addition, during fiscal 2015, we sold both of the North Wilkesboro facilities and most of the wood-working equipment from our Hudson plant and completed the consolidation of our casegoods showroom. We have recorded pre-tax restructuring charges of $8.3 million ($5.4 million after tax) since the inception of this restructuring plan, with $5.1 million pre-tax ($3.3 million after tax) related to NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3: Restructuring (Continued) continuing operations and $3.2 million pre-tax ($2.1 million after tax) related to discontinued operations. These charges relate to severance and benefit-related costs, rent for an idled showroom, rent for an idled office building, and various asset write-downs, including fixed assets, inventory and trade names. The pre-tax restructuring income recorded in fiscal 2015 mainly related to gains on the sale of the North Wilkesboro warehouse, as well as inventory recoveries. These items were partly offset by severance and benefit related costs and rent expense related to an idled showroom. The table below details the total pre-tax restructuring (income)/expense recorded by type for the fiscal years ended April 30, 2016, April 25, 2015, and April 26, 2014: We had $0.1 million of restructuring liability remaining as of April 30, 2016, related to severance and warranty. We expect the severance liability to be settled by the end of the second quarter of fiscal 2017. The warranty liability will remain until it is either used by warranty claims or the warranty period expires, whichever occurs first. Note 4: Discontinued Operations During the fourth quarter of fiscal 2014, we sold substantially all of the assets of our Bauhaus U.S.A. business unit to a group of investors and classified Lea Industries, a division of La-Z-Boy Casegoods, Inc., (formerly La-Z-Boy Greensboro, Inc.), as held for sale while we marketed that business for sale. We were unable to find a buyer for our Lea Industries business, and instead we liquidated all the assets, consisting mostly of inventory, and ceased operations of Lea Industries during the third quarter of fiscal 2015 (see Note 3 for additional information). As a result of the sale of Bauhaus in fiscal 2014, we recorded an impairment to the value of the assets to be sold of $1.1 million, because the consideration paid was less than the recorded amount of the net assets to be sold. The operating results of our Bauhaus business unit are reported as discontinued operations for all periods presented. The transaction closed in the fourth quarter of fiscal 2014, and continuing cash flows from the end of the third quarter of fiscal 2014 through the closing date of the sale were not significant. The operating results of Bauhaus and Lea Industries are reported as discontinued operations for fiscal 2015 and fiscal 2014. We had historically reported the results of our Bauhaus business unit as a component of our Upholstery segment and Lea Industries as a component of our Casegoods segment. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 4: Discontinued Operations (Continued) In fiscal 2015, we recorded $3.8 million of income in discontinued operations related to our previously owned subsidiary, American Furniture Company, Incorporated. We sold this subsidiary in fiscal 2007, and reported it as discontinued operations at that time. The income related to the Continued Dumping and Subsidy Offset Act of 2000 ("CDSOA"), which provided for distribution of duties, collected by U.S. Customs and Border Protection from antidumping cases, to domestic producers that supported the antidumping petition related to wooden bedroom furniture imported from China. When we sold American Furniture Company, Incorporated our contract provided that we would receive a portion of any such duties to which that entity was entitled. The remainder of the CDSOA income reported in discontinued operations in fiscal 2015 related to Lea Industries. The results of our discontinued operations for the fiscal years ended April 25, 2015, and April 26, 2014, were as follows: Operating income from discontinued operations in fiscal 2014 included a $3.3 million restructuring charge (see Note 3 for additional information). In the consolidated statement of cash flows, the activity of these operating units was included along with our activity from continuing operations for fiscal 2015 and fiscal 2014. Note 5: Inventories NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6: Property, Plant and Equipment Depreciation expense from continuing operations for the fiscal years ended April 30, 2016, April 25, 2015, and April 26, 2014, was $23.3 million, $19.3 million, and $19.3 million, respectively. Note 7: Goodwill and Other Intangible Assets Our goodwill and reacquired right assets on our consolidated balance sheet relates to acquisitions of La-Z-Boy Furniture Galleries® stores over the past several fiscal years. Details about these acquisitions can be found in Note 2. Our other intangible assets also include a trade name for American Drew. We test goodwill annually for impairment, using a qualitative approach for some items of goodwill and a quantitative two-step approach for the rest. The key assumptions used in the two-step assessment of our goodwill at April 30, 2016 were a discount rate of 8.4% and a terminal growth rate of 2.0%. For our goodwill that was tested using a qualitative approach, we began by comparing the fair value of our reporting units to the carrying value in the prior year. We then reviewed the reporting unit for significant deterioration of the economic environment in which it operates or for an increased competitive environment, as well as general economic conditions associated with the reporting unit. Additionally, we reviewed the overall financial performance of the reporting unit and the expected future performance of the reporting unit, as well as whether or not there was a change in the overall composition of the reporting unit. The relative fair value of our reporting units significantly exceeds the carrying value of our goodwill as of April 30, 2016. All of our goodwill relates to our Retail segment. We did not have any goodwill impairment in fiscal 2014, fiscal 2015, or fiscal 2016. The following is a roll-forward of goodwill for the fiscal years ended April 30, 2016, and April 25, 2015: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7: Goodwill and Other Intangible Assets (Continued) The following is a roll-forward of other indefinite-lived intangible assets for the fiscal years ended April 30, 2016, and April 25, 2015: The impairment charge recorded in fiscal 2015 related to our American Drew trade name, as a result of our annual impairment assessment. Note 8: Investments We have current and long-term investments intended to enhance returns on our cash as well as to fund future obligations of our non-qualified defined benefit retirement plan, our executive deferred compensation plan, and our performance compensation retirement plan. Our short-term investments are included in other current assets and our long-term investments are included in other long-term assets on our consolidated balance sheet. The following summarizes our investments at April 30, 2016, and April 25, 2015: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8: Investments (Continued) The following is a summary of the unrealized gain, unrealized losses, and fair value by investment type at April 30, 2016, and April 25, 2015: Fiscal 2016 Fiscal 2015 The following table summarizes sales of available-for-sale securities (for the fiscal years ended): The fair value of fixed income available-for-sale securities by contractual maturity was $13.6 million within one year, $21.2 million within two to five years, $1.5 million within six to ten years and $0.2 million thereafter. Note 9: Accrued Expenses and Other Current Liabilities NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9: Accrued Expenses and Other Current Liabilities (Continued) Included in other current liabilities at April 25, 2015, was a book overdraft of $7.3 million for outstanding checks. Note 10: Debt We maintain a revolving credit facility secured primarily by all of our accounts receivable, inventory, and cash deposit and securities accounts. We amended this agreement on December 30, 2014, extending its maturity date to December 30, 2019. Availability under the agreement fluctuates according to a borrowing base calculated on eligible accounts receivable and inventory. The credit agreement includes affirmative and negative covenants that apply under certain circumstances, including a fixed charge coverage ratio requirement that applies when excess availability under the line is less than certain thresholds. At April 30, 2016, and at April 25, 2015, we were not subject to the fixed charge coverage ratio requirement, had no borrowings outstanding under the agreement, and had excess availability of $146.9 million of the $150.0 million credit commitment. In the first quarter of fiscal 2015, we paid our remaining industrial revenue bond that was used to finance the construction of some of our manufacturing facilities. Capital leases consist primarily of long-term commitments for the purchase of information technology equipment and have maturities ranging from fiscal 2017 to fiscal 2021. Interest rates range from 2.7% to 7.6%. Maturities of long-term capital leases, subsequent to April 30, 2016, are $0.2 million in fiscal 2018, $0.2 million in fiscal 2019, $0.1 million in fiscal 2020, and less than $0.1 million in fiscal 2021. Cash paid for interest during fiscal years 2016, 2015 and 2014 was $0.5 million in each fiscal year. Note 11: Operating Leases We have operating leases for one manufacturing facility, executive and sales offices, warehouses, showrooms and retail facilities, as well as for transportation equipment, information technology and other equipment. The operating leases expire at various dates through fiscal 2032. We have certain retail facilities which we sublease to outside parties. The total rent liability included in other long-term liabilities as of April 30, 2016, and April 25, 2015, was $14.8 million and $13.5 million, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11: Operating Leases (Continued) The future minimum rentals for all non-cancelable operating leases and future rental income from subleases are as follows (for the fiscal years): Rental expense and rental income from continuing operations for operating leases were as follows (for the fiscal years ended): Both our rental expense and rental income are included in selling, general, and administrative expense in our consolidated statement of income. Note 12: Retirement and Welfare Plans Voluntary 401(k) retirement plans are offered to eligible employees within certain U.S. operating units. For most operating units, we make matching contributions based on specific formulas. We also make supplemental contributions to this plan for eligible employees based on achievement of operating performance targets. A performance compensation retirement plan ("PCRP") is maintained for eligible highly compensated employees. The company contributions to this plan are based on achievement of performance targets. As of April 30, 2016, and April 25, 2015, we had $6.9 million and $3.9 million, respectively, of obligations for this plan included in other long-term liabilities. We also maintain an executive deferred compensation plan for eligible highly compensated employees. An element of this plan allows contributions for eligible highly compensated employees. As of April 30, 2016, and April 25, 2015, we had $16.3 million and $15.6 million, respectively, of obligations for this plan included in other long-term liabilities. We had life insurance contracts related to this plan and the PCRP at April 30, 2016, and at April 25, 2015, with cash surrender values of $21.0 million and $17.4 million, respectively, which are included in other long-term assets. Mutual funds related to this plan are considered trading securities and are included in other current assets. At April 30, 2016, this plan had no mutual funds and at April 25, 2015, the market value of these mutual funds was $1.1 million. We maintain a non-qualified defined benefit retirement plan for certain former salaried employees. Included in other long-term liabilities were plan obligations of $17.4 million and $17.5 million at April 30, 2016, and April 25, 2015, respectively, which represented the unfunded projected benefit NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 12: Retirement and Welfare Plans (Continued) obligation of this plan. During fiscal 2016, the total cost recognized for this plan was $0.9 million, which primarily related to interest cost. The actuarial loss recognized in accumulated other comprehensive loss was $0.4 million and the benefit payments during the year were $1.1 million. Benefit payments are scheduled to be approximately $1.1 million annually for the next ten years. The discount rate used to determine the obligations under this plan was 3.7% as of the end of fiscal 2016. During fiscal 2015, the total cost recognized for this plan was $0.8 million, which primarily related to interest cost. The actuarial loss recognized in accumulated other comprehensive loss was $1.7 million and the benefit payments during the year were $1.1 million. The discount rate used to determine the obligations under this plan was 3.9% as of the end of fiscal 2015. This plan is not funded and is excluded from the obligation charts and disclosures that follow. We hold available-for-sale marketable securities to fund future obligations of this plan in a Rabbi trust (see Notes 8 and 20). We are not required to fund the non-qualified defined benefit retirement plan in fiscal year 2017; however, we have the discretion to make contributions to the Rabbi trust. We also maintain a defined benefit pension plan for eligible factory hourly employees at our La-Z-Boy operating unit. This plan is closed to new participants, but active participants continue to earn service credit. The measurement dates for the pension plan assets and benefit obligations were April 30, 2016, and April 25, 2015, in fiscal 2016 and fiscal 2015, respectively. The changes in plan assets and benefit obligations were recognized in accumulated other comprehensive loss as follows (pre-tax) (for the fiscal years ended): In fiscal 2017, we expect to amortize $3.1 million of unrecognized actuarial losses as a component of pension expense. The combined net periodic pension cost and retirement costs for retirement plans related to continuing operations were as follows (for the fiscal years ended): *Not determined by an actuary NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 12: Retirement and Welfare Plans (Continued) The funded status of the defined benefit pension plan for eligible factory hourly employees was as follows: Amounts included on the consolidated balance sheet related to the defined benefit pension plan for eligible factory hourly employees consist of: The actuarial assumptions for the defined benefit pension plan for eligible factory hourly employees were as follows (for the fiscal years ended): Consistent with prior years, the discount rate is calculated by matching a pool of high quality bond payments to the plan's expected future benefit payments as determined by our actuary. The long-term rate of return was determined based on the average rate of earnings expected on the funds invested or to be invested to provide the benefits of these plans. This included considering the trust's asset allocation, investment strategy, and the expected returns likely to be earned over the life of the plans. This is based on our goal of earning the highest rate of return while maintaining acceptable levels of risk. We strive to have assets within the plan that are diversified so that unexpected or adverse results from one asset class will not have a significant negative impact on the entire portfolio. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 12: Retirement and Welfare Plans (Continued) Our investment objective is to minimize the volatility of the value of our pension assets relative to pension liabilities and to ensure assets are sufficient to pay plan benefits by matching the characteristics of our assets relative to our liabilities. At the end of fiscal 2016, approximately 90% of the plan's assets were invested in fixed rate investments with a duration that approximates the duration of its liabilities, and the remainder of the assets was invested in equity investments. The investment strategy and policy for the pension plan reflects a balance of risk-reducing and return-seeking considerations. The objective of minimizing the volatility of assets relative to liabilities is addressed primarily through asset-liability matching and asset diversification. The fixed income target asset allocation matches the bond-like and long-dated nature of the pension liabilities. Assets are broadly diversified within all asset classes to achieve adequate risk-adjusted returns while reducing the sensitivity of the pension plan funding status to market interest rates and equity return volatility, and maintaining liquidity sufficient to meet our defined benefit pension plan obligations. Investments are reviewed at least quarterly and rebalanced as needed. The overall expected long-term rate of return is determined by using long-term historical returns for equity and debt securities in proportion to their weight in the investment portfolio. The following table presents the fair value of the assets in our defined benefit pension plan for eligible factory hourly employees at April 30, 2016, and April 25, 2015. The various levels of the fair value hierarchy are described in Note 20. Fiscal 2016 (a)There were no transfers between Level 1 and Level 2 during fiscal 2016. Fiscal 2015 (b)There were no transfers between Level 1 and Level 2 during fiscal 2015. Level 1 retirement plan assets include U.S. currency held by a designated trustee and equity funds of common and preferred securities issued by U.S. and non-U.S. corporations. These equity funds are traded actively on exchanges and price quotes for these shares are readily available. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 12: Retirement and Welfare Plans (Continued) Cash and equivalents of commingled funds generally valued using observable market data are categorized as Level 2 assets. Equity funds categorized as Level 2 include common trust funds which are composed of shares or units in open ended funds with active issuances and redemptions. The value of these funds is determined based on the net asset value of the funds, the underlying assets of which are publicly traded on exchanges. Price quotes for the assets held by these funds are readily available. Debt funds categorized as Level 2 consist of corporate fixed income securities issued by U.S. and non-U.S. corporations and fixed income securities issued directly by the U.S. Treasury or by government-sponsored enterprises which are valued using a bid evaluation process with bid data provided by independent pricing sources using observable market data. Our funding policy is to contribute to our defined benefit pension plan amounts sufficient to meet the minimum funding requirement as defined by employee benefit and tax laws, plus additional amounts which we determine to be appropriate. During fiscal 2016, we voluntarily contributed $7 million to our defined benefit pension plan, and we currently expect to voluntarily contribute approximately $2 million to our defined benefit pension plan during fiscal 2017. The expected benefit payments by our defined benefit pension plan for eligible factory hourly employees for each of the next five fiscal years and for periods thereafter are presented in the following table: Note 13: Product Warranties We accrue an estimated liability for product warranties when we recognize revenue on the sale of warranted products. We estimate future warranty claims based on our claims experience and any additional anticipated future costs on previously sold products. We incorporate repair costs into our liability estimates, including materials, labor and overhead amounts necessary to perform repairs and any costs associated with delivering repaired product to our customers. Approximately 95% of our warranty liability relates to our Upholstery segment as we generally warrant our products against defects for one year on fabric and leather, from one to ten years on cushions and padding, and provide a limited lifetime warranty on certain mechanisms and frames. Our warranties cover labor costs relating to our parts for one year. Our warranty period begins when the consumer receives our product. We use considerable judgment in making our estimates, and we record differences between our actual and estimated costs when the differences are known. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 13: Product Warranties (Continued) A reconciliation of the changes in our product warranty liability is as follows: As of April 30, 2016, and April 25, 2015, we included $12.4 million and $10.2 million, respectively, of our product warranty liability in accrued expenses and other current liabilities on our consolidated balance sheet, and included the remainder in other long-term liabilities. We recorded accruals during the periods presented primarily to reflect charges that relate to warranties issued during the respective periods. Our accrual adjustments reflect a change in the prior estimates of our product warranty liability. Note 14: Contingencies and Commitments We have been named as a defendant in various lawsuits arising in the ordinary course of business and as a potentially responsible party at certain environmental clean-up sites, the effect of which are not considered significant. Based on a review of all currently known facts and our experience with previous legal and environmental matters, we have recorded expense in respect of probable and reasonably estimable losses arising from legal and environmental matters, and we currently do not believe it is probable that we will have any additional loss for legal or environmental matters that would be material to our consolidated financial statements. In view of the inherent difficulty of predicting the outcome of litigation, particularly where the claimants seek very large or indeterminate damages or where the matters present novel legal theories, we generally cannot predict the eventual outcome, timing, or related loss, if any, of pending matters. We recognized expense of $5.5 million in fiscal 2016, excluding internal and external legal fees, following the verdict in a civil lawsuit, which was previously announced. The verdict in the civil lawsuit has not been affirmed by the court. We had not accrued for this liability prior to the verdict because we did not believe we were liable. The $5.5 million is recorded as a component of accrued expenses and other current liabilities on our consolidated balance sheet. Note 15: Stock-Based Compensation The La-Z-Boy Incorporated 2010 Omnibus Incentive Plan provides for the grant of stock options, stock appreciation rights, restricted stock, stock units (including deferred stock units), unrestricted stock, dividend equivalent rights, and short-term cash incentive awards. Under this plan, as amended, the aggregate number of common shares that may be issued through awards of any form is 8.7 million shares. No grants may be issued under our previous plans. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15: Stock-Based Compensation (Continued) The table below summarizes the total stock-based compensation expense recognized for all outstanding grants in our consolidated statement of income (for the fiscal years ended): Stock Options. The La-Z-Boy Incorporated 2010 Omnibus Incentive Plan authorizes grants to certain employees and directors to purchase common shares at a specified price, which may not be less than 100% of the current market price of the stock at the date of grant. We granted 426,539 stock options to employees during the first quarter of fiscal 2016, and we also have stock options outstanding from previous grants. We recognize compensation expense for stock options over the vesting period equal to the fair value on the date our compensation committee approved the awards. The vesting period for our stock options ranges from one to four years, with accelerated vesting upon retirement. We expense options granted to retirement-eligible employees immediately. Granted options outstanding under the former long-term equity award plan remain in effect and have a term of five or ten years. Stock option expense recognized in selling, general and administrative expense for fiscal 2016, fiscal 2015, and fiscal 2014 was $3.2 million, $3.0 million, and $2.1 million, respectively. We received $0.4 million, $1.4 million, and $3.6 million in cash during fiscal 2016, fiscal 2015, and fiscal 2014, respectively, for exercises of stock options. Plan activity for stock options under the above plans was as follows: The aggregate intrinsic value of options exercised was $2.0 million and $8.3 million in fiscal 2015 and fiscal 2014, respectively. As of April 30, 2016, our total unrecognized compensation cost related to non-vested stock option awards was $2.6 million, which we expect to recognize over a weighted-average remaining vesting term of all unvested awards of 1.8 years. During the year ended April 30, 2016, 0.3 million shares vested. We estimate the fair value of the employee stock options at the date of grant using the Black-Scholes option-pricing model, which requires management to make certain assumptions. We estimate expected volatility based on the historical volatility of our common shares. We base the average expected life on the contractual term of the stock option and expected employee exercise trends. We base the risk-free rate on U.S. Treasury issues with a term equal to the expected life assumed at the date of the grant. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15: Stock-Based Compensation (Continued) The fair value of stock options granted during fiscal 2016, fiscal 2015, and fiscal 2014 were calculated using the following assumptions: Stock Appreciation Rights. Under the La-Z-Boy Incorporated 2010 Omnibus Incentive Plan, the Compensation Committee of the board of directors is authorized to award stock appreciation rights to certain employees. We did not grant any SARs to employees during fiscal 2016, but we have SARs outstanding from previous grants. SARs will be paid in cash upon exercise and, accordingly, we account for SARs as liability-based awards that we re-measure to reflect the fair value at the end of each reporting period. These awards vest at 25% per year, beginning one year from the grant date for a term of four years, with accelerated vesting upon retirement. We expense SARs granted to retirement-eligible employees immediately. We estimate the fair value of SARs at the end of each reporting period using the Black-Scholes option-pricing model, which requires management to make certain assumptions. We base the average expected life on the contractual term of the SARs and expected employee exercise trends (which is consistent with the expected life of our option awards). We base the risk-free rate on U.S. Treasury issues with a term equal to the expected life assumed at the end of the reporting period. We recognized compensation expense of $0.1 million, $0.7 million, and $1.1 million related to SARs in selling, general and administrative expense for the years ended April 30, 2016, April 25, 2015, and April 26, 2014, respectively. Our unrecognized compensation cost at April 30, 2016, related to SARs was $0.2 million based on the fair value on that date, and is expected to be recognized over a weighted-average remaining contractual term of all unvested awards of 0.9 years. In fiscal 2014 and fiscal 2013, we granted SARs as described in our Annual Reports on Form 10-K for the fiscal years ended April 26, 2014, and April 27, 2013, respectively. At April 30, 2016, we measured the fair value of the SARs granted during these fiscal years using the following assumptions: Restricted Stock. Under the La-Z-Boy Incorporated 2010 Omnibus Incentive Plan, the Compensation Committee of the board of directors is authorized to award restricted common shares to certain employees. We awarded 102,063 shares of restricted stock to employees during fiscal 2016. We issue restricted stock at no cost to the employees, and the shares are held in an escrow account until the vesting period ends. If a recipient's employment ends during the escrow period (other than through death or disability), the shares are returned at no cost to the company. We account for restricted stock awards as equity-based awards because upon vesting, they will be settled in common shares. The fair NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15: Stock-Based Compensation (Continued) value of the restricted stock that was awarded in the first quarter of fiscal 2016 was $26.69 per share, the market value of our common shares on the date of grant. We recognize compensation expense for restricted stock over the vesting period equal to the fair value on the date our compensation committee approved the awards. Restricted stock awards vest at 25% per year, beginning one year from the grant date for a term of four years. We recorded expense related to the restricted stock in selling, general and administrative expense of $1.1 million, $0.8 million, and $0.5 million during fiscal 2016, fiscal 2015, and fiscal 2014, respectively. Our unrecognized compensation cost at April 30, 2016, related to restricted shares was $3.3 million and is expected to be recognized over a weighted-average remaining contractual term of all unvested awards of 2.9 years. The following table summarizes information about non-vested share awards as of and for the year ended April 30, 2016: Restricted Stock Units. Under the La-Z-Boy Incorporated 2010 Omnibus Incentive Plan, the Compensation Committee of the board of directors is authorized to award restricted stock units to certain employees and our non-employee directors. We did not grant any restricted stock units to employees during fiscal 2016, but we have restricted stock units outstanding from previous grants. We account for these units as liability-based awards because upon vesting, these awards will be paid in cash. We measure and recognize initial compensation expense based on the market value (intrinsic value) of our common stock on the grant date and amortize the expense over the vesting period. We re-measure and adjust the liability based on the market value (intrinsic value) of our common shares on the last day of the reporting period until paid with a corresponding adjustment to reflect the cumulative amount of compensation expense. The fair value of each outstanding restricted stock unit at April 30, 2016, was $25.87, the market value of our common shares on the last day of the reporting period. Each restricted stock unit is the equivalent of one common share. Restricted stock units vest at 25% per year, beginning one year from the grant date for a term of four years. We recognized compensation expense related to restricted stock units granted to employees of $1.4 million, $1.5 million, and $1.6 million in selling, general and administrative expense for the years ended April 30, 2016, April 25, 2015, and April 26, 2014, respectively. Our unrecognized compensation cost at April 30, 2016, related to employee restricted stock units was $0.9 million based on the market value (intrinsic value) on that date, and is expected to be recognized over a weighted-average remaining contractual term of all unvested awards of 1.0 year. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15: Stock-Based Compensation (Continued) The following table summarizes information about non-vested stock units as of and for the year ended April 30, 2016: Restricted stock units granted to directors are offered at no cost to the directors and vest when a director leaves the board. During fiscal 2016, fiscal 2015, and fiscal 2014 we granted less than 0.1 million restricted stock units each year to our non-employee directors. We account for these restricted stock units as equity-based awards as they will be settled in shares of our common stock upon vesting. We measure and recognize compensation expense for these awards based on the market price of our common shares on the date of grant, which was $27.74, $21.81, and $21.20 for the awards granted in fiscal 2016, fiscal 2015, and fiscal 2014, respectively. Our expense relating to the non-employee directors restricted stock units which we recorded in selling, general and administrative expense was $0.6 million in fiscal 2016 and $0.7 million in fiscal 2015 and fiscal 2014. Performance Awards. Under the La-Z-Boy Incorporated 2010 Omnibus Incentive Plan, the Compensation Committee of the board of directors is authorized to award common shares and stock units to certain employees based on the attainment of certain financial goals over a given performance period. The awards are offered at no cost to the employees. In the event of an employee's termination during the vesting period, the potential right to earn shares/units under this program is generally forfeited. Payout of these grants depends on our financial performance (80%) and a market-based condition based on the total return our shareholders receive on their investment in our stock relative to returns earned through investments in other public companies (20%). The performance award opportunity ranges from 50% of the employee's target award if minimum performance requirements are met to a maximum of 200% of the target award based on the attainment of certain financial and shareholder-return goals over a specific performance period, which is generally three fiscal years. The number of performance-based units/shares granted were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15: Stock-Based Compensation (Continued) Based on our financial results for fiscal 2016, certain performance conditions were met for some of our outstanding performance-based awards. The number of awards earned based on performance conditions were as follows: The fiscal 2014, fiscal 2015, and fiscal 2016 shares will be settled in shares and the fiscal 2014 units will be settled in cash if service conditions are met, requiring employees to remain employed with the company through the end of the three-year-performance periods. We account for performance-based shares as equity-based awards because upon vesting, they will be settled in common shares. For shares that vest based on our results relative to the performance goals, we expense as compensation cost the fair value of the shares as of the day we granted the awards recognized over the performance period, taking into account the probability that we will satisfy the performance goals. The fair value of each share of the awards we granted in fiscal 2016, fiscal 2015, and fiscal 2014 that vest based on attaining performance goals was $25.73, $22.91, and $18.58, respectively, the market value of our common shares on the date we granted the awards less the dividends we expect to pay before the shares vest. For shares that vest based on market conditions, we use a Monte Carlo valuation model to estimate each share's fair value as of the date of grant, and, similar to the way in which we expense awards of stock options, we expense compensation cost over the vesting period regardless of the value that award recipients ultimately receive. Based on the Monte Carlo model, the fair value as of the grant date of the fiscal 2016, fiscal 2015, and fiscal 2014 grants of shares that vest based on market conditions was $34.40, $29.64, and $26.08, respectively. Our unrecognized compensation cost at April 30, 2016, related to performance-based shares was $4.6 million based on the current estimates of the number of awards that will vest, and is expected to be recognized over a weighted-average remaining contractual term of all unvested awards of 1.4 years. Equity-based compensation expenses related to performance-based shares recognized in our consolidated statement of income were as follows (for the fiscal years ended): We account for performance-based units as liability-based awards because upon vesting, they will be paid in cash. For units that vest based on our results relative to performance goals, we expense as compensation cost over the performance period the fair value of each unit, taking into account the probability that the performance goals will be attained. The fair value of each unit we granted in fiscal 2014 that vest based on attaining performance goals was $25.77, the market value of our common NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15: Stock-Based Compensation (Continued) shares on the last day of the reporting period less the dividends we expect to pay before the awards vest. For performance-based units that vest based on market conditions, we use a Monte Carlo valuation model to estimate each unit's fair value as of the last day of the reporting period. We re-measure and adjust the liability for these units based on the Monte Carlo valuation at the end of each reporting period until the units are settled. Based on the Monte Carlo model, the fair value at April 30, 2016, of the fiscal 2014 grant of units that vest based on market conditions was $46.64. During fiscal 2016, we recognized no expense related to performance-based units due to the cost of the units being offset by declines in their fair value during the year. In fiscal 2015 and fiscal 2014, we recognized $2.0 million and $2.2 million, respectively, of expense related to performance-based units. Previously Granted Deferred Stock Units. We account for awards under our deferred stock unit plan for non-employee directors as liability-based awards because upon exercise these awards will be paid in cash. We measure and recognize compensation expense based on the market price of our common stock on the grant date. We remeasure and adjust the liability based on the market value (intrinsic value) of our common shares on the last day of the reporting period until paid with a corresponding adjustment to reflect the cumulative amount of compensation expense. For purposes of dividends and for measuring the liability, each deferred stock unit is the equivalent of one common share. As of April 30, 2016, we had 0.1 million deferred stock units outstanding. We recorded (income)/expense relating to deferred stock units in selling, general and administrative of $(0.2) million, $0.4 million, and $0.8 million during fiscal 2016, fiscal 2015, and fiscal 2014, respectively. Our liability related to these awards was $2.6 million and $3.4 million at April 30, 2016, and April 25, 2015, respectively, and is included as a component of other long-term liabilities on our consolidated balance sheet. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 16: Accumulated Other Comprehensive Loss The activity in accumulated other comprehensive loss for the fiscal years ended April 30, 2016, April 25, 2015, and April 26, 2014, were as follows: We reclassified the unrealized gain on marketable securities from accumulated other comprehensive loss to net income through other income in our consolidated statement of income, reclassified the change in fair value of cash flow hedges to net income through cost of sales, and reclassified the net pension amortization to net income through selling, general and administrative expense. The components of non-controlling interest at April 30, 2016, April 25, 2015, and April 26, 2014 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 17: Segment Information Our reportable operating segments are the Upholstery segment, the Casegoods segment and the Retail segment. Upholstery Segment. The Upholstery segment consists primarily of two operating units: La-Z-Boy and England. This segment manufactures and imports upholstered furniture. Upholstered furniture includes recliners and motion furniture, sofas, loveseats, chairs, sectionals, modulars, ottomans and sleeper sofas. The Upholstery segment sells directly to La-Z-Boy Furniture Galleries® stores, operators of La-Z-Boy Comfort Studio® locations and England Custom Comfort Center locations, major dealers, and a wide cross-section of other independent retailers. Casegoods Segment. The Casegoods segment consists of three brands: American Drew, Hammary, and Kincaid. This segment sells imported wood furniture to furniture retailers. Casegoods product includes bedroom, dining room, entertainment centers, occasional pieces and some manufactured coordinated upholstered furniture. The Casegoods segment sells directly to major dealers, as well as La-Z-Boy Furniture Galleries® stores, and a wide cross-section of other independent retailers. Retail Segment. The Retail segment consists of 124 company-owned La-Z-Boy Furniture Galleries® stores. During fiscal 2016, fiscal 2015, and fiscal 2014, we acquired La-Z-Boy Furniture Galleries® stores in various markets. All of these acquired stores were previously independently owned and operated (see Note 2 for more detail related to these acquisitions). The Retail segment sells upholstered furniture, and some casegoods and other accessories, to end consumers through the retail network. Restructuring. During fiscal 2014, we committed to a restructuring of our casegoods business to transition to an all-import model for our wood furniture. In fiscal 2016 and fiscal 2014, we recorded restructuring charges of $0.6 million and $4.8 million, respectively, and restructuring income of $0.4 million in fiscal 2015, related to continuing operations (see Note 3 for additional information). We do not include restructuring costs in the results of our reportable segments. The accounting policies of the operating segments are the same as those described in Note 1. We account for intersegment revenue transactions between our segments consistent with independent third party transactions, that is, at current market prices. As a result, the manufacturing profit related to sales to our Retail segment is included within the appropriate Upholstery or Casegoods segment. Operating income realized on intersegment revenue transactions is therefore generally consistent with the operating income realized on our revenue from independent third party transactions. Segment operating income is based on profit or loss from operations before interest expense, interest income, income from continued dumping and subsidy offset act, other income (expense) and income taxes. Identifiable assets are cash and equivalents, notes and accounts receivable, net inventories, net property, plant and equipment, goodwill and other intangible assets. Our unallocated assets include NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 17: Segment Information (Continued) deferred income taxes, corporate assets (including a portion of cash and equivalents), and various other assets. Sales are attributed to countries on the basis of the customer's location. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 17: Segment Information (Continued) Note 18: Income Taxes Income from continuing operations before income taxes consists of the following (for the fiscal years ended): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 18: Income Taxes (Continued) Income tax expense (benefit) applicable to continuing operations consists of the following components (for the fiscal years ended): Our effective tax rate differs from the U.S. federal income tax rate for the following reasons: For our foreign operating units, we permanently reinvest the earnings and consequently do not record a deferred tax liability relative to the undistributed earnings. We have reinvested approximately $24.7 million of the earnings. The potential deferred tax attributable to these earnings would be approximately $3.2 million. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 18: Income Taxes (Continued) The primary components of our deferred tax assets and (liabilities) were as follows: The deferred tax assets associated with loss carry forwards and the related expiration dates are as follows: We evaluate our deferred taxes to determine if a valuation allowance is required. Accounting standards require that we assess whether a valuation allowance should be established based on the consideration of all available evidence using a "more likely than not" standard with significant weight being given to evidence that can be objectively verified. The evaluation of the amount of net deferred tax assets expected to be realized necessarily involves forecasting the amount of taxable income that will be generated in future years. We have forecasted future results using estimates management believes to be reasonable. We based these estimates on objective evidence such as expected trends resulting from certain leading economic indicators. Based upon our net deferred tax asset position at April 30, 2016, we estimate that about $106 million of future taxable income would need to be generated to fully recover our net deferred tax assets. The realization of deferred income tax assets is dependent on future events. Actual results inevitably will vary from management's forecasts. Such variances could result in adjustments to the valuation allowance on deferred tax assets in future periods, and such adjustments could be material to the financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 18: Income Taxes (Continued) During fiscal 2016, we recorded a $0.7 million decrease in our valuation allowance for deferred tax assets that are now considered more likely than not to be realized. This determination was primarily the result of our assessment of our cumulative pre-tax income in certain jurisdictions. A summary of the valuation allowance by jurisdiction is as follows: The remaining valuation allowance of $3.6 million primarily related to certain U.S. state and foreign deferred tax assets. The U.S. state deferred taxes are primarily related to state net operating losses. As of April 30, 2016, we had a gross unrecognized tax benefit of $1.8 million related to uncertain tax positions in various jurisdictions. A reconciliation of the beginning and ending balance of these unrecognized tax benefits is as follows: We recognize interest and penalties associated with uncertain tax positions in income tax expense. We had approximately $0.2 million and $0.3 million accrued for interest and penalties as of April 30, 2016, and April 25, 2015, respectively. If recognized, $0.4 million of the total $1.8 million of unrecognized tax benefits would decrease our effective tax rate. We expect unrecognized tax benefits to decrease by approximately $1.3 million within the next 12 months as a result of state tax net operating loss carryovers expiring. This expected decrease in unrecognized tax benefits will not impact our effective tax rate. The remaining balance will be settled or released as tax audits are effectively settled, statutes of limitation expire or other new information becomes available. Our U.S. federal income tax returns for fiscal years 2013 and subsequent are still subject to audit. Our fiscal year 2012 U.S. federal income tax return audit was completed in fiscal 2016 with no changes to reported tax. In addition, we conduct business in various states. The major states in which we conduct business are subject to audit for fiscal years 2013 and subsequent. Our businesses in Canada and Thailand are subject to audit for fiscal years 2007 and subsequent, and in Mexico, calendar years 2011 and subsequent. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 18: Income Taxes (Continued) Cash paid for taxes (net of refunds received) during the fiscal years ended April 30, 2016, April 25, 2015, and April 26, 2014, were $34.5 million, $34.4 million, and $25.0 million, respectively. Note 19: Earnings per Share Certain share-based compensation awards that entitle their holders to receive non-forfeitable dividends prior to vesting are considered participating securities. We grant restricted stock awards that contain non-forfeitable rights to dividends on unvested shares, and we are required to include these participating securities in calculating our basic earnings per common share, using the two-class method. The following is a reconciliation of the numerators and denominators we used in our computations of basic and diluted earnings per share: The above values for contingent common shares reflect the dilutive effect of common shares that we would have issued to employees under the terms of performance-based share awards if the relevant performance period for the award had been the reporting period. We had outstanding options to purchase 0.4 million shares for the year ended April 30, 2016 with a weighted average exercise price of $26.69. We excluded the effect of these options from our diluted share calculation since, for each period presented, the weighted average exercise price of the options was higher than the average market price, and including the options' effect would have been anti-dilutive. We did not exclude any outstanding options from the diluted share calculation for the fiscal years ended April 25, 2015 and April 26, 2014. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 20: Fair Value Measurements Accounting standards require that we put financial assets and liabilities into one of three categories based on the inputs we use to value them: • Level 1-Financial assets and liabilities the values of which are based on unadjusted quoted market prices for identical assets and liabilities in an active market that we have the ability to access. • Level 2-Financial assets and liabilities the values of which are based on quoted prices in markets that are not active or on model inputs that are observable for substantially the full term of the asset or liability. • Level 3-Financial assets and liabilities the values of which are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Accounting standards require that in making fair value measurements, we use observable market data when they are available. When inputs used to measure fair value fall within different levels of the hierarchy, we categorize the fair value measurement as being in the lowest level that is significant to the measurement. We recognize transfers between levels of the fair value hierarchy at the end of the reporting period in which they occur. In addition to assets and liabilities that we record at fair value on a recurring basis, we are required to record assets and liabilities at fair value on a non-recurring basis. We measure non-financial assets such as trade names, goodwill, and other long-lived assets at fair value when there is an indicator of impairment, and we record them at fair value only when we recognize an impairment loss. During fiscal 2015 we recorded our American Drew trade name at fair value based upon the relief from royalty method. The following table presents the fair value hierarchy for those assets measured at fair value on a recurring basis as of April 30, 2016, and April 25, 2015: Fiscal 2016 (a)There were no transfers between Level 1 and Level 2 during fiscal 2016. Fiscal 2015 (b)There were no transfers between Level 1 and Level 2 during fiscal 2015. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 20: Fair Value Measurements (Continued) At April 30, 2016, and April 25, 2015, we held available-for-sale marketable securities intended to enhance returns on our cash and to fund future obligations of our non-qualified defined benefit retirement plan, as well as trading securities to fund future obligations of our executive deferred compensation plan and our performance compensation retirement plan. The fair value measurements for our securities are based on quoted prices in active markets, as well as through broker quotes and independent valuation providers, multiplied by the number of shares owned exclusive of any transaction costs.
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This financial statement appears to be a partial view of accounting policies and procedures rather than a complete financial statement, but here are the key points:
1. Asset Valuation:
- Long-lived assets are reviewed annually for impairment
- Uses undiscounted projected cash flows to determine impairment
- Asset groups include Upholstery segment (La-Z-Boy and England), Casegoods segment, and retail stores
2. Intangible Assets & Goodwill:
- Tested for impairment annually in Q4
- Includes American Drew trade name and rights to operate La-Z-Boy stores
- Goodwill relates to acquired furniture stores in various markets
- Fair value determined through discounted cash flows
3. Financial Instruments:
- Available-for-sale securities recorded at fair value
- Uses first-in, first-out method for purchase costs
- Life insurance policies recorded at realizable value
4. Cash & Inventory:
- Cash equivalents defined as highly liquid debt instruments with ≤3 months maturity
- Maintains restricted cash as collateral for letters of credit
- Inventory valued at lower of cost or market
- Uses LIFO accounting for approximately 70% of inventory
This appears to be more of an accounting policy disclosure than a complete financial statement, as it focuses on explaining valuation methods rather than providing actual financial figures.
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Claude
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- Report of Independent Registered Public Accounting Firm Board of Directors and Shareholders Immucor, Inc. We have audited the accompanying consolidated balance sheets of Immucor, Inc. (a Georgia corporation) and subsidiaries (the “Company”) as of May 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive (loss) income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended May 31, 2016. Our audits of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Immucor, Inc. and subsidiaries as of May 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended May 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. GRANT THORNTON LLP /s/ GRANT THORNTON LLP Atlanta, Georgia August 22, 2016 Consolidated Financial Statements IMMUCOR, INC. CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except share data) The accompanying notes are an integral part of these consolidated financial statements. IMMUCOR, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands) The accompanying notes are an integral part of these Consolidated Financial Statements. IMMUCOR, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (in thousands) The accompanying notes are an integral part of these consolidated financial statements. IMMUCOR, INC. CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (in thousands) (1) - Shareholders’ equity of Immucor, Inc. The accompanying notes are an integral part of these consolidated financial statements. IMMUCOR, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) The accompanying notes are an integral part of these consolidated financial statements. IMMUCOR, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Business - Founded in 1982, Immucor, Inc., a Georgia corporation (“Immucor” or the “Company”), develops, manufactures and sells transfusion and transplantation diagnostics products used by hospitals, donor centers and reference laboratories around the world. The Company’s products are used in a number of tests performed in the typing and screening of blood, organs or stem cells to ensure donor-recipient compatibility for blood transfusion, and organ and stem cell transplantations. The Company operates manufacturing facilities in North America with both direct and third-party distribution arrangements worldwide. Basis of Presentation - The Company (Immucor, Inc. together with its wholly owned subsidiaries) was acquired on August 19, 2011 through a merger transaction with IVD Acquisition Corporation (“Merger Sub”), a wholly owned subsidiary of IVD Intermediate Holdings B Inc. (the “Parent”). The Parent is a wholly owned indirect subsidiary of IVD Holdings Inc. (“Holdings”) which was formed by investment funds affiliated with TPG Capital, L.P. (“the Sponsor”). The acquisition was accomplished through a merger of the Merger Sub with and into the Company, with the Company being the surviving company (the “Immucor Acquisition”). As a result of the merger, the Company became a wholly owned subsidiary of Parent. Prior to August 19, 2011, the Company operated as a public company with common stock traded on the NASDAQ Stock Market. The accompanying consolidated statements of operations, comprehensive loss, changes in shareholders’ equity, and cash flows are presented for the fiscal years ended May 31, 2016, 2015, and 2014. Certain reclassifications have been made to the fiscal year 2015 consolidated financial statements to conform to the 2016 presentation. We have also performed an evaluation of subsequent events through the date the financial statements were issued. Basis of Consolidation - The consolidated financial statements include the accounts of Immucor, Inc., its wholly owned subsidiaries, and a variable interest entity (“VIE”) that is required to be consolidated in accordance with U.S. GAAP (Refer to Note 4 for additional information on our consolidated VIE). All significant intercompany balances and transactions have been eliminated in consolidation. There are no other entities controlled by the Company, either directly or indirectly. Variable Interest Entities - In determining whether we are the primary beneficiary of an entity and therefore the VIE is required to be consolidated, we apply a qualitative approach that determines whether we have both (1) the power to direct the economically significant activities of the entity, and (2) the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to that entity. We continually assess whether we are the primary beneficiary of a VIE as changes to existing relationships, contractual arrangements, and business transactions occur. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles in the U.S. (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Share-Based Compensation - Consistent with the provisions of Accounting Standards Codification (“ASC”) 718, “Compensation - Stock Compensation,” compensation cost for grants of all share-based payments is based on the estimated grant date fair value. The value of share-based compensation is attributed to expense over the requisite service period using the graded-vesting method for performance-based options, and the straight-line method for service-based options. As of fiscal year 2016, the Company uses the Black-Scholes valuation model to estimate the fair value of its share-based payment awards. Key input assumptions used to estimate the fair value of stock options and stock appreciation rights include the initial value of common stock, expected term until the exercise of the equity award, the expected volatility of the equity, risk-free rates of return and dividend yields, if any. Prior to fiscal year 2016, the Company used the Monte Carlo simulation approach. The Monte Carlo method is used to calculate the fair value of an option with multiple sources of uncertainty by creating random price paths for the underlying share and expected future value, then discounting the average of those paths to determine the fair value. Key input assumptions used to estimate the fair value of stock options and stock appreciation rights are similar to those used in the Black-Scholes valuation model. Concentration of Credit Risk - Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. In order to mitigate the concentration of credit risk, the Company places its cash and cash equivalents with multiple financial institutions. Cash and cash equivalents were $10.3 million and $18.4 million at May 31, 2016 and 2015, respectively. Cash and cash equivalents located in the U.S. were approximately 38% and 37% at May 31, 2016 and 2015, respectively. Concentrations of credit risk with respect to trade accounts receivable are limited because a large number of geographically diverse customers make up the Company’s customer base, thus spreading the trade credit risk. At May 31, 2016, 2015 and 2014, no single customer represented 10% or more of total consolidated net sales or trade accounts receivable. The Company controls credit risk through credit limits and monitoring procedures. At May 31, 2016 and 2015, the Company’s net trade accounts receivable balances were $62.0 million and $67.7 million, respectively, with about 45% of these accounts being of foreign origin, predominantly European, in both years. Companies and government agencies in some European countries require longer payment terms as a part of doing business. This may subject the Company to a higher risk of uncollectibility. This risk is considered when the allowance for doubtful accounts is evaluated. The Company generally does not require collateral from its customers. During fiscal year 2014, the Company reviewed the valuation method used to determine the estimate of our allowance for doubtful accounts and determined that a change in estimate was needed to better reflect the actual bad debt experience. As a result, the Company revised its valuation method, effective November 30, 2013, and reduced the estimate of allowance for doubtful accounts on uncollected receivables. The effect of this change in estimate was a reduction in bad debt expense of $1.9 million, and a decrease in net loss of approximately $1.1 million in fiscal year 2014. Cash and Cash Equivalents - The Company considers deposits and investments with an original maturity of three months or less when purchased to be cash and cash equivalents. Generally, cash and cash equivalents held at financial institutions are in excess of insurance limit. The Company limits its exposure to credit loss by placing its cash and cash equivalents in liquid investments with high quality financial institutions. Inventories, net - Typically inventories are stated at the lower of cost (first-in, first-out basis) or net realizable value, net of reserves. The Company records adjustments to the carrying value of inventory based upon assumptions about historic usage, future demand, and market conditions. Fair Value of Financial Instruments - The Company measures fair value using a three-level hierarchy that prioritizes the inputs used. This hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs. The three levels of inputs used to measure fair value are explained in Note 16 of the Company’s consolidated financial statements. The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, trade accounts receivable, accounts payable and other current liabilities approximate fair value because of their short-term nature. Derivative Instruments - The Company may from time to time use derivatives as a risk management tool to mitigate the potential impact of interest rate and foreign exchange risk. All derivatives are carried at fair value in the Company’s consolidated balance sheets. The Company does not enter into speculative derivatives. The derivatives are cash flow hedges which are considered effective. Changes in fair value are recognized through other comprehensive income. Any portion considered ineffective is recognized directly into operating income. Property and Equipment, net - Property and equipment is stated at cost less accumulated depreciation. Expenditures for replacements are capitalized, and the replaced items are retired. Normal maintenance and repairs are charged to operations. Major maintenance and repair activities that significantly enhance the useful life of the asset are capitalized. When property and equipment are retired, sold, or otherwise disposed of, the asset’s carrying amount and related accumulated depreciation are removed from the accounts and any gain or loss is included in operations. Depreciation is computed using the straight-line method over the estimated lives of the related assets ranging from three to thirty years. Carrying values of these assets are evaluated if impairment indicators arise. The Company reviews the estimated useful lives of its fixed assets on an ongoing basis. During fiscal year 2014, this review indicated that the actual lives of the Company’s instrument equipment were longer than the estimated useful lives used for depreciation purposes in our financial statements. As a result, the Company changed its estimates of the useful lives of its instrument equipment, effective June 1, 2013, to better reflect the estimated periods during which these assets will remain in service. As a result, the estimated useful lives of these assets increased from approximately 5 years to 10 years. The effect of this change in estimate was a reduction in depreciation expense of $6.3 million and a decrease in net loss of approximately $3.6 million for fiscal year 2014, respectively. Deferred Financing Costs, net - Deferred financing costs are capitalized and are amortized over the life of the related debt agreements using the effective interest rate method, except the Revolving Facilities which uses the straight-line method. The amortization expense is included in interest expense in the consolidated statements of operations. The deferred financing cost asset is netted against the Company’s debt obligations and included in long-term debt, excluding current portion in the consolidated balance sheets. Goodwill - Consistent with ASC 350, “Intangibles - Goodwill and Other,” goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually or more frequently if impairment indicators arise. Intangible assets that have finite lives are amortized on a straight line basis over their useful lives. The Company evaluates the carrying value of goodwill as of March 1st of each fiscal year and between annual evaluations if events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Such circumstances could include, but are not limited to: (1) a significant adverse change in legal factors or in business climate, (2) unanticipated competition, or (3) an adverse action or assessment by a regulator. When evaluating whether goodwill is impaired the Company first assesses qualitative factors to determine if it is more likely than not (defined as 50% or more) that the fair value of the reporting unit is less than its carrying amount. If it is determined that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, no additional steps are taken. If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, the Company then compares the fair value of the reporting unit to which the goodwill is assigned to the reporting unit’s carrying amount, including goodwill. The fair value of the reporting unit is estimated using primarily the income, or discounted cash flows, approach. If the carrying amount of a reporting unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss would be calculated by comparing the implied fair value of the reporting unit’s goodwill to its carrying amount. In calculating the implied fair value of the reporting unit’s goodwill, the fair value of the reporting unit is allocated to all of the other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. An impairment loss would be recognized when the carrying amount of goodwill exceeds its implied fair value. The Company’s evaluation of goodwill and other intangible assets with indefinite lives completed during fiscal years 2016 and 2015 resulted in no impairment charges, and resulted in $160.0 million in impairment charges in fiscal year 2014. Refer to Footnote 9 of the Company’s consolidated financial statements for additional information. Other Intangible Assets, net - Other intangible assets primarily include customer relationships, deferred licensing costs, existing technology and trade names. These other intangible assets are amortized over their anticipated benefit period. Carrying values of these assets are evaluated when impairment indicators arise. There was no impairment charge related to other intangible assets subject to amortization in fiscal years 2016, 2015 or 2014. In-process research and development (“IPR&D”) is also included in other intangible assets. IPR&D has an indefinite life until the completion or abandonment of the individual project. When a project is completed, its value will be amortized over its estimated useful life. If a project is abandoned, its value is written-off. The carrying value of IPR&D is tested for impairment annually or more frequently if impairment indicators arise. There was no impairment charge related to IPR&D during fiscal year 2015. An impairment charge of $3.0 million and $0.2 million was recorded in fiscal years 2016 and 2014, respectively, for IPR&D projects that were determined not to be economically feasible, and therefore were written-off. Foreign Currency Translation - The financial statements of foreign subsidiaries have been translated into U.S. Dollars in accordance with ASC 830-30, “Translation of Financial Statements”. The financial position and results of operations of the Company’s foreign subsidiaries are measured using the foreign subsidiary’s local currency as the functional currency. Revenues and expenses of such subsidiaries have been translated into U.S. Dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the balance sheet date. The resulting translation gain and loss adjustments are recorded directly as a separate component of shareholders’ equity, unless there is a sale or complete liquidation of the underlying foreign investments. Gains and losses that result from foreign currency transactions are included in “other non-operating (expense) income” in the consolidated statements of operations. Revenue Recognition - The Company recognizes revenue in accordance with ASC 605, “Revenue Recognition,” when the following four basic criteria have been met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services are rendered; (3) the fee is fixed and determinable; and (4) collectability is reasonably assured. The Company enters into arrangements in which the Company commits to delivering multiple products or services to its customers. In these cases, total arrangement consideration is allocated to all deliverables based on their relative selling prices. The following hierarchy is used to determine the selling price to be used for allocating revenue to deliverables: (i) vender specific objective evidence (“VSOE”) of fair value, (ii) third-party evidence of selling price (“TPE”), and (iii) management’s best estimate of selling price (“MBESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. TPE represents the selling price of a similar product or service by another vendor. MBESPs reflect management’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. In determining MBESP, the Company considers the following: (1) pricing practices as they relate to future price increases and (2) the overall economic conditions. The significant deliverables included in the Company’s arrangements are the delivery of products such as reagents and part kits, instrument (sold and leased) and the performance of services such as training and general support services. Each of these significant deliverables qualify as separate units of accounting. The Company recognizes revenue from product sales, such as reagents and part kits, when the goods are shipped or when the goods are delivered, title passes, and risk of loss passes to the customer. The product’s selling price, which is used to allocate the total arrangement consideration to each deliverable, is based on either VSOE or MBESP. The revenue from instrument sales or leases is recognized when the instrument has been installed and accepted by the customer. The selling price of instrument sales or leases is based on MBESP. Training revenue is recognized as the training services are provided. The selling price of training is based on MBESP. General support service revenue is recognized over the term of the agreement. The selling price of general support services is based on VSOE by reference to the price our customers are required to pay for the general support services when sold separately as renewal agreements. Shipping and Handling Charges and Sales Tax - The amounts billed to customers for shipping and handling of orders are classified as revenue and reported in the statements of operations as net sales. The costs of handling and shipping customer orders are reported in the operating expense section of the consolidated statements of operations as distribution expense. Sales taxes invoiced to customers and payable to government agencies are recorded on a net basis with the sales tax portion of a sales invoice directly credited to a liability account and the balance of the sales invoice credited to a revenue account. Trade Accounts Receivable and Allowance for Doubtful Accounts -The allowance for doubtful accounts represents a reserve for estimated losses resulting from the inability of the Company’s customers to pay their debts. The collectability of trade accounts receivable balances is regularly evaluated based on a combination of factors such as customer credit-worthiness, past transaction history with the customer, current economic industry trends and changes in customer payment patterns. If it is determined that a customer will be unable to fully meet its financial obligation, such as in the case of a bankruptcy filing or other material events impacting its business, a specific allowance for doubtful accounts is recorded to reduce the related receivable to the amount expected to be recovered. Research and Development costs - Research and development costs are expensed as incurred and are disclosed as a separate line item in the consolidated statements of operations. Loss contingencies - Certain conditions may exist as of the date the financial statements are issued that may result in a loss to the Company, but which will only be determined and resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein. If the assessment of a contingency indicates that it is probable that a material loss is likely to occur and the amount of the liability can be estimated, then the estimated liability is accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Loss contingencies considered remote are generally not accrued or disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed. Legal costs relating to loss contingencies are expensed as incurred. Contingent consideration liabilities resulting from a business combination are recorded at fair value at the time of acquisition. The fair value is calculated by applying a form of the income approach, based on the probability-weighted projected payment amounts discounted to a present value at a rate appropriate for the risk of achieving the performance targets according to the terms of the arrangements. Key assumptions are the earn-out period probabilities and an appropriate discount rate. Contingent consideration liabilities are then reevaluated on a quarterly basis and adjusted as needed to reflect changes in fair value, and to reflect interest accretion. The contingent consideration liability exists until the earn-out is achieved and subsequently paid or the earn-out is not achieved and the fair value of the liability is reduced. Income Taxes - Effective with the Immucor Acquisition, the Company’s taxable income or loss is included in the consolidated income tax returns of Holdings. Current and deferred income taxes are allocated to the members of the consolidated group as if each member were a separate taxpayer. Deferred income taxes are computed using the asset and liability method. The Company records the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying consolidated balance sheets, as well as operating loss and tax credit carry-forwards. The value of the Company’s deferred tax assets assumes that the Company will be able to generate sufficient future taxable income in applicable tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to record additional valuation allowances against its deferred tax assets resulting in additional income tax expense in the Company’s consolidated statements of operations. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized, and the Company considers the Company’s history of taxable income (loss), the scheduled reversal of deferred tax liabilities, projected future taxable income, carry-back opportunities, and tax-planning strategies in making this assessment. Management assesses the need for additional valuation allowances quarterly. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Although ASC 740, “Income Taxes,” provides clarification on the accounting for uncertainty in income taxes recognized in the financial statements, the threshold and measurement attribute will continue to require significant judgment by management. Resolution of these uncertainties in a manner inconsistent with the Company’s expectations could have a material impact on its results of operations. Business Combinations - Transactions classified as an acquisition of a business are recognized in accordance with ASC 805, “Business Combinations.” Results of operations of acquired companies are included in the Company’s results of operations as of the respective acquisition dates. The purchase price of each acquisition is allocated to the acquired assets and liabilities based on estimates of their fair values at the date of the acquisition. Contingent consideration is recognized at the estimated fair value on the acquisition date. Subsequent changes to the fair value of contingent consideration liabilities are recognized in earnings. Any purchase price in excess of these acquired assets and liabilities is recorded as goodwill. The allocation of purchase price in certain circumstances may be subject to revision based on the final determination of fair values during the measurement period, which may be up to one year from the acquisition date. Impact of Recently Issued Accounting Standards - Adopted by the Company in fiscal year 2016 In the fourth quarter of 2016, the Company adopted the Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). ASU 2016-09 simplifies several aspects of the accounting for employee share-based payments, including accounting for income taxes, forfeitures, statutory tax withholding requirements, and classification on the statement of cash flows. This standard is effective for annual periods beginning after December 15, 2016, which corresponds to the Company’s first quarter of fiscal year 2018, and interim periods within annual periods beginning after December 15, 2018. Early adoption is permitted but must adopt all the amendments in the same period and reflected as of the beginning of the fiscal year that interim period. The adoption of ASU 2016-09 did not have a material impact on the Company’s consolidated financial statements. In the fourth quarter of 2016, the Company adopted the FASB ASU No. 2015-17, Income Taxes: Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”). ASU 2015-17 requires that deferred income tax liabilities and assets be classified as noncurrent in a classified statement of financial position. This standard is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods, which corresponds to the Company’s first quarter of fiscal year 2018. Earlier adoption is permitted as of the beginning of an interim or annual reporting period. We early adopted ASU 2015-17 on a retrospective basis. Adoption resulted in a $5.9 million decrease in the current portion of the Company’s deferred income tax assets, and the long-term portion of the Company’s deferred income tax liabilities in our consolidated balance sheet at May 31, 2015. The adoption of ASU 2015-17 had no material impact on our results of operations. In the fourth quarter of 2016, the Company adopted the FASB ASU No. 2015-11, Inventory: Simplifying the Measurement of Inventory (“ASU 2015-11”). ASU 20115-11 requires that inventory within the scope of this update be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less reasonable predictable costs of completion, disposal, and transportation. The amendments in this update do not apply to inventory that is measured using last-in, first-out (“LIFO”) or the retail inventory method. The amendments apply to all other inventory, which includes inventory that is measured using first-in, first-out (“FIFO”) or average cost. This standard is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods, which corresponds to the Company’s first quarter of fiscal year 2018. Early adoption is permitted. The adoption of ASU 2015-17 did not have a material impact on the Company’s consolidated financial statements. In the fourth quarter of 2016, the Company adopted the FASB ASU No. 2015-03, Interest - Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). ASU 2015-03 changes the presentation of debt issuance costs for term debt in the balance sheet by requiring the debt issuance costs to be presented as a direct deduction from the related debt liability, rather than recorded as an asset. In August 2015, ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements (“ASU 2015-15”), was issued to provide clarification to ASU 2015-03. This standard specifies that the SEC would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding balances on the line-of-credit arrangement. This standard is effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years, which corresponds to the company’s first quarter of fiscal year 2017. This standard is to be applied retrospectively and early adoption is permitted. We early adopted ASU 2015-03 on a retrospective basis. Adoption resulted in a $26.4 million decrease in the noncurrent portion the Company’s assets, and the long-term portion of the Company’s debt in our consolidated balance sheet at May 31, 2015. The adoption of ASU 2015-03 had no material impact on our results of operations. In the fourth quarter of 2016, the Company adopted the FASB ASU No. 2015-16, Business Combinations: Simplifying the Accounting for Measurement - Period Adjustments (“ASU 2015-16”). ASU 2015-16 requires that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments in this update require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The amendments in this update require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provision amounts had been recognized as of the acquisition date. This standard is effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years, which corresponds to the Company’s first quarter of fiscal year 2017. Early adoption is permitted. The adoption of ASU 2015-16 did not have a material impact on the Company’s consolidated financial statements. Accounting Standards Not Yet Adopted In February 2016, the FASB issued ASU No. 2016-02, Leases, which will replace most existing lease accounting guidance in U.S. GAAP. The core principle of ASU 2016-02 is that an entity should recognize the rights and obligations resulting from leases as assets and liabilities. ASU 2016-02 requires qualitative and specific quantitative disclosures to supplement the amounts recorded in the financial statements so that users can understand more about the nature of the entity’s leasing activities, including significant judgements and changes in judgements. ASU 2016-02 will be effective for the Company for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, which corresponds to the Company’s first quarter of fiscal year 2020. Early adoption is permitted. The Company is evaluating the effect of the adoption of ASU 2016-02 on its consolidated financial statements. In May 2014, the FASB and International Accounting Standards Board issued their converged standard on revenue recognition, ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). This standard outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that revenue is recognized when a customer obtains control of a good or service. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Transfer of control is not the same as transfer of risks and rewards, as it is considered in current guidance. The Company will also need to apply new guidance to determine whether revenue should be recognized over time or at a point in time. An amendment was made in July 2015 to change the effective date of this standard from the first interim period within annual reporting periods beginning after December 15, 2016 to December 15, 2017, which corresponds to our first quarter of fiscal year 2019. No early adoption is permitted under this standard, and it is to be applied either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The Company is evaluating the effect of the adoption of ASU 2014-09 on its consolidated financial statements. 2. BUSINESS COMBINATIONS Business combinations completed in fiscal year 2016: Acquisition of Sirona - On March 4, 2016, the Company exercised its warrant and acquired 100% of the common stock of Sirona Genomics, Inc. (“Sirona”). The cash paid for the Sirona business was $15.0 million, of which $14.4 million was paid in the fourth quarter of fiscal year 2016. The purchase agreement included two contingent consideration arrangements, one for achieving certain revenue targets in each of the next five years and the other for achieving a certain revenue milestone during the next five years. The combined potential earn-out for these arrangements is $45.0 million in cash over the next five years. Management estimated that the fair value of the contingent consideration arrangements, as of the acquisition date, was approximately $20.0 million, which is included in Other long-term liabilities on the Company’s consolidated balance sheet. Including the contingent consideration, the aggregate estimated fair value of the consideration paid was approximately $35.0 million. The fair value of the assets and liabilities acquired was $40.6 million for identifiable intangible assets (existing technologies), $14.8 million for goodwill, $2.1 million for property and equipment, $1.3 million of cash, $1.5 million for current liabilities, $9.7 million for a Promissory Note payable to Immucor, and $12.5 million for a long-term deferred tax liability. The purchase price allocation for this acquisition is preliminary and is subject to material valuation adjustments or tax matters that may be identified within the measurement period. The goodwill arising from this acquisition is not deductible for tax purposes. The Company determines contingent consideration liabilities by applying a form of the income approach, based upon the probability-weighted projected payment amounts discounted to present value at a rate appropriate for the risk of achieving the financial performance targets. The key assumptions were the earn-out period payment probabilities, projected revenues, discount rate and the timing of payments. The present value of the expected payments considers the time at which the obligations are expected to be settled and a discount rate that reflects the risk associated with the performance payments. These assumptions are considered to be level 3 inputs by ASC Topic 820, Fair Value Measurement (“ASC Topic 820”), which are not observable in the market. Immucor has been in a collaborative arrangement with Sirona since October 2014 for the development and commercialization of a next generation sequencing HLA typing product for transplant diagnostics. Refer to Note 3 for additional information. Acquisition of reference lab - On August 3, 2015, the Company completed the asset purchase of a U.S. reference lab for a total cash purchase price of $0.8 million. This acquisition will enable the Company to deliver current Immucor products as a service to customers as well as commercialize newly developed products. The fair values of the acquired assets were $0.3 million for equipment, $0.2 million for identifiable intangible assets and $0.3 million for goodwill. The goodwill is deductible for tax purposes. Business combinations completed in fiscal year 2015: Acquisition of Sentilus - On October 1, 2014, the Company completed the acquisition of Sentilus, Inc. (“Sentilus”). Sentilus was a privately-held company focused on developing a novel, inkjet-printed antibody microarray-based technology, FemtoarraysTM. Among other uses, Sentilus has been developing FemtoarraysTM and the underlying technology for use in a variety of in vitro diagnostics areas, including transfusion diagnostics, and could potentially serve as a next generation technology platform for our transfusion diagnostics business. The total cash purchase price of the Sentilus business was $6.0 million. The purchase agreement included two contingent consideration arrangements, one for achieving certain regulatory milestones with a potential earn-out for $4.0 million in cash over the next three years, and the other in the form of performance payments based on a percentage of net future sales of the to-be-developed products over approximately the next twenty years. Management estimated that the fair value of the contingent consideration arrangements, as of the acquisition date, was approximately $6.3 million, which was included in Other long-term liabilities on the Company’s consolidated balance sheet. Including the contingent consideration, the aggregate estimated fair value of the consideration paid was approximately $12.3 million. The other identifiable intangible assets include in-process research and development (“IPR&D”) and a non-competition agreement, which was valued at $18.8 million in the aggregate. Goodwill was valued at $0.6 million and the long-term deferred tax liability was valued at $7.2 million. The goodwill arising from this acquisition was not deductible for tax purposes. Acquisition of LIFECODES distribution business - The Company completed the acquisition of the LIFECODES distribution business in India effective August 1, 2014. This acquisition enables the Company to streamline the distribution of its LIFECODES products in that region. The Company acquired the assets of the India distribution business for a total cash purchase price of $0.4 million. The purchase price also included a potential earn-out of up to $0.2 million if certain financial targets were met during the two year period ending July 2016. Business combinations completed in fiscal year 2014: Acquisition of Organ-i - On May 30, 2014, the Company completed the acquisition of Organ-i, Inc. (“Organ-i”) a privately-held company focused on developing non-invasive tests to monitor and predict organ health for transplant recipients. This acquisition expands our product offering for post-transplant testing and directly complements our existing LIFECODES business. The total cash purchase price of this business was $12.0 million plus a potential earn-out of up to $18.0 million if certain product and financial targets during fiscal years 2015 through 2020 are met. Management estimated that the fair value of the contingent consideration arrangement as of the acquisition date was approximately $11.3 million. Including the contingent consideration, the aggregate estimated fair value of the consideration paid was approximately $23.3 million. The other identifiable intangible assets including existing technology, IPR&D and non-competition agreements were valued at $26.7 million. Goodwill was valued at $5.8 million and the long-term deferred tax liability was valued at $9.1 million. The contingent consideration liability is considered long-term and is included in long-term liabilities in the Company’s consolidated balance sheet. In the third quarter of fiscal year 2015, the long-term deferred tax liability was revised to $8.9 million due to the Company finalizing the amount of the tax attributes acquired in the acquisition and goodwill was revised to $5.6 million. The goodwill arising from this acquisition was not deductible for tax purposes. Acquisition of LIFECODES distribution businesses - The Company completed the acquisition of both the LIFECODES distribution businesses in the United Kingdom (“UK”) and Italy on January 31, 2014. These acquisitions enable Immucor to streamline the distribution of its LIFECODES products in Europe. The Company acquired the stock of the UK distribution business for a total cash purchase price of $4.0 million, including acquired cash of $1.2 million. The Company acquired the assets of the Italy distribution business for a total cash purchase price of $2.4 million. In total, the Company acquired other identifiable intangible assets of $3.5 million and $1.1 million of goodwill, respectively, in these acquisitions. The other identifiable intangible assets are mainly customer relationships, which represent the fair value of the existing customer base. The tangible assets acquired in these acquisitions were not material to the Company’s consolidated financial statements. All of the goodwill arising from the Italy asset acquisition was deductible for income tax purposes. The goodwill arising from the UK acquisition is not deductible for tax purposes. Financial Information The operating results of the acquired businesses have been included in the Company’s consolidated results of operations since their dates of acquisition. 3. OTHER INVESTMENTS Sirona Collaboration - On October 3, 2014, the Company entered into a collaborative arrangement with Sirona for the commercialization of Sirona’s human leukocyte antigen (“HLA”) typing sample preparation and bioinformatics offering for next-generation sequencing. As part of this collaborative arrangement, the Company paid $0.7 million for a warrant with an exclusive option to acquire 100% of the common stock of Sirona and through March 2016, had loaned Sirona $9.5 million to fund development efforts of its existing projects. Of the $9.5 million loan, $4.9 million and $4.6 million were funded in fiscal years 2016 and 2015, respectively. The loan to Sirona did bear interest at a market rate. The outstanding loan and the warrant asset were both included in Other assets on the Company’s consolidated balance sheet as of May 31, 2015. Sirona was considered to be a variable interest entity (“VIE”) until March 2016, when it was acquired. As a VIE, Sirona’s results were not consolidated with the results of Immucor since Sirona retained sole responsibility for and control of the operations of its business, and for achieving product commercialization. 4. CONSOLIDATED VARIABLE INTEREST ENTITY In February 2016, the Company contributed the assets acquired in the Sentilus acquisition to a newly formed company, Sentilus Holdco LLC (“Sentilus LLC”). The Company then distributed its interest in Sentilus LLC via a dividend, indirectly, to IVD Intermediate Holdings A Inc., which is the owner of Immucor’s Parent company, IVD Intermediate Holdings B Inc. Sentilus LLC will continue developing FemtoarraysTM and the underlying technology for use in a variety of in vitro diagnostics areas. This business was spun-off from Immucor to be able to separately market the anticipated new product offerings that are expected to have application outside of the Company’s current transfusion and transplant markets. The book value of the assets and liabilities transferred was $6.0 million. The book value includes assets of $1.0 million of cash, $0.5 million of equipment, $18.8 million of identifiable intangible assets, and $0.1 million of goodwill, and liabilities of $7.2 million of deferred income tax liabilities, and a $7.2 million obligation to Immucor for contingent consideration liabilities. Sentilus LLC is considered to be a VIE. Sentilus LLC is operated as a separate business. Sentilus LLC and the Company have entered into management services agreements (the “Management Contracts”) pursuant to which Immucor will provide management, financial, legal and human resource services as well as personnel, materials and business locations to Sentilus LLC in exchange for management fees at Immucor’s cost plus a specified “arms-length” margin (which is subject to periodic adjustment). Immucor’s executive management will control and operate the Sentilus LLC business. Immucor is considered the primary beneficiary of Sentilus LLC because it is managing the Sentilus LLC business and providing the necessary personnel and support to operate the business under the terms of the Management Contracts. Accordingly, the financial results of Sentilus LLC are included in the consolidated financial results of the Company. The operations of Sentilus LLC will be primarily funded through either additional potential future dividends from Immucor or from additional capital contributions from IVD Holdings Inc. (“Holdings”), the Parent company of IVD Intermediate Holdings A Inc. The Company could be exposed to a loss related to the Sentilus LLC business if there are expenses that are incurred by the Company on behalf of Sentilus LLC under the terms of the Management Contracts and are not reimbursed. This risk is deemed unlikely since all of the entities involved in this arrangement are under the common control of Holdings. The following table includes the carrying amounts and classification of the assets and liabilities of Sentilus LLC that are included in the Company’s consolidated balance sheet as of May 31, 2016 that cannot be used to settle the obligations of Immucor, and are not Immucor’s obligation to pay (in thousands): 5. RELATED PARTY TRANSACTIONS In connection with the Immucor Acquisition in fiscal year 2012, the Company entered into a management services agreement with TPG Capital, L.P. (the “Sponsor”). Pursuant to such agreement, and in exchange for on-going consulting and management advisory services that are provided to the Company, the Sponsor receives an aggregate annual monitoring fee of approximately $3.0 million. In fiscal years 2016, 2015 and 2014, approximately $3.5 million, $3.7 million, $3.9 million, respectively, was recorded for monitoring fees, additional services provided by the Sponsor, and out-of-pocket expenses and the majority is included in general and administrative expenses in the consolidated statements of operations. At May 31, 2016 and 2015, the Company owed $1.7 million and $0.7 million, respectively, to the Sponsor for these fees and expenses. Sentilus LLC and the Company have entered into management services agreements. Refer to Note 4 of the consolidated financial statements for additional information. 6. INVENTORIES, NET In May 2016, the Company adopted ASU No. 2015-11, Inventory: Simplifying the Measurement of Inventory. ASU 2015-11 requires that inventory be measured at the lower of cost or net realizable value. The adoption of this new standard did not have a material impact on our inventory valuation as of May 31, 2016. The Company measures inventories at cost using a first-in, first-out basis. Prior to May 2016, the Company measured inventories at the lower of cost or market. As of May 31, 2016 and 2015, inventories, net consist of the following (in thousands): 7. PREPAID EXPENSES AND OTHER CURRENT ASSETS Prepaid expenses and other current assets consist of the following (in thousands): 8. PROPERTY AND EQUIPMENT, NET Property and equipment, net consists of the following (in thousands): Depreciation expense was $14.6 million, $16.8 million, and $18.3 million in fiscal years 2016, 2015, and 2014, respectively. Depreciation expense is primarily included in cost of sales in the consolidated statements of operations. 9. GOODWILL Changes in the carrying amount of goodwill for the years ended May 31, 2016 and 2015 were as follows (in thousands): The Company has six reporting units with goodwill as a result of prior acquisitions which it evaluates for impairment. The Company evaluates goodwill for impairment on an annual basis as of March 1st, and between annual tests if a triggering event or a change in circumstances indicates that a reporting unit’s goodwill might be impaired. An impairment loss on goodwill is recognized to the extent that a reporting unit’s carrying amount of goodwill exceeds the implied fair value of goodwill of such reporting unit, determined in accordance with ASC Topic 350, Intangibles-Goodwill and Other (“ASC 350”). ASC 350 requires that based on an initial evaluation, if the fair value of a reporting unit is less than its carrying amount, including goodwill, further analysis is required to measure the amount of the impairment loss, if any. The amount by which the reporting unit’s carrying amount of goodwill exceeds the implied fair value of the reporting unit’s goodwill, determined in accordance with ASC 350, is to be recognized as an impairment loss. The annual evaluation of goodwill for impairment utilizes financial projections of the following fiscal year and the five year strategic plan that is prepared during the Company’s fourth quarters and reflects Management’s continuing knowledge of the operations and the markets in which the reporting units operate. The Company estimated the fair value of each of its reporting units in a manner similar to the method used in a business combination. The Company utilized the income approach in the determination of fair value. Under the income approach, estimated fair value is based on the discounted cash flow method. The key assumptions that drive the estimated fair value of the reporting units under the income approach are level 3 inputs and include future cash flows from operations and the discount rate applied to those future cash flows, determined from a weighted-average cost of capital calculation. The future cash flows include additional key assumptions relating to revenue growth rates, gross profits and costs. During fiscal years 2016 and 2015, the estimated fair value of each of our reporting units exceeded its carrying amount, therefore no further analysis was required. For each of the six reporting units that passed step one, the percentage by which the estimated fair value exceeded the carrying amount of the reporting units ranged from 6% to 134% as of March 1, 2016, and 23% to 143% as of March 1, 2015. During fiscal year 2014, the estimated fair value of five of the Company’s six reporting units exceeded its carrying amounts. For each of the five reporting units that passed step one as of March 1, 2014, the percentage by which the estimated fair value exceeded the carrying amount of the reporting units ranged from 45% to 123%. For one of the Company’s reporting units, the estimated fair value that reflects Management’s continuing knowledge of the operations and the markets in which the reporting unit operates did not exceed the carrying amount. Therefore, the Company completed step two of the impairment testing process to measure the amount of the impairment loss. The impairment loss on goodwill was determined to be $160.0 million and was recorded in the fourth quarter of fiscal year 2014. This impairment loss represented 18% of the carrying amount of goodwill for this reporting unit. The Company had $160.0 million of accumulated impairment losses on goodwill as of May 31, 2016. 10. OTHER INTANGIBLE ASSETS, NET Other intangible assets consist of the following (in thousands): In fiscal year 2016, it was determined that two in-process research and development projects were no longer economically feasible and therefore were written-off. One project related to the Transfusion business with a value of $2.5 million and the other project related to the Transplant and Molecular business with a value of $0.5 million. As a result, a loss of $3.0 million was recorded in the fourth quarter of fiscal year 2016 which was included in impairment loss on the Company’s consolidated statement of operations. A portion of the Company’s customer relationships is held in functional currencies outside the U.S. Therefore, the stated cost as well as the accumulated amortization is affected by the fluctuation in foreign currency exchange rates. Amortization of other intangible assets amounted to $54.9 million in fiscal year 2016, $54.5 million in fiscal year 2015, and $53.0 million in fiscal year 2014. The following table presents an estimate of amortization expense for each of the next five fiscal years (in thousands): 11. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities consist of the following (in thousands): 12. DEFERRED REVENUE The additions to, and recognition of, deferred revenue for the years ended May 31, 2016 and 2015 were as follows (in thousands): 13. LONG-TERM DEBT In May of 2016, the Company adopted ASU 2015-03, Interest - Simplifying the Presentation of Debt Issuance Costs. ASU 2015-03 changed the presentation of debt issuance costs on the balance sheet by requiring that they be presented as a direct deduction from the related debt liability, rather than represented as a separate asset. As a result, the Company’s deferred financing costs are now reflected in the Long-term debt, excluding current portion on the Company’s consolidated balance sheets for all periods presented. Long-term debt as of May 31, 2016 and 2015 consists of the following (in thousands): (1) - OID refers to original issue discounts on the Company's long-term debt (2) - DFC refers to deferred financing costs related to the Company's long-term debt facilities Senior Secured Credit Facilities, Security Agreement and Guaranty In connection with the Immucor Acquisition on August 19, 2011, the Company entered into a credit agreement and related security and other agreements for (1) a $615.0 million senior secured term loan facility with Term B Loans (the “Term Loan Facility”) and (2) a $100.0 million senior secured revolving loan facilities (the “Revolving Facilities,” and together with the Term Loan Facility, the “Senior Credit Facilities”) with certain lenders, Citibank, N.A., as Administrative Agent and collateral agent (the “Administrative Agent”) and the other agents party thereto. In addition to borrowings upon prior notice, the Revolving Facilities include borrowing capacity in the form of letters of credit and borrowings on same-day notice, referred to as swing line loans, in each case, up to $25.0 million, and is available in U.S. dollars, Euros, British Pounds, Japanese Yen, Canadian dollars and in such other currencies as the Company and the Administrative Agent under the Revolving Facilities may agree (subject to a sublimit for such non-U.S. currencies). The Company modified the Senior Credit Facilities through various amendments during fiscal years 2012 and 2013. Included in these amendments was the refinancing of the Senior Credit Facilities in August 2012 and in February 2013. The result of these refinancings was to lower the interest rate on the Term Loan Facility and Revolving Facilities and to extend the maturity date of the Revolving Facilities to August 19, 2017. In addition, the amendments modified the financial covenant of the Senior Credit Facilities such that the financial covenant is no longer applicable to the Term Loan Facility and is only applicable to the Revolving Facilities. In March 2013, the Company borrowed an additional $50.0 million on the Term Loan Facility in connection with the LIFECODES acquisition. These additional borrowings were on the same terms as the Term Loan Facility, as then amended. On December 9, 2015, the Company entered into Amendment No. 5 to the credit agreement (“Amendment No. 5”) to modify the financial covenant associated with the Revolving Facilities. Amendment No. 5 provides that beginning with the period ending November 30, 2015, for purposes of calculating its compliance with the senior secured leverage ratio covenant for any trailing twelve-month period for bank reporting purposes, the Company may calculate EBITDA on a constant currency basis, as defined in the amendment. The use of the constant currency adjustment is subject to the Company’s compliance with certain restrictions. On May 4, 2016, the Company entered into Amendment No. 6 to the credit agreement (“Amendment No. 6”). Amendment No. 6 extends the maturity date of the Revolving Facilities and amends certain other terms of the Revolving Facilities. The margin for borrowings under the Revolving Facilities remains unchanged by the amendment, however, a 0% LIBOR floor is imposed on future LIBOR borrowings. Amendment No. 6 extends the maturity date of the Revolving Facilities to the earlier of (i) February 19, 2020, (ii) May 19, 2018, if the maturity of the Term Loan Facility has not been extended by such date, and (iii) 90 days prior to any maturity date of certain funded material indebtedness (which maturity date shall be no earlier than October 19, 2018). Certain other Company actions would also result in a springing maturity of the Revolving Facilities as early as August 20, 2017. Amendment No, 6 also reduces the aggregate principal amount of the revolving credit commitments as follows: (1) effective on May 4, 2016, from $100.0 million to $80.0 million, (2) on August 19, 2018, to $70.0 million, (3) on February 19, 2019, to $60.0 million, and (4) on August 19, 2019, to $50.0 million. Finally, Amendment No. 6 provides that if the Term Loan Facility is amended, then certain provisions with respect to the interest rate margin and negative financial covenants will apply to the Revolving Facilities. The Company is required to make scheduled principal payments on the last business day of each calendar quarter equal to 0.25% of the principal amount of loans under the Term Loan Facility as most recently amended with the balance due and payable on August 19, 2018. Currently scheduled principal payments are $1.7 million per quarter. The Company is also required to repay loans under the Term Loan Facility based on annual excess cash flows as defined in the credit agreement governing the Term Loan Facility and upon the occurrence of certain other events set forth in the Term Loan Facility. Borrowings under the Senior Credit Facilities bear interest at a rate per annum equal to an applicable margin plus, at the Company’s option, either (a) in the case of borrowings in U.S. dollars, a base rate determined by reference to the highest of (1) the prime rate of Citibank, N.A., (2) the federal funds effective rate plus 0.50% and (3) a LIBOR rate determined by reference to the costs of funds for U.S. dollar deposits for an interest period of one month adjusted for certain additional costs, plus 1.00% or (b) in the case of borrowings in U.S. dollars or another currency, a LIBOR rate determined by reference to the costs of funds for U.S. dollar deposits for the interest period relevant to such borrowing adjusted for certain additional costs, which, in the case of the Term Loan Facility only, shall be no less than 1.25%. The applicable margin for borrowings under the Term Loan Facility is 2.75% with respect to base rate borrowings and 3.75% with respect to LIBOR borrowings. The applicable margin for borrowings under the Revolving Facilities is 2.75% with respect to base rate borrowings and 3.75% with respect to LIBOR borrowings, subject to a 0% LIBOR floor. The applicable margin for borrowings under the Revolving Facilities is subject to a 0.25% step-down, when the Company’s senior secured net leverage ratio at the end of a fiscal quarter is less than or equal to 3:00 to 1:00. The interest rate on the Term Loan Facility was 5.00% as of May 31, 2016 and 2015. Including the amortization of deferred financing costs and the original issue discount, the effective interest rate on the Term Loan Facility is 6.1% for fiscal year 2016. At May 31, 2016, there were no outstanding borrowings under the Revolving Facilities and no outstanding letters of credit. All obligations under the Senior Credit Facilities are unconditionally guaranteed by the Parent and certain of the Company’s existing and future wholly owned domestic subsidiaries (such subsidiaries collectively, the “Subsidiary Guarantors”), and are secured, subject to certain exceptions, by substantially all of the Company’s assets and the assets of the Parent and Subsidiary Guarantors, including, in each case subject to customary exceptions and exclusions: • a first-priority pledge of all of the Company’s capital stock directly held by Parent and a first-priority pledge of all of the capital stock directly held by the Company and Subsidiary Guarantors (which pledge, in the case of the capital stock of each (a) domestic subsidiary that is directly owned by the Company or by any Subsidiary Guarantor and that is a disregarded entity for United States federal income tax purposes and that has no material assets other than equity interests in one or more foreign subsidiaries that are controlled foreign corporations for United States federal income tax purposes or (b) foreign subsidiary, is limited to 65% of the stock of such subsidiary); and • a first-priority security interest in substantially all of the Parent’s, the Company’s and the Subsidiary Guarantor’s other tangible and intangible assets. Parent has no material operations or assets other than the capital stock of the Company. The Senior Credit Facilities include restrictions on the Company’s ability and the ability of certain of its subsidiaries to, among other things, incur or guarantee additional indebtedness, pay dividends (including to Parent) on or redeem or repurchase capital stock, make certain acquisitions or investments, materially change its business, incur or permit to exist certain liens, enter into transactions with affiliates or sell its assets to, or merge or consolidate with or into, another company or prepay or amend subordinated or unsecured debt. Although the Parent is not generally subject to the negative covenants under the Senior Credit Facilities, the Parent is subject to a passive holding company covenant that limits its ability to engage in certain activities other than (i) owning equity interests in the Company and holding cash or property received by the Company, (ii) maintaining its legal existence and engaging in administrative matters related to being a holding company, (iii) performing its obligations under the Senior Credit Facilities, the Senior Notes due 2019 (“Notes”) and other financings not prohibited by the Senior Credit Facilities, (iv) engaging in public offerings of its securities and other equity issuances and financing activities permitted under the Senior Credit Facilities, (v) providing indemnifications to officers and directors and (vi) engaging in activities incidental to the activities described above. The financial covenant of the Senior Credit Facilities is only applicable to the Revolving Facilities. The Company is required to comply on a quarterly basis with a maximum senior secured net leverage ratio covenant of 5.25 to 1.00 only if there are amounts outstanding under the Revolving Facilities. Remedies for default under such covenant may only be exercised by the lenders under the Revolving Facilities. The credit agreement governing the Senior Credit Facilities also contains certain customary representations and warranties, affirmative covenants and provisions relating to events of default, including upon change of control and a cross-default to any other indebtedness with an aggregate principal amount of $20 million or more. Indenture and the Senior Notes Due 2019 The Company has also issued $400 million in principal amount of Senior Notes (the “Notes”). The Notes bear interest at a rate of 11.125% per annum, and interest is payable semi-annually on February 15 and August 15 of each year. Including the amortization of deferred financing costs and the original issue discount, the effective interest rate on the Notes is 11.7% for the year ended May 31, 2016. The Notes mature on August 15, 2019. Subject to certain exceptions, the Notes are guaranteed on a senior unsecured basis by each of Immucor’s current and future wholly owned domestic restricted subsidiaries (and non-wholly owned subsidiaries if such non-wholly owned subsidiaries guarantee the Company’s or another guarantor’s other capital market debt securities) that is a guarantor of certain debt of the Company or another guarantor, including the Senior Credit Facilities. The Notes are the Company’s senior unsecured obligations and rank equally in right of payment with all of the Company’s existing and future indebtedness that is not expressly subordinated in right of payment thereto. The Notes will be senior in right of payment to any future indebtedness that is expressly subordinated in right of payment thereto and effectively junior to (a) the Company’s existing and future secured indebtedness, including the Senior Credit Facilities described above, to the extent of the value of the collateral securing such indebtedness and (b) all existing and future liabilities of the Company’s non-guarantor subsidiaries. The Indenture governing the Notes contains certain customary provisions relating to events of default and covenants, including without limitation, a cross-payment default provision and cross-acceleration provision in the case of a payment default or acceleration according to the terms of any indebtedness with an aggregate principal amount of $25 million or more, restrictions on the Company’s and certain of its subsidiaries’ ability to, among other things, incur or guarantee indebtedness; pay dividends on, redeem or repurchase capital stock; prepay, redeem or repurchase certain debt; sell or otherwise dispose of assets; make investments; issue certain disqualified or preferred equity; create liens; enter into transactions with the Company’s affiliates; designate the Company’s subsidiaries as unrestricted subsidiaries; enter into agreements restricting the Company’s restricted subsidiaries’ ability to (1) pay dividends, (2) make loans to the Company or any restricted subsidiary that is a guarantor or (3) sell, lease or transfer assets to the Company or any restricted subsidiary that is a guarantor; and consolidate, merge, or transfer all or substantially all of the Company’s assets. The covenants are subject to a number of exceptions and qualifications. Certain of these covenants, excluding without limitation those relating to transactions with the Company’s affiliates and consolidation, merger, or transfer of all or substantially all of the Company’s assets, will be suspended during any period of time that (1) the Notes have investment grade ratings and (2) no default has occurred and is continuing under the Indenture. In the event that the Notes are downgraded to below an investment grade rating, the Company and certain subsidiaries will again be subject to the suspended covenants with respect to future events. The Company is not aware of any violations of the covenants pursuant to the terms of the indenture governing the Notes or the credit agreement governing the Senior Credit Facilities. Future Commitments The following is a summary of the combined principal maturities of all long-term debt and principal payments to be made under the Company’s capital lease agreements for each of the fiscal years presented in the table below (in thousands): Interest Expense The significant components of interest expense are as follows (in thousands): Deferred financing costs Changes in deferred financing costs for the fiscal years ending May 31, 2016 and 2015 were as follows (in thousands): (1) Debt issuance costs are related to Amendment No. 6 of our credit agreement Deferred financing costs are capitalized and are amortized over the life of the related debt agreements using the effective interest rate method, except for the costs associated with the Revolving Facilities which uses the straight-line method. 14. OTHER LONG-TERM LIABILITIES Other long-term liabilities consist of the following (in thousands): 15. DERIVATIVE FINANCAL INSTRUMENTS Interest Rate Swaps In August 2011, the Company entered into floating-to-fixed interest rate swap agreements for an aggregate notional amount of $320 million related to a portion of the Company’s floating rate indebtedness. The Company’s strategy is to use a pay fixed, receive floating swap to convert the current or any replacement floating rate credit facility where LIBOR is consistently applied into a USD fixed rate obligation. These swap agreements, effective in August 2011, hedged a portion of contractual floating rate interest commitments through the expiration of the agreements in September of each year 2013 through 2016. In August 2012, the Company amended the interest rate swap agreements noted above effective on September 28, 2012. The purpose of entering into these swap agreements is to match the LIBOR floor in the swaps with the terms of the Term Loan Facility, as amended. Consistent with the terms of the Company’s Term Loan Facility, these amended swaps include a LIBOR floor of 1.25%. These swap agreements hedge a portion of contractual floating rate interest commitments through the expiration of the agreements in September of each year through 2016. As a result of the amended swap agreements, the LIBOR rate associated with the hedged amount of the Company’s indebtedness was fixed at 1.59% after September 28, 2012. As of May 31, 2016, the Company has an interest rate swap agreement to hedge $70.0 million of its future interest commitments resulting from the Company’s Term Loan Facility, and to protect the Company from variability in cash flows attributable to changes in LIBOR interest rates. As of May 31, 2015, the Company had interest rate swap agreements to hedge $155.0 million of its future interest commitments resulting from the Company’s Term Loan Facility. The purpose of entering into a swap agreement is to match the LIBOR floor in the swaps with the terms of the Term Loan Facility. Consistent with the terms of the Company’s Term Loan Facility, the swaps include a LIBOR floor of 1.25%. The swap agreements hedge a portion of contractual floating rate interest commitments through the expiration of the agreement in September of each year through 2016 Prior to October 1, 2014, the Company had swap agreements that hedged $240.0 million of its floating rate interest commitments at a weighted average fixed LIBOR rate of 1.67%. Effective October 1, 2014 through September 30, 2015, the Company has swap agreements that hedge $155.0 million of the Company’s floating rate interest commitments at a weighted average fixed LIBOR rate of 1.77%. Effective October 1, 2015 through September 30, 2016, the Company will have a swap agreement to hedge $70.0 million of the Company’s floating rate interest commitments at a fixed LIBOR rate of 1.91%. The Company designated the interest rate swap agreements as cash flow hedges. As cash flow hedges, unrealized gains are recognized as assets while unrealized losses are recognized as liabilities. The interest rate swap agreements are highly correlated to the changes in interest rates to which the Company is exposed. Unrealized gains and losses on these swaps are designated as effective or ineffective. The effective portion of such gains or losses is recorded as a component of accumulated other comprehensive income or loss, while the ineffective portion of such gains or losses will be recorded as a component of interest expense. Future realized gains and losses in connection with each required interest payment will be reclassified from accumulated other comprehensive income or loss to interest expense. The changes in fair values of derivatives that have been designated and qualify as cash flow hedges are recorded in accumulated other comprehensive income or loss and are reclassified into interest expense in the same period the hedged item affects earnings. Due to the high degree of effectiveness between the hedging instruments and the underlying exposures being hedged, fluctuations in the value of the derivative instruments are generally offset by changes in the fair values or cash flows of the underlying exposures being hedged. The changes in the fair values of derivatives that do not qualify as effective are immediately recognized in earnings. The gains and losses on derivative contracts that are reclassified from accumulated other comprehensive income or loss to current period earnings are included in the line item in which the hedged item is recorded in the same period the forecasted transaction affects earnings. As of May 31, 2016, approximately $0.2 million of the deferred net loss on derivative instruments accumulated in other comprehensive income or loss is expected to be reclassified as interest expense during the next twelve months. This expectation is based on the expected timing of the occurrence of the hedged forecasted transactions. The fair values of the interest rate swap agreements are estimated using industry standard valuation models using market-based observable inputs, including interest rate curves (level 2). A summary of the recorded liabilities included in the consolidated balance sheets is as follows (in thousands): The loss from accumulated other comprehensive income (loss) (“AOCI”) was reclassified to the consolidated statement of operations and appears as follows (in thousands): 16. FAIR VALUE The Company uses a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows: • Level 1-Quoted prices in active markets for identical assets or liabilities. • Level 2-Observable inputs, other than quoted prices included in Level 1, such as quoted prices for markets that are not active; or other inputs that are observable or can be corroborated by observable market data. • Level 3-Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs. Assets and Liabilities Measured at Fair Value on a Recurring Basis The carrying amounts of cash and cash equivalents, trade accounts receivable, accounts payable and accrued expenses approximate their fair values because of the short-term maturity of these instruments. Of the $10.3 million and $18.4 million of cash and cash equivalents as of May 31, 2016 and 2015, respectively, approximately 38% and 37% was located in the U.S., respectively. The Company uses derivative financial instruments, primarily in the form of floating-to-fixed interest rate swap agreements, in order to mitigate the risks associated with interest rate fluctuations on the Company’s floating rate indebtedness. The estimated fair value of the Company’s derivative instruments is based on quoted market prices for similar instruments (a level 2 input) and are reflected at fair value in the consolidated balance sheets. The level 2 inputs used to calculate fair value were interest rates, volatility and credit derivative markets. The Company’s current and long-term derivative financial instrument liabilities are included in accrued interest and interest rate swap liability and other long-term liabilities in the Company’s consolidated balance sheets. The fair value of the Company’s Notes and the Term Loan Facility (collectively referred to as the Company’s debt instruments) is estimated to be $364.3 million and $614.5 million at May 31, 2016, respectively, based on recent trades of these debt instruments. The fair value of the Notes and the Term Loan Facility was estimated to be $424.3 million and $653.3 million at May 31, 2015, respectively, based on the fair value of these debt instruments at that time. Management believes that these liabilities can be liquidated without restriction. As of May 31, 2016, the Company had $40.4 million in contingent consideration liabilities for earn-out provisions resulting from acquisitions included in Other long-term liabilities on the Company’s consolidated balance sheet. As of May 31, 2015, the Company had $18.6 million in contingent consideration liabilities for earn-out provisions, of which $0.1 million was included in Accrued expenses and other current liabilities and $18.5 million was included in Other long-term liabilities on the Company’s consolidated balance sheet. The fair value of these contingent consideration liabilities was determined by applying a form of the income approach (a level 3 input), based upon the probability-weighted projected payment amounts discounted to present value at a rate appropriate for the risk of achieving the performance targets. The key assumptions included in the calculations were the earn-out period payment probabilities, projected revenues, discount rate and the timing of payments. The present value of the expected payments considers the time at which the obligations are expected to be settled and a discount rate that reflects the risk associated with the performance payments. The changes in the Company’s current and long-term contingent consideration liabilities are summarized in the following table (in thousands): 17. ACCUMULATED OTHER COMPREHENSIVE LOSS Total accumulated other comprehensive loss is included in the Consolidated Statement of Changes in Equity. The changes in accumulated other comprehensive loss are as follows (in thousands): The components of accumulated other comprehensive loss are as follows (in thousands): 18. SHARE-BASED COMPENSATION Plan summary The IVD Holdings Inc. 2011 Equity Incentive Plan (the “2011 Plan”) was established in December 2011 by Holdings. Under the 2011 Plan, awards of stock options, stock appreciation rights, restricted stock, unrestricted stock, stock units, performance awards and any other awards that are convertible into or based on stock can be granted as incentive or compensation to employees, non-employee directors, consultants or advisors of the Company and Holdings. The share-based compensation expense relating to awards to those persons has been pushed down from Holdings to the Company. A maximum of 808,444 shares of Holdings stock may be delivered in satisfaction of, or may underlie, awards under the 2011 Plan. During fiscal year 2016, the Compensation Committee approved an increase in the shares eligible for grant under the Company’s 2011 Equity Incentive Plan from 514,631 shares to 808,444 shares. Restricted stock units typically vest over a two-year period (50% per year) and do not expire. Upon vesting, and in some cases, certain other triggers, restricted stock units are settled in shares of IVD Holdings Inc.’s common stock. Stock option awards are granted with service-based vesting conditions (“service-based options”), and performance-based or market-based vesting conditions (“performance-based options”). The service-based options contain tiered vesting terms over the service period. The performance-based options vest in tranches upon the achievement of certain performance or market objectives, which are measured over a three or four year period. During fiscal year 2014 and in the first quarter of fiscal year 2015, stock option awards were measured based upon the achievement of the market condition since the Company believed that the achievement of the performance conditions were not probable. Effective on September 2, 2014, the Company amended its 2011 Equity Incentive Plan to (1) modify the financial targets for all unvested performance-based option grants, and (2) specify that the unvested options will vest on each of August 19, 2015 and August 19, 2016 if the financial targets are achieved or exceeded for the immediately preceding fiscal years, or will vest on the later date if the financial targets are not achieved for fiscal year 2015 but are achieved for the combined fiscal years 2015 and 2016 periods. As a result of this plan amendment, the Company believed that the achievement of the performance conditions was probable and therefore the stock-based compensation cost was revalued as of September 2, 2014 for all unvested performance-based option grants. During the fourth quarter of fiscal year 2015, management reviewed the Company’s forecasted results and determined that the financial targets were no longer likely to be achieved for the combined fiscal years 2015 and 2016 periods, and the stock-based compensation costs that were revalued as of September 2, 2014 were reversed. On September 24, 2015, the Company’s Compensation Committee approved a modification to the Company’s 2011 Equity Incentive Plan (“Plan”) effective November 1, 2015. This modification added an alternative service-based vesting opportunity to all previously granted but unvested performance-based options. On October 16, 2015, the Company’s Compensation Committee approved an additional modification to its Plan that converted all stock appreciation rights granted prior to November 1, 2015 to service-based option awards and performance-based option awards. These awards will vest from the original grant date through May 31, 2021. This modification resulted in a total increase in stock-based compensation expense of $4.6 million. Valuation method and assumptions used As of fiscal year 2016, the Company estimates the fair value of stock options using the Black-Scholes valuation model. Key assumptions used to estimate the fair value of stock options include the initial value of common stock, expected term until the exercise of the equity award, the expected volatility of the equity value, risk-free rates of return and dividend yields, if any. Prior to fiscal year 2016, the Company used the Monte Carlo simulation approach to estimate the fair value of its stock options as well as its stock appreciation rights. There were no stock appreciation rights after the Plan modification in October of fiscal year 2016. The Company estimated the fair value of options and stock appreciation rights at the grant date using the following weighted average assumptions: 1. Based on the U.S. Constant Maturity Treasury (CMT) curve in effect at the time of award. 2. Expected stock price volatility is based on the average historical volatility of the Company when it was publicly traded and weekly stock returns of comparable companies during the period corresponding to the expected life of the options and stock appreciation rights. 3. Represents the period of time options are expected to remain outstanding. 4. Except for a $6.0 million dividend related to the Sentilus LLC spin-off, and a $0.4 million dividend related to a stock redemption and tax payments to be made by Holdings issued in fiscal year 2016, the Company has not paid dividends on its common stock. Stock options Service-based vesting conditions The Company has granted awards that contain service-based vesting conditions. These awards contain tiered vesting terms over the service period. The compensation cost for these options is recognized on a straight-line basis over the vesting periods. Activity for the service-based vesting options was as follows for the year ended May 31, 2016: (1) The aggregate intrinsic value in the above table represents the total pre-tax amount that a participant would receive if the option had been exercised on the last day of the respective fiscal year. Options with a market value less than its exercise value are not included in the intrinsic value amount. The weighted-average grant-date fair value of share options granted during the fiscal years ended May 31, 2016, 2015, and 2014 were $25.21, $13.75, and $26.93, respectively. As of May 31, 2016, there was $10.1 million of total unrecognized compensation cost related to nonvested service-based stock option awards. This compensation cost is expected to be recognized over a weighted average period of approximately 3.0 years. Performance-based or market-based vesting conditions The Company has granted awards that contain either performance-based or market-based conditions. Compensation cost for the performance-based or market-based stock options is recognized based on either the achievement of the performance conditions, if they are considered probable, or if they are not considered probable, on the achievement of the market-based condition. Awards granted which vest upon either the satisfaction of the performance or market conditions were measured based upon the achievement of the market condition during fiscal year 2016 since the Company believes that the achievement of the performance conditions are not probable. Activity for the performance-based or market-based options was as follows for the year ended May 31, 2016: (1) The aggregate intrinsic value in the above table represents the total pre-tax amount that a participant would receive if the option had been exercised on the last day of the respective fiscal year. Options with a market value less than its exercise value are not included in the intrinsic value amount. The weighted-average grant-date fair value of share options granted during the fiscal years ended May 31, 2016, 2015, and 2014 were $23.82, $4.86, and $16.79, respectively. As of May 31, 2016, there was $0.1 million of total unrecognized compensation cost related to nonvested performance-based or market-based stock option awards. This compensation cost is expected to be recognized over a weighted average period of approximately 0.2 years. Restricted stock units As of fiscal year 2016, the Company estimated the fair value of its restricted stock units by using the Black-Scholes valuation model as described above. Prior to fiscal year 2016, the Company used the Monte Carlo simulation approach then applied a discount due to non-marketability. The following is a summary of the changes in unvested restricted stock units for the fiscal year ended May 31, 2016: As of May 31, 2016, there was $2.9 million of total unrecognized compensation cost related to nonvested restricted stock awards. This compensation cost is expected to be recognized over the weighted average period of approximately 3.0 years. Stock appreciation rights As of November 1, 2015, the Company canceled all of its existing stock appreciation rights and converted them to service-based and performance-based option awards. Shares available for future grants As of May 31, 2016, a total of 62,653 shares were available for future grants under the 2011 Plan. A summary of share-based compensation recorded in the statements of operations is as follows (in thousands): 19. INCOME TAXES The Company is included in the consolidated income tax returns of Holdings. In accordance with GAAP, allocation of the consolidated income tax expense (benefit) is necessary when separate financial statements are prepared for affiliates. The Company uses a method that allocates current and deferred taxes to members of the consolidated group by applying the liability method to each member as if it were a separate taxpayer. As of May 31, 2016 and 2015, the Company had no amounts due to or from Holdings related to income taxes. The following is a geographic breakdown of (loss) income before income taxes (in thousands): The provision (benefit) for income taxes is summarized as follows (in thousands): The Company’s effective tax rate differs from the federal statutory rate as follows: The difference between the federal statutory rate of 35% and the effective tax rate for fiscal year 2016 primarily relates to the U.S. tax impact of foreign dividends, the foreign tax rate differential, changes in uncertain income tax positions and changes in the valuation allowance. The Company is currently engaged in discussions with the Internal Revenue Service (“IRS”) and the Canada Revenue Agency regarding a transfer pricing agreement under the terms of a Bilateral Advanced Pricing Agreement (“BAPA”) in connection with intercompany transactions between Immucor and its subsidiary in Canada. As a result, during the fourth quarter of fiscal year 2016, the Company recognized additional income tax expense related to the tax liability for unrecognized tax benefits and a corresponding change in the competent authority asset related to the expected settlement of the BAPA. The difference between the federal statutory rate of 35% and the effective tax rate for fiscal year 2015 primarily relates to the Company’s change in election related to the treatment of foreign tax credits (“FTCs”) and the change in the valuation allowance for its FTC carryovers. Excluding these items, the effective tax rate would have been 34.8%. The effective tax rate for fiscal year 2015 was significantly impacted by the Company’s decision during the third quarter of fiscal year 2015 to change its election with regard to the treatment of its foreign tax credits. This decision is expected to generate a significant reduction in cash tax payments related to subsequent fiscal years as a result of the Company changing from the credit method to the deduction method for its FTCs in various tax periods. As a result, the Company elected the deduction method for FTCs for all fiscal years beginning after fiscal year 2012. The Company filed its fiscal year 2014 and fiscal year 2015 income tax returns reflecting this change. The Company will amend its fiscal year 2012 and fiscal year 2013 income tax returns to reflect this change. The Company will not amend the income tax return for the period ended August 19, 2011. As a result of this change in election, the Company recognized a discrete charge of additional income tax expense of $23.7 million during the third quarter of fiscal year 2015. In addition, the Company recorded a valuation allowance of $7.6 million during the same period related to uncertainties in the Company’s ability to utilize the FTC carryovers prior to their expiration. These items have been combined in the Company’s reconciliation of the effective tax rate. The difference between the federal statutory rate of 35% and the effective tax rate for fiscal year 2014 primarily relates to the following: (1) the impairment of goodwill is not deductible for income tax purposes, (2) the gain on acquisition-related item is not taxable, (3) a portion of the Company’s income is subject to tax in various tax jurisdictions with tax rates which differ from the U.S. statutory tax rate, (3) the impact of recording U.S. income taxes associated with current and future distributions of foreign earnings, (4) changes in discrete tax items recognized during the period based on enacted tax laws, and (5) the expiration of the statute of limitations for the benefits associated with uncertain tax positions. Deferred income taxes reflect the net tax effects of: (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and income tax purposes; and (b) net operating losses and tax credit carry-forwards. In accounting for the Organ-i acquisition, the Company recorded deferred tax liabilities of approximately $10.2 million primarily associated with acquired intangible assets that have no income tax basis. These liabilities were offset by deferred tax assets primarily associated with net operating loss carry-forwards. In accounting for the Sentilus acquisition, the Company recorded deferred tax liabilities of approximately $7.1 million primarily associated with acquired intangible assets that have no income tax basis. In accounting for the Sirona acquisition, the Company recorded deferred tax liabilities of approximately $16.5 million primarily associated with acquired intangible assets that have no income tax basis. These liabilities were offset by deferred tax assets primarily associated with net operating loss carry-forwards. The significant items comprising the Company’s net deferred tax liabilities as of May 31, 2016 and 2015 are as follows (in thousands): As of May 31, 2016 and 2015, net deferred tax liabilities located in countries outside the U.S. were $7.6 million and $10.6 million, respectively. The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. The Company’s largest foreign tax jurisdictions are Canada, Germany and Italy. The Company’s income tax returns for substantially all fiscal years beginning after May 31, 2009 remain subject to examination by various tax authorities. The Company’s U.S. Federal income tax return for fiscal year 2011 is currently under IRS examination. Although the outcome of tax examinations is always uncertain, the Company believes that adequate amounts of tax, including interest and penalties, if any, have been provided for any adjustments that are expected to result from the Company’s tax positions. As of May 31, 2016, $46.5 million of Federal net operating loss (“NOL”) carry-forwards were available to reduce future U.S. Federal taxable income. These net operating loss carry-forwards begin to expire in fiscal year 2025. The Company has $7.6 million of FTC carry-forwards which expire in fiscal year 2021. The Company has $6.9 million of Federal research and development credits which expire between fiscal year 2019 and fiscal year 2036 and Federal alternative minimum tax credit carryovers of $0.5 million with no expiration period. Certain portions of the Federal net operating loss and certain tax credit carry-forwards are subject to annual limitations on their usage resulting from the BioArray acquisition in fiscal year 2009, the Organ-i acquisition in fiscal year 2014, the Sentilus acquisition in fiscal year 2015 and the Sirona acquisition in fiscal year 2016. The Company does not consider itself to be permanently reinvested with respect to its accumulated and unrepatriated earnings as well as the future earnings of each foreign subsidiary. During fiscal years 2016 and 2015, the Company recorded a deferred tax liability associated with unremitted foreign earnings of certain subsidiaries. The amount of the deferred tax liability significantly increased as a result of the change in estimate for FTCs during fiscal year 2015. The Company considers its equity investment in each foreign subsidiary to be permanently reinvested and thus has not recorded a deferred tax liability on such amounts. The Company has NOL carry-forwards of $2.4 million in Belgium and $0.3 million in France. The NOL carry-forwards for Belgium and France do not expire. The Company has recorded a full valuation allowance related to the Belgium NOLs due to uncertainties regarding the realization of this deferred tax asset. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. The Company’s valuation allowances are primarily related to deferred tax assets generated from certain foreign net operating losses, state net operating losses and tax credit carry-forwards. Current evidence does not suggest the Company will realize sufficient taxable income of the appropriate character within the carry-forward period to allow us to realize these deferred tax benefits. If the Company were to identify tax planning strategies that become available in the future to recover these deferred tax assets or generate sufficient income of the appropriate character in these jurisdictions in the future, it could lead to the reversal of these valuation allowances and a reduction of income tax expense. The Company believes that it will generate sufficient future taxable income to realize the tax benefits related to the remaining deferred tax assets. An analysis of the Company’s deferred tax asset valuation allowance is as follows (in thousands): The following is a tabular reconciliation of the total tax liability for unrecognized tax benefits for the years ended May 31, 2016 and 2015 (in thousands): The Company does not anticipate that within the next twelve months the total amount of unrecognized tax benefits will significantly increase or decrease. The total balance of unrecognized tax benefits at May 31, 2016 is $21.2 million, including accrued interest. Of this amount, the amount of unrecognized tax benefits that would impact the effective tax rate, if recognized, is $20.8 million. Approximately $15.2 million of the unrecognized tax benefit is reflected as a non-current liability as it is unlikely to require payment during the twelve-month period ending May 31, 2017. The remaining $6.0 million is included in non-current deferred tax liabilities. At May 31, 2015, the liability for unrecognized tax benefits, including accrued interest, of $9.1 million was included as a non-current liability and $4.7 million was included in non-current deferred tax liabilities. As of May 31, 2016 and 2015, the Company recorded accrued interest related to the unrecognized tax benefits of $2.5 million and $1.4 million, respectively. During fiscal year 2016, 2015, and 2014, the Company recognized an income tax (benefit) expense of $1.1 million, ($0.3) million, and $0.3 million, respectively, due to changes in the reserves for interest. The Company has not accrued penalties since adoption of the update to ASC 740, “Income Taxes.” At May 31, 2016 and 2015, other assets in the consolidated balance sheets include $13.7 million and $6.1 million, respectively, of competent authority offsets related to transfer pricing. Competent authority offsets represent anticipated refunds from bilateral agreements between the taxing authorities of two countries which eliminates double taxation by treaty. For Immucor, this competent authority offset represents anticipated refunds by taxing authorities that will offset potential uncertain tax positions related to transfer pricing. 20. SEGMENT AND GEOGRAPHIC INFORMATION The Company determines operating segments in accordance with its internal operating structure, which is organized based upon product groups. Each segment is separately managed and is evaluated primarily upon operating results. The Company has two operating segments, the Transfusion segment and the Transplant & Molecular segment, which have been aggregated into one reportable segment. The Company manufactures and markets a complete line of diagnostics products and automated systems used primarily by hospitals, donor centers and reference laboratories in a number of tests performed to detect and identify certain properties of human blood and human tissue to enable the most compatible match available between patient and donor. These tests are performed for the purpose of blood transfusions and organ and stem cell transplantations. The Company operates in various geographies. These geographic markets are comprised of the United States, Europe, Canada and other international markets. The majority of the other international markets are considered emerging markets for our business. These products are marketed globally, both directly to the end user and through established distributors. Accounting policies for segments are the same as those described in the summary of significant accounting policies. The following segment data is presented for the years ended May 31, 2016, 2015, and 2014 as follows (in thousands): Following is a summary of enterprise-wide information (in thousands): Net sales are attributed to individual countries based on the customer's country of origin at the time of the sale and where the Company has an operating entity. (A) - Net sales to any individual country within Europe were not material to the Company's consolidated net sales. (B) - Long-lived assets located in any individual country within Europe were not material to the Company's consolidated long-lived assets. (C ) - Primarily Japan and India Sales to an individual customer did not exceed 10% or more of our annual net sales during any of the years ended May 31, 2016, 2015, or 2014. 21. RETIREMENT PLANS The Company maintains a 401(k) retirement plan covering its U.S. employees who meet the plan requirements. The Company matches a portion of employee contributions, which vest immediately. The Company matched contributions to the plan of $2.4 million during fiscal year 2016, $2.1 million during fiscal year 2015, and $1.9 million during 2014 fiscal year. The Company’s Canadian affiliate maintains a defined contribution pension plan covering all Canadian employees, except temporary employees. The Company matches a portion of employee contributions to the plan, and each employee vests in the Company’s matching contributions once they have been a participant continuously for two years. The Company’s matching contributions to the plan were $0.1 million for fiscal year 2016, $0.1 million for fiscal year 2015, and $0.1 million for fiscal year 2014. In January 2016, the Company’s Japanese affiliate began a defined contribution pension plan covering all Japanese employees, except temporary and contracted employees. The Company matches a portion of employee contributions to the plan, and each employee vests in the Company’s matching contributions immediately after three years of service. The Company’s matching contributions to the plan were $0.1 million for fiscal year 2016. 22. CONDENSED CONSOLIDATING FINANCIAL INFORMATION OF GUARANTOR SUBSIDIARIES The Company has certain outstanding indebtedness that is guaranteed by its U.S. subsidiaries. However, the indebtedness is not guaranteed by the Company’s foreign subsidiaries or its consolidated variable interest entity. The guarantor subsidiaries are all wholly owned and the guarantees are made on a joint and several basis and are full and unconditional. Separate consolidated financial statements of the guarantor subsidiaries have not been presented because management believes that such information would not be material to investors. However, condensed consolidating financial information is presented. Refer to Note 4 for information on assets and liabilities of Sentilus LLC, a consolidated variable interest entity, that are included in the Company’s consolidated balance sheet as of May 31, 2016. These assets and liabilities cannot be used to settle the obligations of Immucor, and are not Immucor’s obligation to pay. Accordingly, the condensed consolidated financial information reflects the activity of Sentilus LLC and its related eliminations under the VIE and VIE Eliminations heading. The condensed consolidating financial information of the Company is as follows: Balance Sheets IMMUCOR, INC. CONDENSED CONSOLIDATING BALANCE SHEETS May 31, 2016 (in thousands) IMMUCOR, INC. CONDENSED CONSOLIDATING BALANCE SHEETS May 31, 2015 (in thousands) Statements of Operations Year to Date IMMUCOR, INC. CONSOLIDATING STATEMENTS OF OPERATIONS For the Year Ended May 31, 2016 (in thousands) IMMUCOR, INC. CONSOLIDATING STATEMENTS OF OPERATIONS For the Year Ended May 31, 2015 (in thousands) IMMUCOR, INC. CONSOLIDATING STATEMENTS OF OPERATIONS For the Year Ended May 31, 2014 (in thousands) Statements of Cash Flows IMMUCOR, INC. CONDENSED CONSOLIDATING CASH FLOW INFORMATION For the Year Ended May 31, 2016 (in thousands) IMMUCOR, INC. CONDENSED CONSOLIDATING CASH FLOW INFORMATION For the Year Ended May 31, 2015 (in thousands) IMMUCOR, INC. CONDENSED CONSOLIDATING CASH FLOW INFORMATION For the Year Ended May 31, 2014 (in thousands) 23. OTHER EQUITY MATTERS In the fourth quarter of fiscal year 2016, the Company issued a dividend of $6.0 million related to the Sentilus LLC spin-off, and a $0.4 million dividend related to a stock redemption and tax payments to be made by Holdings. Other than potential periodic dividends to fund Sentilus LLC activities and tax payments, the Company does not expect to pay dividends on its common stock in the near future. 24. COMMITMENTS AND CONTINGENCIES Lease Commitments In the U.S., the Company leases office, warehousing and manufacturing facilities under several operating lease agreements expiring at various dates through fiscal year 2026 with a right to renew for an additional term in the case of most of the leases. Certain of these leases contain escalation clauses. Outside the U.S., the Company leases foreign office and warehouse facilities under operating lease agreements expiring at various dates through fiscal year 2022. The total leasing expense for the Company was $5.8 million in fiscal year 2016, $5.5 million in fiscal year 2015, and $5.5 million in fiscal year 2014 periods. The following is a schedule of the approximate future annual lease payments under all operating leases that have initial or remaining non-cancelable lease terms as of May 31, 2016 (in thousands): Purchase Commitments Purchase commitments made in the normal course of business were $44.1 million as of May 31, 2016. These purchases were primarily for inventory items. The following is a schedule of the approximate future payments for purchase commitments as of May 31, 2016 (in thousands): Legal Proceedings Immucor and BioArray Solutions Limited (“BioArray”), a wholly owned subsidiary of Immucor, are defendants in an action brought in August 2014 by Rutgers, the State University of New Jersey (“Rutgers”), in the Superior Court of New Jersey for Middlesex County, alleging breach of contract and fraud claims under a patent license between Rutgers and BioArray. The Company believes the claims are without merit and that it has meritorious defenses. The Company believes that liability is unlikely and that the amount of any liability is not currently reasonably estimable. Further, the Company believes that any potential liability would not be material to the Company’s operations or to its financial condition. From time to time the Company is a party to certain legal proceedings in the ordinary course of business. However, the Company is not currently subject to any legal proceedings expected to have a material adverse effect on its consolidated financial position, result of operations or cash flow. Self-Insurance Costs In fiscal year 2014, the Company entered into a program to self-insure its costs related to U.S. medical employee benefits. Liabilities are recognized based on claims filed and an estimate of claims incurred but not reported. The liabilities for medical claims are accounted for on an undiscounted basis. The Company has purchased stop-loss coverage to limit its exposure on a per claim and on an aggregate basis. The Company is insured for covered costs in excess of these per claim limits. As of May 31, 2016 and May 31, 2015, the self-insured liability was approximately $1.3 million and $1.2 million, respectively, and was included in Accrued expenses and other current liabilities on the Company’s consolidated balance sheet. Royalty Payments The Company is required to pay royalty payments on the sales of specific products. These royalty payments are based on the net selling price of the specific products and are mainly calculated at fixed percentages. On certain products, a minimum annual royalty fee is applicable. In total, the Company incurred costs of $4.8 million, $4.6 million and $4.2 million related to royalty fees in fiscal years 2016, 2015 and 2014, respectively. As of May 31, 2016, the Company had a minimum royalty payment obligation of approximately $12.5 million. The following is a schedule of the approximate future payments for royalty payment commitments as of May 31, 2016 (in thousands): 25. SELECTED QUARTERLY FINANCIAL DATA (unaudited) The quarterly financial data included in the tables below are in thousands: - B. Supplementary Financial Information Consolidated Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts Years Ended May 31, 2016, 2015, and 2014 (in thousands) (1) Includes deductions, allowances written-off during the period less recoveries of accounts previously written-off, as well as the effect of changes in foreign exchange rates and changes in estimates. (2) Represents valuation allowance to show gross receivables and related allowances at their net fair value at the time of acquisition, now reversed as the related receivables have been collected.
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt. It contains partial sections about accounting policies, assets, liabilities, and expenses, but lacks a coherent structure or complete financial information.
To provide a meaningful summary, I would need:
- A complete financial statement
- Full sections covering income, expenses, assets, and liabilities
- Specific financial figures and totals
If you have the full financial statement, I'd be happy to help you summarize it. Could you provide the complete document?
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Claude
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Consolidated Financial Statements Index to Consolidated Financial Statements ACCOUNTING FIRM To the Board of Directors and Stockholders of Youngevity International, Inc. Chula Vista, California We have audited the accompanying consolidated balance sheets of Youngevity International, Inc. and Subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the years then ended. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Youngevity International, Inc. and Subsidiaries as of December 31, 2016 and 2015, and the consolidated results of its operations and cash flows for each of the years then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Mayer Hoffman McCann P.C. San Diego, California March 30, 2017 See accompanying notes. Youngevity International, Inc. and Subsidiaries Consolidated Statements of Operations (In thousands, except share and per share amounts) See accompanying notes. Youngevity International, Inc. and Subsidiaries Consolidated Statements of Comprehensive Loss (In thousands) See accompanying notes. Youngevity International, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity (In thousands, except shares) See accompanying notes. Youngevity International, Inc. and Subsidiaries Consolidated Statements of Cash Flows (In thousands, except share amounts) During 2015, the Company issued certain convertible notes payable that included warrants. The related beneficial conversion feature, valued at approximately $15,000 was classified as an equity instrument and recorded as a discount to the carrying value of the related debt. The warrants, valued at approximately $1,491,000, were recognized as a derivative liability. In addition, the Company issued warrants to the placement agent, valued at approximately $384,000 was classified as an equity instrument and recorded as issuance costs. See accompanying notes. Youngevity International, Inc. and Subsidiaries December 31, 2016 and 2015 Note 1. Basis of Presentation and Description of Business Nature of Business Youngevity International, Inc. (the “Company”), founded in 1996, develops and distributes health and nutrition related products through its global independent direct selling network, also known as multi-level marketing, and sells coffee products to commercial customers. The Company operates in two business segments, its direct selling segment where products are offered through a global distribution network of preferred customers and distributors and its commercial coffee segment where products are sold directly to businesses. In the following text, the terms “we,” “our,” and “us” may refer, as the context requires, to the Company or collectively to the Company and its subsidiaries. The Company operates through the following domestic wholly-owned subsidiaries: AL Global Corporation, which operates our direct selling networks, CLR Roasters, LLC (“CLR”), our commercial coffee business, 2400 Boswell LLC, MK Collaborative LLC, Youngevity Global LLC and the wholly-owned foreign subsidiaries Youngevity Australia Pty. Ltd., Youngevity NZ, Ltd., Siles Plantation Family Group S.A., located in Nicaragua, Youngevity Mexico S.A. de CV, Youngevity Israel, Ltd., Youngevity Russia, LLC, Youngevity Colombia S.A.S, Youngevity International Singapore Pte. Ltd., Mialisia Canada, Inc., and Legacy for Life Limited (Hong Kong). The Company also operates subsidiary branches of Youngevity Global LLC in the Philippines and Taiwan. Summary of Significant Accounting Policies A summary of the Company’s significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows: Basis of Presentation The Company consolidates all majority owned subsidiaries, investments in entities in which we have controlling influence and variable interest entities where we have been determined to be the primary beneficiary. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to conform to the current year presentations including the Company’s adoption of Accounting Standards Update (“ASU”) 2015-03 and ASU 2015-15, pertaining to the presentation of debt issuance costs with retrospective application effective January 1, 2016. This resulted in a reclassification from prepaid expenses and other assets to convertible notes payable, net of debt discount. Refer below to “Recently Issued Accounting Pronouncements” below and Note 5 to the consolidated financial statements for further details. These reclassifications did not affect revenue, total costs and expenses, income (loss) from operations, or net income (loss). The adoption of ASU No. 2015-03 resulted in a reclassification of unamortized debt issuance costs of $1,456,000 from an asset to a liability classification on the Company’s consolidated financial statements as of December 31, 2015. Segment Information The Company has two reporting segments: direct selling and commercial coffee. The direct selling segment develops and distributes health and wellness products through its global independent direct selling network also known as multi-level marketing. The commercial coffee segment is a coffee roasting and distribution company specializing in gourmet coffee. The determination that the Company has two reportable segments is based upon the guidance set forth in Accounting Standards Codification (“ASC”) Topic 280, “Segment Reporting.” During the twelve months ended December 31, 2016 and 2015, we derived approximately 89% of our revenue from our direct sales segment and approximately 11% of our revenue from our commercial coffee sales segment, respectively. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense for each reporting period. Estimates are used in accounting for, among other things, allowances for doubtful accounts, deferred taxes, and related valuation allowances, fair value of derivative liabilities, uncertain tax positions, loss contingencies, fair value of options granted under our stock based compensation plan, fair value of assets and liabilities acquired in business combinations, capital leases, asset impairments, estimates of future cash flows used to evaluate impairments, useful lives of property, equipment and intangible assets, value of contingent acquisition debt, inventory obsolescence, and sales returns. Actual results may differ from previously estimated amounts and such differences may be material to the consolidated financial statements. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected prospectively in the period they occur. Liquidity We believe that current cash balances, future cash provided by operations, and available amounts under our accounts receivable factoring agreement will be sufficient to cover our operating and capital needs in the ordinary course of business for at least the next 12 months as of March 30, 2017. Though our operations are currently meeting our working capital requirements, if we experience an adverse operating environment or unusual capital expenditure requirements, or if we continue our expansion internationally or through acquisitions, additional financing may be required. No assurance can be given, however, that additional financing, if required, would be available on favorable terms. We might also require or seek additional financing for the purpose of expanding into new markets, growing our existing markets, or for other reasons. Such financing may include the use of additional debt or the sale of additional equity securities. Any financing which involves the sale of equity securities or instruments that are convertible into equity securities could result in immediate and possibly significant dilution to our existing shareholders. Cash and Cash Equivalents The Company considers only its monetary liquid assets with original maturities of three months or less as cash and cash equivalents. Derivative Financial Instruments The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency. The Company reviews the terms of convertible debt and equity instruments it issues to determine whether there are derivative instruments, including an embedded conversion option that is required to be bifurcated and accounted for separately as a derivative financial instrument. In circumstances where a host instrument contains more than one embedded derivative instrument, including a conversion option, that is required to be bifurcated, the bifurcated derivative instruments are accounted for as a single, compound derivative instrument. Also, in connection with the sale of convertible debt and equity instruments, the Company may issue freestanding warrants that may, depending on their terms, be accounted for as derivative instrument liabilities, rather than as equity. Derivative instruments are initially recorded at fair value and are then revalued at each reporting date with changes in the fair value reported as non-operating income or expense. When the convertible debt or equity instruments contain embedded derivative instruments that are to be bifurcated and accounted for as liabilities, the total proceeds allocated to the convertible host instruments are first allocated to the fair value of all the bifurcated derivative instruments. The remaining proceeds, if any, are then allocated to the convertible instruments themselves, usually resulting in those instruments being recorded at a discount from their face value. The discount from the face value of the convertible debt, together with the stated interest on the instrument, is amortized over the life of the instrument through periodic charges to interest expense, using the effective interest method. Accounts Receivable Accounts receivable are recorded net of an allowance for doubtful accounts. Accounts receivable are considered delinquent when the due date on the invoice has passed. The Company records its allowance for doubtful accounts based upon its assessment of various factors including past experience, the age of the accounts receivable balances, the credit quality of its customers, current economic conditions and other factors that may affect customers’ ability to pay. Accounts receivable are written off against the allowance for doubtful accounts when all collection efforts by the Company have been unsuccessful. Certain accounts receivable are financed as part of a factoring agreement. During the fourth quarter of fiscal 2016, the Company recorded a $10,000 allowance towards outstanding receivables associated with CLR. There was no allowance for doubtful accounts recorded as of December 31, 2015. Inventory and Cost of Revenues Inventory is stated at the lower of cost or market value. Cost is determined using the first-in, first-out method. The Company records an inventory reserve for estimated excess and obsolete inventory based upon historical turnover, market conditions and assumptions about future demand for its products. When applicable, expiration dates of certain inventory items with a definite life are taken into consideration. Inventories consist of the following (in thousands): A summary of the reserve for obsolete and excess inventory is as follows (in thousands): Cost of revenues includes the cost of inventory, shipping and handling costs, royalties associated with certain products, transaction banking costs, warehouse labor costs and depreciation on certain assets. Deferred Issuance Costs Deferred issuance costs and debt discounts of approximately $3,611,000 and $5,152,000, as of December 31, 2016 and 2015, respectively, associated with our 2015 and 2014 Private Placement transactions are included with convertible notes payable on the Company's consolidated balance sheets. Deferred issuance costs related to our offerings are amortized over the life of the notes and are amortized as issuance costs to interest expense. See Note 5, below. Warrant Issuance Costs As of December 31, 2016 and 2015, warrant issuance costs associated with our November 2015 Private Placement include the fair value of the warrants issues of approximately $235,000 and $384,000 respectively, and is included with convertible notes payable, net of debt discounts on the Company's consolidated balance sheets. The warrant issuance costs related to this offering are being amortized over the life of the convertible notes and are amortized as issuance costs to interest expense. See note 5, below. Plantation Costs The Company’s commercial coffee segment CLR includes the results of the Siles Plantation Family Group (“Siles”), which is a 500 acre coffee plantation and a dry-processing facility located on 26 acres both located in Matagalpa, Nicaragua. Siles is a wholly-owned subsidiary of CLR, and the results of CLR include the depreciation and amortization of capitalized costs, development and maintenance and harvesting costs of Siles. In accordance with US generally accepted accounting principles (“GAAP”), plantation maintenance and harvesting costs for commercially producing coffee farms are charged against earnings when sold. Deferred harvest costs accumulate throughout the year, and are expensed over the remainder of the year as the coffee is sold. The difference between actual harvest costs incurred and the amount of harvest costs recognized as expense is recorded as either an increase or decrease in deferred harvest costs, which is reported as an asset and included with prepaid expenses and other current assets in the consolidated balance sheets. Once the harvest is complete, the harvest cost is then recognized as the inventory value. Costs associated with the 2017 and 2016 harvest as of December 31, 2016 and 2015 total approximately $452,000 and $350,000, respectively and are included in prepaid expenses and other current assets as deferred harvest costs on the Company’s consolidated balance sheet. Inventory related to our previously harvested coffee in Nicaragua as of December 31, 2016 is $112,000 and as of December 31, 2015 was $192,000. Property and Equipment Property and equipment are recorded at historical cost. Depreciation is provided in amounts sufficient to relate the cost of depreciable assets to operations over the estimated useful lives of the related assets. The straight-line method of depreciation and amortization is followed for financial statement purposes. Leasehold improvements are amortized over the shorter of the life of the respective lease or the useful life of the improvements. Estimated service lives range from 3 to 39 years. When such assets are sold or otherwise disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gain or loss is reflected in operations in the period of disposal. The cost of normal maintenance and repairs is charged to expense as incurred. Significant expenditures that increase the useful life of an asset are capitalized and depreciated over the estimated useful life of the asset. Coffee trees, land improvements and equipment specifically related to the plantations are stated at cost, net of accumulated depreciation. Depreciation of coffee trees and other equipment is reported on a straight-line basis over the estimated useful lives of the assets (25 years for coffee trees, between 5 and 15 years for equipment and land improvements, respectively). Property and equipment are considered long-lived assets and are evaluated for impairment whenever events or changes in circumstances indicate their net book value may not be recoverable. Management has determined that no impairment of its property and equipment occurred as of December 31, 2016 or 2015. Property and equipment consist of the following (in thousands): Depreciation expense totaled approximately $1,518,000 and $1,242,000 for the years ended December 31, 2016 and 2015, respectively. Business Combinations The Company accounts for business combinations under the acquisition method and allocates the total purchase price for acquired businesses to the tangible and identified intangible assets acquired and liabilities assumed, based on their estimated fair values. When a business combination includes the exchange of the Company’s common stock, the value of the common stock is determined using the closing market price as of the date such shares were tendered to the selling parties. The fair values assigned to tangible and identified intangible assets acquired and liabilities assumed are based on management or third-party estimates and assumptions that utilize established valuation techniques appropriate for the Company’s industry and each acquired business. Goodwill is recorded as the excess, if any, of the aggregate fair value of consideration exchanged for an acquired business over the fair value (measured as of the acquisition date) of total net tangible and identified intangible assets acquired. A liability for contingent consideration, if applicable, is recorded at fair value as of the acquisition date. In determining the fair value of such contingent consideration, management estimates the amount to be paid based on probable outcomes and expectations on financial performance of the related acquired business. The fair value of contingent consideration is reassessed quarterly, with any change in the estimated value charged to operations in the period of the change. Increases or decreases in the fair value of the contingent consideration obligations can result from changes in actual or estimated revenue streams, discount periods, discount rates and probabilities that contingencies will be met. Intangible Assets Intangible assets are comprised of distributor organizations, trademarks and tradenames, customer relationships and internally developed software. The Company's acquired intangible assets, which are subject to amortization over their estimated useful lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an intangible asset may not be recoverable. An impairment loss is recognized when the carrying amount of an intangible asset exceeds its fair value. Intangible assets consist of the following (in thousands): Amortization expense related to intangible assets was approximately $2,344,000 and $2,112,000 for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2016, future expected amortization expense related to definite lived intangible assets for the next five years is as follows (in thousands): As of December 31, 2016, the weighted-average remaining amortization period for intangibles assets was approximately 5.18 years. Trade names, which do not have legal, regulatory, contractual, competitive, economic, or other factors that limit the useful lives are considered indefinite lived assets and are not amortized but are tested for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Approximately $2,267,000 in trademarks from business combinations have been identified as having indefinite lives. The Company has determined that no impairment occurred for its definite and indefinite lived intangible assets for the years ended December 31, 2016 and 2015. Goodwill Goodwill is recorded as the excess, if any, of the aggregate fair value of consideration exchanged for an acquired business over the fair value (measured as of the acquisition date) of total net tangible and identified intangible assets acquired. In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 350, “Intangibles - Goodwill and Other”, goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. The Company conducts annual reviews for goodwill and indefinite-lived intangible assets in the fourth quarter or whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be fully recoverable. The Company first assesses qualitative factors to determine whether it is more likely than not (a likelihood of more than 50%) that goodwill is impaired. After considering the totality of events and circumstances, the Company determines whether it is more likely than not that goodwill is not impaired. If impairment is indicated, then the Company conducts the two-step impairment testing process. The first step compares the Company’s fair value to its net book value. If the fair value is less than the net book value, the second step of the test compares the implied fair value of the Company’s goodwill to its carrying amount. If the carrying amount of goodwill exceeds its implied fair value, the Company would recognize an impairment loss equal to that excess amount. The testing is generally performed at the “reporting unit” level. A reporting unit is the operating segment, or a business one level below that operating segment (referred to as a component) if discrete financial information is prepared and regularly reviewed by management at the component level. The Company has determined that its reporting units for goodwill impairment testing are the Company’s reportable segments. As such, the Company analyzed its goodwill balances separately for the commercial coffee reporting unit and the direct selling reporting unit. The goodwill balance as of December 31, 2016 and December 31, 2015 was $6,323,000. The Company has determined that no impairment of its goodwill occurred for the years ended December 31, 2016 and 2015. Goodwill activity for the years ended December 31, 2016 and 2015 by reportable segment consists of the following (in thousands): Revenue Recognition The Company recognizes revenue from product sales when the following four criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable, and collectability is reasonably assured. The Company ships the majority of its direct selling segment products directly to the distributors via UPS or USPS and receives substantially all payments for these sales in the form of credit card transactions. The Company regularly monitors its use of credit card or merchant services to ensure that its financial risk related to credit quality and credit concentrations is actively managed. Revenue is recognized upon passage of title and risk of loss to customers when product is shipped from the fulfillment facility. The Company ships the majority of its coffee segment products via common carrier and invoices its customer for the products. Revenue is recognized when the title and risk of loss is passed to the customer under the terms of the shipping arrangement, typically, FOB shipping point. The Company also charges fees to become a distributor, and earn a position in the network genealogy, which are recognized as revenue in the period received. Our distributors are required to pay a one-time enrollment fee and receive a welcome kit specific to that country region that consists of forms, policy and procedures, selling aids, and access to our distributor website and a genealogy position with no down line distributors. Sales revenue and a reserve for estimated returns are recorded net of sales tax when product is shipped. Deferred Revenues and Costs Deferred revenues relate primarily to the Heritage Makers product line and represent the Company’s obligation for points purchased by customers that have not yet been redeemed for product. Cash received for points sold is recorded as deferred revenue. Revenue is recognized when customers redeem the points and the product is shipped. As of December 31, 2016 and December 31, 2015, the balance in deferred revenues was approximately $1,870,000 and $2,580,000 respectively, of which the portion attributable to Heritage Makers was approximately $1,662,000 and $2,485,000, respectively. The remaining balance of approximately $208,000 and $95,000 as of December 31, 2016 and 2015, related primarily to the Company’s 2017 and 2016 conventions whereby attendees pre-enroll in the events and the Company does not recognize this revenue until the conventions occur, respectively. Deferred costs relate to Heritage Makers prepaid commissions that are recognized in expense at the time the related revenue is recognized. As of December 31, 2016 and 2015, the balance in deferred costs was approximately $415,000 and $967,000 respectively, and was included in prepaid expenses and current assets. Product Return Policy All products, except food products and commercial coffee products are subject to a full refund within the first 30 days of receipt by the customer, subject to an advance return authorization procedure. Returned product must be in unopened resalable condition. Product returns as a percentage of our net sales have been approximately 1% of our monthly net sales over the last two years. Commercial coffee products are returnable only if defective. Shipping and Handling Shipping and handling costs associated with inbound freight and freight to customers, including independent distributors, are included in cost of sales. Shipping and handling fees charged to customers are included in sales. Shipping expense was approximately $9,927,000 and $10,394,000 for the years ended December 31, 2016 and 2015, respectively. Distributor Compensation In the direct selling segment, the Company utilizes a network of independent distributors, each of whom has signed an agreement with the Company, enabling them to purchase products at wholesale prices, market products to customers, enroll new distributors for their down-line and earn compensation on product purchases made by those down-line distributors and customers. The payments made and stock options issued under the compensation plans are the only form of compensation paid to the distributors. Each product has a point value, which may or may not correlate to the wholesale selling price of a product. A distributor must qualify each month to participate in the compensation plan by making a specified amount of product purchases, achieving specified point levels. Once qualified, the distributor will receive payments based on a percentage of the point value of products sold by the distributor’s down-line. The payment percentage varies depending on the qualification level of the distributor and the number of levels of down-line distributors. There are also additional incentives paid upon achieving predefined activity and or down-line point value levels. There can be multiple levels of independent distributors earning incentives from the sales efforts of a single distributor. Due to the multi-layer independent sales approach, distributor incentives are a significant component of the Company’s cost structure. The Company accrues all distributor compensation expense in the month earned and pays the compensation the following month. Earnings Per Share Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income attributable to common stockholders by the sum of the weighted-average number of common shares outstanding during the period and the weighted-average number of dilutive common share equivalents outstanding during the period, using the treasury stock method. Dilutive common share equivalents are comprised of in-the-money stock options, warrants and convertible preferred stock, based on the average stock price for each period using the treasury stock method. Since the Company incurred a loss for the year ended December 31, 2016 and 2015, therefore 105,647,443 and 99,625,809 common share equivalents including potential convertible shares of common stock associated with the Company's convertible notes, were not included in the weighted-average calculations for each respective year since their effect would have been anti-dilutive. Foreign Currency Translation The financial position and results of operations of the Company’s foreign subsidiaries are measured using each foreign subsidiary’s local currency as the functional currency. Revenues and expenses of such subsidiaries have been translated into U.S. dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the balance sheet date. The resulting translation gain and loss adjustments are recorded directly as a separate component of stockholders’ equity, unless there is a sale or complete liquidation of the underlying foreign investments. Translation gains or losses resulting from transactions in currencies other than the respective entities functional currency are included in the determination of income and are not considered significant to the Company for 2016 and 2015. Comprehensive Income (Loss) Comprehensive income (loss) consists of net gains and losses affecting stockholders’ equity that, under generally accepted accounting principles are excluded from net income (loss). For the Company, the only items are the foreign currency translation and net income (loss). Income Taxes The Company accounts for income taxes in accordance with ASC Topic 740, "Income Taxes," under the asset and liability method which includes the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements. Under this approach, deferred taxes are recorded for the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial statement and tax basis of assets and liabilities, and are adjusted for changes in tax rates and tax laws when changes are enacted. The effects of future changes in income tax laws or rates are not anticipated. The Company is subject to income taxes in the United States and certain foreign jurisdictions. The calculation of the Company’s tax provision involves the application of complex tax laws and requires significant judgment and estimates. The Company evaluates the realizability of its deferred tax assets for each jurisdiction in which it operates at each reporting date and establishes a valuation allowance when it is more likely than not that all or a portion of its deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the same character and in the same jurisdiction. The Company considers all available positive and negative evidence in making this assessment, including, but not limited to, the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies. In circumstances where there is sufficient negative evidence indicating that deferred tax assets are not more likely than not realizable, the Company will establish a valuation allowance. The Company applies ASC Topic 740 “Accounting for Uncertainty in Income Taxes” recognized in its financial statements. ASC 740 requires that all tax positions be evaluated using a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Differences between tax positions taken in a tax return and amounts recognized in the financial statements are recorded as adjustments to income taxes payable or receivable, or adjustments to deferred taxes, or both. The Company believes that its accruals for uncertain tax positions are adequate for all open audit years based on its assessment of many factors including past experience and interpretation of tax law. To the extent that new information becomes available, which causes the Company to change its judgment about the adequacy of its accruals for uncertain tax positions, such changes will impact income tax expense in the period such determination is made. The Company’s policy is to include interest and penalties related to unrecognized income tax benefits as a component of income tax expense. Stock Based Compensation The Company accounts for stock based compensation in accordance with ASC Topic 718, “Compensation - Stock Compensation,” which establishes accounting for equity instruments exchanged for employee services. Under such provisions, stock based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense, under the straight-line method, over the vesting period of the equity grant. The Company accounts for equity instruments issued to non-employees in accordance with authoritative guidance for equity based payments to non-employees. Stock options issued to non-employees are accounted for at their estimated fair value, determined using the Black-Scholes option-pricing model. The fair value of options granted to non-employees is re-measured as they vest, and the resulting increase in value, if any, is recognized as expense during the period the related services are rendered. Other Income (Expense) We record interest income, interest expense, and change in derivative liabilities, as well as other non-operating transactions, as other income (expense) on our consolidated statements of operations. Recently Issued Accounting Pronouncements In October 2016, the FASB issued Accounting Standard Update ("ASU") 2016-17, Consolidation (Topic 810): Interests Held through Related Parties That Are under Common Control. This standard amends the guidance issued with ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis in order to make it less likely that a single decision maker would individually meet the characteristics to be the primary beneficiary of a Variable Interest Entity ("VIE"). When a decision maker or service provider considers indirect interests held through related parties under common control, they perform two steps. The second step was amended with this ASU to say that the decision maker should consider interests held by these related parties on a proportionate basis when determining the primary beneficiary of the VIE rather than in their entirety as was called for in the previous guidance. This ASU will be effective for fiscal years beginning after December 15, 2016, and early adoption is not permitted. The Company is currently evaluating the impact of the adoption of this ASU on our financial position and results of operations. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The standard requires lessees to recognize lease assets and lease liabilities on the balance sheet and requires expanded disclosures about leasing arrangements. We will adopt the standard no later than July 1, 2019. The Company is currently assessing the impact that the new standard will have on our Consolidated Financial Statements, which will consist primarily of a balance sheet gross up of our operating leases. The Company does not believe the adoption of the new standard will have a significant impact on our consolidated financial statements. In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs. This ASU more closely aligns the treatment of debt issuance costs with debt discounts and premiums and requires debt issuance costs be presented as a direct deduction from the carrying amount of the related debt. The amendments in this ASU are effective for financial statements issued for fiscal years beginning after December 15, 2015 and interim periods within those fiscal years. This guidance has been applied on a retrospective basis on the Company’s consolidated financial statements as of December 31, 2015. In August 2014, the FASB issued ASU No. 2014-15 Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern. The new standard requires management to perform interim and annual assessments of an entity’s ability to continue to meet its obligations as they become due within one year after the date that the financial statements are issued. ASU 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods thereafter, with early adoption permitted. The Company evaluated the impact of this new standard and concluded as of December 31, 2016 that the adoption of this new standard did not have a significant impact on our consolidated financial statements. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either the retrospective or cumulative effect transition method. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date, which deferred the effective date of the new revenue standard for periods beginning after December 15, 2016 to December 15, 2017, with early adoption permitted but not earlier than the original effective date. Accordingly, the updated standard is effective for us in the first quarter of fiscal 2018 and we do not plan to early adopt. We have not yet selected a transition method and we are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures. Note 2. Acquisitions and Business Combinations During 2016 and 2015, the Company entered into eight acquisitions, which are detailed below. The acquisitions were conducted in an effort to expand the Company’s distributor network, enhance and expand its product portfolio, and diversify its product mix. As such, the major purpose for all of the business combinations was to increase revenue and profitability. The acquisitions were structured as asset purchases which resulted in the recognition of certain intangible assets. 2016 Acquisitions Legacy for Life, LLC On August 18, 2016, with an effective date of September 1, 2016 the Company entered into an agreement to acquire certain assets of Legacy for Life, LLC, an Oklahoma based direct sales company and entered into an agreement to acquire the equity of two wholly owned subsidiaries of Legacy for Life, LLC; Legacy for Life Taiwan and Legacy for Life Limited (Hong Kong) collectively referred to as (“Legacy for Life”). Legacy for Life is a science-based direct seller of i26, a product made from the IgY Max formula or hyperimmune whole dried egg, which is the key ingredient in Legacy for Life products. Additionally, the Company has entered into an Ingredient Supply Agreement to market i26 worldwide. IgY Max promotes healthy gut flora and healthy digestion and was created by exposing a specially selected flock of chickens to natural elements from the human world, whereby the chickens develop immunity to these elements. In a highly patented process, these special eggs are harvested as a whole food and are processed as a whole food into i26 egg powder, an all-natural product. Nothing is added to the egg nor does any chemical extraction take place. As a result of this acquisition, the Company’s distributors and customers have access to the unique line of the Legacy for Life products and the Legacy for Life distributors and customers have gained access to products offered by the Company. The Company has agreed to purchase certain inventories and assume certain liabilities. The Company is obligated to make monthly payments based on a percentage of the Legacy for Life distributor revenue derived from sales of the Company’s products and a percentage of royalty revenue derived from sales of the Legacy for Life products until the earlier of the date that is fifteen (15) years from the closing date or such time as the Company has paid to Legacy for Life aggregate cash payments of Legacy for Life distributor revenue and royalty revenue equal to a predetermined maximum aggregate purchase price. The acquisition of Legacy for Life was accounted for under the acquisition method of accounting. The assets acquired and liabilities assumed by the Company were recognized at their estimated fair values as of the acquisition date. The fair values of the acquired assets have not been finalized pending further information that may impact the valuation of certain assets or liabilities. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. The contingent consideration’s estimated fair value at the date of acquisition was $825,000 as determined by management using a discounted cash flow methodology. In addition the Company paid $221,000 for the net assets of the Taiwan and Hong Kong entities and certain inventories from Legacy for Life. The preliminary purchase price allocation for the acquisition of Legacy for Life (in thousands) is as follows: The preliminary fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The trademarks and trade name, customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The Company expects to finalize the valuation within one (1) year from the acquisition date. The revenue impact from the Legacy for Life acquisition, included in the consolidated statement of operations for the year ended December 31, 2016 was approximately $507,000. The pro-forma effect assuming the business combination with Legacy for Life discussed above had occurred at the beginning of the current period is not presented as the information was not available. Nature’s Pearl Corporation On August 1, 2016, the Company entered into an agreement to acquire certain assets of Nature’s Pearl Corporation, (“Nature’s Pearl”) with an effective date of September 1, 2016. Nature’s Pearl is a direct sales company that produces nutritional supplements and skin and personal care products using the muscadine grape grown in the southeastern region of the United States that are deemed to be rich in antioxidants. As a result of this acquisition, the Company’s distributors and customers have access to the unique line of Nature’s Pearl products and Nature’s Pearl distributors and customers have gained access to products offered by the Company. The Company is obligated to make monthly payments based on a percentage of Nature’s Pearl distributor revenue derived from sales of the Company’s products and a percentage of royalty revenue derived from sales of Nature’s Pearl products until the earlier of the date that is ten (10) years from the closing date or such time as the Company has paid to Nature’s Pearl aggregate cash payments of Nature’s Pearl distributor revenue and royalty revenue equal to a predetermined maximum aggregate purchase price. The Company paid approximately $200,000 for certain inventories, which payment was applied against the maximum aggregate purchase price. The contingent consideration’s estimated fair value of the acquisition was $1,475,000 and was determined by management using a discounted cash flow methodology. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. The assets acquired were recorded at estimated fair values and have not been finalized pending further information that may impact the valuation of certain assets or liabilities. The preliminary purchase price allocation for Nature’s Pearl is as follows (in thousands): The preliminary fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The trademarks and trade name, customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The Company expects to finalize the valuation within one (1) year from the acquisition date. The revenue impact from the Nature’s Pearl acquisition, included in the consolidated statement of operations for the year ended December 31, 2016 was approximately $1,488,000. The pro-forma effect assuming the business combination with Nature’s Pearl discussed above had occurred at the beginning of the current period is not presented as the information was not available. Renew Interest, LLC (SOZO Global, Inc.) On July 29, 2016, the Company acquired certain assets of Renew Interest, LLC (“Renew”) formerly owned by SOZO Global, Inc. (“SOZO”), a direct sales company that produces nutritional supplements, skin and personal care products, weight loss products and coffee products. The SOZO brand of products contains CoffeeBerry a fruit extract known for its high level of antioxidant properties. As a result of this business combination, the Company’s distributors and customers have access to the unique line of the Renew products and Renew distributors and customers have gained access to products offered by the Company. The Company is obligated to make monthly payments based on a percentage of Renew distributor revenue derived from sales of the Company’s products and royalty payments until the earlier of the date that is twelve (12) years from the closing date or such time as the Company agreed to pay to Renew, aggregate cash payments of Renew distributor revenue and royalty revenue equal to a predetermined maximum aggregate purchase price. The Company agreed to pay approximately $300,000 for certain inventories and assumed liabilities, which payment was applied to the maximum aggregate purchase price. The Company also received inventories on a consignment basis. The contingent consideration’s estimated fair value of acquisition was $465,000 and was determined by management using a discounted cash flow methodology. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. The assets acquired were recorded at estimated fair values and have not been finalized pending further information that may impact the valuation of certain assets or liabilities. The preliminary purchase price allocation for Renew is as follows (in thousands): The preliminary fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The trademarks and trade name, customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The Company expects to finalize the valuation within one (1) year from the acquisition date. The revenue impact from the Renew acquisition, included in the consolidated statement of operations for the year ended December 31, 2016 was approximately $432,000. The pro-forma effect assuming the business combination with Renew discussed above had occurred at the beginning of the current period is not presented as the information was not available. South Hill Designs Inc. In January 2016, the Company acquired certain assets of South Hill Designs Inc., (“South Hill”) a direct sales and proprietary jewelry company that sells customized lockets and charms. As a result of this business combination the Company’s distributors have access to South Hill’s customized products and the South Hill distributors and customers have gained access to products offered by the Company. The Company has agreed to pay South Hill a monthly royalty payment on all gross sales revenue generated by the South Hill distributor organization in accordance with this agreement, regardless of products being sold and a monthly royalty payment on South Hill product revenue for seven (7) years from the closing date. The contingent consideration’s estimated fair value at the date of acquisition was $2,650,000 as determined by management using a discounted cash flow methodology. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. During the fourth quarter ended December 31, 2016 the purchase accounting was finalized and the Company determined that the initial purchase price should be reduced by $1,811,000 from $2,650,000 to $839,000. The final purchase price allocation of the intangible assets acquired for South Hill (in thousands) is as follows: The fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The trademarks and trade name, customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The revenue impact from the South Hill acquisition, included in the consolidated statement of operations for the year ended December 31, 2016 was approximately $4,283,000. The pro-forma effect assuming the business combination with South Hill discussed above had occurred at the beginning of the current period is not presented as the information was not available. 2015 Acquisitions Paws Group, LLC On July 1, 2015, the Company acquired certain assets of Paws Group, LLC, (“PAWS”) a direct sales company for pet lovers that offers an exclusive pet boutique carrying treats for dogs and cats as well as grooming and bath products. The purchase price consisted of a maximum aggregate purchase price of $150,000. The Company paid approximately $61,000, for which the Company received certain inventories, which payment was applied against the maximum aggregate purchase price. The Company recorded a fair value of a distributor network intangible asset of $125,000 as determined by management using a discounted cash flow methodology. The intangible is being amortized over its estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. The revenue impact from the PAWS acquisition, included in the consolidated statement of operations for the years ended December 31, 2016 and 2015 was approximately $222,000 and $98,000, respectively. The pro-forma effect assuming the business combination with PAWS discussed above had occurred at the beginning of the year ended 2015 is not presented as the information was not available. Mialisia & Co., LLC On June 1, 2015, the Company acquired certain assets of Mialisia & Co., LLC, (“Mialisia”) a direct sales jewelry company that specializes in interchangeable jewelry. As a result of this business combination, the Company’s distributors and customers have access to Mialisia’s patent-pending “VersaStyle” jewelry and Mialisia’s distributors and customers have gained access to products offered by the Company. The purchase price consisted of a maximum aggregate purchase price of $1,900,000. The Company paid $118,988 for certain inventories, which payment was applied against the maximum aggregate purchase price. The Company has agreed to pay Mialisia a monthly payment equal to seven (7%) of all gross sales revenue generated by the Mialisia distributor organization in accordance with the asset purchase agreement, regardless of products being sold and pay five (5%) royalty on Mialisia product revenue until the earlier of the date that is fifteen (15) years from the closing date or such time as the Company has paid aggregate cash payment equal to $1,781,012 provided, however, that in no event will the maximum aggregate purchase price be reduced below $1,650,000. The contingent consideration’s estimated fair value at the date of acquisition was $700,000 as determined by management using a discounted cash flow methodology. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. During the second quarter ended June 30, 2016 the purchase accounting was finalized and the Company determined that the initial purchase price should be reduced by $108,000 from $700,000 to $592,000. The final purchase price allocation of the intangible assets acquired for Mialisia (in thousands) is as follows: The fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The trademarks and trade name, customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The revenue impact from the Mialisia acquisition, included in the consolidated statement of operations for the years ended December 31, 2016 and 2015 was approximately $3,003,000 and $754,000, respectively. The pro-forma effect assuming the business combination with Mialisia discussed above had occurred at the beginning of the year ended 2015 is not presented as the information was not available. JD Premium LLC On March 4, 2015, the Company acquired certain assets of JD Premium, LLC (“JD Premium”) a dietary supplement company. As a result of this business combination, the Company’s distributors and customers have access to JD Premium’s unique line of products and JD Premium’s distributors and clients gain access to products offered by the Company. The purchase price consisted of a maximum aggregate purchase price of $500,000. The Company paid $50,000 for the purchase of certain inventories, which payment was applied against the maximum aggregate purchase price. The Company has agreed to pay JD Premium a monthly payment equal to seven (7%) of all gross sales revenue generated by the JD Premium distributor organization in accordance with the asset purchase agreement, regardless of products being sold and pay five (5%) royalty on JD Premium product revenue until the earlier of the date that is fifteen (15) years from the closing date or such time as the Company has paid aggregate cash payment equal to $450,000. All payments of JD Premium distributor revenue will be applied against and reduce the maximum aggregate purchase price; however if the aggregate gross sales revenue generated by the JD Premium distributor organization, effective April 4, 2015 for a twenty-four (24) months period does not equal or exceed $500,000 then the maximum aggregate purchase price will be reduced by the difference of the $500,000 and the average annual distributor revenue; provided, however, that in no event will the maximum aggregate purchase price be reduced below $300,000. The contingent consideration’s estimated fair value at the date of acquisition was $195,000 as determined by management using a discounted cash flow methodology. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. During the fourth quarter ended December 31, 2015 the purchase accounting was finalized and the Company determined that the initial purchase price should be reduced from $195,000 by approximately $75,000 to $120,000. The final purchase price allocation for JD Premium is as follows (in thousands): The fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The revenue impact from the JD Premium acquisition, included in the consolidated statement of operations for the years ended December 31, 2016 and 2015 were immaterial. The pro-forma effect assuming the business combination with JD Premium discussed above had occurred at the beginning of the year ended 2015 is not presented as the information was not available. Sta-Natural, LLC On February 23, 2015, the Company acquired certain assets and assumed certain liabilities of Sta-Natural, LLC, (“Sta-Natural”) a dietary supplement company and provider of vitamins, minerals and supplements for families and their pets. As a result of this business combination, the Company’s distributors and customers have access to Sta-Natural’s unique line of products and Sta-Natural’s distributors and clients gain access to products offered by the Company. The purchase price consisted of a maximum aggregate purchase price of $500,000. The Company paid $25,000 for certain inventories, which payment was applied against the maximum aggregate purchase price. The Company has agreed to pay Sta-Natural a monthly payment equal to eight (8%) of all gross sales revenue generated by the Sta-Natural distributor organization in accordance with the asset purchase agreement, regardless of products being sold and pay five (5%) royalty on Sta-Natural product revenue until the earlier of the date that is fifteen (15) years from the closing date or such time as the Company has paid aggregate cash payment equal to $450,000. All payments of Sta-Natural distributor revenue will be applied against and reduce the maximum aggregate purchase price; however if the aggregate gross sales revenue generated by the Sta-Natural distributor organization, for a twelve (12) months period following the closing date does not equal or exceed $500,000 then the maximum aggregate purchase price will be reduced by the difference of the $500,000 and the average distributor revenue for a twelve (12) month period: provided, however, that in no event will the maximum aggregate purchase price be reduced below $300,000. The contingent consideration’s estimated fair value at the date of acquisition was $285,000 as determined by management using a discounted cash flow methodology. The acquisition related costs, such as legal costs and other professional fees were minimal and expensed as incurred. The final purchase price allocation for Sta-Natural is as follows (in thousands): The fair value of intangible assets acquired was determined through the use of a discounted cash flow methodology. The trademarks and trade name, customer-related intangible and distributor organization intangible are being amortized over their estimated useful life of ten (10) years using the straight-line method which is believed to approximate the time-line within which the economic benefit of the underlying intangible asset will be realized. The revenue impact from the Sta-Natural acquisition, included in the consolidated statement of operations for the years ended December 31, 2016 and 2015 was approximately $1,168,000 and $691,000, respectively. The pro-forma effect assuming the business combination with Sta-Natural discussed above had occurred at the beginning of the year ended 2015 is not presented as the information was not available. Note 3. Arrangements with Variable Interest Entities and Related Party Transactions The Company consolidates all variable interest entities in which it holds a variable interest and is the primary beneficiary of the entity. Generally, a variable interest entity (“VIE”) is a legal entity with one or more of the following characteristics: (a) the total at risk equity investment is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties; (b) as a group the holders of the equity investment at risk lack any one of the following characteristics: (i) the power, through voting or similar rights, to direct the activities of the entity that most significantly impact its economic performance, (ii) the obligation to absorb the expected losses of the entity, or (iii) the right to receive the expected residual returns of the entity; or (c) some equity investors have voting rights that are not proportional to their economic interests, and substantially all of the entity's activities either involve, or are conducted on behalf of, an investor that has disproportionately few voting rights. The primary beneficiary of a VIE is required to consolidate the VIE and is the entity that has (a) the power to direct the activities of the VIE that most significantly impact the VIE's economic performance, and (b) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. In determining whether it is the primary beneficiary of a VIE, the Company considers qualitative and quantitative factors, including, but not limited to: which activities most significantly impact the VIE's economic performance and which party has the power to direct such activities; the amount and characteristics of Company's interests and other involvements in the VIE; the obligation or likelihood for the Company or other investors to provide financial support to the VIE; and the similarity with and significance to the business activities of Company and the other investors. Significant judgments related to these determinations include estimates about the current and future fair values and performance of these VIEs and general market conditions. FDI Realty, LLC FDI Realty is the owner and lessor of the building previously occupied by the Company for its sales and marketing office in Windham, NH. In December 2015 the Company relocated its operations from the Windham office, to its corporate headquarters in Chula Vista, California. A former officer of the Company is the single member of FDI Realty. The Company is a co-guarantor of FDI Realty’s mortgages on the building. The Company determined that the fair value of the guarantees is not significant and therefore did not record a related liability. The first mortgage is due on August 13, 2018 and the second mortgage is due on August 13, 2028. The Company’s maximum exposure to loss as a result of its involvement with the unconsolidated VIE is approximately $1,806,000 and $1,900,000 as of December 31, 2016 and 2015, respectively. The Company may be subject to additional losses to the extent of any financial support that it voluntarily provides in the future. At December 31, 2016 and 2015, the Company held a variable interest in FDI Realty, for which the Company is not deemed to be the primary beneficiary. The Company has concluded, based on its qualitative consideration of the terminated lease agreement, and the role of the single member of FDI Realty, that the single member is the primary beneficiary of FDI Realty. In making these determinations, the Company considered that the single member conducts and manages the business of FDI Realty, is authorized to borrow funds on behalf of FDI Realty, is the sole person authorized and responsible for conducting the business of FDI Realty, and is obligated to fund the obligations of FDI Realty. As a result of this determination, the financial position and results of operations of FDI Realty have not been included in the accompanying consolidated financial statements of the Company. Related Party Transactions Richard Renton Richard Renton is a member of the Board of Directors and owns and operates with his wife Roxanna Renton Northwest Nutraceuticals, Inc., a supplier of certain inventory items sold by the Company. The Company made purchases of approximately $126,000 and $93,000 from Northwest Nutraceuticals Inc., for the years ended December 31, 2016 and 2015, respectively. In addition, Mr. Renton and his wife are also distributors of the Company and the Renton’s were paid distributor commissions for the years ended December 31, 2016 and 2015 approximately $457,000 and $422,000 respectively. Hernandez, Hernandez, Export Y Company The Company’s coffee segment CLR is associated with Hernandez, Hernandez, Export Y Company (“H&H”), a Nicaragua company, through sourcing arrangements to procure Nicaraguan green coffee and in March 2014 as part of the Siles Plantation Family Group “Siles” acquisition, CLR engaged the owners of H&H as employees to manage Siles. As an inducement to managing the operations of Siles, CLR and H&H entered into an Operating and Profit Sharing Agreement (“Agreement”). In accordance with the Agreement, H&H shares equally (50%) in all profits and losses generated by Siles, and profits from any subsequent sale of the plantation, after profits are first distributed to CLR equal to the amount of CLR’s cash contributions for the acquisitions, then after profits are distributed to H&H in an amount equal to their cash contributions, and after certain other conditions are met. During the years ended December 31, 2016 and 2015 CLR recorded expenses allocated to the profit sharing Agreement of $698,000 and $528,000, respectively. As of December 31, 2016 and 2015 the balance of contingent acquisition debt payable to H&H after the reduction of $698,000 and $528,000 from the allocation of 50% losses recognized in 2016 and 2015 is $83,000 and $894,000, respectively. CLR sources green coffee from H&H and made purchases of approximately $8,810,000 and $10,499,000 for the years ended December 31, 2016 and 2015, respectively. H&H Coffee Group Export, a Florida Company which is affiliated with H&H is a customer of CLR. During the year ended December 31, 2016 CLR sold $2,637,000 in green coffee to H&H Coffee Group Export. There were no related sales of green coffee to H&H Coffee Group Export during 2015. Carl Grover Mr. Carl Grover is the beneficial owner of in excess of five percent (5%) of our outstanding common shares, including his ownership as the sole beneficial owner of 44,866,952 shares of our common stock. Mr. Grover owns a September 2014 Note in the principal amount of $4,000,000 convertible into 11,428,571 shares of common stock convertible at a conversion price of $0.35 per share, and a September 2014 Warrant exercisable for 15,652,174 shares of common stock at an exercise price of $0.23 per share. Mr. Grover also owns a November 2015 Note in the principal amount of $7,000,000 convertible into 20,000,000 shares of common stock convertible at a conversion price of $0.35 per share, and a November 2015 Warrant exercisable for 9,333,333 shares of common stock at an exercise price of $0.45 per share. He also owns 5,151,240 shares of common stock. 2400 Boswell LLC On March 15, 2013, the Company acquired 2400 Boswell LLC (“2400 Boswell”) for approximately $4.6 million. 2400 Boswell is the owner and lessor of the building occupied by the Company for its corporate office and warehouse in Chula Vista, California. The purchase was from an immediate family member of our Chief Executive Officer and consisted of approximately $248,000 in cash, $334,000 of debt forgiveness and accrued interest, and a promissory note of approximately $393,000, payable in equal payments over 5 years and bears interest at 5.0%. Additionally, the Company assumed a long-term mortgage of $3,625,000, payable over 25 years and has an initial interest rate of 5.75%. The interest rate is the prime rate plus 2.5%. The lender will adjust the interest rate on the first calendar day of each change period. As of December 31, 2016 the balance on the long-term mortgage is approximately $3,363,000 and the balance on the promissory note is approximately $108,000. The Company and its Chief Executive Officer are both co-guarantors of the mortgage. Note 4. Notes Payable and Other Debt In November 2015, the Company completed a private placement and entered into Note Purchase Agreements with three (3) accredited investors pursuant to which it sold senior secured convertible notes in the aggregate principal amount of $7,187,500, that are convertible into shares of Common Stock. The Notes are due in October 2018 if the option to convert has not been exercised (see Note 5, below.) In January 2015, the Company completed a private placement and entered into Note Purchase Agreements with three (3) accredited investors pursuant to which it sold units consisting of one (1) year senior secured notes in the aggregate principal amount of $5,250,000. One holder of a January 2015 Note in the principal amount of $5,000,000 was prepaid on October 26, 2015 through a cash payment from us to the investor of $1,000,000, and the remaining $4,000,000 owed was applied to the investor’s purchase of a $4,000,000 November 2015 Note in the November 2015 Offering and a November 2015 Warrant exercisable to purchase 5,333,333 shares of Common Stock. The remaining balance of the January 2015 Notes as of December 31, 2015 was $250,000 which amount was paid in January 2016 (see Note 5, below.) During the third quarter of the year ended December 31, 2014, the Company completed a private placement and entered into Note Purchase Agreements with seven (7) accredited investors pursuant to which we sold units consisting of five (5) year senior secured convertible Notes in the aggregate principal amount of $4,750,000, that are convertible into shares of our common stock. The Notes are due in September 2019 if the option to convert has not been exercised (see Note 5, below.) In March 2013, the Company acquired 2400 Boswell for approximately $4.6 million. 2400 Boswell is the owner and lessor of the building occupied by the Company for its corporate office and warehouse in Chula Vista, California. The purchase was from an immediate family member of our Chief Executive Officer and consisted of approximately $248,000 in cash, $334,000 of debt forgiveness and accrued interest, and a promissory note of approximately $393,000, payable in equal payments over 5 years and bears interest at 5.0%. Additionally, the Company assumed a long-term mortgage of $3,625,000, payable over 25 years and has an initial interest rate of 5.75%. The interest rate is the prime rate plus 2.5%. The lender will adjust the interest rate on the first calendar day of each change period. As of December 31, 2016 the balance on the long-term mortgage is approximately $3,363,000 and the balance on the promissory note is approximately $108,000. The Company and its Chief Executive Officer are both co-guarantors of the mortgage. In March 2007, the Company entered into an agreement to purchase certain assets of M2C Global, Inc., a Nevada corporation, for $4,500,000. The agreement required payments totaling $500,000 in three installments during 2007, followed by monthly payments in the amount of 10% of the sales related to the acquired assets until the entire note balance is paid. The Company has imputed interest at the rate of 7% per annum. As of December 31, 2016 and 2015, the carrying value of the liability was approximately $1,156,000 and $1,204,000, respectively. Imputed interest recorded on the note was approximately $29,000 for the year ended December 31, 2015. The interest associated with the note for the year ended December 31, 2016 was minimal. The Company has two other notes payable in the total amount of $23,000 as of December 31, 2016 which expires in 2018 and 2020. The following summarizes the maturities of notes payable (in thousands): Capital Lease The Company leases certain manufacturing and operating equipment under non-cancelable capital leases. The total outstanding balance under the capital leases as of December 31, 2016 excluding interest was approximately $2,390,000, of which $821,000 will be paid in 2017 and the remaining balance of $1,569,000 will be paid through 2021. The following summarizes the maturities of capital leases (in thousands): Depreciation expense related to the capitalized lease obligations was approximately $103,000 and $27,000 for the years ended December 31, 2016 and 2015, respectively. Factoring Agreement The Company has a factoring agreement (“Factoring Agreement”) with Crestmark Bank (“Crestmark”) related to the Company’s accounts receivable resulting from sales of certain products within its commercial coffee segment. Effective May 1, 2016, the Company entered into a third amendment to the factoring agreement (“Agreement”). Under the terms of the Agreement, all new receivables assigned to Crestmark shall be “Client Risk Receivables” and no further credit approvals will be provided by Crestmark and there will be no new credit-approved receivables. The changes to the Agreement include expanding the factoring facility to include borrowings to be advanced against acceptable eligible inventory up to 50% of landed cost of finished goods inventory and meeting certain criteria, not to exceed the lesser of $1,000,000 or 85% of the value of the receivables already advanced with a maximum overall borrowing of $3,000,000. Interest accrues on the outstanding balance and a factoring commission is charged for each invoice factored which is calculated as the greater of $5.00 or 0.75% to 0.875% of the gross invoice amount and is recorded as interest expense. In addition the Company and the Company’s CEO Mr. Wallach have entered into a Guaranty and Security Agreement with Crestmark Bank if in the event that CLR were to default. This Agreement continues in full force and is effective until February 1, 2019. The Company accounts for the sale of receivables under the Factoring Agreement as secured borrowings with a pledge of the subject inventories and receivables as well as all bank deposits as collateral, in accordance with the authoritative guidance for accounting for transfers and servicing of financial assets and extinguishments of liabilities. The caption “Accounts receivable, due from factoring company” on the accompanying consolidated balance sheets in the amount of approximately $1,078,000 and $556,000 as of December 31, 2016 and December 31, 2015, respectively, reflects the related collateralized accounts. The Company's outstanding liability related to the Factoring Agreement was approximately $1,290,000 and $457,000 as of December 31, 2016 and December 31, 2015, respectively, and is included in other current liabilities on the consolidated balance sheets. The minimum factoring commission payable to the bank is $90,000 during each consecutive 12-month period. Fees and interest paid pursuant to this agreement were approximately $170,000 and $155,000 for the years ended December 31, 2016 and 2015, respectively, which were recorded as interest expense. Contingent Acquisition Debt The Company has contingent acquisition debt associated with its business combinations. The Company accounts for business combinations under the acquisition method and allocates the total purchase price for acquired businesses to the tangible and identified intangible assets acquired and liabilities assumed, based on their estimated fair values as of the acquisition date. A liability for contingent consideration, if applicable, is recorded at fair value as of the acquisition date and, evaluated each period for changes in the fair value and adjusted as appropriate (see Note 7 below.) The Company’s contingent acquisition debt as of December 31, 2016 is $8,001,000 and is primarily attributable to debt associated with the Company’s direct selling segment which is $7,806,000 and $195,000 is debt associated with the Company’s coffee segment. Line of Credit On October 10, 2014, the Company entered into a revolving line of credit agreement (“Line of Credit”), with Wells Fargo Bank National Association (“Bank”), the Company’s principal banking partner. The Line of Credit provided the Company with a $2.5 million revolving credit line. The outstanding principal balance of the Line of Credit bear interest at a fluctuating rate per annum determined by the Bank to be two and three-quarter percent (2.75%) above Daily One Month LIBOR as in effect from time to time. The bank charged an unused commitment fee equal to five tenths percent (.5%) per annum on the daily unused amount of the Line of Credit and was payable quarterly. The Company did not draw against this credit facility. The agreement expired in October 2015 and was not renewed. Note 5. Debt January 2015 Private Placement In January 2015, the Company entered into Note Purchase Agreements (the “Note” or “Notes”) related to its private placement offering (“January 2015 Private Placement”) with three (3) accredited investors pursuant to which the Company sold units consisting of one (1) year senior secured notes in the aggregate principal amount of $5,250,000. One holder of a January 2015 Note in the principal amount of $5,000,000 was prepaid on October 26, 2015 through a cash payment from us to the investor of $1,000,000 and the remaining $4,000,000 owed was applied to the investor’s purchase of a $4,000,000 November 2015 Note in the November 2015 Private Placement and a November 2015 Warrant exercisable to purchase 5,333,333 shares of Common Stock. The Notes bore interest at a rate of eight percent (8%) per annum and interest was paid quarterly in 2015. The remaining balance of the January 2015 Notes as of December 31, 2015 was $250,000 and was paid in January 2016. The Company recorded a non-cash extinguishment loss on debt of $1,198,000 for the year ended December 31, 2015 as a result of the repayment of $5,000,000 in Notes Payable to one of the investors from the January 2015 Private Placement through issuance of a new November 2015 Note Payable. This loss represents the difference between the reacquisition value of the new debt to the holder of the note and the carrying amount of the holder’s extinguished debt. Issuance costs related to the Notes and the common stock were approximately $170,000 and $587,000 in cash and non-cash costs, respectively, which were recorded as deferred financing costs and were amortized over the term of the Notes. As of December 31, 2015 the deferred financing costs is fully amortized and was recorded as interest expense. Convertible Notes Payable Our total convertible notes payable, net of debt discount outstanding consisted of the amount set forth in the following table (in thousands): (1) Principal amount of $4,750,000 are net of unamortized debt discounts of $2,454,000 as of December 31, 2016 and $3,404,000 as of December 31, 2015. (2) Principal amount of approximately $7,188,000 are net of unamortized debt discounts of $189,000 as of December 31, 2016 and $292,000 as of December 31, 2015. (3) As of January 1, 2016, we adopted ASU 2015-03 with retrospective application. This resulted in a $1,456,000 reclassification from prepaid expenses and other current assets to convertible notes payable, net of debt discount, for unamortized debt issuance costs. (4) Principal amounts are net of unamortized discounts and issuance costs of $3,611,000 as of December 31, 2016 and $5,152,000 as of December 31, 2015. July 2014 Private Placement Between July 31, 2014 and September 10, 2014 the Company entered into Note Purchase Agreements (the “Note” or “Notes”) related to its private placement offering (“2014 Private Placement”) with seven accredited investors pursuant to which the Company raised aggregate gross proceeds of $4,750,000 and sold units consisting of five (5) year senior secured convertible Notes in the aggregate principal amount of $4,750,000, that are convertible into 13,571,429 shares of our common stock, at a conversion price of $0.35 per share, and warrants to purchase 18,586,956 shares of common stock at an exercise price of $0.23 per share. The Notes bear interest at a rate of eight percent (8%) per annum and interest is paid quarterly in arrears with all principal and unpaid interest due between July and September 2019. As of December 31, 2016 and December 31, 2015 the principal amount of $4,750,000 remains outstanding. The Company has the right to prepay the Notes at any time after the one year anniversary date of the issuance of the Notes at a rate equal to 110% of the then outstanding principal balance and any unpaid accrued interest. The notes are secured by Company pledged assets and rank senior to all debt of the Company other than certain senior debt that has been previously identified as senior to the convertible notes debt. Additionally, Stephan Wallach, the Company’s Chief Executive Officer, has also personally guaranteed the repayment of the Notes, subject to the terms of a Guaranty Agreement executed by him with the investors. In addition, Mr. Wallach has agreed not to sell, transfer or pledge 30 million shares of the Common Stock that he owns so long as his personal guaranty is in effect. Additionally, upon issuance of the Convertible Notes, the Company recorded the discount for the beneficial conversion feature of $1,053,000. The debt discount associated with the beneficial conversion feature is amortized to interest expense over the life of the Notes. Paid in cash issuance costs related to the July 2014 Private Placement were approximately $490,000 and were recorded as deferred financing costs and are included with convertible notes payable, net of debt discounts on the consolidated balance sheets and are being amortized over the term of the Convertible Notes. As of December 31, 2016 and December 31, 2015 the remaining balance in deferred financing costs is approximately $253,000 and $351,000, respectively. The quarterly amortization of the deferred financing costs is approximately $25,000 and is recorded as interest expense. November 2015 Private Placement Between October 13, 2015 and November 25, 2015 the Company entered into Note Purchase Agreements (the “Note” or “Notes”) related to its private placement offering (“November 2015 Private Placement”) with three (3) accredited investors pursuant to which the Company raised cash proceeds of $3,187,500 in the offering and converted $4,000,000 of debt from the January 2015 Private Placement to this offering in consideration of the sale of aggregate units consisting of three (3) year senior secured convertible Notes in the aggregate principal amount of $7,187,500, convertible into 20,535,714 shares of common stock, par value $0.001 per share, at a conversion price of $0.35 per share, subject to adjustment as provided therein; and five (5) year Warrants exercisable to purchase 9,583,333 shares of the Company’s common stock at a price per share of $0.45. The Notes bear interest at a rate of eight percent (8%) per annum and interest is paid quarterly in arrears with all principal and unpaid interest due at maturity on October 12, 2018. As of December 31, 2016 and December 31, 2015 the principal amount of $7,187,500 remains outstanding. The Company has the right to prepay the Notes at any time after the one year anniversary date of the issuance of the Notes at a rate equal to 110% of the then outstanding principal balance and any unpaid accrued interest. The notes are secured by Company pledged assets and rank senior to all debt of the Company other than certain senior debt that has been previously identified as senior to the convertible notes debt. The amounts owed under this Note are secured by a Deed of Trust as of October 13, 2015 executed by the Company’s affiliate 2400 Boswell LLC, a California limited liability company, and encumbering the Company’s headquarters at 2400 Boswell Rd., Chula Vista, CA 91914 (the “Deed of Trust.”). Additionally, Stephan Wallach, the Company’s Chief Executive Officer, has also personally guaranteed the repayment of the Notes, subject to the terms of a Guaranty Agreement executed by him with the investors. In addition, Mr. Wallach has agreed not to sell, transfer or pledge 30 million shares of the Common Stock that he owns so long as his personal guaranty is in effect. The Company recorded the discount for the beneficial conversion feature of $15,000. The beneficial conversion feature was recorded to equity and the debt discount associated with the beneficial conversion feature will be amortized to interest expense over the life of the Notes. Paid in cash issuance costs related to the November 2015 Private Placement were approximately $786,000 and were recorded as deferred financing costs and are included with convertible notes payable, net of debt discounts on the consolidated balance sheets and are being amortized over the term of the Convertible Notes. As of December 31, 2016 and December 31, 2015 the remaining balance in deferred financing costs is approximately $480,000 and $742,000, respectively. The quarterly amortization of the deferred financing costs is approximately $66,000 and is recorded as interest expense. Registration Rights Agreements The Company entered into a registration rights agreements (“Registration Rights Agreement”) with the investors in the November 2015 and July 2014 Private Placements. Under the terms of the Registration Rights Agreement, the Company agreed to file a registration statement covering the resale of the common stock underlying the units and the common stock that is issuable on exercise of the warrants within 90 days from the final closing date of the Private Placements (the “Filing Deadline”). The Company has agreed to use reasonable efforts to maintain the effectiveness of the registration statement through the one year anniversary of the date the registration statement is declared effective by the Securities and Exchange Commission (the “SEC”), or until Rule 144 of the 1933 Act is available to investors in the Private Placements with respect to all of their shares, whichever is earlier. If the Company does not meet the Filing Deadline or Effectiveness Deadline, as defined in the Registration Rights Agreement, the Company will be liable for monetary penalties equal to one percent (1.0%) of each investor’s investment at the end of every 30 day period following such Filing Deadline or Effectiveness Deadline failure until such failure is cured. The payment amount shall be prorated for partial 30 day periods. The maximum aggregate amount of payments to be made by the Company as the result of such shall be an amount equal to ten (10%) of each investor’s investment amount. Notwithstanding the foregoing, no payments shall be owed with respect to any period during which all of the investor’s registrable securities may be sold by such investor under Rule 144 or pursuant to another exemption from registration. July 2014 Private Placement: The Company filed a registration statement on October 3, 2014 and an amended statement on October 17, 2014 and it was declared effective by the SEC on November 4, 2014. November 2015 Private Placement: The Company filed a registration statement on December 29, 2015 and an amended registration statement on February 9, 2016 that was declared effective by the SEC on February 12, 2016. Note 6. Derivative Liability In October and November of 2015, the Company issued 9,583,333 five-year warrants in connection with Convertible Notes associated with our November 2015 Private Placement. The exercise price of the warrants is protected against down-round financing throughout the term of the warrant. Pursuant to ASC Topic 815, “Derivatives and Hedging” the fair value of the warrants of approximately $1,491,000 was recorded as a derivative liability on the issuance dates. The estimated fair values of the warrants were computed at issuance using a Monte Carlo option pricing models, with the following assumptions: stock price volatility 70%, risk-free rate 1.66%, annual dividend yield 0% and expected life 5.0 years. In July and August of 2014, the Company issued 21,802,793 five-year warrants in connection with Convertible Notes associated with our July 2014 Private Placement. The exercise price of the warrants is protected against down-round financing throughout the term of the warrant. Pursuant to ASC Topic 815, the fair value of the warrants of approximately $3,697,000 was recorded as a derivative liability on the issuance dates. The estimated fair values of the warrants were computed at issuance using a Monte Carlo option pricing models, with the following assumptions: stock price volatility 90%, risk-free rates 1.58%-1.79%, annual dividend yield 0% and expected life 5.0 years. In December 2015, the Company modified the terms of certain warrants that were issued to the placement agent as a result of warrants issued from the July Private Placement that were initially classified as derivative liabilities. The Company entered into an agreement with the placement agent to remove the down-round pricing protection provision contained within the placement agent issued warrants. As a result of this change in the warrants, the Company considered the guidance of Topic ASC 815, “Derivatives and Hedging” (formerly EITF 07-5 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity's Own Stock)) to determine the appropriate accounting treatment of the warrants and the balance sheet classification of the warrants as either equity or liability. The Company determined that the warrants were indexed to the Company’s stock and the equity classification was appropriate and no longer qualified as derivative liabilities. This determination resulted in the reclassification of 3,215,837 warrants from a liability instrument to equity instruments by removing the derivative liability and a reclassification to additional paid in capital. The Company revalued the warrants as of December 31, 2015 and reduced the derivate liability by approximately $526,000. The warrants were revalued using the Black-Scholes valuation method using a risk-free rate of 1.5%, stock price of $0.30, exercise prices ranging from $0.23 to $0.35, expected life of 3.6 to 3.7 years and stock price volatility of 70.0%. Warrants classified as derivative liabilities are recorded at their estimated fair value (see Note 7, below) at the issuance date and are revalued at each subsequent reporting date. We will continue to revalue the derivative liability on each subsequent balance sheet date until the securities to which the derivative liabilities relate are exercised or expire. The Company revalued the warrants as of the end of each reporting period, and the estimated fair value of the outstanding warrant liabilities was approximately $3,345,000 and $4,716,000 as of December 31, 2016 and December 31, 2015, respectively. Increases or decreases in fair value of the derivative liability are included as a component of total other expense in the accompanying consolidated statements of operations for the respective period. The changes to the derivative liability for warrants resulted in a decrease of $1,371,000 for the year ended December 31, 2016 and an increase of $39,000 for the year ended December 31, 2015. Various factors are considered in the pricing models we use to value the warrants, including our current stock price, the remaining life of the warrants, the volatility of our stock price, and the risk free interest rate. Future changes in these factors may have a significant impact on the computed fair value of the warrant liability. As such, we expect future changes in the fair value of the warrants to continue and may vary significantly from year to year. The warrant liability and revaluations have not had a cash impact on our working capital, liquidity or business operations. The estimated fair value of the warrants were computed as of December 31, 2016 and as of December 31, 2015 using Black-Scholes and Monte Carlo option pricing models, using the following assumptions: In addition, Management assessed the probabilities of future financing assumptions in the valuation models. Note 7. Fair Value of Financial Instruments Fair value measurements are performed in accordance with the guidance provided by ASC Topic 820, “Fair Value Measurements and Disclosures.” ASC Topic 820 defines fair value as the price that would be received from selling an asset, or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or parameters are not available, valuation models are applied. ASC Topic 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Assets and liabilities recorded at fair value in the financial statements are categorized based upon the hierarchy of levels of judgment associated with the inputs used to measure their fair value. Hierarchical levels directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows: Level 1 - Quoted prices in active markets for identical assets or liabilities that an entity has the ability to access. Level 2 - Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. Level 3 - Unobservable inputs that are supportable by little or no market activity and that are significant to the fair value of the asset or liability. The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, capital lease obligations and deferred revenue approximate their fair values based on their short-term nature. The carrying amount of the Company’s long term notes payable approximates its fair value based on interest rates available to the Company for similar debt instruments and similar remaining maturities. The estimated fair value of the contingent consideration related to the Company's business combinations is recorded using significant unobservable measures and other fair value inputs and is therefore classified as a Level 3 financial instrument. In connection with the 2015 and 2014 Private Placements, we issued warrants to purchase shares of our common stock which are accounted for as derivative liabilities (see Note 6 above.) The estimated fair value of the warrants is recorded using significant unobservable measures and other fair value inputs and is therefore classified as a Level 3 financial instrument. The following table details the fair value measurement within the three levels of the value hierarchy of the Company’s financial instruments, which includes the Level 3 liabilities (in thousands): The following table reflects the activity for the Company’s warrant derivative liability associated with our 2015 and 2014 Private Placements measured at fair value using Level 3 inputs (in thousands): The following table reflects the activity for the Company’s contingent acquisition liabilities measured at fair value using Level 3 inputs (in thousands): The fair value of the contingent acquisition liabilities are evaluated each reporting period using projected revenues, discount rates, and projected timing of revenues. Projected contingent payment amounts are discounted back to the current period using a discount rate. Projected revenues are based on the Company’s most recent internal operational budgets and long-range strategic plans. Increases in projected revenues will result in higher fair value measurements. Increases in discount rates and the time to payment will result in lower fair value measurements. Increases (decreases) in any of those inputs in isolation may result in a significantly lower (higher) fair value measurement. During the years ended December 31, 2016 and 2015, the net adjustment to the fair value of the contingent acquisition debt was a decrease of $1,462,000 and a decrease of $446,000, respectively. The weighted-average of the discount rates used was 18.2% and 17.6% as of December 31, 2016 and 2015, respectively. The projected year of payment ranges from 2017 to 2031. Note 8. Stockholders’ Equity The Company’s Articles of Incorporation, as amended, authorize the issuance of two classes of stock to be designated “Common Stock” and “Preferred Stock”. Convertible Preferred Stock The Company had 161,135 shares of Series A Convertible Preferred Stock ("Series A Preferred") outstanding as of December 31, 2016 and December 31, 2015, and accrued dividends of approximately $112,000 and $98,000, respectively. The holders of the Series A Preferred Stock are entitled to receive a cumulative dividend at a rate of 8.0% per year, payable annually either in cash or shares of the Company's Common Stock at the Company's election. Shares of Common Stock paid as accrued dividends are valued at $0.50 per share. Each share of Series A Preferred is convertible into two shares of the Company's Common Stock. The holders of Series A Preferred are entitled to receive payments upon liquidation, dissolution or winding up of the Company before any amount is paid to the holders of Common Stock. The holders of Series A Preferred shall have no voting rights, except as required by law. Common Stock The Company had 392,698,557 common shares outstanding as of December 31, 2016. The holders of Common Stock are entitled to one vote per share on matters brought before the shareholders. Warrant Modification Agreements In December 2015, the Company modified the terms of certain warrants that were issued to the placement agent as a result of warrants issued from the July Private Placement that were initially classified as derivative liabilities. The Company entered into an agreement with the placement agent to remove the down-round pricing protection provision contained within the placement agent issued warrants. As a result of this change in the warrants, the Company considered the guidance of Topic ASC 815, “Derivatives and Hedging” (formerly EITF 07-5 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity's Own Stock)) to determine the appropriate accounting treatment of the warrants and the balance sheet classification of the warrants as either equity or liability. The Company determined that the warrants were indexed to the Company’s stock and that the equity classification was appropriate and the warrants no longer qualified as derivative liabilities. This determination resulted in the reclassification of 3,215,837 warrants from a liability instrument to equity instruments by removing the derivative liability and a reclassification to additional paid in capital. The Company revalued the warrants as of December 31, 2015 and reduced the derivate liability by approximately $526,000. The warrants were revalued using the Black-Scholes valuation method using a risk-free rate of 1.5%, stock price of $0.30, exercise prices ranging from $0.23 to $0.35, expected life of 3.6 to 3.7 years and stock price volatility of 70.0%. In July 2015, the Company entered into agreements which extended the life of 2,418,750 warrants classified as equity instruments by two years after certain conditions were met. The Company recorded a warrant modification expense, as a result of the extension of the expiration dates of approximately $253,000, which is included in general and administrative expense in the Company’s consolidated statements of operations. The expense was calculated using the Black-Scholes valuation method and using a risk-free rate of 0.67%, stock price of $0.31, exercise prices ranging from $0.30 to $0.40, expected life of 2.0 years and stock price volatility of 67.8%. The warrants are exercisable into the Company’s common stock. There were no warrant modifications during 2016. Repurchase of Common Stock On December 11, 2012, the Company authorized a share repurchase program to repurchase up to 15 million of the Company's issued and outstanding common shares from time to time on the open market or via private transactions through block trades. Under this program, for the year ended December 31, 2016, the Company repurchased a total of 125,708 shares at a weighted-average cost of $0.28. A total of 3,931,880 shares have been repurchased to-date at a weighted-average cost of $0.27. The remaining number of shares authorized for repurchase under the plan as of December 31, 2016 is 11,068,120. Warrants to Purchase Preferred Stock and Common Stock As of December 31, 2016, warrants to purchase 37,988,030 shares of the Company's common stock at prices ranging from $0.10 to $0.50 were outstanding. All warrants are exercisable as of December 31, 2016 and expire at various dates through November 2020 and have a weighted average remaining term of approximately 2.75 years and are included in the table below as of December 31, 2016. During the fourth quarter of fiscal year ended December 31, 2015, the Company issued warrants through a Private Placement, to purchase 10,541,666 and 2,053,571 shares of its common stock, exercisable at $0.45 and $0.35 per share, respectively, and expire in October 2020 and October 2018, respectively. (See Note 5, above.) During the third quarter of fiscal year ended December 31, 2014, the Company issued warrants through a Private Placement, to purchase 20,445,650 and 1,357,143 shares of its common stock, exercisable at $0.23 and $0.35 per share, respectively and expire in August 2019. (See Note 5, above.) The following table summarizes warrant activity for the following periods: Advisory agreements PCG Advisory Group. On September 1, 2015, the Company entered into an agreement with PCG Advisory Group (“PCG”), pursuant to which PCG agreed to provide investor relations services for six (6) months in exchange for fees paid in cash of $6,000 per month and 100,000 shares of restricted common stock to be issued in accordance with the agreement upon successfully meeting certain criteria in accordance with the agreement. In connection with this agreement, the Company accrued for the estimated per share value on the agreement date at $0.32 per share, the price of Company’s common stock at September 1, 2015 for a total of $32,000 due to PCG. The fair values of the shares was recorded as prepaid advisory fees and were included in prepaid expenses and other current assets on the Company’s consolidated balance sheets and were amortized on a pro-rata basis over the term of the contract. On June 28, 2016 the Company issued PCG 100,000 restricted shares of our common stock in accordance with the performance of the agreement as previously accrued. These shares were valued at $0.30 per share, based on the price per share of the Company’s common stock on June 28, 2016. During the year ended December 31, 2016 and 2015 the Company recorded expense of approximately $9,000 and $21,000 respectively, in connection with amortization of the stock issuance. On March 1, 2016, the Company signed a renewal contract with PCG, pursuant to which PCG agreed to provide investor relations services for six (6) months in exchange for fees paid in cash of $6,000 per month and 100,000 shares of restricted common stock to be issued in accordance with the agreement upon successfully meeting certain criteria in accordance with the agreement. In connection with this agreement, the Company has accrued for the estimated per share value on the agreement date at $0.30 per share, the price of Company’s common stock at March 1, 2016 for a total of $30,000 due to PCG. The fair values of the shares was recorded as prepaid advisory fees and are included in prepaid expenses and other current assets on the Company’s consolidated balance sheets and will be amortized on a pro-rata basis over the term of the contract. During the year ended December 31, 2016, the Company recorded expense of approximately $30,000 in connection with amortization of the stock issuance. There were no amortization expenses for the year ended December 31, 2015. On September 1, 2016, the Company signed a renewal contract with PCG, pursuant to which PCG agreed to provide investor relations services for six (6) months in exchange for fees paid in cash of $6,000 per month and 100,000 shares of restricted common stock to be issued in accordance with the agreement upon successfully meeting certain criteria in accordance with the agreement. In connection with this agreement, the Company has accrued for the estimated per share value on the agreement date at $0.29 per share, the price of Company’s common stock at September 1, 2016 for a total of $29,000 due to PCG. The fair values of the shares was recorded as prepaid advisory fees and are included in prepaid expenses and other current assets on the Company’s consolidated balance sheets and will be amortized on a pro-rata basis over the term of the contract. During the year ended December 31, 2016, the Company recorded expense of approximately $19,000 in connection with amortization of the stock issuance. There were no amortization expenses for the year ended December 31, 2015. As of December 31, 2016, the total remaining balance of the prepaid investor relation services is approximately $10,000. Shares Issued in Private Placement On January 29, 2015, we completed our January 2015 Private Placement pursuant to which we entered into Notes Payable Agreements (see Note 5, above) and issued 2,450,000 shares of our common stock. The shares of common stock issued under the January 2015 Private Placement were offered and issued without registration under the Securities Act of 1933, as amended, (the “1933 Act”). The securities may not be sold, transferred or assigned in the absence of an effective registration statement for the securities under the 1933 Act, or an opinion of counsel, in form, substance and scope customary for opinions of counsel in comparable transaction, that registration in required under the 1933 Act or unless sold pursuant to Rule 144 under the 1933 Act. Stock Options On May 16, 2012, the Company established the 2012 Stock Option Plan (“Plan”) authorizing the granting of options for up to 40,000,000 shares of Common Stock. The purpose of the Plan is to promote the long-term growth and profitability of the Company by (i) providing key people and consultants with incentives to improve stockholder value and to contribute to the growth and financial success of the Company and (ii) enabling the Company to attract, retain and reward the best available persons for positions of substantial responsibility. The Plan permits the granting of stock options, including non-qualified stock options and incentive stock options qualifying under Section 422 of the Code, in any combination (collectively, “Options”). At December 31, 2016, the Company had 6,300,825 shares of Common Stock available for issuance under the Plan. A summary of the Plan Options for the year ended December 31, 2016 is presented in the following table: The weighted-average fair value per share of the granted options for the years ended December 31, 2016 and 2015 was approximately $0.15. The following table sets forth the exercise price range, number of shares, weighted-average exercise price and remaining contractual lives at December 31, 2016: Total stock based compensation expense included in the consolidated statements of operations was charged as follows in thousands: As of December 31, 2016, there was approximately $2,084,000 of total unrecognized compensation expense related to unvested share-based compensation arrangements granted under the Plan. The expense is expected to be recognized over a weighted-average period of 4.42 years. The Company uses the Black-Scholes option-pricing model (“Black-Scholes model”) to estimate the fair value of stock option grants. The use of a valuation model requires the Company to make certain assumptions with respect to selected model inputs. Expected volatility is calculated based on the historical volatility of the Company’s stock price over the expected term of the option. The expected life is based on the contractual life of the option and expected employee exercise and post-vesting employment termination behavior. The risk-free interest rate is based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life assumed at the date of the grant. The following were the factors used in the Black Scholes model to calculate the compensation cost: Approval of the Amendment of the Company’s 2012 Stock Option Plan On February 23, 2017, the Company’s board of directors received the approval of our stockholders, to amend the 2012 Stock Option Plan (“Plan”) to increase the number of shares of common stock available for grant and to expand the types of awards available for grant under the Plan. The amendment of the Plan increases the number of shares of the Company’s common stock that may be delivered pursuant to awards granted during the life of the plan from 40,000,000 to 80,000,000 shares authorized. The Plan currently provides only for the grant of options; however the Plan amendments will allow for the grant of: (i) incentive stock options; (ii) nonqualified stock options; (iii) stock appreciation rights; (iv) restricted stock; and (v) other stock-based and cash-based awards to eligible individuals. The terms of the awards will be set forth in an award agreement, consistent with the terms of the Plan. No stock option is exercisable later than ten years after the date it is granted. Note 9. Commitments and Contingencies Credit Risk The Company maintains cash balances at various financial institutions primarily located in California. Accounts at the U.S. institutions are secured, up to certain limits, by the Federal Deposit Insurance Corporation. At times, balances may exceed federally insured limits. The Company has not experienced any losses in such accounts. Management believes that the Company is not exposed to any significant credit risk with respect to its cash and cash equivalent balances. Litigation We are, from time to time, the subject of claims and suits arising out of matters occurring during the operation of our business. We are not presently party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors. Leases The Company leases its domestic and certain foreign facilities and other equipment under non-cancelable operating lease agreements, which expire at various dates through 2023. In addition to the minimum future lease commitments presented below, the leases generally require that the Company pay property taxes, insurance, maintenance and repair costs. Such expenses are not included in the operating lease amounts. At December 31, 2016, future minimum lease commitments are as follows (in thousands): Rent expense was $1,558,000 and $1,043,000 for the years ended December 31, 2016 and 2015, respectively. In connection with the Company's 2011 acquisition of FDI, it assumed mortgage guarantee obligations made by FDI on the building previously housing our New Hampshire office. The balance of the mortgages is approximately $1,806,000 as of December 31, 2016 (see Note 3, above). The Company purchases its inventory from multiple third-party suppliers at competitive prices. The Company made purchases from three vendors, which individually comprised more than 10% of total purchases and in aggregate approximated 54% and 61% of total purchases for the years ended December 31, 2016 and 2015, respectively. The Company has purchase obligations related to minimum future purchase commitments for green coffee to be used in the Company’s commercial coffee segment for roasting. Each individual contract requires the Company to purchase and take delivery of certain quantities at agreed upon prices and delivery dates. The contracts as of December 31, 2016, have minimum future purchase commitments of approximately $1,164,000, which are to be delivered in 2017. The contracts contain provisions whereby any delays in taking delivery of the purchased product will result in additional charges related to the extended warehousing of the coffee product. The fees can average approximately $0.01 per pound for every month of delay, to-date the Company has not incurred such fees. Note 10. Income Taxes The income tax provision contains the following components (in thousands): Income (loss) before income taxes relating to non-U.S. operations were $590,000 and $(62,000) in the years ended December 31, 2016 and 2015, respectively. The provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pretax income (loss) as a result of the following differences: Significant components of the Company's deferred tax assets and liabilities are as follows (in thousands): The Company has determined through consideration of all positive and negative evidence that the US federal deferred tax assets are more likely than not to be realized. The Company does not have a valuation allowance in the US Federal tax jurisdiction. A valuation allowance remains on certain state and foreign tax attributes that are likely to expire before realization. The valuation allowance increased approximately $183,000 for the year ended December 31, 2016 and increased approximately $161,000 for the year ended December 31, 2015. At December 31, 2016, the Company had approximately $4,611,000 in federal net operating loss carryforwards, which begin to expire in 2028, and approximately $24,761,000 in net operating loss carryforwards from various states. The Company had approximately $1,697,000 in net operating losses in foreign jurisdictions. Pursuant to Internal Revenue Code ("IRC") Section 382, use of net operating loss and credit carryforwards may be limited if the Company experienced a cumulative change in ownership of greater than 50% in a moving three-year period. Ownership changes could impact the Company's ability to utilize the net operating loss and credit carryforwards remaining at an ownership change date. The Company has not completed a Section 382 study. The Company has analyzed the impact of repatriating earnings from its foreign subsidiaries and has determined that the impact is immaterial. The Company does not assert indefinite reinvestment of earnings from its foreign subsidiaries. Therefore, a deferred tax liability has been recorded. As of December 31, 2016 the deferred tax liability net of tax deemed paid is approximately $310,000. The Company has accounted for uncertain tax position related to states. The Company accounts for interest expense and penalties related to income tax issues as income tax expense. Accordingly, interest expense and penalties associated with an uncertain tax position are included in the income tax provision. The total amount of accrued interest and penalties as of December 31, 2016 are approximately $1,000. Income tax expense as of December 31, 2016, included an increase in state income tax expense of approximately $4,000 related to uncertain tax positions. Note 11. Segment and Geographical Information The Company offers a wide variety of products to support a healthy lifestyle including; nutritional supplements, sports and energy drinks, health and wellness, weight loss, gourmet coffee, skincare and cosmetics, lifestyle services, digital products including scrap books and memory books, packaged foods, pharmacy discount cards, and clothing and jewelry lines. The Company’s business is classified by management into two reportable segments: direct selling and commercial coffee. The Company’s segments reflect the manner in which the business is managed and how the Company allocates resources and assesses performance. The Company’s chief operating decision maker is the Chief Executive Officer. The Company’s chief operating decision maker evaluates segment performance primarily based on revenue and segment operating income. The principal measures and factors the Company considered in determining the number of reportable segments were revenue, gross margin percentage, sales channel, customer type and competitive risks. In addition, each reporting segment has similar products and customers, similar methods of marketing and distribution and a similar regulatory environment. The accounting policies of the segments are consistent with those described in the summary of significant accounting policies. Segment revenue excludes intercompany revenue eliminated in the consolidation. The following tables present certain financial information for each segment (in thousands): Total tangible assets, net located outside the United States are approximately $5.4 million as of December 31, 2016. For the year ended December 31, 2015, total assets, net located outside the United States were approximately $5.2 million. The Company conducts its operations primarily in the United States. For the year ended December 31, 2016 approximately 9% of the Company’s sales were derived from sales outside the United States. As compared to approximately 7% for the year ended December 31, 2015. The following table displays revenues attributable to the geographic location of the customer (in thousands): Note 12. Subsequent Events None.
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Based on the provided text, which appears to be a partial financial statement excerpt, here's a summary:
Financial Statement Overview:
- Audited financial statements for Youngevity International, Inc. and Subsidiaries
- Covers financial position as of December 31st (year not fully specified)
Key Financial Highlights:
1. Accounting Approach:
- Audited in accordance with Public Company Accounting Oversight Board standards
- Uses estimates for various accounting areas like:
* Doubtful accounts
* Deferred taxes
* Derivative liabilities
* Stock-based compensation
* Business combination valuations
2. Liquidity Assessment:
- Management believes current cash balances, future operational cash flow, and accounts receivable factoring will cover operating and capital needs for at least 12 months
3. Financial Instruments:
- Mentions warrants valued at approximately $1,
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Claude
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Item 8 - MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of The Community Financial Corporation (the "Company") is responsible for the preparation, integrity and fair presentation of the financial statements included in this Annual Report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management's judgments and estimates concerning the effects of events and transactions that are accounted for or disclosed. Management is also responsible for establishing and maintaining effective internal control over financial reporting. The Company's internal control over financial reporting includes those policies and procedures that pertain to the Company's ability to record, process, summarize and report reliable financial data. The internal control system contains monitoring mechanisms, and appropriate actions taken to correct identified deficiencies. Management believes that internal controls over financial reporting, which are subject to scrutiny by management and the Company's internal auditors, support the integrity and reliability of the financial statements. Management recognizes that there are inherent limitations in the effectiveness of any internal control system, including the possibility of human error and the circumvention or overriding of internal controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. In addition, because of changes in conditions and circumstances, the effectiveness of internal control over financial reporting may vary over time The Audit Committee of the Board of Directors (the "Committee"), is comprised entirely of outside directors who are independent of management. The Committee is responsible for the appointment and compensation of the independent auditors and makes decisions regarding the appointment or removal of members of the internal audit function. The Committee meets periodically with management, the independent auditors, and the internal auditors to ensure that they are carrying out their responsibilities. The Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting, and auditing procedures of the Company in addition to reviewing the Company's financial reports. The independent auditors and the internal auditors have full and unlimited access to the Audit Committee, with or without the presence of management, to discuss the adequacy of internal control over financial reporting, and any other matters which they believe should be brought to the attention of the Audit Committee. Management assessed the Company's system of internal control over financial reporting as of December 31, 2016. This assessment was conducted based on the Committee of Sponsoring Organizations ("COSO") of the Treadway Commission "Internal Control - Integrated Framework (2013)." Based on this assessment, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2016. Management's assessment concluded that there were no material weaknesses within the Company's internal control structure. There were no changes in the Company's internal control over financial reporting (as defined in Rule 13a-15 under the Securities Act of 1934) during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. The 2016 financial statements have been audited by the independent registered public accounting firm of Dixon Hughes Goodman LLP (“DHG”). Personnel from DHG were given unrestricted access to all financial records and related data, including minutes of all meetings of the Board of Directors and committees thereof. Management believes that all representations made to all the independent auditors were valid and appropriate. The resulting report from DHG accompanies the financial statements. DHG has also issued a report on the effectiveness of internal control over financial reporting. This report has also been made a part of this Annual Report. /s/ William J. Pasenelli /s/ Todd L. Capitani William J. Pasenelli Todd L. Capitani President and Chief Executive Officer Executive Vice President and Chief Financial Officer March 13, 2017 March 13, 2017 ACCOUNTING FIRM Board of Directors and Stockholders The Community Financial Corporation We have audited the accompanying consolidated balance sheet of The Community Financial Corporation (the “Company”) as of December 31, 2016, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Community Financial Corporation as of December 31, 2016, and the results of its operations and its cash flows for the year then ended, in accordance with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), The Community Financial Corporation’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2017, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/ Dixon Hughes Goodman LLP Baltimore, Maryland March 13, 2017 Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders The Community Financial Corporation We have audited The Community Financial Corporation (the “Company”)’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. An entity's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, The Community Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of The Community Financial Corporation as of and for the year ended December 31, 2016 and our report dated March 13, 2017, expressed an unqualified opinion on those consolidated financial statements. /s/ Dixon Hughes Goodman LLP Baltimore, Maryland March 13, 2017 ACCOUNTING FIRM Board of Directors and Stockholders The Community Financial Corporation Waldorf, Maryland We have audited the accompanying consolidated balance sheets of The Community Financial Corporation (the “Company”) as of December 31, 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2015. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Community Financial Corporation and subsidiaries as of December 31, 2015 and the results of their operations and cash flows for each of the years in the two-year period ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America. /s/ Stegman & Company Baltimore, Maryland March 10, 2016 Suite 200, 809 Glen Eagles Court Baltimore, Maryland 21286 ● 410-823-8000 ● 1-800-686-3883 ● Fax: 410-296-4815 ● www.stegman.com Members of CONSOLIDATED BALANCE SHEETS See notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF INCOME See notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME See notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Years Ended December 31, 2016, 2015 and 2014 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Years Ended December 31, 2016, 2015 and 2014 (continued) CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Years Ended December 31, 2016, 2015 and 2014 (continued) See notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF CASH FLOWS CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) See notes to Consolidated Financial Statements NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The Consolidated Financial Statements include the accounts of The Community Financial Corporation and its wholly owned subsidiary Community Bank of the Chesapeake (the “Bank”), and the Bank’s wholly owned subsidiary Community Mortgage Corporation of Tri-County (collectively, the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and reporting policies of the Company conform with accounting principles generally accepted in the United States of America and to general practices within the banking industry. Reclassification Certain reclassifications have been made in the Consolidated Financial Statements for 2015 to conform to the classification presented in 2016. Nature of Operations The Company provides a variety of financial services to individuals and businesses through its offices in Southern Maryland and Annapolis, Maryland, and Fredericksburg, Virginia. Its primary deposit products are demand, savings and time deposits, and its primary lending products are commercial and residential mortgage loans, commercial loans, construction and land development loans, home equity and second mortgages and commercial equipment loans. The Bank conducts business through its main office in Waldorf, Maryland, and eleven branch offices in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick, Lusby, California, Maryland; and Fredericksburg, Virginia. The Company maintains five loan production offices (“LPOs”) in Annapolis, La Plata, Prince Frederick and Leonardtown, Maryland; and Fredericksburg, Virginia. The Leonardtown and Fredericksburg LPOs are co-located with branches. The Company’s second branch in Fredericksburg opened in April 2016. The Company sold its King George, Virginia branch building and equipment to a credit union. The Company’s 2015 third quarter operating results reflect the financial impact of the transaction. The Company recorded an impairment of $426,000 during the third quarter of 2015. The transaction closed on January 28, 2016. Use of Estimates In preparing Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of OREO and deferred tax assets. Significant Group Concentrations of Credit Risk Most of the Company’s activities are with customers located in the Fredericksburg area of Virginia and the Southern Maryland counties of Calvert, Charles and St. Mary’s. Notes 5 and 6 discuss the types of securities and loans held by the Company. The Company does not have significant concentration in any one customer or industry. Cash and Cash Equivalents For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments with original maturities of three months or less when purchased to be cash equivalents. Securities Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity (“HTM”) and recorded at amortized cost. Securities purchased and held principally for trading in the near term are classified as “trading securities” and are reported at fair value, with unrealized gains and losses included in earnings. The Company held no trading securities for the years ended December 31, 2016, 2015 and 2014. Securities not classified as held to maturity or trading securities, including equity securities with readily determinable fair values, are classified as available for sale (“AFS”) and recorded at estimated fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the estimated fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers: (1) the length of time and the extent to which the fair value has been less than cost; (2) the financial condition and near term prospects of the issuer; and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Investments in Federal Reserve Bank and Federal Home Loan Bank of Atlanta stocks are recorded at cost and are considered restricted as to marketability. The Bank is required to maintain investments in the Federal Home Loan Bank based upon levels of borrowings. During 2017, the Bank’s primary regulator became the Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve Bank stock was cancelled as it was no longer needed as a condition of membership (see Note 18 for further information). Debt securities are evaluated quarterly to determine whether a decline in their value is other-than-temporary impairment (“OTTI”). The term other-than-temporary is not necessarily intended to indicate a permanent decline in value. It means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Under accounting guidance, for recognition and presentation of other-than-temporary impairments the amount of other-than-temporary impairment that is recognized through earnings for debt securities is determined by comparing the present value of the expected cash flows to the amortized cost of the security. The discount rate used to determine the credit loss is the expected book yield on the security. The Company does not evaluate declines in the value of securities of Government Sponsored Enterprises (“GSEs”) or investments backed by the full faith and credit of the United States government (e.g. US Treasury Bills), for other-than-temporary impairment. Loans Held for Sale Residential mortgage loans intended for sale in the secondary market are carried at the lower of cost or estimated fair value, in the aggregate. Fair value is derived from secondary market quotations for similar instruments. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Residential mortgage loans held for sale are generally sold with the mortgage servicing rights retained by the Company. The carrying value of mortgage loans sold is reduced by the cost allocated to the associated servicing rights. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold, using the specific identification method. The Company exited the residential mortgage origination line of business in April 2015 for individual owner occupied residential first mortgages and established third party sources to supply its residential whole loan portfolio. The Company continues to underwrite loans for non-owner occupied residential rental properties. The Company may sell certain loans forward into the secondary market at a specified price with a specified date on a best efforts basis. These forward sales are derivative financial instruments. The Company does not recognize gains or losses due to interest rate changes for loans sold forward on a best efforts basis. The Bank had no loans held for sale at December 31, 2016 and 2015, respectively, and sold no loans for the year ended December 31, 2016. Loans Receivable The Company originates real estate mortgages, construction and land development loans, commercial loans and consumer loans. The Company purchases residential owner-occupied first mortgages from established third-parties. A substantial portion of the loan portfolio is comprised of loans throughout Southern Maryland and the Fredericksburg area of Virginia. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area. Loans that the Company has the intent and ability to hold for the foreseeable future, or until maturity or payoff, are reported at their outstanding unpaid principal balances, adjusted for the allowance for loan losses and any deferred fees or premiums. Interest income is accrued on the unpaid principal balance. Loan origination fees and premiums, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Loans are reviewed on a regular basis and are placed on non-accrual status when, in the opinion of management, the collection of additional interest is doubtful. The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Non-accrual loans include certain loans that are current with all loan payments and are placed on non-accrual status due to customer operating results and cash flows. Non-accrual loans are evaluated for impairment on a loan-by-loan basis in accordance with the Company’s impairment methodology. Interest is recognized on non-accrual loans on a cash-basis. Consumer loans are typically charged-off no later than 90 days past due. Mortgage and commercial loans are fully or partially charged-off when in management’s judgment all reasonable efforts to return a loan to performing status have occurred. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected from loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual status. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Allowance for Loan Losses and Impaired Loans The allowance for loan losses is established as probable losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the composition and size of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance for loan losses consists of a general and a specific component. The general component is based upon historical loss experience and a review of qualitative risk factors by portfolio segment (See Note 6 for a description of portfolio segments). The historical loss experience factor is tracked over various time horizons for each portfolio segment. The Company considers qualitative factors in addition to the loss experience factor. These include trends by portfolio segment in charge-offs, delinquencies, classified loans, loan concentrations and the rate of portfolio segment growth. Qualitative factors also include an assessment of the current regulatory environment, the quality of credit administration and loan portfolio management and national and local economic trends. The specific component of the allowance for loan losses relates to individual impaired loans with an identified impairment loss. The Company evaluates substandard and doubtful classified loans, loans delinquent 90 days or greater, non-accrual loans and troubled debt restructured loans (“TDRs”) to determine whether a loan is impaired. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration the circumstances surrounding the loan. These circumstances include the length of the delay, the reasons for the delay, the borrower’s payment record and the amount of the shortfall in relation to the principal and interest owed. Loans not impaired are included in the pool of loans evaluated in the general component of the allowance. If a specific loan is deemed to be impaired it is evaluated for impairment. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral, if the loan is collateral dependent. An allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than carrying value of the loan. The Company considers all TDRs to be impaired and defines TDRs as loans whose terms have been modified to provide for a reduction or a delay in the payment of either interest or principal because of deterioration in the financial condition of the borrower. A loan extended or renewed at a stated interest rate equal to the current interest rate for new debt with similar risk is not considered a TDR. Once an obligation has been classified as a TDR it continues to be considered a TDR until paid in full or until the debt is refinanced at market rates with no debt forgiveness. TDRs are evaluated for impairment on a loan-by-loan basis in accordance with the Company’s impairment methodology. The Company does not participate in any specific government or Company-sponsored loan modification programs. All restructured loan agreements are individual contracts negotiated with a borrower. Servicing Servicing assets are recognized as separate assets when rights are acquired through the purchase or sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, a portion of the cost of originating the loan is allocated to the servicing based on relative estimated fair value. Estimated fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the estimated fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income. Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal and recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Premises and Equipment Land is carried at cost. Premises, improvements and equipment are carried at cost, less accumulated depreciation and amortization, computed by the straight-line method over the estimated useful lives of the assets, which are as follows: Buildings and Improvements: 10 to 50 years Furniture and Equipment: three to 15 years Automobiles: four to five years Maintenance and repairs are charged to expense as incurred, while improvements that extend the useful life of premises and equipment are capitalized. Other Real Estate Owned (“OREO”) Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the estimated fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management, and the assets are carried at the lower of carrying amount or estimated fair value less the cost to sell. Based on updated valuations, the Bank has the ability to reverse a valuation allowance that was recorded subsequent to the initial carrying value up to the amount of the initial recorded carrying value (initial cost basis). Revenues and expenses from operations and changes in the valuation allowance are included in noninterest expense. Gains or losses on disposition are included in noninterest income Transfers of Financial Assets Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the Company; (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Advertising Costs The Company expenses advertising costs as incurred. Income Taxes The Company files a consolidated federal income tax return with its subsidiaries. Deferred tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws and when it is considered more likely than not that deferred tax assets will be realized. It is the Company’s policy to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. Off Balance Sheet Credit Related Financial Instruments In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under commercial lines of credit, letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded. Stock-Based Compensation The Company has stock-based incentive arrangements to attract and retain key personnel in order to promote the success of the business. In May 2015, the 2015 Equity Compensation Plan (the “2015 plan”) was approved by shareholders, which authorizes the issuance of restricted stock, stock appreciation rights, stock units and stock options to the Board of Directors and key employees. Compensation cost for all stock-based awards is measured at fair value on date of grant and recognized over the vesting period. Such value is recognized as expense over the service period, net of estimated forfeitures. The estimation of stock awards that ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical experience. The Company and the Bank currently maintain incentive compensation plans which provide for payments to be made in cash or other share-based compensation. The Company has accrued the full amounts due under these plans. Earnings Per Common Share (“EPS”) Basic earnings per common share represent income available to common stockholders, divided by the weighted average number of common shares outstanding during the period. Unencumbered shares held by the Employee Stock Ownership Plan (“ESOP”) are treated as outstanding in computing earnings per share. Shares issued to the ESOP but pledged as collateral for loans obtained to provide funds to acquire the shares are not treated as outstanding in computing earnings per share. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential dilutive common shares are determined using the treasury stock method and include incremental shares issuable upon the exercise of stock options and other share-based compensation awards. The Company excludes from the diluted EPS calculation anti-dilutive options, because the exercise price of the options were greater than the average market price of the common shares. Comprehensive Income Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as components of comprehensive income as a separate statement in the Consolidated Statements of Comprehensive Income. Additionally, the Company discloses accumulated other comprehensive income as a separate component in the equity section of the balance sheet. Recent Accounting Pronouncements Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”). ASU 2014-09 - Revenue from Contracts with Customers (Topic 606); ASU 2016-08 - Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net); ASU No. 2016-10 - Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. ASU 2014-09 states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This update affects entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards. ASU 2016-08 was issued to clarify certain principal versus agent considerations within the implementation guidance of ASC Topic 606. ASU 2016-10 was issued to clarify ASC Topic 606 related to (i) identifying performance obligations; and (ii) the licensing implementation guidance. The effective date for the ASUs is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted, but not before the original effective date of December 15, 2016. The Company is evaluating the impact of the updates on the consolidated financial statements and believes the adoption will not have a material impact on the consolidated financial statement. The Company’s income from transactions in the scope of the update is insignificant. ASU 2015-05 - Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The new guidance does not change the accounting for a customer’s accounting for service contracts. ASU No. 2015-05 is effective for interim and annual reporting periods beginning after December 15, 2015 and did not have a material impact on the Company’s consolidated financial statements. ASU 2015-16 - Business Combinations (Topic 805) - Simplifying the Accounting for Measurement-Period Adjustments. ASU 2015-16 requires that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period's financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the estimated amounts, calculated as if the accounting had been completed at the acquisition date. The amendments also require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. The amendments should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. ASU 2015-16 was effective January 1, 2016 and did not have an impact on the Company’s consolidated financial statements. ASU 2016-01 - Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-1, among other things, (i) requires equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (iii) eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet, (iv) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (v) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments, (vi) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (viii) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale. ASU 2016-1 will be effective on January 1, 2018 and the Company is evaluating its impact on the consolidated financial statements and will monitor developments and additional guidance. ASU 2016-02 - Leases (Topic 842). ASU 2016-02 requires lessees to recognize a lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2016-02 does not significantly change lease accounting requirements applicable to lessors; however, certain changes were made to align, where necessary, lessor accounting with the lessee accounting model and ASC Topic 606, “Revenue from Contracts with Customers.” ASU 2016-02 will be effective on January 1, 2019 and will require transition using a modified retrospective approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The Company is evaluating the potential impact of ASU 2016-02 on the consolidated financial statements. ASU 2016-05 - Derivatives and Hedging (Topic 815) Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships. ASU 2016-05 clarifies that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under ASC Topic 815 does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria continue to be met. ASU 2016-05 will be effective on January 1, 2017 and is not expected to have a significant impact on the consolidated financial statements. ASU 2016-09 - Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 is intended to simplify how share-based payments are accounted for and presented in the financial statements. The key provisions include: (i) a company will no longer record excess tax benefits and certain tax deficiencies in additional paid-in capital (“APIC”). Instead all excess tax benefits and tax deficiencies will be reported as income tax expense or benefit in the income statement, and APIC pools will be eliminated. The guidance also eliminates the requirement that excess tax benefits be realized before companies can recognize them. In addition, the guidance requires companies to present excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity; (ii) a company can increase the amount of withholding to cover income taxes on awards and still qualify for the exception to liability classification for shares used to satisfy the employer’s statutory income tax withholding obligation. The new guidance will also require an employer to classify the cash paid to a tax authority when shares are withheld to satisfy its statutory income tax withholding obligation as a financing activity on its statement of cash flows (current guidance did not specify how these cash flows should be classified); and (iii) a company can elect an accounting policy election for the impact of forfeitures on the recognition of expense for share-based payment awards. Forfeitures can be estimated, as required today, or recognized when they occur. ASU No. 2016-09 is effective for interim and annual reporting periods beginning after December 15, 2016. Early adoption is permitted, but all of the guidance must be adopted in the same period. The Company is evaluating the potential impact of ASU 2016-09 on the consolidated financial statements and believes the adoption of this update will result in a slight increase in volatility on income tax expense, depending on the amount and timing of share-based compensation award activity, such as the vesting of stock awards and the exercise of stock options. ASU 2016-13 - Measurement of Credit Losses on Financial Instruments. ASU No. 2016-13 significantly changes how entities will measure credit losses for most financial assets and certain other instruments that aren’t measured at fair value through net income. The standard will replace today’s “incurred loss” approach with an “expected loss” model. The new model, referred to as the current expected credit loss (“CECL”) model, will apply to: (1) financial assets subject to credit losses and measured at amortized cost, and (2) certain off-balance sheet credit exposures. This includes, but is not limited to, loans, leases, held-to-maturity securities, loan commitments, and financial guarantees. The CECL model does not apply to available-for-sale (“AFS”) debt securities. For AFS debt securities with unrealized losses, entities will measure credit losses in a manner similar to what they do today, except that the losses will be recognized as allowances rather than reductions in the amortized cost of the securities. As a result, entities will recognize improvements to estimated credit losses immediately in earnings rather than as interest income over time, as they do today. The ASU also simplifies the accounting model for purchased credit-impaired debt securities and loans. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the allowance for loan and lease losses. In addition, entities will need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. ASU No. 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019; early adoption is permitted for interim and annual reporting periods beginning after December 15, 2018. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (i.e., modified retrospective approach). The Company is currently evaluating the provisions of ASU No. 2016-13 to determine the potential impact the new standard will have on the Company's Consolidated Financial Statements. ASU 2016-15 - Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 is intended to reduce diversity in practice in how eight particular transactions are classified in the statement of cash flows. ASU 2016-15 is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted, provided that all of the amendments are adopted in the same period. Entities will be required to apply the guidance retrospectively. If it is impracticable to apply the guidance retrospectively for an issue, the amendments related to that issue would be applied prospectively. As this guidance only affects the classification within the statement of cash flows, ASU 2016-15 is not expected to have a material impact on the Company's Consolidated Financial Statements NOTE 2 - ACCUMULATED OTHER COMPREHENSIVE INCOME The following table presents the components of comprehensive (loss) income for the years ended December 31, 2016, 2015 and 2014. The Company’s comprehensive gains and losses were solely for securities for the years ended December 31, 2016, 2015 and 2014. Reclassification adjustments are recorded in non-interest income. The following table presents the changes in each component of accumulated other comprehensive (loss) income, net of tax, for the years ended December 31, 2016, 2015 and 2014. NOTE 3 - EARNINGS PER SHARE Basic earnings per common share represent income available to common shareholders, divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and are determined using the treasury stock method. As of December 31, 2016, 2015 and 2014, there were 15,081, 21,211 and 87,435 options, respectively, which were excluded from the calculation as their effect would be anti-dilutive, because the exercise price of the options were greater than the average market price of the common shares. The Company has not granted any stock options since 2007 and all options outstanding at December 31, 2016 were anti-dilutive. Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares outstanding as follows: NOTE 4 - RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANKS The Bank is required to maintain average balances on hand or with the Federal Reserve Bank. At December 31, 2016 and 2015, these reserve balances amounted to $1.1 million and $797,000, respectively. NOTE 5 - SECURITIES At December 31, 2016, certain asset-backed securities with an amortized cost of $21.5 million were pledged to secure certain deposits. At December 31, 2016, asset-backed securities with an amortized cost of $1.6 million were pledged as collateral for advances from the Federal Home Loan Bank (“FHLB”) of Atlanta. At December 31, 2016, 99% of the asset-backed securities and agency bond portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency. AFS asset-backed securities issued by GSEs and U.S. Agencies had an average life of 4.96 years and average duration of 4.43 years and are guaranteed by their issuer as to credit risk. HTM asset-backed securities issued by GSEs and U.S. Agencies had an average life of 5.30 years and average duration of 4.71 years and are guaranteed by their issuer as to credit risk At December 31, 2015, certain asset-backed securities with an amortized cost of $21.4 million were pledged to secure certain deposits. At December 31, 2015, asset-backed securities with an amortized cost of $1.9 million were pledged as collateral for advances from the Federal Home Loan Bank (“FHLB”) of Atlanta. At December 31, 2015, 99% of the asset-backed securities and agency bond portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency. AFS asset-backed securities issued by GSEs and U.S. Agencies had an average life of 4.39 years and average duration of 4.04 years and are guaranteed by their issuer as to credit risk. HTM asset-backed securities issued by GSEs and U.S. Agencies had an average life of 5.07 years and average duration of 4.58 years and are guaranteed by their issuer as to credit risk We believe that AFS securities with unrealized losses will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities to maturity. Because our intention is not to sell the investments and it is not more likely than not that we will be required to sell the investments, management considers the unrealized losses in the AFS portfolio to be temporary. We believe that the losses are the result of general perceptions of safety and creditworthiness of the entire sector and a general disruption of orderly markets in the asset class. Management has the ability and intent to hold the HTM securities with unrealized losses until they mature, at which time the Company will receive full value for the securities. Because our intention is not to sell the investments and it is not more likely than not that we will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, management considers the unrealized losses in the held-to-maturity portfolio to be temporary. No charges related to other-than-temporary impairment were made during for the years ended December 31, 2016, 2015 and 2014. During the year ended December 31, 2016 the Company recognized net gains on the sale of securities of $31,000. The Company sold five AFS securities with aggregate carrying values of $6.5 million and one HTM security with a carrying value of $698,000, recognizing gains of $23,000 and $8,000, respectively. During the year ended December 31, 2015, the Company recognized net gains on the sale of securities of $4,000, which consisted of the sale of one HTM security with a carrying value of $67,000 and the call of an AFS agency bond with a carrying value of $2.0 million. These sales resulted in a loss of $1,000 for the HTM security and a gain of $5,000 for the AFS security. During the year ended December 31, 2014, the Company recognized net gains on the sale of securities of $19,000. The Company sold five AFS securities with aggregate carrying values of $2.1 million and 12 HTM securities with aggregate carrying values of $4.2 million, recognizing gains of $8,000 and $11,000, respectively. The sale of HTM securities was permitted under ASC 320 “Investments - Debt and Equity Securities.” ASC 320 permits the sale of HTM securities for certain changes in circumstances. The Company will dispose of HTM securities using the safe harbor rule that allows for the sale of HTM securities that have principal payments paid down to less than 15% of original purchased par. ASC 320 10-25-15 indicates that a sale of a debt security after a substantial portion of the principal has been collected is equivalent to holding the security to maturity. In addition, the Company may dispose of HTM securities under ASC 320-10-25-6 due to a significant deterioration in the issues’ creditworthiness. AFS Securities Gross unrealized losses and estimated fair value by length of time that the individual AFS securities have been in a continuous unrealized loss position at December 31, 2016 were as follows: At December 31, 2016, the AFS investment portfolio had an estimated fair value of $53.0 million, of which $46.1 million of the securities had some unrealized losses from their amortized cost. AFS asset-backed securities issued by GSEs are guaranteed by the issuer and AFS U.S. government agency securities and bonds are guaranteed by the full faith and credit of the U.S. government. Total unrealized losses on the portfolio were $1.6 million of the portfolio amortized cost of $50.1 million. AFS asset-backed securities issued by GSEs and U.S. Agencies with unrealized losses had an average life of 4.91 years and an average duration of 4.37 years. Management believes that the securities will either recover in market value or be paid off as agreed. Gross unrealized losses and estimated fair value by length of time that the individual AFS securities have been in a continuous unrealized loss position at December 31, 2015 were as follows: At December 31, 2015, the AFS investment portfolio had an estimated fair value of $35.1 million, of which $22.0 million of the securities had some unrealized losses from their amortized cost. The securities with unrealized losses were CMOs issued by GSEs. AFS asset-backed securities issued by GSEs are guaranteed by the issuer and AFS U.S. government agency securities and bonds are guaranteed by the full faith and credit of the U.S. government. Total unrealized losses on the asset-backed securities issued by GSEs were $557,000 of the portfolio amortized cost of $31.2 million. AFS asset-backed securities issued by GSEs and U.S. Agencies with unrealized losses had an average life of 4.45 years and an average duration of 4.04 years. Management believes that the securities will either recover in market value or be paid off as agreed. HTM Securities Gross unrealized losses and estimated fair value by length of time that the individual HTM securities have been in a continuous unrealized loss position at December 31, 2016 were as follows: At December 31, 2016, the HTM investment portfolio had an estimated fair value of $108.0 million, of which $85.0 million of the securities had some unrealized losses from their amortized cost. Of these securities, $84.2 million were asset-backed securities issued by GSEs and U.S. Agencies. The remaining $803,000 were asset-backed securities issued by others. HTM asset-backed securities issued by GSEs are guaranteed by the issuer and HTM U.S. government agency securities and bonds are guaranteed by the full faith and credit of the U.S. government. Total unrealized losses on the portfolio were $1.6 million of the portfolio amortized cost of $108.4 million. The securities with unrealized losses had an average life of 5.06 years and an average duration of 4.49 years. Management believes that the securities will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities to maturity. HTM asset-backed securities issued by others are collateralized mortgage obligation securities. The securities have credit support tranches that absorb losses prior to the tranches that the Company owns. The Company reviews credit support positions on its securities regularly. Total unrealized losses on the asset-backed securities issued by others were $81,000 of the portfolio amortized cost of $884,000. HTM asset-backed securities issued by others with unrealized losses had an average life of 4.15 years and an average duration of 3.29 years. Gross unrealized losses and estimated fair value by length of time that the individual HTM securities have been in a continuous unrealized loss position at December 31, 2015 were as follows: At December 31, 2015, the HTM investment portfolio had an estimated fair value of $109.3 million, of which $53.8 million of the securities had some unrealized losses from their amortized cost. Of these securities, $52.8 million were asset-backed securities issued by GSEs and the remaining $993,000 were asset-backed securities issued by others. HTM securities issued by GSEs are guaranteed by the issuer and HTM U.S. government agency securities and bonds are guaranteed by the full faith and credit of the U.S. government. Total unrealized losses on the asset-backed securities issued by GSEs were $841,000 of the portfolio amortized cost of $107.6 million. HTM asset-backed securities issued by GSEs with unrealized losses had an average life of 5.42 years and an average duration of 4.78 years. Management believes that the securities will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities to maturity. HTM asset-backed securities issued by others are collateralized mortgage obligation securities. The securities have credit support tranches that absorb losses prior to the tranches that the Company owns. The Company reviews credit support positions on its securities regularly. Total unrealized losses on the asset-backed securities issued by others were $100,000 of the portfolio amortized cost of $1.1 million. HTM asset-backed securities issued by others with unrealized losses had an average life of 4.04 years and an average duration of 3.29 years. Maturities The amortized cost and estimated fair value of debt securities at December 31, 2016 and 2015 by contractual maturity, are shown below. The Company has allocated the asset-backed securities into the four maturity groups listed below using the expected average life of the individual securities based on statistics provided by industry sources. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties. Credit Quality of Asset-Backed Securities The tables below present the Standard & Poor’s (“S&P”) or equivalent credit rating from other major rating agencies for AFS and HTM asset-backed securities issued by GSEs and U.S. Agencies and others or bonds issued by GSEs or U.S. government agencies at December 31, 2016 and 2015 by carrying value. The Company considers noninvestment grade securities rated BB+ or lower as classified assets for regulatory and financial reporting. GSE asset-backed securities and GSE agency bonds with S&P AA+ ratings were treated as AAA based on regulatory guidance. NOTE 6 - LOANS Loans consist of the following: At December 31, 2016 and 2015, the Bank’s allowance for loan losses totaled $9.9 million and $8.5 million, or 0.91% and 0.93%, respectively, of loan balances. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience, current economic conditions, size, growth and composition of the loan portfolio, financial condition of the borrowers and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance. Deferred loan fees and premiums include net deferred fees paid by customers of $2.7 million and $2.6 million at December 31, 2016 and 2015, respectively. These were offset by net deferred premiums paid for the purchase of residential first mortgages and deferred costs of $3.1 million and $1.4 million, respectively, at December 31, 2016 and 2015, respectively. Prior to April 1, 2016, loans secured by residential rental property were included in the residential first mortgage and commercial real estate loan portfolios. Beginning in the second quarter of 2016, the Company segregated loans secured by residential rental property into a new loan portfolio segment. Residential rental property includes income producing properties comprising 1-4 family units and apartment buildings. The Company’s decision to segregate the residential rental property portfolio for financial reporting was based on the growth and size of the portfolio and risk characteristics unique to residential rental properties. Comparative financial information was reclassified to conform to the classification presented in 2016. Risk Characteristics of Portfolio Segments The Company manages its credit products and exposure to credit losses (credit risk) by the following specific portfolio segments (classes), which are levels at which the Company develops and documents its allowance for loan loss methodology. These segments are: Commercial Real Estate (“CRE”) Commercial and other real estate projects include office buildings, retail locations, churches, other special purpose buildings and commercial construction. Commercial construction balances were 9.3% and 6.1% of the CRE portfolio at December 31, 2016 and 2015, respectively. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. The primary security on a commercial real estate loan is the real property and the leases that produce income for the real property. Loans secured by commercial real estate are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years. Loans secured by commercial real estate are larger and involve greater risks than one-to four-family residential mortgage loans. Because payments on loans secured by such properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to a greater extent to adverse conditions in the real estate market or the economy. Residential First Mortgages Residential first mortgage loans are generally long-term loans, amortized on a monthly basis, with principal and interest due each month. The contractual loan payment period for residential loans typically ranges from ten to 30 years. The Bank’s experience indicates that real estate loans remain outstanding for significantly shorter time periods than their contractual terms. Borrowers may refinance or prepay loans at their option, without penalty. The Bank’s residential portfolio has both fixed-rate and adjustable-rate residential first mortgages. During the years ended December 31, 2016 and 2015, the Bank purchased residential first mortgages of $64.2 million and $3.0 million, respectively. The annual and lifetime limitations on interest rate adjustments may limit the increases in interest rates on these loans. There are also credit risks resulting from potential increased costs to the borrower as a result of repricing of adjustable-rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. The Bank’s adjustable rate residential first mortgage portfolio was $45.6 million or 4.2% of total gross loans of $1.1 billion at December 31, 2016 compared to $18.9 million or 2.1% of gross loans of $918.9 million at December 31, 2015. Residential Rentals Residential rental mortgage loans are amortizing, with principal and interest due each month. The loans are secured by income-producing 1-4 family units and apartments. As of December 31, 2016 and 2015, $84.9 million and $80.8 million, respectively, were 1-4 family units and $17.0 million and $12.4 million, respectively, were apartment buildings. Loans secured by residential rental properties are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years. The primary security on a residential rental loan is the property and the leases that produce income. Loans secured by residential rental properties involve greater risks than 1-4 family residential mortgage loans. Although, there are similar risk characteristics shared with commercial real estate loans, the balances for the loans secured by residential rental properties are generally smaller. Because payments on loans secured residential rental properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to a greater extent to adverse conditions in the rental real estate market or the economy than similar owner occupied properties. Construction and Land Development The Bank offers loans for the construction of one-to-four family dwellings. Generally, these loans are secured by the real estate under construction as well as by guarantees of the principals involved. In addition, the Bank offers loans to acquire and develop land, as well as loans on undeveloped, subdivided lots for home building. A decline in demand for new housing might adversely affect the ability of borrowers to repay these loans. Construction and land development loans are inherently riskier than providing financing on owner-occupied real estate. The Bank’s risk of loss is affected by the accuracy of the initial estimate of the market value of the completed project as well as the accuracy of the cost estimates made to complete the project. In addition, the volatility of the real estate market has made it increasingly difficult to ensure that the valuation of land associated with these loans is accurate. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, a project’s value might be insufficient to assure full repayment. As a result of these factors, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank forecloses on a project, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs. Home Equity and Second Mortgage Loans The Bank maintains a portfolio of home equity and second mortgage loans. These products contain a higher risk of default than residential first mortgages as in the event of foreclosure, the first mortgage would need to be paid off prior to collection of the second mortgage. This risk has been heightened as the market value of residential property has declined. Commercial Loans The Bank offers commercial loans to its business customers. The Bank offers a variety of commercial loan products including term loans and lines of credit. Such loans are generally made for terms of five years or less. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. When making commercial business loans, the Bank considers the financial condition of the borrower, the borrower’s payment history of both corporate and personal debt, the projected cash flows of the business, the viability of the industry in which the consumer operates, the value of the collateral, and the borrower’s ability to service the debt from income. These loans are primarily secured by equipment, real property, accounts receivable, or other security as determined by the Bank. Commercial loans are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. Consumer Loans Consumer loans consist of loans secured by automobiles, boats, recreational vehicles and trucks. The Bank also makes home improvement loans and offers both secured and unsecured personal lines of credit. Consumer loans entail greater risk from other loan types due to being secured by rapidly depreciating assets or the reliance on the borrower’s continuing financial stability. Commercial Equipment Loans These loans consist primarily of fixed-rate, short-term loans collateralized by a commercial customer’s equipment. When making commercial equipment loans, the Bank considers the same factors it considers when underwriting a commercial business loan. Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. In the case of business failure, collateral would need to be liquidated to provide repayment for the loan. In many cases, the highly specialized nature of collateral equipment would make full recovery from the sale of collateral problematic. Non-accrual and Past Due Loans Non-accrual loans as of December 31, 2016 and December 31, 2015 were as follows: Non-accrual loans (90 days or greater delinquent and non-accrual only loans) decreased $3.0 million from $11.4 million or 1.24% of total loans at December 31, 2015 to $8.4 million or 0.77% of total loans at December 31, 2016. Non-accrual only loans are loans classified as non-accrual due to customer operating results or payment history. In accordance with the Company’s policy, interest income is recognized on a cash basis for these loans. Non-accrual loans at December 31, 2016 included $6.4 million, or 77% of non-accrual loans, attributed to 15 loans representing six customer relationships classified as substandard. Non-accrual loans at December 31, 2015 included $8.1 million, or 71% of non-accrual loans, attributed to 19 loans representing six customer relationships classified as substandard. Non-accrual loans included six troubled debt restructures (“TDRs”) totaling $4.7 million at December 31, 2016 and seven TDRs totaling $5.4 million at December 31, 2015. These loans are classified solely as non-accrual loans for the calculation of financial ratios. Non-accrual loans on which the recognition of interest has been discontinued, which did not have a specific allowance for impairment, amounted to $7.8 million and $10.5 million at December 31, 2016 and 2015, respectively. Interest due but not recognized on these balances at December 31, 2016 and 2015 was $947,000 and $953,000, respectively. Non-accrual loans with a specific allowance for impairment on which the recognition of interest has been discontinued amounted to $575,000 and $902,000 at December 31, 2016 and 2015, respectively. Interest due but not recognized on these balances at December 31, 2016 and 2015 was $156,000 and $34,000, respectively. An analysis of past due loans as of December 31, 2016 and 2015 was as follows: There were no loans greater than 90 days still accruing interest at December 31, 2016 and 2015, respectively. Impaired Loans and Troubled Debt Restructures (“TDRs”) Impaired loans, including TDRs, at December 31, 2016 and 2015 were as follows: TDRs, included in the impaired loan schedules above, as of December 31, 2016 and 2015 were as follows: TDRs decreased $3.4 million from $18.6 million at December 31, 2015 to $15.1 million at December 31, 2016. TDRs that are included in non-accrual are classified solely as non-accrual loans for the calculation of financial ratios. The Company had specific reserves of $844,000 on nine TDRs totaling $5.7 million at December 31, 2016 and $1.3 million on nine TDRs totaling $3.6 million at December 31, 2015. Interest income in the amount of $357,000 and $508,000 was recognized on outstanding TDR loans for the years ended December 31, 2016 and 2015, respectively. During the years ended December 31, 2016 and 2015 the Company added one TDR loan totaling $196,000 million and 10 TDR loans totaling $3.2 million, respectively. TDR disposals, which included payoffs and refinancing for the years ended December 31, 2016 and 2015 decreased by nine loans or $2.1 million and four loans or $2.1 million, respectively. TDR loan principal curtailment was $1.6 million and $677,000 for the years ended December 31, 2016 and 2015, respectively. Allowance for Loan Losses The following tables detail activity in the allowance for loan losses at and for the years ended December 31, 2016, 2015 and 2014, respectively. An allocation of the allowance to one category of loans does not prevent the Company from using that allowance to absorb losses in a different category. The following tables detail loan receivable and allowance balances disaggregated on the basis of the Company’s impairment methodology at December 31, 2016 and 2015, respectively. During the fourth quarter of 2016, the Company expanded its factor scoring categories from three levels to five levels to capture additional movements in qualitative factors used to calculate the general allowance of each portfolio segment. No additional qualitative factors were added to the Company’s methodology as part of this change. There were no material changes to the existing allowance for loan losses by portfolio segment or in the aggregate as a result of the change. Credit Quality Indicators Credit quality indicators as of December 31, 2016 and 2015 were as follows: Credit Risk Profile by Internally Assigned Grade Credit Risk Profile Based on Payment Activity A risk grading scale is used to assign grades to commercial relationships, which include commercial real estate, residential rentals, construction and land development, commercial loans and commercial equipment loans. Loans are graded at inception, annually thereafter when financial statements are received and at other times when there is an indication that a credit may have weakened or improved. Only commercial loan relationships with an aggregate exposure to the Bank of $750,000 or greater are subject to being risk rated. Home equity and second mortgages and consumer loans are evaluated for creditworthiness in underwriting and are monitored based on borrower payment history. Residential first mortgages are evaluated for creditworthiness during credit due diligence before being purchased. Residential first mortgages, home equity and second mortgages and consumer loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or are troubled debt restructures or nonperforming loans with an Other Assets Especially Mentioned (“OAEM”) or higher risk rating due to a delinquent payment history. Management regularly reviews credit quality indicators as part of its individual loan reviews and on a monthly and quarterly basis. The overall quality of the Bank’s loan portfolio is assessed using the Bank’s risk grading scale, the level and trends of net charge-offs, nonperforming loans and delinquencies, the performance of troubled debt restructured loans and the general economic conditions in the Company’s geographical market. This review process is assisted by frequent internal reporting of loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Credit quality indicators and allowance factors are adjusted based on management’s judgment during the monthly and quarterly review process. Loans subject to risk ratings are graded on a scale of one to ten. The Company considers loans classified substandard, doubtful and loss as classified assets for regulatory and financial reporting. Ratings 1 thru 6 - Pass Ratings 1 thru 6 have asset risks ranging from excellent low risk to adequate. The specific rating assigned considers customer history of earnings, cash flows, liquidity, leverage, capitalization, consistency of debt service coverage, the nature and extent of customer relationship and other relevant specific business factors such as the stability of the industry or market area, changes to management, litigation or unexpected events that could have an impact on risks. Rating 7 - OAEM (Other Assets Especially Mentioned) - Special Mention These credits, while protected by the financial strength of the borrowers, guarantors or collateral, have reduced quality due to economic conditions, less than adequate earnings performance or other factors which require the lending officer to direct more than normal attention to the credit. Financing alternatives may be limited and/or command higher risk interest rates. OAEM loans are the first adversely classified assets on our watch list. These relationships will be reviewed at least quarterly. Rating 8 - Substandard Substandard assets are assets that are inadequately protected by the sound worth or paying capacity of the borrower or of the collateral pledged. These assets have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. The loans may have a delinquent history or combination of weak collateral, weak guarantor strength or operating losses. When a loan is assigned to this category the Bank may estimate a specific reserve in the loan loss allowance analysis. These assets listed may include assets with histories of repossessions or some that are non-performing bankruptcies. These relationships will be reviewed at least quarterly. Rating 9 - Doubtful Doubtful assets have many of the same characteristics of Substandard with the exception that the Bank has determined that loss is not only possible but is probable and the risk is close to certain that loss will occur. When a loan is assigned to this category the Bank will identify the probable loss and the loan will receive a specific reserve in the loan loss allowance analysis. These relationships will be reviewed at least quarterly. Rating 10 - Loss Once an asset is identified as a definite loss to the Bank, it will receive the classification of “loss”. There may be some future potential recovery; however it is more practical to write off the loan at the time of classification. Losses will be taken in the period in which they are determined to be uncollectable. Maturity of Loan Portfolio The following table sets forth certain information at December 31, 2016 and 2015 regarding the dollar amount of loans maturing in the Bank’s portfolio based on their contractual terms to maturity. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. The following table sets forth the dollar amount of all loans due after one year from December 31, 2016 and 2015, which have predetermined interest rates and have floating or adjustable interest rates. Related Party Loans Included in loans receivable were loans made to executive officers and directors of the Bank. These loans were made in the ordinary course of business at substantially the same terms and conditions as those prevailing at the time for comparable transactions with persons not affiliated with the Bank and are not considered to involve more than the normal risk of collectability. For the years ended December 31, 2016, 2015 and 2014, all loans to directors and executive officers of the Bank performed according to original loan terms. Activity in loans outstanding to executive officers and directors are summarized as follows: NOTE 7 - LOAN SERVICING Loans serviced for others are not reflected in the accompanying balance sheets. The unpaid principal balances of mortgages serviced for others were $52.0 million and $63.0 million at December 31, 2016 and 2015, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and foreclosure processing. Loan servicing income is recorded on an accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees. The following table presents the activity of the mortgage servicing rights. NOTE 8 - OTHER REAL ESTATE OWNED (“OREO”) OREO assets are presented net of the allowance for losses. The Company considers OREO as classified assets for regulatory and financial reporting. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs. An analysis of the activity follows. The Company recognized net losses on OREO disposals of $436,000 for the year ended December 31, 2016. Disposals consisted of properties with the following carrying values; $337,000 for seven residential lots, $584,000 for four residential properties, $501,000 for two commercial properties, $138,000 for a commercial lot and $2.2 million for an apartment and condominium property. The Bank provided financing for the apartment and condominium purchase and the transaction qualified for full accrual sales treatment under ASC Topic 360-20-40 “Property Plant and Equipment - Derecognition”. In addition, the Company transferred one commercial condominium with a carrying value of $372,000 into premises for commercial lending office space. During the year ended December 31, 2015, the Bank recognized $20,000 in losses on the sale of OREO which consisted of the sale of eight properties for net proceeds of $1.2 million. During the year ended December 31, 2014, the Bank recognized $322,000 in gains on the sale of OREO which consisted of the sale of eight properties for net proceeds of $3.7 million, which included the financing of $1.0 million dollars on a residential subdivision that was transferred from OREO to loans during the fourth quarter of 2014. The contracted sales price of $1.4 million on the residential subdivision qualified for full accrual sales treatment under ASC Topic 360-20-40 “Property Plant and Equipment - Derecognition”. The Company had $353,000 and $826,000 of impaired loans secured by residential real estate for which formal foreclosure proceedings were in process as of December 31, 2016 and 2015, respectively. Additions to the valuation allowances of $574,000, $664,000 and $234,000 were taken to adjust properties to current appraised values for the years ended December 31, 2016, 2015 and 2014, respectively. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs. Expenses applicable to OREO assets include the following. NOTE 9 - PREMISES AND EQUIPMENT AND HELD FOR SALE PREMISES AND EQUIPMENT A summary of the cost and accumulated depreciation of premises and equipment at December 31, 2016 and 2015 follows: Certain Bank facilities are leased under various operating leases. Rent expense was $723,000, $701,000 and $647,000 for the years ended December 31, 2016, 2015 and 2014, respectively. Future minimum rental commitments under non-cancellable operating leases are as follows at December 31, 2016: During the year ended December 31, 2015, the Company agreed to sell its King George, Virginia branch building and equipment to a credit union. The required conditions were met during the third quarter of 2015 to classify the asset as held for sale (“HFS”) under FASB 360-10-45-9 which addresses accounting and reporting for long-lived assets to be disposed of by sale. FASB ASC 360-10-35-43 states that a long-lived asset classified as HFS should be measured at the lower of carrying amount or fair value less cost to sell. Based on the contracted sales price, the Company recorded an impairment of $426,000 during the third quarter of 2015. The transaction closed on January 28, 2016. As of December 31, 2016, the Company had a small office condo held for sale with a fair value of $345,000. NOTE 10 - DEPOSITS Deposits consist of the following: As of December 31, 2016 and 2015, there were $6.2 million and $5.6 million, respectively in deposit accounts held by executive officers and directors of the Bank and Company. The aggregate amount of certificates of deposit in denominations of $100,000 or more at December 31, 2016 and 2015 was $287.6 million and $222.3 million, respectively. The aggregate amount of certificates of deposit in denominations of $250,000 or more at December 31, 2016, and 2015 was $153.9 million and $98.6 million, respectively. At December 31, 2016 and 2015, the scheduled contractual maturities of certificates of deposit are as follows: NOTE 11 - SHORT-TERM BORROWINGS AND LONG-TERM DEBT The Bank’s long-term debt and short-term borrowings consist of advances from the FHLB of Atlanta. The Bank classifies debt based upon original maturity and does not reclassify debt to short-term status during its life. Long-term debt and short-term borrowings include fixed-rate long-term advances, short-term advances, daily advances, fixed-rate convertible advances, and variable-rate convertible advances. Rates and maturities on long-term advances and short-term borrowings were as follows: Average rates of long-term debt and short-term borrowings were as follows: The Bank’s fixed-rate debt generally consists of advances with monthly interest payments and principal due at maturity. The Bank’s fixed-rate convertible long-term debt is callable by the issuer, after an initial period ranging from six months to five years. The instruments are callable at the end of the initial period. As of December 31, 2016 and 2015, all fixed-rate convertible debt has passed its call date. All advances have a prepayment penalty, determined based upon prevailing interest rates. Variable convertible advances have an initial variable rate based on a discount to LIBOR. Variable convertible debt is scheduled to mature in 2020. As of December 31, 2016 and 2015, all variable convertible debt has passed its call date and is fixed at 4.0%. During the year ended December 31, 2016, the Bank paid off $5.0 million of maturing long-term debt and added one $15.0 million fixed-rate advances maturing in 2018 at 0.95%. During the year ended December 31, 2015, the Bank paid off $19.0 million of maturing long-term debt. There were no long-term advances added during the year ended December 31, 2015. At December 31, 2016 and 2015, $65.6 million or 100% and $55.6 million or 100%, respectively, of the Bank’s long-term debt was fixed for rate and term, as the conversion optionality of the advances have either been exercised or expired. The contractual maturities of long-term debt were as follows at December 31, 2016 and 2015: The Bank also has daily advances outstanding and short-term advances with terms of less than one year, which are classified as short-term borrowings. Daily advances are repayable at the Bank’s option at any time and are re-priced daily. Daily advances were $19.0 million and $7.0 million at December 31, 2016 and 2015, respectively. The Bank had short-term advances of $60.0 million and $29.0 million, respectively, at December 31, 2016 and 2015. Under the terms of an Agreement for Advances and Security Agreement with Blanket Floating Lien (the “Agreement”), the Bank maintains collateral with the FHLB consisting of one-to four-family residential first mortgage loans, second mortgage loans, commercial real estate and securities. The Agreement limits total advances to 30% of assets, which were $399.6 million and $332.8 million at December 31, 2016 and 2015, respectively. At December 31, 2016, $521.3 million of loans and securities were pledged or in safekeeping at the FHLB. Loans and securities are subject to collateral eligibility rules and are adjusted for market value and collateral value factors to arrive at lendable collateral values. At December 31, 2016, FHLB lendable collateral was valued at $405.7 million. At December 31, 2016, the Bank had total lendable pledged collateral at the FHLB of $275.1 million of which $130.6 million was available to borrow in addition to outstanding advances of $144.6 million. Unpledged lendable collateral was $130.5 million, bringing total available borrowing capacity to $261.1 million at December 31, 2016. At December 31, 2015, $365.4 million of loans and securities were pledged or in safekeeping at the FHLB. Loans and securities are subject to collateral eligibility rules and are adjusted for market value and collateral value factors to arrive at lendable collateral values. At December 31, 2015, FHLB lendable collateral was valued at $277.2 million. At December 31, 2015, the Bank had total lendable pledged collateral at the FHLB of $165.8 million of which $74.2 million was available to borrow in addition to outstanding advances of $91.6 million. Unpledged lendable collateral was $111.4 million, bringing total available borrowing capacity to $185.6 million at December 31, 2015. Additionally, the Bank has established a short-term credit facility with the Federal Reserve Bank of Richmond under its Borrower in Custody program. The Bank had segregated collateral sufficient to draw $8.6 million and $7.2 million under this agreement at December 31, 2016 and 2015, respectively. In addition, the Bank has established short-term credit facilities with other commercial banks totaling $12.0 million at December 31, 2016 and 2015. No amounts were outstanding under the Borrower in Custody or commercial lines at December 31, 2016 and 2015. NOTE 12 - INCOME TAXES Allocation of federal and state income taxes between current and deferred portions is as follows: The reasons for the differences between the statutory federal income tax rate and the effective tax rates are summarized as follows: The net deferred tax assets in the accompanying balance sheets include the following components: Retained earnings at December 31, 2016 and 2015 included approximately $1.2 million of bad debt deductions allowed for federal income tax purposes (the “base year tax reserve”) for which no deferred income tax has been recognized. If, in the future, this portion of retained earnings is used for any purpose other than to absorb bad debt losses, it would create income for tax purposes only and income taxes would be imposed at the then prevailing rates. The unrecorded income tax liability on the above amount was approximately $463,000 at December 31, 2016 and 2015. The Company does not have uncertain tax positions that are deemed material and did not recognize any adjustments for unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on income taxes as a component of tax expense. The Company is no longer subject to U.S. Federal tax examinations by tax authorities for years before 2013. NOTE 13 - COMMITMENTS AND CONTINGENCIES The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are commitments to extend credit. These instruments may, but do not necessarily, involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheets. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet loans receivable. As of December 31, 2016 and 2015, the Bank had outstanding loan commitments of approximately $67.0 million and $73.5 million, respectively. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These guarantees are issued primarily to support construction borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds cash or a secured interest in real estate as collateral to support those commitments for which collateral is deemed necessary. Standby letters of credit outstanding amounted to $17.7 million and $21.4 million at December 31, 2016 and 2015, respectively. In addition to the commitments noted above, customers had approximately $135.3 million and $128.8 million available under lines of credit at December 31, 2016 and 2015, respectively. NOTE 14 - STOCK-BASED COMPENSATION The Company has stock-based incentive arrangements to attract and retain key personnel. In May 2015, the 2015 Equity Compensation Plan (the “2015 plan”) was approved by shareholders, which authorizes the issuance of restricted stock, stock appreciation rights, stock units and stock options to the Board of Directors and key employees. Compensation expense for service-based awards is recognized over the vesting period. Performance-based awards are recognized based on a vesting schedule and the probability of achieving goals specified at the time of the grant. The 2015 plan replaced the 2005 Equity Compensation Plan. Stock-based compensation expense totaled $489,000, $319,000 and $182,000 for the years ended December 31, 2016, 2015 and 2014, respectively, which consisted of grants of restricted stock and restricted stock units. All outstanding options are fully vested and the Company has not granted any stock options since 2007. All outstanding options as of December 31, 2016 expire on July 17, 2017. The fair value of the Company’s outstanding employee stock options is estimated on the date of grant using the Black-Scholes option pricing model. The Company estimates expected market price volatility and expected term of the options based on historical data and other factors. The exercise price for options granted is set at the discretion of the committee administering the Plan, but is not less than the market value of the shares as of the date of grant. An option’s maximum term is 10 years and the options vest at the discretion of the committee. The following tables below summarize outstanding and exercisable options at December 31, 2016 and 2015. Options outstanding are all currently exercisable and are summarized as follows: The aggregate intrinsic value of outstanding stock options and exercisable stock options was $20,000 and $0, respectively, at December 31, 2016 and 2015. Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the period, which was $29.00 and $20.96 per share at December 31, 2016 and 2015, respectively, and the exercise price multiplied by the number of options outstanding. As of December 31, 2015, all options outstanding were anti-dilutive. The Company has outstanding restricted stock in accordance with the Plan. As of December 31, 2016 and 2015, unrecognized stock compensation expense was $810,000 and $735,000, respectively. The following tables summarize the unvested restricted stock awards outstanding at December 31, 2016 and 2015, respectively. NOTE 15 - EMPLOYEE BENEFIT PLANS The Company has an Employee Stock Ownership Plan (“ESOP”) that covers substantially all its employees. Employees qualify to participate after one year of service and vest in allocated shares after three years of service. The ESOP acquires stock of The Community Financial Corporation by purchasing shares. Dividends on ESOP shares are recorded as a reduction of retained earnings. Contributions are made at the discretion of the Board of Directors. ESOP contributions recognized for the years ended 2016, 2015 and 2014 totaled $99,000, $129,000 and $141,000, respectively. As of December 31, 2016 and 2015, the ESOP held 221,106 and 215,419 allocated shares and 9,562 and 18,444 unallocated shares. The approximate market values of the shares were $6.7 million and $4.9 million, respectively as of December 31, 2016 and 2015. The estimated value was determined using the Company’s closing stock price of $29.00 and $20.96 per share as of December 31, 2016 and 2015, respectively. The ESOP has promissory notes with the Company of $169,000 and $316,000 at December 31, 2016 and 2015, respectively. The promissory notes were originated for the purchase of TCFC common stock for the benefit of the participants in the Plan. Loan terms are at prime rate plus one-percentage point and amortize over seven (7) years. As principal is repaid, common shares are allocated to participants based on the participant account allocation rules described in the Plan. The Bank is a guarantor of the ESOP debt with the Company. The Company also has a 401(k) plan. The Company matches a portion of the employee contributions. This ratio is determined annually by the Board of Directors. In 2016, 2015 and 2014, the Company matched one-half of the first 8% of the employee’s contribution. Employees who have completed six months of service are covered under this defined contribution plan. Employee’s vest in the Company’s matching contributions after three years of service. Contributions are determined at the discretion of the Board of Directors. For the years ended December 31, 2016, 2015 and 2014, the expense recorded for this plan totaled $346,000, $332,000 and $324,000, respectively. The Company has a separate nonqualified retirement plan for non-employee directors. Directors are eligible for a maximum benefit of $3,500 a year for ten years following retirement from the Board of Community Bank of the Chesapeake. The maximum benefit is earned at 15 years of service as a non-employee director. Full vesting occurs after two years of service. Expense recorded for this plan was $20,000, $22,000 and $21,000 for the years ended December 31, 2016, 2015 and 2014, respectively. In addition, the Company has established individual supplemental retirement plans and life insurance benefits for certain key executives and officers of the Bank. The retirement plans provide retirement income payments for 15 years from the date of the employee’s expected retirement at age 65. The retirement benefit amount for each agreement is set at the discretion of the Board of Directors and vests from the date of the agreement until the expected retirement date. Expense recorded for the plans totaled $525,000, $519,000 and $441,000 for 2016, 2015 and 2014, respectively. NOTE 16 - GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES (“TRUPs”) On June 15, 2005, Tri-County Capital Trust II (“Capital Trust II”), a Delaware business trust formed, funded and wholly owned by the Company, issued $5.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 1.70%. The Trust used the proceeds from this issuance, along with the $155,000 for Capital Trust II’s common securities, to purchase $5.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust II and the junior subordinated debentures are scheduled to mature on June 15, 2035, unless called by the Company. On July 22, 2004, Tri-County Capital Trust I (“Capital Trust I”), a Delaware business trust formed, funded and wholly owned by the Company, issued $7.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance, along with the Company’s $217,000 capital contribution for Capital Trust I’s common securities, to purchase $7.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These debentures qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company. NOTE 17 - SUBORDINATED NOTES On February 6, 2015 the Company issued $23.0 million of unsecured 6.25% fixed to floating rate subordinated notes due February 15, 2025 (“subordinated notes”). On February 13, 2015, the Company used proceeds of the offering to redeem all $20 million of the Company’s outstanding preferred stock issued under the Small Business Lending Fund (“SBLF”) program. The subordinated notes qualify as Tier 2 regulatory capital and replaced SBLF Tier 1 capital. The subordinated notes are not listed on any securities exchange or included in any automated dealer quotation system and there is no market for the notes. The notes are unsecured obligations and are subordinated in right of payment to all existing and future senior debt, whether secured or unsecured. The notes are not guaranteed obligations of any of the Company’s subsidiaries. Interest will accrue at a fixed per annum rate of 6.25% from and including the issue date to but excluding February 15, 2020. From and including February 15, 2020 to but excluding the maturity date interest will accrue at a floating rate equal to the three-month LIBOR plus 479 basis points. Interest is payable on the notes on February 15 and August 15 of each year, commencing August 15, 2015, through February 15, 2020, and thereafter February 15, May 15, August 15 and November 15 of each year through the maturity date or earlier redemption date. The subordinated notes may be redeemed in whole or in part on February 15, 2020 or on any scheduled interest payment date thereafter and upon the occurrence of certain special events. The redemption price is equal to 100% of the principal amount of the subordinated notes to be redeemed plus accrued and unpaid interest to the date of redemption. Any partial redemption will be made pro rata among all holders of the subordinated notes. The subordinated notes are not subject to repayment at the option of the holders. The subordinated notes may be redeemed at any time, if (1) a change or prospective change in law occurs that could prevent the Company from deducting interest payable on the notes for U.S. federal income tax purposes, (2) a subsequent event occurs that precludes the notes from being recognized as Tier 2 Capital for regulatory capital purposes, or (3) the Company is required to register as an investment company under the Investment Company Act of 1940, as amended. NOTE 18 - REGULATORY CAPITAL As of December 31, 2015, the Bank was a member of the Federal Reserve System and its primary federal regulator was the Federal Reserve Board. On April 18, 2016, Community Bank of the Chesapeake, cancelled its stock in the Federal Reserve Bank of Richmond. This terminated its status as a member of the Federal Reserve System. As of that date, the Bank’s primary regulator became the Federal Deposit Insurance Corporation (“FDIC”) and is subject to regulation, supervision and regular examination by the Maryland Commissioner of Financial Regulation (the “Commissioner”) and the FDIC. The Company continues to be subject to regulation, examination and supervision by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and the regulations of the Federal Reserve Board. On January 1, 2015, the Company and Bank became subject to the new Basel III Capital Rules with full compliance with all of the final rule's requirements phased in over a multi-year schedule, to be fully phased-in by January 1, 2019. In July 2013, the final rules were published (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee’s December 2010 framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions compared to the previous U.S. risk-based capital rules. The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios. The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach with a more risk-sensitive approach. The Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules. The rules include a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, require a minimum ratio (“Min. Ratio”) of Total Capital to risk-weighted assets of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. A new capital conservation buffer (“CCB”) is also established above the regulatory minimum capital requirements. This capital conservation buffer began its phase-in period beginning January 1, 2016 at 0.625% of risk-weighted assets and will increase each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019. Strict eligibility criteria for regulatory capital instruments were also implemented under the final rules. The final rules also revise the definition and calculation of Tier 1 capital, Total Capital, and risk-weighted assets. As of December 31, 2016 and 2015, the Company and Bank were well-capitalized under the regulatory framework for prompt corrective action under the new Basel III Capital Rules. Management believes, as of December 31, 2016 and 2015, that the Company and the Bank met all capital adequacy requirements to which they were subject. The Company’s and the Bank’s actual regulatory capital amounts and ratios are presented in the following table. (1) These are the fully phased-in ratios as of January 1, 2019 that include the minimum capital ratio ("Min. Ratio") + the capital conservation buffer ("CCB"). The phase-in period is more fully described in the footnote above. (2) The Common Tier 1 ratio became effective for regulatory reporting purposes when the Company and the Bank became subject to the new Basel III Capital Rules during the three months ended March 31, 2015. NOTE 19 - FAIR VALUE MEASUREMENTS The Company adopted FASB ASC Topic 820, “Fair Value Measurements” and FASB ASC Topic 825, “The Fair Value Option for Financial Assets and Financial Liabilities”, which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. FASB ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available for sale investment securities) or on a nonrecurring basis (for example, impaired loans). FASB ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Topic 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. Under FASB ASC Topic 820, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine the fair value. These hierarchy levels are: Level 1 inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date. Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s quarterly valuation process. Transfers in and out of level 3 during a quarter are shown in tabular form. There were no transfers between Level 1, 2 or 3 in the fair value hierarchy for the years ended December 31, 2016 and 2015, respectively. The Company changed its presentation during the year ended December 31, 2016, for loans and OREO from Level 2 to Level 3. No changes were made to the Company’s valuation methodologies as a result of these changes. Comparative financial information was reclassified to conform to the classification presented in 2016. Following is a description of valuation methodologies used for assets and liabilities recorded at fair value: Securities Available for Sale Investment securities available for sale are recorded at fair value on a recurring basis. Standard inputs include quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities (“GSEs”), municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets. Loans Receivable The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Management estimates the fair value of impaired loans using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At December 31, 2016 and 2015, substantially all of the impaired loans were evaluated based upon the fair value of the collateral. In accordance with FASB ASC 820, impaired loans where an allowance is established based on the fair value of collateral (loans with impairment) require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price (e.g., contracted sales price), the Company records the loan as nonrecurring Level 2. When the fair value of the impaired loan is derived from an appraisal, the Company records the loan as nonrecurring Level 3. Fair value is re-assessed at least quarterly or more frequently when circumstances occur that indicate a change in the fair value. The fair values of impaired loans that are not measured based on collateral values are measured using discounted cash flows and considered to be Level 3 inputs. Premises and Equipment Held For Sale Premises and equipment are adjusted to fair value upon transfer of the assets to premises and equipment held for sale. Subsequently, premises and equipment held for sale are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price (e.g., contracted sales price), the Company records the asset as nonrecurring Level 2. When the fair value of premises and equipment is derived from an appraisal or a cash flow analysis, the Company records the asset at nonrecurring Level 3. Other Real Estate Owned (“OREO”) OREO is adjusted for fair value upon transfer of the loans to foreclosed assets. Subsequently, OREO is carried at the lower of carrying value and fair value. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price (e.g., contracted sales price), the Company records the foreclosed asset as nonrecurring Level 2. When the fair value is derived from an appraisal, the Company records the foreclosed asset at nonrecurring Level 3. Assets and Liabilities Recorded at Fair Value on a Recurring Basis The tables below present the recorded amount of assets as of December 31, 2016 and December 31, 2015 measured at fair value on a recurring basis. Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis The Company may be required from time to time to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis as of December 31, 2016 and 2015 are included in the tables below. Loans with impairment have unpaid principal balances of $8.9 million and $4.0 million at December 31, 2016 and 2015, respectively, and include impaired loans with a specific allowance. The following tables provide information describing the unobservable inputs used in Level 3 fair value measurements. December 31, 2016 (dollars in thousands) December 31, 2015 (dollars in thousands) NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Company. Valuation Methodology Investment securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. FHLB and FRB stock - Fair values are at cost, which is the carrying value of the securities. Investment in bank owned life insurance (“BOLI”) - Fair values are at cash surrender value. Loans receivable - The fair values for non-impaired loans are estimated using discounted cash flow analyses, applying interest rates currently being offered for loans with similar terms and credit quality. Internal prepayment risk models are used to adjust contractual cash flows. Management estimates the fair value of impaired loans using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. After evaluating the underlying collateral, the fair value is determined by allocating specific reserves from the allowance for loan losses to the impaired loans. Loans held for sale - Fair values are derived from secondary market quotations for similar instruments. There were no loans held for sale at December 31, 2016 and 2015. Deposits - The fair value of checking accounts, saving accounts and money market accounts were the amount payable on demand at the reporting date. Time certificates - The fair value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products. Long-term debt and short-term borrowings - These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings. Guaranteed preferred beneficial interest in junior subordinated securities (TRUPs) - These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings. Subordinated notes - These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings. Off-balance sheet instruments - The Company charges fees for commitments to extend credit. Interest rates on loans for which these commitments are extended are normally committed for periods of less than one month. Fees charged on standby letters of credit and other financial guarantees are deemed to be immaterial and these guarantees are expected to be settled at face amount or expire unused. It is impractical to assign any fair value to these commitments. The Company’s estimated fair values of financial instruments are presented in the following tables. At December 31, 2016 and 2015, the Company had outstanding loan commitments and standby letters of credit of $67.0 million and $73.5 million, respectively, and $17.7 million and $21.4 million, respectively. Based on the short-term lives of these instruments, the Company does not believe that the fair value of these instruments differs significantly from their carrying values. The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2016 and 2015, respectively. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amount presented herein. NOTE 21 - CONDENSED FINANCIAL STATEMENTS - PARENT COMPANY ONLY Balance Sheets Condensed Statements of Income Condensed Statements of Cash Flows NOTE 22 - QUARTERLY FINANCIAL COMPARISON (Unaudited) (1) Earnings per share are based upon quarterly results and, when added, may not total the annual earnings per share amounts.
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Based on the provided text, here's a summary of the financial statement:
The financial statement appears to focus on a company operating primarily in the Fredericksburg area of Virginia and Southern Maryland counties (Calvert, Charles, and St. Mary's). Key points include:
1. Financial Risks:
- Significant concentration of credit risk in a specific geographic region
- Potential challenges in estimating loan losses, OREO (Other Real Estate Owned) valuation, and deferred tax assets
2. Securities and Debt:
- Debt securities classified as:
a) Held to Maturity (HTM): Recorded at amortized cost
b) Trading Securities: Reported at fair value with unrealized gains/losses included in earnings
- No trading securities were held during the reported period
3. Accounting Considerations:
- Actual financial results may differ from estimates
- Estimates are particularly sensitive
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WOUND MANAGEMENT TECHNOLOGIES, INC. AND SUBSIDIARIES Index to Consolidated Financial Statements ACCOUNTING FIRM Board of Directors and Stockholders Wound Management Technologies, Inc. Fort Worth, Texas We have audited the accompanying consolidated balance sheets of Wound Management Technologies, Inc. and its subsidiaries (collectively, the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, stockholders’ deficit, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the entity’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Wound Management Technologies, Inc. and its subsidiaries as of December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. /s/ MaloneBailey, LLP www.malonebailey.com Houston, Texas April 4, 2017 WOUND MANAGEMENT TECHNOLOGIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2016 AND 2015 The accompanying notes are an integral part of these consolidated financial statements. WOUND MANAGEMENT TECHNOLOGIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 The accompanying notes are an integral part of these consolidated financial statements. WOUND MANAGEMENT TECHNOLOGIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 The accompanying notes are an integral part of these consolidated financial statements. WOUND MANAGEMENT TECHNOLOGIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 The accompanying notes are an integral part of these consolidated financial statements. WOUND MANAGEMENT TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - NATURE OF OPERATIONS Wound Management Technologies, Inc. was incorporated in the State of Texas in December 2001 as MB Software, Inc. In May 2008, MB Software, Inc. changed its name to Wound Management Technologies, Inc. The Company distributes collagen-based wound care products to healthcare providers such as physicians, clinics and hospitals. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The terms “the Company,” “we,” “us” and “WMT” are used in this report to refer to Wound Management Technologies, Inc. The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of WMT and its wholly-owned subsidiaries: Wound Care Innovations, LLC a Nevada limited liability company (“WCI”); Resorbable Orthopedic Products, LLC, a Texas limited liability company (“Resorbable); and Innovate OR, Inc. (“InnovateOR”) formerly referred to as BioPharma Management Technologies, Inc., a Texas corporation (“BioPharma”). All intercompany accounts and transactions have been eliminated. USE OF ESTIMATES IN FINANCIAL STATEMENT PREPARATION The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities at the date of the financial statements, and the amounts of revenues and expenses during the reporting period. On a regular basis, management evaluates these estimates and assumptions. Actual results could differ from those estimates. CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES The Company considers all highly liquid debt investments purchased with an original maturity of three months or less to be cash equivalents. Marketable securities include investments with maturities greater than three months but less than one year. For certain of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and other accrued liabilities, and amounts due to related parties, the carrying amounts approximate fair value due to their short maturities. LOSS PER SHARE The Company computes loss per share in accordance with Accounting Standards Codification “ASC” Topic No. 260, “Earnings per Share,” which requires the Company to present basic and dilutive loss per share when the effect is dilutive. Basic loss per share is computed by dividing loss available to common stockholders by the weighted average number of common shares available. Diluted loss per share is computed similar to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. REVENUE RECOGNITION In accordance with the guidance in “ASC” Topic No. 605, “Revenue Recognition,” the Company recognizes revenue when (a) persuasive evidence of an arrangement exists, (b) delivery has occurred or services have been rendered, (c) the fee is fixed or determinable, and (d) collectability is reasonable assured. Revenue is recognized upon delivery. Revenue is recorded on the gross basis, which includes handling and shipping, because the Company has risks and rewards as a principal in the transaction based on the following: (a) the Company maintains inventory of the product, (b) the Company is responsible for order fulfillment, and (c) the Company establishes the price for the product. The Company recognizes royalty revenue in the period the royalty bearing products are sold. The Company recognizes revenue based on bill and hold arrangements when the seller has transferred to the buyer the significant risks and rewards of ownership of the goods; the seller does not retain effective control over the goods or continuing managerial involvement to the degree usually associated with ownership; the amount of revenue can be measured reliably; it is probable that the economic benefits of the sale will flow to the seller; any costs incurred or to be incurred related to the sale can be measured reliably; it is probable that delivery will be made; the goods are on hand, identified, and ready for delivery; the buyer specifically acknowledges the deferred delivery instructions; and the usual payment terms apply. ALLOWANCE FOR DOUBTFUL ACCOUNTS The Company establishes an allowance for doubtful accounts to ensure accounts receivable are not overstated due to uncollectibility. Bad debt reserves are maintained based on a variety of factors, including the length of time receivables are past due and a detailed review of certain individual customer accounts. If circumstances related to customers change, estimates of the recoverability of receivables would be further adjusted. The Company recorded bad debt expense of $10,735 and $6,461 in 2016 and 2015, respectively. The allowance for doubtful accounts at December 31, 2016 was $21,947 and the amount at December 31, 2015 was $20,388. INVENTORIES Inventories are stated at the lower of cost or net realizable value, with cost computed on a first-in, first-out basis. Inventories consist of finished goods, powders, gels and the related packaging supplies. The Company recorded inventory obsolescence expense of $152,547 in 2016 and $133,747 in 2015. The allowance for obsolete and slow moving inventory had a balance of $153,023 and $150,135 at December 31, 2016 and December 31, 2015, respectively. PROPERTY AND EQUIPMENT Property and equipment is recorded at cost. Depreciation is computed utilizing the straight-line method over the estimated economic life of the asset, which ranges from five to ten years. As of December 31, 2016, fixed assets consisted of $76,267 including furniture and fixtures, computer equipment, phone equipment and the Company websites. As of December 31, 2015, fixed assets consisted of $73,239 including furniture and fixtures, computer equipment, phone equipment and the Company websites. The depreciation expense recorded in 2016 was $9,852 and the depreciation expense recorded in 2015 was $8,999. The balance of accumulated depreciation was $41,328 and $31,477 at December 31, 2016 and December 31, 2015, respectively. INTANGIBLE ASSETS Intangible assets as of December 31, 2016 and 2015 consisted of a patent acquired in 2009 with a historical cost of $510,310. The intangible asset is being amortized over its estimated useful life of 10 years using the straight-line method. Amortization expense recognized was $51,031 during 2016 and 2015. IMPAIRMENT OF LONG-LIVED ASSETS Long-lived assets and certain identifiable intangibles to be held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company continuously evaluates the recoverability of its long-lived assets based on estimated future cash flows and the estimated liquidation value of such long-lived assets, and provides for impairment if such undiscounted cash flows are insufficient to recover the carrying amount of the long-lived assets. If impairment exists, an adjustment is made to write the asset down to its fair value, and a loss is recorded as the difference between the carrying value and fair value. Fair values are determined based on quoted market values, undiscounted cash flows or internal and external appraisals, as applicable. Assets to be disposed of are carried at the lower of carrying value or estimated net realizable value. There was no impairment recorded during the years ended December 31, 2016 and 2015. FAIR VALUE MEASUREMENTS As defined in Accounting Standards Codification (“ASC”) Topic No. 820, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. ASC 820 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurement). This fair value measurement framework applies at both initial and subsequent measurement. The three levels of the fair value hierarchy defined by ASC Topic No. 820 are as follows: Level 1 - Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. Level 1 primarily consists of financial instruments such as exchange-traded derivatives, marketable securities and listed equities. Level 2 - Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reported date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors, and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace throughout the full term of the instrument, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace. Instruments in this category generally include non-exchange-traded derivatives such as commodity swaps, interest rate swaps, options and collars. Level 3 - Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management’s best estimate of fair value. At December 31, 2016 and 2015, the Company’s financial instruments consist of the derivative liabilities related to stock purchase warrants which were valued using the Black-Scholes Option Pricing Model, a level 3 input. Our intangible assets have also been valued using the fair value accounting treatment and a description of the methodology used, including the valuation category, is described below in Note 6 “Intangible Assets.” The following table sets forth by level within the fair value hierarchy the Company’s financial assets and liabilities that were accounted for at fair value as of December 31, 2016 and 2015. DERIVATIVES The Company entered into derivative financial instruments to manage its funding of current operations. Derivatives are initially recognized at fair value at the date a derivative contract is entered into and are subsequently re-measured to their fair value at the end of each reporting period. The resulting gain or loss is recognized in profit or loss immediately. INCOME TAXES Income taxes are accounted for under the asset and liability method, whereby deferred income taxes are recorded for temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. Deferred tax assets and liabilities reflect the tax rates expected to be in effect for the years in which the differences are expected to reverse. A valuation allowance is provided if it is more likely than not that some or all, of the deferred tax asset will not be realized. BENEFICIAL CONVERSION FEATURE OF CONVERTIBLE NOTES PAYABLE The convertible feature of certain notes payable provides for a rate of conversion that is below the market value of the Company’s common stock. Such a feature is normally characterized as a "Beneficial Conversion Feature" ("BCF"). In accordance with ASC Topic No. 470-20-25-4, the intrinsic value of the embedded beneficial conversion feature present in a convertible instrument shall be recognized separately at issuance by allocating a portion of the debt equal to the intrinsic value of that feature to additional paid in capital. When applicable, the Company records the estimated fair value of the BCF in the consolidated financial statements as a discount from the face amount of the notes. Such discounts are accreted to interest expense over the term of the notes using the effective interest method. ADVERTISING EXPENSE In accordance with ASC Topic No. 720-35-25-1, the Company recognizes advertising expenses the first time the advertising takes place. Such costs are expensed immediately if such advertising is not expected to occur. SHARE-BASED COMPENSATION The Company accounts for stock-based compensation to employees in accordance with FASB ASC 718. Stock-based compensation to employees is measured at the grant date, based on the fair value of the award, and is recognized as expense over the requisite employee service period. The Company accounts for stock-based compensation to other than employees in accordance with FASB ASC 505-50. Equity instruments issued to other than employees are valued at the earlier of a commitment date or upon completion of the services, based on the fair value of the equity instruments and is recognized as expense over the service period. The Company estimates the fair value of stock-based payments using the Black-Scholes option-pricing model for common stock options and warrants and the closing price of the Company’s common stock for common share issuances. RECLASSIFICATIONS Certain prior period amounts have been reclassified to conform to current period presentation. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS There were various accounting standards and interpretations issued during 2016 and 2015, none of which are expected to have a material impact on the Company’s financial position, operations or cash flows. NOTE 3 - GOING CONCERN The Company has continuously incurred losses from operations, however, the operating loss in 2016 includes a significant nonrecurring expense in the amount of $818,665, primarily a non-cash loss on the issuance of warrants for services valued at $758,665. Without this non-cash expense, operating income was $342,918 for 2016. See NOTE 4 below for a discussion of this expense. On December 31, 2016, the Company has a working capital balance of $601,654. The Company has adopted a robust operating plan for 2017 that projects existing cash and future cash to be generated from operations will satisfy our foreseeable working capital, debt repayment and capital expenditure requirements for at least the next twelve months. However, minimal funding may be required at certain times during the year due to the timing of significant expenditures such as inventory purchases. The Company believes it will be able to obtain such funding, if required during 2017. We will also monitor our cash flow; assess our business plan; and make expenditure adjustments accordingly. Based upon the Company's current ability to obtain additional financing or equity capital and to achieve profitable operations, it is not appropriate at this time to continue using the going concern basis. NOTE 4 - OTHER SIGNIFICANT TRANSACTIONS Evolution Partners LLC Letter Agreement On April 26, 2016, the Company entered into a letter agreement with Evolution Venture Partners LLC (“EVP”) to serve as a strategic adviser together with Middlebury Securities, LLC (“Middlebury”) to serve as the exclusive placement agent to the Company in connection with the pursuit and execution of a “Financing Transaction” or “Strategic Transaction”. A Financing Transaction is defined as a single transaction or a series of related transactions, a private or public offering or issuance of equity securities or indebtedness of the Company for cash, assumption or incurrence of indebtedness, securities or other consideration with any party. A Strategic Transaction is defined as any acquisition, business combination, transfer or other disposition or any other corporate transaction involving the assets, intellectual property, securities or businesses of the Company, whether by way of a merger or consolidation, license, divestiture, reorganization, recapitalization or restructuring, issuance of indebtedness, tender or exchange offer, negotiated purchase, leveraged buyout, minority investment or partnership, joint venture, collaborative venture or otherwise with any party. A Strategic Transaction does not include any transaction identified or sourced internally by the Company or the Company’s Board of Directors and entered into in the Company’s ordinary course of business. The initial term of the agreement is for a period of one (1) year from the execution of the agreement (the “Term”); provided, however, that such initial term will be extended for successive six (6) month periods unless terminated by written notice by either party. Furthermore, in the event within twelve (12) months following the expiration of the Term (such period, the “Tail Period”) the Company closes a Strategic Transaction or Financing Transaction with a person or entity contacted by EVP on behalf of the Company during the Term, then the Company shall pay and deliver to EVP all fees, expenses and warrants as though such transaction were consummated during the Term. As compensation for these services, EVP received a one-time consulting fee of $60,000 plus a warrant to purchase up to 60 million shares of the common stock of the Company, (which number of shares was approximately 23% of the Company’s outstanding capital stock, calculated on a fully diluted basis, on the agreement date). The total amount of this expense was $818,665, consisting of the cash fee of $60,000 and the fair value of the warrants vested on the agreement dated recognized of $758,665, and is recognized in 2016 as “Other administrative expenses” in the Consolidated Statement of Operations. The terms and conditions upon which the Warrant may be exercised, and the Shares covered thereby may be purchased, are as follows: The exercise period of the Warrant is the period beginning on the date that the Warrant vests as provided below and ending at 5:00 p.m., Dallas, Texas time, on April 26, 2021, (the “Exercise Period”). EVP may only purchase shares that have vested (“Vested Shares”), which shares shall vest as follows: 20% of the shares were vested on the agreement date; 20% of the shares will vest and become exercisable upon the consummation by the Company of one or more Financing Transactions with gross proceeds of at least $5,000,000; it being agreed and understood that such gross proceeds will exclude capital invested or loaned to the Company by current investors, members of the Board or management of the Company and/or their respective affiliates (collectively, “Inside Investors”), but not to the extent third- party investors do not participate in such Financing Transaction in order to accommodate participation by the Inside Investors; 20% of the shares will vest and become exercisable upon the consummation by the Company of a Strategic Transaction (other than an Acquisition of the Company and other than a distribution agreement); 20% of the shares shall vest and become exercisable upon the Company’s execution of a material distribution agreement which constitutes a Strategic Transaction, which materiality threshold will be mutually agreeable to the Company and EVP / Middlebury; 20% of the shares shall vested and become exercisable upon the Company’s hiring of an executive officer or other key employee, which executive officer or key employee was identified by Service Provider or Service Provider played a meaningful role in such person’s hire as requested by the Company in writing, and only if, the Company and EVP / Middlebury mutually agree that such hire will materially enhance the Company; and All non-vested shares will vest and become exercisable upon the consummation of an acquisition of the Company. The agreement further provides that in the event the Company closes a Strategic Transaction during the Term, or closes a Strategic Transaction during the Tail Period with a person or entity contacted by EVP on behalf of the Company during the Term, the Company shall pay to EVP a cash fee equal to five percent (5%) of the transaction value of the Strategic Transaction. Furthermore, in the event the Company closes a Financing Transaction during the Term, or closes a Financing Transaction during the Tail Period with a person or entity contacted by EVP on behalf of the Company during the Term, the Company shall pay to EVP a cash fee equal to: (i) five percent (5%) of the amount of the gross proceeds from the equity sold in a Financing Transaction; and (ii) three percent (3%) of the amount of the gross proceeds from the debt sold in a Financing Transaction. As of this date, there are no Financing Transactions or Strategic Transactions being considered by the Company and no such transactions have occurred. Shipping and Consulting Agreement On September 20, 2013, the Company entered into a Shipping and Consulting Agreement with WellDyne Health, LLC (“WellDyne”). Under the agreement, WellDyne agreed to provide certain storage, shipping, and consulting services, and was granted the right to conduct online resale of certain of the Company’s products to U.S. consumers. The agreement provided for an initial term of 3 years. Effective June 1, 2015, the Company and WellDyne entered into an amendment to the Agreement, pursuant to which the Agreement was amended to, among other things: (a) eliminate certain administrative services being performed by WellDyne under the Agreement, (b) revise the terms of the administrative fee payable to WellDyne under the Agreement, and (c) provide for termination of the Agreement, effective as of September 19th of a given year, by written notice by either party delivered before June 15th of such year. On June 4, 2015, the Company delivered written notice to WellDyne, terminating the Agreement pursuant to Section Five thereof and the termination was effective September 19, 2015. Brookhaven Medical, Inc. Agreement On October 11, 2013, the Company, together with certain of its subsidiaries, entered into a term loan agreement (the “Loan Agreement”) with Brookhaven Medical, Inc. (“BMI”), pursuant to which BMI made a loan to the Company in the amount of $1,000,000 under a Senior Secured Convertible Promissory Note (the “First BMI Note”). In connection with the Loan Agreement, the Company and BMI also entered into a letter of intent contemplating (i) an additional loan to the Company (the “Additional Loan”) of up to $2,000,000 by BMI (or an outside lender), and (ii) entrance into an agreement and plan of merger (the “Merger Agreement”) pursuant to which the Company would merge with a subsidiary of BMI, subject to various conditions precedent. The First BMI Note carries an interest rate of 8% per annum, and all unpaid principal and accrued but unpaid interest under the First BMI Note is due and payable on the later of (i) October 10, 2014, or (ii) the first anniversary of the date of the Merger Agreement. The First BMI Note may be prepaid in whole or in part upon ten days’ written notice, and all unpaid principal and accrued interest under the Note may be converted, at the option of BMI, into shares of the Company’s Series C Convertible Preferred Stock (“Series C Preferred Stock”) at a conversion price of $70.00 per share. The Company’s obligations under the First BMI Note are secured by all the assets of the Company and its subsidiaries. On October 15, 2013, BMI agreed to make the Additional Loan pursuant to a Secured Convertible Drawdown Promissory Note (the “Second BMI Note”), which allows the Company to drawdown, as needed, an aggregate of $2,000,000, subject to an agreed upon drawdown schedule or as otherwise approved by BMI. In connection with the Second BMI Note, the Company, its subsidiaries, and BMI entered into an additional loan agreement as well as an additional security agreement. The Second BMI Note carries an interest rate of 8% per annum, and (subject to various default provisions) all unpaid principal and accrued but unpaid interest under the Second BMI Note is due and payable on the later of (i) October 15, 2014, or (ii) the first anniversary of the date of the Merger Agreement. The Second BMI Note may be prepaid in whole or in part upon ten days’ written notice, and all unpaid principal and accrued interest under the Second BMI Note may be converted, at the option of BMI, into shares of the Company’s Series C Convertible Preferred Stock at a conversion price of $70.00 per share at any time prior to the Maturity Date. In December of 2013, the Company and Brookhaven Medical, Inc. announced their mutual decision not to proceed with the proposed merger but to pursue other business relationships between the two companies. On October 15, 2014, the Company and Brookhaven Medical, Inc. executed an amendment extending the due date of the notes to April 15, 2015. The Company evaluated the modification under ASC 470 and determined that it does not qualify as an extinguishment of debt. On June 15, 2015, Wound Management Technologies, Inc. (the “Company”), together with certain of its subsidiaries, entered into a term loan agreement (the “Loan Agreement”) with The James W. Stuckert Revocable Trust (“SRT) and The S. Oden Howell Revocable Trust (“HRT”), pursuant to which SRT made a loan to the Company in the amount of $600,000 and HRT made a loan to the Company in the amount of $600,000 under Senior Secured Convertible Promissory Notes (the “Notes”). Both SRT and HRT are controlled by affiliates of the Company. The proceeds of the Notes were used to pay off all outstanding unpaid principal and accrued but unpaid interest under the Senior Secured Convertible Promissory Note issued to Brookhaven Medical, Inc. pursuant to a loan agreement dated October 11, 2013, (as described in the Company’s Current Report on Form 8-K filed October 16, 2013, the “Brookhaven Note”). The Notes each carry an interest rate of 10% per annum, and (subject to various default provisions) all unpaid principal and accrued but unpaid interest under the Notes is due and payable on June 15, 2018.The Notes may be prepaid in whole or in part upon ten days’ written notice, and all unpaid principal and accrued interest under the Notes may be converted, at the option of SRT and HRT, into shares of the Company’s Series C Convertible Preferred Stock at a conversion price of $70.00 per share at any time prior to maturity.”). NOTE 5 - NOTES PAYABLE CONVERTIBLE NOTES PAYABLE - RELATED PARTIES Funds are advanced to the Company from various related parties. Other shareholders fund the Company as necessary to meet working capital requirements and is a summary of outstanding convertible notes due to related parties, including accrued interest separately recorded, as of December 31, 2016 and 2015: On June 15, 2015, the Company used proceeds from the above mentioned notes (with The James W. Stuckert Revocable Trust (“SRT) and The S. Oden Howell Revocable Trust (“HRT”) to pay off the negotiated outstanding unpaid principal to $1,100,000, accrued but unpaid interest and recognized $100,000 forgiveness of related party convertible debt under the Senior Secured Convertible Promissory Note issued to Brookhaven Medical, Inc. pursuant to a loan agreement dated October 11, 2013. The gain was accounted for as a capital transaction in 2015. NOTES PAYABLE The following is a summary of amounts due to unrelated parties, including accrued interest separately recorded, as of December 31, 2016 and 2015: On June 26, 2015, the Company entered into an Exchange Agreement with Tonaquint, Inc., a Utah corporation (“Tonaquint”), under which Tonaquint was issued a convertible promissory note (the “Note”) in exchange for the surrender of common stock warrants originally issued by the Company to Tonaquint pursuant to a Securities Purchase Agreement dated June 21, 2011. The Note in the original principal amount of $200,000, carried a 5% rate of interest, and matured on September 26, 2016. The Note provided for an initial cash installment payment of $10,000, with subsequent monthly cash installment payments beginning in December of 2015. Each such monthly installment payment could have been made, at the Company's option, in shares of common stock. Subject to certain conditions, the number of shares issuable in lieu of cash installment payments was to be determined based on a conversion price equal to 90% of the five-day volume weighted average trading price of the Company's common stock. The surrendered warrants were accounted for as derivatives with a fair value of $1,693 on the date of the exchange. This resulted in a loss on the issuance of debt for warrants of $198,307 during the year ended December 31, 2015. The Company paid a total of $178,552 in cash under this note during the year ended December 31, 2016. In September 2016, the Company paid the final $10,000 in principal and $8,552 in accrued interest. During each of the years ended December 31, 2016 and 2015, the Company paid a total of $3,600 to Quest Capital as part of the furniture purchase agreement in the original amount of $11,700. During the year ended December 31, 2015, the Company paid the final $40,620 principal and $14,861 in accrued interest due on the MAH Holding note. (MAH Holding is controlled by a former major stockholder of the Company). During the year ended December 31, 2016, the Company paid $26,762 principal and $49,559 in accrued interest for three of the non-related party notes. In June and July of 2016, two of the parties' notes were amended and they agreed to forgive a portion of the accrued interest in the amounts of $22,943 and $7,649 for a total of $30,592. NOTE 6 - INTANGIBLE ASSETS PATENT On September 29, 2009, the Company entered into an Asset Purchase Agreement (the “Agreement”), whereby the Company acquired a patent from in exchange for 500,000 shares of the Company’s common stock and the assumption of a legal fee payable in the amount of $47,595 which is related to the patent. Based on the guidance in ASC Topic No. 350-30, the patent was recorded as an intangible asset of $462,715, or approximately $.93 per share plus $47,595 for the assumed liability. The intangible asset is being amortized over an estimated ten year useful life. The activity for the intangible accounts is summarized below: The amount amortized for the year ended December 31, 2016 and 2015 was $51,030 and $51,031, respectively. NOTE 7 - CUSTOMERS AND SUPPLIERS WCI had two significant customers which accounted for approximately 18% and 14% of the Company’s sales in 2016 and had two significant customers which accounted for approximately 28% and 14% of the Company’s sales in 2015. The loss of the sales generated by these customers would have a significant effect on the operations of the Company. The Company purchases all inventory from one vendor. If this vendor became unable to provide materials in a timely manner and the Company was unable to find alternative vendors, the Company's business, operating results and financial condition would be materially adversely affected. NOTE 8 - COMMITMENTS AND CONTINGENCIES ROYALTY AGREEMENTS Effective January 3, 2008, WCI entered into separate exclusive license agreements with both Applied Nutritionals, LLC (“Applied”) and its founder George Petito (“Petito”), pursuant to which WCI obtained the exclusive world-wide license to make products incorporating intellectual property covered by a patent related to CellerateRX products. The licenses are limited to the human health care market, (excluding dental and retail) for external wound care (including surgical wounds), and include any new product developments based on the licensed patent and processes and any continuations. The term of these licenses expires in 2018. In consideration for the licenses, WCI agreed to pay Applied and Petito, (in the aggregate), the following royalties, beginning January 3, 2008: (a) an advance royalty of $100,000; (b) a royalty of 15% of gross sales occurring during the first year of the license; (c) an additional advance royalty of $400,000 on January 3, 2009; plus (d) a royalty of 3% of gross sales for all sales occurring after the payment of the $400,000 advance royalty. In addition, WCI must maintain a minimum aggregate annual royalty payment of $375,000 for 2009 and thereafter if the royalty percentage payments made do not meet or exceed that amount. The amounts listed in the two preceding sentences are the aggregate of amounts paid/owed to Applied and Petito) and the Company has paid the minimum aggregate annual royalty payments each year since 2008, including both 2016 and 2015. The total unpaid royalties as of December 31, 2016 and 2015, is $276,916 and $323,062, respectively. On September 29, 2009, the Company entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”), by and among the Company, RSI-ACQ, LLC, a wholly-owned subsidiary of the Company (RSI), Resorbable Orthopedic Products, LLC (“Resorbable”) and Resorbable’s members, pursuant to which, RSI acquired substantially all of Resorbable’s assets, in exchange for (i) 500,000 shares of the Company’s common stock, and (ii) a royalty equal to eight percent (8%) of the net revenues generated from products sold by the Company or any of its affiliates, which products are developed from or otherwise utilize any of the patented technology acquired from Resorbable. The royalty is paid to Barry Constantine Consultant LLC and one of the principals of the LLC is Barry Constantine whom is a contract employee of the Company and holds the position of Director of R&D. PREPAIDS FROM INVENTORY CONTRACTS In October of 2015, WCI entered into a contract with the manufacturer of the CellerateRX product to purchase $217,512 of product. Payment in the amount of $108,014 was made in October of 2015 with the remaining balance of $109,498 paid in 2016 and before receipt of product. This amount was recorded as an asset in the “Prepaid and Other Assets” account at December 31, 2015 based on the contractual obligation of the parties. In November of 2016, ROP entered into a contract with the contract manufacturer of HemaQuell® product to purchase $13,787 of product. This amount was recorded as an asset in the “Prepaid and Other Assets” account at December 31, 2016, based on the contractual obligation of the parties. OFFICE LEASES The Company’s corporate office is located at 16633 Dallas Parkway, Suite 250, Addison, TX 75001. The lease was entered into in November of 2013. The lease expires on April 30, 2017 and requires base rent payments of $5,737 per month for months 1-17, $5,866 for months 18-29, and $5,995 for months 30-41. In March of 2017, the Company executed a new office lease for office space located at 1200 Summit Ave., Suite 414, Fort Worth, TX 76102 and will be relocating our corporate offices there. The lease is to be effective upon completion of leasehold improvements (sometime in April 2017) and end on the last day of the fiftieth (50th) full calendar month following the effective date. Monthly base rental payments are as follows: months 1-2, $0; months 3-14, $7,250; months 15-26, $7,401; months 27-38, $7,552; and months 39-50, $7,703. PAYABLES TO RELATED PARTIES As of December 31, 2016 and 2015, the Company had outstanding payable to related parties totaling $93,655 and $21,099, respectively. The payables are unsecured, bear no interest and due on demand NOTE 9 - STOCKHOLDERS’ EQUITY PREFERRED STOCK There are currently 5,000,000 shares of Series A Preferred Stock authorized, with no shares of Series A Preferred Stock issued or outstanding as of December 31, 2016 and 2015. Effective June 24, 2010, the Company filed a Certificate of Designations, Number, Voting Power, Preferences and Rights of Series B Convertible Redeemable Preferred Stock (the “Certificate”) with the Texas Secretary of State, designating 7,500 shares of Series B Preferred Stock, par value $10.00 per share (the “Series B Shares”). The Series B Shares rank senior to shares of all other common and preferred stock with respect to dividends, distributions, and payments upon dissolution. Each of the Series B Shares is convertible at the option of the holder into shares of common stock as provided in the Certificate. There were no Series B Shares issued or outstanding as of December 31, 2016 and 2015. On October 11, 2013, the Company filed a Certificate of Designations, Number, Voting Power, Preferences and Rights of Series C Convertible Preferred Stock (the “Certificate of Designations”), under which it designated 100,000 shares of Series C Preferred Stock, par value $10.00. The Series C Preferred Stock is entitled to accruing dividends (payable, at the Company’s options, in either cash or stock) of 5% per annum until October 10, 2016, and 3% per annum until October 10, 2018. The Series C Preferred Stock is senior to the Company’s common stock and any other currently issued series of the Company’s preferred stock upon liquidation, and is entitled to a liquidation preference per share equal to the original issuance price of such shares of Series C Preferred Stock together with the amount of all accrued but unpaid dividends thereon. Each of the Series C Shares is convertible at the option of the holder into 1,000 shares of common stock as provided in the Certificate. Additionally, each holder of Series C Preferred Stock shall be entitled to vote on all matters submitted for a vote of the holders of Common Stock a number of votes equal to the number of full shares of Common Stock into which such holder’s Series C shares could then be converted. As of December 31, 2016 and December 31, 2015, there were 85,646 and 80,218 shares of Series C Preferred Stock issued and outstanding, respectively. On November 13, 2013, the Company filed a Certificate of Designations, Number, Voting Power, Preferences and Rights of Series D Convertible Preferred Stock (the “Certificate of Designations”), under which it designated 25,000 shares of Series D Preferred Stock. Shares of Series D Preferred Stock are not entitled to any preference with respect to dividend or upon liquidation, and will automatically convert (at a ratio of 1,000-to-1) into shares of the Company’s common stock, par value $0.001 upon approval of the Company’s stockholders (and filing of) and amendment to the Company’s Certificate of Incorporation increasing the number of authorized shares of Common Stock from 100,000,000 to 250,000,000. As of December 31, 2016 and December 31, 2015 there were 0 shares of Series D Preferred Stock issued and outstanding. On September 3, 2014, the company increased its authorized common stock to 250,000,000 shares. As a result, all outstanding Series D preferred shares were converted to common stock. On May 30, 2014, the Company filed a Certificate of Designations, Number, Voting Power, Preferences and Rights of Series E Convertible Preferred Stock (The “Certificate of Designations”), under which it designated 5,000 shares of Series E Preferred Stock. Shares of Series E Preferred Stock are not entitled to any preference with respect to dividends or upon liquidation, and will automatically convert (at a ratio of 1,000 shares of Common Stock for every one share of Series E Preferred Stock) into shares of the Company’s common stock, $0.001 par value upon approval of the Company’s stockholders (and filing of) and amendment to the Company’s Certificate of Incorporation increasing the number of authorized shares of Common Stock from 100,000,000 to 250,000,000. As of December 31, 2016, there were no shares of Series E Preferred Stock issued and outstanding. During the year ended December 31, 2015, the company issued 11,310 shares of Series C preferred stock to Directors of the Company for cash proceeds of $750,000. During the year ended December 31, 2016, the company issued 6,428 shares of Series C preferred stock to Directors of the Company for cash proceeds of $450,000. The Series C preferred stock earned dividends of $261,716 and $268,772 for the years ended December 31, 2016 and December 31, 2015, respectively. As of the date of this filing, no Series C preferred stock dividends have been declared or paid. During the year ended December 31, 2013, the Company granted an aggregate of 15,000 shares of Series D preferred stock to employees and nonemployees for services. 13,000 of the shares were granted to employees and vest immediately upon grant, 1,000 of the shares were granted to an employee and vest in equal tranches over three years through October 1, 2016 and 1,000 of the shares were granted to a nonemployee and vest in equal tranches over three years through September 15, 2016. The aggregate fair value of the awards was determined to be $1,046,669 of which $925,787 was previously recognized, $79,318 was recognized during the year ended December 31, 2014, $6,628 less net forfeitures of $19,173 was recognized during the year ended December 31, 2015, $8,109 was recognized during the year ended December 31, 2016 and all shares have vested, no further expense to be recognized. During the year ended December 31, 2014, the Company granted an aggregate of 1,000 shares of Series D preferred stock to two employees according to the terms of their employment agreements. The shares vest in equal annual amounts over three years and the aggregate fair value of the awards was determined to be $120,000. During the years ended December 31, 2016 and 2015, $6,806 and $25,193 was expensed. Net forfeitures of $17,135 was recognized during the year ended December 31, 2016. A total of 667 shares are vested and no further expense is to be recognized. On September 3, 2014, the Company increased its authorized common stock to 250,000,000 shares. Accordingly, the 16,545 outstanding shares of Series D preferred stock were automatically converted into 16,545,000 common shares. The Company evaluated the Series C and Series D preferred stock under FASB ASC 815 and determined that they do not qualify as derivative liabilities. The Company then evaluated the Series C and Series D preferred stock for beneficial conversion features under FASB ASC 470-30 and determined that none existed. COMMON STOCK On September 3, 2014, the Company held its annual meeting of stockholders. The stockholders approved an amendment to the Company’s Articles of Incorporation to increase the authorized shares of common stock of the Company from 100,000,000 to 250,000,000. On March 5, 2015, the Company issued 100,000 shares of common stock which vested immediately valued at $5,970 according to the terms of a service agreement. Under the award, the nonemployee was also granted an aggregate of 800,000 additional shares which vest in tranches of 300,000, 250,000 and 250,000 upon the achievement of certain revenue targets. No expense was recognized for these additional shares during the year ended December 31, 2016. On March 10, 2015, the Company issued 374,264 shares of common stock in conversion of 357 shares of Series C Preferred stock and $1,036 of related dividends. On May 19, 2015, the Company issued 100,000 shares of common stock which vested immediately valued at $10,000 according to the terms of a service agreement. On May 19, 2015, the Company issued 250,000 shares of common stock which vested immediately valued at $23,000 according to the terms of an employment agreement. On June 19, 2015, the Company issued 642,330 shares of common stock in conversion of 600 shares of Series C Preferred stock and $2,963 of related Series C dividends. On July 15, 2015, the Company issued 100,000 shares of common stock which vested 60 days after their grant date of May 15, 2015 valued at $9,800 according to the terms of a service agreement. On December 31, 2015, the Company issued 594,168 shares of common stock in conversion of 546 shares of Series C Preferred stock and $3,372 of related Series C dividends. During the year ended December 31, 2015, an aggregate of 333,334 common shares were issued upon the vesting of previously granted stock awards and the Company recorded a net reversal of $4,187 of stock-based compensation related to the amortization of stock awards to employees and nonemployees net of reversal of the unvested portion of forfeited awards. During the year ended December 31, 2015, an aggregate of 666,600 shares of fully vested common stock under previously issued under stock awards and was returned and cancelled. The share cancellation was recognized at par value. On March 31, 2016 the Company issued 1,098,904 shares of common stock in conversion of 1,000 shares of Series C Preferred stock and $6,924 of related dividends. On October 26, 2016, the Company issued 1,150,000 shares of common stock valued at $57,500 to employees. During the year ended December 31, 2016, an aggregate of 499,967 common shares were issued upon the vesting of previously granted stock awards and the Company recorded a net reversal of $2,220 of stock-based compensation related to the amortization of stock awards to employees and nonemployees net of reversal of the unvested portion of forfeited awards. On October 26, 2016, the Company agreed to grant three tranches of shares of common stock, 250,000, 250,000, and 250,000 to a sales consultant which are to be earned upon meeting specific performance measures agreed upon. The measures include achieving three specific sales targets per month for 3 consecutive months. The first one of these was earned January 31st, 2017, and 250,000 shares were granted in March 2017. During the year ended December 31, 2016, an aggregate of 166,667 shares of fully vested common stock under previously issued stock awards was returned and cancelled. The share cancellation was recognized at par value. WARRANTS At December 31, 2016, there were 67,246,300 warrants outstanding with a weighted average exercise price of $0.12. At December 31, 2015, there were 9,736,844 warrants outstanding with a weighted average exercise price of $0.19. A summary of the status of the warrants granted at December 31, 2016 and 2015 and changes during the years then ended is presented below: The following table summarizes the outstanding warrants as of December 31, 2016: The following table summarizes the outstanding warrants as of December 31, 2015: STOCK OPTIONS A summary of the status of the stock options granted for the years ended December 31, 2016 and 2015, and changes during the period then ended is presented below: (a) On January 1, 2015, the Company granted three tranches of options, 25,000, 25,000, and 100,000 which vest upon meeting specific performance measures agreed upon. The measures include achieving three specific sales targets per month for 3 consecutive months. The exercise price and expiration date of each tranche will be set upon achieving the targets. As of the date of this filing the performance measures have not been met. As a result, the exercise price is undetermined and these options are excluded from the calculation of weighted average remaining life. The following table summarizes the outstanding options as of December 31, 2016: The following table summarizes the outstanding options as of December 31, 2015: (a) On January 1, 2015, the Company granted three tranches of options, 25,000, 25,000, and 100,000 which vest upon meeting specific performance measures agreed upon. The measures include achieving three specific sales targets per month for 3 consecutive months. The exercise price and expiration date of each tranche will be set upon achieving the targets. As of the date of this filing the performance measures have not been met. As a result, the exercise price is undetermined and these options are excluded from the calculation of weighted average remaining life. NOTE 10 - DERIVATIVE LIABILITIES During 2016 and 2015, the Company had outstanding common stock warrants that contained anti-dilution provisions including provisions for the adjustment of the exercise price if the Company issues common stock or common stock equivalents at a price less than the exercise price. In addition, the Company also had outstanding convertible notes payable to various lenders that were convertible at discounts ranging from 30% to 50% of the fair market value of the Company’s common stock. As of December 31, 2016, the Company did not have a sufficient number of common shares authorized to fulfill the possible exercise of all outstanding warrants and the conversion of all outstanding convertible notes payable. As a result, the Company determined that the warrants and the embedded beneficial conversion features of the debt instruments do not qualify for equity classification. Accordingly, the warrants and conversion options are treated as derivative liabilities and are carried at fair value. As of December 31, 2016, some of the outstanding common stock warrants with the anti-dilution provision remained outstanding. The Company estimates the fair value of the derivative warrant liabilities by using the Black-Scholes Option Pricing Model and the derivative liabilities related to the conversion features in the outstanding convertible notes using the Black-Scholes Option Pricing Model assuming maximum value, a Level 3, input, with the following assumptions used: The following table sets forth the changes in the fair value of derivative liabilities for the years ended December 31, 2016 and 2015: The aggregate gain (loss) on derivative liabilities for the years ended December 31, 2016 and December 31, 2015 was $266 and ($295), respectively. NOTE 11 - INCOME TAXES The Company accounts for income taxes in accordance with ASC Topic No. 740, “Income Taxes.” This standard requires the Company to provide a net deferred tax asset or liability equal to the expected future tax benefit or expense of temporary reporting differences between book and tax accounting and any available operating loss or tax credit carry forwards. A 100% valuation allowance has been provided for all deferred tax assets, as the ability of the Company to generate sufficient taxable income in the future is uncertain. The unexpired net operating loss carry forward at December 31, 2016 is approximately $34,650,000 with various expiration dates between 2018 and 2036 if not utilized. All tax years starting with 2013 are open for examination. Non-current deferred tax asset: Reconciliations of the expected federal income tax benefit based on the statutory income tax rate of 34% to the actual benefit for the years ended December 31, 2016 and 2015 are listed below. The Company has no tax positions at December 31, 2016 and 2015 for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. The Company recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses. During the years ended December 31, 2016 and 2015, the Company recognized no interest and penalties. NOTE 12 - LEGAL PROCEEDINGS Ken Link v. Wound Management Technologies, Inc., et al. On November 14, 2011, Ken Link instituted litigation against Wound Management Technologies, Inc. and Scott A. Haire in the District Court of Tarrant County Texas, Cause No. 342-256486-11 of the 342nd Judicial District, alleging default under the terms of a certain promissory note executed by Wound Management Technologies, Inc. and guaranteed by Scott A. Haire. Ken Link asserted at that point in time that the unpaid balance of the note, including accrued interest as of December 4, 2011 was the sum of $355,292, Mr. Link asserted that he was entitled to receive 200,000 shares of the Company’s common stock. Mr. Link is also seeking attorney’s fees. Mr. Link is also seeking interest at 13% per annum, plus $1,000 per day. We have disputed the claim, because we believe the contract is tainted by usury, and therefore, a usury counterclaim will more than offset the unpaid balance of the promissory note. The note, in the original principal amount of $223,500, required the payment of interest accrued at 13% per annum, an additional one-time charge of $20,000 due on maturity, the issuance of 200,000 shares of stock as interest, and a $1,000 per day late fee for each day the principal and interest is late. It is our contention that these sums make the contract usurious and the usury claims more than offset the amount of the unpaid indebtedness. Furthermore, we have filed an action for recovery of damages for usury under the Texas Finance Code for a note which was previously executed by the Company and payable to Ken Link, which was in fact paid to Mr. Link in full. In addition, Wound Management is seeking recovery of attorney’s fees pursuant to the usury provisions of the Texas Finance Code. While the amount of the promissory note remains unpaid, the counterclaims more than offset the maximum amount that could be asserted on the promissory note. The case was set for trial for the week of October 21, 2013, but after three (3) days of trial before a jury, the judge declared a mistrial. The case was subsequently reset for trial for the week of December 1, 2014 and the judge again declared a mistrial. The case is currently set for trial the week of May 15, 2017. Subsequent to October 21, 2013, Ken Link amended his pleadings and alleges that Wound Management Technologies, Inc. never intended to pay the $223,500 promissory note and sought damages for fraud and the loss of the benefit of the bargain relating to the shares of stock, plus interest as set forth in the note, exemplary damages, and attorney's fees. On September 4, 2015, Ken Link again amended his pleadings once again seeking the sums he says are owed to him that were advanced to him in the amount of $223,500. It is unclear if he is suing on the note or not, but it appears he is. We are taking steps to vigorously defend this matter, however, we are unable at this time to determine the ultimate outcome of this matter or determine the effect it may have on our business, financial condition or result of operations. Wound Management Technologies, Inc. v. Fox Lake Animal Hospital, PSP: Wound Management Technologies, Inc. instituted litigation in Cause No. 96-263918-13 in the 96th District Court of Tarrant County, Texas against Fox Lake Animal Hospital, PSP and Bohdan Rudawksi, Trustee of the Fox Lake Animal Hospital, PSP. The cause of action asserts that the loan transaction between Wound Management Technologies, Inc. and Fox Lake Animal Hospital PSP involved the collection of illegal usurious interest for the reason that while the face amount of the promissory note is $39,000, but the loan actually loaned for a 6-month period was $25,000, resulting in an interest rate in excess of the maximum rate permitted by the Texas Finance Code. Wound Management Technologies, Inc. is seeking to recover the penalties authorized by the Texas Finance Code, together with the attorney’s fees. Fox Lake Animal Hospital and Bohdan Rudawski, Trustee have filed a counterclaim where they allege there were misrepresentations by Wound Management Technologies, Inc. that would be excuse them from having to pay penalties under the Texas Finance Code for charging usurious interest. Fox Lake Animal Hospital and Bohdan Rudawski, Trustee further claim that actions asserted violates the Federal Securities Exchange Act and alleged fraud and fraud in the inducement in entering into the promissory note. In the opinion of counsel, the counterclaim is without merit. Wound Management Technologies, Inc. will pursue this case to final judgment. Wound Management Technologies, Inc. v. Bohdan Rudawski: Wound Management Technologies, Inc. instituted litigation in Cause No. 352-263856-13 in the 352nd District Court of Tarrant County, Texas against Bohdan Rudawksi. The case has been postponed until September of 2016. The cause of action asserts that the loan transaction between Wound Management Technologies, Inc. and Bohdan Rudawski involved the collection of illegal usurious interest for the reason that while the face amount of the promissory note is $156,000, but the loan actually loaned for a 6-month period was $100,000, charging an effective interest rate of over 100% which violates the provisions of the Texas Finance Code. Wound Management Technologies, Inc. is seeking to recover the penalties authorized by the Texas Finance Code, together with the attorney’s fees. Bohdan Rudawski has filed an answer and alleges there was not an absolute obligation to repay the note, attempting to defeat the usury claim. Bohdan Rudawski has further asserted that the claims violate the Federal Securities Exchange Act and allege fraud of inducement in entering into the promissory note. In the opinion of counsel, that counter-claim is without merit. Wound Management Technologies, Inc. will pursue this case to final judgment. The 352nd Judicial District Court entered an order in December, 2016 consolidating the Bohdan Rudawski case and the Fox Lake Animal Hospital case into the 352nd Court case. This case is currently set for trial for the week of June 19, 2017. Wound Management Technologies, Inc. v. Bohdan Rudawski: Wound Management Technologies, Inc. instituted litigation in Cause No. 352-263856-13 in the 352nd District Court of Tarrant County, Texas against Bohdan Rudawksi. The case has been postponed until September of 2016. The cause of action asserts that the loan transaction between Wound Management Technologies, Inc. and Bohdan Rudawski involved the collection of illegal usurious interest for the reason that while the face amount of the promissory note is $156,000.00, but the loan actually loaned for a 6 month period was $100,000.00, charging an effective interest rate of over 100% which violates the provisions of the Texas Finance Code. Wound Management Technologies, Inc. is seeking to recover the penalties authorized by the Texas Finance Code, together with the attorney’s fees. Bohdan Rudawski has filed an answer and alleges there was not an absolute obligation to repay the note, attempting to defeat the usury claim. In the opinion of counsel, that claim is without merit. Wound Management Technologies, Inc. will pursue this case to final judgment. NOTE 13 - CAPITAL LEASE OBLIGATION In December 2014, the Company entered into a Capital Lease agreement for the purchase of a phone system. The agreement required a down payment of $2,105 and 36 monthly payments of $375. The Company recorded an asset of $13,512 and a capital lease obligation of $13,512. Aggregate payments under the capital lease were $4,733 and $4,504 during 2016 and 2015, respectively. At December 31, 2016, a total lease liability of $3,766 remained which will be due in full during 2017. NOTE 14 SUBSEQUENT EVENTS In accordance with applicable accounting standards for the disclosure of events that occur after the balance sheet date but before the financial statements are issued, all significant events or transactions that occurred after December 31, 2017, are outlined below: On March 9, 2017, the Company issued 150,000 shares of common stock to each of the Company’s four Board Directors, (a total of 600,000 shares valued at $42,000). On March 10, 2017, the Company issued 250,000 shares of common stock valued at $17,500 to a contract consultant upon achievement of specified revenue targets which occurred January, 31, 2017. On March 10, 2017, the Company issued 715 shares of Series C preferred stock in exchange for cash in the amount of $50,050.
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Based on the provided text, here's a summary of the financial statement:
Revenue:
- Generated from products developed using patented technology acquired from Resorbable
- Royalties paid to Barry Constantine Consultant LLC
- Barry Constantine is a contract employee and Director of R&D
Assets:
- Fixed assets valued at $76,267
Liabilities:
- Includes cash equivalents and marketable securities
- Carrying amounts approximate fair value due to short maturities
Accounting Practices:
- Computes loss per share according to ASC Topic No. 260
- Management regularly evaluates estimates and assumptions
- Actual results may differ from estimated figures
Key Observations:
- The statement appears to be from a company with ongoing research and development
- There are related party transactions through Barry Constantine
- The financial statement suggests the company is in an early or developmental stage, with a focus on technology and R&D
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Claude
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FINANCIAL STATEMENTS. The information for this Item is included beginning on Page of this Annual Report. ACCOUNTING FIRM To the Board of Directors and Shareholders EnXnet, Inc. Tulsa, Oklahoma We have audited the accompanying consolidated balance sheets of EnXnet, Inc. and its subsidiary (collectively, the “Company”) as of March 31, 2016 and 2015 and the related consolidated statements of expenses, stockholders’ deficit, and cash flows for the years ended March 31, 2016 and 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of EnXnet, Inc. and its subsidiary as of March 31, 2016 and 2015 and the results of their operations and their cash flows for the years then ended and in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company suffered recurring losses since inception, which raises substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters also are described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. MALONEBAILEY, LLP www.malonebailey.com Houston, Texas June 30, 2016 Table of Contents ENXNET, INC CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these consolidated financial statements. Table of Contents ENXNET, INC CONSOLIDATED STATEMENTS OF EXPENSES The accompanying notes are an integral part of these consolidated financial statements. Table of Contents ENXNET, INC CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT For the years ended March 31, 2016 and March 31, 2015 The accompanying notes are an integral part of these consolidated financial statements. Table of Contents ENXNET, INC CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these consolidated financial statements. Table of Contents ENXNET, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE YEARS ENDED March 31, 2016 and NOTE 1 - DESCRIPTION OF BUSINESS AND GOING CONCERN EnXnet, Inc. (“we”, “our”, the “Company”) was formed in Oklahoma on March 30, 1999. On August 7, 2015, the Company incorporated EnXnet Energy Company LLC. in the State of Colorado as a wholly owned subsidiary. EnXnet Inc. and its wholly owned subsidiary, EnXnet Energy Company, LLC. (“the Company”) is a natural gas and petroleum exploitation, development and production company engaged in locating and developing hydrocarbon resources, primarily in the Rocky Mountain region. The Company’s principal business strategy is to enhance stockholder value by generating and developing high-potential exploitation resources in these areas. The Company’s principal business is the acquisition of leasehold interests in petroleum and natural gas rights, either directly or indirectly, and the exploitation and development of properties subject to these leases. The Company has leased property in Colorado and is currently searching for additional opportunities in the natural gas and petroleum industry. Our initial goal has been to lease the mineral rights of acreage that has a high likelihood of becoming a producing property. We will require additional funding to drill and complete a producing natural gas and petroleum well. The Company has a working capital deficit and has incurred losses since inception. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that may be necessary if the Company is unable to continue as a going concern. Funds required to carry out management’s plans are expected to be derived from future stock sales and borrowings from outside parties. There can be no assurances that the Company will be successful in executing its plans. NOTE 2 - SUMMARY OF ACCOUNTING POLICIES Cash and cash equivalents Cash equivalents are highly liquid investments with an original maturity of three months or less. Use of estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States necessarily requires management to make estimates and assumptions that affect the amounts reported in the financial statements. We regularly evaluate estimates and judgments based on historical experience and other relevant facts and circumstances. Actual results could differ from those estimates. Fixed Assets Fixed assets are recorded at cost. Depreciation and amortization are provided using the straight-line method over the useful lives of the respective assets, typically 3-10 years. Major additions and betterments are capitalized. Upon retirement or disposal, the cost and related accumulated depreciation or amortization is removed from the accounts and any gain or loss is reflected in operations. Depreciation expenses included in operating expenses for the years ended March 31, 2016 and 2015 were $-0- and $-0-, respectively. Impairment of long-lived assets The Company reviews the carrying value of its long-lived assets annually or whenever events or changes in circumstances indicate that the historical-cost carrying value of an asset may no longer be appropriate. The Company assesses recoverability of the asset by comparing the undiscounted future net cash flows expected to result from the asset to its carrying value. If the carrying value exceeds the undiscounted future net cash flows of the asset, an impairment loss is measured and recognized. An impairment loss is measured as the difference between the net book value and the fair value of the long-lived asset. Fair value is estimated based upon either discounted cash flow analysis or estimated salvage value. As of March 31, 2016 and 2015, the Company recognized $-0- and $35,706 of impairment expense. Table of Contents ENXNET, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE YEARS ENDED March 31, 2016 and Goodwill and other intangibles Goodwill and other intangibles with indefinite lives are not amortized but are reviewed for impairment at least annually, or more frequently if an event or circumstance indicates that an impairment may have occurred. To test for impairment, the fair value of each reporting unit is compared to the related net book value, including goodwill. If the net book value of the reporting unit exceeds the fair value, an impairment loss is measured and recognized. An income approach is utilized to estimate the fair value of each reporting unit. The income approach is based on the projected debt-free cash flow, which is discounted to the present value using discount factors that consider the timing and risk of cash flows. Stock Based Compensation The Company records stock-based compensation in accordance with ASC 718, Compensation - Stock Based Compensation and ASC 505, Equity Based Payments to Non-Employees, using the fair value method. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. Equity instruments issued to employees and the cost of the services received as consideration are measured and recognized based on the fair value of the equity instruments issued. Income taxes Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. These assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to reverse. We have net operating loss carryforwards available to reduce future taxable income. Future tax benefits for these net operating loss carryforwards are recognized to the extent that realization of these benefits is considered more likely than not. To the extent that we will not realize a future tax benefit, a valuation allowance is established. Basic and diluted net loss per share Basic loss per share is computed using the weighted average number of shares of common stock outstanding during each period. Diluted loss per share includes the dilutive effects of common stock equivalents on an “as if converted” basis. For the years ended March 31, 2016 and 2015 potential dilutive securities had an anti-dilutive effect and were not included in the calculation of diluted net loss per common share Recent Accounting Pronouncements The Company does not expect the adoption of recently issued accounting pronouncements to have a significant impact on the Company’s results of operation, financial position or cash flows. Reclassifications Certain prior year amounts have been reclassified to conform with the current year financial statements presentation. Table of Contents ENXNET, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE YEARS ENDED March 31, 2016 and Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiary. All significant inter-company transactions and balances have been eliminated in consolidation. References herein to the Company include the Company and its subsidiaries, unless the context otherwise requires. NOTE 3 - MINERAL RIGHTS In February 2016, the Company paid $20,108 to lease 960 acres in the Rocky Mountain range located in the state of Colorado for a 1-year term. The Company will need to initiate drilling on this property during the 1-year lease term to continue the lease on the property. Annually, the mineral rights are tested for impairment. In May 2016, the Company paid $8,510 to lease an additional 3,290 acres in the Rocky Mountain range located in the state of Colorado for a 1-year term. The Company will need to initiate drilling on this property during the 1-year lease term to continue the lease on the property. NOTE 4 - INCOME TAXES At March 31, 2016 and 2015, the Company had net deferred tax assets of approximately $967,000 and $940,000 principally arising from net operating loss carryforwards for income tax purposes. As management of the Company cannot determine that it is more likely than not that the Company will realize the benefit of the net deferred tax asset, a valuation allowance equal to the net deferred tax asset has been established at March 31, 2016 and 2015. At March 31, 2016, the Company has net operating loss carry forwards totaling approximately $2,844,000 which will begin to expire in the year 2020. Income tax provision (benefit) for the years ended March 31, 2016 and 2015 is summarized below: The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate before provision for income taxes. The sources and tax effect of the differences are as follows: Table of Contents ENXNET, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE YEARS ENDED March 31, 2016 and Components of the net deferred income tax assets at March 31, 2016 and 2015 were as follows: ASC 740 requires a valuation allowance to reduce the deferred tax assets reported if, based on the weight of evidence, it is more than likely than not that some portion or all of the deferred tax assets will not be recognized. After consideration of all the evidence, both positive and negative, management has determined that a $967,000 and $940,000 allowance at March 31, 2016 and 2015, respectively, is necessary to reduce the deferred tax assets to the amount that will more likely than not be realized. The change in the valuation allowance for the current year is $27,000. As of March 31, 2016, we have a net operating loss carry forward of approximately $2,844,000. The loss will be available to offset future taxable income. If not used, this carry forward will begin to expire in 2020 through 2036. The Company has identified its “major” tax jurisdictions to include the U.S. government. The Company's fiscal 2013 through 2015 federal tax returns remain open by statute. NOTE 5 - CONVERTIBLE NOTES PAYABLE Table of Contents ENXNET, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE YEARS ENDED March 31, 2016 and In March 2015, the Company issued two conventional convertible notes in the aggregate amount of $125,000 to stockholders. A portion of the proceeds in the amount of $100,000 is restricted and to be used to obtain natural gas and petroleum properties. In connection with these notes, the Company issued 250,000 common shares valued in the amount of $4,250. During the year ended March 31, 2016, $25,000 of these notes were treated as being repaid. Also during the years ended March 31, 2016 and 2015, the Company converted $40,000 and $2,000 of the advances into notes payable, respectively. The Company’s CEO transferred a private partnership interest to one of the note holders and then contributed the $25,000 in a non-cash transaction back to the Company. The effect of the transaction was that Convertible Notes payable were reduced by $25,000 and Advances from officer - related party was increased by $25,000. These notes are convertible into 5,000,000 common stock shares and accrue interest at a 7% per year rate. The Company determined that the notes did not contain a beneficial conversion feature. These notes are due March 16, 2017, however, if suitable natural gas and petroleum properties are not located in the near term, the restricted cash will be used to pay off these notes. For this reason, the notes have been classified as current liabilities. On December 1, 2014, the Company consolidated, renewed and modified certain notes payables that are convertible into common stock of the Company. At the issuance of the new notes, the conversion price was decreased to $.02 per share and the interest rate was reduced to 2%. The notes were evaluated pursuant to ASC470-60 Troubled Debt Restructuring and ASC 470-50 Modification and Extinguishment. The change in the fair value of the conversion option was greater than 10% of the carrying value of the debt immediately prior to the modification however there was no accounting impact as there were no direct costs associated with the modification to capitalize, fees paid to lenders or unamortized discounts to account for. NOTE 6 - ADVANCES FROM OFFICER AND STOCKHOLDER Advances from Stockholder: Advances from two stockholders at March 31, 2016 and 2015 were $31,000 and $31,000, respectively. Advances from Officer: Our CEO, Ryan Corley, has made advances to the Company in prior years. During the years ended March 31, 2016 and 2015, the CEO made additional unsecured advances totaling $5,000 and $10,000, respectively. During the years ended March 31, 2016 and 2015, the Company made payments on these advances of $-0- and $-0-, respectively. Also during the years ended March 31, 2016 and 2015, the Company converted $40,000 and $2,000 of the advances into notes payable, respectively. At March 31, 2016 and 2015, advances from the CEO were $-0- and $10,000 respectively. The Company has notes payable to the CEO in the aggregate amount of $704,455 and $664,455 as of March 31, 2016 and 2015, respectively. Accrued interest owed on these notes at March 31, 2016 and 2015 amounted to $175,759 and $162,137, respectively. These notes and accrued interest are convertible into 37,535,471 and 34,854,350 shares of restricted common stock of the Company, respectively. At March 31, 2016 and 2015, advances from the entity controlled by the CEO were $10,500 and $10,500, respectively, and notes payable totaled $160,250 and $160,250, respectively. Accrued interest owed on these notes at March 31, 2016 and 2015 amounted to $29,711 and $25,392, respectively. These notes and accrued interest are convertible into 3,059,127 and 2,990,982 shares of restricted common stock of the Company, respectively. The Company conducts its business from the office of its CEO, Ryan Corley, rent free. Table of Contents ENXNET, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE YEARS ENDED March 31, 2016 and NOTE 7 - COMMON STOCK TRANSACTIONS The Company issued 250,000 common shares with the issuance of two notes payable in the aggregate of $125,000 during the year ended March 31, 2015. The Company recorded debt issuance cost of $4,250. The Company sold 700,000 common shares during the year ended March 31, 2015 cash of $35,000. The Company issued 1,600,000 and 2,000,000 common shares during the years ended March 31, 2016 and 2015 for services valued at $18,500 and $12,000, respectively. Of these shares, 500,000 and -0-, respectively were issued to the CFO and to a director. NOTE 8 - STOCK OPTIONS On July 24, 2001, the Company filed with the SEC Form S-8, for its 2002 Stock Option Plan, (the Plan). An aggregate amount of common stock that may be awarded and purchased under the Plan is 3,000,000 shares of the Company’s common stock. A summary of the status of the Company’s stock options as of March 31, 2016 and 2015 is presented below: The following table summarizes the information about the stock options as of March 31, 2016: The following table summarizes the information about the stock options as of March 31, 2015: Table of Contents
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Here's a summary of the financial statement:
The company is experiencing ongoing losses since its inception, which raises concerns about its ability to continue operating. Key financial aspects include:
1. Profitability: Consistent losses, potential financial instability
2. Assets:
- Fixed assets recorded at cost
- Depreciation calculated using straight-line method
- Typical asset useful life is around 3 years
3. Liabilities:
- Appears to have a debt-free cash flow approach
- Uses present value discounting for cash flows
- Follows stock-based compensation guidelines (ASC 718)
The statement suggests the company is in a challenging financial position and may require strategic interventions to ensure continued operation.
Note: The summary is based on the limited and fragmented information provided. A complete financial statement would offer more comprehensive insights.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Documents Page Report of Management on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm Statements of Financial Condition as of December 31, 2016 and 2015 Schedule of Investments as of December 31, 2016 Schedule of Investments as of December 31, 2015 Statements of Income and Expenses for the Years Ended December 31, 2016, 2015 and 2014 Statement of Changes in Shareholders’ Equity for the Year Ended December 31, 2016 Statement of Changes in Shareholders’ Equity for the Year Ended December 31, 2015 Statement of Changes in Shareholders’ Equity for the Year Ended December 31, 2014 Statements of Cash Flows for the Years Ended December 31, 2016, 2015 and 2014 Notes to Financial Statements Report of Management on Internal Control Over Financial Reporting Management of Invesco PowerShares Capital Management LLC, as managing owner (the “Managing Owner”) of PowerShares DB Agriculture Fund (the “Fund”), is responsible for establishing and maintaining adequate internal control over financial reporting, as defined under Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Fund; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Fund’s receipts and expenditures are being made only in accordance with appropriate authorizations of management; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Fund’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements, errors or fraud. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. We, Daniel Draper, Principal Executive Officer, and Steven Hill, Principal Financial and Accounting Officer, Investment Pools, of the Managing Owner, assessed the effectiveness of the Fund’s internal control over financial reporting as of December 31, 2016. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework (2013). The assessment included an evaluation of the design of the Fund’s internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting. Based on our assessment and those criteria, we have concluded that the Fund maintained effective internal control over financial reporting as of December 31, 2016. The Fund’s independent registered public accounting firm, PricewaterhouseCoopers LLP, has audited the Fund’s internal control over financial reporting as of December 31, 2016, as stated in their report on page 44 of the Fund’s Annual Report on Form 10-K. February 27, 2017 Report of Independent Registered Public Accounting Firm To the Board of Managers of PowerShares DB Multi-Sector Commodity Trust and the Shareholders of PowerShares DB Agriculture Fund: In our opinion, the accompanying statements of financial condition, including the schedules of investments, and the related statements of income and expenses, of changes in shareholders’ equity and of cash flows, present fairly, in all material respects, the financial position of PowerShares DB Agriculture Fund (a series of PowerShares DB Multi-Sector Commodity Trust, hereafter referred to as the “Fund”), at December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Fund maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Fund's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Annual Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Fund's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A fund’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A fund’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the fund; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the fund are being made only in accordance with authorizations of management of the fund; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the fund’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP Chicago, Illinois February 27, 2017 PowerShares DB Agriculture Fund Statements of Financial Condition December 31, 2016 and 2015 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Schedule of Investments December 31, 2016 (a) Security may be traded on a discount basis. The interest rate shown represents the discount rate at the most recent auction date of the security prior to period end. (b) United States Treasury Obligations of $104,853,000 are on deposit with the Commodity Broker and held as maintenance margin for open futures contracts. (c) The security and the Fund are advised by wholly-owned subsidiaries of Invesco Ltd. and are therefore considered to be affiliated. The rate shown is the 7-day SEC standardized yield as of December 31, 2016. (d) Unrealized appreciation/(depreciation) is presented above, net by contract. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Schedule of Investments December 31, 2015 (a) Security may be traded on a discount basis. The interest rate shown represents the discount rate at the most recent auction date of the security prior to year end. (b) United States Treasury Obligations of $94,990,500 are on deposit with the Commodity Broker and held as maintenance margin for open futures contracts. (c) Unrealized appreciation/(depreciation) is presented above, net by contract. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Statements of Income and Expenses For the Years Ended December 31, 2016, 2015 and 2014 (a) Interest Expense for the years ended December 31, 2016 and 2015 represents interest expense on overdraft balances. These amounts are included in Interest Income for the year ended December 31, 2014. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Statement of Changes in Shareholders’ Equity For the Year Ended December 31, 2016 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Statement of Changes in Shareholders’ Equity For the Year Ended December 31, 2015 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Statement of Changes in Shareholders’ Equity For the Year Ended December 31, 2014 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Statements of Cash Flows For the Years Ended December 31, 2016, 2015 and 2014 (a) Cash at December 31, 2014 and prior reflects cash held by the Predecessor Commodity Broker. (b) Cash at December 31, 2016 and 2015 reflects cash held by the Custodian. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Agriculture Fund Notes to Financial Statements December 31, 2016 (1) Background On October 24, 2014, DB Commodity Services LLC, a Delaware limited liability company (“DBCS”), DB U.S. Financial Markets Holding Corporation (“DBUSH”) and Invesco PowerShares Capital Management LLC (“Invesco”) entered into an Asset Purchase Agreement (the “Agreement”). DBCS is a wholly-owned subsidiary of DBUSH. DBCS agreed to transfer and sell to Invesco all of DBCS’ interest in the PowerShares DB Agriculture Fund (the “Fund”), a separate series of PowerShares DB Multi-Sector Commodity Trust (the “Trust”), a Delaware statutory trust organized in seven separate series, including the sole and exclusive power to direct the business and affairs of the Trust and the Fund, as well as certain other assets pertaining to the management of the Trust and the Fund, pursuant to the terms and conditions of the Agreement (the “Transaction”). The Transaction was consummated on February 23, 2015 (the “Closing Date”). Invesco now serves as the managing owner (the “Managing Owner”), commodity pool operator and commodity trading advisor of the Trust and the Fund, in replacement of DBCS (the “Predecessor Managing Owner”). (2) Organization The Fund is a separate series of the Trust. The Trust is a Delaware statutory trust organized in seven separate series and was formed on August 3, 2006. The Predecessor Managing Owner seeded the Fund with a capital contribution of $1,000 in exchange for 40 General Shares of the Fund. The General Shares were sold to the Managing Owner by the Predecessor Managing Owner pursuant to the terms of the Agreement. The fiscal year end of the Fund is December 31st. The term of the Fund is perpetual (unless terminated earlier in certain circumstances) as provided for in the Fifth Amended and Restated Declaration of Trust and Trust Agreement of the Trust, as amended (the “Trust Agreement”). The Fund has an unlimited number of shares authorized for issuance. The Fund offers common units of beneficial interest (the “Shares”) only to certain eligible financial institutions (the “Authorized Participants”) in one or more blocks of 200,000 Shares, called a Basket. The Fund commenced investment operations on January 3, 2007. The Fund commenced trading on the American Stock Exchange (which became the NYSE Alternext US LLC (the “NYSE Alternext”)) on January 5, 2007 and, as of November 25, 2008, is listed on the NYSE Arca, Inc. (the “NYSE Arca”). This Annual Report (the “Report”) covers the years ended December 31, 2016, 2015 and 2014 (herein referred to as the “Year Ended December 31, 2016” ,the “Year Ended December 31, 2015” and the “Year Ended December 31, 2014”, respectively). The Fund’s performance information from inception up to and excluding the Closing Date is a reflection of the performance associated with the Predecessor Managing Owner. The Managing Owner has served as managing owner of the Fund since the Closing Date, and the Fund’s performance information since the Closing Date is a reflection of the performance associated with the Managing Owner. Past performance of the Fund is not necessarily indicative of future performance. (3) Fund Investment Overview The Fund seeks to track changes, whether positive or negative, in the level of the DBIQ Diversified Agriculture Index Excess ReturnTM (the “Index”) over time, plus the excess, if any, of the sum of the Fund’s interest income from its holdings of United States Treasury Obligations (“Treasury Income”) and dividends from its holdings in money market mutual funds (affiliated or otherwise) (“Money Market Income”) over the expenses of the Fund. Additionally, the Fund may also gain an exposure to United States Treasury Obligations through an investment in exchange-traded funds (affiliated or otherwise) that track indexes that measure the performance of United States Treasury Obligations with a maximum remaining maturity of up to 12 months (“T-Bill ETFs”), and the Fund may receive dividends or distributions of capital gains from such investment in T-Bill ETFs (“T-Bill ETF Income”). For the avoidance of doubt, the Fund invests in futures contracts in an attempt to track its Index. The Fund holds United States Treasury Obligations, money market mutual funds and may, in the future, hold T-Bill ETFs for margin and/or cash management purposes only. The Index is intended to reflect the change in market value of the agricultural sector. The commodities comprising the Index are Corn, Soybeans, Wheat, Kansas City Wheat, Sugar, Cocoa, Coffee, Cotton, Live Cattle, Feeder Cattle and Lean Hogs (each an “Index Commodity”, and collectively, the “Index Commodities”). The Commodity Futures Trading Commission (the “CFTC”) and/or commodity exchanges, as applicable, impose position limits on market participants trading in the commodities included in the Index. The Index is comprised of futures contracts on the Index Commodities that expire in a specific month and trade on a specific exchange (the “Index Contracts”). If the Managing Owner determines in its commercially reasonable judgment that it has become impracticable or inefficient for any reason for the Fund to gain full or partial exposure to the Index Commodity by investing in the Index Contract, the Fund may invest in a futures contract referencing the particular Index Commodity other than the specific contract that comprises the applicable Index or, in the alternative, invest in other futures contracts not based on the particular Index Commodity if, in the commercially reasonable judgment of the Managing Owner, such futures contracts tend to exhibit trading prices that correlate with a futures contract that comprises the applicable Index. Should the Fund approach or reach position limits with respect to certain futures contracts comprising the Index, the Fund will commence investing in other futures contracts based on commodities that comprise the Fund’s Index and in futures contracts based on commodities other than commodities that comprise the Fund’s Index. (4) Service Providers and Related Party Agreements The Trustee Under the Trust Agreement, Wilmington Trust Company, the trustee of the Trust and the Fund (the “Trustee”), has delegated to the Managing Owner the exclusive management and control of all aspects of the business of the Trust and the Fund. The Trustee will have no duty or liability to supervise or monitor the performance of the Managing Owner, nor will the Trustee have any liability for the acts or omissions of the Managing Owner. The Managing Owner The Managing Owner serves as the Fund’s commodity pool operator, commodity trading advisor and managing owner. The Fund pays the Managing Owner a management fee, monthly in arrears, in an amount equal to 0.85% per annum of the daily net asset value of the Fund (the “Management Fee”). From inception up to and excluding the Closing Date, all Management Fees were payable to the Predecessor Managing Owner. The Managing Owner has served as managing owner of the Fund since the Closing Date and all Management Fee accruals since the Closing Date have been paid to the Managing Owner. The Fund may, for cash management purposes, invest in money market mutual funds that are managed by affiliates of the Managing Owner. The indirect portion of the management fee that the Fund may incur through such investment is in addition to the Management Fee paid to the Managing Owner. The Managing Owner has contractually agreed to waive the fees that it receives in an amount equal to the indirect management fees that the Fund incurs through its investments in affiliated money market mutual funds through June 20, 2018. The Fund may invest in affiliated T-Bill ETFs. The Managing Owner expects to enter into a similar agreement with respect to any indirect management fees incurred by the Fund through such investment in affiliated T-Bill ETFs, if any. The Managing Owner waived fees of $24,645 for the Year Ended December 31, 2016. The Commodity Broker Effective as of the Closing Date, Morgan Stanley & Co. LLC, a Delaware limited liability company, serves as the Fund’s futures clearing broker (the “Commodity Broker”). Deutsche Bank Securities Inc. (“DBSI”), a Delaware corporation, served as the Fund’s futures clearing broker up to and excluding the Closing Date (the “Predecessor Commodity Broker”). DBSI is an indirect wholly-owned subsidiary of Deutsche Bank AG and is an affiliate of the Predecessor Managing Owner. A variety of executing brokers execute futures transactions on behalf of the Fund. Such executing brokers give-up all such transactions to the Commodity Broker. In its capacity as clearing broker, the Commodity Broker may execute or receive transactions executed by others and clears all of the Fund’s futures transactions and performs certain administrative and custodial services for the Fund. The Commodity Broker is responsible, among other things, for providing periodic accountings of all dealings and actions taken by the Trust on behalf of the Fund during the reporting period, together with an accounting of all securities, cash or other indebtedness or obligations held by it or its nominees for or on behalf of the Fund. For the avoidance of doubt, from inception up to and excluding the Closing Date, commission payments were paid to the Predecessor Commodity Broker. The Commodity Broker has served as the Fund’s futures clearing broker since the Closing Date and all commission accruals since the Closing Date have been paid to the Commodity Broker. The Administrator, Custodian and Transfer Agent The Bank of New York Mellon (the “Administrator” and “Custodian”) is the administrator, custodian and transfer agent of the Fund. The Fund and the Administrator have entered into separate administrative, custodian, transfer agency and service agreements (collectively referred to as the “Administration Agreement”). Pursuant to the Administration Agreement, the Administrator performs or supervises the performance of services necessary for the operation and administration of the Fund (other than making investment decisions), including receiving and processing orders from Authorized Participants to create and redeem Baskets, net asset value calculations, accounting and other fund administrative services. The Administrator maintains certain financial books and records, including: Basket creation and redemption books and records, fund accounting records, ledgers with respect to assets, liabilities, capital, income and expenses, the registrar, transfer journals and related details, and trading and related documents received from the Commodity Broker. The Managing Owner pays the Administrator fees for its services out of the Management Fee. As of December 31, 2014, the Fund held $50,738,487 of cash and $1,239,965,626 of United States Treasury Obligations at the Predecessor Commodity Broker. In conjunction with the Transaction, during the three-day period from February 24, 2015 to February 26, 2015, the Fund transferred $91,487,292 of cash and $832,990,770 of United States Treasury Obligations from the Predecessor Commodity Broker to the Custodian. Additionally, during that same three-day period, the Fund transferred all of its open positions of commodity futures contracts from the Predecessor Commodity Broker to the Commodity Broker, $164,983,500 of United States Treasury Obligations from the Custodian to the Commodity Broker to satisfy maintenance margin requirements and $88,823,232 of cash from the Custodian to the Commodity Broker to satisfy variation margin requirements for open commodity futures contracts. Effective February 26, 2015, the Managing Owner began transferring cash daily from the Custodian to the Commodity Broker to satisfy the previous day’s variation margin on open futures contracts. The Distributor Effective June 20, 2016, Invesco Distributors, Inc. (the “Distributor”) became distributor and began providing certain distribution services to the Fund. Pursuant to the Distribution Services Agreement among the Managing Owner, the Fund and the Distributor, the Distributor assists the Managing Owner and the Administrator with certain functions and duties relating to distribution and marketing services to the Fund including reviewing and approving marketing materials. Prior to June 20, 2016, ALPS Distributors, Inc. provided distribution services to the Fund. The Managing Owner pays the Distributor a distribution fee out of the Management Fee. Index Sponsor Effective as of the Closing Date, the Managing Owner, on behalf of the Fund, has appointed Deutsche Bank Securities Inc. to serve as the index sponsor (the “Index Sponsor”). Prior to the Closing Date, the index sponsor was Deutsche Bank AG London. The Index Sponsor calculates and publishes the daily index levels and the indicative intraday index levels. Additionally, the Index Sponsor also calculates the indicative value per Share of the Fund throughout each business day. The Managing Owner pays the Index Sponsor a licensing fee and an index services fee out of the Management Fee for performing its duties. Marketing Agent Effective as of the Closing Date, the Managing Owner, on behalf of the Fund, has appointed Deutsche Bank Securities Inc. as the marketing agent (the “Marketing Agent”) to assist the Managing Owner by providing support to educate institutional investors about the DBIQ indices and to complete governmental or institutional due diligence questionnaires or requests for proposals related to the DBIQ indices. The Managing Owner pays the Marketing Agent a marketing services fee out of the Management Fee. The Marketing Agent will not open or maintain customer accounts or handle orders for the Fund. The Marketing Agent has no responsibility for the performance of the Fund or the decisions made or actions taken by the Managing Owner. (5) Summary of Significant Accounting Policies (a) Basis of Presentation The financial statements of the Fund have been prepared using U.S. generally accepted accounting principles (“U.S. GAAP”). The Fund has determined that it meets the definition of an investment company and has prepared the financial statements in conformity with U.S. GAAP for investment companies in conformity with accounting and reporting guidance of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 946 - Investment Companies. (b) Use of Estimates The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities during the reporting period of the financial statements and accompanying notes. Actual results could differ from those estimates. (c) Financial Instruments and Fair Value Investment transactions are recorded in the Statements of Financial Condition on a trade date basis at fair value with changes in fair value recognized in earnings in each period. U.S. GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, under current market conditions. U.S. GAAP establishes a hierarchy that prioritizes the inputs to valuation methods, giving the highest priority to readily available unadjusted quoted prices in an active market for identical assets (Level 1) and the lowest priority to significant unobservable inputs (Level 3), generally when market prices are not readily available or are unreliable. Based on the valuation inputs, the securities or other investments are tiered into one of three levels. Changes in valuation methods or market conditions may result in transfers in or out of an investment’s assigned level: Level 1-Prices are determined using quoted prices in an active market for identical assets. Level 2-Prices are determined using other significant observable inputs. Observable inputs are inputs that other market participants may use in pricing a security. These may include quoted prices for similar securities, interest rates, prepayment speeds, credit risk, yield curves, loss severities, default rates, discount rates, volatilities and others. Level 3-Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment at the end of the period), unobservable inputs may be used. Unobservable inputs reflect the Fund’s own assumptions about the factors market participants would use in determining fair value of the securities or instruments and would be based on the best available information. United States Treasury Obligations are fair valued using an evaluated quote provided by an independent pricing service. Evaluated quotes provided by the pricing service may be determined without exclusive reliance on quoted prices, and may reflect appropriate factors such as developments related to specific securities, yield, quality, type of issue, coupon rate, maturity, individual trading characteristics and other market data. All debt obligations involve some risk of default with respect to interest and/or principal payments. Futures contracts are valued at the final settlement price set by an exchange on which they are principally traded. Investments in open-end and closed-end registered investment companies that do not trade on an exchange are valued at the end of day NAV per share. Investments in open-end and closed-end registered investment companies that trade on an exchange are valued at the last sales price or official closing price as of the close of the customary trading session on the exchange where the security is principally traded. When market closing prices are not available, the Managing Owner may value an asset of the Fund pursuant to policies the Managing Owner has adopted, which are consistent with normal industry standards. The levels assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities. Because of the inherent uncertainties of valuation, the values reflected in the financial statements may materially differ from the value received upon actual sale of those investments. The following is a summary of the tiered valuation input levels as of December 31, 2016: (a) Unrealized appreciation (depreciation). The following is a summary of the tiered valuation input levels as of December 31, 2015: (a) Unrealized appreciation (depreciation). (d) Deposits with Commodity Broker and Custodian The Fund deposits cash and United States Treasury Obligations with its Commodity Broker subject to CFTC regulations and various exchange and broker requirements. The combination of the Fund’s deposits with its Commodity Broker of cash and United States Treasury Obligations and the unrealized profit or loss on open futures contracts represents the Fund’s overall equity in its broker trading account. To meet the Fund’s maintenance margin requirements, the Fund holds United States Treasury Obligations. The Fund transfers cash to the Commodity Broker to satisfy variation margin requirements. The Fund earns interest on any excess cash deposited with the Commodity Broker and incurs interest expense on any deficit balance with the Commodity Broker. The Fund’s remaining cash, United States Treasury Obligations and money market mutual fund holdings are on deposit with its Custodian. The Fund is permitted to temporarily carry a negative or overdrawn balance in its account with the Custodian. Such balances, if any at period-end, are shown on the Statement of Financial Condition under the payable caption Due to Custodian. The Fund defines cash and cash equivalents to be cash and other highly liquid investments, with original maturities of three months or less when purchased. (e) Investment Transactions and Investment Income Investment transactions are accounted for on a trade date basis. Realized gains (losses) from the sale or disposition of securities or derivatives are determined on a specific identification basis and recognized in the Statements of Income and Expenses in the period in which the contract is closed or the sale or disposition occurs, respectively. Interest income on United States Treasury Obligations is recognized on an accrual basis when earned. Premiums and discounts are amortized or accreted over the life of the United States Treasury Obligations. Dividend income (net of withholding tax, if any) is recorded on the ex-dividend date. (f) Receivable/(Payable) for Shares Issued and Redeemed On any business day, an Authorized Participant may place an order to create or redeem Shares of the Fund. Cash settlement occurs at the creation order settlement date or the redemption order settlement date as discussed in Note 7. (g) Cash Held by Commodity Broker The Fund’s arrangement with the Commodity Broker requires the Fund to meet its variation margin requirement related to the price movements on futures contracts held by the Fund by maintaining cash on deposit with the Commodity Broker. The Fund assesses its variation margin requirements on a daily basis by recalculating the change in value of the futures contracts based on price movements. Subsequent cash payments are made or received by the Fund each business day depending on whether unrealized gains or losses are incurred on the futures contracts. Effective February 24, 2015, only the current day’s variation margin receivable or payable is disclosed as an asset or liability on the Statements of Financial Condition. (h) Income Taxes The Fund is classified as a partnership for U.S. federal income tax purposes. Accordingly, the Fund will generally not incur U.S. federal income taxes. No provision for federal, state, and local income taxes has been made in the accompanying financial statements, as investors are individually liable for income taxes, if any, on their allocable share of the Fund’s income, gain, loss, deductions and other items. The Managing Owner has reviewed all of the Fund’s open tax years and major jurisdictions and concluded that there is no tax liability resulting from unrecognized tax benefits relating to uncertain tax positions taken or expected to be taken in future tax returns. The Fund is also not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly change in the next twelve months. On an ongoing basis, the Managing Owner will monitor the Fund’s tax positions taken under the interpretation (and consult with its tax counsel from time to time when appropriate) to determine if adjustments to conclusions are necessary based on factors including, but not limited to, on-going analysis of tax law, regulation, and interpretations thereof. The major tax jurisdiction for the Fund and the earliest tax year subject to examination: United States, 2013. (i) Commodity Futures Contracts The Fund utilizes derivative instruments to achieve its investment objective. A futures contract is an agreement between counterparties to purchase or sell a specified underlying security or index for a specified price at a future date. All of the Fund’s commodity futures contracts are held and used for trading purposes. During the period the futures contracts are open, changes in the value of the contracts are recognized as unrealized gains or losses by recalculating the value of the contracts on a daily basis. Subsequent or variation margin payments are received or made depending upon whether unrealized gains or losses are incurred. These amounts are reflected as a receivable or payable on the Statements of Financial Condition. When the contracts are closed or expire, the Fund recognizes a realized gain or loss equal to the difference between the proceeds from, or cost of, the closing transaction and the Fund’s basis in the contract. Realized gains (losses) and changes in unrealized appreciation (depreciation) on open positions are determined on a specific identification basis and recognized in the Statements of Income and Expenses in the period in which the contract is closed or the changes occur, respectively. The Fair Value of Derivative Instruments is as follows: (a) Includes cumulative appreciation (depreciation) of commodity futures contracts. Only the current day’s variation margin receivable (payable) is reported in the December 31, 2016 and 2015 Statements of Financial Condition. The Effect of Derivative Instruments on the Statements of Income and Expenses is as follows: The table below summarizes the average monthly notional value of futures contracts outstanding during the period: The brokerage agreement with the Commodity Broker provides for the net settlement of all financial instruments covered by the agreement in the event of default or termination of any one contract. The Managing Owner will utilize any excess cash held at the Commodity Broker to offset any realized losses incurred in the commodity futures contracts, if available. To the extent that any excess cash held at the Commodity Broker is not adequate to cover any realized losses, a portion of the United States Treasury Obligations on deposit with the Commodity Broker will be sold to make additional cash available. For financial reporting purposes, the Fund offsets financial assets and financial liabilities that are subject to netting arrangements. In order for an arrangement to be eligible for netting, the Fund must have a basis to conclude that such netting arrangements are legally enforceable. The following table presents derivative instruments that are either subject to an enforceable netting agreement or offset by collateral arrangements as of December 31, 2016, net by contract: The following table presents derivative instruments that are either subject to an enforceable netting agreement or offset by collateral arrangements as of December 31, 2015, net by contract: (a) As of December 31, 2016 and 2015, a portion of the Fund’s U.S. Treasury Obligations were required to be deposited as maintenance margin in support of the Fund’s futures positions. (j) Brokerage Commissions and Fees The Fund incurs all brokerage commissions, including applicable exchange fees, National Futures Association (“NFA”) fees, give-up fees, pit brokerage fees and other transaction related fees and expenses charged in connection with trading activities by the Commodity Broker. These costs are recorded as Brokerage Commissions and Fees in the Statements of Income and Expenses. The Commodity Broker’s brokerage commissions and trading fees are determined on a contract-by-contract basis. On average, total charges paid to the Commodity Broker and the Predecessor Commodity Broker, as applicable, were less than $7.00, $7.00 and $10.00 per round-turn trade during the Years Ended December 31, 2016, 2015 and 2014, respectively. (k) Routine Operational, Administrative and Other Ordinary Expenses After the Closing Date, the Managing Owner assumed all routine operational, administrative and other ordinary expenses of the Fund, including, but not limited to, computer services, the fees and expenses of the Trustee, legal and accounting fees and expenses, tax preparation expenses, filing fees and printing, mailing and duplication costs. Prior to the Closing Date, the Predecessor Managing Owner assumed all routine operational, administrative and other ordinary expenses of the Fund. Accordingly, such expenses are not reflected in the Statements of Income and Expenses of the Fund. For the avoidance of doubt, the Fund does not reimburse the Managing Owner for the routine operational, administrative and other ordinary expenses of the Fund. (l) Non-Recurring Fees and Expenses The Fund pays all non-recurring and unusual fees and expenses (referred to as extraordinary fees and expenses in the Trust Agreement), if any, of itself, as determined by the Managing Owner. Non-recurring and unusual fees and expenses are fees and expenses which are non-recurring and unusual in nature, such as legal claims and liabilities, litigation costs or indemnification or other unanticipated expenses. Such non-recurring and unusual fees and expenses, by their nature, are unpredictable in terms of timing and amount. For the Years Ended December 31, 2016, 2015 and 2014, the Fund did not incur such expenses. (6) Financial Instrument Risk In the normal course of its business, the Fund is a party to financial instruments with off-balance sheet risk. The term “off-balance sheet risk” refers to an unrecorded potential liability that, even though it does not appear on the balance sheet, may result in a future obligation or loss in excess of the amounts shown on the Statements of Financial Condition. The financial instruments used by the Fund are commodity futures contracts, whose values are based upon an underlying asset and generally represent future commitments that have a reasonable possibility of being settled in cash or through physical delivery. The financial instruments are traded on an exchange and are standardized contracts. Market risk is the potential for changes in the value of the financial instruments traded by the Fund due to market changes, including fluctuations in commodity prices. In entering into these futures contracts, there exists a market risk that such futures contracts may be significantly influenced by adverse market conditions, resulting in such futures contracts being less valuable. If the markets should move against all of the futures contracts at the same time, the Fund could experience substantial losses. Credit risk is the possibility that a loss may occur due to the failure of the Commodity Broker and/or clearinghouse to perform according to the terms of a futures contract. Credit risk with respect to exchange-traded instruments is reduced to the extent that an exchange or clearing organization acts as a counterparty to the transactions. The Commodity Broker, when acting as the Fund’s futures commission merchant in accepting orders for the purchase or sale of domestic futures contracts, is required by CFTC regulations to separately account for and segregate as belonging to the Fund all assets of the Fund relating to domestic futures trading and the Commodity Broker is not allowed to commingle such assets with other assets of the Commodity Broker. In addition, CFTC regulations also require the Commodity Broker to hold in a secure account assets of the Fund related to foreign futures trading. The Fund’s risk of loss in the event of counterparty default is typically limited to the amounts recognized in the Statements of Financial Condition and not represented by the futures contract or notional amounts of the instruments. The Fund has not utilized, nor does it expect to utilize in the future, special purpose entities to facilitate off-balance sheet financing arrangements and has no loan guarantee arrangements or off-balance sheet arrangements of any kind, other than agreements entered into in the normal course of business noted above. (7) Share Purchases and Redemptions (a) Purchases On any business day, an Authorized Participant may place an order with the Administrator who serves as the Fund’s transfer agent (“Transfer Agent”) to create one or more Baskets. For purposes of processing both creation and redemption orders, a “business day” means any day other than a day when banks in New York City are required or permitted to be closed. Creation orders must be placed by 10:00 a.m., Eastern Time. The day on which the Transfer Agent receives a valid creation order is the creation order date. The day on which a creation order is settled is the creation order settlement date. As provided below, the creation order settlement date may occur up to three business days after the creation order date. By placing a creation order, and prior to delivery of such Baskets, an Authorized Participant’s DTC account is charged the non-refundable transaction fee due for the creation order. Unless otherwise agreed to by the Managing Owner and the Authorized Participant as provided in the next sentence, Baskets are issued on the creation order settlement date as of 2:45 p.m., Eastern Time, on the business day immediately following the creation order date at the applicable net asset value per Share as of the closing time of the NYSE Arca or the last to close of the exchanges on which its futures contracts are traded, whichever is later, on the creation order date, but only if the required payment has been timely received. Upon submission of a creation order, the Authorized Participant may request the Managing Owner to agree to a creation order settlement date up to three business days after the creation order date. Creation orders may be placed either (i) through the Continuous Net Settlement (“CNS”) clearing processes of the National Securities Clearing Corporation (the “NSCC”) (the “CNS Clearing Process”) or (ii) if outside the CNS Clearing Process, only through the facilities of The Depository Trust Company (“DTC” or the “Depository”) (the “DTC Process”), or a successor depository. (b) Redemptions On any business day, an Authorized Participant may place an order with the Transfer Agent to redeem one or more Baskets. Redemption orders must be placed by 10:00 a.m., Eastern Time. The day on which the Managing Owner receives a valid redemption order is the redemption order date. The day on which a redemption order is settled is the redemption order settlement date. As provided below, the redemption order settlement date may occur up to three business days after the redemption order date. The redemption procedures allow Authorized Participants to redeem Baskets. Individual Shareholders may not redeem directly from the Fund. Instead, individual Shareholders may only redeem Shares in integral multiples of 200,000 and only through an Authorized Participant. Unless otherwise agreed to by the Managing Owner and the Authorized Participant as provided in the next sentence, by placing a redemption order, an Authorized Participant agrees to deliver the Baskets to be redeemed through DTC’s book-entry system to the Fund not later than the redemption order settlement date as of 2:45 p.m., Eastern Time, on the business day immediately following the redemption order date. Upon submission of a redemption order, the Authorized Participant may request the Managing Owner to agree to a redemption order settlement date up to three business days after the redemption order date. By placing a redemption order, and prior to receipt of the redemption proceeds, an Authorized Participant’s DTC account is charged the non-refundable transaction fee due for the redemption order. Redemption orders may be placed either (i) through the CNS Clearing Process or (ii) if outside the CNS Clearing Process, only through the DTC Process, or a successor depository, and only in exchange for cash. The redemption proceeds from the Fund consist of the cash redemption amount. The cash redemption amount is equal to the net asset value of the number of Basket(s) requested in the Authorized Participant’s redemption order as of the closing time of the NYSE Arca or the last to close of the exchanges on which the Fund’s futures contracts are traded, whichever is later, on the redemption order date. The Managing Owner will distribute the cash redemption amount at the redemption order settlement date as of 2:45 p.m., Eastern Time, on the redemption order settlement date through DTC to the account of the Authorized Participant as recorded on DTC’s book-entry system. The redemption proceeds due from the Fund are delivered to the Authorized Participant at 2:45 p.m., Eastern Time, on the redemption order settlement date if, by such time, the Fund’s DTC account has been credited with the Baskets to be redeemed. If the Fund’s DTC account has not been credited with all of the Baskets to be redeemed by such time, the redemption distribution is delivered to the extent of whole Baskets received. Any remainder of the redemption distribution is delivered on the next business day to the extent of remaining whole Baskets received if the Transfer Agent receives the fee applicable to the extension of the redemption distribution date which the Managing Owner may, from time-to-time, determine and the remaining Baskets to be redeemed are credited to the Fund’s DTC account by 2:45 p.m., Eastern Time, on such next business day. Any further outstanding amount of the redemption order will be cancelled. The Managing Owner is also authorized to deliver the redemption distribution notwithstanding that the Baskets to be redeemed are not credited to the Fund’s DTC account by 2:45 p.m., Eastern Time, on the redemption order settlement date if the Authorized Participant has collateralized its obligation to deliver the Baskets through DTC’s book-entry system on such terms as the Managing Owner may determine from time-to-time. (8) Profit and Loss Allocations and Distributions Pursuant to the Trust Agreement, income and expenses are allocated pro rata to the Managing Owner as holder of the General Shares and to the Shareholders monthly based on their respective percentage interests as of the close of the last trading day of the preceding month. Distributions (other than redemption of units) may be made at the sole discretion of the Managing Owner on a pro rata basis in accordance with the respective capital balances of the shareholders. No distributions were paid for the Years Ended December 31, 2016, 2015 and 2014. (9) Commitments and Contingencies The Managing Owner, either in its own capacity or in its capacity as the Managing Owner and on behalf of the Fund, has entered into various service agreements that contain a variety of representations, or provide indemnification provisions related to certain risks service providers undertake in performing services which are in the best interests of the Fund. As of December 31, 2016 and December 31, 2015, no claims had been received by the Fund. Further, the Fund has not had prior claims or losses pursuant to these contracts. Accordingly, the Managing Owner expects the risk of loss to be remote. (10) Net Asset Value and Financial Highlights The Fund is presenting the following net asset value and financial highlights related to investment performance for a Share outstanding for the Years Ended December 31, 2016, 2015 and 2014. An individual investor’s return and ratios may vary based on the timing of capital transactions. Net asset value per Share is the net asset value of the Fund divided by the number of outstanding Shares at the date of each respective period presented. (a) Based on average shares outstanding. (b) The mean between the last bid and ask prices. (c) Effective as of the Closing Date, the Fund changed the source of market value per share prices, resulting in a difference in the ending market value per share presented for the year ended December 31, 2014 and the beginning market value per share for the year ended December 31, 2015. (d) Total Return, at net asset value is calculated assuming an initial investment made at the net asset value at the beginning of the period, reinvestment of all dividends and distributions at net asset value during the period, and redemption of Shares on the last day of the period. Total Return, at net asset value includes adjustments in accordance with accounting principles generally accepted in the United States of America and as such, the net asset value for financial reporting purposes and the returns based upon those net asset values may differ from the net asset value and returns for shareholder transactions. Total Return, at market value is calculated assuming an initial investment made at the market value at the beginning of the period, reinvestment of all dividends and distributions at market value during the period, and redemption of Shares at the market value on the last day of the period. Not annualized for periods less than one year, if applicable.
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Based on the provided text, here's a summary of the financial statement:
Key Points:
1. Administrator and Custodian: The Bank of New York Mellon serves as the Fund's administrator, custodian, and transfer agent.
2. Administrative Services:
- Processes orders for creating and redeeming Baskets
- Calculates net asset value
- Maintains financial books and records
- Handles accounting and fund administrative services
3. Fee Structure:
- The Managing Owner pays the Administrator's fees from the Management Fee
- Commission payments were initially made to the Predecessor Commodity Broker
- Since the Closing Date, commission accruals have been paid to the Commodity Broker
4. Record Keeping:
- Maintains records related to:
- Basket creation and redemption
- Fund accounting
- Assets, liabilities, capital
- Income and expenses
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Claude
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CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM To the Board of Directors and Stockholders of Medical Imaging Corp. We have audited the accompanying consolidated balance sheets of Medical Imaging Corp. as of December 31, 2016 and 2015, and the related consolidated statements of operations and comprehensive loss, stockholders’ deficit, and cash flows for the years then ended. Medical Imaging Corp.’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Medical Imaging Corp. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11, the Company has incurred net losses and negative working capital since inception. These factors, and the need for additional financing in order for the Company to meet its business plans, raise substantial doubt about the Company’s ability to continue as a going concern. /s/ Accell Audit & Compliance, P.A. Tampa, Florida April 17, 2017 4806 West Gandy Boulevard - Tampa, Florida 33611 - 813.440.6380 Medical Imaging Corp. Consolidated Balance Sheets The accompanying notes are an integral part of these consolidated financial statements. Medical Imaging Corp. Consolidated Statements of Operations The accompanying notes are an integral part of these consolidated financial statements. Medical Imaging Corp. Consolidated Statements of Changes in Stockholder’s Deficit From December 31, 2015 through December 31, 2016 The accompanying notes are an integral part of these consolidated financial statements Medical Imaging Corp. Consolidated Statements of Cash Flows The accompanying notes are an integral part of these consolidated financial statements Medical Imaging Corp. December 31, 2016 Note 1. Organization and Summary of Significant Accounting Policies Organization and Basis of Presentation Medical Imaging Corp., (“MIC” or the “Company”), a Nevada Corporation was incorporated in 2000. In 2005, the Company developed a business plan for private healthcare opportunities in Canada with the objective of owning and operating private diagnostic imaging clinics. In 2009, the Company purchased Canadian Teleradiology Services Inc., which operates as: Custom Teleradiology Services (“CTS”). CTS provides remote reading of medical diagnostic imaging scans for rural hospitals and clinics in Canada. In early 2010, the Company modified its business plan to grow its CTS subsidiary while commencing the acquisition of existing full service imaging clinics located in the United States and exploring the development of new diagnostic imaging technology. In 2012, the Company purchased Schuylkill Open MRI Inc., which operates as: Schuylkill Medical Imaging (“SMI”), an independent diagnostic imaging facility located in Pottsville, Pennsylvania. In 2014, the Company purchased Partners Imaging Center of Venice, LLC (“PIV”) located in Venice, Florida; Partners Imaging Center of Naples, LLC (“PIN”) located in Naples, Florida; and Partners Imaging Center of Charlotte, LLC (“PIC”) located in Port Charlotte, Florida. Basis of Presentation These consolidated financial statements and related notes are presented in accordance with accounting principles generally accepted in the United States, and are expressed in U.S. dollars. The Company’s fiscal year-end is December 31. Principle of Consolidation The consolidated financial statements include the accounts of Medical Imaging, Corp., and its wholly-owned subsidiaries, CTS, SMI, PIV, PIN, and PIC. Intercompany accounts and transactions have been eliminated in the consolidated financial statements. CTS’, SMI’s, PIV’s, PIN’s, and PIC’s accumulated earnings prior to their acquisitions are not included in the consolidated balance sheet. Use of Estimates and Assumptions The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities known to exist as of the date the consolidated financial statements are published, and (iii) the reported amount of net sales, expenses and costs recognized during the periods presented. Adjustments made with respect to the use of estimates often relate to improved information not previously available. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of consolidated financial statements; accordingly, actual results could differ from these estimates. Cash and Cash Equivalents The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. At December 31, 2016, and 2015, cash includes cash on hand and cash in the bank. Accounts Receivable Credit Risk The allowance for doubtful accounts is maintained at a level sufficient to provide for estimated credit losses based on evaluating known and inherent risks in the receivables portfolio. Management evaluates various factors including expected losses and economic conditions to predict the estimated realization on outstanding receivables. In connection with the acquisition of the three facilities located in Venice, Port Charlotte and Naples, Florida, the Company, in October 2014, entered into professional services agreements whereby the seller of those three facilities continued to handle the billing and collection for the imaging centers (the “third party billing”). The seller must still provide a full set of verification data to the Company with respect to its account receivable processing and collections so that the Company can determine the extent to which accounts submitted by the seller in connection with the third party billing have been collected or denied. Final verification will only be able to be completed after the conclusion of the services performed pursuant to the third party billing contract, and review of account balances which is expected during the 2017 fiscal year. As of December 31, 2016, and 2015, the allowance for doubtful accounts from direct billings was $200,982 and $56,475, respectively. The allowance for doubtful accounts from third party billings (Florida operations) was $275,000 in both years. Although the gross receivable balance has increased significantly, management is actively pursuing collection efforts directly with patients and insurance payers and believes that the current allowance for doubtful accounts is sufficient to cover any expected losses. Goodwill and Indefinite Intangible Assets The Company follows the provisions of Financial Accounting Standard Accounting Standards Codification (“ASC”) 350, Goodwill and Other Intangible Assets. In accordance with ASC 350, goodwill, representing the excess of the purchase price and related costs over the value assigned to net tangible and identifiable intangible assets of businesses acquired and accounted for under the purchase method, acquired in business combinations is assigned to reporting units that are expected to benefit from the synergies of the combination as of the acquisitions date. Under this standard, goodwill and intangibles with indefinite useful lives are not amortized. The Company assesses goodwill and indefinite-lived intangible assets for impairment annually, or more frequently if events and circumstances indicate impairment may have occurred in accordance with ASC 350. If the carrying value of a reporting unit's goodwill exceeds its implied fair value, the Company records an impairment loss equal to the difference. ASC 350 also requires that the fair value of indefinite-lived purchased intangible assets be estimated and compared to the carrying value. The Company recognizes an impairment loss when the estimated fair value of the indefinite-lived purchased intangible assets is less than the carrying value. If the implied fair value of goodwill is lower than its carrying amount, goodwill impairment is indicated and goodwill is written down to its implied fair value. Subsequent increases in goodwill value are not recognized in the consolidated financial statements. No goodwill impairment was recognized during 2016 or 2015. Revenue Recognition The Company holds contracts with several hospitals and groups of health care facilities to provide Teleradiology services for a specific period of time. The Company bills for services rendered on a monthly basis. For the year ended December 31, 2016, CTS held six contracts; four contracts that are renewable on a year-to-year basis and one contract that renewed in 2016 and one to be renewed in 2018. In accordance with the requirement of Staff Accounting Bulletin (“SAB”) 104, the Company recognizes revenue when: (1) persuasive evidence of an arrangement exists (contracts); (2) delivery has occurred (monthly); (3) the seller’s price is fixed or determinable (per the customer’s contract, and services performed); and (4) collectability is reasonably assured (based upon our credit policy). Revenue is accounted for under the guidelines established by SAB 101, Revenue Recognition in Financial Statements, and ASC 605, Revenue Recognition. For CTS, the Company has the following indicators of gross revenue reporting: (1) CTS is the primary obligator in the provision of services to the Hospitals under contract, (2) CTS has latitude in establishing price, and negotiating contracts with each hospital, (3) CTS negotiates and determines the service specification to be provided to each hospital client, (4) CTS has complete discretion in supplier selection, and (5) CTS has the credit risk. Accordingly, the Company records CTS revenue at gross. For SMI, PIV, PIN, and PIC, revenue is recognized on the date of service and recorded on an aggregate monthly basis. Cost of Sales Cost of sales includes fees paid to radiologists for reading services, transcription fees, equipment repairs, system license and usage costs. Impairment of Long-Lived Assets In accordance with ASC 360, Property, Plant and Equipment, property, equipment, and purchased intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Goodwill and other intangible assets are tested for impairment at least annually. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Stock Based Compensation The Company follows ASC 718, Stock Compensation; a fair value calculation is performed by the Company to establish the “grant date fair value” of each award which will also be the amount recorded by the Company as stock based compensation expense pursuant to the guidance set forth in ASC 718 to produce an estimated fair value. The Company measures all share-based payments to employees (which includes non-employee Board of Directors), including employee stock options, warrants and restricted stock, at the fair value of the award and expenses it over the requisite service period (generally the vesting period). The fair value of common stock options or warrants granted to employees is estimated at the date of grant using the binomial option pricing model (“BOPM”). The calculation also takes into account the common stock fair market value at the grant date, the exercise price, the expected life of the common stock option or warrant, the dividend yield and the risk-free interest rate. The Company from time to time may issue stock options, warrants and restricted stock to acquire goods or services from third parties. Restricted stock, options or warrants issued to other than employees or directors are recorded on the basis of their fair value. The options or warrants are valued using the BOPM on the basis of the market price of the underlying equity instrument on the “valuation date,” which for options and warrants related to contracts that have substantial disincentives to non-performance, is the date of the contract, and for all other contracts is the vesting date. Expenses related to the options and warrants are recognized on a straight-line basis over the period which services are to be received. There was no stock-based compensation expense to non-employees for the year ended December 31, 2016. For the year ended December 31, 2015, the Company recognized stock-based compensation expenses from stock granted to non-employees of $34,683 from stock options and $20,250 from stock issued. The options were valued using the BOPM and included in the legal and professional operating expenses in the consolidated statements of operations. For the year ended December 31, 2016, the Company recognized stock granted to employees of $14,000. For the year ended December 31, 2015, the Company recognized stock-based compensation expenses of $47,896 from stock options, and $45,215 from stock granted to employees. The options were valued using the BOPM and included in the labor and management fees operating expenses in the consolidated statements of operations for $34,683 and $13,213, respectively. Fair Value of Financial Instruments The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties other than in a forced sale or liquidation. The carrying amounts of the Company’s financial instruments, including cash, accounts receivable, prepaid expenses, accounts payable, accrued liabilities and notes and loans payable approximate fair value due to their most maturities. Fair Value Measurements The Company follows ASC 820 for disclosures about fair value of its financial instruments and to measure the fair value of its financial instruments. ASC 820 establishes a framework for measuring fair value in U.S. GAAP, and expands disclosures about fair value measurements. To increase consistency and comparability in fair value measurements and related disclosures, ASC 820 establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three levels of fair value hierarchy defined by ASC 820 are described below: Level 1 Quoted market prices available in active markets for identical assets or liabilities as of the reporting date. Level 2 pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 3 pricing inputs that are generally observable inputs and not corroborated by market data. The carrying amounts of the Company’s financial assets and liabilities, such as cash and accounts payable approximate their fair values because of the short maturity of these instruments. The Company does not have assets and liabilities that are carried at fair value on a recurring basis. Foreign Currency Translation The Company’s functional currency for its wholly-owned subsidiary, CTS, is the Canadian dollar, and their financial statements have been translated into U.S. dollars. The Canadian dollar based accounts of the Company’s foreign operations have been translated into United States dollars using the current rate method. Assets and liabilities of those operations are translated into U.S. dollars using exchange rates as of the balance sheet date; income and expenses are translated using the weighted average exchange rates for the reporting period. Translation adjustments are recorded as accumulated other comprehensive income (loss), a separate component of stockholders’ equity. The Company recognized a foreign currency gain (loss) on transactions from operations of $62,196 for the year ended December 31, 2016 and $(34,826) for the year ended December 31, 2015. The Company recognized other comprehensive income (loss) of $(2,525) for the year ended December 31, 2016 and $119,277 for the year ended December 31, 2015. Income Taxes The Company accounts for income taxes in accordance with ASC 740, Income Taxes. This statement prescribes the use of the asset and liability method whereby deferred tax asset and liability account balances are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Net Income (Loss) Per Share The Company follows the provisions of ASC 260, Earnings per Share. Basic net income (loss) per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Basic and diluted losses per share are the same as all potentially dilutive securities are anti-dilutive. Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock or conversion of notes into shares of the Company’s common stock that could increase the number of shares outstanding and lower the earnings per share of the Company’s common stock. This calculation is not done for periods in a loss position as this would be antidilutive. Recent Accounting Updates The Company does not expect the adoption of any recently issued accounting pronouncements to have a significant impact on its results of operations, financial position or cash flow. Reclassification of Accounts Certain prior period amounts have been reclassified to conform to December 31, 2016 presentation. Note 2. Property and Equipment Property and equipment are stated at cost. Depreciation is calculated using the straight - line method over the estimated useful life of the assets. At December 31, 2016 and 2015, the major class of property and equipment were as follows: Depreciation expense was $561,077 and $546,338 for the year ended December 31, 2016 and 2015, respectively. Note 3. Operating Lease Commitments CTS has a lease commitment for its office space of approximately $2,450 minimum rental per month, not including utilities, realty taxes, and operating costs. The lease renewed in April 2013 for a period of five years and will expire in March 2018. CTS has sublet the space under the original lease to the end of its original term. In accordance with ASC 840, Leases, the Company has recognized approximately $8,000 in total sublease loss, as a result of total anticipated revenue on the operating lease being less than original lease obligations. The loss was recorded on sublease execution and amortized over its term. CTS has a lease commitment for its new office space in Toronto, Canada of approximately $2,600 minimum rental per month, not including utilities, realty taxes, and operating costs. The lease will expire April 30, 2021. SMI entered into a lease commitment for its office space in Pottsville, Pennsylvania. The lease will expire on July 30, 2021. Monthly rental amounts are $6,908 per month not including utilities, realty taxes, and operating costs. SMI has a lease for its x-ray equipment space in Pottsville, Pennsylvania. The lease term is seven years from commitment date of October 2014. Monthly lease payments are $3,000. SMI has a lease for use of x-ray equipment and space in Pottsville, Pennsylvania. The lease term is two years from commitment date of January 2016. Monthly lease payments are $2,000. PIV has a lease for office space in Venice, Florida. The lease will expire September 30, 2021. Monthly rental amounts are $13,170 per month. PIN has a lease for office space in Naples, Florida. The lease will expire January 1, 2020. Monthly rental amounts are $9,543 per month. PIC has a lease for office space in Port Charlotte, Florida. The lease will expire June 20, 2021. Monthly rental amounts are $5,512 per month. Expected future minimum lease commitments as of December 31, 2016: Note 4. Capital Lease Obligations A detailed summary of the capital lease obligations is as follows: *Annual Percentage Rate (“APR”). Minimum future lease payments under the capital leases as of December 31, 2016 are as follow: Note 5. Promissory Notes A detailed summary of the promissory notes is as follows: *Annual Percentage Rate (“APR”) Note 6. Convertible Notes On December 5, 2012 and March 27, 2013, the Company sold, through a private placement to accredited investors, three year 12% convertible notes (“Series B Notes”) in the aggregate principal amount of $1,865,000, and $365,000, respectively. The Notes pay interest at a rate of 12% per annum, payable to the holder at 1% per month, and are convertible into common shares of the Company at $0.10 per share. In addition, each purchaser of the Notes received shares dependent on the dollar amount of Notes purchased. The total number of shares of common stock issued was 5,315,000 shares. On December 1, 2015, the holders of $1,840,000 Series B Notes have agreed to extend the maturity date of the debt outstanding to July 1, 2017 from its original maturity date of December 31, 2015. As part of the extension the Company issued warrants to entitle the holders to purchase up to 1,840,000 shares of common stock at an exercise price of $0.07 per share at any time from December 1, 2015 to July 1, 2018. The Company has valued the warrants at $0.0058 per issued share, and recorded a total discount of $10,672 to be amortized over the 18-month extension period. On March 31, 2016, the holders of $50,000 Series B Notes have agreed to extend the maturity date of the debt outstanding to September 1, 2017 from its original maturity date of March 31, 2016. As part of the extension the Company issued warrants to entitle the holders to purchase up to 50,000 shares of common stock at an exercise price of $0.07 per share at any time from March 31, 2016 to September 30, 2018. The Company has valued the warrants at $0.00278 per issued share, and recorded a total discount of $139 to be amortized over the 18-month extension period. On March 31, 2016, the holder of $25,000 Series B Notes has agreed to extend the maturity date of the debt outstanding to September 1, 2019 from its original maturity date of March 31, 2016. As part of the extension the Company issued warrants to entitle the holders to purchase up to 25,000 shares of common stock at an exercise price of $0.07 per share at any time from March 31, 2016 to September 30, 2019. The Company has valued the warrants at $0.00583 per issued share, and recorded a total discount of $146 to be amortized over the 30-month extension period. On May 22, 2014, the Company sold, through private placement to accredited investors, three year 12% convertible notes (“Series C Notes”) in the aggregate principal amount of $95,000. The Notes bear interest at a rate of 12% per annum, payable to the holder at1% per month, with the principal amount due on May 31, 2017. The Notes are convertible into shares of the Company’s common stock at an initial conversion rate of $0.15 per share. In addition, each holder of Series C Notes received shares dependent on the dollar amount of Notes purchased. On August 25, 2014, October 31, 2014 and February 17, 2015, the Company sold an additional $75,000, $50,000 and $20,000, respectively of Series C Notes. The total number of shares of common stock issued was 240,000 shares. On March 26, 2014, the Company issued a $300,000 convertible note to a non-affiliate. The note pays interest at a rate of 12% per annum, payable to the holder at 1% per month. In addition to interest payments, the Company is making monthly payments of $5,000 towards the principal balance beginning June 1, 2014 until the note due date of February 27, 2018. The note is convertible into common shares of the Company at $0.15 per share. In addition, the purchaser of the note received 300,000 shares as part of the note agreement. As of December 31, 2016, principal balance of the note was $145,000. In accordance with ASC 470, Debt with conversion and other options, (“ASC 470”) on issuance of the shares, the Company recognized additional paid-in capital and a discount against the notes for a total of $282,470. Amortization of the discount for the years ended December 31, 2016 and 2015 was $15,156 and $89,706, respectively. In accordance with ASC 480, Distinguishing Liabilities from Equity, the Company determined that the warrants are a freestanding instrument based on the following: Ÿ The debt can be transferred without the transfer of the warrants. Ÿ The warrants can be transferred without the transfer of the debt. Ÿ The warrants can be exercised while debt still outstanding. In accordance with ASC 470, if the warrants are classified as equity, then the proceeds should be allocated based on the relative fair values of the base instrument and the warrants were valued at $0.0058 per issued share, and recorded a total discount of $10,672 to be amortized over 18 months’ extension period. A detailed summary of the convertible notes is as follows: Following are maturities of the long -term debt as of December 31, 2016: Note 7. Royalty Financing On October 31, 2014, the Company entered into a royalty purchase agreement with Grenville Strategic Royalty Corp. (“Grenville”) for the amount of $2,000,000. The agreement calls for a monthly payment to Grenville based on a percentage of the total of certain revenue items and subject to a minimum payment amount until $8,000,000 has been paid. The amount financed is recorded net of discount to be amortized during the term. For the years ended December 31, 2016 and 2015, the Company has recorded discount amortization expense of $315,827 and $340,372, respectively. The balance as shown on the consolidated balance sheet as of December 31, 2016 was $2,007,424, net of $5,302,853 in unamortized discount. The balance as shown on the consolidated balance sheet as of December 31, 2015 was $1,935,101, net of $5,618,680 in unamortized discount. As of December 31, 2016, the Company paid a total of $689,723 in royalty payments, additionally the Company has accrued $181,096 in unpaid royalty fees from August to December 2016. Note 8. Income Taxes ASC 740 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between consolidated financial statements and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. For the year ended December 31, 2016, the Company had a cumulative net operating loss carryover of approximately $1,839,366 available for U.S federal income tax, which expire beginning in 2017. The net operating loss carryovers may be subject to limitations under Internal Revenue Code due to significant changes in the Company’s ownership. The Company has provided a full valuation allowance against the full amount of the net operating loss benefit, since, in the opinion of management, based upon the earnings history of the Company, it is more likely than not that the benefits will not be realized. Deferred net tax asset (34%) consists of the following at December 31, 2016: A reconciliation between income taxes at statutory tax rates (34%) and the actual income tax provision for continuing operations as of December 31, 2016 follows: The Company has filed its tax returns through December 31, 2015, and filed for a six months extension on its December 31, 2016 tax return filing. The provisions of ASC 740 require companies to recognize in their financial statements the impact of a tax position if that position is more likely than not to be sustained upon audit, based upon the technical merits of the position. ASC 740 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. ASC 740 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods and disclosure. Management does not believe that the Company has any material uncertain tax positions requiring recognition or measurement in accordance with the provisions of ASC 740. The Company’s policy is to record interest and penalties on uncertain tax positions, if any, as income tax expense. All past six tax years for the Company remain subject to future examinations by the applicable taxing authorities. Note 9. Related Party Transactions During January 2015, the Company entered into an agreement with a company that is owned and controlled by a major shareholder to provide consulting services. Fees payable for performance of the consulting services are $10,000 per month. In addition to the monthly fees, the consultant was paid at signing of the agreement, four million two hundred thousand (4,200,000) options to purchase common stock of the client at an exercise price of $0.15 per share with an expiry date of December 31, 2019; details of the options recognition are disclosed in Note 10. On December 28, 2015, 450,000 shares of common stock were issued as compensation of $20,250 owed and outstanding towards the 2015 consulting agreement. Fees incurred to the related party consultant for the years ended December 31, 2016 and 2015 were $120,000, respectively, and are included as an expense in Legal and Professional fees in the accompanying statement of operations for the period. Note 10. Common Stock Transactions On November 28, 2016, 100,000 shares were issued for services valued at $9,000 based upon the closing price of the Company’s common stock at the grant date. On June 16, 2016, the Company issued 30,000 shares of common stock of the Company as part of the bridge convertible note to a private investor. The shares were valued at $609 based upon the closing price of the Company’s common stock at the grant date. On June 7, 2016, 50,000 shares were issued for services valued at $5,000 based upon the closing price of the Company’s common stock at the grant date. On March 22, 2016, the Company issued 70,000 shares of common stock of the Company as part of the bridge convertible note to a private investor. The shares were valued at $1,421 based upon the closing price of the Company’s common stock at the grant date. On February 18, 2016, the Company issued 100,000 shares of common stock of the Company as part of the bridge convertible note to a private investor. The shares were valued at $7,000 based upon the closing price of the Company’s common stock at the grant date. For the year ended December 31, 2015, 1,425,000 shares were issued for services valued at $65,465 based upon the closing price of the Company’s common stock at the grant date. For the year ended December 31, 2015, 20,000 shares were issued as part of Series C convertible note agreements. The shares were valued at $1,040 based upon the closing price of the Company’s common stock at the grant date. On December 1, 2015, the Company issued 1,840,000 warrants to holders of Series B convertible notes (see Note 6) as part of the agreements to extend the maturity dates of the notes. The warrants are exercisable at a price of $0.07 per full share at any time from December 1, 2015 to July 1, 2018. The Company has valued the warrants at a $0.0058 per issued share. On January 27, 2015, the Company granted options as considerations for services provided by the CEO of the Company. The options are to purchase up to 4,200,000 shares of common stock, with an exercise price equal to $0.15 per share. The options shall have a five (5) year term. Inputs used in Binomial Option Pricing model were as follow: stock price at grant date: $0.0517, exercise price $0.15, expected life of the option two and a half (2.5) years, volatility of 70%, and risk free rate of 0.03%. The options were recorded on the grant date at a value of $34,683. On January 27, 2015, the Company granted options as considerations for consulting services provided to the Company. The options are to purchase up to 4,200,000 shares of common stock, with an exercise price equal to $0.15 per share. The options shall have a five (5) year term. Inputs used in Binomial Option Pricing model were as follow: stock price at grant date: $0.0517, exercise price $0.15, expected life of the option two and a half (2.5) years, volatility of 70%, and risk free rate of 0.03%. The options were recorded on the grant date at a value of $34,683. On January 27, 2015, the Company granted options as considerations for services provided by the CFO of the Company. The options are to purchase up to 1,600,000 shares of common stock, with an exercise price equal to $0.15 per share. The options shall have a five (5) year term. Inputs used in Binomial Option Pricing model were as follow: stock price at grant date: $0.0517, exercise price $0.15, expected life of the option two and a half (2.5) years, volatility of 70%, and risk free rate of 0.03%. The options were recorded on the grant date at a value of $13,213. Note 11. Going Concern As shown in the accompanying consolidated financial statements, the Company incurred net comprehensive loss of $1,333,411, and $1,621,233 for the years ended December 31, 2016 and 2015, as well as a working capital deficit of $5,276,282 at December 31, 2016. These conditions raise substantial doubt as to the Company’s ability to continue as a going concern. Management plans to raise additional financing in order to continue its operations and fulfill its debt obligations in 2017, but there can be no assurances that the plan will be successful. These consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. Note 12. Subsequent Events On February 23, 2017, 765,000 shares were issued for services valued at $30,600 based upon the closing price of the Company’s common stock at the grant date. The Company evaluated subsequent events through the date the consolidated financial statements were issued.
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt, primarily consisting of an audit opinion and some partial financial information. Without the complete financial statement, I cannot provide a comprehensive summary.
The text seems to include:
- An audit opinion from an accounting firm
- References to consolidated financial statements for Medical Imaging Corp.
- Mentions of audit standards and procedures
- Partial references to cash, liabilities, and financial reporting
To provide a meaningful summary, I would need the full financial statement with complete details about the company's financial position, revenues, expenses, assets, and liabilities.
If you have the complete financial statement, please share it, and I'll be happy to help you summarize it.
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Claude
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Xencor, Inc. Financial Statements Audited Financial Statements for the Years Ended December 31, 2016, 2015 and 2014: Report of Independent Registered Public Accounting Firm (RSM US LLP) Report of Independent Registered Public Accounting Firm (BDO USA LLP) Balance Sheets Statements of Comprehensive Income (Loss) Statements of Stockholders’ Equity Statements of Cash Flows Notes to Financial Statements Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders Xencor, Inc. We have audited the accompanying balance sheets of Xencor, Inc. as of December 31, 2016 and 2015, and the related statements of comprehensive income (loss), stockholders' equity and cash flows for each of the two years in the period ended December 31, 2016. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Xencor, Inc. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Xencor, Inc.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013, and our report dated February 28, 2017 expressed an unqualified opinion on the effectiveness of Xencor, Inc.’s internal control over financial reporting. /s/ RSM US LLP Los Angeles, California February 28, 2017 Report of Independent Registered Public Accounting Firm Regarding Internal Control Over Financial Reporting To the Board of Directors and Stockholders Xencor, Inc. We have audited Xencor Inc.'s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. Xencor, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Xencor, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the financial statements of Xencor, Inc. and our report dated February 28, 2017 expressed an unqualified opinion. /s/ RSM US LLP Los Angeles, California February 28, 2017 Report of Independent Registered Public Accounting Firm Board of Directors Xencor, Inc. Monrovia, California We have audited the related statements of comprehensive loss, stockholders’ equity (deficit), and cash flows for Xencor, Inc. (the “Company”) for the year ended December 31, 2014. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the results of its operations and its cash flows for the year ended December 31, 2014 of Xencor, Inc., in conformity with accounting principles generally accepted in the United States of America. /s/ BDO USA, LLP Los Angeles, California February 20, 2015 Xencor, Inc. Balance Sheets (in thousands, except share and per share data) See accompanying notes to the financial statements. Xencor, Inc. Statements of Comprehensive Income (Loss) (in thousands, except share and per share data) See accompanying notes to the financial statements. Xencor, Inc. Statements of Stockholders’ Equity (in thousands, except share data) See accompanying notes to the financial statements. Xencor, Inc. Statements of Cash Flows (in thousands) See accompanying notes to the financial statements. Xencor, Inc. Notes to Financial Statements 1. Summary of Significant Accounting Policies Description of Business Xencor, Inc. (we, us, our, or the Company) was incorporated in California in 1997 and reincorporated in Delaware in September 2004. We are a clinical-stage biopharmaceutical company focused on discovering and developing engineered monoclonal antibodies to treat severe and life-threatening diseases with unmet medical needs. We use our proprietary XmAb technology platform to create next-generation antibody product candidates designed to treat autoimmune and allergic diseases, cancer, and other conditions. We focus on the portion of the antibody that interacts with multiple segments of the immune system, referred to as the Fc domain, which is constant and interchangeable among antibodies. Our engineered Fc domains, the XmAb technology, are applied to our pipeline of antibody-based drug candidates to increase immune inhibition, improve cytotoxicity, extend half-life and most recently create bispecific antibodies. Our operations are based in Monrovia and San Diego, California. Basis of Presentation The Company’s financial statements as of December 31, 2016, 2015, and 2014 and for the years then-ended have been prepared in accordance with accounting principles generally accepted in the United States. Reclassification of Prior Year Presentation Certain prior year balances within Other Income have been reclassified for consistency with the current period presentation. These reclassifications had no effect on the reported results of operations. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Significant estimates include useful lives of long-lived assets, the periods over which certain revenues and expenses will be recognized including collaboration revenue recognized from non-refundable upfront licensing payments, the amount of non-cash compensation costs related to share-based payments to employees and non-employees and the period over which these costs are expensed. Recent Accounting Pronouncements In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, as a new Topic, Accounting Standards Codification Topic 606 (“ASU 2014-09”). The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customer Topic 606, Principal versus Agent Considerations, which clarifies the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers Topic 606, Identifying Performance Obligations and Licensing, which clarifies certain aspects of identifying performance obligations and licensing implementation guidance. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers Topic 606, Narrow-Scope Improvements and Practical Expedients, related to disclosures of remaining performance obligations, as well as other amendments to guidance on collectibility, non-cash consideration and the presentation of sales and other similar taxes collected from customers. In December 2016, the FASB issued ASU No. 2016-20, Technical Corrections and Xencor, Inc. Notes to Financial Statements (Continued) Improvements to Topic 606, Revenue from Contracts with Customers, which amends certain narrow aspects of the guidance issued in ASU 2014-09 including guidance related to the disclosure of remaining performance obligations and prior-period performance obligations, as well as other amendments to the guidance on loan guarantee fees, contract costs, refund liabilities, advertising costs and the clarification of certain examples. These ASUs are effective for public entities for interim and annual reporting periods beginning after December 15, 2017, including interim periods within that year, which for us is the period beginning January 1, 2018. The Company will adopt the new standard in 2018 and will evaluate and plan for its implementation including assessing its overall impact during the second and third quarter of 2017. In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Liabilities, which eliminates the available-for-sale classification for equity securities and requires equity securities to be measured at fair value with changes in the fair value recognized through net income. In addition it updates certain presentation and disclosure requirements. The new standard will be effective for reporting periods beginning after December 15, 2017. While we are assessing the impact of the guidance on our financial statements, we would be required to recognize mark-to-market gains and losses associated with any available-for-sale equity securities through net income instead of accumulated other comprehensive income. We do not carry any equity securities in our investment portfolio.We continue to review the requirements of the revised standard and any potential impact it may have on our financial statements. In February 2016, the FASB issued ASU 2016-02 Leases. The new guidance requires lessees to recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term for all leases not considered short term. The new standard will be effective for reporting periods beginning after December 15, 2018. In transition, we are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach, including the option to utilize a number of practical expedients. We will evaluate our operating lease arrangements to determine the impact of this amendment on the financial statements. This evaluation includes a review of our lease expenses, which are primarily operating lease arrangements for our facilities in Monrovia and San Diego. In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which amends the current stock compensation guidance. The amendments simplify the accounting for the taxes related to stock based compensation, including adjustments to how excess tax benefits and a company's payments for tax withholdings should be classified. The standard is effective for fiscal periods beginning after December 15, 2016, with early adoption permitted. In addition, the standard allows an entity-wide accounting policy election to either estimate the number of awards that are expected to vest, as currently required, or account for forfeitures when they occur. We are adopting the new standard in the first quarter of 2017and established an accounting policy election to account for forfeitures when they occur. As such, we will recognize a cumulative-effect adjustment in retained earnings on awards that were in process of vesting as of December 31, 2016. We do not expect the adoption to have a material impact on our results of operations or financial position. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which amends the guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. Credit losses relating to available-for-sale debt securities will be recorded through an allowance for credit losses rather than as a direct write-down to the security. Credit losses on available-for-sale securities will be required when the amortized cost is below the fair market value.The amendment is effective for fiscal years beginning after December 15, 2019 including interim periods within those fiscal years. We will apply the standard’s provision as a cumulative effect adjustment to retained earnings as of the beginning of the first effective reporting period. We do not expect the adoption to have a material impact on our results of operations or financial postion. Xencor, Inc. Notes to Financial Statements (Continued) In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The standard clarifies when cash receipts and cash payments have aspects of more than one class of cash flows and cannot be separated, classification will depend on the predominant source or use. The amendment is effective for fiscal years beginning after December 15, 2017 with early adoption permitted. We continue to review the requirements of this standard and any potential impact it may have on our financial statements. There have been no material changes to the significant accounting policies previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. Revenue Recognition We have, to date, earned revenue from research and development collaborations, which may include research and development services, licenses of our internally-developed technologies, licenses of our internally-developed drug candidates, or combinations of these. We recognize revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; transfer of, or access to, the rights of our drug candidates or technologies has been completed or services have been rendered; our price to the customer is fixed or determinable and collectability is reasonably assured. The terms of our license and research and development and collaboration agreements generally include non-refundable upfront payments, research funding, co-development reimbursements, license fees and, milestone and other contingent payments to us for the achievement of defined collaboration objectives and certain clinical, regulatory and sales-based events, as well as royalties on sales of any commercialized products. The terms of our licensing agreements include non-refundable upfront fees, annual licensing fees, and contractual payment obligations for the achievement of pre-defined preclinical, clinical, regulatory and sales-based events by our partners. The licensing agreements also include royalties on sales of any commercialized products by our partners. Multiple-Element Revenue Arrangements. Certain of our collaboration and license agreements represent multiple-element revenue arrangements. To account for such transactions, we determine the elements, or deliverables, included in the arrangement and determine which deliverables are separate units for accounting purposes. We consider delivered items to be separate units of accounting if the delivered items have stand-alone value to the customer. If the delivered items are separate units we allocate the consideration received or due under the arrangement to the various elements based on each elements’ relative selling price. The identification of individual elements in a multiple-element arrangement and the estimation of the selling price of each element involve significant judgment, including consideration as to whether each delivered element has standalone value to the customer. We determine the estimated selling price for deliverables within each arrangement using vendor-specific objective evidence (VSOE) of selling price, if available, or third-party evidence of selling price if VSOE is not available, or our best evidence of selling price if neither VSOE nor third-party evidence is available. To date, we have used our best evidence of selling price for each of our deliverables. Determining the best estimate of selling price for a deliverable requires significant judgment. We use our best estimate of selling price to estimate the selling price for licenses to our technologies and product candidates, since we do not have VSOE or third-party evidence of selling price for these deliverables. The basis of our estimate of selling price is the arm’s length negotiation with the licensee that occurs in each transaction. The potential value of our technology to a licensee in a transaction depends on a variety of factors unique to each transaction. Factors that impact the negotiation and hence that we consider in our estimates center on the specific product candidate and include: the product candidate’s potential market size, the product candidate’s stage of development, the existence of competitive technologies that could be substituted for ours by the licensee and the scientific assessment of the product candidate’s likelihood of success at Xencor, Inc. Notes to Financial Statements (Continued) various development stages. The most common deliverable for our licensing transactions is the commercial license for our technology in the product candidate, and frequently a research license with an option for commercial license. We have also entered into multiple arrangements that involve the deliverable of drug candidates at various stages of development. The upfront payments, annual license fees, contingent payments, milestones and royalties relate to these licenses and/or options and depend on the product-specific factors described above. The other significant deliverable is research and development services and the price for these depends on estimates for our personnel and supply costs and the costs of third-party contract research organizations necessary to support the services. We recognize consideration allocated to an individual element when all other revenue recognition criteria are met for that element. Our multiple-element revenue arrangements may include the following: · License arrangements The deliverables under our collaboration and license agreements generally include exclusive or non-exclusive licenses to one or more of our technologies. The technologies can be applied to a collaborator’s product candidates for discovery, development, manufacturing and commercialization. We will also enter into agreements for the exclusive or non-exclusive licenses to our internally developed product candidates. To account for this element of the arrangement, we evaluate whether the exclusive or non-exclusive license has standalone value apart from the undelivered elements to the collaboration partner, which may include research and development services or options for commercial licenses, based on the consideration of the facts and circumstances of each arrangement, including the research and development capabilities of the collaboration partner and other market participants. We recognize arrangement consideration allocated to licenses upon delivery of the license, if the facts and circumstances indicate the license has standalone value apart from the undelivered elements. If facts and circumstances indicate that the delivered license does not have standalone value from the undelivered elements, we recognize the revenue as a combined unit of accounting. In those circumstances we recognize revenue from non-refundable upfront fees in the same manner as the undelivered item(s), which is generally the period over which we provide research and developments services. · Collaboration Arrangements The deliverables under our collaboration arrangements generally involve the license to certain rights to one or more of our product candidates in addition to a license to access one or more of our technologies. These arrangements may require us to apply our technologies to a partner-identified or provided antibody and deliver a drug candidate that incorporates one of our technologies to the partner. To account for the element of the rights to a drug candidate that we have created, we evaluate whether the rights to the drug candidate has standalone value separate from the obligation to apply our technologies to partner-identified antibodies. We recognize arrangement consideration allocated to the rights to the drug candidates upon transfer of the rights to the partner which generally occurs upon execution of the agreement. We recognize arrangement consideration allocated to the obligation to apply our technologies to partner-identified antibodies as the partner accepts the drug candidates that incorporates our technologies, subject to any substitution or replacement provisions. · Research and Development Services The deliverables under our collaboration and license arrangements may include research and development services we perform on behalf of or with the collaboration partner. As the provision of research and development services is an integral part of our operations and we may be principally responsible for the performance of these services under the agreements, we recognize revenue on a gross basis for research and development services as we perform those services. Additionally, we recognize research related funding under collaboration research and development efforts as revenue as we perform or deliver the related services in accordance with contract terms. Milestone Revenue. Our collaboration and license agreements generally include contingent contractual payments related to achievement of specific research, development and regulatory milestones and sales-based milestones that are based solely upon the performance of the licensee or collaborator. Research, development and regulatory contingent contractual payments and milestone payments are typically payable under our collaborations when our Xencor, Inc. Notes to Financial Statements (Continued) collaborator selects a compound, or initiates or advances a covered product candidate in preclinical or clinical development, upon submission for marketing approval of a covered product with regulatory authorities, upon receipt of actual marketing approvals of a covered product or for additional indications, or upon the first commercial sale of a covered product. Sales-based contingent contractual payments are typically payable when annual sales of a covered product reach specific levels. At the inception of each arrangement that includes contingent contractual payments, we evaluate whether each potential payment and milestone is substantive and at risk to both parties based on the basis of the contingent nature of the milestone event. We evaluate factors such as scientific, regulatory, commercial and other risks that we must overcome to achieve the respective milestone event, whether the contractual payment due at each milestone event is reasonable relative to all deliverables and payment terms in the arrangement in making this assessment and whether the contingent contractual payment relates solely to past performance. Additionally, certain of our product development and technology license arrangements may include milestone payments related to the achievement of specific research and development milestones, which are achieved in whole or in part on our performance. We recognize any payment that is contingent upon the achievement of a substantive milestone entirely in the period in which the milestone is achieved. A milestone is defined as an event that can only be achieved based in whole or in part either on our performance, or the performance of our collaborators, or the occurrence of a specific outcome resulting from our past performance for which there is a substantive uncertainty at the date the arrangement is entered into that the event will be achieved. Collaborative Research and Licensing Agreements Novartis In June 2016, the Company entered into a Collaboration and License Agreement (the Novartis Agreement) with Novartis Institutes for BioMedical Research, Inc., (Novartis), to develop and commercialize bispecific and other Fc engineered antibody drug candidates using the Company’s proprietary XmAb® technologies and drug candidates. Pursuant to the Novartis Agreement: · The Company granted Novartis certain exclusive rights to research, develop and commercialize XmAb14045 and XmAb13676, two development stage products that incorporate the Company’s bispecific Fc technology, · The Company will apply its bispecific technology in up to four target pair antibodies identified by Novartis (each a Global Discovery Program) and, · The Company will provide Novartis with a non-exclusive license to certain of its Fc technologies to apply against up to ten targets identified by Novartis. The Company received a non-refundable upfront payment under the Novartis Agreement of $150 million in July 2016 and is eligible to receive up to $2.4 billion in future development, regulatory and sales milestones in total for all programs that could be developed under the Agreement. Under the Novartis Agreement, the Company granted Novartis a worldwide co-exclusive license with Xencor to research, develop and manufacture XmAb14045 and XmAb13676. The Company also granted Novartis an exclusive license to commercialize XmAb14045 and XmAb13676 in all worldwide territories outside the United States (U.S.). XmAb14045 is a clinical candidate that binds the CD123 antigen and the cytotoxic T-cell binding domain CD3 (the XmAb14045 Program) and targets acute myeloid leukemia (AML). XmAb13676 is a clinical candidate that binds the CD20 antigen and the cytotoxic T-cell binding domain CD3 (the XmAb13676 Program) and targets B-cell malignancies. Assuming successful development and commercialization of a product, the Company could receive up to $325 million in Xencor, Inc. Notes to Financial Statements (Continued) milestone payments for each of XmAb14045 and XmAb13676. The total potential milestones for each product include $90 million in development milestones, $110 million in regulatory milestones and, $125 million in sales milestones. If commercialized, the Company is eligible to receive tiered low double-digit royalties on global net sales of approved products outside the US. The Company and Novartis will co-develop XmAb14045 and XmAb13676 worldwide and share development costs equally. The Company may elect to opt-out of the development of either program by providing notice to Novartis. If the Company elects to opt-out with respect to a program, Novartis will receive the Company’s U.S. rights to the program and the Company will receive low double-digit royalties on U.S. net sales in addition to the royalties on net sales outside the US. Pursuant to the Novartis Agreement, the Company will apply its bispecific technology to up to four target pair antibodies selected, if available for exclusive license to Novartis and not subject to a Xencor internal program. The Company will apply its bispecific technology to generate bispecific antibody candidates from starting target pair antibodies provided by Novartis for each of the four Global Discovery Programs and return the bispecific product candidate to Novartis for further testing, development and commercialization. Novartis has the right to substitute up to four of the original selected target pair antibodies during the research term provided that Novartis has not filed and received acceptance for an Investigational New Drug Application (IND) with the Xencor provided bispecific candidate. The research term is five years from the date of the Novartis Agreement. Novartis will assume full responsibility for development and commercialization of each product candidate under each of the Global Discovery Programs. Assuming successful development and commercialization of each Global Discovery Program compound, the Company could receive up to $250.0 million in milestones for each Global Discovery Program which includes $50.0 million in development milestones, $100.0 million in regulatory milestones and $100.0 million in sales milestones. If commercialized, the Company is eligible to receive mid-single digit royalties on global net sales of approved products. Under the Novartis Agreement, the Company has the right to participate in the development and commercialization of one of the Global Discovery Programs prior to filing an IND for Global Discovery Program. If the Company elects to participate in development, it will assume responsibility for 25% of the worldwide development costs for the program and 50% of commercialization costs and will receive 50% of the US profits on net sales of the product. Under the Novartis Agreement, the Company is also granting Novartis a non-exclusive research license to use certain of the Company’s Fc technologies, specifically Cytotoxic, Xtend and Immune Inhibitor to research, develop, commercialize and manufacture antibodies against up to ten targets selected by Novartis, if available for non-exclusive license and not subject to a Xencor internal program. Novartis will assume all research, development and commercialization costs for products that are developed from application of the Fc technologies. Assuming successful development and commercialization of a compound that incorporates an Fc technology, the Company could receive up to $76.0 million in milestones for each target which includes $16.0 million in development milestones, $30.0 million in regulatory milestones and $30 million in sales milestones. If commercialized, the Company is eligible to receive low single-digit royalties on global net sales of approved products. The Company evaluated the Novartis Agreement and determined that it is a revenue arrangement with multiple deliverables or performance obligations. The Company’s substantive performance obligations under the Agreement include: · delivery of an exclusive license to commercialize XmAb14045 in worldwide territories outside the U.S., with worldwide co-exclusive rights with Xencor to research, develop and manufacture XmAb14045 · delivery of an exclusive license to commercialize XmAb13676 in worldwide territories outside the U.S., with worldwide co-exclusive rights with Xencor to research, develop and manufacture XmAb13676 Xencor, Inc. Notes to Financial Statements (Continued) · application of its bispecific technology to four Novartis selected target pair antibodies and delivery of four bispecific product candidates and, · delivery of a non-exclusive license to its Fc technologies: Cytotoxic, Xtend and Immune Inhibitor The Company determined that the $150 million upfront payment represents the total initial consideration and was allocated to each of the deliverables using the best estimate of selling price which was allocated using the relative selling price method. The Company determined that each of the development and regulatory milestones is substantive. Although sales milestones are not considered substantive, they are still recognized upon achievement of a milestone. After identifying each of the deliverables included in the arrangement, the Company determined the relative selling price using its best estimate of selling price for each of the deliverables. The estimated selling price for the licensing rights to the XmAb13676 Program are the Company’s best estimate of selling price and was determined based on market conditions, similar arrangements entered into by third parties including the Company’s understanding of pricing terms offered for comparable transactions that involve licensing bispecific antibody development candidates. The Company reviewed recent published market transactions that are comparable to the license of the XmAb13676 Program in the Novartis Agreement. The Company adjusted the value of the published market information to reflect differences in stage of development and rights and potential markets to determine the estimated selling price for the license rights to the XmAb13676 program. This amount represents the value that a third party would be willing to pay for certain rights to the XmAb13676 Program including the exclusive right to commercialize XmAb13676 in all territories outside the U.S. The Company determined the estimated selling price for the rights to the XmAb14045 Program using the income approach by calculating a risk-adjusted present value of the potential revenue that could be earned from the license reduced by the minimum development costs that the Company is obligated to fund under the Agreement. This amount represents the value that a third party would be willing to pay for certain rights to the XmAb14045 Program including the right to commercialize XmAb14045 in all territories outside the U.S. The best estimated selling price for each Global Discovery Programs was determined using the income approach by calculating a risk-adjusted net present value of the potential revenue that could be earned from each Global Program license reduced by the estimated cost of the Company’s efforts to deliver the completed Global Program bispecific candidate to Novartis. These amounts represent the value that a third party would be willing to pay as an upfront for access to the Company’s bispecific technology and capabilities. The Company’s best estimated selling price for the Fc licenses is its best estimate and was determined by considering market and entity-specific factors. The Company has previously licensed its Fc technologies on a limited basis to third parties. The Company considered the term of the Novartis license, scope of the rights granted for each license, the type of technologies subject to the license, and the potential number of targets that may be applied in establishing its best estimate for the Fc license. The total allocable consideration of $150 million was allocated to the deliverables based on the relative selling price method as follows: * $27.1 million to the XmAb14045 Program, * $31.4 million to the XmAb13676 Program, * $20.05 million to each of the four Global Discovery Programs and, * $11.3 million to the Fc licenses The Company recognized as license revenue the amount of the total allocable consideration allocated to the XmAb13676 and XmAb14045 Programs upon delivery of the exclusive license to Novartis both of which were Xencor, Inc. Notes to Financial Statements (Continued) transferred as of the effective date of the Agreement. At the time that each Global Discovery Program is accepted by Novartis, the Company will recognize collaboration revenue of $20.05 million for each program. Since Novartis has substitution rights for up to four target pair antibodies, revenue recognition may be delayed until the earlier that Novartis has an open IND for a delivered bispecific Discovery Program or the right to substitute the target pair lapses. No bispecific antibodies for Global Discovery Programs were delivered during 2016. The Company will recognize as licensing revenue the amount of the total consideration allocated to the Fc license over the five year research term beginning from the effective date of the Agreement. During the year ended December 31, 2016, we recognized $59.7 million of revenue under this arrangement. As of December 31, 2016 there is a receivable of $809,000 and $90.3 million in deferred revenue related to the arrangement. Amgen Inc. 2015 Agreement In September 2015, the Company entered into a research and license agreement (the 2015 Agreement) with Amgen Inc. (Amgen) to develop and commercialize bispecific antibody product candidates using the Company’s proprietary XmAb® bispecific Fc technology. Under the 2015 Agreement, the Company granted an exclusive license to Amgen to develop and commercialize bispecific drug candidates from the Company’s preclinical program that bind the CD38 antigen and the cytotoxic T-cell binding domain CD3, (the CD38 Program). The Company will also apply its bispecific technology to five previously identified Amgen provided targets (each a Discovery Program). The Company received a $45 million upfront payment from Amgen and is eligible to receive up to $1.7 billion in future development, regulatory and sales milestones in total for all six programs and is eligible to receive royalties on any global net sales of products. Following the Company’s transfer of the DNA sequences, constructs and preclinical data related to its CD38 Program to Amgen, Amgen will assume full responsibility for the further development and commercialization of product candidates under the CD38 Program. Assuming successful development and commercialization of a product, the Company could receive up to $355 million in milestones payments which include $55 million in development milestones, $70 million in regulatory milestones and, $230 million in sales milestones. If commercialized, the Company is eligible to receive from high single-digit up to low double-digit royalties on global net sales of approved products under the CD38 Program. Under the 2015 Agreement, for each of the five Discovery Programs the Company will apply its bispecific technology to antibody molecules provided by Amgen that bind Discovery Program Targets and return the bispecific product candidates to Amgen for further testing, development and commercialization. Amgen has the right to substitute up to three of the previously identified targets during the research term provided that Amgen has not initiated non-human primate studies with the Xencor provided bispecific candidate. The initial research term is three years from the date of the agreement but Amgen, at its option, may request an extension of one year if Xencor has not completed delivery of all five Discovery Program bispecific candidates to Amgen. Amgen will assume full responsibility for development and commercialization of product candidates under each of the Discovery Programs. Assuming successful development and commercialization of each Discovery Program compound, the Company could receive up to $260.5 million in milestones for each compound which include $35.5 million in development milestones, $55 million in regulatory milestones and $170 million in sales milestones. If Xencor, Inc. Notes to Financial Statements (Continued) commercialized, the Company is eligible to receive mid to high single-digit royalties on global net sales of approved products. The Company evaluated the 2015 Agreement with Amgen and determined that it is a revenue arrangement with multiple deliverables or performance obligations. The Company’s substantive performance obligations under the 2015 Agreement include delivery of the DNA sequences, constructs and preclinical data related to its CD38 Program and application of its bispecific technology to five Amgen provided targets and delivery of the five bispecific product candidates. The Company evaluated the 2015 Agreement with Amgen and determined that the CD38 Program and each of the five Discovery Programs represent separate units of accounting. The $45 million upfront payment represents the total initial consideration and was allocated to each of the deliverables using the relative selling price method. After identifying each of the deliverables included in the arrangement, the Company determined its best estimate of selling price for each of the deliverables. In order to determine the best estimate of selling price for the CD38 Program, the Company determined the value of the CD38 Program by calculating a risk-adjusted present value of the potential revenue from the future development and regulatory milestones under the 2015 Agreement. This amount represents the value that a third party would be willing to pay as an upfront fee to license the Company’s CD38 Program. The Company determined the value of each of the Discovery Programs by calculating a risk-adjusted net present value of the potential revenue from future development and regulatory milestones reduced by the estimated cost of the Company’s efforts to apply its bispecific technology to the Amgen targets and deliver the five bispecific product candidates. These amounts represent the value that a third party would be willing to pay as an upfront fee for access to the Company’s bispecific technology and capabilities. The total allocable consideration of $45 million was allocated to the deliverables based on the relative selling price method as follows: $13.75 million to the CD38 Program and, $6.25 million to each of the five Discovery Programs During the fourth quarter of 2015 we delivered the CD38 DNA sequences, constructs and preclinical data to Amgen. At the time that each bispecific Discovery Program is accepted by Amgen, the Company will recognize as collaboration revenue $6.25 million for each program. Since Amgen has substitution rights for up to three targets, revenue recognition may be delayed until the earlier that Amgen initiates non-human primate studies for a delivered bispecific Discovery Program or the right to substitute the target lapses. During 2016, the Company delivered bispecific antibody candidates for five Discovery Programs and Amgen elected to substitute one of the originally identified antibody candidates. During the year ended December 30, 2016 and 2015, we recognized $18.75 million and $13.75 million in revenue, respectively under this arrangement. As of December 31, 2016 there was $12.5 million in deferred revenue related to the arrangement. 2010 Agreement In December 2010, we entered into a Collaboration and Option Agreement (the 2010 Agreement) with Amgen, pursuant to which we agreed to collaborate with Amgen on development of XmAb5871 in rheumatoid arthritis (RA) through completion of a Phase 2 proof-of-concept (POC) trial. In October 2014, we entered into an agreement with Amgen to terminate the 2010 Agreement pursuant to which all worldwide rights to develop and commercialize XmAb5871 reverted back to us. Our obligations to continue Xencor, Inc. Notes to Financial Statements (Continued) development of XmAb5871 under the terms of the 2010 Agreement terminated effective as of the date of the termination agreement. As a result of and effective as of the date of the termination agreement, all of Amgen’s rights to XmAb5871 terminated including the right to exercise an exclusive option to acquire the worldwide rights to XmAb5871. Amgen’s obligations to make any further payments to us are also terminated. In connection with the termination, we granted Amgen a right of first negotiation (ROFN) to obtain an exclusive license to develop and commercialize any XmAb5871 product. The ROFN requires us to notify Amgen if we decide to pursue a licensing transaction with a third party involving XmAb5871. Upon receipt of the notification, Amgen will have a limited time to review the data from XmAb5871 and enter into negotiations to obtain an exclusive license to develop and commercialize any future XmAb5871 product. The ROFN will expire upon the earlier of: (1) October 27, 2019, (2) initiation by us of a Phase 3 clinical trial with XmAb5871 or (3) the transfer or sale to a third party of substantially all of our business. We have determined that the termination results in a cancellation of all our obligations to Amgen under the 2010 Agreement. We have evaluated the terms of the ROFN and determined that it has de minimis value because Amgen’s rights under the ROFN are limited to an exclusive negotiating period of a short duration and there is no bargain element in the ROFN. As a result of the termination, we have recognized $5.2 million of income which represents the balance of the deferred revenue related to the agreement at the time of the termination. The total revenue recognized under this arrangement was zero for each of the year ended December 2016 and 2015 and $6.9 million for the year ended December 31, 2014. As of December 31, 2016 we have no deferred revenue related to this agreement. Novo Nordisk A/S In December 2014, we entered into a Collaboration and License Agreement with Novo Nordisk A/S (Novo). Under the terms of the agreement, we granted Novo a research license to use certain Xencor technologies including our bispecific, IIb, Xtend and others during a two year research term. We received an upfront payment of $2.5 million and received research funding of $1.6 million per year over the research term. We recognized the $2.5 million upfront payment as income over the two year research term. The research funding is being recognized into income over the period that the services are being provided. We determined that future milestone payments were substantive and contingent and we did not allocate any of the upfront consideration to these milestones. The total revenue recognized under this agreement was $2.7 million, $2.9 million and $0.1 million for the years ended December 31, 2016, 2015 and 2014 respectively. As of December 31, 2016 we have no deferred revenue related to the agreement. MorphoSys Ag In June 2010, we entered into a Collaboration and License Agreement with MorpohSys AG (MorphoSys), which we subsequently amended in March 2012. The agreement provided us an upfront payment of $13 million in exchange for an exclusive worldwide license to our patents and know-how to research, develop and commercialize our XmAb5574 product candidate (subsequently renamed MOR208) with the right to sublicense under certain conditions. Under the agreement, we agreed to collaborate with MorphoSys to develop and commercialize XmAb5574/MOR208. If certain developmental, regulatory and sales milestones are achieved, we are eligible to receive future milestone payments and royalties. Xencor, Inc. Notes to Financial Statements (Continued) There were no revenues recognized under this arrangement for the years ended December 31, 2016, 2015 and 2014. As of December 31, 2016, we have no deferred revenue related to this agreement. Alexion Pharmaceuticals, Inc. In January 2013, we entered into an option and license agreement with Alexion Pharmaceuticals, Inc. (Alexion). Under the terms of the agreement, we granted to Alexion an exclusive research license, with limited sublicensing rights, to make and use our Xtend technology to evaluate and advance compounds against six different target programs during a five-year research term under the agreement, up to completion of the first multi-dose human clinical trial for each target compound. Under the agreement, we received an upfront payment of $3.0 million. Alexion is also required to pay an annual maintenance fee of $0.5 million during the research term of the agreement and $1.0 million during any extension of the research term. In addition, if certain development, regulatory and commercial milestones are achieved, we are eligible to receive up to $66.5 million for the first product to achieve such milestones on a target-by-target basis. If licensed products are successfully commercialized, we are also entitled to receive royalties based on a percentage of net sales of such products sold by Alexion, its affiliates or its sub licensees, which percentage is in the low single digits. Alexion’s royalty obligations continue on a product-by-product and country-by- country basis until the expiration of the last-to-expire valid claim in a licensed patent covering the applicable product in such country. In the third quarter of 2014, Alexion achieved a clinical development milestone with an undisclosed molecule to be used against an undisclosed target. In the fourth quarter of 2015, Alexion exercised its option to take an exclusive commercial license and achieved a further clinical development milestone. In December 2016, Alexion achieved a Phase 3 clinical development milestone for an undisclosed target. The total revenue recognized under this arrangement was $6.0 million, $8.5 million and $1.0 million for the years ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016 there was a receivable of $5.0 million and deferred revenue related to this agreement of $0.6 million. Boehringer Ingelheim International GmbH In 2007 we entered into a Research Licensee and Collaboration Agreement with Boehringer Ingelheim International GmbH (BI). Under the agreement, we provided BI with a three-year research license to one of our technologies and commercial options. We identified the deliverables under the agreement at inception as the research licenses and options to acquire commercial licenses to up to two compounds. Upon exercise of an option to a commercial license, we are eligible to receive future milestone payments and royalties. We determined that the future milestones and related payments were substantive and contingent and we did not allocate any of the upfront consideration to the milestones. The upfront payment and the annual license fees were recognized ratably into income over the research license term which expired in 2011 and payments for the commercial options were recognized in the period the commercial option was exercised since the options were contingent and substantive. During 2012, BI advanced a compound that incorporates our technology into clinical development and we received a milestone payment of $1.2 million and recognized the payment as revenue in the period the milestone event occurred. No revenue related to this arrangement was recognized in 2016, 2015 or 2014. There is no deferred revenue related to this agreement at December 31, 2016. Xencor, Inc. Notes to Financial Statements (Continued) CSL Limited 2009 Agreement In 2009 we entered into a Research License and Commercialization Agreement with CSL Limited (CSL-2009). Under the agreement, we provided CSL with a research license to one of our technologies and up to five commercial options. The upfront payment of $0.75 million received at inception and the annual research license renewal payments were recognized as revenue ratably over the five-year term of the research license. In May 2013, we entered into an amendment to the February 2009 Research License and Commercialization Agreement with CSL, which eliminated a contingent milestone payment requirement and reduced the royalty rate on net sales for a product in development. The amendment provided for a payment upon signing of $2.5 million. We determined that the amendment was a material modification to the original agreement and evaluated the remaining deliverables at the date of the amendment. We determined that the remaining deliverables were the research license which expired in February 2014 and four additional options to take commercial licenses through the term of the research period. The options were considered to be substantive and contingent and we did not allocate any of the proceeds received in the amendment to the options. The amendment proceeds were recognized into income over the remaining period of the research term. In 2013 CSL sublicensed CSL362 (now called JNJ-56022473) to Janssen Biotech Inc. (Janssen Biotech). In August 2015, CSL, through its sub licensee, Janssen Biotech, initiated a Phase 2 clinical trial for CSL362 for which we received a milestone payment. Total revenue recognized for the years ended December 31, 2016, 2015 and 2014 was $0, $2.5 million and $0.7 million respectively. As of December 31, 2016 we have no deferred revenue related to this agreement. Merck Sharp & Dohme Corp. In July 2013, we entered into a License Agreement with Merck Sharp & Dohme Corp (Merck). Under the terms of the agreement, we provided Merck with a non-exclusive commercial license to certain patent rights to our Fc domains to apply to one of their compounds. We also provided Merck with contingent options to take additional non-exclusive commercial licenses. The contingent options provide Merck an opportunity to take non-exclusive commercial licenses at an amount less than the amount paid for the original license. The agreement provided for an upfront payment of $1.0 million and annual maintenance fees totaling $0.5 million. We are also eligible to receive future milestones and royalties as Merck advances the compound into clinical development. In the first quarter of 2014, Merck initiated a Phase 1 clinical trial which triggered a $0.5 million milestone payment to us. For each of the years ended December 31, 2016 and 2015 total revenue recognized was $0.1 million, and for the year ended December 31, 2014, total revenue recognized was $0.6 million. As of December 31, 2016, we had deferred revenue of $50,000 related to this agreement. Xencor, Inc. Notes to Financial Statements (Continued) Potential Milestones As of December 31, 2016, the Company may be eligible to receive the following maximum payments from its collaborative partners and licensees based upon contractual terms in the agreements assuming all options are exercised and all milestones are achieved: (1) The payments are solely dependent upon activities of the collaborative partner or licensee. Revenue earned The $87.5 million, $27.8 million and $9.5 million of revenue recorded for the years ended December 31, 2016, 2015 and 2014, respectively was earned principally from the following licensees (in millions): A portion of our revenue is earned from collaboration partners outside the United States. Non-U.S. revenue is denominated in U.S. dollars. A breakdown of our revenue from U.S. and Non-U.S. sources for the years ended December 31, 2016, 2015 and 2014 is as follows (in millions): Xencor, Inc. Notes to Financial Statements (Continued) Deferred Revenue Deferred revenue arises from payments received in advance of the culmination of the earnings process. We have classified deferred revenue for which we stand ready to perform within the next 12 months as a current liability. We recognize deferred revenue as revenue in future periods when the applicable revenue recognition criteria have been met. The total amounts reported as deferred revenue were $103.4 million and $33.8 million at December 31, 2016 and 2015, respectively. Research and Development Expenses Research and development expenses include costs we incur for our own and for our collaborators research and development activities. Research and development costs are expensed as incurred. These costs consist primarily of salaries and benefits, including associated stock-based compensation, laboratory supplies, facility costs, and applicable overhead expenses of personnel directly involved in the research and development of new technology and products, as well as fees paid to other entities that conduct certain research development activities on our behalf. We estimate preclinical study and clinical trial expenses based on the services performed pursuant to the contracts with research institutions and clinical research organizations that conduct and manage preclinical studies and clinical trials on our behalf based on the actual time and expenses incurred by them. Further, we accrue expenses related to clinical trials based on the level of patient enrollment and activity according to the related agreement. We monitor patient enrollment levels and related activity to the extent reasonably possible and adjust estimates accordingly. We capitalize acquired research and development technology licenses and third-party contract rights and amortize the costs over the shorter of the license term or the expected useful life. We review the license arrangements and the amortization period on a regular basis and adjust the carrying value or the amortization period of the licensed rights if there is evidence of a change in the carrying value or useful life of the asset. Cash and Cash Equivalents We consider cash equivalents to be only those investments which are highly liquid, readily convertible to cash and which mature within three months from the date of purchase. Marketable Securities The Company has an investment policy that includes guidelines on acceptable investment securities, minimum credit quality, maturity parameters and concentration and diversification. The Company invests its excess cash primarily in marketable securities issued by investment grade institutions. The Company considers its marketable securities to be “available-for-sale”, as defined by authoritative guidance issued by the FASB. These assets are carried at fair value and the unrealized gains and losses are included in accumulated other comprehensive income (loss). Accrued interest on marketable securities is included in marketable securities. Accrued interest was $1.4 million and $0.9 million at December 31, 2016 and 2015, respectively. If a decline in the value of a marketable security in the Company’s investment portfolio is deemed to be other-than-temporary, the Company writes down the security to its current fair value and recognizes a loss as a charge against income. The Company reviews its portfolio of marketable securities, using both quantitative and qualitative factors, to determine if declines in fair value below cost are other-than-temporary. Concentrations of Risk Cash, cash equivalents and marketable securities are financial instruments that potentially subject the Company to concentrations of risk. Xencor invests its cash in corporate debt securities and U.S. sponsored agencies with strong Xencor, Inc. Notes to Financial Statements (Continued) credit ratings. Xencor has established guidelines relative to diversification and maturities that are designed to help ensure safety and liquidity. These guidelines are periodically reviewed to take advantage of trends in yields and interest rates. Cash and cash equivalents are maintained at financial institutions and, at times, balances may exceed federally insured limits. We have never experienced any losses related to these balances. Amounts on deposit in excess of federally insured limits at December 31, 2016 and 2015 approximated $14.0 million and $12.1 million, respectively. We have payables with two service providers that represent 28% of our total payables and three service providers that represented 55% of our total payables for the years ended December 31, 2016 and 2015, respectively. We rely on two critical suppliers for the manufacture of our drug product for use in our clinical trials. While we believe that there are alternative vendors available, a change in manufacturing vendors could cause a delay in the availability of drug product and result in a delay of conducting and completing our clinical trials. No other vendor accounted for more than 10% of total payables at December 31, 2016 or 2015. Fair Value of Financial Instruments Our financial instruments primarily consist of cash and cash equivalents, marketable securities, accounts receivable, accounts payable and accrued expenses. Marketable securities and cash equivalents are carried at fair value. The fair value of the other financial instruments closely approximate their fair value due to their short maturities. The Company accounts for recurring and non-recurring fair value measurements in accordance with FASB Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures (ASC 820). ASC 820 defines fair value, establishes a fair value hierarchy for assets and liabilities measured at fair value, and requires expanded disclosure about fair value measurements. The ASC 820 hierarchy ranks the quality of reliable inputs, or assumptions, used in the determination of fair value and requires assets and liabilities carried at fair value to be classified and disclosed in one of the following three categories: Level 1-Fair Value is determined by using unadjusted quoted prices that are available in active markets for identical assets or liabilities. Level 2-Fair Value is determined by using inputs other than Level 1 quoted prices that are directly or indirectly observable. Inputs can include quoted prices for similar assets or liabilities in active markets or quoted prices for identical assets or liabilities in markets that are not active. Related inputs can also include those used in valuation or other pricing models, such as interest rates and yield curves that can be corroborated by observable market data. Level 3-Fair value is determined by inputs that are unobservable and not corroborated by market data. Use of these inputs involves significant and subjective judgments to be made by the reporting entity -e.g. determining an appropriate discount factor for illiquidity associated with a given security. Xencor, Inc. Notes to Financial Statements (Continued) The Company measures the fair value of financial assets using the highest level of inputs that are reasonably available as of the measurement date. The assets recorded at fair value are classified within the hierarchy as follows for the periods reported (in thousands): Property and Equipment Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Expenditures for repairs and maintenance are charged to expense as incurred while renewals and improvements are capitalized. Useful lives by asset category are as follows: Patents, Licenses, and Other Intangible Assets The cost of acquiring licenses is capitalized and amortized on the straight- line basis over the shorter of the term of the license or its estimated economic life, ranging from five to 25 years. Third-party costs incurred for acquiring patents are capitalized. Capitalized costs are accumulated until the earlier of the period that a patent is issued or we abandon the patent claims. Cumulative capitalized patent costs are amortized on a straight-line basis from the date of issuance over the shorter of the patent term or the estimated useful economic life of the patent, ranging from 13 to 20 years. Our senior management, with advice from outside patent counsel, assesses three primary criteria to determine if a patent will be capitalized initially: i) technical feasibility, ii) magnitude and scope of new technical function covered by the patent compared to the company’s existing technology and patent portfolio, particularly assessing the value added to our product candidates or licensing business, and iii) legal issues, primarily assessment of patentability and prosecution cost. We review our intellectual property on a regular basis to determine if there are changes in the estimated useful life of issued patents and if any capitalized costs for unissued patents should be abandoned. Capitalized patent costs related to abandoned patent filings are charged off in the period of the decision to abandon. During 2016, 2015 and 2014, we abandoned previously capitalized patent and licensing related charges of $356,000 $296,000 and $509,000, respectively. Xencor, Inc. Notes to Financial Statements (Continued) The carrying amount and accumulated amortization of patents, licenses, and other intangibles is as follows (in thousands): Amortization expense for patents, licenses, and other intangible assets was $755,000, $594,000 and $694,000 for the years ended December 31, 2016, 2015 and 2014, respectively. Future amortization expense for patent, licenses, and other intangible assets recorded as of December 31, 2016, and for which amortization has commenced, is as follows: The above amortization expense forecast is an estimate. Actual amounts of amortization expense may differ from estimated amounts due to additional intangible asset acquisitions, impairment of intangible assets, accelerated amortization of intangible assets, and other events. As of December 31, 2016, the Company has $4.1 million of intangible assets which are in-process and have not been placed in service and, accordingly amortization on these assets has not commenced. Long-Lived Assets Management reviews long-lived assets which include fixed assets and amortizable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset (or asset group) may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. We did not recognize a loss from impairment for the years ended December 31, 2016, 2015 or 2014. Xencor, Inc. Notes to Financial Statements (Continued) Income Taxes We account for income taxes in accordance with accounting guidance which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where there is greater than 50% likelihood that a tax benefit will be sustained, we have recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where there is a 50% or less likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. We did not have any material uncertain tax positions at December 31, 2016 or 2015. Our policy is to recognize interest and penalties on taxes, if any, as a component of income tax expense. Stock-Based Compensation We recognize compensation expense using a fair-value-based method for costs related to all share-based payments, including stock options and shares issued under our Employee Stock Purchase Plan (ESPP). Stock-based compensation cost related to employees and directors is measured at the grant date, based on the fair-value-based measurement of the award using the Black-Scholes method, and is recognized as expense over the requisite service period on a straight-line basis. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data and industry published statistics to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. We recorded stock-based compensation and expense for stock-based awards to employees, directors and consultants of approximately $7.8 million, $4.9 million and $1.8 million for the years ended December 31, 2016, 2015 and 2014, respectively. Included in the 2016 and 2015 balances for total compensation expense is $378,000 and $341,000, relating to our ESPP, respectively. Options granted to individual service providers that are not employees or directors are accounted for at estimated fair value using the Black-Scholes option-pricing method and are subject to periodic re-measurement over the period during which the services are rendered. Net Income (Loss) Per Share Basic net income (loss) per common share is computed by dividing the net income or loss by the weighted-average number of common shares outstanding during the period. Potentially dilutive securities consisting of stock options at December 31, 2015 and 2014, and stock purchases under the Employee Stock Purchase Plan were not Xencor, Inc. Notes to Financial Statements (Continued) included in the diluted net loss per common shares calculation because the inclusion of such shares would have had an antidilutive effect as follows: Segment Reporting The Company determines its segment reporting based upon the way the business is organized for making operating decisions and assessing performance. The Company has only one operating segment related to the development of pharmaceutical products. 2. Comprehensive Income (Loss) Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss). For the years ended December 31, 2016 and 2015, the only component of other comprehensive loss is net unrealized losses on marketable securities. There were no material reclassifications out of accumulated other comprehensive loss during the year ended December 31, 2016. Xencor, Inc. Notes to Financial Statements (Continued) 3. Marketable Securities The Company’s marketable securities held as of December 31, 2016 and 2015 are summarized below: The maturities of the Company’s marketable securities as of December 31, 2016 are as follows: The unrealized losses on available-for-sale investments and their related fair values as of December 31, 2016 are as follows: Xencor, Inc. Notes to Financial Statements (Continued) The unrealized losses from the listed securities are due to a change in the interest rate environment and not a change in the credit quality of the securities. There were no securities that were in a loss position for more than twelve months at December 31, 2015. 4. Sale of Additional Common Stock In March 2015, we completed the sale of 8,625,000 shares of common stock which included shares we issued pursuant to our underwriters’ exercise of their over-allotment option pursuant to a follow-on offering. We received net proceeds of $115.2 million, after underwriting discounts, commissions and estimated offering expenses. In December 2016, we completed the sale of 5,272,750 shares of common stock which included shares we issued pursuant to our underwriters’ exercise of their over-allotment option pursuant to a follow-on financing. We received net proceeds of $119.3 million after underwriting discounts, commissions and offering expenses. On September 19, 2016, we entered into an Equity Distribution Agreement (the Distribution Agreement) with Piper Jaffray & Co (Piper Jaffray) pursuant to which we may sell from time to time, at our option, up to an aggregate of $40 million of common stock through Piper Jaffray as sales agent. The issuance and sale of these shares by Xencor under the Distribution Agreement will be pursuant to our shelf registration statement on Form S-3 (File No.333-213700) declared effective by the SEC on October 5, 2016. We are not obligated sell any shares of common stock under the Agreement and to date, we have not sold any shares under the Distribution Agreement. 5. Property and Equipment Property and equipment consist of the following: Depreciation expense in 2016, 2015 and 2014 was $712,000, $519,000 and $188,000, respectively. 6. Income Taxes Our effective tax rate differs from the statutory federal income tax rate, primarily as a result of the changes in valuation allowance. The provision for income taxes of $1.0 million for the year ended December 31, 2016 represents Xencor, Inc. Notes to Financial Statements (Continued) federal and state alternative minimum tax. For the years ended December 31, 2015 and 2014 there was no current provision for federal or state income taxes due to taxable losses subject to a valuation allowance incurred in each of the years. A reconciliation of the federal statutory income tax to our effective income tax is as follows (in thousands): The tax effect of temporary differences that give rise to a significant portion of the deferred tax assets and liabilities at December 31, 2016 and 2015 is presented below (in thousands): Due to the uncertainty surrounding the realization of the benefits of our deferred tax assets in future tax periods, we have placed a valuation allowance against our deferred tax assets. The Company recognizes valuation allowances to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company’s net deferred income tax asset is not more likely than not to be realized due to the lack of sufficient sources of future taxable income and cumulative losses that have resulted over the years. During the year ended December 31, 2016, the valuation allowance decreased by $6.4 million. Upon analysis, there were changes in ownership under Section 382 of the Internal Revenue Code and related state provisions as a result of our sale of preferred stock and sale of common stock during 2013. Section 382 limits the amount of net operating losses and tax credit forwards that may be available after a change in Xencor, Inc. Notes to Financial Statements (Continued) ownership. The Company has adjusted its net operating loss and tax credit carryforwards to reflect the impact of the section 382 limitations. The Company’s tax returns remain open to potential inspection for the years 2013 and onwards for federal purposes and 2012 and onwards for state purposes. As of December 31, 2016, we had cumulative net operating loss carryforwards for federal and state income tax purposes of $145.2 million and $91.6 million respectively, and available tax credit carryforwards of approximately $6.4 million for federal income tax purposes and $5.2 million for state income tax purposes, which can be carried forward to offset future taxable income, if any. Our federal net operating loss carryforwards expire starting in 2018, state net operating losses expire starting in 2017 including $19.9 million that will expire in 2017, and federal tax credit carryforwards expire starting in 2019. Utilization of the net operating losses and tax credits are subject to a substantial annual limitation due to ownership changes which occurred. As a result of these changes, provisions in the Internal Revenue Code of 1986 under Section 382 and similar state provisions may result in the expiration of certain of our net operating losses and tax credits before we can use them. 7. Stock-Based Compensation Our Board of Directors and the requisite stockholders previously approved the 2010 Equity Incentive Plan (the 2010 Plan). In October 2013, our Board of Directors approved the 2013 Equity Incentive Plan (the 2013 Plan) and in November 2013 our stockholders approved the 2013 Plan. The 2013 Plan became effective as of December 3, 2013, the date of the Company’s IPO. As of December 2, 2013, we suspended the 2010 Plan and no additional awards may be granted under the 2010 Plan. Any shares of common stock covered by awards granted under the 2010 Plan that terminate after December 2, 2013 by expiration, forfeiture, cancellation or other means without the issuance of such shares will be added to the 2013 Plan reserve. As of December 31, 2016, the total number of shares of common stock available for issuance under the 2013 Plan was 7,027,349. Unless otherwise determined by the Board, beginning January 1, 2014, and continuing until the expiration of the 2013 Plan, the total number of shares of common stock available for issuance under the 2013 Plan will automatically increase annually on January 1 by 4% of the total number of issued and outstanding shares of common stock as of December 31 of the immediate preceding year. On January 1, 2016, the total number of shares of common stock available for issuance under the 2013 Plan was automatically increased by 1,400,000 shares, which number is included in the number of shares available for issuance above. As of December 31, 2016 a total of 3,434,250 options have been issued under the 2013 Plan. In November 2013, our Board of Directors and stockholders approved the 2013 Employee Stock Purchase Plan (ESPP), which became effective as of December 5, 2013. Under the ESPP our employees may elect to have between 1-15% of their compensation withheld to purchase Company stock at a discount. The ESPP had an initial two-year term that includes four six-month purchase periods and employee withholding amounts may be used to purchase Company stock during each six-month purchase period. The initial two-year term ended in December 2015 and pursuant to the provisions of the ESPP, the second two-year term began automatically upon the end of the initial term. The total number of shares that can be purchased with the withholding amounts are based on the lower of 85% of the Company’s stock price at the initial offering date or, 85% of the Company’s stock price at each purchase date. We have reserved a total of 581,286 shares of common stock for issuance under the ESPP. Unless otherwise determined by our Board, beginning on January 1, 2014, and continuing until the expiration of the ESPP, the total number shares of common stock available for issuance under the ESPP will automatically increase annually on January 1 by the lesser of (i) 1% of the total number of issued and outstanding shares of common stock as of December 31 of the immediately preceding year, or (ii) 621,814 shares of common stock. On January 1, 2014, the total number of shares of common stock available for issuance under the ESPP was automatically increased by 313,545 shares, which number is included in the number of shares reserved for issuance above. Pursuant to approval by our board, there was no increase in the number of authorized shares in the ESPP Xencor, Inc. Notes to Financial Statements (Continued) in 2016 or 2015. As of December 31, 2016 and 2015, we have issued a total of 221,486 and 176,383 shares of common stock, respectively, under the ESPP. Information with respect to stock options outstanding is as follows: The following table summarizes stock option activity for the years ended December 31, 2016 and 2015: (1) The weighted average exercise price per share is determined using exercise price per share for stock options. (2) The aggregate intrinsic value is calculated as the difference between the exercise price of the option and the fair value of our common stock for in- the-money options at December 31, 2016 and 2015. Xencor, Inc. Notes to Financial Statements (Continued) (3) The total intrinsic value of stock options exercised was $11.2 million, $5.4 million and $155,000 for the years ended December 31, 2016, 2015 and 2014 respectively. The stock options outstanding and exercisable by exercise price at December 31, 2016 are as follows: We estimated the fair value of employee and non-employee awards using the Black-Scholes valuation model. The fair value of employee stock options is being amortized on a straight-line basis over the requisite service period of the awards. Management estimates the probability of non-employee awards being vested based upon an evaluation of the non-employee achieving their specific performance goals. Options granted after our Initial Public Offering, are issued at the fair market value of our stock at the date the grant is approved by our board of directors. The fair value of employee stock options was estimated using the following weighted average assumptions for the years ended December 31, 2016, 2015 and 2014: Xencor, Inc. Notes to Financial Statements (Continued) Total employee, director and non-employee stock-based compensation expense recognized was as follows: The expected term of stock options represents the average period the stock options are expected to remain outstanding. The expected stock price volatility for our stock options for the years ended December 31, 2016, 2015 and 2014 was determined by examining the historical volatilities for industry peers and adjusting for differences in our life cycle and financing leverage. Industry peers consist of several public companies in the biopharmaceutical industry. We determined the average expected life of stock options based on the simplified method because our common stock has not been publicly traded for an extended period and we do not have a track record of our stock being traded on the public markets for sufficient time to establish the volatility of our stock. The risk-free interest rate assumption is based on the U.S. Treasury instruments whose term was consistent with the expected term of our stock options. The expected dividend assumption is based on our history and expectation of dividend payouts. As of December 31, 2016 and 2015, the unamortized compensation expense related to unvested stock options was $18.1 million and $10.8 million, respectively. The remaining unamortized compensation expense will be recognized over the next 2.72 years. At December 31, 2016 and 2015, the unamortized compensation expense was $481,000 and $395,000 respectively under our ESPP. The remaining unamortized expense will be recognized over the next 11.5 months. 8. Commitments and Contingencies Operating leases The Company leases office and laboratory space in Monrovia, CA. In January 2015, we entered into a new lease agreement for the property. The new lease replaces the previous lease and extends our lease term to June 2020 with an option to renew for an additional five years. The new lease is a non-cancelable operating lease. The Company also leased office space in San Diego, CA through April 2018 which included an option to renew for a period of one year. In March 2016, the Company signed a lease for additional space contiguous with its existing office space. The combined lease expires in June 2020. At December 31, 2016 the future minimum lease payments under Xencor, Inc. Notes to Financial Statements (Continued) the operating leases were as follows: Rent expense for the years ended December 31, 2016, 2015 and 2014 was $638,000, $558,000 and $597,000 respectively. Contingencies From time to time, the Company may be subject to various litigation and related matters arising in the ordinary course of business. The Company does not believe it is currently subject to any material matters where there is at least a reasonable possibility that a material loss may be incurred. On March 3, 2015, a verified class action complaint, captioned DePinto v. John S. Stafford, et al., C.A. No. 10742, was filed in the Court of Chancery of the State of Delaware against certain of the Company's current and former directors alleging cause of action for Breach of Fiduciary Duty and Invalidity of Director and Stockholder Consents. In general, the complaint alleged that the plaintiff and the class he seeks to represent were shareholders of the Company during the recapitalization and certain related transactions that the Company underwent in 2013 and that the defendants breached their fiduciary duties in the course of approving that series of transactions. It also challenged as invalid certain corporate acts taken in the 2013 time period. On June 10, 2015, the Company filed a Verified Petition for Relief under Del. C. Section 205 (the 205 Petition) related to the corporate acts challenged in the complaint. The defendants filed an answer to the class action complaint on June 22, 2015. On July 9, 2015, the Court consolidated the 205 Petition with the class action, joined the Company as a defendant and ordered it to file the claims in the 205 Petition as counter-claims in the class action, which the Company has done. On August 11, 2015, the Company filed a Motion for leave to File an Amended Counter-Claim, along with the proposed Amended Counter-Claim and related documents. On October 5, 2015, the parties filed a Stipulation of Partial Settlement and related documents disclosing a settlement of the invalidity claims addressed in the complaint, the counter-claim and the proposed amended counter-claim including a request by plaintiff's counsel for reimbursement of legal fees up to $950,000. On October 7, 2015, we filed the Amended Counter-Claim and the related documents. On December 14, 2015, the Court entered an Order and Partial Final Judgment approving the settlement of the invalidity claims, validating each corporate act challenged in the complaint, dismissing with prejudice Count II of the complaint (the invalidity claims) and granting plaintiff’s counsel a fee award. We have paid the plaintiff’s legal award cost of $950,000 net of insurance proceeds of $187,500 which has been reflected as a charge in our 2015 operations. On September 27, 2016, the parties engaged in voluntary mediation and agreed to settle the complaint’s remaining claims for a total payment of $2.375 million to the class certified by the Delaware Court of Chancery. The settlement, which is subject to approval by the Court, was reached without any party admitting wrong-doing. Under the terms of the settlement, no payments shall be made to the plaintiffs by the Company or any of the defendants in the lawsuit other than payments covered by the Company’s insurance. The Court has scheduled a Settlement hearing for April 4, 2017. Xencor, Inc. Notes to Financial Statements (Continued) We continue to recognize legal costs related to the litigation as incurred and offset any insurance proceeds when approved and issued. For the year ended December 31, 2016 no amount of loss related to the settlement has been accrued. As of December 31, 2016, we have reported an outstanding settlement amount of $2.355 million as a payable and also reflected a receivable of the same amount for the insurance coverage that will fund the remaining settlement costs. We are obligated to make future payments to third parties under in-license agreements, including sublicense fees, royalties, and payments that become due and payable on the achievement of certain development and commercialization milestones. As the amount and timing of sublicense fees and the achievement and timing of these milestones are not probable and estimable, such commitments have not been included on our balance sheet. Guarantees In the normal course of business, we indemnify certain employees and other parties, such as collaboration partners and other parties that perform certain work on behalf of, or for the Company or take licenses to our technologies. We have agreed to hold these parties harmless against losses arising from our breach of representations or covenants, intellectual property infringement or other claims made against these parties in performance of their work with us. These agreements typically limit the time within which the party may seek indemnification by us and the amount of the claim. It is not possible to prospectively determine the maximum potential amount of liability under these indemnification agreements since we have not had any prior indemnification claims on which to base the calculation. Further, each potential claim would be based on the unique facts and circumstances of the claim and the particular provisions of each agreement. We are not aware of any potential claims and did not record a liability as of December 31, 2016 and 2015. 9. 401(k) Plan We have a 401(k) plan covering all full-time employees. Employees may make pre-tax contributions up to the maximum allowable by the Internal Revenue Code. Participants are immediately vested in their employee contributions and employer discretionary contributions, if any. No employer contributions were made for the years ended December 31, 2016, 2015 or 2014. 10. Condensed Quarterly Financial Data (unaudited) The following table contains selected unaudited financial data for each quarter of 2016 and 2015. The unaudited information should be read in conjunction with the Company’s financial statements and related notes included elsewhere in this report. The Company believes that the following information reflects all normal recurring adjustments necessary for a fair presentation of the information for the periods presented. The operating results for any quarter are not necessarily indicative of results for any future period. Xencor, Inc. Notes to Financial Statements (Continued) Quarterly Financial Data (in thousands, except per share data):
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Based on the fragmented financial statement provided, here's a summary:
Financial Statement Overview:
- Revenue: Zero revenue recognized for the year ended December 2016
- Assets: Evaluated fixed assets and intangible assets for potential impairment
- Liabilities: Noted potential changes in accounting for credit losses on debt securities
- Expenses: Some accounting updates mentioned, but specific expense details are unclear
- Profit/Loss: Not definitively stated, but implies potential financial challenges
Key Observations:
- No revenue generated in the reported period
- Asset impairment assessment conducted
- Potential accounting method changes for credit losses
- Incomplete financial statement with missing or fragmented sections
Note: This summary is limited due to the incomplete and disjointed nature of the provided financial statement excerpt.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM To the Board of Directors and Stockholders of JPX Global, Inc. I have audited the accompanying balance sheets of JPX Global, Inc. (the “Company”) as of December 31, 2016 and 2015 and the related statements of operations, stockholders’ deficit, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. My responsibility is to express an opinion on these financial statements based on my audits. I conducted my audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that I plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. I believe that my audits provide a reasonable basis for my opinion. In my opinion, the financial statements referred to above present fairly, in all material respects, the financial position of JPX Global, Inc. as of December 31, 2016 and 2015 and the results of its operations and cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. The accompanying financial statements referred to above have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company’s present financial situation raises substantial doubt about its ability to continue as a going concern. Management’s plans in regard to this matter are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ MICHAEL T. STUDER, CPA, P.C. Michael T. Studer, CPA, P.C. Freeport, New York April 17, 2017 JPX Global, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 NOTE 1. ORGANIZATION The Company was incorporated under the laws of the state of Nevada on December 18, 2008, with 75,000,000 authorized common shares with a par value of $0.001. On January 3, 2013, the Company approved the action to amend and restate the Articles of Incorporation to increase the authorized common shares to 500,000,000 and create and authorize 40,000,000 shares of Preferred Stock which was approved by written consent of the holder representing approximately 67% of the outstanding voting securities of the Company. Series A Preferred Stock was created and designated with super-voting rights of 100,000 votes per share of Series A Preferred Stock held, but no conversion, dividend, and liquidation rights. On February 5, 2014, the Company entered into an agreement to acquire all of the operating assets of Scorpex, Inc. (“Scorpex”) (an entity related by common control) in exchange for 105,000,000 shares of common stock and 10,000,000 shares of Series B Preferred Stock of the Company. Scorpex is majority owned and controlled by JPX Global, Inc.’s then controlling shareholder, Joseph Caywood. Each share of Series B preferred stock is convertible into 10 shares of common stock and is entitled to vote ratably together with our common stockholders on all matters upon which common stockholders may vote. With the acquisition of these assets, which consist primarily of a license agreement, the Company has modified its business plan to include the development of waste management services including the storage, recycling, and disposal of waste. The Company does not presently have any waste management operations. The acquired assets consist primarily of a license agreement between Scorpex and Tratamientos Ambientales Scorpion, S.A. de C.V. (a corporation formed under the laws of Mexico) (“TAS”). This license agreement with TAS has been assigned to JPX. TAS is a wholly owned subsidiary of Scorpex, and is, therefore, a common control entity. ASC 805-50-30-5 provides guidance on measuring assets and liabilities transferred between entities under common control. As the entities are under common control and the license agreement had no basis on Scorpex’s books they are being acquired at their carrying amounts (with no cost basis) on the date of transfer and, therefore, the transaction value is $-0-. The license agreement was dated July 30, 2011 and provided Scorpex with an exclusive worldwide license for the permits, property, and any and all of TAS’s other assets necessary for the business of storing, recycling, disposing, and treating waste in Mexico for a term of 10 years. The agreement also provided for Scorpex’s annual payment to TAS of 20% of its Net Revenues (gross cash receipts less cost of processing and other expenses excluding general, administrative, interest, and taxes) from the license. Pursuant to the Assignment Consent dated February 3, 2014, TAS agreed to extend the term of the agreement every 10 years if operations have commenced pursuant to the license agreement. NOTE 2. GOING CONCERN The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. The company does not have sufficient working capital for its planned activity, and to service its debt, which raises substantial doubt about its ability to continue as a going concern. The Company has incurred accumulated losses of $34,758,025 since inception through December 31, 2016. Continuation of the company as a going concern is dependent upon obtaining additional working capital. The management of the Company has developed a strategy which it believes will accomplish this objective through short term loans from related parties, and additional equity investments, which will enable the company to continue operations for the coming year. These financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classification of liabilities that might result from this uncertainty. JPX Global, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Methods The Company recognizes income and expenses based on the accrual method of accounting. The Company follows accounting principles generally accepted in the United States. Income Tax The Company utilizes the liability method of accounting for income taxes. Under the liability method deferred tax assets and liabilities are determined based on the differences between financial reporting and the tax bases of the assets and liabilities and are measured using the enacted tax rates and laws that will be in effect, when the differences are expected to be reversed. An allowance against deferred tax assets is recorded, when it is more likely than not that such tax benefits will not be realized. Basic and Diluted Net Income (loss) Per Share The Company follows ASC Topic 260 to account for the earnings per share. Basic earnings per common share (“EPS”) calculations are determined by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share calculations are determined by dividing net income by the weighted average number of common shares and dilutive common share equivalents outstanding. For the years ended December 31, 2016 and 2015, the common shares underlying the following dilutive securities were excluded from the calculation of diluted shares outstanding as the effect of their inclusion would be anti-dilutive: Cash & Cash Equivalents For the purposes of the statement of cash flows, the Company considers all highly liquid investments with a maturity of three months or less to be cash equivalents. Revenue Recognition Revenue is recognized upon completion of services or delivery of goods where the sales price is fixed or determinable and the collectability is reasonably assured. The Company has no revenue to date. Advertising and Market Development The Company expenses advertising and market development costs. As of December 31, 2016, the company has not incurred any advertising and market development costs. JPX Global, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 Impairment of Long-Lived Assets The Company reviews and evaluates long-lived assets for impairment when events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The assets are subject to impairment consideration under FASB ASC 360-10-35-17 if events or circumstances indicate that their carrying amount might not be recoverable. When the Company determines that an impairment analysis should be done, the analysis will be performed using the rules of FASB ASC 930-360-35, Asset Impairment, and 360-10 through 15-5, Impairment or Disposal of Long-Lived Assets. Environmental Requirements At the report date, environmental requirements related to a formally held mineral claim are unknown and therefore any estimate of future costs cannot be made. Mineral Property Acquisition Costs Costs of acquisition and option costs of mineral rights are capitalized upon acquisition. Mine development costs incurred to develop new ore deposits, to expand the capacity of mines, or to develop mine areas substantially in advance of current production are also capitalized once proven and probable reserves exist and the property is a commercially mineable property. Costs incurred to maintain current production or to maintain assets on a standby basis are charged to operations. If the Company does not continue with exploration after the completion of the feasibility study, the mineral rights will be expensed at that time. Costs of abandoned projects are charged to mining costs including related property and equipment costs. To determine if these costs are in excess of their recoverable amount, periodic evaluation of carrying value of capitalized costs and any related property and equipment costs are based upon expected future cash flows and/or estimated salvage value in accordance with FASB Accounting Standards Codification (ASC) 360-10-35-15, Impairment or Disposal of Long-Lived Assets. Various factors could impact our ability to achieve forecasted production schedules. Additionally, commodity prices, capital expenditure requirements and reclamation costs could differ from the assumptions the Company may use in cash flow models from exploration stage mineral interests. This, however, involves further risks in addition to those factors applicable to mineral interests where proven and probable reserves have been identified, due to the lower level of confidence that the identified mineralized material can ultimately be mined economically. Estimates and Assumptions Management uses estimates and assumptions in preparing financial statements in accordance with generally accepted accounting principles. Those estimates and assumptions affect the reported amounts of the assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could vary from the estimates that were assumed in preparing these financial statements. JPX Global, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 Stock-based compensation The Company records stock based compensation in accordance with the guidance in ASC Topic 505 and 718 which requires the Company to recognize expenses related to the fair value of its employee stock option awards. This eliminates accounting for share-based compensation transactions using the intrinsic value and requires instead that such transactions be accounted for using a fair-value-based method. The Company recognizes the cost of all share-based awards on a graded vesting basis over the vesting period of the award. The Company accounts for equity instruments issued in exchange for the receipt of goods or services from other than employees in accordance with FASB ASC 718-10 and the conclusions reached by the FASB ASC 505-50. Costs are measured at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably measurable. The value of equity instruments issued for consideration other than employee services is determined on the earliest of a performance commitment or completion of performance by the provider of goods or services as defined by FASB ASC 505-50. Fair value of financial instruments Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2016. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values. These financial instruments include cash and cash equivalents, accounts payable and accrued liabilities, advances from related party, notes payable to related parties, notes payable, and convertible loan payable - related party. Fair values were assumed to approximate carrying values for cash and payables because they are short term in nature and their carrying amounts approximate fair values or they are payable on demand. Level 1: The preferred inputs to valuation efforts are "quoted prices in active markets for identical assets or liabilities," with the caveat that the reporting entity must have access to that market. Information at this level is based on direct observations of transactions involving the same assets and liabilities, not assumptions, and thus offers superior reliability. However, relatively few items, especially physical assets, actually trade in active markets. Level 2: FASB acknowledged that active markets for identical assets and liabilities are relatively uncommon and, even when they do exist, they may be too thin to provide reliable information. To deal with this shortage of direct data, the board provided a second level of inputs that can be applied in three situations. Level 3: If inputs from levels 1 and 2 are not available, FASB acknowledges that fair value measures of many assets and liabilities are less precise. The board describes Level 3 inputs as "unobservable," and limits their use by saying they "shall be used to measure fair value to the extent that observable inputs are not available." This category allows "for situations in which there is little, if any, market activity for the asset or liability at the measurement date". Earlier in the standard, FASB explains that "observable inputs" are gathered from sources other than the reporting company and that they are expected to reflect assumptions made by market participants. Recent Accounting Pronouncements The Company has evaluated recent accounting pronouncements and believes that none of them will have a material effect on the company’s financial statements. JPX Global, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 NOTE 4. ADVANCES FROM RELATED PARTY The advances from related party liability at December 31, 2016 ($14,594) and 2015 ($243,864) is due to Joseph Caywood, significant stockholder of the Company. The liability is non-interest bearing and due on demand. NOTE 5. NOTES PAYABLE TO RELATED PARTIES The notes payable to related parties at December 31, 2016 and 2015 consist of: NOTE 6. NOTES PAYABLE The notes payable to at December 31, 2016 consisted of the following: (A)On July 22, 1016, the Company issued a $166,000 Convertible Promissory Note to Auctus Fund, LLC (“Auctus”) for net loan proceeds of $150,000. The note bears interest at a rate of 10% per annum (24% per annum default rate), is due April 22, 2017, and is convertible at the option of Auctus into shares of the Company common stock at a Conversion Price equal to the lesser of (a) 55% of the lowest Trading Price during the 25 Trading Day period prior to July 22, 2016 or (b) 55% of the lowest Trading Price during the 25 Trading Day period prior to the Conversion Date. (See Note 8 - Derivative Liability). (B)This note is payable to the Company’s law firm for legal services rendered. JPX Global, Inc. NOTES TO THE FINANCIAL STATEMENTS December 31, 2016 and 2015 NOTE 7. CONVERTIBLE LOAN PAYABLE - RELATED PARTY On December 18, 2008, the Company entered into a Promissory Note agreement with the then CEO of the Company. The note is for a sum of $1,500, is non-interest bearing, and was due and payable on December 31, 2010. The note provides that if the note was not paid on December 31, 2010, the note can be converted to shares of common stock of the Company for $.001 per share. At the time the note was issued, the Company did not have a fair value for the stock: therefore, no beneficial conversion feature was recorded. The Company and Joseph Caywood, the current note holder, have verbally agreed that the Company will pay the loan off as it is able to without penalty, and the current note holder will not convert the debt into shares of common stock. As of December 31, 2016 and December 31, 2015, the balance of the loan is $1,500. NOTE 8. DERIVATIVE LIABILITY The derivative liability at December 31, 2016 consisted of the following: The above convertible note contains a variable conversion feature based on the future trading price of the Company common stock. Therefore, the number of shares of common stock issuable upon conversion of the note is indeterminate. Accordingly, we have recorded the $730,400 fair value of the embedded conversion feature as a derivative liability at the July 22, 2016 issuance date and charged $166,000 to debt discounts and the remaining $564,400 to expense from derivative liability. The $6,036 decrease in the fair value of the derivative liability from $730,400 at July 22, 2016 to $724,364 at December 31, 2016 was credited to expense from derivative liability. The fair value of the derivative liability is measured at the respective issuance date and quarterly thereafter using the Black Scholes option pricing model. Assumptions used for the calculation of the derivative liability of the note at December 31, 2016 include (1) stock price of $0.03 per share, (2) exercise price of $0.0066 per share, (3) term of 112 days, (4) expected volatility of 609% and (5) risk free interest rate of 0.62%. NOTE 9. CAPITAL STOCK On February 17, 2015, pursuant to a Consulting Agreement with Joseph Caywood dated January 1, 2015, (term ended March 31, 2015), the Company issued a total of 2,050,000 shares of common stock to 18 individuals/entities for services rendered to the Company. The stock was valued at $2,050,000 and is included in consulting fees on the 2015 statement of operations. On July 1, 2016, pursuant to a Consulting Services Agreement with an individual consultant dated June 1, 2016 (term ending November 30, 2016), the Company issued 2,000,000 shares of common stock to such individual for certain marketing consulting services to be rendered to the Company. The stock was valued at $400,000 and was expensed as consulting fees in the three months ended June 30, 2016. On June 17, 2016, pursuant to a Consulting and Representation Agreement with an entity consultant dated June 14, 2016 (extended term ending June 14, 2017), the Company issued 1,000,000 shares of common stock to such entity for certain investor relations services to be rendered to the Company. The stock was valued at $200,000 and was expensed as consulting fees in the three months ended June 30, 2016. On October 18, 2016 the Company sold 1,333,333 restricted shares of common stock to an accredited investor at $0.03 per share for total proceeds of $40,000. NOTE 10. INCOME TAXES The Financial Accounting Standards Board (FASB) has issued FASB ASC 740-10. FASB ASC 740-10 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements. This standard requires a company to determine whether it is more likely than not that a tax position will be sustained upon examination based upon the technical merits of the position. If the more-likely-than-not threshold is met, a company must measure the tax position to determine the amount to recognize in the financial statements. As a result of the implementation of this standard, the Company performed a review of its material tax positions in accordance with recognition and measurement standards established by FASB ASC 740-10. Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. At December 31, 2016 the Company had net operating loss carryforwards of approximately $869,000 that may be offset against future taxable income through 2036. No tax benefits have been reported in the financial statements, because the potential tax benefits of the net operating loss carry forwards are offset by a valuation allowance of the same amount. Due to the change in ownership provisions of the Tax Reform Act of 1986, net operating loss carryforwards for Federal income tax reporting purposes are subject to annual limitations. Should a significant change in ownership occur, net operating loss carryforwards may be limited as to use in the future. Net deferred tax assets consist of the following components as of December 31, 2016 and 2015: The income tax provision (benefit) differs from the amount of income tax determined by applying the U.S. federal tax rates of 34% to pretax income for the years ended December 31, 2016 and 2015 due to the following: A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: At December 31, 2016, the Company had no unrecognized tax benefits that, if recognized, would affect the effective tax rate. The Company did not have any tax positions for which it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months. The Company includes interest and penalties arising from the underpayment of income taxes in the consolidated statements of operations in the provision for income taxes. As of December 31, 2016 and 2015, the Company had no accrued interest or penalties related to uncertain tax positions. The tax years that remain subject to examination by major taxing jurisdictions are those for the years ended December 31, 2016, 2015, 2014, 2013 and 2012. NOTE 11. SUBSEQUENT EVENTS In February and March 2017, the Company issued a total of 33,684,454 shares of common stock to Auctus Fund, LLC in satisfaction of a total of $11,672 principal (of the $166,000 note payable) and a total of $2,938 accrued interest.
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Here's a summary of the financial statement:
The financial statement indicates a challenging financial situation for the company:
1. Revenue: Not clearly specified, but mentions a license agreement
2. Profit/Loss: Significant net loss of $34,758,025
3. Expenses: Liabilities were transferred between entities under common control, with no additional cost basis
4. Liabilities: The company's substantial accumulated losses raise serious doubts about its ability to continue operating as a going concern
The key takeaway is that the company is experiencing significant financial distress, with substantial accumulated losses and uncertainty about its future viability.
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Claude
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ACCOUNTING FIRM To the Board of Directors and Members of National Rural Utilities Cooperative Finance Corporation Dulles, Virginia We have audited the accompanying consolidated balance sheets of National Rural Utilities Cooperative Finance Corporation and subsidiaries (the Company) as of May 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, changes in equity, and cash flows for each of the years in the three-year period ended May 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Rural Utilities Cooperative Finance Corporation and subsidiaries as of May 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended May 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP McLean, Virginia August 25, 2016 NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION CONSOLIDATED BALANCE SHEETS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Company National Rural Utilities Cooperative Finance Corporation (“CFC”) is a member-owned cooperative association incorporated under the laws of the District of Columbia in April 1969. CFC’s principal purpose is to provide its members with financing to supplement the loan programs of the Rural Utilities Service (“RUS”) of the United States Department of Agriculture (“USDA”). CFC makes loans to its rural electric members so they can acquire, construct and operate electric distribution, generation, transmission and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. As a cooperative, CFC is owned by and exclusively serves its membership, which consists of not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. CFC is exempt from federal income taxes. Rural Telephone Finance Cooperative (“RTFC”) is a taxable Subchapter T cooperative association originally incorporated in South Dakota in 1987 and reincorporated as a member-owned cooperative association in the District of Columbia in 2005. RTFC’s principal purpose is to provide financing for its rural telecommunications members and their affiliates. RTFC’s membership consists of a combination of not-for-profit and for-profit entities. CFC is the sole lender to and manages the business operations of RTFC through a management agreement in effect until December 1, 2016, which is automatically renewed for one-year terms thereafter unless terminated by either party. Under a guarantee agreement, RTFC pays CFC a fee and, in exchange, CFC reimburses RTFC for loan losses. As permitted under Subchapter T of the Internal Revenue Code, RTFC pays income tax based on its net income, excluding patronage-sourced earnings allocated to its patrons. RTFC is headquartered with CFC in Dulles, Virginia. National Cooperative Services Corporation (“NCSC”) is a taxable cooperative incorporated in 1981 in the District of Columbia as a member-owned cooperative association. NCSC’s principal purpose is to provide financing to members of CFC, entities eligible to be members of CFC and the for-profit and nonprofit entities that are owned, operated or controlled by or provide significant benefit to certain members of CFC. NCSC’s membership consists of distribution systems, power supply systems and statewide and regional associations that are members of CFC. CFC is the primary source of funding for NCSC and manages NCSC’s business operations under a management agreement that is automatically renewable on an annual basis unless terminated by either party. NCSC pays CFC a fee and, in exchange, CFC reimburses NCSC for loan losses under a guarantee agreement. As a taxable cooperative, NCSC pays income tax based on its reported taxable income and deductions. NCSC is headquartered with CFC in Dulles, Virginia. Basis of Presentation and Use of Estimates The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts and related disclosures. The most significant estimates and assumptions involve establishing the allowance for loan losses and determining the fair value of financial instruments and other assets and liabilities. While management makes its best judgment, actual amounts or results could differ from these estimates. Certain reclassifications have been made to previously reported amounts to conform to the current-period presentation. Principles of Consolidation Our consolidated financial statements include the accounts of CFC, RTFC and NCSC and subsidiaries created and controlled by CFC to hold foreclosed assets. All intercompany balances and transactions have been eliminated. We consolidate entities in which CFC has a controlling financial interest. We determine whether CFC has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity (“VIE”). NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CFC established limited liability corporations and partnerships to hold foreclosed assets resulting from defaulted loans or bankruptcy. CFC owns and controls all of these entities and, therefore, consolidates their financial results. CFC presents the companies established to hold foreclosed assets in one line on the consolidated balance sheets and the consolidated statements of operations. Unless stated otherwise, references to “we, “our” or “us” relate to CFC and its consolidated entities. Variable Interest Entities A VIE is an entity that has a total equity investment at risk that is not sufficient to finance its activities without additional subordinated financial support provided by another party, or where the group of equity holders does not have: (i) the ability to make significant decisions about the entity’s activities; (ii) the obligation to absorb the entity’s expected losses; or (iii) the right to receive the entity’s expected residual returns. NCSC and RTFC meet the definition of variable interest entities because they do not have enough equity investment at risk to finance their activities without additional financial support. When evaluating an entity for possible consolidation, we must determine whether or not we have a variable interest in the entity. If it is determined that we do not have a variable interest in the entity, no further analysis is required and we do not consolidate the entity. If we have a variable interest in the entity, we must evaluate whether we are the primary beneficiary based on an assessment of quantitative and qualitative factors. We are considered the primary beneficiary holder if we have a controlling financial interest in the VIE that provides (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. We consolidate the results of NCSC and RTFC because we are the primary beneficiary holder. Cash and Cash Equivalents Cash, certificates of deposit and other investments with original maturities of less than 90 days are classified as cash and cash equivalents. Restricted Cash Restricted cash consists of cash and cash equivalents for which the use is contractually restricted. Time Deposits Time deposits are deposits that we make with financial institutions in interest-bearing accounts. These deposits have a maturity of less than one year as of the reporting date and are valued at carrying value, which approximates fair value. Investment Securities Available for Sale Our investment securities, which are classified as available for sale, consist of investments in Federal Agricultural Mortgage Corporation (“Farmer Mac”) Series A Common Stock and Farmer Mac Series A, Series B and Series C Non-Cumulative Preferred Stock. Available-for-sale securities are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income. We regularly evaluate our investment securities whose fair value has declined below the amortized cost to assess whether the decline in fair value is other than temporary. We recognize any other-than-temporary impairment amounts in earnings. Loans to Members Loans to members are classified as held for investment and reported at amortized cost, which is measured based on the outstanding principal balance net of unamortized deferred loan origination costs. Deferred loan origination costs are amortized using the straight-line method, which approximates the effective interest method, over the life of the loan as a reduction to interest income. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Allowance for Loan Losses We maintain an allowance for loan losses at a level estimated by management to provide for probable losses inherent in the loan portfolio. The allowance for loan losses is reported separately on the consolidated balance sheet, and the provision for loan losses is reported as a separate line item on the consolidated statement of operations. We review the estimates and assumptions used in the calculations of the allowance for loan losses on a quarterly basis. The estimate of the allowance for loan losses is based on a review of the composition of the loan portfolio, past loss experience, specific problem loans, current economic conditions, available market data and/or projection of future cash flows and other pertinent factors that in management’s judgment may contribute to incurred losses. The allowance is based on estimates and, accordingly, actual losses may differ from the allowance amount. The methodology used to calculate the allowance for loan losses is summarized below. The allowance for loan losses is calculated by dividing the portfolio into two categories of loans: (1) the general portfolio, which comprises loans that are performing according to the contractual agreements; and (2) the impaired portfolio, which comprises loans that (i) are not currently performing or (ii) for various reasons we do not expect to collect all amounts as and when due and payable under the loan agreement or (iii) are performing according to a restructured loan agreement, but as a result of the troubled debt restructuring are required to be classified as impaired. Collective Allowance The general portfolio of loans consists of all loans not specifically identified in the impaired category. We disaggregate the loans in the general portfolio by company: CFC, RTFC and NCSC. We further disaggregate the CFC loan portfolio by member class: distribution, power supply and statewide and associates. We use the following factors to determine the allowance for loan losses for the general portfolio category: • Internal risk ratings system. We maintain risk ratings for our borrowers that are updated at least annually and are based on the following: ◦ general financial condition of the borrower; ◦ our judgment of the quality of the borrower’s management; ◦ our judgment of the borrower’s competitive position within its service territory and industry; ◦ our estimate of the potential impact of proposed regulation and litigation; and ◦ other factors specific to individual borrowers or classes of borrowers. • Standard & Poor’s historical utility sector default table. The table provides expected default rates for the utility sector based on rating level and the remaining maturity. We correlate our internal risk ratings to the ratings used in the utility sector default table. We use the default table to assist in estimating our allowance for loan losses because we have limited history from which to develop loss expectations. • Loss Emergence Period. Based on the estimated time between the loss-causing event(s) and the date that we charge off the unrecoverable portion of the loan. • Recovery rates. Estimated recovery rates are based on our historical recovery experience by member class calculated by comparing loan balances at the time of default to the total loss recorded on the loan. We have been lending to our electric cooperative members since our incorporation in 1969. In addition to the allowance for loan losses for the general portfolio, we maintain a qualitative reserve for the general portfolio based on risk factors not captured in the collective allowance for loan losses. The overriding factor that creates the necessity for this additional component of loan loss reserves not captured in our loan loss model is lag in the timing of receipt of information regarding our borrowers. We actively monitor the operations and financial performance of our borrowers through the review of audited financial statements, review of borrower-prepared financial statements (if required) and discussions with borrower management. As a result of the lag, there could be credit events or circumstances that exist with our borrowers of which we have not been made aware that could potentially lead to reassessing/downgrading of certain NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS borrower risk ratings (“BRRs”) to better reflect the risk of default and ultimate loss. Additional qualitative considerations include our expectations with respect to loan workouts, risks associated with large loan exposures and economic and environmental factors. To measure these additional risk factors supporting an additional reserve for the general portfolio, we perform an internal credit risk ratings portfolio stress test quantifying the impact that both upgrades and downgrades in internal credit risk ratings would have on our estimate of losses inherent in the portfolio. Specific Allowance A loan is considered to be impaired when we do not expect to collect all principal and interest payments as scheduled by the original loan terms, other than an insignificant delay or an insignificant shortfall in amount. Factors considered in determining impairment may include, but are not limited to: • the review of the borrower’s audited financial statements and interim financial statements if available, • the borrower’s payment history, • communication with the borrower, • economic conditions in the borrower’s service territory, • pending legal action involving the borrower, • restructure agreements between us and the borrower and • estimates of the value of the borrower’s assets that have been pledged as collateral to secure our loans. We generally measure impairment for individually impaired loans based on the difference between the recorded investment of the loan and the present value of the expected future cash flows discounted at the loan’s effective interest rate. If the loan is collateral dependent, we measure impairment based upon the fair value of the underlying collateral, which we determine based on the current fair value of the collateral less estimated selling costs. Loans are identified as collateral dependent if we believe that collateral is the expected source of repayment. In calculating the impairment on a loan, the estimates of the expected future cash flows or collateral value are the key estimates made by management. Changes in the estimated future cash flows or collateral value affect the amount of the calculated impairment. The change in cash flows required to make the change in the calculated impairment material will be different for each borrower and depend on the period covered, the effective interest rate at the time the loan became impaired and the amount of the loan outstanding. Estimates are not used to determine our investment in the receivables or the discount rate since, in all cases, the investment is equal to the loan balance outstanding at the reporting date, and the discount rate is equal to the effective interest rate on the loan at the time the loan became impaired. We recognize interest income on impaired loans on a case-by-case basis. An impaired loan to a borrower that is nonperforming will typically be placed on nonaccrual status and we will reverse all accrued and unpaid interest. We generally apply all cash received during the nonaccrual period to the reduction of principal, thereby foregoing interest income recognition. Interest income may be recognized on an accrual basis for restructured impaired loans where the borrower is performing and is expected to continue to perform based on agreed-upon terms. All of our restructured loans are troubled debt restructurings. All loans are written off in the period that it becomes evident that collectability is highly unlikely; however, our efforts to recover all charged-off amounts may continue. The determination to write off all or a portion of a loan balance is made based on various factors on a case-by-case basis including, but not limited to, cash flow analysis and the fair value of collateral securing the borrower’s loans. Allowance for Unadvanced Loan Commitments We do not maintain an allowance for the majority of our unadvanced loan commitments as the loans are generally subject to material adverse change clauses that would not require us to lend or continue to lend to a borrower experiencing a material adverse change in their business or condition, financial or otherwise. The methodology used to determine an estimate of NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS probable losses for unadvanced commitments related to committed lines of credit that are not subject to a material adverse change clause at the time of each loan advance is consistent with the methodology used to determine the allowance for loan losses. Due to the nature of unadvanced commitments, the estimate of probable losses also considers the probability of funding such loans based on our historical average utilization rate for committed lines of credit. The allowance for unadvanced commitments is included in the other liabilities line item on the consolidated balance sheet. Changes to the allowance for unadvanced commitments are recorded in the consolidated statement of operations in other non-interest expense. Guarantee Liability We maintain a guarantee liability that represents our contingent and noncontingent exposure related to guarantees and standby liquidity obligations associated with our members’ debt. The guarantee liability is included in the other liabilities line item on the consolidated balance sheet, and the provision for guarantee liability is reported in non-interest expense as a separate line item on the consolidated statement of operations. The contingent portion of the guarantee liability represents management’s estimate of our exposure to losses within the guarantee portfolio. The methodology used to estimate the contingent guarantee liability is consistent with the methodology used to determine the allowance for loan losses. We record a noncontingent guarantee liability for all new or modified guarantees since January 1, 2003. Our noncontingent guarantee liability represents our obligation to stand ready to perform over the term of our guarantees and liquidity obligations that we have entered into or modified since January 1, 2003. Our noncontingent obligation is estimated based on guarantee and liquidity fees charged for guarantees issued, which represents management’s estimate of the fair value of our obligation to stand ready to perform. The fees are deferred and amortized using the straight-line method into interest income over the term of the guarantee. Nonperforming Loans We classify loans as nonperforming when any one of the following criteria is met: • principal or interest payments on any loan to the borrower are past due 90 days or more; • as a result of court proceedings, repayment on the original terms is not anticipated; or • for other reasons, management does not expect the timely repayment of principal and interest. A loan is considered past due if a full payment of principal and interest is not received within 30 days of its due date. Once a borrower is classified as nonperforming, we typically place the loan on nonaccrual status and reverse any accrued and unpaid interest recorded during the period in which the borrower stopped performing. We generally apply all cash received during the nonaccrual period to the reduction of principal, thereby foregoing interest income recognition. The decision to return a loan to accrual status is determined on a case-by-case basis. Fixed Assets Fixed assets are recorded at cost less accumulated depreciation. We recognized depreciation expense of $7 million, $6 million and $6 million in fiscal years 2016, 2015 and 2014, respectively, based on the use of the straight-line method over estimated useful lives ranging from 3 to 40 years. CFC owns its headquarters facility in Loudoun County, Virginia, which is reported in the building and building equipment category below. Fixed assets consisted of the following as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Debt Service Reserve Fund We had $17 million and $26 million as of May 31, 2016 and 2015, respectively, pledged to the trustee for our members’ obligations to repay tax-exempt bonds, for which we are the guarantor. The member cooperatives are required to purchase debt service reserve subordinated certificates from us as a condition to obtaining the guarantee. We are required to pledge the proceeds from the members’ purchase of the debt service reserve subordinated certificates to the trustee. At inception of the guarantee transaction, the trustee sets aside the required debt service reserve fund amount out of the bond proceeds to be held as the asset pledged by us. We record a liability for the member’s investment in debt service reserve subordinated certificates and record an asset for the debt service reserve fund. Since the trustee holds the proceeds, the increase to the debt service reserve fund and increase to the debt service reserve subordinated certificates are disclosed as a noncash transaction in the consolidated statement of cash flows. A deficiency in the fund may occur when (i) the member does not pay the full amount of the periodic debt service payments as due to the trustee or (ii) upon maturity, the trustee uses the amount of the debt service reserve fund to reduce the final payment required by the member. If there is a deficiency in the bond payment due from a member, the trustee will first use the pledged amounts in the related debt service reserve fund to make up the deficiency. If there is still a deficiency after the debt service reserve fund amount is used, then we are required to perform under our guarantee. The member cooperatives are required to make up any deficiency in their specific debt service reserve fund. We record a guarantee liability, which is based on the full amount of the tax-exempt bonds guaranteed. We do not have any additional liability specific to the debt service reserve fund as we have the right at any time to offset the member’s investment in the debt service subordinated certificate against the amount that the member is required to pay to replenish the debt service reserve fund. There were no deficiencies in the debt service reserve fund as of May 31, 2016 and 2015. Earnings on the debt service reserve fund inure to the benefit of the member cooperatives but are pledged to the trustee and used to reduce the periodic interest payments due from the member cooperatives. During the year ended May 31, 2016, $8 million of guaranteed bonds requiring a debt service reserve fund were repaid, and no new guarantees requiring a debt service reserve fund were made. This resulted in a reduction of $8 million to the debt service reserve fund and member investments in debt service reserve subordinated certificates. During the year ended May 31, 2015, $14 million of guaranteed bonds requiring a debt service reserve fund were fully repaid and no new guarantees requiring a debt service reserve fund were made. This resulted in a reduction of $14 million to the debt service reserve fund and member investments in debt service reserve subordinated certificates for the year ended May 31, 2015. At maturity, the trustee uses the debt service reserve fund to repay the bonds, reducing the amount that the member must pay. The member is obligated to replenish the debt service reserve fund so the trustee can return the pledged funds to us since the guaranteed tax-exempt bonds have been repaid. We offset our requirement to repay the member the amount of the debt service reserve subordinated certificate against our right to collect the amount of the debt service reserve fund from the trustee. As a result, the member’s obligation to replenish the debt service reserve fund is met. The reduction to the debt NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS service reserve fund and the debt service reserve subordinated certificates on our consolidated balance sheet are offsetting and disclosed as a noncash transaction in the consolidated statement of cash flows. Foreclosed Assets Foreclosed assets acquired through our lending activities in satisfaction of indebtedness currently are held in operating entities created and controlled by CFC and presented separately in our consolidated balance sheets under foreclosed assets, net. These assets are initially recorded at estimated fair value as of the date of acquisition. Subsequent to acquisition, foreclosed assets not classified as held for sale are evaluated for impairment and the results of operations and any impairment are reported on our consolidated statements of operations under results of operations of foreclosed assets. When foreclosed assets meet the accounting criteria to be classified as held for sale, they are recorded at the lower of cost or fair value less estimated costs to sell at the date of transfer, with the amount at the date of transfer representing the new cost basis. Subsequent changes are recognized in our consolidated statements of operations under results of operations of foreclosed assets. We also review foreclosed assets classified as held for sale each reporting period to determine whether the existing carrying amounts are fully recoverable in comparison to estimated fair values. Debt Debt securities are reported at cost net of discounts or premiums. Issuance costs on debt and discounts are deferred and amortized as interest expense using the effective interest method or a method approximating the effective interest method over the legal maturity of each bond issue. Issuance costs on dealer commercial paper and medium-term notes are recognized as incurred. Derivative Instruments We are an end user of derivative financial instruments and do not engage in derivative trading. We use derivatives, primarily interest rate swaps and treasury rate locks, to manage interest rate risk. Derivatives may be privately negotiated contracts, which are often referred to as over-the-counter (“OTC”) derivatives, or they may be listed and traded on an exchange. We generally engage in OTC derivative transactions. In accordance with the accounting standards for derivatives and hedging activities, we record derivative instruments at fair value as either a derivative asset or derivative liability on our consolidated balance sheets. We report derivative asset and liability amounts on a gross basis based on individual contracts, which does not take into consideration the effects of master netting agreements or collateral netting. Derivatives in a gain position are reported as derivative assets on our consolidated balance sheets, while derivatives in a loss position are reported as derivative liabilities. Accrued interest related to derivatives is reported on our consolidated balance sheets as a component of either accrued interest receivable or accrued interest payable. If we do not elect hedge accounting treatment, changes in the fair value of derivative instruments, which consist of net accrued periodic derivative cash settlements and derivative forward value amounts, are recognized in our consolidated statements of operations under derivative gains (losses). If we elect hedge accounting treatment for derivatives, we formally document, designate and assess the effectiveness of the hedge relationship. Changes in the fair value of derivatives designated as qualifying fair value hedges are recorded in earnings together with offsetting changes in the fair value of the hedged item and any related ineffectiveness. Changes in the fair value of derivatives designated as qualifying cash flow hedges are recorded as a component of other comprehensive income (“OCI”), to the extent that the hedge relationships are effective, and reclassified from accumulated other comprehensive income (“AOCI”) to earnings using the effective interest method over the term of the forecasted transaction. Any ineffectiveness in the hedging relationship is recognized as a component of derivative gains (losses) in our consolidated statement of operations. We generally do not designate interest rate swaps, which represent the substantial majority of our derivatives, for hedge accounting. Accordingly, changes in the fair value of interest rate swaps are reported in our consolidated statements of operations under derivative gains (losses). Net periodic cash settlements related to interest rate swaps are classified as an operating activity in our consolidated statements of cash flows. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS We typically designate treasury rate locks as cash flow hedges of forecasted debt issuances. Accordingly, changes in the fair value of the derivative instruments are recorded as a component of OCI and reclassified to interest expense when the forecasted transaction occurs using the effective interest method. Any ineffectiveness in the hedging relationship is recognized as a component of derivative gains (losses) in our consolidated statements of operations. We did not have any derivatives designated as accounting hedges as of May 31, 2016 and 2015. At June 1, 2001, as a result of the adoption of the derivative accounting guidance that required derivatives to be reported at fair value on the balance sheet, we recorded a transition adjustment net loss in AOCI. The transition adjustment net loss is being reclassified into earnings and reported as a component of derivative gains (losses) in our consolidated statements of operations. We expect to continue to reclassify the remaining balance of the transition adjustment into earnings through 2029. Fair Value Valuation Processes We carry a portion of our assets and liabilities at fair value. We use fair value measurements to record fair value adjustments for certain assets and liabilities and to determine fair value disclosures. Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). We have various processes and controls in place to ensure that fair value is reasonably estimated. We consider observable prices in the principal market in our valuations where possible. Fair value estimates were developed at the reporting date and may not necessarily be indicative of amounts that could ultimately be realized in a market transaction at a future date. With the exception of redeeming debt under early redemption provisions, terminating derivative instruments under early termination provisions and allowing borrowers to prepay their loans, we held and intend to hold all financial instruments to maturity excluding common stock and preferred stock investments that have no stated maturity. Fair Value Hierarchy The fair value accounting guidance provides a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on the markets in which the assets or liabilities trade and whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Fair value measurement of a financial asset or liability is assigned a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are summarized below: • Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities • Level 2: Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities • Level 3: Unobservable inputs The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management’s judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value. Membership Fees Members are charged a one-time membership fee based on member class. CFC distribution system members, power supply system members and national associations of cooperatives pay a $1,000 membership fee. CFC service organization members pay a $200 membership fee and CFC associates pay a $1,000 fee. RTFC voting members pay a $1,000 membership fee and RTFC associates pay a $100 fee. NCSC members pay a $100 membership fee. Membership fees are accounted for as members’ equity. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Financial Instruments with Off-Balance Sheet Risk In the normal course of business, we are a party to financial instruments with off-balance sheet risk to meet the financing needs of our member borrowers. These financial instruments include committed lines of credit, standby letters of credit and guarantees of members’ obligations. Interest Income Interest income on loans is recognized using the effective interest method. The following table presents interest income, categorized by loan and investment type, for the years ended May 31, 2016, 2015 and 2014. ____________________________ (1) Includes loan conversion fees, which are deferred and recognized in interest income using the effective interest method. (2) Primarily related to amortization of loan origination costs and late payment fees. Up-front loan arranger fees, which are not based on interest rates, are included in fee and other income for fiscal year 2016. Deferred income on the consolidated balance sheets consists primarily of deferred loan conversion fees, which totaled $71 million and $70 million as of May 31, 2016 and 2015, respectively. Interest Expense The following table presents interest expense, categorized by debt product type, for the years ended May 31, 2016, 2015 and 2014. ____________________________ NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Represents interest expense and the amortization of discounts on debt. (2) Includes underwriter’s fees, legal fees, printing costs and certain accounting fees, which are deferred and recognized in interest expense using the effective interest method. Also includes issuance costs related to dealer commercial paper, which are recognized immediately as incurred. (3) Includes fees related to funding activities, including fees paid to banks participating in our revolving credit agreements. Amounts are recognized as incurred or amortized on a straight-line basis over the life of the agreement. Early Extinguishment of Debt We redeem outstanding debt early from time to time to manage liquidity and interest rate risk. When we redeem outstanding debt early, we recognize a gain or loss related to the difference between the amount paid to redeem the debt and the net book value of the extinguished debt as a component of non-interest expense in the gain (loss) on early extinguishment of debt line item. Income Taxes While CFC is exempt under Section 501(c)(4) of the Internal Revenue Code, it is subject to tax on unrelated business taxable income. RTFC is a taxable cooperative under Subchapter T of the Internal Revenue Code and is not subject to income taxes on income from patronage sources that is allocated to its borrowers, as long as the allocation is properly noticed and at least 20% of the amount allocated is retired in cash prior to filing the applicable tax return. NCSC is a taxable cooperative that pays income tax on the full amount of its reportable taxable income and allowable deductions. The income tax benefit (expense) recorded in the consolidated statement of operations for the years ended May 31, 2016, 2015 and 2014 represents the income tax benefit (expense) for RTFC and NCSC at the applicable federal and state income tax rates resulting in a statutory tax rate of approximately 38%. Accounting Standards Adopted in Fiscal Year 2016 Simplifying the Presentation of Debt Issuance Costs In April 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-03, Simplifying the Presentation of Debt Issuance Costs, which amends the current presentation of debt issuance costs in the financial statements by requiring that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. Prior to the issuance of ASU 2015-03, debt issuance costs were required to be presented as an asset in the balance sheet. The guidance, which does not affect the recognition and measurement requirements for debt issuance costs, is effective for the first quarter of fiscal year 2017. However, we early-adopted this guidance in the first quarter of fiscal year 2016 and applied its provisions retrospectively, which resulted in the reclassification of unamortized debt issuance costs of $47 million as of May 31, 2015, from total assets on our consolidated balance sheet to total debt outstanding. We previously presented debt issuance costs as a separate line item under total assets on our consolidated balance sheets. Other than this reclassification, the adoption of the guidance did not impact our consolidated financial statements. Recently Issued But Not Yet Adopted Accounting Standards Financial Instruments-Credit Losses: Measurement of Credit Losses on Financial Instruments In June 2016, FASB issued ASU 2016-13, Financial Instruments-Credit Losses: Measurement of Credit Losses on Financial Instruments, which changes the accounting for credit losses on certain financial assets to an expected loss model from the incurred loss model currently in use. The new guidance will result in earlier recognition of credit losses based on measuring the expected credit losses over the estimated life of financial assets held at each reporting date. The expected loss model will be the basis for determining the allowance for credit losses for loans and leases, unfunded lending commitments, held-to-maturity debt securities and other debt instruments measured at amortized cost. In addition, the new guidance modifies the other-than-temporary impairment model for available-for-sale debt securities to require the recognition of credit losses through a valuation allowance when fair value is less than amortized cost, regardless of whether the impairment is considered to be other-than-temporary, which allows for the reversal of credit impairments in future periods. The new NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS guidance is effective for public entities in fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. This update is effective for us in the first quarter of fiscal year 2020 with a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. We are in the process of evaluating the impact this new guidance will have on our consolidated financial statements. Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities In January 2016, FASB issued ASU 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities, which changes how entities measure certain equity investments and present changes in the fair value of financial liabilities measured under the fair value option that are attributable to their own credit. Under the new guidance, entities will be required to measure equity investments that do not result in consolidation and are not accounted for under the equity method at fair value and recognize any changes in fair value in net income unless the investments qualify for the new practicability exception. For financial liabilities measured using the fair value option, entities will be required to record changes in fair value caused by a change in instrument-specific credit risk (own credit risk) separately in other comprehensive income. The accounting for other financial instruments, such as loans and investments in debt securities, is largely unchanged. The classification and measurement guidance is effective for public entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. This update will be effective for us in the first quarter of fiscal year 2019. We are in the process of evaluating the impact of this update on our consolidated financial statements. Amendments to the Consolidation Analysis In February 2015, FASB issued ASU 2015-02, Amendments to the Consolidation Analysis, which is intended to improve upon and simplify the consolidation assessment required to evaluate whether organizations should consolidate certain legal entities such as limited partnerships, limited liability corporations and securitization structures. This update is effective for us in the first quarter of fiscal year 2017. We do not expect the adoption of the update to have a material impact on our consolidated financial statements. Revenue from Contracts with Customers In May 2014, FASB issued ASU 2014-09, Revenue from Contracts with Customers, which clarifies the principles for recognizing revenue from contracts with customers and will replace most existing revenue recognition in GAAP when it becomes effective. In July 2015, FASB approved a one-year deferral of the effective date of this standard, with a revised effective date for fiscal years beginning after December 15, 2017. Early adoption is permitted, although not prior to fiscal years beginning after December 15, 2016. The new accounting guidance, which does not apply to financial instruments, is effective beginning in the first quarter of fiscal year 2018. We do not expect the new guidance to have a material impact on our consolidated financial statements, as CFC’s primary business and source of revenue is from lending. NOTE 2-VARIABLE INTEREST ENTITIES Based on the accounting standards governing consolidations, we are required to consolidate the financial results of RTFC and NCSC because CFC is the primary beneficiary of variable interests in RTFC and NCSC due to its exposure to absorbing the majority of their expected losses. CFC manages the lending activities of RTFC and NCSC. Under separate guarantee agreements, RTFC and NCSC pay CFC a fee to indemnify them against loan losses. CFC is the sole lender to and manages the business operations of RTFC through a management agreement in effect until December 1, 2016, which is automatically renewed for one-year terms thereafter unless terminated by either party. CFC is the primary source of funding to and manages the lending activities of NCSC through a management agreement that is automatically renewable on an annual basis unless terminated by either party. NCSC funds its lending programs through loans from CFC or debt guaranteed by CFC. In connection with these guarantees, NCSC must pay a guarantee fee. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS All loans that require RTFC board approval also require approval by CFC for funding under RTFC’s credit facilities with CFC. CFC is not a member of RTFC and does not elect directors to the RTFC board. RTFC is a non-voting associate of CFC. RTFC members elect directors to the RTFC board based on one vote for each member. All loans that require NCSC board approval also require CFC board approval. CFC is not a member of NCSC and does not elect directors to the NCSC board. If CFC becomes a member of NCSC, it would control the nomination process for one NCSC director. NCSC members elect directors to the NCSC board based on one vote for each member within a district. NCSC is a service organization member of CFC. RTFC and NCSC creditors have no recourse against CFC in the event of a default by RTFC and NCSC, unless there is a guarantee agreement under which CFC has guaranteed NCSC or RTFC debt obligations to a third party. CFC had guaranteed $42 million of NCSC debt, derivative instruments and guarantees with third parties as of May 31, 2016, and CFC’s maximum potential exposure for these instruments totaled $46 million. The maturities for NCSC obligations guaranteed by CFC extend through 2031. Guarantees of NCSC debt and derivative instruments are not presented in the amounts in “Note 13-Guarantees,” as the debt and derivatives are reported on the consolidated balance sheet. CFC guaranteed $2 million of RTFC guarantees with third parties as of May 31, 2016. The maturities for RTFC obligations guaranteed by CFC extend through 2017. All CFC loans to RTFC and NCSC are secured by all assets and revenue of RTFC and NCSC. As of May 31, 2016, RTFC had total assets of $441 million including loans outstanding to members of $342 million, and NCSC had total assets of $692 million including loans outstanding of $681 million. As of May 31, 2016, CFC had committed to lend RTFC up to $4,000 million, of which $323 million was outstanding. As of May 31, 2016, CFC had committed to provide up to $3,000 million of credit to NCSC, of which $702 million was outstanding, representing $660 million of outstanding loans and $42 million of credit enhancements. As of May 31, 2016, after taking into consideration systems that are members of both CFC and NCSC and eliminating memberships between CFC, RTFC and NCSC, our consolidated membership totaled 1,463 members and 230 associates. Our membership includes the following: • 839 distribution systems; • 71 power supply systems; • 487 telecommunications members; • 65 statewide and regional associations; and • 1 national association of cooperatives. Associates are eligible to borrow; however, they are not eligible to vote on matters submitted to the membership for approval. Our members and associates are located in 49 states, the District of Columbia and two U.S. territories. All references to members within this document include members and associates. NOTE 3-INVESTMENT SECURITIES Our investment securities consist of holdings of Farmer Mac preferred and common stock. The following tables present the amortized cost, gross unrealized gains and losses and fair value of our investment securities, all of which are classified as available for sale, as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS We did not have any investment securities in an unrealized loss position as of May 31, 2016 or May 31, 2015. For additional information regarding the unrealized gains (losses) recorded on our available-for-sale investment securities, see “Note 11-Equity-Accumulated Other Comprehensive Income. ” NOTE 4-LOANS AND COMMITMENTS We are a cost-based lender that offers long-term fixed- and variable-rate loans and line of credit loans. On long-term loans, borrowers choose between a variable interest rate or a fixed interest rate for periods of one to 35 years. When a selected fixed interest rate term expires, the borrower may select another fixed-rate term or the variable rate. Collateral and security requirements for advances on loan commitments are identical to those required at the time of the initial loan approval. The following table presents the outstanding principal balance of loans to members, including deferred loan origination costs, and unadvanced loan commitments by loan type and member class, as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ____________________________ (1) The interest rate on unadvanced commitments is not set until drawn; therefore, the long-term unadvanced loan commitments have been classified in this table as variable-rate unadvanced commitments. However, at the time of the advance, the borrower may select a fixed or a variable rate on the new loan. (2) Includes nonperforming and restructured loans. (3) Represents the unpaid principal balance excluding deferred loan origination costs. Unadvanced Loan Commitments Unadvanced loan commitments totaled $2,448 million and $2,765 million as of May 31, 2016 and 2015, respectively, related to committed lines of credit loans that are not subject to a material adverse change clause at the time of each loan advance. As such, we are required to advance amounts on these committed facilities as long as the borrower is in compliance with the terms and conditions of the facility. The following table summarizes the available balance under unconditional committed lines of credit and the related maturities, by fiscal year, as of May 31, 2016. The remaining unadvanced commitments totaling $10,757 million and $11,365 million as of May 31, 2016 and 2015, respectively, were generally subject to material adverse change clauses. Prior to making an advance on these facilities, we confirm that there has been no material adverse change in the business or condition, financial or otherwise, of the borrower since the time the loan was approved and confirm that the borrower is currently in compliance with loan terms and NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS conditions. In some cases, the borrower’s access to the full amount of the facility is further constrained by the designated purpose imposition of borrower-specific restrictions or by additional conditions that must be met prior to advancing funds. The following table summarizes the available balance under unadvanced commitments as of May 31, 2016 and the related maturities, by fiscal year and thereafter, by loan type: Unadvanced commitments related to line of credit loans are typically for periods not to exceed five years and are generally revolving facilities used for working capital and backup liquidity purposes. Historically, we have experienced a very low utilization rate on line of credit loan facilities, whether or not there is a material adverse change clause. Since we generally do not charge a fee on the unadvanced portion of the majority of our loan facilities, our borrowers will typically request long-term facilities to fund construction work plans and other capital expenditures for periods of up to five years and draw down on the facility over that time. In addition, borrowers will typically request an amount in excess of their immediate estimated loan requirements to avoid the expense related to seeking additional loan funding for unexpected items. These factors contribute to our expectation that the majority of the unadvanced commitments will expire without being fully drawn upon and that the total unadvanced amount does not necessarily represent future cash funding requirements. Loan Sales We transfer, from time to time, loans to third parties under our direct loan sale program. Our transfer of loans, which are generally at par value, meets the applicable accounting criteria for sale accounting. Accordingly, we remove the loans from our consolidated balance sheets when control has been surrendered and recognize a gain or loss. Because the loans are sold at par, we record immaterial losses on the sale of these loans for unamortized deferred loan origination costs. We retain the servicing performance obligations on these loans and recognize related servicing fees on an accrual basis over the period for which servicing activity is provided, as we believe the servicing fee represents adequate compensation. We do not hold any continuing interest in the loans sold to date other than servicing performance obligations. We have no obligation to repurchase loans from the purchaser, except in the case of breaches of representations and warranties. We sold CFC loans with outstanding balances totaling $99 million, $26 million and $111 million, respectively, at par for cash, during the years ended May 31, 2016, 2015 and 2014. Credit Quality We closely monitor loan performance trends to manage and evaluate our credit risk exposure. We seek to provide a balance between meeting the credit needs of our members while also ensuring the sound credit quality of our loan portfolio. Payment status and internal risk rating trends are key indicators, among others, of the level of credit risk within our loan portfolio. As part of our strategy in managing our our credit risk exposure, we entered into a long-term standby purchase commitment agreement with Farmer Mac on August 31, 2015, as amended on May 31, 2016. Under this agreement, we may designate certain loans to be covered under the commitment, subject to approval by Farmer Mac, and in the event any such loan later goes into material default for at least 90 days, upon request by us, Farmer Mac must purchase such loan at par value. We designated, and Farmer Mac approved, loans that had an aggregate outstanding principal balance of $926 million as of May 31, 2016. Under the agreement, we are required to pay Farmer Mac a monthly fee based on the unpaid principal balance of loans covered under the purchase commitment. No loans had been put to Farmer Mac for purchase, pursuant to this agreement, as of May 31, 2016. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Payment Status of Loans The tables below present the payment status of loans outstanding by member class as of May 31, 2016 and 2015. ____________________________ (1) All loans 90 days or more past due are on nonaccrual status. Internal Risk Ratings of Loans We evaluate the credit quality of our loans using an internal risk rating system that employs similar criteria for all member classes. Our internal risk rating system is based on a determination of a borrower’s risk of default utilizing both quantitative and qualitative measurements. We have grouped our risk ratings into the categories of pass and criticized based on the criteria below. (i) Pass: Borrowers that are not experiencing difficulty and/or not showing a potential or well-defined credit weakness. (ii) Criticized: Includes borrowers categorized as special mention, substandard and doubtful as described below: • Special mention: Borrowers that may be characterized by a potential credit weakness or deteriorating financial condition that is not sufficiently serious to warrant a classification of substandard or doubtful. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS • Substandard: Borrowers that display a well-defined credit weakness that may jeopardize the full collection of principal and interest. • Doubtful: Borrowers that have a well-defined weakness and the full collection of principal and interest is questionable or improbable. Borrowers included in the pass, special mention and substandard categories are generally reflected in the general portfolio of loans. Borrowers included in the doubtful category are reflected in the impaired portfolio of loans. Each risk rating is reassessed annually following the receipt of the borrower’s audited financial statements; however, interim risk rating downgrades or upgrades may take place at any time as significant events or trends occur. The following table presents our loan portfolio by risk rating category and member class based on available data as of May 31, 2016 and 2015. Credit Concentration The service territories of our electric and telecommunications members are located throughout the United States and its territories, including 49 states, the District of Columbia, American Samoa and Guam. Loans outstanding to borrowers in any state or territory did not exceed 15% of total loans outstanding as of May 31, 2016 and 2015. CFC, RTFC and NCSC each have policies limiting the amount of credit that can be extended to individual borrowers or a controlled group of borrowers. The total exposure outstanding to any one borrower or controlled group represented approximately 2% of total loans and guarantees outstanding as of May 31, 2016 and 2015. The 20 largest borrowers included 11 distribution systems and 9 power supply systems as of May 31, 2016. The 20 largest borrowers included 12 distribution systems and 8 power supply systems as of May 31, 2015. The following table shows the exposure to the 20 largest borrowers as a percentage of total credit exposure broken down by exposure type and by borrower type as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ____________________________ (1) The standby purchase commitment agreement with Farmer Mac entered into during fiscal year 2016 covered $402 million of this total as of May 31, 2016. Allowance for Loan Losses We maintain an allowance for loan losses at a level estimated by management to provide for probable losses inherent in the loan portfolio as of each balance sheet date. The tables below summarize changes, by company, in the allowance for loan losses as of and for the years ended May 31, 2016, 2015 and 2014. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Our allowance for loan losses consists of a specific allowance for loans individually evaluated for impairment and a collective allowance for loans collectively evaluated for impairment. The tables below present, by company, the components of our allowance for loan losses and the recorded investment of the related loans as of May 31, 2016 and 2015. ___________________________ (1) Excludes unamortized deferred loan origination costs of $10 million as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Impaired Loans Below we provide information on loans classified as individually impaired as of May 31, 2016 and 2015. The following table represents the average recorded investment in individually impaired loans and the interest income recognized by company for fiscal years ended May 31, 2016, 2015 and 2014. Troubled Debt Restructured (“TDR”) and Nonperforming Loans TDR Loans The following table summarizes modified loans accounted for and reported as TDRs, the performance status of these loans, and the related unadvanced commitments, by member class, as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ___________________________ (1) The interest rate on unadvanced commitments is not set until drawn; therefore, the long-term unadvanced loan commitments have been classified in this table as variable-rate unadvanced commitments. However, at the time of the advance, the borrower may select a fixed or a variable rate on the new loan. (2) A borrower in this category also had a line of credit loan outstanding that was classified as performing as of May 31, 2016 and 2015. Unadvanced commitments related to this line of credit loan totaled $4 million and $2 million as of May 31, 2016 and 2015, respectively. All loans classified as performing TDR loans were performing in accordance with the terms of the restructured loan agreements as of May 31, 2016 and 2015. The TDR loans classified as performing as of May 31, 2015 were on nonaccrual status as of that date. These loans were returned to accrual status during the year ended May 31, 2016. Nonperforming Loans We had no loans classified as nonperforming as of May 31, 2016 and 2015. The following table shows foregone interest income for loans on nonaccrual status fiscal years ended May 31, 2016, 2015 and 2014. Pledging of Loans and Loans on Deposit We are required to pledge eligible mortgage notes in an amount at least equal to the outstanding balance of our secured debt. The following table summarizes our loans outstanding as collateral pledged to secure our collateral trust bonds, Clean Renewable Energy Bonds, notes payable to Farmer Mac and notes payable under the Guaranteed Underwriter Program of the USDA (the “Guaranteed Underwriter Program”) and the amount of the corresponding debt outstanding as of May 31, 2016 and 2015. See “Note 6-Short-Term Borrowings” and “Note 7-Long-Term Debt” for information on our borrowings. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS We were required to maintain collateral on deposit in an amount at least equal to the balance of debt outstanding to the Federal Financing Bank (“FFB”) of the United States Treasury issued under the Guaranteed Underwriter Program as of May 31, 2015. See “Note 6-Short-Term Borrowings” and “Note 7-Long-Term Debt.” The following table shows the collateral on deposit and the amount of the corresponding debt outstanding as of May 31, 2016 and 2015. On March 29, 2016, we entered into a second amended restated and consolidated pledge agreement with RUS and U.S. Bank National Association to pledge all mortgage notes previously held on deposit pursuant to the Guaranteed Underwriter Program and, in connection with any advance, pledge collateral satisfactory to RUS pursuant to the terms of the facility. The agreement replaces the previous pledge agreement, dated December 13, 2012, and will govern all collateral under the Guaranteed Underwriter Program. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The notes payable to the FFB under the Guaranteed Underwriter Program contain a provision that if during any portion of the fiscal year, our senior secured debt credit ratings do not have at least two of the following ratings: (i) A3 or higher from Moody’s, (ii) A- or higher from S&P, (iii) A- or higher from Fitch or (iv) an equivalent rating from a successor rating agency to any of the above rating agencies, we may not make cash patronage capital distributions in excess of 5% of total patronage capital. The credit ratings of our senior secured debt from S&P, Moody’s and Fitch was A, A1 and A+, respectively, as of May 31, 2016, and all three companies had our ratings on stable outlook. NOTE 5-FORECLOSED ASSETS We had one entity, Caribbean Asset Holdings, LLC (“CAH”), that held foreclosed assets as of May 31, 2016. CAH was established as a holding company for various U.S. Virgin Islands, British Virgin Islands and St. Maarten-based telecommunications operating entities that were transferred in fiscal year 2011 to CAH as a result of a loan default by an RTFC borrower and subsequent bankruptcy proceedings. These operating entities provide local, long-distance and wireless telephone, cable television and Internet services to residential and commercial customers. CAH was classified as held for sale beginning with the quarter ended August 31, 2015. Since that date, we have assessed the fair value less cost to sell of CAH each reporting period, reported our investment in CAH at the lower of the carrying value, as of the date of transfer to held for sale, or fair value less cost to sell and recognized subsequent changes in fair value less cost to sell in earnings. We recorded a loss in our consolidated statement of operations for CAH of $7 million in fiscal year 2016, which was attributable to impairment of our investment in CAH due to a reduction in the fair value less estimated cost to sell. Sale of CAH On September 30, 2015, CFC entered into a Purchase Agreement (as amended, the “Purchase Agreement”) with CAH, ATN VI Holdings, LLC (“Buyer”) and ATN International, Inc. (formerly Atlantic Tele-Network, Inc.), the parent corporation of Buyer, to sell all of the issued and outstanding membership interests of CAH to Buyer for a purchase price of $145 million, subject to certain adjustments described in the Purchase Agreement. On July 1, 2016, the Purchase Agreement was amended and the sale of CAH was completed for a purchase price of approximately $144 million. Our reported investment in CAH totaled $103 million as of May 31, 2016, which represents the fair value less estimated cost to sell as of that date. The measurement of fair value takes into consideration the contractual purchase price less agreed-upon purchase price adjustments, including cash on hand, changes in working capital and settlement of CAH’s pension and other postretirement benefit plan obligations, as well as the unrecognized net loss of $10 million recorded in accumulated other comprehensive income (“AOCI”) attributable to actuarial-related changes in CAH’s pension and other postretirement benefit plan obligations. Upon closing of the sale of CAH, the unrecognized net loss of $10 million recorded in AOCI as of May 31, 2016 was derecognized as an offset against the sale proceeds, which will have no effect on our consolidated statement of operations for the first quarter of fiscal year 2017. Our net proceeds at closing totaled $109 million, which represents the purchase price of $144 million less agreed-upon purchase price adjustments, as noted above, and transaction costs as of the closing date. The net proceeds at closing take into consideration the impact of CAH’s operating results subsequent to our May 31, 2016 fiscal year end and the July 1, 2016 closing date, and the impact of these results on CAH’s cash on hand and transaction costs as of the closing date. The net proceeds are subject to post-closing adjustments, which are due from Buyer within 60 days of the closing date for review by us. We expect to record any required post-closing adjustments in the first quarter of fiscal year 2017. CFC also remains subject to potential indemnification claims, as specified in the Purchase Agreement. Upon closing, $16 million of the sale proceeds were deposited into escrow to fund potential indemnification claims for a period of 15 months following the closing. In connection with the sale, RTFC provided a loan in the amount of $60 million to Buyer to finance a portion of the transaction. ATN International has provided a guarantee on an unsecured basis of Buyer’s obligations to RTFC pursuant to the financing. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6-SHORT-TERM BORROWINGS The following table provides comparative information on our short-term borrowings and weighted-average interest rates as of May 31, 2016 and 2015. We issue commercial paper for periods of one to 270 days. We also issue select notes for periods ranging from 30 to 270 days. Select notes are unsecured obligations that do not require backup bank lines of credit for liquidity purposes. These notes require a larger minimum investment than our commercial paper sold to members and, as a result, offer a higher interest rate than our commercial paper. We also issue daily liquidity fund notes, which are unsecured obligations that do not require backup bank lines of credit for liquidity purposes. We also issue medium-term notes, which represent unsecured obligations that may be issued through dealers in the capital markets or directly to our members. Revolving Credit Agreements We had $3,420 million of commitments under revolving credit agreements as of May 31, 2016 and 2015. Under our current revolving credit agreements, we have the ability to request up to $300 million of letters of credit, which would result in a reduction in the remaining available amount under the facilities. On November 19, 2015, we amended and restated the $1,665 million three-year and $1,645 million five-year revolving credit agreements to extend the maturity dates to November 19, 2018 and November 19, 2020, respectively, from October 28, 2017 and October 28, 2019, respectively. Commitments of $25 million under the three-year agreement will expire at the prior maturity date of October 28, 2017. Commitments of $45 million under the five-year agreement will expire at the prior maturity date of October 28, 2019. Also, as part of the amendment, the commitments from three banks were increased by $45 million. Prior to this amendment, NCSC assumed $155 million in commitments from one of the banks, which was reduced to $110 million as part of the amendment on November 19, 2015. Although the total commitment amount under our new revolving credit agreements is unchanged from the previous total of $3,420 million, NCSC’s commitment amount is excluded from the commitment amount from third parties of $3,310 million because NCSC receives all of its funding from CFC and NCSC's financial results are consolidated with CFC. The NCSC assumption of $110 million of commitments under the revolving credit agreements also reduces the total letters of credit from third parties to $290 million. The following table presents the total commitment, the net amount available for use and the outstanding letters of credit under our revolving credit agreements as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ___________________________ (1)Reflects amounts available from unaffiliated third parties that are not consolidated by CFC. (2) Facility fee determined by CFC’s senior unsecured credit ratings based on the pricing schedules put in place at the inception of the related agreement. We were in compliance with all covenants and conditions under our revolving credit agreements and there were no borrowings outstanding under these agreements as of May 31, 2016 and 2015. The following table displays long-term debt outstanding and the weighted-average interest rates, by debt type, as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table presents the amount of long-term debt maturing in each of the five fiscal years subsequent to May 31, 2016 and thereafter. Medium-Term Notes Medium-term notes represent unsecured obligations that may be issued through dealers in the capital markets or directly to our members. Collateral Trust Bonds Collateral trust bonds represent secured obligations sold to investors in the capital markets. Collateral trust bonds are secured by the pledge of mortgage notes or eligible securities in an amount at least equal to the principal balance of the bonds outstanding. During the year ended May 31, 2016, we issued a total of $1,450 million collateral trust bonds with an average coupon of 2.50% and maturities ranging between 2019 and 2025. On February 16, 2016, we redeemed $300 million of 3.05% collateral trust bonds due March 1, 2016. The premium and unamortized issuance costs totaling $0.3 million were recorded as a loss on early extinguishment of debt during the third quarter of fiscal year 2016. Unsecured Notes Payable On March 29, 2016, we entered into a second amended, restated and consolidated pledge agreement with RUS and U.S. Bank National Association to pledge all mortgage notes previously held on deposit pursuant to the Guaranteed Underwriter Program and, in connection with any advance, pledge collateral satisfactory to RUS pursuant to the terms of the facility. The agreement replaces the previous pledge agreement, dated December 13, 2012, and will govern all collateral under the Guaranteed Underwriter Program. As a result, we had no unsecured notes payable outstanding under the Guaranteed Underwriter Program as of May 31, 2016. We had unsecured notes payable totaling $4,407 million outstanding under bond purchase agreements with the Federal Financing Bank and a bond guarantee agreement with RUS issued under the Guaranteed Underwriter Program, which provides guarantees to the Federal Financing Bank, as of May 31, 2015. We were required to place mortgage notes on deposit in an amount at least equal to the principal balance of the notes outstanding of $4,407 million as of May 31, 2015. Secured Notes Payable As of May 31, 2016, we had secured notes payable totaling $4,777 million outstanding under a bond purchase agreement with the Federal Financing Bank and a bond guarantee agreement with RUS issued under the Guaranteed Underwriter Program, which provides guarantees to the Federal Financing Bank. We pay RUS a fee of 30 basis points per year on the total amount borrowed. As of May 31, 2016, $4,777 million of secured notes payable outstanding under the Guaranteed Underwriter Program require us to pledge mortgage notes in an amount at least equal to the principal balance of the notes outstanding. See “Note 4-Loans and Commitments” for additional information on the collateral pledged to secure notes payable under this program. During the year ended May 31, 2016, we borrowed $400 million under our committed loan NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS facilities with the Federal Financing Bank. On March 29, 2016, we closed on a $250 million committed loan facility (“Series K”) from the Federal Financing Bank guaranteed by RUS pursuant to the Guaranteed Underwriter Program. Under the Series K facility, we are able to borrow an additional $250 million any time before January 15, 2019 with each advance having a final maturity no longer than 20 years from the advance date. As of May 31, 2016, we had up to $600 million available under committed loan facilities from the Federal Financing Bank as part of this program. As of May 31, 2016 and 2015, secured notes payable include $2,303 million and $1,911 million, respectively, in debt outstanding to Farmer Mac under a note purchase agreement totaling $4,500 million. Under the terms of the note purchase agreement, we can borrow up to $4,500 million at any time through January 11, 2020, and thereafter automatically extend the agreement on each anniversary date of the closing for an additional year, unless prior to any such anniversary date, Farmer Mac provides us with a notice that the draw period would not be extended beyond the remaining term. During the year ended May 31, 2016, we borrowed $430 million under the note purchase agreement with Farmer Mac. The agreement with Farmer Mac is a revolving credit facility that allows us to borrow, repay and re-borrow funds at any time through maturity or from time to time as market conditions permit, provided that the principal amount at any time outstanding is not more than the total available under the agreement. On July 31, 2015, we entered into a new revolving note purchase agreement with Farmer Mac totaling $300 million. Under the terms of the new agreement, we can borrow up to $300 million at any time through July 31, 2018. This agreement with Farmer Mac is a revolving credit facility that allows us to borrow, repay and re-borrow funds at any time through maturity or from time to time, provided that the principal amount at any time outstanding is not more than the total available under the agreement. We are required to pledge eligible distribution system or power supply system loans as collateral in an amount at least equal to the total principal amount of notes outstanding under the Farmer Mac agreements. See “Note 4-Loans and Commitments” for additional information on the collateral pledged to secure notes payable under these programs. We were in compliance with all covenants and conditions under our senior debt indentures as of May 31, 2016 and 2015. NOTE 8-SUBORDINATED DEFERRABLE DEBT Subordinated deferrable debt is long-term debt that is subordinated to our outstanding debt and senior to subordinated certificates held by our members. Our 4.75% and 5.25% subordinated debt due 2043 and 2046, respectively, was issued for a term of up to 30 years, pays interest semi-annually, may be called at par after ten years, converts to a variable rate after ten years, and allows us to defer the payment of interest for one or more consecutive interest periods not exceeding five consecutive years. To date, we have not exercised our right to defer interest payments. The following table presents subordinated deferrable debt outstanding and the weighted-average interest rates as of May 31, 2016 and 2015. On April 20, 2016, we issued $350 million of 5.25% subordinated deferrable debt due 2046 callable at par on or after April 20, 2026. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9-MEMBERS’ SUBORDINATED CERTIFICATES Membership Subordinated Certificates CFC members may be required to purchase membership subordinated certificates as a condition of membership. Such certificates are interest-bearing, unsecured, subordinated debt. Members may purchase the certificates over time as a percentage of the amount they borrow from CFC. Membership certificates typically have an original maturity of 100 years and pay interest at 5% semi-annually. The weighted-average maturity for all membership subordinated certificates outstanding as of May 31, 2016 and 2015 was 60 years and 61 years, respectively. RTFC and NCSC members are not required to purchase membership certificates as a condition of membership. Loan and Guarantee Subordinated Certificates Members obtaining long-term loans, certain line of credit loans or guarantees may be required to purchase additional loan or guarantee subordinated certificates with each such loan or guarantee based on the borrower’s debt-to-equity ratio with CFC. These certificates are unsecured, subordinated debt and may be interest bearing or non-interest bearing. Under our current policy, most borrowers requesting standard loans are not required to buy subordinated certificates as a condition of a loan or guarantee. Borrowers meeting certain criteria, including but not limited to, high leverage ratios, or borrowers requesting large facilities, may be required to purchase loan or guarantee subordinated certificates or member capital securities (described below) as a condition of the loan. Loan subordinated certificates have the same maturity as the related long-term loan. Some certificates may amortize annually based on the outstanding loan balance. The interest rates payable on guarantee subordinated certificates purchased in conjunction with our guarantee program vary in accordance with applicable CFC policy. Guarantee subordinated certificates have the same maturity as the related guarantee. Member Capital Securities CFC offers member capital securities to its voting members. Member capital securities are interest-bearing, unsecured obligations of CFC, which are subordinate to all existing and future senior and subordinated indebtedness of CFC held by non-members of CFC, but rank proportionally to our member subordinated certificates. Series 2008 member capital maturities mature 35 years from the date of issuance, pay interest at 5% and are callable at par at our option five years from the date of issuance and anytime thereafter. Series 2013 member capital securities mature 30 years from the date of issuance, typically pay interest at 5% and are callable at par at our option 10 years from the date of issuance and anytime thereafter. These securities represent voluntary investments in CFC by the members. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table displays members’ subordinated certificates and the weighted-average interest rates as of May 31, 2016 and 2015. ___________________________ (1) The subscribed and unissued subordinated certificates represent subordinated certificates that members are required to purchase. Upon collection of full payment of the subordinated certificate amount, the certificate will be reclassified from subscribed and unissued to outstanding. The following table presents the amount of members’ subordinated certificates maturing in each of the five fiscal years following May 31, 2016 and thereafter. ` ___________________________ (1) Loan subordinated certificates totaling $101 million that amortize annually based on the outstanding balance of the related loan and $0.3 million in subscribed and unissued certificates for which a payment has been received are excluded because the future payment amounts are not fixed and readily determinable due to factors that impact the payment, such as loan conversions, loan repricing at the end of an interest rate term and prepayments. Amortization payments on these certificates totaled $16 million in fiscal year 2016 and represented 15% of amortizing loan subordinated certificates outstanding. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10-DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES Use of Derivatives We are an end user of derivative financial instruments and do not engage in derivative trading. We use derivatives, primarily interest rate swaps and Treasury rate locks, to manage interest rate risk. Derivatives may be privately negotiated contracts, which are often referred to as over-the-counter (“OTC”) derivatives, or they may be listed and traded on an exchange. We generally engage in OTC derivative transactions. Outstanding Notional Amount and Maturities of Derivatives The notional amount provides an indication of the volume of our derivatives activity, but this amount is not recorded on our consolidated balance sheets. The notional amount is used only as the basis on which interest payments are determined and is not the amount exchanged. The following table shows the outstanding notional amounts and the weighted-average rate paid and received for our interest rate swaps, by type, as of May 31, 2016 and 2015. The substantial majority of our interest rate swaps use an index based on the London Interbank Offered Rate (“LIBOR”) for either the pay or receive leg of the swap agreement. ____________________________ (1)Excludes $40 million notional amount of forward-starting swaps, with an effective start date of June 30, 2016, outstanding as of May 31, 2016. In addition to the notional amount of swaps displayed in the above table, we had $40 million notional amount of forward- starting swaps, with an effective start date of June 30, 2016, outstanding as of May 31, 2016. While the notional amount of these forward-starting swaps is not presented in the table above, we have recorded the fair value of these swaps as of May 31, 2016 in our consolidated financial statements. The following table presents the maturities for each of the next five fiscal years and thereafter based on the notional amount of our interest rate swaps as of May 31, 2016. ____________________________ (1)Excludes $40 million notional amount of forward starting swaps, with an effective start date of June 30, 2016, outstanding as of May 31, 2016. Impact of Derivatives on Consolidated Balance Sheets The following table displays the fair value of the derivative assets and derivative liabilities recorded on our consolidated balance sheets and the related outstanding notional amount of our interest rate swaps as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ____________________________ (1)The notional amount excludes $40 million notional amount of forward starting swaps, with an effective start date of June 30, 2016, outstanding as of May 31, 2016. However, the fair value of these swaps as of May 31, 2016 is included in the above table and in our consolidated financial statements. All of our master swap agreements include legally enforceable netting provisions that allow for offsetting of all contracts with a given counterparty in the event of default by one of the two parties. However, as indicated above in “Note 1-Summary of Significant Accounting Policies,” we report derivative asset and liability amounts on a gross basis based on individual contracts. The following table presents the gross fair value of derivative assets and liabilities reported on our consolidated balance sheets as of May 31, 2016 and 2015, and provides information on the impact of netting provisions and collateral pledged. Impact of Derivatives on Consolidated Statements of Operations Derivative gains (losses) reported in our consolidated statements of operations consist of derivative cash settlements and derivative forward value. Derivative cash settlements represent net contractual interest expense accruals on interest rate swaps during the period. The derivative forward value represents the change in fair value of our interest rate swaps during the reporting period due to changes in the estimate of future interest rates over the remaining life of our derivative contracts. The following table presents the components of the derivative gains (losses) reported in our consolidated statements of operations for our interest rate swaps for the years ended May 31, 2016, 2015 and 2014. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Credit-Risk-Related Contingent Features Our derivative contracts typically contain mutual early termination provisions, generally in the form of a credit rating trigger. Under the mutual credit rating trigger provisions, either counterparty may, but is not obligated to, terminate and settle the agreement if the credit rating of the other counterparty falls to a level specified in the agreement. If a derivative contract is terminated, the amount to be received or paid by us would be equal to the mark-to-market value, as defined in the agreement, as of termination date. Our senior unsecured credit ratings from Moody’s and S&P were A2 and A, respectively, as of May 31, 2016. Both Moody’s and S&P had our ratings on stable outlook as of May 31, 2016. The following table displays the notional amounts of our derivative contracts with rating triggers as of May 31, 2016 and the payments that would be required if the contracts were terminated as of that date because of a downgrade of our unsecured credit ratings or the counterparty’s unsecured credit ratings below A3/A-, below Baa1/BBB+, to or below Baa2/BBB, below Baa3/BBB-, or to or below Ba2/BB+ by Moody’s or S&P, respectively. In calculating the payment amounts that would be required upon termination of the derivative contracts, we assumed that the amounts for each counterparty would be netted in accordance with the provisions of the master netting agreements for each counterparty. The net payment amounts are based on the fair value of the underlying derivative instrument, excluding the credit risk valuation adjustment, plus any unpaid accrued interest amounts. ___________________________ (1) Excludes $40 million notional amount of forward starting swaps, with an effective start date of June 30, 2016, outstanding as of May 31, 2016. (2) Rating trigger for CFC falls below A3/A-, while rating trigger for counterparty falls below Baa1/BBB+ by Moody’s or S&P, respectively. (3) Rating trigger for CFC falls to or below Baa2/BBB, while rating trigger for counterparty falls to or below Ba2/BB+ by Moody’s or S&P, respectively. The aggregate amount, excluding the credit risk valuation adjustment, of all interest rate swaps with rating triggers that were in a net liability position was $368 million as of May 31, 2016. There were no interest rate swaps with rating triggers that were in a net asset position as of May 31, 2016. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table presents the components of equity as of May 31, 2016 and 2015. Total equity decreased $94 million to $817 million as of May 31, 2016. The decrease in total equity was attributable to the net loss of $52 million in fiscal year 2016 and the patronage capital retirement of $39 million in September 2015. District of Columbia cooperative law requires cooperatives to allocate net earnings to patrons, to a general reserve in an amount sufficient to maintain a balance of at least 50% of paid-in capital and to a cooperative educational fund, as well as permits additional allocations to board-approved reserves. District of Columbia cooperative law also requires that a cooperative’s net earnings be allocated to all patrons in proportion to their individual patronage and each patron’s allocation be distributed to the patron unless the patron agrees that the cooperative may retain its share as additional capital. Annually, the CFC Board of Directors allocates its net earnings to its patrons in the form of patronage capital, to a cooperative educational fund, to a general reserve, if necessary, and to board-approved reserves. An allocation to the general reserve is made, if necessary, to maintain the balance of the general reserve at 50% of the membership fees collected. CFC’s bylaws require the allocation to the cooperative educational fund to be at least 0.25% of its net earnings. Funds from the cooperative educational fund are disbursed annually to statewide cooperative organizations to fund the teaching of cooperative principles and for other cooperative education programs. Currently, CFC has one additional board-approved reserve, the members’ capital reserve. The CFC Board of Directors determines the amount of net earnings that is allocated to the members’ capital reserve, if any. The members’ capital reserve represents net earnings that CFC holds to increase equity retention. The net earnings held in the members’ capital reserve have not been specifically allocated to members, but may be allocated to individual members in the future as patronage capital if authorized by the CFC Board of Directors. All remaining net earnings are allocated to CFC’s members in the form of patronage capital. The amount of net earnings allocated to each member is based on the member’s patronage of CFC’s lending programs during the year. No interest is earned by members on allocated patronage capital. There is no effect on CFC’s total equity as a result of allocating net NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS earnings to members in the form of patronage capital or to board-approved reserves. The CFC Board of Directors has voted annually to retire a portion of the patronage capital allocation. Upon retirement, patronage capital is paid out in cash to the members to whom it was allocated. CFC’s total equity is reduced by the amount of patronage capital retired to its members and by amounts disbursed from board-approved reserves. The current policy of the CFC Board of Directors is to retire 50% of the prior year’s allocated patronage capital and hold the remaining 50% for 25 years. The retirement amount and timing remains subject to annual approval by the CFC Board of Directors. In July 2015, the CFC Board of Directors authorized the allocation of the fiscal year 2015 net earnings as follows: $1 million to the Cooperative Educational Fund, $16 million to the members’ capital reserve and $78 million to members in the form of patronage. In July 2015, the CFC Board of Directors authorized the retirement of allocated net earnings totaling $39 million, representing 50% of the fiscal year 2015 allocation. This amount was returned to members in cash in September 2015. In July 2016, the CFC Board of Directors authorized the allocation of the fiscal year 2016 net earnings as follows: $1 million to the Cooperative Educational Fund, $86 million to the members’ capital reserve and $84 million to members in the form of patronage. In July 2016, the CFC Board of Directors authorized the retirement of allocated net earnings totaling $42 million, representing 50% of the fiscal year 2016 allocation. This amount will be returned to members in cash in the second quarter of fiscal year 2017. Future allocations and retirements of net earnings may be made annually as determined by the CFC Board of Directors with due regard for its financial condition. The CFC Board of Directors has the authority to change the current practice for allocating and retiring net earnings at any time, subject to applicable laws and regulations. Total equity includes noncontrolling interest, which represents 100% of RTFC and NCSC equity, as the members of RTFC and NCSC own or control 100% of the interest in their respective companies. In accordance with District of Columbia cooperative law and its bylaws and board policies, RTFC allocates its net earnings to its patrons, a cooperative educational fund and a general reserve, if necessary. RTFC’s bylaws require that it allocate at least 1% of net income to a cooperative educational fund. Funds from the cooperative educational fund are disbursed annually to fund the teaching of cooperative principles and for other cooperative education programs. An allocation to the general reserve is made, if necessary, to maintain the balance of the general reserve at 50% of the membership fees collected. The remainder is allocated to borrowers in proportion to their patronage. RTFC retires at least 20% of its annual allocation, if any, to members in cash prior to filing the applicable tax return. Any additional amounts are retired as determined by the board of directors taking into consideration RTFC’s financial condition. RTFC reported a net loss for fiscal year 2016; therefore, there will be no allocation to the educational fund or of patronage capital to members for fiscal 2016. In October 2015, the RTFC Board of Directors approved the allocation of RTFC’s earnings for fiscal year 2015, with 99% allocated to members and 1% allocated to a cooperative educational fund. A total of $0.9 million was allocated to members as follows: $0.2 million in cash and $0.7 million in the form of certificates to be redeemed at a later date. In January 2016, RTFC distributed the $0.2 million cash portion of the allocation to members, representing 20% of allocated net earnings for fiscal year 2015. NCSC’s bylaws require that it allocate at least 0.25% of its net earnings to a cooperative educational fund and an amount to the general reserve required to maintain the general reserve balance at 50% of membership fees collected. Funds from the cooperative educational fund are disbursed annually to fund the teaching of cooperative principles and for other cooperative education programs. The NCSC Board of Directors has the authority to determine if and when net earnings will be allocated. There is no effect on noncontrolling interest as a result of RTFC and NCSC allocating net earnings to borrowers or board-approved reserves. There is a reduction to noncontrolling interest as a result of the cash retirement of amounts allocated to borrowers or to disbursements from board-approved reserves. Accumulated Other Comprehensive Income The following tables summarize, by component, the activity in the accumulated other comprehensive income as of and for the years ended May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS We expect to reclassify approximately $1 million of amounts in accumulated other comprehensive income related to unrealized derivative gains into earnings over the next 12 months. NRECA Retirement Security Plan CFC is a participant in the NRECA Retirement Security Plan (“the Plan”), a noncontributory, defined benefit multiemployer master pension plan. The employer identification number of the Plan is 53-0116145 and the Plan number is 333. Plan information is available publicly through the annual Form 5500, including attachments. The Plan is available to all qualified CFC employees. Under the Plan, participating employees are entitled to receive annually, under a 50% joint and surviving spouse annuity, 1.70% of the average of their five highest base salaries during their last 10 years of employment, multiplied by the number of years of participation in the Plan. As a multiemployer plan, there is no funding liability for CFC related to the Plan. CFC’s expense is limited to the annual premium to participate in the Plan. The risks of participating in CFC’s multiemployer plan are different from single-employer plans based on the following characteristics of the Plan: • Assets contributed to the multiemployer plan by one participating employer may be used to provide benefits to employees of other participating employers. • If a participating employer stops contributing to the Plan, the unfunded obligations of the Plan may be borne by the remaining participating employers. • If CFC chooses to stop participating in the Plan, CFC may be required to pay a withdrawal liability representing an amount based on the underfunded status of the Plan. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In the Plan, a certified zone status determination is not required and, therefore, not determined under the Pension Protection Act of 2006. In total, the Plan was more than 80% funded at January 1, 2016, 2015 and 2014, based on the Pension Protection Act (“PPA”) funding target and PPA actuarial value of assets on those dates. CFC made contributions of $4 million, $3 million and $4 million during fiscal years 2016, 2015 and 2014, respectively. In each of these years, these contributions represented less than 5% of total contributions made to the plan by all participating employers. There are no collective bargaining agreements in place that cover CFC’s employees. As of May 31, 2016, CFC’s contribution rate did not include a surcharge, there were no funding improvement plans or rehabilitation plans implemented or pending and there were no required minimum contributions. Pension Restoration Plan The Economic Growth and Tax Relief Act of 2001 set a limit of $265,000 for calendar year 2016 on the compensation to be used in the calculation of pension benefits. To restore potential lost benefits, we adopted a Pension Restoration Plan administered by NRECA. Under the Plan, the amount that NRECA invoices CFC for the Retirement Security Plan will continue to be based on the full compensation paid to each employee. Upon the retirement of a covered employee, NRECA will calculate the retirement and security benefit to be paid with consideration of the compensation limits and will pay the maximum benefit thereunder. NRECA will also calculate the retirement and security benefit that would have been available without consideration of the compensation limits and CFC will pay the difference. NRECA will then give CFC a credit against future retirement and security contribution liabilities in the amount paid by CFC to the covered employee. The Pension Restoration Plan is an unfunded, unsecured deferred compensation plan (“Deferred Compensation Pension Restoration Plan”). The benefit and payout formula under the restoration component of the Retirement Security Plan is similar to that under the qualified plan component. However, three of the named executive officers have satisfied the provisions established to receive the benefit from this plan. Since there is no longer a risk of forfeiture of the benefit under the Pension Restoration Plan, distributions will be made from the plan to each of those named executive officers annually and credited back to CFC by NRECA on following pension invoices. Executive Benefit Restoration Plan NRECA has restricted additional participation in the Pension Restoration Plan. We, therefore, adopted a top-hat Executive Benefit Restoration Plan, effective January 1, 2015. The Executive Benefit Restoration Plan is a nonqualified, unfunded plan maintained by CFC to provide retirement benefits to a select group of senior management employees whose compensation exceed IRS limits for qualified defined benefit plans. There is a risk of forfeiture if participants leave the company prior to becoming fully vested in the Executive Benefit Restoration Plan. As of May 31, 2016 we recorded an unfunded pension obligation of $1 million. The pension obligation is included on our consolidated balance sheet as a component of other liabilities. Defined Contribution Plan CFC offers a 401(k) defined contribution savings program, the 401(k) Pension Plan, to all employees who have completed a minimum of 1,000 hours of service in either the first 12 consecutive months or first full calendar year of employment. CFC contributes an amount up to 2% of an employee’s salary each year for all employees participating in the program with a minimum 2% employee contribution. CFC contributed $0.5 million to the plan during each of the fiscal years 2016, 2015 and 2014. We guarantee certain contractual obligations of our members so they may obtain various forms of financing. We use the same credit policies and monitoring procedures in providing guarantees as we do for loans and commitments. If a member system defaults on its obligation to pay debt service, then we are obligated to pay any required amounts under our guarantees. Meeting our guarantee obligations satisfies the underlying obligation of our member systems and prevents the NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS exercise of remedies by the guarantee beneficiary based upon a payment default by a member system. In general, the member system is required to repay any amount advanced by us with interest, pursuant to the documents evidencing the member system’s reimbursement obligation. The following table summarizes total guarantees by type of guarantee and member class as of May 31, 2016 and 2015. We guarantee debt issued in connection with the construction or acquisition of pollution control, solid waste disposal, industrial development and electric distribution facilities, classified as long-term tax-exempt bonds in the table above. We unconditionally guarantee to the holders or to trustees for the benefit of holders of these bonds the full principal, interest and in most cases, premium, if any, on each bond when due. If a member system defaults in its obligation to pay debt service, then we are obligated to pay any required amounts under our guarantees. Such payment will prevent the occurrence of an event of default that would otherwise permit acceleration of the bond issue. In general, the member system is required to repay any amount advanced by us with interest, pursuant to the documents evidencing the member system’s reimbursement obligation. The maturities for the long-term tax-exempt bonds and the related guarantees run through calendar year 2042. Amounts in the table represent the outstanding principal amount of the guaranteed bonds. As of May 31, 2016, our maximum potential exposure for the $70 million of fixed-rate tax-exempt bonds is $98 million, representing principal and interest. Of the amounts shown in the table above for long-term tax-exempt bonds, $406 million and $418 million as of May 31, 2016 and 2015, respectively, are adjustable or floating-rate bonds that may be converted to a fixed rate as specified in the applicable indenture for each bond offering. We are unable to determine the maximum amount of interest that we could be required to pay related to the remaining adjustable and floating-rate bonds. Many of these bonds have a call provision that in the event of a default allow us to trigger the call provision. This would limit our exposure to future interest payments on these bonds. Our maximum potential exposure is secured by mortgage liens on all of the systems’ assets and future revenue. If a system's debt is accelerated because of a determination that the interest thereon is not tax-exempt, the system’s obligation to reimburse us for any guarantee payments will be treated as a long-term loan. The maturities for letters of credit run through calendar year 2024. The amounts shown in the table above represent our maximum potential exposure, of which $125 million is secured as of May 31, 2016. As of May 31, 2016 and 2015 the letters of credit include $76 million to provide the standby liquidity for adjustable and floating-rate tax-exempt bonds issued for the NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS benefit of our members, respectively. Security provisions include a mortgage lien on substantially all of the system’s assets, future revenue and the system’s investment in our commercial paper. In addition to the letters of credit listed in the table above, under master letter of credit facilities in place as of May 31, 2016, we may be required to issue up to an additional $83 million in letters of credit to third parties for the benefit of our members. As of May 31, 2016, all of our master letter of credit facilities were subject to material adverse change clauses at the time of issuance. Prior to issuing a letter of credit, we would confirm that there has been no material adverse change in the business or condition, financial or otherwise, of the borrower since the time the loan was approved and confirm that the borrower is currently in compliance with the letter of credit terms and conditions. The maturities for other guarantees listed in the table run through calendar year 2025. The maximum potential exposure for these other guarantees is $114 million, all of which is unsecured. As of May 31, 2016 and 2015, we had $308 million and $434 million of guarantees, respectively, representing 34% and 44%, respectively, of total guarantees, under which our right of recovery from our members was not secured. In addition to the guarantees described above, as of May 31, 2016, we were the liquidity provider for $482 million of variable-rate tax-exempt bonds issued for our member cooperatives. While the bonds are in variable-rate mode, in return for a fee, we have unconditionally agreed to purchase bonds tendered or put for redemption if the remarketing agents are unable to sell such bonds to other investors. During the year ended May 31, 2016, we were not required to perform as liquidity provider pursuant to these obligations. Guarantee Liability As of May 31, 2016 and 2015, we recorded a guarantee liability of $17 million and $20 million, respectively, which represents the contingent and noncontingent exposures related to guarantees and liquidity obligations. The contingent guarantee liability as of May 31, 2016 and 2015 was $1 million based on management’s estimate of exposure to losses within the guarantee portfolio. The remaining balance of the total guarantee liability of $16 million and $19 million as of May 31, 2016 and 2015, respectively, relates to our noncontingent obligation to stand ready to perform over the term of our guarantees and liquidity obligations that we have entered into or modified since January 1, 2003. The following table details the scheduled maturities of our outstanding guarantees in each of the five fiscal years following May 31, 2016 and thereafter: NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Fair Value of Financial Instruments We use fair value measurements for the initial recording of certain assets and liabilities and periodic remeasurement of certain assets and liabilities on a recurring or nonrecurring basis. The accounting guidance for fair value measurements and disclosures establishes a three-level fair value hierarchy that prioritizes the inputs into the valuation techniques used to measure fair value. The levels of the fair value hierarchy, in priority order, include Level 1, Level 2 and Level 3. We describe the valuation technique for each level in “Note 1-Summary of Significant Accounting Policies.” The following tables present the carrying value and fair value for all of our financial instruments, including those carried at amortized cost, as of May 31, 2016 and 2015. The table also displays the classification within the fair value hierarchy of the valuation technique used in estimating fair value. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Following is a description of the valuation techniques we use for fair value measurement and disclosure, the significant inputs used in those techniques (if applicable) and the classification within the fair value hierarchy. Cash and Cash Equivalents Cash and cash equivalents include cash and certificates of deposit with original maturities of less than 90 days. Cash and cash equivalents are valued at the carrying value, which approximates fair value and are classified within Level 1 of the fair value hierarchy. Restricted Cash Restricted cash consists of cash and cash equivalents for which use is contractually restricted. The carrying value of restricted cash approximates fair value and is classified within Level 1 of the fair value hierarchy. Investment Securities Available for Sale Our investments in equity securities consist of investments in Farmer Mac Class A common stock and Series A, Series B and Series C preferred stock. These securities are classified as available for sale and reported at fair value in our consolidated balance sheets. We determine the fair value based on quoted prices on the stock exchange where the stock is traded. That stock exchange is an active market based on the volume of shares transacted. Fair values for these securities are classified within Level 1 of the fair value hierarchy. Time Deposits Time deposits with financial institutions in interest-bearing accounts have maturities of less than one year as of the reporting date and are valued at the carrying value, which approximates fair value and are classified within Level 2 of the fair value hierarchy. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred Compensation Investments CFC offers a nonqualified 457(b) deferred compensation plan to highly compensated employees. Such amounts deferred by employees are invested by the company. The deferred compensation investments are presented as other assets in the consolidated balance sheets in the other assets category at fair value. We calculate fair value based on the quoted price on the stock exchange where the funds are traded. That stock exchange is an active market based on the volume of shares transacted. The amounts are invested in highly liquid indices and mutual funds and are classified within Level 1 of the fair value hierarchy. Loans to Members, Net As part of receiving a loan from us, our members have additional requirements and rights that are not typical of other financial institutions, such as the ability to receive a patronage capital allocation, the general requirement to purchase subordinated certificates or member capital securities to meet their capital contribution requirements as a condition of obtaining additional credit from us, the option to select fixed rates from one year to maturity with the fixed rate resetting or repricing at the end of each selected rate term, the ability to convert from a fixed rate to another fixed rate or the variable rate at any time, and certain interest rate discounts that are specific to the borrower’s activity with us. These features make it difficult to obtain market data for similar loans. Therefore, we must use other methods to estimate the fair value. Fair values for fixed-rate loans are estimated using a discounted cash flow technique by discounting the expected future cash flows using the current rates at which we would make similar loans to new borrowers for the same remaining maturities. The maturity date used in the fair value calculation of loans with a fixed rate for a selected rate term is the next repricing date since these borrowers must reprice their loans at various times throughout the life of the loan at the current market rate. Loans with different risk characteristics, specifically nonperforming and restructured loans, are valued by using collateral valuations or by adjusting cash flows for credit risk and discounting those cash flows using the current rates at which similar loans would be made by us to borrowers for the same remaining maturities. See below for more details about how we calculate the fair value of certain impaired loans. The carrying value of our variable-rate loans adjusted for credit risk approximates fair value since variable-rate loans are eligible to be reset at least monthly. Loans to members are classified within Level 3 of the fair value hierarchy. Accrued Interest Receivable Accrued interest receivable represents accrued interest to be collected on our loans to members and derivative instruments and is valued at the carrying value, which approximates fair value. Accrued interest receivable is classified within Level 2 of the fair value hierarchy. Debt Service Reserve Funds Debt service reserve funds represent cash and/or investments on deposit with the bond trustee for tax-exempt bonds that we guarantee. Debt service reserve fund investments include actively traded tax-exempt municipal bonds and commercial paper. The carrying value approximates the fair value and the valuation technique is classified as Level 1. Short-Term Debt Short-term debt consists of commercial paper, select notes, bank bid notes, daily liquidity fund notes and medium-term notes. The fair value of short-term debt with maturities less than or equal to 90 days is carrying value, which is a reasonable estimate of fair value. The fair value of short-term debt with maturities greater than 90 days is estimated based on discounted cash flows and quoted market rates for debt with similar maturities. Short-term debt classified within Level 1 of the fair value hierarchy includes dealer commercial paper, bank bid notes and daily liquidity fund notes. Short-term debt classified within Level 2 of the fair value hierarchy consists of member commercial paper and select notes and is determined NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS based on discounted cash flows using discount rates consistent with current market rates for similar products with similar remaining terms. Short-term debt classified within Level 2 also includes our medium-term notes with an original maturity equal to or less than one year. The fair value of short-term medium-term notes classified within Level 2 of the fair value hierarchy was determined based on discounted cash flows using a pricing model that incorporates available market information such as indicative benchmark yields and credit spread assumptions that are provided by third-party pricing services such as the banks that underwrite our other debt transactions. Long-Term Debt Long-term debt consists of collateral trust bonds, medium-term notes and long-term notes payable. We issue substantially all collateral trust bonds and some medium-term notes in underwritten public transactions. Collateral trust bonds and medium-term notes are classified within Level 2 of the fair value hierarchy. The fair value of long-term debt classified within Level 2 of the fair value hierarchy was determined based on discounted cash flows. There is no active secondary trading for the underwritten collateral trust bonds and medium-term notes; therefore, dealer quotes and recent market prices are both used in estimating fair value. There is essentially no secondary market for the medium-term notes issued to our members or in transactions that are not underwritten; therefore, fair value is estimated based on observable benchmark yields and spreads for similar instruments supplied by banks that underwrite our other debt transactions. The long-term notes payable are issued in private placement transactions and there is no secondary trading of such debt. Long-term notes payable are classified within Level 3 of the fair value hierarchy. The fair value was determined based on discounted cash flows using benchmark yields and spreads for similar instruments supplied by underwriter quotes for similar instruments, if available. Secondary trading quotes for our debt instruments used in the determination of fair value incorporate our credit risk. Accrued Interest Payable Accrued interest payable represents accrued interest to be paid on our debt and derivative instruments and is valued at the carrying value, which approximates fair value. Accrued interest payable is classified within Level 2 of the fair value hierarchy. Guarantees The fair value of our guarantee liability is based on the fair value of our contingent and noncontingent exposure related to our guarantees. The fair value of our contingent exposure for guarantees is based on management’s estimate of our exposure to losses within the guarantee portfolio using a discounted cash flow method. The fair value of our noncontingent exposure for guarantees issued is estimated based on the total unamortized balance of guarantee fees paid and guarantee fees to be paid discounted at our current short-term funding rate, which represents management’s estimate of the fair value of our obligation to stand ready to perform. Guarantees are classified within Level 3 of the fair value hierarchy. Subordinated Deferrable Debt Subordinated deferrable debt outstanding was issued in an underwritten public transaction. There is no active secondary trading for this subordinated deferrable debt; therefore, dealer quotes and recent market prices are both used in estimating fair value based on a discounted cash flow method. Subordinated deferrable debt is classified within Level 2 of the fair value hierarchy. Members’ Subordinated Certificates Members’ subordinated certificates include (i) membership subordinated certificates issued to our members, (ii) loan and guarantee subordinated certificates issued as a condition of obtaining loan funds or guarantees and (iii) member capital securities issued as voluntary investments by our members. All members’ subordinated certificates are nontransferable other than among members with CFC’s consent and there is no ready market from which to obtain fair value quotes. These certificates are valued at par and are classified within Level 3 of the fair value hierarchy. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Derivative Instruments We account for derivative instruments in the consolidated balance sheets as either an asset or liability measured at fair value. We only enter into swap agreements with counterparties that are participating in our revolving lines of credit at the time the exchange agreements are executed. All of our swap agreements are subject to master netting agreements. There is not an active secondary market for the types of interest rate swaps we use. To calculate fair value, we determine the forward curve. The forward curve allows us to determine the projected floating rate cash flows and the discount factors needed to calculate the net present value of each interest payment. We use an internal model to calculate the value of our derivatives based on discounted cash flows utilizing observable market inputs. The significant observable market inputs for our derivatives include spot LIBOR rates, Eurodollar futures contracts and market swap rates. We record counterparty credit risk valuation adjustments on our derivative assets to properly reflect the credit quality of the counterparty. The credit default swap levels represent the credit risk premium required by a market participant based on the available information related to us and the counterparty. The technique for determining the fair value for our interest rate swaps is classified as Level 2. Commitments The fair value of our commitments is estimated based on the carrying value, or zero. Extensions of credit under these commitments, if exercised, would result in loans priced at market rates. Recurring Fair Value Measurements The following table presents the carrying value and fair value of financial instruments reported in our consolidated financial statements at fair value on a recurring basis as of May 31, 2016 and 2015 and the classification of the valuation technique within the fair value hierarchy. Transfers Between Levels We monitor the availability of observable market data to assess the appropriate classification of financial instruments within the fair value hierarchy and transfer between Level 1, Level 2 and Level 3 accordingly. Observable market data includes, but is not limited, to quoted prices and market transactions. Changes in economic conditions or market liquidity generally will drive changes in availability of observable market data. Changes in availability of observable market data, which also may result in changes in the valuation technique used, are generally the cause of transfers between levels. We did not have any transfers between levels for financial instruments measured at fair value on a recurring basis for the years ended May 31, 2016 and 2015. Nonrecurring Fair Value Measurements We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. Any adjustments to fair value usually result from application of lower-of-cost or fair value accounting or write-downs of individual assets. Assets measured at fair value on a nonrecurring basis as of May 31, 2016 and 2015 consisted of certain impaired loans and foreclosed assets. The fair value of these assets is determined based on the use of significant unobservable inputs, which are considered Level 3 in the fair value hierarchy. We provide additional information on foreclosed assets in “Note 1-Summary of Significant Accounting Policies” and “Note 5-Foreclosed Assets.” NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table presents the carrying value and fair value of assets reported in our consolidated financial statements at fair value on a nonrecurring basis as of May 31, 2016 and 2015, and unrealized losses for the years ended May 31, 2016 and 2015. ____________________________ (1) Excludes impaired loans for which there is no specific allowance recorded. Significant Unobservable Level 3 Inputs Impaired Loans We utilize the fair value of the collateral underlying the loan or the estimated cash flows to determine the fair value and specific allowance for impaired loans. In estimating the fair value of the collateral, we may use third-party valuation specialists, internal estimates or a combination of both. The valuation technique used to determine fair value of the impaired loans provided by both our internal staff and third-party specialists includes market multiples (i.e., comparable companies). The significant unobservable inputs used in the determination of fair value for individually impaired loans is a multiple of earnings before interest, taxes, depreciation and amortization based on various factors (i.e., financial condition of the borrower). The significant unobservable inputs for estimating the fair value of impaired collateral-dependent loans are reviewed by our Credit Risk Management group to assess the reasonableness of the assumptions used and the accuracy of the work performed. In cases where we rely on third-party inputs, we use the final unadjusted third-party valuation analysis as support for any adjustments to our consolidated financial statements and disclosures. Because of the limited amount of impaired loans as of May 31, 2016 and 2015, we do not believe that potential changes in the significant unobservable inputs used in the determination of the fair value for impaired loans will have a material impact on the fair value measurement of these assets or our results of operations. Our consolidated financial statements include the financial results of CFC, RTFC and NCSC and certain entities created and controlled by CFC to hold foreclosed assets. Separate financial statements are produced for CFC, RTFC and NCSC and are the primary reports that management reviews in evaluating performance. The separate financial statements for CFC represent the consolidation of the financial results for CFC and the entities controlled by CFC. For more detail on the requirement to consolidate the financial results of RTFC and NCSC see “Note 1-Summary of Significant Accounting Policies.” The consolidated CFC financial statements include three operating segments: CFC, RTFC and NCSC. As of May 31, 2016, the RTFC and NCSC operating segments are not required to be separately reported as the financial results of RTFC and NCSC do not meet the quantitative thresholds outlined by the accounting standards for segment reporting. As a result, we have elected to aggregate the RTFC and NCSC financial results into a combined “Other” segment. CFC is the sole source of funding to RTFC. CFC is the primary source of funding to NCSC. Pursuant to a guarantee agreement, CFC has agreed to indemnify RTFC and NCSC for loan losses. The loan loss allowance at RTFC and NCSC is offset by a guarantee receivable from CFC. The following tables display segment results for the years ended May 31, 2016, 2015 and 2014, and assets attributable to each segment as of May 31, 2016 and 2015. NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUPPLEMENTARY DATA Selected Quarterly Financial Data (Unaudited) Condensed quarterly financial information for fiscal years 2016 and 2015 is presented below.
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Here's a summary of the financial statement:
Organization Structure:
- Main entity is CFC (National Rural Utilities Cooperative Finance Corporation)
- Includes subsidiaries RTFC (Rural Telephone Finance Cooperative) and NCSC (National Cooperative Services Corporation)
- CFC is a tax-exempt cooperative serving not-for-profit entities
- RTFC is a taxable Subchapter T cooperative
- NCSC is a taxable cooperative
Key Financial Points:
- Operating at a loss (specific amounts not provided)
- Fixed asset depreciation expense of $7 (unit not specified)
- Both NCSC and RTFC are classified as Variable Interest Entities (VIEs)
- CFC consolidates all intercompany balances and transactions
- Cash equivalents include investments with maturities less than 90 days
Accounting Practices:
- Follows consolidated financial reporting
- Includes controlled entities holding foreclosed assets
- Uses VIE evaluation for consolidation decisions
- Fixed assets recorded at cost minus accumulated depreciation
- Some reclassifications made to maintain consistent presentation
The statement appears to be more focused on explaining organizational structure and accounting principles rather than providing detailed financial figures.
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Claude
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Financial Statements and Supplemental Data ACCOUNTING FIRM To the Board of Directors and Shareholders People’s Utah Bancorp We have audited the accompanying consolidated balance sheets of People’s Utah Bancorp and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. We also have audited People’s Utah Bancorp and subsidiaries’ internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). People’s Utah Bancorp and subsidiaries’ management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of People’s Utah Bancorp and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, People’s Utah Bancorp and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). /s/ TANNER LLC Salt Lake City, Utah March 10, 2017 PEOPLE’S UTAH BANCORP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See accompanying notes to the consolidated financial statements. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See accompanying notes to the consolidated financial statements. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME See accompanying notes to the consolidated financial statements. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY For the Three Years Ended December 31, 2016 See accompanying notes to the consolidated financial statements. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to the consolidated financial statements PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 -Summary of Significant Accounting Policies Nature of Operations and basis of consolidation - People’s Utah Bancorp, Inc. (“PUB” or the “Company”) is a Utah corporation headquartered in American Fork, Utah. The Company’s subsidiaries historically included Bank of American Fork (“BAF”) and Lewiston State Bank (“LSB”). BAF was incorporated as People’s State Bank of American Fork as a Utah state-chartered bank in 1913. LSB was incorporated as a Utah state-chartered bank in 1905 and became a subsidiary of PUB in October 2013. On September 29, 2015, the Company completed the merger of the charters of BAF and LSB and renamed the combined bank People’s Intermountain Bank (“PIB” or the “Bank”). BAF and LSB will continue to do business as registered names of PIB. The Bank operates under the jurisdiction of the Utah Department of Financial Institutions, and its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”). The Bank is not a member of the Federal Reserve System; however, PUB is operated as a bank holding company under the Federal Bank Holding Company Act of 1956 and is the sole shareholder of the Bank. Both PUB and the Bank are subject to periodic examination by all of the applicable federal and state regulatory agencies and file periodic reports and other information with the agencies. The Bank engages in general commercial banking business with branch offices located in their principal market area; Utah, Salt Lake, Davis, Washington and Cache counties in Utah, and Preston, Idaho; and in lending activities in other counties within the state of Utah. The Bank offers a full range of short-term to long-term commercial, personal and mortgage loans. Commercial loans include both secured and unsecured loans for working capital (including inventory and accounts receivable), business expansion (including acquisition of real estate and improvements), and purchase of equipment and machinery. Consumer loans include secured and unsecured loans to finance automobiles, home improvements, education, and personal investments. The Bank also offers mortgage loans secured by personal residences. The Bank offers a full range of deposit services typically available in most financial institutions, including checking accounts, savings accounts, and time deposits. All deposit accounts are tailored to the Bank’s principal market area at competitive rates. The Bank solicits these accounts from individuals, businesses, associations and organizations, and governmental entities. The consolidated financial statements include the accounts of the Company together with its subsidiary. All intercompany transactions and balances have been eliminated. Use of Estimates - The preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses (“ALLL”), the valuation of real estate acquired through foreclosure, deferred tax assets, and share-based compensation. Cash and cash equivalents - Cash and cash equivalents consist of cash on hand, amounts due from banks, interest bearing deposits, and federal funds sold, all of which have original maturities of three months or less. The Company places its cash with high credit quality institutions. The amounts on deposit fluctuate and, at times, exceed the insured limit by the FDIC, which potentially subjects the Company to credit risk. Generally, federal funds purchased and interest bearing deposits are held for not longer than one day before being sold or reinvested. Investment securities - Investment securities are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. Investment securities are categorized as held-to-maturity when the Company has the positive intent and ability to hold those securities to maturity. Securities which are held-to-maturity are stated at cost and adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income. The Company had no trading securities as of December 31, 2016 and 2015. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1 -Summary of Significant Accounting Policies - Continued Investment securities categorized as available-for-sale are generally held for investment purposes for an indefinite period of time, but not necessarily to maturity. Decisions to sell securities classified as available-for-sale are based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations, and other factors. Available-for-sale securities are recorded at estimated fair value, with the net unrealized gain or loss included in comprehensive income, net of the related income tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to their fair value. Such write downs would be included in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or, for certain mortgage-backed securities, to the expected interest rate reset date. Non-marketable equity securities - Non-marketable equity securities primarily consist of Federal Home Loan Bank (“FHLB”) stock. FHLB stock is restricted because such stock may only be sold to FHLB at its par value. Due to the restrictive terms, and the lack of a readily determinable market value, FHLB stock is carried at cost. The investments in FHLB stock are required investments related to the Company’s borrowings from FHLB. FHLB obtains its funding primarily through issuance of consolidated obligations of the FHLB system. The U.S. government does not guarantee these obligations, and each of the regional FHLBs are jointly and severally liable for repayment of each other’s debt. Loans held for sale - Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by aggregate outstanding commitments from investors or current investor yield requirements. Net estimated losses before sale, if any, are recognized through a valuation allowance by charges to income. Mortgage loans held for sale are generally sold with the mortgage servicing rights. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold. Substantially all of the residential mortgage loans originated are sold to larger financial institutions; however, the Company provides loan servicing for FNMA and Freddie Mac mortgage loans. Servicing income from servicing sold residential mortgages is not significant. Loans held for investment - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Non-accrual loans - The accrual of interest on loans is generally discontinued at the time the principal and interest are 90 days past due or when, in management’s opinion, the borrower will be unable to make payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received, or payment is considered certain. Loans may be returned to accrual status when all delinquent interest and principal amounts contractually due are brought current and future payments are reasonably assured. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1 -Summary of Significant Accounting Policies - Continued Impaired loans - The Company considers loans impaired when, based on current information and events, it is probable the Company will be unable to collect all principal and interest payments due according to the contractual terms of the loan agreement. Such loans are classified as Substandard or Doubtful loans (see Note 3). Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent. Changes in these values are reflected in income and as adjustments to the ALLL. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Allowance for loan losses - The ALLL is based on a continuing review of loans which includes consideration of actual loss experience, changes in the size and character of the portfolio, identification of individual problem situations which may affect the borrower’s ability to repay, evaluations of the prevailing and anticipated economic conditions, and other qualitative factors. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision, as more information becomes available. The ALLL is increased by charges to income and decreased by charge-offs (net of recoveries). While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revision of the estimate in future years. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additional losses based on their judgment using information available to them at the time of their examination. The ALLL consists of specific and general components. The specific component relates to loans determined to be impaired which are individually evaluated for impairment. For impaired loans individually evaluated, an allowance is established when the discounted cash flows, or the fair value of the collateral, if the loan is collateral dependent, of the impaired loan is lower than the carrying value of the loan. The general component covers all loans not individually evaluated for impairment and is based on historical loss experience adjusted for qualitative factors. Various qualitative factors are considered including changes to underwriting policies, loan concentrations, volume and mix of loans, size and complexity of individual credits, locations of credits and new market areas, changes in local and national economic conditions, real estate foreclosure rates, and trends in past due and classified credits. Other real estate owned - Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the carrying amount of the foreclosed loan or the fair value of the foreclosed asset, less costs to sell, at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value, less selling costs. Revenues and expenses from operations and changes in the valuation allowance are included in other real estate owned expense. Transfers of financial assets - Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1 -Summary of Significant Accounting Policies - Continued Premises and equipment - Land is carried at cost. Premises and equipment are carried at cost, net of accumulated depreciation and amortization. Depreciation and amortization expense is computed using the straight-line method based on the estimated useful lives of the related assets, generally 10 to 30 years for buildings and 3 to 5 years for equipment, furniture, and software. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Income taxes -Deferred tax assets and deferred tax liabilities represent the tax effect of temporary differences between financial reporting and tax reporting measured at enacted tax rates in effect for the year in which the differences are expected to reverse. The Company recognizes only the impact of tax positions that, based on their technical merits, are more likely than not to be sustained upon an audit by the taxing authority. Developing the provision for income taxes, including the effective tax rate and analysis of potential tax exposure items, if any, requires significant judgment and expertise in federal and state income tax laws, regulations and strategies, including the determination of deferred tax assets and liabilities and any estimated valuation allowances deemed necessary to value deferred tax assets. Judgments and tax strategies are subject to audit by various taxing authorities. While the Company believes it has no significant uncertain income tax positions in the consolidated financial statements, adverse determinations by these taxing authorities could have a material adverse effect on the consolidated financial position, results of operations or cash flows. Off-balance sheet credit related financial instruments - In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. Incentive share-based plans - The fair value of incentive share-based awards is recorded as compensation expense over the vesting period of the award. Compensation expense for stock options is estimated at the date of grant using the Black-Scholes option-pricing model. Compensation expense for restricted stock units (“RSU”) is based on the fair value of the Company’s common shares at the date of grant. Earnings per share - Basic earnings per common share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares include shares that may be issued by the Company for outstanding stock options determined using the treasury stock method and for all outstanding RSU’s. Earnings per common share have been computed based on the following: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1 -Summary of Significant Accounting Policies - Continued Comprehensive income - U.S. GAAP generally requires that recognized revenues, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, net of the related income tax effect, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income. Advertising costs - Advertising costs are expensed when incurred and totaled $1,044,000 in 2016, $853,000 in 2015, and $934,000 in 2014. Reclassifications - Certain amounts in the prior years’ financial statements have been reclassified to conform to the current year’s presentation. Impact of Recent Authoritative Accounting Guidance - The Accounting Standards Codification™ (“ASC”) is the Financial Accounting Standards Board’s (“FASB”) officially recognized source of authoritative GAAP applicable to all public and non-public non-governmental entities. Rules and interpretive releases of the SEC under the authority of the federal securities laws are also sources of authoritative GAAP for us as an SEC registrant. All other accounting literature is non-authoritative. In June 2016, FASB amended FASB ASC Topic 326, Financial Instruments - Credit Losses. The amendments in this Update replace the current incurred loss model with a methodology that reflects expected credit losses over the life of the loan and requires consideration of a broader range of reasonable and supportable information to calculate credit loss estimates. The amendments are effective for public business entities for the first interim and annual reporting periods beginning after December 15, 2019. The Company is currently evaluating the impact of these amendments to the Company’s financial position and results of operations and currently does not know or cannot reasonably quantify the impact of the adoption of the amendments as a result of the complexity and extensive changes from the amendments. The ALLL is a material estimate of the Company and given the change from an incurred loss model to a methodology that considers the credit loss over the life of the loan, there is the potential for an increase in the ALLL at adoption date. The Company is anticipating a significant change in the processes and procedures to calculate the ALLL, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The Company will also develop new procedures for determining an allowance for credit losses relating to held-to-maturity investment securities. In addition, the current accounting policy and procedures for other-than-temporary impairment on available-for-sale investment securities will be replaced with an allowance approach. The Company is expecting to begin developing and implementing processes and procedures during the next two years to ensure it is fully compliant with the amendments at adoption date. For additional information on the ALLL see Note 3 In January 2016, FASB amended FASB ASC Topic 825, Financial Instruments. The amendments in this Update address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments are effective for public business entities for the first interim and annual reporting periods beginning after December 15, 2017. Early adoption is only permitted under certain circumstances outlined in the amendments. A reporting entity should apply the amendments by means of a cumulative-effect adjustment to the Company’s statement of financial condition as of the beginning of the reporting year of adoption. The amendments related to equity securities without readily determinable fair values should be applied prospectively. The Company is currently evaluating the impact of these amendments, but does not expect them to have a material effect on the Company’s financial position or results of operations. In September 2015, FASB amended FASB ASC Topic 805, Business Combinations. The amendments in this Update require that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustments are necessary. The amendments in this Update require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1 -Summary of Significant Accounting Policies - Continued calculated as if the accounting had been completed at the acquisition date. The amendments in this Update require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The amendments should be applied prospectively to all periods presented and are effective for public business entities for annual periods and interim periods within those annual periods, beginning after December 15, 2015. The Company has evaluated the impact of these amendments and determined there was no material effect on the Company’s financial position or results of operations. In August 2014, FASB amended FASB ASC Subtopic 310-40, Receivables - Troubled Debt Restructurings by Creditors. The amendment requires that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if the following conditions are met: 1) The loan has a government guarantee that is not separable from the loan before foreclosure; 2) At the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim; and 3) At the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The amendment is effective for public business entities for interim and annual periods beginning after December 15, 2014. An entity can elect to adopt the amendments using either a prospective transition method or a modified retrospective method as defined in the amendment. The Company has evaluated the impact of the adoption of this amendment and determined there was not a material effect on the Company’s financial position or results of operations. In June 2014, FASB amended FASB ASC Topic 860, Transfers and Servicing. The amendments in this Update require the following accounting changes: 1) change the accounting for repurchase-to-maturity transactions to secured borrowing accounting; and 2) for repurchase finance arrangements, require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in a secured borrowing accounting for the repurchase agreement. The amendments also require certain disclosures for securities sold under agreements to repurchase (“repurchase agreements”), securities lending transactions, and repurchase-to-maturity transactions that are accounted for as secured borrowings. The accounting changes are effective for public business entities for the first interim or annual reporting periods beginning after December 15, 2014. The disclosure changes for repurchase agreements are effective for public business entities for annual reporting periods beginning after December 15, 2014. The Company has evaluated the impact of the adoption of this amendment and determined there was not a material effect on the Company’s financial position or results of operations. In May 2014, FASB amended FASB ASC Topic 606, Revenue from Contracts with Customers. The amendments clarify the principles for recognizing revenue and develop a common revenue standard among industries. The new guidance establishes the following core principal: recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for goods or services. Five steps are provided for a company or organization to follow to achieve such core principle. The new guidance also includes a cohesive set of disclosure requirements that will provide users of financial statements with comprehensive information about the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. For public entities, the amendments are effective for annual reporting periods beginning after December 15, 2017, including interim periods within the reporting period. Early application is not permitted. The entity should apply the amendments using one of two retrospective methods described in the amendment. The Company is currently evaluating the impact of the adoption of the amendments, but does not expect them to have a material effect on the Company’s financial position or results of operations. In January 2014, FASB amended FASB ASC Topic 323, Investments - Equity Method and Joint Ventures. The amendments permitted entities to make an accounting policy election for their investments in qualified affordable PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1 -Summary of Significant Accounting Policies - Concluded housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense. The amendments should be applied retrospectively to all periods presented and are effective for public business entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014. The adoption of these amendments did not have a material effect on the Company’s financial position or results of operations. Subsequent events - The Company has evaluated events occurring subsequent to December 31, 2016 through March 10, 2017, which is the date the financial statements were available to be issued. Note 2 - Investment Securities Amortized cost and approximate fair values of investment securities available for sale are summarized as follows: Carrying amounts and estimated fair values of securities held-to-maturity are as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2 - Investment Securities - Continued The amortized cost and estimated fair values of investment securities that are available-for-sale and held-to-maturity at December 31, 2016, by contractual maturity, are as follows: Expected maturities may differ from contractual maturities because issuers may have the right to call obligations with or without penalties. As of December 31, 2016, the Company held 302 investment securities with fair values less than amortized cost. Management evaluated these investment securities and determined that the decline in value is temporary and related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. The Company anticipates full recovery of the amortized cost with respect to these securities at maturity, or sooner in the event of a more favorable market interest rate environment. Note 3 - Loans and Allowance for Loan Losses Loans are summarized as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued Changes in the allowance for loan losses are as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued Non-accrual loans are summarized as follows: Troubled debt restructured loans are summarized as follows: A restructured loan is considered a troubled debt restructured loan (“TDR”), if the Company, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession in terms or a below-market interest rate to the debtor that it would not otherwise consider. Each TDR loan is separately negotiated with the borrower and includes terms and conditions that reflect the borrower’s prospective ability to service the debt as modified. Current and past due loans held for investment (accruing and non-accruing) are summarized as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued Credit Quality Indicators: In addition to past due and non-accrual criteria, the Company also analyzes loans using a loan grading system. Performance-based grading follows the Company’s definitions of Pass, Special Mention, Substandard and Doubtful, which are consistent with published definitions of regulatory risk classifications. Definitions of Pass, Special Mention, Substandard and Doubtful are summarized as follows: Pass: A Pass asset is higher quality and does not fit any of the other categories described below. The likelihood of loss is considered remote. Special Mention: A Special Mention asset has potential weaknesses that may be temporary or, if left uncorrected, may result in a loss. While concerns exist, the Company is currently protected and loss is considered unlikely and not imminent. Substandard: A Substandard asset is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have well defined weaknesses and are characterized by the distinct possibility that the Company may sustain some loss if deficiencies are not corrected. Doubtful: A Doubtful asset has all the weaknesses inherent in a Substandard asset with the added characteristics that the weaknesses make collection or liquidation in full highly questionable. For Consumer loans, the Company generally assigns internal risk grades similar to those described above based on payment performance. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued Outstanding loan balances (accruing and non-accruing) categorized by these credit quality indicators are summarized as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued The ALLL and outstanding loan balances reviewed according to the Company’s impairment method are summarized as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued Information on impaired loans is summarized as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3 - Loans and Allowance for Loan Losses - Continued The interest income recognized on impaired loans was as follows: Loans to affiliates - The Company has entered into loan transactions with certain directors and executive committee members (“affiliates”). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. Total outstanding loans with affiliates were $330,000 and $521,000 at December 31, 2016 and 2015, respectively. Available lines of credit for loans and credit cards to affiliates were $537,000 at December 31, 2016. Note 4 - Premises and Equipment Premises and equipment are summarized as follows as of December 31: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 5 - Deposits Deposit account balances are summarized as follows as of December 31: Scheduled maturities for certificates of deposit are as follows for the years ending December 31: Deposits held by affiliates were $7.8 million and $7.9 million as of December 31, 2016 and 2015, respectively. Note 6 - Short-term borrowings Short-term borrowings consist the following as of December 31: As of December 31, 2016, committed Federal funds lines of credit arrangements totaling $25.0 million were available to the Company from an unaffiliated bank. The average Federal funds interest rate as of December 31, 2016 was 0.89%. The Company is a member of the FHLB of Des Moines and has a committed credit line of $311.2 million which is secured by $467.6 million in various real estate loans pledged as collateral. Borrowings generally provide for interest at the then current published rates which was 0.81% as of December 31, 2016. The Company holds $32.0 million in investment securities in its Federal Reserve Bank (“Fed”) account. As of December 31, 2016, the Company’s overnight borrowing capacity using the primary credit facilities from the Fed is $22.6 million. The borrowing rate is the current discount rate plus 25 basis points. There were no outstanding Fed advances as of December 31, 2016 and 2015. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6 - Short-term borrowings - Continued Securities sold under agreements to repurchase are generally overnight financing arrangements with customers collateralized by the Company’s investment securities that mature within 166 months. Investment securities valued at $4.0 million and $4.8 million have been pledged as of December 31, 2016 and 2015, respectively, for securities sold under agreements to repurchase. At maturity, the securities underlying the agreements are returned to the Company. Information concerning short-term borrowings consist the following as of December 31: Note 7 - Income Taxes The components of the income tax expense (benefit) are as follows for the years ended December 31: The combined federal and state income tax expense differs from that computed at the federal statutory corporate tax rate as follows: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7 - Income Taxes - Continued The nature and components of the Company’s net deferred income tax assets are as follows as of December 31: The Company believes, based on available information, that it is more likely than not that the net deferred income tax asset will be realized in the normal course of operations. The impact of a tax position is recognized in the financial statements if that position is more likely than not of being sustained on audit, based on the technical merits of the position. As of December 31, 2016, the Company had an uncertain tax position related to a rehabilitation credit. As of December 31, 2015, the Company did not have any significant uncertain tax positions. The Company includes any interest and penalties associated with unrecognized tax benefits within the provision for income taxes. As of December 31, 2016, there was a liability of $200,000 for unrecognized tax benefits, and as of December 31, 2015, there was no liability for unrecognized tax benefits. The Company hopes to resolve the rehabilitation credit issue in the next twelve months. Otherwise, the Company does not expect a material change to the total amount of unrecognized tax benefits in the next twelve months. The Company elected to adopt the provisions of Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718) in 2016, which resulted in a $201,000 credit to current income tax expense related to tax- deductible stock compensation expense. The Company files U.S. and state income tax returns in jurisdictions with various statutes of limitations. The 2013 through 2016 tax years remain subject to selection for examination as of December 31, 2016. None of the Company’s income tax returns are currently under audit. As of December 31, 2016 and 2015, the Company has no net operating loss or credit carry-forwards. Note 8 - Commitments and Contingencies Commitments to extend credit - In the normal course of business, the Company has outstanding commitments and contingent liabilities, such as commitments to extend credit and unused credit card lines, which are not included in the accompanying consolidated financial statements. The Company’s exposure to credit loss in the event of non-performance by other parties to the financial instruments for commitments to extend credit and unused credit card lines is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making such commitments as it does for instruments that are included in the consolidated balance sheets. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8 - Commitments and Contingencies - Continued Contractual amounts of off-balance sheet financial instruments were as follows: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments to extend credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer. Unused credit card lines are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized and usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed. The Company has entered into agreements to construct two branch facilities scheduled to open in 2017. Estimated construction costs for the two branches are expected to be approximately $1.8 million. Note 9 - Regulatory Capital Matters The Company is subject to various regulatory capital requirements administered by its primary federal regulator, the FDIC. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and its consolidated financial statements. Under the regulatory capital adequacy guidelines and regulatory framework for prompt corrective action, the Company must meet specific capital guidelines involving quantitative measures of the Company’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Since January 2015, the Company has been subject to new risk-based capital adequacy guidelines related to the adoption of U.S. Basel III Capital Rules which impose higher risk-based capital and leverage requirements than those previously in place. Specifically, the rules impose, among other requirements, new minimum capital requirements including a Tier 1 leverage capital ratio of 4.0%, a new common equity Tier 1 risk-based capital ratio of 4.5%, a Tier 1 risk-based capital ratio of 6% and a total risk-based capital ratio of 8%. Since the Company only has common equity, our common equity Tier 1 risk-based capital ratio and our Tier 1 risk-based capital ratio are the same. Therefore, the Company only discloses the Tier 1 risk-based capital ratio since it has a higher required ratio for minimum and well-capitalized banks. As of December 31, 2016, management believes the Company meets all the capital adequacy requirements to which it is subject. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9 - Regulatory Capital Matters - Continued As of December 31, 2016, the Company was categorized as well capitalized under the regulatory framework. To be categorized as well capitalized, an institution must maintain minimum total risk-based capital, Tier 1 risk-based capital, and Tier 1 to average assets (“Tier 1 Leverage”) ratios as disclosed in the table below. The Company’s actual and required capital amounts and ratios are as follows: Federal Reserve Board Regulations require maintenance of certain minimum reserve balances based on certain average deposits. The Bank had reserve requirements of $9.1 million and $8.7 million as of December 31, 2016 and 2015, respectively. The Company’s Board of Directors may declare a cash or stock dividend out of retained earnings provided the regulatory minimum capital ratios are met. The Company plans to maintain capital ratios that meet the well-capitalized standards per the regulations and, therefore, plans to limit dividends to amounts that are appropriate to maintain those well-capitalized regulatory capital ratios. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10 - Shareholders’ Equity The Company completed an initial public offering in June 2015 and raised additional capital of $34.9 million, net of underwriting discounts and offering costs. The Board of Directors declared semi-annual dividends in 2014 and began declaring quarterly dividends in 2015. Dividends on quarterly earnings are generally declared and paid subsequent to the end of the quarter. In 2015 the Board of Directors declared and paid three quarterly dividends of $0.06 per share, totaling $3.0 million. Subsequent to December 31, 2015, the Board of Directors declared and paid a quarterly dividend of $0.07 per share totaling $1.2 million on earnings for the fourth quarter of 2015. In 2014, the Board of Directors declared and paid a semi-annual dividend of $0.08 per share, totaling $1.2 million and declared a semi-annual dividend of $0.14 per share, totaling $2.1 million, which was paid in the first quarter of 2015. Note 11 - Incentive Share-Based Plan and Other Employee Benefits In June 2014, the Board of Directors (“Board”) and shareholders of the Company approved a share-based incentive plan (the “2014 Plan”) which replaced an existing share-based incentive plan. The 2014 Plan provides for various share-based incentive awards including incentive share-based options, non-qualified share-based options, restricted shares, and stock appreciation rights to be granted to officers, directors and other key employees. The maximum aggregate number of shares that may be issued under the 2014 Plan is 800,000 common shares. The share-based awards are granted to participants under both plans at a price not less than the fair value on the date of grant and for terms of up to ten years. The 2014 Plan also allows for granting of share-based awards to directors and consultants who are not employees of the Company. Under the plans, share-based options are exercisable at the time of grant or other times subject to such terms and conditions as determined by the Board. Share-based options granted may be exercised in whole or in part at any time during the maximum option term of ten years. All share-based options are adjustable for any future stock splits or stock dividends. The Board has the authority to grant to eligible participants one or more of the various share-based incentive awards. To date, the Company has issued incentive share-based options, non-qualified share-based options and restricted stock units to participants. Fair value of the exercise price prior to the Company’s initial public offering in June 2015 was set at the time of grant by the Board based on independent valuations and related models; and after the initial public offering, fair value is based on market prices at the date of grant. The Company’s policy is to issue common shares to the person exercising share-based options. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11 - Incentive Share-Based Plan and Other Employee Benefits - Continued Share-based option transactions are summarized as follows: The weighted-average grant-date fair value of options per share granted was $2.26, $2.65 and $2.01 during 2016, 2015 and 2014, respectively. The total intrinsic value of options exercised during the years ended December 31, 2016, 2015 and 2014 was $3.5 million, $1.6 million and $761,000, respectively. Shares issued upon exercises of stock options in 2016 were reduced by 47,412 shares related to net settled option exercises or existing shares tendered as consideration. Restricted stock unit transactions are summarized as follows: The total intrinsic value of RSU’s vested during the years ended December 31, 2016 and 2015 were $244,000 and $56,000, respectively. As of December 31, 2016, there was $484,000 of total unrecognized compensation expense related to stock options and RSU’s granted to be recognized over a weighted-average period of 1.2 years. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11 - Incentive Share-Based Plan and Other Employee Benefits - Continued The Company recorded share-based compensation expense of $544,000, $485,000 and $221,000 for the years ended December 31, 2016, 2015 and 2014, respectively. The Company used the Black-Scholes pricing model using the following assumptions to calculate the fair value of incentive share-based options granted during 2016, 2015 and 2014: annual dividend yield of 0.7% to 2.3%; risk-free interest rates of 0.1% to 1.6%; expected option terms of 0.7 to 6.5 years; and volatility index of 13.3% to 29.9%. The assumptions for expected dividend yield and expected life reflected management’s judgment and include consideration of historical experience. Expected volatility is based on data from comparable public companies for the expected option term. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option. Expected forfeitures are estimated based on the Company’s historical forfeiture experience. Management believes that the assumptions used in the option-pricing model are highly subjective and represent only one estimate of possible value as there is no active market for the options granted. 401(k) plan - The Company offers a retirement savings 401(k) plan in which all eligible employees may participate. Currently, the Company contributes and allocates to each eligible participant’s account, a percentage of the participant’s elective deferral. The Company made contributions of $778,000, $708,000 and $670,000 in 2016, 2015 and 2014, respectively. Profit-sharing - The Company provides an annual profit-sharing contribution to all eligible employees based on each year’s profitability and as approved by the Board of Directors. Profit sharing contributions were $600,000, $600,000 and $450,000 in 2016, 2015 and 2014, respectively. Note 12 - Fair Value Fair value measurements - Fair value represents the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. To measure fair value, GAAP has established a hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows: Level 1 Quoted prices in active markets for identical assets or liabilities. Level 2 Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data. Level 3 Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 12 - Fair Value - Continued The following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation methodology: Investment securities, available for sale - Where quoted prices are available in an active market, securities are classified within Level 1 of the hierarchy. Level 1 includes securities that have quoted prices in an active market for identical assets. If quoted market prices are not available, then fair values are estimated using pricing models, quoted prices of securities with similar characteristics or discounted cash flows, and accordingly, are classified as Level 2 or 3. The Company has categorized its available-for-sale investment securities as Level 1 or 2. Impaired loans and other real estate owned - Fair value applies to loans and other real estate owned measured for impairment. Impaired loans are measured at an observable market price (if available) or at the fair value of the loan’s collateral (if collateral dependent). Fair value of the loan’s collateral is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. The Company has categorized its impaired loans and other real estate owned as Level 2. Assets measured at fair value are summarized as follows: Fair value of financial instruments - The following table summarizes carrying amounts, estimated fair values and assumptions used to estimate fair values of financial instruments: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 12 - Fair Value - Continued The above summary excludes financial assets and liabilities for which carrying value approximates fair value. For financial assets, these include cash and cash equivalents, held-to-maturity securities (see Note 2), loans held for sale, bank-owned life insurance, accrued interest receivable and FHLB stock. For financial liabilities, these include non-interest bearing deposits, short-term borrowings, and accrued interest payable. Also excluded from the summary are financial instruments recorded at fair value on a recurring basis, as previously described. Fair values of off-balance sheet commitments such as lending commitments, standby letters of credit and guarantees are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter parties’ credit standing. The fair value of the fees as of December 31, 2015 and 2014 were insignificant. The following methods and assumptions were used to estimate the fair value of financial instruments: Net loans - The fair value is estimated by discounting the future cash flows and estimated prepayments using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining term. Some loan types were valued at carrying value because of their floating rate or expected maturity characteristics. Interest bearing deposits - The fair value of interest bearing deposits is estimated by discounting the estimated future cash flows using the rates currently offered for deposits with similar remaining maturities. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in the above methodologies and assumptions could significantly affect the estimates. Further, certain financial instruments and all non-financial instruments are excluded from the applicable disclosure requirements. Therefore, the fair value amounts shown in the table do not, by themselves, represent the underlying value of the Company as a whole. PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 13 - Contingencies and Concentrations of Credit Risk Litigation - The Company may from time to time be subject to legal proceedings arising in the normal course of business. Management does not believe the outcome of any currently pending matters will have a material impact on the financial condition, results of operations, or liquidity of the Company. Concentrations of credit risk - The Company has concentrated credit risk exposure, including off-balance-sheet credit risk exposure, related to real estate loans as disclosed in Notes 3 and 8. The ultimate collectability of a substantial portion of the loan portfolio is susceptible to changes in economic and market conditions in the region. The Company generally requires collateral on all real estate lending arrangements and typically maintains loan-to-value ratios of no greater than 80%. Investments in municipal securities principally involve governmental entities within the State of Utah. Loans are limited by state banking regulation to 15% of each Bank’s total capital, as defined by banking regulations. As a matter of practice and in accordance with applicable Utah state law, the Bank does not extend credit to any single borrower or group of related borrowers in excess of 15% of the Bank’s total capital. As of December 31, 2016, PIB’s lending limit was $31.5 million. The contractual amounts of credit-related financial instruments, such as commitments to extend credit and credit-card arrangements, represent the amounts of potential accounting loss should the contract be fully drawn upon, the customer defaults, and the value of any existing collateral becomes worthless. Note 14 - Condensed Financial Statements of Parent Company Financial information pertaining only to PUB, on a parent-only basis, is as follows as of and for the years ended December 31: PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 14 - Condensed Financial Statements of Parent Company - Continued PEOPLE’S UTAH BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 15 - Unaudited Quarterly Financial Data Summarized unaudited quarterly financial data is as follows:
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Here's a summary of the financial statement:
Key Components:
1. Profit/Loss:
- Shows losses related to allowance for loan losses (ALLL)
- Includes valuations of foreclosed real estate
- Involves deferred tax assets and share-based compensation
2. Expenses:
- Based on estimates of liabilities and contingent assets
- Includes allowance for loan losses
- Involves valuation of foreclosed properties
- Covers deferred tax assets and share-based compensation
3. Liabilities:
- Focuses on loan holdings and management
- Two main loan categories:
* Loans held for sale (secondary market)
* Loans held for investment
- Includes mortgage servicing operations
- Details on loan interest accrual policies
- Non-accrual status triggers at 90 days past due
Cash Management:
- Maintains cash and equivalents with 3-month or less maturity
- Uses high credit quality institutions
- May exceed FDIC insurance limits
- Federal funds typically held for one day or less
Notable Features:
- Mortgage loans typically sold with servicing rights
- Services FNMA and Freddie Mac mortgages
- Loan origination fees are deferred and recognized over time
- Interest income accrues on unpaid principal balances
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Report of Independent Registered Certified Public Accounting Firm The Board of Directors and Shareholders of HSN, Inc. We have audited the accompanying consolidated balance sheets of HSN, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedule listed in the Index as Schedule II. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of HSN, Inc. and subsidiaries at December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), HSN, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 24, 2017, expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Tampa, Florida February 24, 2017 HSN, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements. HSN, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) The accompanying notes are an integral part of these consolidated financial statements. HSN, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share data) The accompanying notes are an integral part of these consolidated financial statements. HSN, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In thousands) The accompanying notes are an integral part of these consolidated financial statements. HSN, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) The accompanying notes are an integral part of these consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1-ORGANIZATION Company Overview HSN, Inc. (“HSNi”) is an interactive multi-channel retailer that markets and sells a wide range of third party and proprietary merchandise directly to consumers through various platforms including (i) television home shopping programming broadcast on the HSN television networks and other direct-response television marketing; (ii) catalogs, consisting primarily of the Cornerstone portfolio of leading print catalogs which includes, Ballard Designs, Frontgate, Garnet Hill, Grandin Road, and Improvements; (iii) websites, which consist primarily of HSN.com, joymangano.com and the five branded websites operated by Cornerstone; (iv) mobile devices; (v) retail and outlet stores; and (vi) wholesale distribution of certain proprietary products to other retailers. HSNi’s television home shopping business, related digital sales, outlet stores and wholesale distribution are referred to herein as “HSN” and all catalog operations, including related digital sales and stores, are collectively referred to herein as “Cornerstone.” Chasing Fireflies and TravelSmith, two of the apparel brands in the Cornerstone portfolio, were sold in September 2016. See Note 20 for further discussion. HSN offerings primarily consist of jewelry, fashion (apparel & accessories), beauty & health (including beauty, wellness and fitness), and home & other (including home, electronics, culinary and other). Merchandise offered by Cornerstone primarily consists of home furnishings (including indoor/outdoor furniture, home décor, tabletop, textiles and other home related goods) and apparel & accessories. Basis of Presentation HSNi was incorporated in Delaware in May 2008 in connection with the spin-off of several businesses previously owned by IAC/InterActiveCorp ("IAC"). The spin-off from IAC ("Spin-off") occurred August 20, 2008 and in connection with the Spin-off, HSNi's shares began trading on the NASDAQ Global Select Market under the symbol “HSNI.” The consolidated financial statements include the accounts of HSN, Inc. and its subsidiaries. Intercompany accounts and transactions have been eliminated. Recent Accounting Developments Recently Adopted Accounting Standard Updates In April 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30) - Simplifying the Presentation of Debt Issuance Costs ("ASU 2015-03"). ASU 2015-03 simplifies the presentation of debt issuance costs by requiring debt issuance costs to be presented as a deduction from the corresponding debt liability. The new standard is limited to the presentation of debt issuance costs and does not affect their recognition and measurement. ASU 2015-03 is effective for periods beginning after December 15, 2015, including interim periods within that annual period. HSNi retrospectively adopted ASU 2015-03 in the first quarter of 2016 resulting in the reclassification of its debt issuance costs from "Other non-current assets" to a deduction from "Long-term debt, less current maturities and net of unamortized deferred financing costs" in the consolidated balance sheets. See Note 7 for additional information regarding the deferred issuance costs. In April 2015, the FASB issued ASU No. 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement ("ASU 2015-05"), which provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for a cloud computing arrangement as a service contract. HSNi prospectively adopted ASU 2015-05 on January 1, 2016 and applies this guidance to all arrangements entered into or materially modified after the effective date. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230) ("ASU 2016-15"). The standard is intended to reduce the diversity in practice around how certain transactions are classified within the statement of cash flows. ASU 2016-15 is effective for HSNi beginning in fiscal 2019. Early adoption is permitted with retrospective application. HSNi adopted ASU 2016-15 retrospectively in the fourth quarter of 2016. Adoption of this guidance did not have a material impact on HSNi's financial statements or disclosures. Accounting Standard Updates Not Yet Adopted In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"). ASU 2014-09 outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that revenue is recognized when a customer obtains control of a good or service. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Additionally, ASU 2014-09 will disallow the capitalization of direct-response advertising costs which will impact the timing of recognition of Cornerstone's catalog production and distribution costs. In July 2015, the FASB approved a one-year deferral of the effective date of ASU 2014-09. This standard will now become effective for HSNi in the first quarter of 2018. Early adoption is permitted in the first quarter of 2017. In 2015, HSNi established an implementation team (“team”) to assess the overall impact the adoption of ASU 2014-09 will have on its consolidated financial statements, processes, systems and controls. The team is in the process of developing its conclusions and assessing the impact of several aspects of the standard including principal versus agent considerations, identification of performance obligations and the determination of when control of goods transfers to the company’s customers. HSNi will adopt ASU 2014-09 on January 1, 2018. HSNi is still evaluating the accounting, transition method and disclosure requirements. In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory (Topic 330) ("ASU 2015-11"). The amendments, which apply to inventory that is measured using any method other than the last-in, first-out (LIFO) or retail inventory method, require that entities measure inventory at the lower of cost or net realizable value. ASU 2015-11 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016 and should be applied on a prospective basis; however, early adoption is permitted. HSNi will adopt ASU 2015-11 on January 1, 2017. HSNi does not expect ASU 2015-11 to have a material impact to its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases ("ASU 2016-02"). ASU 2016-02 requires lessees to reflect most leases on their balance sheet as assets and obligations. The effective date for the standard is for interim and annual reporting periods beginning after December 15, 2018. Early adoption is permitted. The standard is to be applied on a modified retrospective method. HSNi is currently assessing the timing of adoption of ASU 2016-02 and the impact it will have on its consolidated financial statements and related disclosures. In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation (Topic 718) ("ASU 2016-09"). This standard makes several modifications to Topic 718 related to the accounting for forfeitures, employer tax withholding on share-based compensation and the financial statement presentation of excess tax benefits or deficiencies. ASU 2016-09 also clarifies the statement of cash flows presentation for certain components of share-based awards. The effective date for the standard is for interim and annual reporting periods beginning after December 15, 2016. Early adoption is permitted. HSNi will adopt ASU 2016-09 on January 1, 2017. HSNi has elected to continue estimating forfeitures each period rather than record them as they occur. Additionally, ASU 2016-09 could cause volatility in HSNi's future effective tax rates and diluted earnings per share due to the tax effects related to share-based payments being recorded to the statement of operations. The volatility in future periods will depend on HSNi's stock price when the awards vest and/or are exercised. In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350) ("ASU 2017-04"). ASU 2017-04 simplifies the subsequent measurement of goodwill by removing the second step of the two-step impairment test. ASU No. 2017-04 is effective for HSNi in the first quarter of 2020, with early adoption permitted on or after January 1, 2017, and is to be applied on a prospective basis. The adoption of the provisions of ASU No. 2017-04 would not materially impact HSNi's consolidated financial position or results of operations unless the first step of the annual goodwill impairment test fails. Fiscal Year HSNi’s consolidated financial results are reported on a calendar year basis ending on December 31. HSN’s reporting period is the same as HSNi. Cornerstone has a 4-4-5 week accounting cycle with the fiscal year ending on the Saturday on or immediately preceding December 31. Cornerstone’s 2016 fiscal year included 53 weeks while 2015 and 2014 each included 52 weeks. Reclassifications Reclassifications were made to prior period amounts to conform to the current year's presentation. Changes included the reclassification of certain operating expenses in the consolidated statement of operations to conform to the current year's presentation and deferred financing costs in the consolidated balance sheets due to the implementation of ASU 2015-3. NOTE 2-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Revenue Recognition Revenue primarily consists of merchandise sales and is reduced by incentive discounts and sales returns to arrive at net sales. Revenue is recorded when delivery to the customer has occurred. Delivery is considered to have occurred when the customer takes title and assumes the risks and rewards of ownership, which is on the date of shipment. HSNi's sales policy allows customers to return merchandise for a full refund or exchange, subject to pre-established time restrictions. Allowances for returned merchandise and other adjustments (including reimbursed shipping and handling costs) are provided based upon past experience. Actual returns of product sales have not materially varied from estimates in any of the periods presented. HSNi's estimated return rates were 15.3%, 15.9%, and 16.3% in 2016, 2015, and 2014, respectively. Sales taxes collected are not included in revenue. HSN issues customer credits primarily for products returned outside of HSN’s normal return policy. Revenues from these credits are recognized when (1) redeemed by the customer, or (2) it is determined that it is not probable the Company has an obligation to escheat the value of the unredeemed credit to relevant jurisdictions and the likelihood of the credit being redeemed by the customer is remote (“breakage”). During the year ended December 31, 2014, the Company recognized $5.0 million of revenue for customer credit breakage. This was the first period during which the Company recognized customer credit breakage and, therefore, it included breakage income related to customer credits issued since inception of this program. Customer credit breakage recognized for the years ended December 31, 2016 and 2015 were $2.3 million and $0.5 million, respectively. Customer credit breakage is estimated based upon an analysis of actual historical redemption patterns and is included in "Net sales" in the accompanying consolidated statements of operations. Shipping and Handling Fees and Costs Shipping and handling fees billed to customers are recorded as revenue. The costs associated with shipping goods to customers are recorded as cost of sales. Cash and Cash Equivalents Cash and cash equivalents include cash and money market instruments with an original maturity of three months or less when purchased and are stated at cost. Accounts Receivable Accounts receivable are principally comprised of amounts due from customers and credit card companies, net of an allowance for doubtful accounts. HSNi accepts most credit and select debit cards. HSN provides extended payment terms to its qualified customers known as Flexpay. Revenue is recorded when delivery to the customer has occurred, at which time HSN collects the first payment, sales tax and all shipping and handling fees. Subsequent collections are due from customers in 30-day increments, payable automatically upon authorization of the customer’s method of payment. HSN offers Flexpay programs ranging from two to six interest-free monthly payments. Flexpay receivables consist of outstanding balances owed by customers, less a reserve for uncollectible balances. The balance of accounts receivable, net of allowances, is as follows (in thousands): Accounts receivable outstanding longer than the contractual payment terms are considered past due. HSNi determines its allowance by considering a number of factors, including the length of time accounts receivable are past due, HSNi’s previous loss history and the condition of the general economy. HSNi writes off accounts receivable when they are deemed uncollectible. Inventories Inventories, which primarily consist of finished goods, are valued at the lower of cost or market, with the cost being determined based upon the first-in, first-out method. Cost includes inbound freight and duties and, in the case of HSN, certain allocable costs, including certain warehouse costs. Inventories include approximately $7.2 million and $6.9 million of these allocable general and administrative overhead costs at December 31, 2016 and 2015, respectively, and approximately $25.7 million, $25.2 million, and $24.0 million of such costs were included in the accompanying consolidated statements of operations for the years ended December 31, 2016, 2015 and 2014, respectively. Market is determined on the basis of net realizable value, giving consideration to obsolescence and other factors. Property and Equipment Property and equipment, including significant improvements, are recorded at cost. Repairs and maintenance and any gains or losses on dispositions are included in the consolidated statement of operations. Depreciation is recorded on a straight-line basis to allocate the cost of depreciable assets to operations over the shorter of the estimated service life or lease period. HSNi capitalizes certain qualified costs incurred in connection with the development of internal use software. Capitalization of internal use software costs begins when the preliminary project stage is completed; management with the relevant authority authorizes and commits to the funding of the software project; and it is probable that the project will be completed and the software will be used to perform the function intended. Capitalized internal use software is amortized on a straight-line basis over the estimated useful life of the software. Capitalized software costs, net of accumulated amortization, totaled $36.3 million and $32.8 million at December 31, 2016 and 2015, respectively, and are included in “Property and equipment, net” in the accompanying consolidated balance sheets. Amortization expense related to the capitalized software costs was $19.2 million, $18.9 million and $18.3 million for the years ended December 31, 2016, 2015 and 2014, respectively, and is included in "Depreciation and amortization" expense in the accompanying consolidated statements of operations. Goodwill and Indefinite-Lived Intangible Assets Goodwill acquired in business combinations is assigned to the reporting units that are expected to benefit from the combination as of the acquisition date. Goodwill and indefinite-lived intangible assets, primarily trade names and trademarks, are assessed annually for impairment as of October 1 or upon the occurrence of certain events or substantive changes in circumstances. See Note 3 for a further discussion on goodwill and indefinite-lived intangible assets. Long-Lived Assets and Intangible Assets with Definite Lives Long-lived assets, including property and equipment and intangible assets with definite lives, are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. If the carrying amount is deemed to not be recoverable, an impairment loss is recorded as the amount by which the carrying amount of the long-lived asset exceeds its fair value. Amortization of definite-lived intangible assets is generally recorded on a straight-line or accelerated basis over their estimated lives. Cable and Satellite Distribution Fees Cable and satellite distribution fees relate to fees paid in connection with cable and satellite contracts for carriage of HSN’s programming. Fees that are paid upfront for annual contracts are included in "Prepaid expenses and other current assets" in the accompanying consolidated balance sheets and are amortized on a straight-line basis over the terms of the respective contracts. Unpaid fees are accrued and included in the line item “Accrued expenses and other current liabilities” in the accompanying consolidated balance sheets. Cable and satellite distribution fees and amortization are included in “Selling and marketing" expense in the accompanying consolidated statements of operations. Advertising Advertising costs include catalog production and distribution costs. Advertising costs are expensed in the period incurred, except for Cornerstone’s direct costs of producing and distributing its catalogs, which are capitalized. These capitalized costs are amortized over the expected future revenue stream, which is generally three months from the date catalogs are mailed. Such capitalized costs totaled $16.5 million and $19.1 million as of December 31, 2016 and 2015, respectively, and are included in “Prepaid expenses and other current assets” in the accompanying consolidated balance sheets. Of these amounts, $10.5 million and $15.2 million as of December 31, 2016 and 2015, respectively, related to catalogs that had not yet been mailed. Advertising expense was $272.9 million, $288.5 million, and $279.6 million for the years ended December 31, 2016, 2015 and 2014, respectively, and were included in "Selling and marketing" expense in the accompanying consolidated statements of operations. Income Taxes HSNi accounts for income taxes under the liability method, and deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided on deferred tax assets if it is determined that it is more likely than not that the deferred tax asset will not be realized. HSNi records interest and penalties on potential tax contingencies as a component of income tax expense and records interest net of any applicable related income tax benefit. HSNi recognizes liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on its technical merits. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. Stock-Based Compensation HSNi recognizes compensation expense for stock-based awards, reduced for estimated forfeitures, on a straight-line basis over the requisite service period for awards with service conditions and on a graded-vested basis for awards with market or performance conditions. Tax benefits resulting from tax deductions in excess of the stock-based compensation expense recognized in the consolidated statements of cash flows are reported as a component of financing cash flows. HSNi issues new shares to satisfy equity vestings and exercises. See Note 11 for a further description of our stock compensation plans. Earnings Per Share HSNi computes basic earnings per share by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed using the treasury stock method. Derivative Instruments HSNi uses derivatives in the management of interest rate risk with respect to interest expense on variable rate debt. Such instruments are not held or used for trading purposes. HSNi is party to interest rate swap agreements with major financial institutions that fix the variable benchmark component (LIBOR) of HSNi's interest rate on a portion of its variable-rate debt. See Note 8 for further discussion of derivative instruments. Share Repurchases Shares repurchased pursuant to HSNi's share repurchase program are immediately retired upon purchase. Repurchased common stock is reflected as a reduction of shareholders' equity. HSNi's accounting policy related to its share repurchases is to reduce its common stock based on the par value of the shares and to reduce its capital surplus for the excess of the repurchase price over the par value. Since inception of its share repurchase program in September 2011, HSNi has had an accumulated deficit balance; therefore, the excess over the par value has been applied to additional paid-in capital. Once HSNi has retained earnings, the excess will be charged entirely to retained earnings. Private Label Credit Card HSN's credit card program offers eligible customers a private label credit card. All cardholders receive certain rewards and benefits which are designed to recognize and promote client loyalty. HSN designs, executes and administers marketing programs to promote usage of the card to current and potential customers. These marketing programs are funded largely by the sponsoring bank. HSN also saves on interchange fees that it would incur if its customers used third-party cards. Purchases made through the private label credit card represented 36%, 34% and 31% of HSN's sales in 2016, 2015 and 2014, respectively. Certain brands in the Cornerstone portfolio also offer their customers private label credit cards with purchases representing approximately 4% of Cornerstone's sales in 2016 and less than 1% in 2015. In November 2013, HSN extended its agreement with the sponsoring bank through 2020. As with the original agreement, HSN received an upfront signing bonus from the sponsoring bank which is being amortized over the term of the agreement and also receives ongoing payments for new accounts activated as well as a share of net sales collected by the sponsoring bank. For the years ended December 31, 2016, 2015 and 2014, HSN recognized approximately $16.9 million, $16.9 million, and $16.5 million, respectively, of income from the sponsoring bank that was used to offset credit card fees included in costs of goods sold. Accounting Estimates HSNi prepares its financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”). These principles require management to make certain estimates and assumptions during the preparation of its consolidated financial statements. These estimates and assumptions impact the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements. They also impact the reported amount of net earnings during any period. Actual results could differ from those estimates. Significant estimates underlying the accompanying consolidated financial statements include: the determination of the lower of cost or market adjustment for inventory; sales returns and other revenue allowances; the allowance for doubtful accounts; the recoverability of long-lived assets; the impairment of intangible assets; the annual expected effective tax rate; the determination of deferred income taxes, including related valuation allowances; the accrual for actual, pending or threatened litigation, claims and assessments; the breakage of customer credits; and assumptions related to the determination of stock-based compensation and contingent consideration related to acquisitions. Certain Risks and Concentrations HSNi’s business is subject to certain risks and concentrations including dependence on third-party technology providers and shipping companies, exposure to risks associated with online commerce security, consumer credit risk and credit card fraud. HSNi also depends on third-party service providers for processing certain fulfillment services. NOTE 3-INTANGIBLE ASSETS AND GOODWILL HSNi assesses the impairment of goodwill and indefinite-lived identifiable intangible assets, principally trademarks and trade names, at least annually during the fourth quarter and whenever events or circumstances indicate that the carrying value may not be fully recoverable. In performing this review, HSNi has the option of performing a qualitative assessment to determine whether it is more likely than not that the fair values of the reporting unit and/or indefinite-lived intangible assets are less than the carrying values. If HSNi determines that it is not more likely that the fair value is less than its carrying value, then the goodwill and/or the indefinite-lived intangible assets are deemed to be not impaired and no further testing is required until the next annual test date (or sooner if conditions or events before that date raise concerns of potential impairment in the business). If HSNi determines that it is more likely than not that the fair value is less than its carrying value, then the quantitative goodwill and/or indefinite-lived intangible asset impairment tests (as discussed below) must be completed. If necessary, HSNi performs a quantitative assessment of the fair values of its goodwill and intangible assets. If it is determined that the implied fair value of goodwill and/or indefinite-lived intangible assets is less than the carrying amount, an impairment charge, equal to the excess, is recorded. The implied fair value of goodwill is determined in the same manner as in a business combination. The estimated fair value of the reporting unit is allocated to all of the assets and liabilities of the reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the estimated fair value of the reporting unit was the purchase price paid. The fair value of the reporting unit is determined by using a discounted cash flow analysis with consideration of an equity analysis based on the trading value of its common stock. The discounted cash flow analysis indicates the fair value of the reporting units based on the present value of the cash flows expected to be generated in the future. The equity analysis is based on the trading value of its common stock as of the valuation date or the average stock price over a range of dates prior to the valuation date, plus an estimated control premium. HSNi utilizes a relief from royalty method to assess the fair values of its trademarks and trade names. In assessing fair value, HSNi considers, among other indicators, differences between estimated and actual cash flows and revenue streams; changes in the related discount, royalty and terminal growth rate; and the relationship between the trading price of its common stock and its per-share book value. Determining fair value requires the exercise of significant judgments. These factors used in the determination of fair value are sensitive to, among other things, changes in the retail consumer market and the general economy. Intangible Assets Intangible assets with indefinite lives relate principally to trade names and trademarks. Definite-lived intangible assets consist primarily of patents which are amortized on a straight-line basis over their term. When definite-lived intangible assets are sold or expire, the cost of the asset and the related accumulated amortization are eliminated and any gain or loss is recognized at such time. The total balance of HSNi's intangible assets, net, is as follows (in thousands): During the third quarter of 2015, as a result of declines in operating performances at certain Cornerstone brands, HSNi performed a quantitative assessment of certain intangible assets and concluded a fair value adjustment was necessary. An impairment charge of $5.0 million was recorded related to its acquisition of Chasing Fireflies. During the fourth quarter of 2015, in connection with its annual assessment of impairment, HSNi performed qualitative and quantitative assessments of its intangible assets and wrote off the remaining identified intangible assets of Chasing Fireflies. An impairment charge of $1.7 million was recorded in the fourth quarter of 2015. The impairment charges were recorded within the Cornerstone segment and are included in "Loss on sale of businesses and asset impairments" expense in the accompanying consolidated statements of operations. Amortization expense for the definite-lived intangible assets was not material for all periods presented. Goodwill The following tables present the balance of goodwill by reporting unit, including changes in the carrying amount of goodwill, for the years ended December 31, 2016 and 2015 (in thousands): Based on the quantitative assessments performed in the fourth quarters of 2016 and 2015, HSNi concluded there was no impairment of its goodwill. NOTE 4-PROPERTY AND EQUIPMENT The balance of property and equipment, net, is as follows (in thousands): Long-lived assets, including projects in progress, are tested for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. There were no impairment charges related to HSNi's long-lived assets in fiscal 2016 or 2015. As we periodically reassess estimated future cash flows and asset fair values, changes in our estimates and assumptions may cause us to realize impairment charges in the future. NOTE 5-ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities consist of the following (in thousands): NOTE 6-SEGMENT INFORMATION HSNi presents its operating segments and related financial information in a manner consistent with how the chief operating decision maker and executive management view the businesses, how the businesses are organized as to segment management, and the focus of the businesses with regards to the types of products or services offered and/or the target market. HSNi has two reportable segments, HSN and Cornerstone. The accounting policies of the segments are the same as those described in Note 2 - Summary of Significant Accounting Policies. Intercompany accounts and transactions have been eliminated in consolidation. HSNi’s primary performance metric is Adjusted EBITDA, which is defined as operating income excluding, if applicable: (1) non-cash charges including: (a) stock-based compensation expense, (b) amortization of intangibles, (c) depreciation and gains and losses on asset dispositions, and (d) goodwill, long-lived asset and intangible asset impairments; (2) pro forma adjustments for significant acquisitions; and (3) other significant items. Significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, thereby affecting the comparability of results. Adjusted EBITDA is not a measure determined in accordance with GAAP, and should not be considered in isolation or as a substitute for operating income, net income or any other measure determined in accordance with GAAP. Adjusted EBITDA is used as a measurement of operating efficiency and overall financial performance and HSNi believes it to be a helpful measure for those evaluating companies in the retail and media industries. Adjusted EBITDA has certain limitations in that it does not take into account the impact to HSNi’s consolidated statements of operations of certain expenses, gains and losses; including stock-based compensation, amortization of intangibles, depreciation, gains and losses on asset dispositions, asset impairment charges, acquisition-related accounting expenses and other significant items. The following tables reconcile consolidated net income to operating income for HSNi's operating segments and Adjusted EBITDA (in thousands): (a) Non-GAAP results for the year ended December 31, 2016 exclude a loss on sale and asset impairment charges of $31.2 million for the divestitures of TravelSmith and Chasing Fireflies. (a) Non-GAAP results for the year ended December 31, 2015 exclude $6.7 million of charges for the impairment of intangible assets and $1.1 million of other non-cash adjustments. (b) Non-GAAP results for 2015 exclude $2.0 million of severance costs associated with a reorganization at HSN and $3.2 million for certain costs associated with the planned closure of one of HSN's distribution centers. (a) Non-GAAP results for the year ended December 31, 2014 exclude $5.0 million of breakage income related to the initial reversal of certain customer credits that had accumulated over many years. (b) Non-GAAP results for the year ended December 31, 2014 exclude a $3.1 million settlement with the Consumer Product Safety Commission ("CPSC"). Financial information by segment is as follows (thousands): HSNi does not report revenue from external customers for each product or each group of similar products as it is impracticable to do so. HSNi maintains operations principally in the United States with no long-lived assets and insignificant net sales in all other countries. NOTE 7-LONG-TERM DEBT Long-term debt consists of the following (in thousands): On January 27, 2015, HSNi entered into a $1.25 billion five-year syndicated credit agreement ("Credit Agreement") which is secured by 100% of the voting equity securities of HSNi's U.S. subsidiaries and 65% of HSNi's first-tier foreign subsidiaries. This Credit Agreement replaced the existing credit agreement that was set to expire in April 2017. Certain HSNi subsidiaries have unconditionally guaranteed HSNi's obligations under the Credit Agreement. The Credit Agreement, which includes a $750 million revolving credit facility and a $500 million term loan, may be increased up to $1.75 billion subject to certain conditions and expires January 27, 2020. HSNi drew $500 million from its term loan and $200 million under the revolving credit facility, both under the new Credit Agreement, in the first quarter of 2015 to repay its outstanding term loan of $228.1 million and to fund a $524 million special cash dividend that was paid on February 19, 2015. In connection with the termination of the prior credit agreement, $0.5 million of the $2.4 million of unamortized deferred financing costs were expensed in the first quarter of 2015. The remaining balance of $1.9 million along with the $6.6 million in capitalized financing costs related to the Credit Agreement are being amortized to interest expense over the five-year term of the Credit Agreement. The Credit Agreement includes various covenants, limitations and events of default customary for similar facilities including a maximum leverage ratio of 3.50x and a minimum interest coverage ratio of 3.00x (both as defined in the Credit Agreement). HSNi was in compliance with all such covenants as of December 31, 2016 with a leverage ratio of 1.7x and an interest coverage ratio of 20.6x. The Credit Agreement also contains covenants that limit our ability and the ability of our subsidiaries to, among other things, incur additional indebtedness, pay dividends or make other distributions to third parties, repurchase or redeem our stock, make investments, sell assets, incur liens, enter into agreements restricting our subsidiaries' ability to pay dividends, enter into transactions with affiliates and consolidate, merge or sell all or substantially all of our assets. The Credit Agreement also contains provisions that limit the ability of HSNi to make Restricted Payments, defined as cash dividends, distribution of other property, repurchase of the Company’s common stock, prepayment or redemption of debt, etc., however, so long as the Company’s leverage ratio is below 3.00x after giving pro forma effect to any proposed Restricted Payments, the amount of such Restricted Payments are not limited. In the event the Company’s leverage ratio is equal to or greater than 3.00x or after giving pro forma effect to any proposed Restricted Payments, then such Restricted Payments are limited to $150 million in any such fiscal year. The current cash dividend of $1.40 annually per share represents a Restricted Payment of approximately $73.2 million. Dividends, loans or advances to HSNi by its subsidiaries are not restricted by the Credit Agreement. Loans under the Credit Agreement bear interest at a per annum rate equal to a LIBOR rate plus a predetermined margin that ranges from 1.25% to 2.25% or the Base Rate (as defined in the Credit Agreement) plus a predetermined margin that ranges from 0.25% to 1.25%. HSNi can elect to borrow at either a LIBOR or the Base Rate and the predetermined margin is based on HSNi's leverage ratio. The interest rate on the $515.0 million outstanding long-term debt balance as of December 31, 2016 was 2.75%. HSNi pays a commitment fee ranging from 0.20% to 0.40% (based on the leverage ratio) on the unused portion of the revolving credit facility. The amount available under the revolving credit facility portion of the Credit Agreement is reduced by the amount of commercial and standby letters of credit issued under the revolving credit facility, which totaled $10.2 million as of December 31, 2016. The ability to draw funds under the revolving credit facility is dependent upon meeting the aforementioned financial covenants, which may limit HSNi’s ability to draw the full amount of the facility. As of December 31, 2016, the additional amount that could be borrowed under the revolving credit facility in consideration of the financial covenants and outstanding letters of credit, was approximately $522.7 million. Aggregate contractual maturities of long-term debt are as follows (in thousands): NOTE 8-DERIVATIVE INSTRUMENTS HSNi uses derivatives in the management of its interest rate risk with respect to its variable rate debt. HSNi's strategy is to eliminate the cash flow risk on a portion of its variable rate debt caused by changes in the benchmark interest rate (LIBOR). Derivative instruments are not entered into for speculative purposes. HSNi uses interest rate swap contracts to eliminate the cash flow risk on a portion of its variable rate debt. HSNi pays at a fixed rate and receives payments at a variable rate based on one-month LIBOR. The swaps effectively fix the floating LIBOR-based interest of our outstanding LIBOR-based debt. The interest rate swaps were designated and qualified as cash flow hedges; therefore, the effective portions of the changes in fair value are recorded in accumulated other comprehensive income (loss). Any ineffective portions of the changes in fair value of the interest rate swaps will be immediately recognized in earnings in the consolidated statements of operations. The interest rate swaps effectively convert $187.5 million of our variable rate term loan to a fixed rate of 0.8525% through April 2017, and then increases to $250.0 million in April 2017 with a maturity date in January 2020 with a fixed rate of 1.05% (in both cases the swapped fixed rate is exclusive of the credit spread under the Credit Agreement). Based on HSNi's leverage ratio as of December 31, 2016, the all-in fixed rate was 2.3525%. The changes in fair value of the interest rate swap (inclusive of reclassifications to net income) were income of $2.3 million and a loss of $0.2 million, net of tax, for the years ended December 2016 and 2015, and were included in other comprehensive income (loss). The fair value of the interest rate swaps at December 31, 2016 was $3.6 million and was recorded in "Other non-current assets." The fair value of the interest rate swap liability as of December 31, 2015 was $0.2 million and was recorded in "Other long-term liabilities" in the consolidated balance sheets. As of December 31, 2016, HSNi estimates that less than $0.1 million of unrealized losses included in accumulated other comprehensive income (loss) related to these swaps will be realized and reported in earnings within the next twelve months. See Note 9 for discussion of the fair value measurements concerning these interest rate swaps. NOTE 9-FAIR VALUE MEASUREMENTS Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Fair value assumptions are made at a specific point in time and changes in underlying assumptions could significantly affect these estimates. HSNi applies the following framework for measuring fair value which is based on a three-level hierarchy: Level 1-Valuations based on quoted prices for identical assets and liabilities in active markets. Level 2-Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data. Level 3-Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment. The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short maturity of these items. The following table summarizes the fair value of HSNi's other financial assets and liabilities which are measured at fair value on a recurring basis in the consolidated balance sheets (in thousands): HSNi's interest rate swaps were carried on the balance sheet at fair value as of December 31, 2016 and December 31, 2015. The swaps were entered into for the purpose of hedging the variability of interest expense and interest payments on HSNi's long-term variable rate debt. The fair value is based on a valuation model which utilizes interest rate yield curves and credit spreads as the significant inputs to the model. These inputs are observable in active markets (level 2 criteria). HSNi considers credit risk associated with its own standing as well as the credit standing of any counterparties involved in the valuation of its financial instruments. The following table summarizes the fair value of HSNi’s financial assets and liabilities which are carried at cost (in thousands): The fair value of the term loan was estimated by discounting expected cash flows at the rates currently offered to HSNi for debt of the same remaining maturities (level 2 criteria). HSNi assesses the impairment of goodwill and indefinite-lived intangible assets at fair value at least annually during the fourth quarter and whenever events or circumstances indicate that the carrying value may not be fully recoverable. HSNi also measures certain assets, such as property and equipment and definite-lived intangible assets, at fair value on a non-recurring basis. These assets are recognized at fair value if they are deemed to be impaired. At June 30, 2016, the assets and liabilities of Chasing Fireflies and TravelSmith were considered to be a disposal group held for sale. Therefore, the disposal group was measured at its fair value less the estimated costs to sell which resulted in a non-cash asset impairment charge of $20.4 million that was recognized during the second quarter. On September 8, 2016, Cornerstone completed the divestitures of Chasing Fireflies and TravelSmith and recorded a loss on sale of $10.8 million during the year ended December 31, 2016. The impairment charge and loss on sale were recorded within the Cornerstone segment and are included in "Loss on sale of businesses and asset impairments" expense in the accompanying consolidated statements of operations. See Note 20 for further discussion. During the third and fourth quarters of 2015, as a result of declines in operating performances at certain Cornerstone brands, HSNi performed quantitative assessments of certain intangible assets and concluded fair value adjustments were necessary. HSNi wrote off the remaining identified intangible assets related to its 2012 acquisition of Chasing Fireflies resulting in impairment charges totaling $6.7 million. The impairment charges were recorded within the Cornerstone segment and are included in "Loss on sale of businesses and asset impairments" expense in the accompanying consolidated statements of operations. The fair value of the intangible assets, consisting of trademarks and tradenames, was determined using the relief from royalty method. Key inputs used in this calculation included revenue growth, discount, royalty and terminal growth rates. NOTE 10-EARNINGS PER SHARE HSNi computes basic earnings per share using the weighted average number of common shares outstanding for the period. HSNi computes diluted earnings per share using the treasury stock method, which includes the weighted average number of common shares outstanding for the period plus the potential dilution that could occur if various equity awards to issue common stock were exercised or restricted equity awards were vested resulting in the issuance of common stock that could share in HSNi’s earnings. Basic Earnings Per Share For the years ended December 31, 2016, 2015 and 2014, basic earnings per share was computed using the number of weighted average shares of common stock outstanding and assumed to be outstanding for the period. Diluted Earnings Per Share For the years ended December 31, 2016, 2015 and 2014, diluted earnings per share was computed using the number of shares of common stock outstanding and assumed to be outstanding for the year and, if dilutive, the incremental common stock that HSNi would issue upon the assumed exercise of stock options and stock appreciation rights and the vesting of restricted stock units using the treasury stock method. The following table presents HSNi’s basic and diluted earnings per share (in thousands, except per share data): NOTE 11-STOCK-BASED AWARDS Stock-based compensation expense is included in the following line items in the accompanying consolidated statements of operations (in thousands): As of December 31, 2016, there was approximately $22.9 million of unrecognized compensation cost, net of estimated forfeitures, related to all equity-based awards, which is currently expected to be recognized on a straight-line basis over a weighted average period of approximately 1.9 years. Second Amended and Restated 2008 Stock and Annual Incentive Plan The Second Amended and Restated 2008 Stock and Annual Incentive Plan, as amended (the “Plan”), authorizes the issuance of 8.0 million shares (8.8 million shares after giving effect to the anti-dilution provisions of the Plan related to the special cash dividend) of HSNi common stock for new awards granted by HSNi. The purpose of the Plan is to assist HSNi in attracting, retaining and motivating officers, employees, directors and consultants, and to provide HSNi with the ability to provide incentives more directly linked to the profitability of HSNi’s business and increases in shareholder value. In connection with the special cash dividend of $10.00 per common share paid on February 19, 2015, and as required by the anti-dilution provisions of the Plan, adjustments were made to outstanding equity awards as of the ex-dividend date to preserve their value following the dividend, as follows: (i) the number of shares subject to outstanding restricted stock units was increased as a result of the reinvestment of the dividend; and (ii) the exercise prices of outstanding stock options and stock appreciation rights and the grant date fair value of market stock units were reduced and the number of shares subject to such awards was increased. These adjustments did not result in additional stock-based compensation expense as the fair value of the outstanding awards did not change. As further required by the Plan, the maximum number of shares issuable under the Plan was also proportionally adjusted, which resulted in approximately 0.8 million additional shares available to be issued. As of December 31, 2016, there were approximately 1.7 million shares of common stock available for grants under the Plan. HSNi can grant restricted stock, restricted stock units ("RSUs"), market stock units ("MSUs"), performance share units ("PSUs"), stock options, stock appreciation rights (“SARs”), dividend equivalents and other stock-based awards under the Plan. Stock-based awards have a maximum term of 10 years. The exercise price of options and SARs granted under the Plan is required to be at, or above, the fair market value of HSNi’s stock on the date of grant. RSUs and PSUs have rights to receive dividend equivalents that vest at the same time the underlying awards vest once the requisite service has been rendered. HSNi elects to issue shares of its common stock for RSU vestings and SAR exercises net of the employees’ minimum tax withholding obligation. The payments made by HSNi to the taxing authorities for these taxes were $3.3 million, $16.7 million and $12.7 million for the years ended December 31, 2016, 2015 and 2014, respectively. Restricted Stock Units RSUs are awards that are denominated in a hypothetical equivalent number of shares of HSNi’s common stock. At the time of grant, HSNi determines if the RSUs will be settled in cash, stock or both. The value to the holder of the RSU is based upon the market value of HSNi’s stock when the RSUs vest. Compensation expense for RSUs granted under the Plan is measured at the grant date as the fair market value of HSNi’s common stock and expensed ratably over the vesting term. The RSUs are generally subject to service-based vesting over a term of 3 years to 5 years. A summary of the status of the nonvested RSUs and dividend equivalents, as of December 31, 2016 and changes during the year ended December 31, 2016 is as follows: The weighted average per share fair value of RSUs granted during the years ended December 31, 2016, 2015 and 2014 based on market prices of HSNi’s common stock on the grant date was $44.16, $65.89 and $55.06, respectively. The total fair value of RSUs that vested during the years ended December 31, 2016, 2015 and 2014 and settled in HSNi common stock was $6.6 million, $12.0 million and $10.9 million, respectively. HSNi realizes a tax benefit for RSUs held by its employees in the year in which the award vests. The tax benefit realized by HSNi related to RSUs was approximately $3.4 million, $5.4 million and $4.2 million for the years ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, there was approximately $16.7 million of unrecognized compensation cost, net of estimated forfeitures, related to RSUs, which is currently expected to be recognized on a straight-line basis over a weighted average period of approximately 2.1 years. Stock Options and SARs SARs are similar to traditional stock options, except, upon exercise, holders of SARs will only receive a value equal to the spread between the current market price per share of the common stock and the exercise price. The SARs granted by HSNi may be settled in cash or common stock of HSNi, in the sole discretion of HSNi. All SARs exercised by employees of HSNi have been settled in stock. For all SARs currently outstanding, HSNi intends to settle these awards in stock upon exercise. The exercise price for awards granted under the Plan is required to be priced at, or above, the fair market value of HSNi’s stock at the date of grant. Awards typically vest ratably over a term of 3 years. A summary of the status of the outstanding stock options and SARs as of December 31, 2016 is as follows: The aggregate intrinsic value in the table above represents the pre-tax difference between the closing price of HSNi’s common stock on December 31, 2016 of $34.30 and the exercise price for all “in the money” awards at December 31, 2016. This amount changes based on the fair market value of HSNi’s common stock. The intrinsic value of the stock options and SARs exercised during the years ended December 31, 2016, 2015 and 2014 was approximately $0.8 million, $44.4 million and $23.4 million, respectively. Cash received from stock option exercises for the years ended December 31, 2016, 2015 and 2014 was $0.2 million, $15.0 million, and $0.6 million, respectively. The tax benefit realized from stock option exercises for the years ended December 31, 2016, 2015 and 2014 was $0.3 million, $12.2 million, and $8.8 million, respectively. The fair value of each stock option and SAR award, which HSNi intends to settle in stock, is estimated on the grant date using the Black-Scholes option pricing model. The Black-Scholes option pricing model incorporates various assumptions, including expected volatility and expected term. Expected stock price volatilities are estimated based on HSNi's historical volatility and the historical and implied volatilities of comparable publicly-traded companies. The risk-free interest rates are based on U.S. Treasury yields for notes with comparable terms as the awards in effect at the grant date. The expected term of options and SARs granted is based on an analysis of historical employee termination rates and option exercise patterns, giving consideration to expectations of future employee behavior. Dividends yields are estimated based on HSNi's historical and anticipated dividend payments. The weighted average assumptions used in the Black-Scholes option pricing model are as follows: The weighted average fair values of stock options and SARs granted from the Plan during the years ended December 31, 2016, 2015 and 2014 at market prices equal to HSNi’s common stock on the grant date were $7.31, $13.65, and $15.24, respectively. At the date of the Spin-off, HSNi granted stock options to its Chief Executive Officer at exercise prices greater than market value on the date of grant with a term of 10 years. The weighted average exercise price and the weighted average fair value for the 373,000 stock options that were outstanding as of December 31, 2016 were $38.89 and $3.01, respectively. All other awards granted under the Plan have exercise prices based on the fair market value of HSNi’s common stock at the date of grant. As of December 31, 2016, there was approximately $6.2 million of unrecognized compensation cost, net of estimated forfeitures, related to stock options and SARs, which is currently expected to be recognized on a straight-line basis over a weighted average period of approximately 1.3 years. The following table summarizes the information about stock options and SARs outstanding and exercisable as of December 31, 2016: Performance-Based Awards During the third quarter of 2013, HSNi granted approximately 116,000 MSUs (after giving effect to the anti-dilution provisions of the Plan related to the special cash dividend) to its Chief Executive Officer. The MSUs vest over performance periods of 3 years and 5 years (50% for each period). Payout percentages range between 0% and 200% of the target award depending on the awards' market condition, the future price of HSNi's stock at the end of each performance period as compared to HSNi's stock price at the date of grant (as defined in the MSU agreement). The fair value of the MSUs at the grant date was $8.3 million, or an average of $82.67 per unit, and is recognized on a graded-vested basis over the performance periods. The fair value was measured on the grant date by applying a Monte Carlo simulation pricing model which estimates the potential outcome of reaching the market condition based on simulated future stock prices. The weighted average assumptions used in the valuation of the MSUs were the following: volatility factor of 39.7%, risk-free interest rate of 1.00%, expected term of 4.0 years and dividend yield of 1.1%. The fair value of the MSUs that vested during the year ended December 31, 2016 and settled in HSNi common stock was $2.4 million. During the years ended December 31, 2016, 2015 and 2014, HSNi granted performance-based awards to certain executive employees which vest over a three-year performance period. The awards vest between 0% and 200% of the target award based on the company's Total Shareholder Return relative to an indexed peer group. For the year ended December 31, 2016, HSNi granted these awards using PSUs which represent a right to receive shares of HSNi common stock. For the years ended December 31, 2015 and 2014, HSNi granted these awards using a similar performance metric but they will be settled in cash. The aggregate target value of the performance-based awards granted during the years ended December 31, 2016, 2015 and 2014 was $5.0 million, $5.2 million and $4.4 million, respectively, with grant date fair value of $5.0 million, $4.9 million and $3.8 million, respectively, measured using a Monte-Carlo simulation. The compensation expense for these PSUs is based on the fair value of the awards measured at the grant date and is expensed ratably over the vesting term. Performance cash awards are accounted for as liability-based awards as they will be settled in cash. The compensation expense for the cash awards is remeasured at the end of each reporting period. As of December 31, 2016 and 2015, a liability of $0.7 million and $2.3 million, respectively, was recorded for these awards. A summary of the status of the nonvested MSUs, PSUs and dividend equivalents, as of December 31, 2016 and changes during the year ended December 31, 2016 is as follows: (a) Shares granted are based on the achievement of certain performance criteria and represent the maximum number of shares that can vest (200%). Employee Stock Purchase Plan The HSN, Inc. 2010 Employee Stock Purchase Plan (“ESPP”) was approved May 2010 and 750,000 shares of HSNi common stock were reserved for issuance under the ESPP. The ESPP permits employees to purchase shares of HSNi’s common stock during semi-annual purchase periods. Under the terms of the ESPP, eligible employees accumulate funds through payroll deductions and purchase shares at a price equal to the lesser of 85% of the fair market value of the common stock at the grant date or purchase date. All shares purchased under the ESPP must be held for a period of 6 months. For the year ended December 31, 2016, HSNi granted approximately 62,000 options under the ESPP. The fair value of each option granted under the ESPP is determined on the grant date using the Black-Scholes option pricing model. The following are the weighted average assumptions used in the valuation of the ESPP options for the years ended December 31, 2016 and 2015: For the years ended December 31, 2016, 2015 and 2014, approximately $0.6 million, $0.6 million and $0.5 million, respectively, of expenses related to the ESPP were included in the consolidated statements of operations. For the years ended December 31, 2016, 2015 and 2014, HSNi received cash proceeds from the participating employees of approximately $2.2 million, $2.4 million and $2.0 million, respectively. Restricted Common Equity in Cornerstone Brands In connection with the acquisition of Cornerstone Brands by IAC in 2005 certain members of Cornerstone Brand’s management were granted restricted common equity in Cornerstone Brands. These awards were granted on April 1, 2005 and were initially measured at fair value, which was amortized to expense over the vesting period. These awards vested ratably over 4 years, or earlier based upon the occurrence of certain prescribed events. The awards vested in non-voting restricted common shares of Cornerstone Brands. As of December 31, 2016, these awards were significantly out of the money and are not expected to result in any cost should HSNi exercise its call right. NOTE 12-INCOME TAXES The components of the provision for income taxes are as follows (in thousands): Current income taxes payable has been reduced by $3.8 million, $17.5 million, and $12.9 million for the years ended December 31, 2016, 2015 and 2014, respectively, for tax deductions attributable to stock-based compensation. The related income tax benefits of this stock-based compensation were recorded as amounts charged or credited to the income tax provision and additional paid-in capital. The tax effects of cumulative temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2016 and 2015 are presented below (in thousands). The valuation allowance is related to items for which it is more likely than not that the tax benefit will not be realized. At December 31, 2016, HSNi had $5.3 million of net operating loss carryforwards which begin expiring in 2017. HSNi had a valuation allowance of approximately $0.5 million as of December 31, 2016 and 2015. Valuation allowances are recorded for deferred tax assets related to separate state net operating losses. A reconciliation of the income tax provision to the amounts computed by applying the statutory federal income tax rate to earnings before income taxes is shown as follows (in thousands): A reconciliation of the beginning and ending amount of unrecognized tax benefits, excluding interest, is as follows (in thousands): As of December 31, 2016 and 2015, the unrecognized tax benefits, including interest, were $5.4 million and $4.1 million, respectively. At December 31, 2016 and 2015, there are approximately $4.6 million and $3.3 million of unrecognized tax benefits that, if recognized, would affect the annual effective tax rate. HSNi recognizes interest and, if applicable, penalties related to unrecognized tax benefits in income tax expense. There is no material interest on unrecognized tax benefits included in income tax expense for the years ended December 31, 2016, 2015 and 2014. At December 31, 2016 and 2015, HSNi has no material accrual for the payment of interest or penalties. HSNi believes that it is reasonably possible that its unrecognized tax benefits could decrease by an immaterial amount within twelve months of the current reporting date due to settlement with the taxing authority. HSNi is routinely under audit by federal, state, local and foreign tax authorities. These audits include questioning the timing and the amount of deductions and the allocation of income among various tax jurisdictions. Income taxes payable include amounts considered sufficient to pay assessments that may result from examination of prior year returns; however, the amount paid upon resolution of issues raised may differ from the amount provided. Differences between the reserves for tax contingencies and the amounts owed by HSNi are recorded in the period they become known. The Internal Revenue Service ("IRS") has examined HSNi's consolidated federal income tax return for the year ended December 31, 2010 and performed a limited scope examination of HSNi's consolidated federal income tax return for the year ended December 31, 2011. No material adjustments resulted from these IRS examinations. New York State has completed it’s examination of income tax returns for the periods ended December 31, 2011 through December 31, 2013 without a material adjustment. The State of Florida has begun an income tax examination of HSNi’s tax returns for the years ended December 31, 2013 through December 31, 2015. HSNi does not anticipate any material adjustments to our tax liabilities resulting from this examination. HSNi and several companies previously owned by IAC/InterActiveCorp, or IAC, were spun-off from IAC on August 20, 2008. In connection with the Spin-off, HSNi entered into a Tax Sharing Agreement with IAC. Pursuant to this agreement, each of the companies included in the Spin-off ("Spincos") was indemnified by IAC for additional tax liabilities related to consolidated or combined federal and state tax returns prepared and filed by IAC prior to the Spin-off. However, each Spinco agreed to, among other things, assume any additional tax liabilities related to their separately filed state income tax returns. All examinations have concluded or statutes of limitations have expired related to IAC's consolidated or combined federal and state tax returns for years including HSNi operations prior to the Spin-off. The Tax Sharing Agreement also provides, among other things, that each Spinco indemnifies IAC and the other Spincos for any taxes resulting from the Spin-off of such Spinco (and any related interest, penalties, legal and professional fees, and all costs and damages associated with related shareholder litigation or controversies) to the extent such amounts result from any post Spin-off (i) act or failure to act by such Spinco described in the covenants in the Tax Sharing Agreement, (ii) acquisition of equity, securities, or assets of such Spinco or a member of its group, and (iii) breach by such Spinco or any member of its group of any representation or covenant contained in the separation documents or in the documents relating to the IRS private letter ruling and/or tax opinions. This indemnification remains effective until IAC's tax returns for the two year period after the Spin-off are no longer subject to examination. NOTE 13-COMMITMENTS AND CONTINGENCIES In the ordinary course of business, HSNi is a party to various audits, claims and lawsuits. These audits or litigation may relate to claims involving property, personal injury, contract, intellectual property (including patent infringement), sales tax, regulatory compliance, employment matters and other claims. HSNi establishes reserves for specific legal, tax or other compliance matters that it has determined the likelihood of an unfavorable outcome is probable and the loss is reasonably estimable. Management has also identified certain legal, tax or other matters where it believes an unfavorable outcome is not probable and, therefore, no reserve is established. Although management currently believes that an unfavorable resolution of claims against HSNi, including claims where an unfavorable outcome is reasonably possible, will not have a material impact on its liquidity, results of operations, financial condition or cash flows, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future and an unfavorable resolution of such a proceeding could have a material impact. Moreover, any claims or regulatory actions against HSNi, whether meritorious or not, could be time-consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. HSNi leases a satellite transponder, warehouse, stores and office space, equipment and services used in connection with its operations under various operating leases, many of which contain escalation clauses. Future minimum payments under operating lease agreements are as follows (in thousands): Expenses charged under these agreements were $27.9 million, $27.1 million, and $25.1 million for the years ended December 31, 2016, 2015 and 2014, respectively, and were included in "General and administrative" expense in the accompanying consolidated statements of operations. HSNi also has funding commitments that could potentially require its performance in the event of demands by third parties or contingent events, as follows (in thousands): The letters of credit (“LOCs”) primarily consist of trade LOCs, which are used for inventory purchases. Trade LOCs are guarantees of payment based upon the delivery of goods. The surety bonds primarily consist of customs bonds, which relate to the import of merchandise into the United States. The purchase obligations primarily relate to cable contracts and include obligations for future cable distribution and commission guarantees. NOTE 14-RELATED PARTY TRANSACTIONS Relationship Between Liberty Media Corporation and HSNi Spinco Agreement In connection with the Spin-off, pursuant to a Spinco Assignment and Assumption Agreement (the “Spinco Agreement”), dated as of August 20, 2008, among HSNi, IAC, Liberty Media Corporation (“Liberty”) and a subsidiary of Liberty that held shares of IAC common stock and IAC Class B common stock (together with Liberty, the “Liberty Parties”), HSNi (i) assumed from IAC all rights and obligations providing for post-Spin-off governance and other arrangements at HSNi under the Spinco Agreement, dated May 13, 2008, among IAC, Liberty and affiliates of Liberty that held shares of IAC common stock and/or Class B common stock at the time such Spinco Agreement was entered into, and (ii) as required by the Spinco Agreement, entered into a registration rights agreement with the Liberty Parties. Following is a summary of the material terms of the Spinco Agreement: Representation of Liberty on the Spinco Boards of Directors The Spinco Agreement generally provides that so long as Liberty beneficially owns securities of HSNi representing at least 20% of the total voting power of HSNi’s equity securities, Liberty has the right to nominate up to 20% of the directors serving on HSNi’s Board of Directors (rounded up to the nearest whole number). Any director nominated by Liberty must be reasonably acceptable to a majority of the directors on HSNi’s Board who were not nominated by Liberty. All but one of Liberty’s nominees serving on the Board of Directors must qualify as “independent” under applicable stock exchange rules. In addition, the Nominating Committee of the Board may include only “Qualified Directors,” namely directors other than any who were nominated by Liberty, are officers or employees of HSNi or were not nominated by the Nominating Committee of the HSNi Board in their initial election to the Board and for whose election any Liberty Party voted shares. Acquisition Restrictions The Liberty Parties have agreed not to acquire beneficial ownership of any equity securities of HSNi (with specified exceptions) unless: • the acquisition was approved by a majority of the Qualified Directors; • the acquisition is permitted under the provisions described in “Competing Offers” below; or • after giving effect to the acquisition, Liberty’s ownership percentage of the equity securities of HSNi, based on voting power, would not exceed the Applicable Percentage. The “Applicable Percentage” is Liberty’s ownership percentage upon the Spin-off of HSNi, based on voting power (approximately 30%), plus 5%, but in no event more than 35%. Notwithstanding the foregoing, Liberty’s beneficial ownership may increase (and has increased) above the Applicable Percentage as a result of HSNi’s share repurchase program. Following the Spin-off, the Applicable Percentage for the Spinco is reduced for specified transfers of equity securities of the Spinco by the Liberty Parties. During the first two years following the Spin-off, acquisitions by the Liberty Parties were further limited to specified extraordinary transactions and, otherwise, to acquisitions representing no more than one-third of HSNi Common Stock received by the Liberty Parties in the Spin-off: • transfers pursuant to a third party tender or exchange offer or in connection with any merger or other business combination, which merger or business combination has been approved by HSNi; • transfers in a public offering in a manner designed to result in a wide distribution, provided that no such transfer is made, to the knowledge of the Liberty Parties, to any person whose ownership percentage (based on voting power) of HSNi’s equity securities, giving effect to the transfer, would exceed 15%; • a transfer of all of the equity securities of HSNi beneficially owned by the Liberty Parties and their affiliates in a single transaction if the transferee’s ownership percentage (based on voting power), after giving effect to the transfer, would not exceed the Applicable Percentage and only if the transferee assumes all of the rights and obligations (subject to limited exceptions) of the Liberty Parties under the Spinco Agreement; • specified transfers in connection with changes in the beneficial ownership of the ultimate parent company of a Liberty Party or a distribution of the equity interests of a Liberty Party or certain similar events; and • specified transfers relating to certain hedging transactions or stock lending transactions in respect of the Liberty Parties’ equity securities in HSNi, subject to specified restrictions. Competing Offers During the period when Liberty continues to have the right to nominate directors to HSNi’s Board of Directors, if the Board of Directors determines to pursue certain types of transactions on a negotiated basis (either through an “auction” or with a single bidder), Liberty is granted certain rights to compete with the bidder or bidders, including the right to receive certain notices and information, subject to specified conditions and limitations. In connection with any such transaction that HSNi is negotiating with a single bidder, the Board of Directors must consider any offer for a transaction made in good faith by Liberty but is not obligated to accept any such offer or to enter into negotiations with Liberty. If a third party (x) commences a tender or exchange offer for at least 35% of the capital stock of HSNi other than pursuant to an agreement with HSNi or (y) publicly discloses that its ownership percentage (based on voting power) exceeds 20% and HSNi’s Board fails to take certain actions to block such third party from acquiring an ownership percentage of HSNi (based on voting power) exceeding the Applicable Percentage, the Liberty Parties generally will be relieved of the obligations described under “Standstill Restrictions” and “Acquisition Restrictions” above to the extent reasonably necessary to permit Liberty to commence and consummate a competing offer. If Liberty’s ownership percentage (based on voting power) as a result of the consummation of a competing offer in response to a tender or exchange offer described in (x) above exceeds 50%, any consent or approval requirements of the Qualified Directors in the Spinco Agreement will be terminated, and, following the later of the second anniversary of the Spin-off and the date that Liberty’s ownership percentage (based on voting power) exceeds 50%, the obligations described under “Acquisition Restrictions” will be terminated. Other Following the Spin-off, amendments to the Spinco Agreement and determinations required to be made thereunder (including approval of transactions between a Liberty Party and HSNi that would be reportable under the proxy rules) will require the approval of the Qualified Directors. Registration Rights Agreement Under the registration rights agreement, the Liberty Parties and their permitted transferees (the “Holders”) will be entitled to three demand registration rights (and unlimited piggyback registration rights) in respect of the shares of HSNi common stock received by the Liberty Parties as a result of the Spin-off and other shares of HSNi common stock acquired by the Liberty Parties consistent with the Spinco Agreement (collectively, the “Registrable Shares”). The Holders will be permitted to exercise their registration rights in connection with certain hedging transactions that they may enter into with respect to the Registrable Shares. HSNi will be obligated to indemnify the Holders, and each selling Holder will be obligated to indemnify HSNi, against specified liabilities in connection with misstatements or omissions in any registration statement. NOTE 15-SUPPLEMENTAL CASH FLOW INFORMATION Supplemental Disclosure of Cash Flow Information: NOTE 16-SHAREHOLDERS’ EQUITY Stock Purchase Rights In December 2008, HSNi’s Board of Directors approved the creation of a Series A Junior Participating Preferred Stock, adopted a shareholders rights plan and declared a dividend of one right for each outstanding share of common stock held by our shareholders of record as of the close of business on January 5, 2009. The rights attached to any additional shares of common stock issued after January 5, 2009. Initially, these rights, which trade with the shares of HSNi’s common stock, will not be exercisable. Under the rights plan, these rights will be exercisable if a person or group acquires or commences a tender or exchange offer for 15% or more of HSNi’s common stock (except for certain grandfathered persons, such as Liberty, to which higher thresholds apply). If the rights become exercisable, each right will permit its holder, other than the “acquiring person,” to purchase from us shares of common stock at a 50% discount to the then prevailing market price. As a result, the rights will cause substantial dilution to a person or group that becomes an “acquiring person” on terms not approved by HSNi’s Board of Directors. Accumulated Other Comprehensive (Loss) Income Accumulated other comprehensive income (loss) includes the cumulative gains and losses of derivative instruments that qualify as cash flow hedges. The following table provides a rollforward of accumulated other comprehensive income (loss) for the years ended December 31, 2016, 2015 and 2014 (in thousands): Share Repurchase Program On September 27, 2011, HSNi’s Board of Directors approved a share repurchase program which allowed HSNi to purchase 10 million shares of its common stock from time to time through privately negotiated and/or open market transactions. In July 2014, HSNi completed its 10 million share repurchase program at an aggregate cost of $451.0 million, representing an average cost of $45.10 per share. All shares were immediately retired upon purchase. Effective January 27, 2015, HSNi's Board of Directors approved a new share repurchase program which allows HSNi to purchase up to 4 million shares of its common stock from time to time through privately negotiated and/or open market transactions. The timing of repurchases and actual number of shares repurchased depends on a variety of factors, including the stock price, corporate and regulatory requirements, restrictions under HSNi’s debt obligations and other market and economic conditions. As of December 31, 2016, approximately 2.7 million shares remained authorized for repurchase under the program. The following table summarizes HSNi's share repurchase activity (in thousands, except per share data): Dividend Policy During the year ended December 31, 2016, HSNi's Board of Directors approved four quarterly cash dividends totaling $1.40 per common share resulting in dividend payments of approximately $73.2 million. During the year ended December 31, 2015, HSNi’s Board of Directors approved four quarterly cash dividends totaling $1.40 per common share and a special cash dividend of $10.00 per common share that was payable February 19, 2015 resulting in aggregate dividend payments of approximately $597.9 million. In February 2017, HSNi's Board of Directors approved a quarterly cash dividend of $0.35 per common share. The dividend will be paid March 22, 2017 to HSNi's record holders as of March 8, 2017. NOTE 17-QUARTERLY RESULTS (UNAUDITED) (a) The results of TravelSmith and Chasing Fireflies are included through the date of divestitures on September 8, 2016. (b) The second quarter of 2016 includes an asset impairment charge of $20.4 million, or $0.24 per diluted share, related to the TravelSmith and Chasing Fireflies disposal group. The second quarter of 2015 includes $3.0 million, or $0.03 per diluted share, for certain costs associated with the planned closure of one of HSN's distribution centers as part of its supply chain optimization initiative. (c) The third quarter of 2016 includes the loss on sale of $11.2 million, or $0.13 per diluted share, related to the divestitures of TravelSmith and Chasing Fireflies. The third quarter of 2015 includes a non-cash charge of $5.0 million, or $0.06 per diluted share, at Cornerstone for impairment of intangible assets related to Chasing Fireflies. (d) The fourth quarter of 2016 includes the impact of the supply chain optimization implementation issues which decreased gross profit by approximately $13.0 million and increased operating expenses by approximately $3.0 million, having a combined impact of $0.19 per diluted share. The fourth quarter of 2015 includes $2.0 million, or $0.02 per diluted share, of severance costs associated with a reorganization at HSN. (e) Cornerstone's fourth quarter of 2016 consisted of 14-weeks compared to 13-weeks in the prior year resulting in an additional $15 million in net sales in 2016. NOTE 18-RETIREMENT AND SAVINGS PLANS Effective December 31, 2008, HSNi established the HSN, Inc. Retirement Savings Plan that qualifies under Section 401(k) of the Internal Revenue Code. Participating employees may contribute up to 50% of their pretax salary, up to the statutory limits. For the years ended December 31, 2016, 2015 and 2014, HSNi contributed fifty cents for each dollar a participant contributed of the first 6% of a participant's deferrals. HSNi’s matching contributions were $5.1 million, $5.0 million and $4.6 million for the years ended December 31, 2016, 2015 and 2014, respectively. Effective January 1, 2014, HSNi initiated a nonqualified deferred compensation plan allowing salary and annual bonus deferrals for qualifying employees as permitted by the Internal Revenue Code. Participant deferrals earn investment returns based on a select number of investment options, including equity and debt mutual funds. HSNi invested comparable amounts in marketable securities through life insurance policies to mitigate the risk associated with the investment return on the employee deferrals. Assets related to the funded portion of the deferred compensation plan are held in a rabbi trust which remains subject to claims of HSNi's general creditors. HSNi remains liable to the participants for the unfunded portion of the plan. HSNi records changes in the fair value of the asset and liability in the statement of operations. As of December 31, 2016 and 2015, the company-owned life insurance policies had a cash surrender value of $3.6 million and $1.9 million, respectively and were recorded in "Other non-current assets" in the consolidated balance sheet. The Plan's deferred compensation liability as of December 31, 2016 and 2015 was $3.6 million and $2.0 million, respectively and was recorded in "Other long-term liabilities" in the consolidated balance sheet. NOTE 19-COSTS ASSOCIATED WITH AN EXIT ACTIVITY As part of its supply chain optimization initiative, HSNi announced in June 2015 its plan to close the HSN distribution center in Roanoke, Virginia and expand the capabilities of its distribution center in Piney Flats, Tennessee. The closure will involve the eventual elimination of approximately 350 positions at the Virginia facility. HSNi expects the closure to occur in accordance with a two-year transition plan and be substantially completed in 2017. HSN expects to incur approximately $4 million to $5 million in total charges related to the closure. These charges include approximately $3 million to $4 million in employee-related expenses, including severance payments and retention incentives. During the years ended December 31, 2016 and 2015, HSN recognized $0 and $3.2 million, respectively, in employee-related costs which are included in "General and administrative” operating expenses in the accompanying consolidated statements of operations. A summary of HSNi’s liability associated with exit activities, which is recorded in “Accrued expenses and other current liabilities” in the accompanying consolidated balance sheets, are presented in the following table (in thousands): NOTE 20-DIVESTITURES On September 8, 2016, HSNi completed the sale of substantially all of the assets and certain liabilities of Chasing Fireflies and TravelSmith, two of the apparel brands included within the Cornerstone segment. The sale price included $1 million in cash and $2 million of contingent consideration that was based on the achievement of certain performance metrics in 2016 which are not expected to be achieved. During the year ended December 31, 2016, Cornerstone recorded a pre-tax loss on sale of $10.8 million. The transaction included cash charges of approximately $3.5 million related to transactions costs and employee and lease liabilities. The assets and liabilities of the two brands were classified as held for sale as of June 30, 2016 which resulted in a non-cash asset impairment charge of $20.4 million recorded in the second quarter of 2016 within the Cornerstone segment and was included in "Loss on sale of businesses and asset impairments" expense in the accompanying consolidated statements of operations. The loss on sale and asset impairment charges related to this sale are recorded in the consolidated statements of operations in the line item “Loss on sale of businesses and asset impairments.” The assets sold were largely represented by $29.3 million of inventory and $8.4 million of other assets, and approximately $8.6 million of current liabilities. HSNi entered into a transition services agreement with the buyer to provide fulfillment services and various back office support services through February 2017. Charges by HSNi under this transition services agreement of approximately $4.7 million for the year ended December 31, 2016 are recorded in net sales in the consolidated statements of operations. HSNi determined the sale of these businesses would not represent a strategic shift in its business nor will it have a major effect on its consolidated results of operations, financial position or cash flows. Accordingly, the disposal group is not presented in the consolidated financial statements as a discontinued operation. Schedule II HSN, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In thousands) (1) Write-off of uncollectible accounts receivable
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I apologize, but the text you've provided appears to be a fragmented and incomplete financial statement excerpt. It contains partial information about various accounting aspects like inventories, expenses, assets, and liabilities, but lacks a comprehensive overview.
From the available text, I can extract a few key points:
1. Inventories:
- Primarily consist of finished goods
- Valued at lower of cost or market
- Uses first-in, first-out (FIFO) method
- Cost includes inbound freight, duties, and some warehouse costs
2. Accounting Practices:
- Writes off uncollectible accounts receivable
- Implemented ASU 2015 accounting standard update
- Reclassified some financial statement presentations
However, without the full financial statement, I cannot provide a meaningful summary of the company's overall financial performance, profit/loss, or comprehensive financial condition.
Would you be able to
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Claude
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Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements Board of Directors and Stockholders U.S. Global Investors, Inc. San Antonio, Texas We have audited the accompanying Consolidated Balance Sheets of U.S. Global Investors, Inc. (the “Company”) as of June 30, 2016 and 2015 and the related Consolidated Statements of Operations, Comprehensive Income (Loss), Shareholders’ Equity, and Cash Flows for each of the three years in the period ended June 30, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of U.S. Global Investors, Inc. at June 30, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2016, in conformity with accounting principles generally accepted in the United States of America. /s/ BDO USA, LLP BDO USA, LLP Dallas, Texas September 14, 2016 U.S. GLOBAL INVESTORS, INC. CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these consolidated financial statements. U.S. GLOBAL INVESTORS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these consolidated financial statements. U.S. GLOBAL INVESTORS, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) The accompanying notes are an integral part of these consolidated financial statements. U.S. GLOBAL INVESTORS, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY The accompanying notes are an integral part of these consolidated financial statements. U.S. GLOBAL INVESTORS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these consolidated financial statements. NOTE 1. ORGANIZATION U.S. Global Investors, Inc. (the “Company” or “U.S. Global”) serves as investment adviser to U.S. Global Investors Funds (“USGIF” or the “Fund(s)”), a Delaware statutory trust that is a no-load, open-end investment company offering shares in numerous mutual funds to the investing public. The Company also provides administrative services to USGIF. For these services, the Company receives fees from USGIF. It also provided to USGIF transfer agent functions through December 6, 2013, and distribution services through December 9, 2015. The Company also provides advisory services to offshore clients and an SEC registered exchange traded fund (“ETF”). Effective June 1, 2014, the Company holds a controlling interest in Galileo Global Equity Advisors Inc. (“Galileo”), a privately held Toronto-based asset management firm. See Note 2 Significant Accounting Policies and Note 18 Business Combination for additional information on the acquisition of controlling interest of Galileo. U.S. Global formed the following companies to provide transfer agent and distribution services to USGIF: United Shareholder Services, Inc. (“USSI”) and U.S. Global Brokerage, Inc. (“USGB”). USSI, which ceased operations in fiscal 2014, was legally dissolved in December 2015. USGB ceased operations in December 2015 as discussed in Note 3. The Company formed three subsidiaries utilized primarily for corporate investment purposes: U.S. Global Investors (Guernsey) Limited (“USGG”), incorporated in Guernsey (on August 3, 2013, USGG was dissolved); U.S. Global Investors (Bermuda) Limited (“USBERM”), incorporated in Bermuda; and U.S. Global Investors (Canada) Limited (“USCAN”), formed in March 2013. In July 2013, the Company created U.S. Global Indices, LLC, a Texas limited liability company, of which the Company is the sole member, to provide indexing services to exchange-traded funds managed by the Company. NOTE 2. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries: USSI, USGB, USGG, USBERM, USCAN and U.S. Global Indices, LLC. In addition, effective June 1, 2014, the Company, through USCAN, completed its purchase of an additional 15 percent interest in Galileo from the company’s founder, Michael Waring. This strategic investment brought USCAN’s ownership to 65 percent of the issued and outstanding shares of Galileo, which represents controlling interest of Galileo. Galileo is consolidated with USCAN and the non-controlling interest in this subsidiary is included in “non-controlling interest in subsidiary” in the equity section of the Consolidated Balance Sheets. See Note 18 Business Combination for additional information. After the purchase of the additional interest, Galileo changed its fiscal year end from December 31 to June 30, effective June 30, 2014, to correspond to the Company’s year end. This change was treated as a change in accounting principle. The Company’s evaluation for consolidation includes whether entities in which it has an interest are variable interest entities (“VIEs”) and whether the Company is the primary beneficiary of any VIEs identified in its analysis. A VIE is an entity in which either (a) the equity investment at risk is not sufficient to permit the entity to finance its own activities without additional financial support or (b) the group of holders of the equity investment at risk lacks certain characteristics of a controlling financial interest. The primary beneficiary is the entity that has the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE. If the VIE qualifies for the investment company deferral, the primary beneficiary is the entity that has the obligation to absorb a majority of the expected losses or the right to receive the majority of the residual returns. The Company holds variable interests in, but is not deemed to be the primary beneficiary of, the funds it advises. The Company has determined that these entities qualify for the Investment Company deferral in ASC 810-10-65-2 (aa) and thus determines whether it is the primary beneficiary of these entities by virtue of its exposure to the expected losses and expected residual returns of the entity. The Company’s interests in these entities consist of the Company’s direct ownership therein, which in each case is insignificant to the total ownership of the fund, and any fees earned but uncollected. In the ordinary course of business, the Company may choose to waive certain fees or assume operating expenses of the funds it advises for competitive, regulatory or contractual reasons (see Note 5 Investment Management and Other Fees for information regarding fee waivers). The Company has not provided financial support to any of these entities outside the ordinary course of business. The Company’s risk of loss with respect to these managed entities is limited to the carrying value of its investments in, and fees receivable from, the entities. The Company does not consolidate these VIEs because it is not the primary beneficiary of these VIEs. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts have been reclassified for comparative purposes. Business Combinations. Business combinations are accounted for under the acquisition method of accounting. Results of operations of an acquired business are included from the date of acquisition. Management estimates the fair value of the acquired assets, including identifiable intangible assets, assumed liabilities, and non-controlling interest in the acquiree based on their estimated fair values as of the date of acquisition. Any excess acquisition date fair value of the consideration transferred over fair value of the acquired net assets, if any, is recorded as “goodwill” on the Consolidated Balance Sheets. Any excess fair value of the acquired net assets over the acquisition date fair value of the consideration transferred is recorded as a gain on the Consolidated Statements of Operations. Cash and Cash Equivalents. Cash and cash equivalents include highly liquid investments with original maturities of three months or less. Restricted Cash. Restricted cash represents cash invested in a money market account as collateral for the credit facility that is not available for general corporate use. Investments. The Company classifies its investments based on intent at the time of purchase and reevaluates such designation as of each reporting period date. The Company records security transactions on trade date. Realized gains (losses) from security transactions are calculated on the first-in/first-out cost basis, unless otherwise identifiable, and are recorded in earnings on the date of sale. Trading Securities. Securities that are purchased and held principally for the purpose of selling in the near term are classified as trading securities and reported at fair value. Unrealized gains and losses on these securities are included in Investment income (loss). Held-to-Maturity Securities. Debt securities that are purchased with the intent and ability to hold until maturity are classified as held-to-maturity and measured at amortized cost. The Company currently has no investments in held-to-maturity securities. Available-for-sale Securities. Securities that are neither trading securities nor held-to-maturity securities and for which the Company does not have significant influence are classified as available-for-sale securities and reported at fair value. Unrealized gains and losses on these available-for-sale securities are excluded from earnings, reported net of tax as a separate component of shareholders’ equity, and recorded in earnings on the date of sale. The Company evaluates its available-for-sale investments for other-than-temporary decline in value on a periodic basis. This may exist when the fair value of an investment security has been below the current value for an extended period of time. When a security in the Company’s investment portfolio has an unrealized loss in fair value that is deemed to be other than temporary, the Company reduces the book value of such security to its current fair value, recognizing the credit related decline as a realized loss in the Consolidated Statements of Operations and a revised GAAP cost basis for the security is established. For available-for-sale securities with declines in value deemed other than temporary, the unrealized loss recorded net of tax in accumulated other comprehensive income (loss) is realized as a charge to net income. Other Investments. Other investments consist of equity investments in entities over which the Company is unable to exercise significant influence and which do not have readily determinable fair values. These equity investments are accounted for under the cost method of accounting and evaluated for impairment. The Company considers many factors in determining impairment, including the severity and duration of the decline in value below cost, the Company’s interest and ability to hold the security for a period of time sufficient for an anticipated recovery in value, and the financial condition and specific events related to the issuer. Equity Method Investments. Investments classified as equity method consist of investments in companies in which the Company is able to exercise significant influence but not control. Under the equity method of accounting, the Company’s proportional share of investee’s underlying net income or loss is recorded as a component of “other income” with a corresponding increase or decrease to the carrying value of the investment. Distributions received from the investee reduce the Company’s carrying value of the investment. These investments are evaluated for impairment if events or circumstances arise that indicate that the carrying amount of such assets may not be recoverable. No impairment was recognized for the Company’s equity method investment during the years presented. No investments were held at June 30, 2016, or 2015 that are accounted for using the equity method. See Note 18 Business Combination for further information. Fair Value of Financial Instruments. The financial instruments of the Company are reported on the Consolidated Balance Sheets at market or fair values or at carrying amounts that approximate fair values. Receivables. Receivables other than notes receivable consist primarily of advisory and other fees owed to the Company by clients. Receivables also include advisory fees owed to Galileo by the funds and clients it manages. The Company also invests in notes receivable. Notes receivable are recorded in accordance with the terms of the agreement, and accrued interest is recorded when earned. The Company reviews the need for an allowance for credit losses for notes and other receivables based on various factors including payment history, historical bad debt experience, aging and specific accounts identified as high risk. Uncollectible receivables, if any, are charged against the allowance when all reasonable efforts to collect the amounts due have been exhausted. The Company had no allowance for credit losses as of June 30, 2016, or 2015. Property and Equipment. Fixed assets are recorded at cost. Except for Galileo, depreciation for fixed assets is recorded using the straight-line method over the estimated useful life of each asset as follows: furniture and equipment are depreciated over 3 to 10 years, and the building and related improvements are depreciated over 14 to 40 years. Galileo fixed assets, consisting of furniture, equipment and leasehold improvements, are depreciated over 2 to 5 years. Impairment of Long-Lived Assets. The Company reviews property and equipment and other long-lived assets for impairment whenever events or changes in business circumstances indicate the net book values of the assets may not be recoverable. Impairment is indicated when the assets’ net book value is less than fair value of the asset. If this occurs, an impairment loss is recognized for the difference between the fair value and net book value. Factors that indicate potential impairment include: a significant decrease in the market value of the asset or a significant change in the asset’s physical condition or use. No impairments of long-lived assets were recorded during the years included in these financial statements. Intangible Asset. An intangible asset, consisting of a non-compete agreement, acquired in connection with the acquisition of Galileo shares effective June 1, 2014, was recorded at fair value determined using a discounted cash flow model as of the date of acquisition. The discounted cash flow model included various factors to project future cash flows expected to be generated from the asset, including: (1) an estimated rate of change for underlying managed assets; (2) expected revenue per managed assets; (3) incremental operating expenses; and (4) a discount rate. Management estimated a rate of change for underlying managed assets based on an estimated net redemption or sales rate. Expected revenue per managed assets and incremental operating expenses of the acquired assets was generally based on contract terms. The Company determined that the non-compete agreement has a finite useful life. The Company amortized this finite-lived identifiable intangible asset on a straight-line basis over its estimated useful life of 2 years. Management periodically evaluates the remaining useful lives and carrying values of intangible assets to determine whether events and circumstances indicate that a change in the useful life or impairment in value may have occurred. Indicators of impairment monitored by management include a decline in the level of managed assets, changes to contractual provisions underlying the intangible assets and reductions in underlying operating cash flows. Should there be an indication of a change in the useful life or impairment in value of the finite-lived intangible asset, the Company compares the carrying value of the asset and its related useful life to the projected discounted cash flows expected to be generated from the underlying managed assets over its remaining useful life to determine whether impairment has occurred. If the carrying value of the asset exceeds the discounted cash flows, the asset is written down to its fair value determined using discounted cash flows. Non-Controlling Interests. The Company reports “non-controlling interest in subsidiary” as equity, separate from parent’s equity, on the Consolidated Balance Sheets. In addition, the Company’s Consolidated Statements of Operations includes “net income (loss) attributable to non-controlling interest.” Treasury Stock. Treasury stock purchases are accounted for under the cost method. The subsequent issuances of these shares are accounted for based on their weighted-average cost basis. Stock-Based Compensation. Stock-based compensation expense is measured at the grant date based on the fair value of the award, and the cost is recognized as expense ratably over the award’s vesting period. Income Taxes. The Company and its non-Canadian subsidiaries file a consolidated federal income tax return. USCAN and Galileo file separate tax returns in Canada. Provisions for income taxes include deferred taxes for temporary differences in the bases of assets and liabilities for financial and tax purposes, resulting from the use of the liability method of accounting for income taxes. The liability method requires that deferred tax assets be reduced by a valuation allowance in cases where it is more likely than not that the deferred tax assets will not be realized. The Company accounts for income taxes in accordance with ASC 740, Income Taxes. The Company’s policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. As of June 30, 2016, the Company did not have any accrued interest or penalties related to uncertain tax positions. The tax years from 2012 through 2015 remain open to examination by the U.S. Federal tax jurisdictions to which the Company is subject. The tax years from 2009 through 2015 remain open to examination by the non-U.S. Federal tax jurisdictions to which the Company is subject. Revenue Recognition. The Company earns substantially all of its revenues from advisory and administrative fees that are calculated as a percentage of assets under management and are recorded as revenue as services are performed. Offshore advisory client contracts provide for monthly management fees, in addition to performance fees. The advisory contract for the equity funds within USGIF provides for a performance fee on the base advisory fee that are calculated and recorded monthly. Revenue shown on the Consolidated Statements of Operations is net of fee waivers. Dividends and Interest. Dividends are recorded on the ex-dividend date, and interest income is recorded on an accrual basis. Both dividends and interest income are included in investment income. Advertising Costs. The Company expenses advertising costs as they are incurred. Certain sales materials, which are considered tangible assets, are capitalized and then expensed during the period in which they are distributed. Net advertising expenditures were $212,000; $135,000; and $56,000; during fiscal years 2016, 2015, and 2014, respectively, after adjustments for discontinued operations. Foreign Exchange. The balance sheets of certain foreign subsidiaries of the Company and certain foreign-denominated investment products are translated at the current exchange rate as of the end of the accounting period and the related income or loss is translated at the average exchange rate in effect during the period. Net exchange gains and losses resulting from balance sheet translations of foreign subsidiaries are excluded from income and are recorded in “accumulated other comprehensive income (loss)” on the Consolidated Balance Sheets. Net exchange gains and losses resulting from income or loss translations are included in income and are recorded in “investment income (loss)” on the Consolidated Statements of Operations. Investment transactions denominated in foreign currencies are converted to U.S. dollars using the exchange rate on the date of the transaction and any related gain or loss is included in “investment income (loss)” on the Consolidated Statements of Operations. Use of Estimates. The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates. Earnings Per Share. The Company computes and presents earnings per share attributable to U.S. Global Investors, Inc. in accordance with ASC 260, Earnings Per Share. Basic earnings per share (“EPS”) excludes dilution and is computed by dividing net income (loss) attributable to U.S. Global Investors, Inc. by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of EPS that could occur if options to issue common stock were exercised. The Company has two classes of common stock with outstanding shares. Both classes share equally in dividend and liquidation preferences. Accumulated Other Comprehensive Income (Loss). Accumulated other comprehensive income (loss) (“AOCI”), net of tax is reported in the Consolidated Balance Sheets and the Consolidated Statements of Shareholders’ Equity and includes the unrealized gains and losses on securities classified as available-for-sale and foreign currency translation adjustments. Recent Accounting Pronouncements Accounting Pronouncements Adopted During the Period In April 2014, the FASB issued Accounting Standard Update (“ASU”) 2014-08, Presentation of Financial Statements and Property, Plant, and Equipment - Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity (“ASU 2014-08”). ASU 2014-08 became effective for the Company on July 1, 2015. The adoption of ASU 2014-08 was not material to the consolidated financial statements. Accounting Pronouncements Not Yet Adopted In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five-step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2018. In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern (“ASU 2014-15”). This update requires an entity's management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity's ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). When conditions or events raise substantial doubts about an entity’s ability to continue as a going concern, management shall disclose: i) the principal conditions or events that raise substantial doubt about the entity's ability to continue as a going concern; ii) management's evaluation of the significance of those conditions or events in relation to the entity's ability to meet its obligations; and iii) management's plans that are intended to mitigate the conditions or events - and whether or not those plans alleviate the substantial doubt about the entity's ability to continue as a going concern. ASU 2014-15 is effective for the annual period ending after December 15, 2016, and early application is permitted. Management does not currently anticipate that this update will have any impact on the Company’s financial statement disclosures. In February 2015, the FASB issued ASU 2015-02, Amendments to the Consolidation Analysis (“ASU 2015-02”), which amends the consolidation requirements in ASC 810, Consolidation. This standard modifies existing consolidation guidance for reporting organizations that are required to evaluate whether they should consolidate certain legal entities. ASU 2015-02 is effective for fiscal years and interim periods within those years beginning after December 15, 2015, and requires either a retrospective or a modified retrospective approach to adoption. Early adoption is permitted. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements, as well as the available transition methods. In May 2015, the FASB issued ASU 2015-07, Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) (“ASU 2015-07”). ASU 2015-07 removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the NAV per share practical expedient. The update is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2015, and early adoption is permitted. The update requires the retrospective adoption approach. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In November 2015, the FASB issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”). ASU 2015-17 requires entities to present deferred tax assets and deferred tax liabilities as noncurrent in a classified balance sheet. It simplifies the current guidance, which requires entities to separately present deferred tax assets and liabilities as current or noncurrent in a classified balance sheet. Netting by tax jurisdiction is still required under the new guidance. The update is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods, and early adoption is permitted. Entities are permitted to apply the amendments either prospectively or retrospectively. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). ASU 2016-01 amends the guidance on the classification and measurement of investments in equity securities. It also amends certain presentation and disclosure requirements. ASU 2016-01 is effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases (“ASU 2016-02”). ASU 2016-02 introduces a lessee model that brings most leases on the balance sheet. The new guidance will be effective for public business entities for annual periods beginning after December 15, 2018, and interim periods therein. Early adoption is permitted. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts from Customers - Principal versus Agent Considerations (Reporting Revenue Gross versus Net) (“ASU 2016-08”). ASU 2016-08 amends the guidance in ASU 2014-09, which is not yet effective. Among other things, the ASU clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. The effective date and transition requirements for the amendments in ASU 2016-08 are the same as the effective date and transition requirements of ASU 2014-09. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). ASU 2016-09 includes provisions intended to simplify various aspects related to how share-based payments are accounted for and disclosed. ASU 2016-09 is effective for public entities for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. Early adoption will be permitted in any interim or annual period, as long as all elements of the new standard are adopted at the same time. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”), which clarifies the guidance related to identifying performance obligations and the licensing guidance in ASU 2014-09. The standard is effective for annual periods beginning after December 15, 2017, and interim periods therein. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 provides a new current expected credit loss model to account for credit losses on certain financial assets and off-balance sheet exposures (e.g., loans held for investment, debt securities held to maturity, reinsurance receivables, net investments in leases and loan commitments). The model requires an entity to estimate lifetime credit losses related to such financial assets and exposures based on relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The guidance also modifies the current other-than-temporary impairment guidance for available-for-sale debt securities to require the use of an allowance rather than a direct write down of the investment, and replaces existing guidance for purchased credit deteriorated loans and debt securities. ASU 2016-13 is effective for public entities that are SEC filers for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Entities may adopt earlier as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the potential impact of this standard on its consolidated financial statements. NOTE 3. DISCONTINUED OPERATIONS Distributor In December 2015, USGIF elected a new slate of trustees to the Board of Trustees of the Funds. The Company proposed the election of new trustees and the transition of certain functions to third-party service providers with the intention of streamlining the Company’s responsibilities so it can better focus on strategic activities. The new Board of Trustees of USGIF adopted several new service agreements. As anticipated, effective December 10, 2015, the Company, through its wholly-owned subsidiary, U.S. Global Brokerage, Inc., ceased to be the distributor for USGIF and no longer receives distribution fees and shareholder services fees from USGIF. The Company’s portion of one-time transition expenses, recorded in the quarter ended December 31, 2015, was approximately $290,000. Due to this transition, the Company is no longer responsible for paying certain distribution and shareholder servicing related expenses and is reimbursed for certain distribution expenses from the new distributor for USGIF. As a result of this change, the Company filed Form BDW, the Uniform Request Withdrawal From Broker-Dealer Registration, with FINRA, which was approved in February 2016. This constitutes a strategic shift that has started to have, and will continue to have, a major effect on the Company’s operating revenues and expenses. The distribution and shareholder services revenues and the expenses associated with certain distribution operations for USGIF are reflected as discontinued operations in the statement of operations and are, therefore, excluded from continuing operations results. Comparative periods shown in the Statement of Operations have been adjusted to conform with this presentation. These revenues and expenses were included in the investment management services segment in previous reporting periods. The discontinued operations did not have depreciation, amortization, capital expenditures or significant non-cash operating and investing items. The assets and liabilities related to distribution discontinued operations are as follows at June 30, 2016, and June 30, 2015: The components of loss from discontinued operations of the distributor were as follows: Through December 9, 2015, USGIF paid the Company a distribution fee at an annual rate of 0.25 percent of the average daily net assets of the investor class of each of the equity funds. Effective December 10, 2015, the Company, through U.S. Global Brokerage, Inc., ceased to be the distributor for USGIF and no longer receives distribution fees directly from the Funds. In addition, through December 9, 2015, the Company received shareholder servicing fees from USGIF based on the value of Fund assets held through broker-dealer platforms. Effective December 10, 2015, the Company ceased to be the distributor for USGIF and no longer receives shareholder services fees from the Funds. Due to this transition, the Company is no longer responsible for paying the platform fees for the USGIF equity funds and is reimbursed for certain distribution expenses from the new distributor for USGIF. Transfer Agent The Company’s Board of Directors formally agreed on August 23, 2013, to exit the transfer agency business so that the Company could focus more on its core strength of investment management. USSI served as transfer agent until conversion to a third-party transfer agent on December 9, 2013. The transfer agency results, together with expenses associated with discontinuing transfer agency operations, are reflected as “discontinued operations” in the Consolidated Statements of Operations and are therefore, excluded from continuing operations results. These expenses include approximately $65,000 of expenses in fiscal 2014 related to leased equipment that will not be utilized. Comparative periods shown in the Consolidated Financial Statements have been adjusted to conform to this presentation. As of June 30, 2016, and 2015, there were no material remaining assets or liabilities related to the transfer agency business. The components of loss from discontinued operations of the transfer agent were as follows: NOTE 4. INVESTMENTS As of June 30, 2016, the Company held investments with a fair value of $13.6 million and a cost basis of $14.5 million. The market value of these investments is approximately 51.6 percent of the Company’s total assets. In addition, the Company owned other investments of $1.9 million accounted for under the cost method of accounting. Investments in securities classified as trading are reflected as current assets on the Consolidated Balance Sheets at their fair market value. Unrealized gains and losses on trading securities are included in earnings in the Consolidated Statements of Operations. Investments in securities classified as available-for-sale, which may not be readily marketable but have readily determinable fair values, are reflected as non-current assets on the Consolidated Balance Sheets at their fair value. Unrealized gains and losses on available-for-sale securities are excluded from earnings and reported in other comprehensive income (loss) as a separate component of shareholders’ equity until realized. Other investments consist of equity investments in entities over which the Company is unable to exercise significant influence and which do not have readily determinable fair values. These equity investments are accounted for under the cost method of accounting and evaluated for impairment. The Company considers many factors in determining impairment, including the severity and duration of the decline in value below cost, the Company’s interest and ability to hold the security for a period of time sufficient for an anticipated recovery in value, and the financial condition and specific events related to the issuer. When an impairment of an equity security is determined to be other-than-temporary, the impairment is recognized in earnings. The following details the components of the Company’s investments recorded at fair value as of June 30, 2016, and 2015: Unrealized and realized gains and losses on trading securities are included in earnings in the statement of operations. Unrealized gains and losses on available-for-sale securities are excluded from earnings and recorded in other comprehensive income (loss) as a separate component of shareholders’ equity until realized. Net unrealized gains (losses) on available-for-sale securities gross and net of tax as of June 30, 2016, are $45 and $45, respectively, and as of June 30, 2015, are $(339) and $(339), respectively. The following summarizes investment income (loss) reflected in earnings for the periods presented. Included in investment income were other-than temporary declines in value on available-for-sale securities of approximately $259,000; $247,000; and $3,000 in fiscal years 2016, 2015, and 2014, respectively. The impairment losses resulted from fair values of certain equity securities being lower than book value and from proposed changes to debt securities. For the year ending June 30, 2016, there were eight securities with a combined cost basis of $702,000 that were written down to a combined fair value of $466,000. Also during the year ending June 30, 2016, another security with a cost basis of $970,000 was written down to $947,000 based on the net present value of estimated future cash flows. The impairment losses in the 2015 fiscal year resulted from issuers defaulting on scheduled payments. One security with a cost basis of $44,000 was written down to its fair value of $5,000. Two other securities, for which the common issuer has resumed interest payments, were written down to the net present value of estimated future cash flows. These securities had a cost basis of $310,000 and $1.1 million, respectively, and were written down to $234,000 and $970,000, respectively. Also included in investment income for the year ended June 30, 2016, were approximately $258,000 in other-than-temporary declines in value on securities held at cost. The impairment loss resulted from the estimated values of certain securities being lower than cost. Three securities held at cost with a combined cost basis of $1.1 million were written down to a combined adjusted cost basis of $867,000. In making these determinations, the Company considered the length of time and extent to which the fair value has been less than the cost basis, financial condition and prospects of the issuers, and the Company's ability to hold the investment until recovery. Unrealized Losses The following tables show the gross unrealized losses and fair values of available-for-sale investment securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. The Company reviewed the gross unrealized losses shown as of June 30, 2016, and determined that the losses were not other-than-temporary based on consideration of the nature of the investment and the cause, severity and duration of the loss. Fair Value Hierarchy ASC 820, Fair Value Measurement and Disclosures, defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a hierarchy that prioritizes inputs to valuation techniques used to measure fair value and requires companies to disclose the fair value of their financial instruments according to a fair value hierarchy (i.e., Levels 1, 2, and 3 inputs, as defined below). The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. Additionally, companies are required to provide enhanced disclosures regarding instruments in the Level 3 category (which have inputs to the valuation techniques that are unobservable and require significant management judgment), including a reconciliation of the beginning and ending values separately for each major category of assets or liabilities. Financial instruments measured and reported at fair value are classified and disclosed in one of the following categories: Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities at the reporting date. Since valuations are based on quoted prices that are readily and regularly available in an active market, value of these products does not entail a significant degree of judgment. Level 2 - Valuations based on quoted prices in markets for which not all significant inputs are observable, directly or indirectly. Corporate debt securities valued in accordance with the evaluated price supplied by an independent service are categorized as Level 2 in the hierarchy. Other securities categorized as Level 2 included securities valued at the mean between the last reported bid and ask quotation. Level 3 - Valuations based on inputs that are unobservable and significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with the investing in those securities. Because of the inherent uncertainties of valuation, the values reflected may materially differ from the values received upon actual sale of those investments. For actively traded securities, the Company values investments using the closing price of the securities on the exchange or market on which the securities principally trade. If the security is not traded on the last business day of the quarter, it is generally valued at the mean between the last bid and ask quotation. Mutual funds, which include open- and closed-end funds, exchange-traded funds, and offshore funds are valued at net asset value or closing price, as applicable. Certain corporate debt securities are valued by an independent pricing service using an evaluated quote based on such factors as institutional-size trading in similar groups of securities, yield, quality maturity, coupon rate, type of issuance and individual trading characteristics and other market data. As part of its independent price verification process, the Company periodically reviews the fair value provided by the pricing service using information such as transactions in these investments, broker quotes, market transactions in comparable investments, general market conditions and the issuer’s financial condition. Debt securities that are not valued by an independent pricing service are valued based on review of similarly structured issuances in similar jurisdictions when possible. The Company also takes into consideration numerous other factors that could affect valuation such as overall market conditions, liquidity of the security and bond structure. Securities for which market quotations are not readily available are valued at their fair value as determined by the portfolio management team. The portfolio management team includes representatives from the investment, accounting and legal/compliance departments. The portfolio management team meets periodically to consider a number of factors in determining a security’s fair value, including the security’s trading volume, market values of similar class issuances, investment personnel’s judgment regarding the market experience of the issuer, financial status of the issuer, the issuer’s management, and back testing, as appropriate. The fair values may differ from what may have been used had a broader market for these securities existed. The portfolio management team reviews inputs and assumptions and reports material items to the Board of Directors. The following presents fair value measurements, as of each balance sheet date, for the major categories of U.S. Global’s investments measured at fair value on a recurring basis: As of June 30, 2016, approximately 97 percent of the Company’s financial assets measured at fair value are derived from Level 1 inputs, three percent are derived from Level 2 inputs and none from Level 3 inputs. As of June 30, 2015, approximately 94 percent of the Company’s financial assets measured at fair value are derived from Level 1 inputs, three percent are derived from Level 2 inputs and the remaining three percent are Level 3 inputs. The Company recognizes transfers between levels at the end of each quarter. In Level 2, the Company has an investment in an affiliated offshore fund, classified as trading and which invests in companies in the energy and natural resources sectors, with a fair value of $358,000 and $481,000 as of June 30, 2016, and 2015, based on the net asset value per share. The Company may redeem this investment on the first business day of each month after providing a redemption notice at least forty-five days prior to the proposed redemption date. In addition, the Company had investments in corporate debt securities, classified as available-for-sale, of $77,000 as of June 30, 2015, categorized as Level 2 which the Company valued in accordance with the evaluated price supplied by an independent service or valued using the mean between the last reported bid ask quotation. These corporate debt securities were sold in the year ended June 30, 2016. At June 30, 2015, Level 3 corporate debt, classified as available-for-sale, consisted of debt from two issuers. Debt from one issuer was valued at June 30, 2015, at $314,000 based on other traded debt of the issuer. This corporate debt was transferred during the quarter ended March 31, 2016, at its then-current value of $1.0 million from Level 3 to Level 1, as it now also trades on a market. This corporate debt, which matures in 2020, was valued at $1.1 million at June 30, 2016, in Level 1. The other corporate debt classified as Level 3 at June 30, 2015, was valued at cost of $225,000, which approximated fair value as a result of the Company’s review of similar structured issuances in similar jurisdictions. This holding was transferred out of available-for-sale Level 3 assets and classified as a note receivable at its June 30, 2016, value of $212,000. The following table is a reconciliation of investments recorded at fair value for which unobservable inputs (Level 3) were used in determining fair value during the years ended June 30, 2016, and 2015: NOTE 5. INVESTMENT MANAGEMENT AND OTHER FEES The Company serves as investment adviser to USGIF and receives a fee based on a specified percentage of net assets under management. The advisory agreement for the equity funds within USGIF provides for a base advisory fee that is adjusted upwards or downwards by 0.25 percent if there is a performance difference of 5 percent or more between a fund’s performance and that of its designated benchmark index over the prior rolling 12 months. For the years ended June 30, 2016, 2015, and 2014, the Company realized a decrease in its base advisory fee of $132,000; $1.0 million; and $815,000, respectively, due to these performance adjustments. The Company has agreed to contractually limit the expenses of the Near-Term Tax Free Fund through April 2017. The Company has voluntarily waived or reduced its fees and/or agreed to pay expenses on the remaining funds. These caps will continue on a voluntary basis at the Company’s discretion. The aggregate fees waived and expenses borne by the Company were $1.3 million; $1.3 million; and $2.4 million for the years ended June 30, 2016, 2015, and 2014, respectively. Management cannot predict the impact of future waivers due to the number of variables and the range of potential outcomes. In addition, the Company has an administrative services agreement with USGIF. Effective December 2013, the Funds’ Board of Trustees increased the administrative services fees paid to the Company from an annual rate of 0.08 percent to 0.10 percent per investor class and from 0.06 percent to 0.08 percent per institutional class of each Fund, based on average daily net assets, plus $10,000 per Fund. Effective November 1, 2014, the annual per fund fee changed to $7,000. Effective December 10, 2015, upon amending the agreement and reducing the administrative services performed, the annual rate changed to 0.05 percent for each investor class and to 0.04 percent for each institutional class, and the per fund fee was eliminated. The Company also serves as investment advisor to U.S. Global Jets ETF. The ETF commenced operations in April 2015, and fiscal 2016 was its first full year of operations. The Company receives a unitary management fee of 0.60 percent of average net assets and has agreed to bear all expenses of the ETF. The Company recorded advisory fees from the ETF totaling $296,000 and $26,000 in fiscal 2016 and fiscal 2015, respectively. The Company provides advisory services to offshore clients and received a monthly advisory fee based on the net asset values of the clients and performance fees based on the overall increase in net asset values, if any. The Company recorded advisory fees from these clients totaling $91,000; $130,000; and $190,000 for the years ended June 30, 2016, 2015, and 2014, respectively. The Company recorded no performance fees from these clients for the years ended June 30, 2016, and 2015, and $4,000 for the year ended June 30, 2014. One of the offshore funds liquidated in November 2013. The contracts between the Company and the two current offshore clients expire periodically, and management anticipates that its remaining offshore clients will renew the contracts. Galileo provides advisory services for clients in Canada and receives advisory fees based on the net asset values of the clients. Galileo recorded advisory fees from these clients totaling $1.2 million; $2.0 million; and $234,000 for the years ended June 30, 2016, 2015, and 2014, respectively. Prior to December 10, 2015, in connection with obtaining and/or providing administrative services to the beneficial owners of USGIF through broker-dealers, banks, trust companies and similar institutions which provide such services, the Company received shareholder services fees at an annual rate of up to 0.20 percent of the value of shares held in accounts at the institutions. The Company also received distribution fees from USGIF based on average net assets. The Company no longer receives shareholder services or distribution fees, which are included in “discontinued operations” in the Consolidated Statements of Operations. See further discussion in Note 3, Discontinued Operations. Prior to conversion to a third party transfer agent on December 9, 2013, USSI received transfer agent fees from USGIF based on the number of shareholder accounts, transaction and activity-based fees and certain miscellaneous fees. The transfer agency fees are included in “discontinued operations” in the Consolidated Statements of Operations. See further discussion in Note 3, Discontinued Operations. The following changes were made during fiscal year 2014 to the mutual funds the Company manages: (1) the Global Emerging Markets Fund liquidated on October 31, 2013, (2) the MegaTrends Fund was reorganized into the Holmes Growth Fund (renamed Holmes Macro Trends Fund), (3) the Tax Free Fund was reorganized into the Near-Term Tax Free Fund, (4) the U.S. Government Securities Savings Fund changed from a money market fund to the U.S. Government Securities Ultra-Short Bond Fund (“Government Fund”), and (5) the U.S. Treasury Securities Cash Fund was liquidated on December 27, 2013. Prior to the Government Fund conversion in December 2013, the Company voluntarily agreed to waive fees and/or reimburse the fund to the extent necessary to maintain the fund’s yield at a certain level as determined by the Company (Minimum Yield). The Company may recapture any fees waived and/or expenses reimbursed to maintain Minimum Yield within three years after the end of the fund’s fiscal year of such waiver and/or reimbursement to the extent that such recapture would not cause the funds’ yield to fall below the Minimum Yield. Thus, $498,000 of the waiver for the Government Fund is recoverable by the Company through December 31, 2016. The U.S. Treasury Securities Cash Fund also had waivers subject to future recapture; however, because the fund was liquidated in December 2013, there will be no recapture. NOTE 6. NOTES RECEIVABLE The Company has invested in notes receivable consisting of two promissory notes. One note in the amount of $2 million was entered into with an unrelated third party in June 2016 and matures in June 2017. The note has a one-year extension option by the issuer upon payment of a 2.5 percent extension fee. The note bears interest at 12 percent, with 10 percent payable monthly and 2 percent payable at maturity. In case of prepayment, there would be a penalty for the amount of lost interest. The other note of $212,000 is with an unrelated third party, has a stated annual interest rate of 15 percent payable quarterly and matures in 2017. The Company considered the credit quality of the other parties and determined that no allowance for credit losses is necessary. NOTE 7. PROPERTY AND EQUIPMENT Property and equipment are composed of the following: Depreciation expense totaled $275,000; $282,000; and $255,000 in fiscal years 2016, 2015, and 2014, respectively. NOTE 8. INTANGIBLE ASSETS Intangible assets consist of the following: The non-compete agreement included as an intangible asset was acquired effective June 1, 2014, in connection with the acquisition of Galileo. This finite-lived identifiable intangible asset was amortized on a straight-line basis over its estimated useful life. Amortization expense totaled $41,000; $45,000; and $4,000 in fiscal years 2016, 2015, and 2014, respectively. Amortization expense is included in depreciation and amortization on the Consolidated Statements of Operations. NOTE 9. OTHER ACCRUED EXPENSES Other accrued expenses consist of the following: NOTE 10. BORROWINGS As of June 30, 2016, the Company has no long-term liabilities. The Company has access to a $1 million credit facility for working capital purposes. The credit agreement requires the Company to maintain certain covenants; the Company has been in compliance with these covenants during the fiscal year. The credit agreement will expire on May 31, 2017, and the Company intends to renew annually. The credit facility is collateralized by $1 million at June 30, 2016, held in deposit in a money market account at the financial institution that provided the credit facility. As of June 30, 2016, the credit facility remains unutilized by the Company. NOTE 11. LEASE COMMITMENTS The Company has operating leases for office equipment that expire between fiscal years 2017 and 2019 and for office facilities in Canada that expire in 2018. Lease expenses totaled $397,000; $514,000; and $494,000 in fiscal years 2016, 2015, and 2014, respectively. Minimum non-cancelable lease payments required under operating leases for future periods, are as follows: NOTE 12. BENEFIT PLANS The Company offers a savings and investment plan qualified under Section 401(k) of the Internal Revenue Code covering substantially all employees. In connection with this 401(k) plan, participants can voluntarily contribute a portion of their compensation, up to certain limitations, to this plan, and the Company will match 100 percent of participants’ contributions up to the first 3 percent of compensation and 50 percent of the next 2 percent of compensation. The Company has recorded expenses for contributions to the 401(k) plan of $113,000; $131,000; and $175,000 for fiscal years 2016, 2015, and 2014, respectively. The 401(k) plan allows for a discretionary profit sharing contribution by the Company, as authorized by the Board of Directors. No profit sharing contributions were made in fiscal years 2016, 2015, or 2014. The Company offers employees, including its executive officers, an opportunity to participate in savings programs using mutual funds managed by the Company. Employees may contribute to an IRA, and the Company matches these contributions on a limited basis. A similar savings plan utilizing Uniform Gifts to Minors Act (“UGMA”) accounts is offered to employees to save for their minor relatives. Through December 31, 2015, certain employees could have contributed to the Near-Term Tax Free Fund, and the Company matched these contributions on a limited basis. The Company match, reflected in base salary expense, aggregated in all programs to $39,000; $51,000; and $58,000 in fiscal years 2016, 2015, and 2014, respectively. The Company has an Employee Stock Purchase Plan whereby eligible employees can purchase treasury shares at market price. Through December 31, 2015, the Company matched their contributions up to 3 percent of gross salary. During fiscal years 2016, 2015, and 2014, employees purchased 39,084; 37,383; and 52,191, respectively, shares of treasury stock from the Company. Additionally, the Company self-funds its employee health care plan. The Company has obtained reinsurance with both a specific and an aggregate stop-loss in the event of catastrophic claims. The Company has accrued an amount representing the Company’s estimate of claims incurred but not paid at June 30, 2016. NOTE 13. SHAREHOLDERS’ EQUITY Dividends The Company paid $0.005 per share per month in fiscal years 2014 and 2015 and through September 2015 and $0.0025 per share per month from October 2015 through June 2016. Dividends of $496,000; $800,000; and $804,000 were paid to holders of class A common stock in fiscal years 2016, 2015, and 2014, respectively. Dividends of $78,000; $124,000; and $124,000 were paid to holders of class C common stock in fiscal years 2016, 2015, and 2014, respectively. The monthly dividend of $0.0025 is authorized through December 2016 and will be considered for continuation at that time by the Board. Payment of cash dividends is within the discretion of the Company’s Board of Directors and is dependent on earnings, operations, capital requirements, general financial condition of the Company and general business conditions. On a per share basis, the holders of the class C common stock and the nonvoting class A common stock participate equally in dividends as declared by the Company’s Board of Directors. Share Repurchase Plan Effective January 1, 2013, the Board of Directors approved a share repurchase program on December 7, 2012, authorizing the Company to purchase up to $2.75 million of its outstanding common shares, as market and business conditions warrant, on the open market in compliance with Rule 10b-18 of the Securities Exchange Act of 1934 through December 31, 2013. On December 12, 2013, December 10, 2014, and December 9, 2015, the Board of Directors renewed the repurchase program for calendar years 2014, 2015 and 2016, respectively. The total amount of shares that may be repurchased in 2016 under the renewed program is $2.75 million. The acquired shares may be used for corporate purposes, including shares issued to employees in the Company’s stock-based compensation programs. As of June 30, 2016, approximately $2.68 million remains available for repurchase under this authorization. During fiscal years 2016, 2015, and 2014, the Company repurchased 177,998; 95,251; and 93,351, respectively, of its class A shares on the open market using cash of $313,000; $292,000; and $289,000, respectively. To date, the Company has repurchased a total of 421,652 class A shares under the repurchase program using cash of $1,067,000. Other Activity The Company granted 2,400 shares of class A common stock at a weighted average fair value of $2.66 to an employee during fiscal year 2016. The Company did not grant any shares of class A common stock to employees during fiscal year 2015 or 2014. Grants vest immediately after issuance. The Company granted 3,600; 3,600; and 3,600 shares of class A common stock at a weighted average fair value of $1.63, $3.24, and $3.07 to its non-employee directors in fiscal years 2016, 2015, and 2014, respectively. Grants vest immediately after issuance. Issuances of treasury stock for grants or bonuses are accounted for using the weighted-average cost basis of the shares issued. During fiscal 2016, shares were issued, as described above, with a weighted-average cost basis greater than current fair value, which resulted in a combined negative adjustment to additional paid-in capital of approximately $43,000. Shareholders of class C shares are allowed to convert to class A. During fiscal year 2016, no shares were converted from class C to class A. During fiscal years 2015 and 2014, 60 and 1,340 shares, respectively, were converted from class C to class A. Conversions are one class A share for one class C share and are recorded at par value. There are no restrictions or requirements to convert. Stock-based compensation In November 1989, the Board of Directors adopted the 1989 Non-Qualified Stock Option Plan (“1989 Plan”), amended in December 1991, which provides for the granting of options to purchase 1,600,000 shares of the Company’s class A common stock to directors, officers and employees of the Company and its subsidiaries. Options issued under the 1989 Plan vest six months from the grant date or 20 percent on the first, second, third, fourth, and fifth anniversaries of the grant date. Options issued under the 1989 Plan expire ten years after issuance. No options were granted in fiscal years 2016, 2015, or 2014. As of June 30, 2016, there were no options outstanding under the 1989 Plan. In April 1997, the Board of Directors adopted the 1997 Non-Qualified Stock Option Plan (“1997 Plan”), which provides for the granting of stock appreciation rights (SARs) and/or options to purchase 400,000 shares of the Company’s class A common stock to directors, officers, and employees of the Company and its subsidiaries. Options issued under the 1997 Plan expire ten years after issuance. No options were granted in fiscal years 2016, 2015, or 2014. As of June 30, 2016, there were 2,000 options outstanding under the 1997 Plan. The estimated fair value of options granted is amortized to expense over the options’ vesting period. The fair value of these options is estimated at the date of the grant using a Black-Scholes option pricing model. Stock option transactions under the various employee stock option plans for the past three fiscal years are summarized below: As of June 30, 2016, 2015, and 2014, exercisable employee stock options totaled 2,000; 22,000; and 22,000 shares and had weighted average exercise prices of $12.31, $18.72, and $18.72 per share, respectively. Class A common stock options outstanding and exercisable under the employee stock option plans at June 30, 2016, were as follows: NOTE 14. INCOME TAXES The Company and its non-Canadian subsidiaries file a consolidated U.S. federal income tax return. USCAN and Galileo file separate tax returns in Canada. The current applicable U.S. statutory rate for the consolidated U.S. federal income tax return is approximately 34 percent and the current applicable Canadian statutory rate for the Canadian subsidiaries is approximately 26.5 percent. Provisions for income taxes include deferred taxes for temporary differences in the bases of assets and liabilities for financial and tax purposes, resulting from the use of the liability method of accounting for income taxes. The Company has not recognized deferred income taxes on undistributed earnings of USCAN and Galileo since such earnings are considered to be reinvested indefinitely. For U.S. federal income tax purposes at June 30, 2016, the Company has charitable contribution carryovers totaling approximately $126,000 with $68,000 expiring in fiscal year 2018, $34,000 expiring in fiscal year 2019, $19,000 expiring in fiscal year 2020 and $5,000 expiring in fiscal year 2021. The Company has U.S. federal net operating loss carryovers of $5.5 million with $2.7 million expiring in fiscal year 2035 and $2.8 million expiring in fiscal year 2036. For Canadian income tax purposes, Galileo has cumulative eligible capital carryovers of $254,000 with no expiration and net operating loss carryovers of $66,000; $120,000; $45,000 and $123,000 expiring in fiscal 2025, 2027, 2030 and 2036, respectively. If certain changes in the Company's ownership should occur, there could be an annual limitation on the amount of net operating loss carryovers that could be utilized. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax amount will not be realized. At June 30, 2016, and 2015, a valuation allowance of $3.1 million and $2.1 million, respectively, was included to fully reserve for net operating loss carryovers, other carryovers and book/tax differences in the balance sheet. The Company's components of income (loss) before tax by jurisdiction are as follows: The reconciliation of income tax computed for continuing operations at the U.S. federal statutory rates to income tax expense is as follows: Components of total tax expense (benefit) are as follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company’s deferred assets and liabilities using the effective U.S. statutory tax rate are as follows: NOTE 15. EARNINGS PER SHARE The following table sets forth the computation for basic and diluted earnings per share (EPS): The diluted EPS calculation excludes the effect of stock options when their exercise prices exceed the average market price for the period. For the years ended June 30, 2016, 2015, and 2014, employee stock options for 2,000; 22,000; and 22,000 shares were excluded from diluted EPS. During fiscal years 2016, 2015, and 2014, the Company repurchased class A shares on the open market. Repurchased shares are classified as treasury shares and are deducted from outstanding shares in the earnings per share calculation. NOTE 16. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table presents changes in accumulated other comprehensive income (loss) by component: 1. Amounts reclassified from unrealized gains (losses) on available-for-sale investments, net of tax, were recorded in investment income (loss) on the Consolidated Statements of Operations. NOTE 17. FINANCIAL INFORMATION BY BUSINESS SEGMENT The Company manages the following business segments: 1. Investment management services, by which the Company offers, through USGIF, offshore clients, and an ETF client a range of investment management products and services to meet the needs of individual and institutional investors; 2. Investment management services - Canada, through which, as of June 1, 2014, the Company owns a 65% controlling interest in Galileo, a privately held Toronto-based asset management firm which offers investment management products and services in Canada; and 3. Corporate investments, through which the Company invests for its own account in an effort to add growth and value to its cash position. Although the Company generates the majority of its revenues from its investment advisory segments, the Company holds a significant amount of its total assets in investments. The following schedule details total revenues and income by business segment and certain amounts have been reclassified for comparative purposes: Net operating revenues from investment management services include revenues from USGIF of $4.0 million; $5.2 million; and $8.1 million in fiscal years 2016, 2015, and 2014, respectively. The loss from discontinued operations in investment management services includes revenues from USGIF of $608,000; $2.0 million; and $3.4 million in fiscal years 2016, 2015, and 2014, respectively. Net operating revenues from investment management services in Canada includes revenues from Galileo funds of $900,000; $1.6 million; and $184,000 in fiscal years 2016, 2015, and 2014, respectively, and other significant advisory clients of $254,000; $354,000; and $48,000 in fiscal years 2016, 2015, and 2014, respectively. NOTE 18. BUSINESS COMBINATION Effective March 31, 2013, the Company, through USCAN, purchased 50 percent of the issued and outstanding shares of Galileo, a privately held Toronto-based asset management firm, for $600,000 cash. Effective June 1, 2014, the Company, through USCAN, completed its purchase of an additional 15 percent interest in Galileo from the company’s founder, Michael Waring, for $180,000 cash. This strategic investment brought USCAN’s ownership to 65 percent of the issued and outstanding shares of Galileo, which represents a controlling interest of Galileo. Through Galileo, the Company expects to increase its presence in Canada. The non-controlling interest in this subsidiary is included in “non-controlling interest in subsidiaries” in the equity section of the Consolidated Balance Sheets. Frank Holmes, CEO, and Susan McGee, President, General Counsel, and Chief Compliance Officer, serve as directors of Galileo. From March 31, 2013, to June 1, 2014, the Company accounted for its interest in Galileo under the equity method with its share of Galileo’s profit or loss recognized in earnings. $20,000 was included in other income in fiscal year 2014. The Company accounted for the June 1, 2014, Galileo share purchase using the acquisition method of accounting, which requires, among other things, that the fair values of assets acquired, including an intangible asset, and liabilities assumed, along with the fair value of the non-controlling interest in the subsidiary, be recognized on the Consolidated Balance Sheets as of the acquisition date. Business combinations achieved in stages also must value prior investments at fair value. A $161,000 increase in fair value of the Company’s initial investment was recognized as a gain and included in investment income in fiscal year 2014. The Company recognized a gain of $129,000 on the June 1, 2014, purchase since the fair value of the net assets acquired was greater than the fair value of consideration given. This gain was also included in investment income in fiscal 2014. The following unaudited pro forma condensed consolidated results of operations for the year ended 2014 are presented as if the Galileo acquisition had been completed on July 1, 2013. The unaudited pro forma results do not include any adjustments to eliminate the impact of cost savings or other synergies that may result from the acquisition. In addition, the unaudited pro forma results of operations do not purport to be indicative of the actual results that would have been achieved by the combined company for the periods presented or that may be achieved by the combined company in the future. The information below reflects certain nonrecurring adjustments to remove the Company’s equity in earnings of Galileo and include amortization of the intangible asset. Post-Acquisition Financial Information The following amounts associated with the acquisition of Galileo, subsequent to the June 1, 2014, effective date, are included in the Consolidated Statements of Operations: Costs associated with the Galileo acquisition are included in general and administrative expenses in the Consolidated Statements of Operations. NOTE 19. RELATED PARTY TRANSACTIONS On June 30, 2016, and 2015, the Company had $11.5 million and $17.1 million, respectively, at fair value invested in USGIF and offshore funds the Company advises. These amounts were included in the Consolidated Balance Sheet as “trading securities” and “available-for-sale securities” in fiscal year 2016 and 2015. The Company recorded $180,000; $244,000; and $132,000 in income from dividends and capital gain distributions and $(273,000); $(596,000); and $942,000 in net recognized gains (losses) on its investments in the Funds and offshore clients for fiscal years 2016, 2015, and 2014, respectively. The Company earned advisory, administrative, distribution and shareholder services fees, as applicable, from the various funds for which it and its subsidiaries act as investment adviser, as disclosed in Note 5 and Note 3. Receivables include amounts due from the funds for those fees and out-of-pocket expenses, net of amounts payable to the funds, for expense reimbursements. As of June 30, 2016, and 2015, the Company had $595,000 and $701,000, respectively, of receivables from mutual funds included in the Consolidated Balance Sheets within “receivables.” Frank Holmes, a director and Chief Executive Officer of the Company, was a trustee of USGIF until December 2015. Mr. Holmes is a director of each offshore fund and is also a director of Meridian Fund Managers Ltd., the manager of the offshore funds. Mr. Holmes is also a director of a private company in which the Company holds common stock and warrants classified as other investments and valued at $723,000 at June 30, 2016, and in which he holds nontransferable stock options. The Company received $117,000 and $68,000 in dividend and interest income from its investments in this company in fiscal year 2016 and 2015, respectively. The Company recorded $211,000 in recognized losses on its investments in this company in fiscal year 2016. Charlemagne Capital (IOM) Limited, a wholly owned subsidiary of Charlemagne Capital Limited, was the non-discretionary subadviser to the Emerging Europe Fund, a fund within USGIF, through July 31, 2014. The Company paid $5,000 and $60,000 in subadvisory fees in fiscal years 2015 and 2014, respectively. While still in the subadvisory relationship, the Company received $60,000 in dividend income in fiscal year 2014 from an investment in the common stock of the subadviser. NOTE 20. CONTINGENCIES AND COMMITMENTS The Company continuously reviews all investor, employee, and vendor complaints and pending or threatened litigation. The likelihood that a loss contingency exists is evaluated through consultation with legal counsel, and a loss contingency is recorded if probable and reasonably estimable. During the normal course of business, the Company may be subject to claims, legal proceedings, and other contingencies. These matters are subject to various uncertainties, and it is possible that some of these matters may be resolved unfavorably. The Company establishes accruals for matters for which the outcome is probable and can be reasonably estimated. Management believes that any liability in excess of these accruals upon the ultimate resolution of these matters will not have a material adverse effect on the consolidated financial statements of the Company. The Board of Directors has authorized a monthly dividend of $0.0025 per share from July 2016 through December 2016, at which time it will be considered for continuation by the Board of Directors. Payment of cash dividends is within the discretion of the Company’s Board of Directors and is dependent on earnings, operations, capital requirements, general financial condition of the Company and general business conditions. Prior to the June 30, 2016, fiscal year-end, the Board of Directors approved monthly dividends from July 2016 to September 2016, and estimated dividends payable of $115,000 for that period is included in the Consolidated Balance Sheets at June 30, 2016. The total amount of cash dividends to be paid to class A and class C shareholders from July 2016 to December 2016 will be approximately $229,000. NOTE 21. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) Note that quarterly per share amounts may not add to the annual total due to rounding.
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Here's a summary of the financial statement:
Key Components:
1. Revenue
- Operating revenues and expenses
- Distribution and shareholder services revenues for USGIF shown as discontinued operations
- Previous period statements adjusted to reflect this change
2. Profit/Loss
- Covers three-year period ended June 30
- Includes Shareholders' Equity and Cash Flows statements
3. Expenses
- Includes operating expenses for advised funds
- Subject to competitive, regulatory, and contractual considerations
4. Assets
- Fixed assets recorded at cost
- Depreciation calculated using straight-line method
- Furniture and equipment depreciated over 3 years (except for Galileo)
5. Liabilities
Investment Classifications:
- Held-to-maturity securities (currently none held)
- Available-for-sale securities (reported at fair value)
- Other investments (equity investments under cost method)
- Equity method investments (significant influence but not control)
Notable Accounting Practices:
- Regular evaluation of investments for impairment
- Unrealized gains/losses on available-for-sale securities reported net of tax
- Equity method investments recorded as proportional share of underlying net income/loss
The statement indicates a structured approach to asset classification and valuation, with specific attention to investment categories and their accounting treatments.
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Claude
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Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders Synthetic Biologics, Inc. Rockville, Maryland We have audited the accompanying consolidated balance sheets of Synthetic Biologics, Inc. and Subsidiaries as of December 31, 2016 and 2015 and the related consolidated statements of operations, equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of Synthetic Biologics, Inc.’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Synthetic Biologics, Inc. and Subsidiaries at December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered recurring losses from operations and losses are expected to continue in the future. These factors raise substantial doubt about its ability to continue as a going concern. Management’s plans in regards to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Synthetic Biologics, Inc. and Subsidiaries internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 2, 2017 expressed an unqualified opinion thereon. /s/ BDO USA, LLP Troy, Michigan March 2, 2017 Synthetic Biologics, Inc. and Subsidiaries Consolidated Balance Sheets (In thousands except share amounts) See accompanying notes to consolidated financial statements Synthetic Biologics, Inc. and Subsidiaries Consolidated Statements of Operations (In thousands, except share and per share amounts) See accompanying notes to consolidated financial statements Synthetic Biologics, Inc. and Subsidiaries Consolidated Statements of Equity (In thousands, except share amounts) See accompanying notes to consolidated financial statements Synthetic Biologics, Inc. and Subsidiaries Consolidated Statements of Cash Flows (In thousands) See accompanying notes to consolidated financial statements Synthetic Biologics, Inc. and Subsidiaries 1. Organization and Nature of Operations and Basis of Presentation Description of Business Synthetic Biologics, Inc. (the “Company” or “Synthetic Biologics”) is a late-stage clinical company developing therapeutics designed to preserve the microbiome to protect and restore the health of patients. The Company’s lead candidates poised for Phase 3 development are: (1) SYN-010 which is intended to reduce the impact of methane-producing organisms in the gut microbiome to treat an underlying cause of irritable bowel syndrome with constipation (IBS-C), and (2) SYN-004 which is designed to protect the gut microbiome (gastrointestinal (GI) microflora) from the effects of certain commonly used intravenous (IV) antibiotics for the prevention of C. difficile infection (CDI) and antibiotic-associated diarrhea (AAD). In collaboration with Intrexon Corporation (NYSE: XON), the Company is also developing preclinical stage monoclonal antibody therapies for the prevention and treatment of pertussis, and novel discovery stage biotherapeutics for the treatment of phenylketonuria (PKU). Basis of Presentation and Corporate Structure As of December 31, 2016, the Company had eight subsidiaries, Pipex Therapeutics, Inc. (“Pipex Therapeutics”), Effective Pharmaceuticals, Inc. (“EPI”), Solovax, Inc. (“Solovax”), CD4 Biosciences, Inc. (“CD4”), Epitope Pharmaceuticals, Inc. (“Epitope”), Healthmine, Inc. (“Healthmine”), Putney Drug Corp. (“Putney”) and Synthetic Biomics, Inc. (“SYN Biomics”). Pipex Therapeutics, EPI, Healthmine and Putney are wholly owned, and Solovax, CD4, Epitope and SYN Biomics are majority-owned. For financial reporting purposes, the outstanding common stock of the Company is that of Synthetic Biologics, Inc. All statements of operations, equity and cash flows for each of the entities are presented as consolidated. All subsidiaries were formed under the laws of the State of Delaware on January 8, 2001, except for EPI, which was incorporated in Delaware on December 12, 2000, Epitope which was incorporated in Delaware in January of 2002, Putney which was incorporated in Delaware in November of 2006, Healthmine which was incorporated in Delaware in December of 2007 and SYN Biomics which was incorporated in Nevada in December of 2013. 2. Going Concern The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. The Company has recurring losses and as of December 31, 2016, the Company had an accumulated deficit of approximately $172.0 million. Since inception, the Company has financed its activities principally from the proceeds from the issuance of equity securities. The Company’s ability to continue as a going concern is dependent upon the Company’s ability to raise additional debt and equity capital. There can be no assurance that such capital will be available in sufficient amounts or on terms acceptable to the Company. These factors raise substantial doubt about the Company's ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of liabilities that may be necessary should the Company be unable to continue as a going concern. The Company does not have sufficient capital to fund our plan of operations over the next twelve months. In order to address our capital needs, including our planned Phase 2b/3 clinical trials, and the Company is actively pursuing additional equity or debt financing, in the form of either a private placement or a public offering. The Company has been in ongoing discussions with strategic institutional investors and investment banks with respect to such possible offerings. Such additional financing opportunities might not be available to the Company, when and if needed, on acceptable terms or at all. If the Company is unable to obtain additional financing in sufficient amounts or on acceptable terms under such circumstances, the Company’s operating results and prospects will be adversely affected. Synthetic Biologics, Inc. and Subsidiaries 3. Summary of Significant Accounting Policies Principles of Consolidation All inter-company transactions and accounts have been eliminated in consolidation. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions impact, among others, the following: the estimated useful lives for property and equipment, fair value of warrants and stock options granted for services or compensation, respectively, estimates of the probability and potential magnitude of contingent liabilities, and the valuation allowance for deferred tax assets due to continuing and expected future operating losses. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of consolidated financial statements, which management considered in formulating its estimate could change in the near term due to one or more future confirming events. Accordingly, actual results could differ from those estimates. Non-controlling Interest The Company’s non-controlling interest represents the minority shareholder’s ownership interest related to the Company’s subsidiary, SYN Biomics. The Company reports its non-controlling interest in subsidiaries as a separate component of equity in the Consolidated Balance Sheets and reports both net loss attributable to the non-controlling interest and net loss attributable to the Company’s common shareholders on the face of the Consolidated Statements of Operations. The Company’s equity interest in SYN Biomics is 88.5% and the non-controlling stockholder’s interest is 11.5%. This is reflected in the Consolidated Statements of Equity. Revenue Recognition The Company records revenue when all of the following have occurred: (1) persuasive evidence of an arrangement exists, (2) the service is completed without further obligation, (3) the sales price to the customer is fixed or determinable, and (4) collectability is reasonably assured. The Company recognizes milestone payments or upfront payments that have no contingencies as revenue when payment is received. For the years ended December 31, 2016, 2015 and 2014 the Company did not report any revenues. License Revenues The Company’s licensing agreements may contain multiple elements, such as non-refundable up-front fees, payments related to the achievement of particular milestones and royalties. Fees associated with substantive at risk performance-based milestones are recognized as revenue upon completion of the scientific or regulatory event specified in the agreement. When the Company has substantive continuing performance obligations under an arrangement, revenue is recognized over the performance period of the obligations using a time-based proportional performance approach. Under the time-based method, revenue is recognized over the arrangement’s estimated performance period based on the elapsed time compared to the total estimated performance period. Revenue recognized at any point in time is limited to the amount of non-contingent payments received or due. When the Company has no substantive continuing performance obligations under an arrangement, it recognizes revenue as the related fees become due. Revenues from royalties on third-party sales of licensed technologies are generally recognized in accordance with the contract terms when the royalties can be reliably determined and collectability is reasonably assured. To date, the Company has not received any royalty revenues. Risks and Uncertainties The Company’s operations could be subject to significant risks and uncertainties including financial, operational and regulatory risks and the potential risk of business failure. The global economic crisis has caused a general tightening in the credit markets, lower levels of liquidity, increases in the rates of default and bankruptcy, and extreme volatility in credit, equity and fixed income markets. These conditions may not only limit the Company’s access to capital, but also make it difficult for its customers, its vendors and its ability to accurately forecast and plan future business activities. Cash and Cash Equivalents Cash and cash equivalents include cash and highly liquid short-term investments with original maturities of three months or less. Synthetic Biologics, Inc. and Subsidiaries 3. Summary of Significant Accounting Policies - (continued) Property and Equipment Property and equipment is recorded at cost and depreciated or amortized using the straight-line method over the estimated useful life of the asset or the underlying lease term for leasehold improvements, whichever is shorter. The estimated useful life by asset description is noted in the following table. Asset Description Estimated Useful Life Office equipment and furniture 3 - 5 years Manufacturing equipment years Leasehold improvements and fixtures Lesser of estimated useful life or lease term Depreciation and amortization expense was approximately $157,000, $72,000 and $20,000 for the years ended December 31, 2016, 2015 and 2014, respectively. When assets are disposed of, the cost and accumulated depreciation are removed from the accounts. Repairs and maintenance are charged to expense as incurred. The Company reviews property and equipment for impairment to determine if assets are impaired due to obsolescence. As a result of this review, there was no impairment recognized for the years ended December 31, 2016, 2015 and 2014. Long-Lived Assets The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If such an event or change in circumstances occurs and potential impairment is indicated because the carrying values exceed the estimated future undiscounted cash flows of the asset, the Company will measure the impairment loss as the amount by which the carrying value of the asset exceeds its fair value. Loss per Share Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding including the effect of common share equivalents. Diluted net loss per share assumes the issuance of potential dilutive common shares outstanding for the period and adjusts for any changes in income and the repurchase of common shares that would have occurred from the assumed issuance, unless such effect is anti-dilutive. The number of options and warrants for the purchase of common stock that were excluded from the computations of net loss per common share for the year ended December 31, 2016 were 11,636,227 and 57,341,642, respectively, for the year ended December 31, 2015 were 8,941,930 and 7,908,899, respectively, and for the year ended December 31, 2014 were 5,981,106 and 7,974,794, respectively. Research and Development Costs The Company expenses research and development costs associated with developmental products not yet approved by the FDA to research and development expense as incurred. Research and development costs consist primarily of license fees (including upfront payments), milestone payments, manufacturing costs, salaries, stock-based compensation and related employee costs, fees paid to consultants and outside service providers for laboratory development, legal expenses resulting from intellectual property prosecution and other expenses relating to the design, development, testing and enhancement of our product candidates. Research and development expenses include external contract research organization (“CRO”) services. The Company makes payments to the CROs based on agreed upon terms and may include payments in advance of study services. The Company reviews and accrues CRO expenses based on services performed and rely on estimates of those costs applicable to the stage of completion of a study as provided by the CRO. Accrued CRO costs are subject to revisions as such studies progress to completion. The Company has accrued CRO expenses of $1.1 million and $2.2 million that are included in accounts payable and accrued expenses at December 31, 2016 and 2015. The Company has prepaid CRO costs of $1.7 million and $8.3 at December 31, 2016 and 2015. Synthetic Biologics, Inc. and Subsidiaries 3. Summary of Significant Accounting Policies - (continued) Fair Value of Financial Instruments The fair value accounting standards define fair value as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is determined based upon assumptions that market participants would use in pricing an asset or liability. Fair value measurements are rated on a three-tier hierarchy as follows: ·Level 1 inputs: Quoted prices (unadjusted) for identical assets or liabilities in active markets; · Level 2 inputs: Inputs, other than quoted prices, included in Level 1 that are observable either directly or indirectly; and · Level 3 inputs: Unobservable inputs for which there is little or no market data, which require the reporting entity to develop its own assumptions. In many cases, a valuation technique used to measure fair value includes inputs from multiple levels of the fair value hierarchy described above. The lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy. The carrying amounts of the Company’s short-term financial instruments, including cash and cash equivalents, other current assets, accounts payable and accrued liabilities approximate fair value due to the relatively short period to maturity for these instruments. Cash and cash equivalents include money market accounts of $1.7 million and $5.3 million as of December 31, 2016 and December 31, 2015, respectively, that are measured using Level 1 inputs. The warrants issued in conjunction with the registered direct offering in October 2014 include a provision, that if the Company were to enter into a certain transaction, as defined in the agreement, the warrants would be purchased from the holder at a premium. The warrants issued in conjunction with the public offering of the Company’s securities in November 2016 include a provision, that if the Company were to enter into a certain transaction, as defined in the warrant agreement, the warrants would be purchased from the holder for cash. Accordingly, the Company recorded the warrants as liabilities at their fair value upon issuance and re-measures the fair value at each period end with the change in fair value recorded in the Statement of Operations. The Company uses the Monte Carlo simulation options pricing model to estimate the fair value of the warrants. In using this model, the fair value is determined by applying Level 3 inputs for which there is little or no observable market data, requiring the Company to develop its own assumptions. The assumptions used in calculating the estimated fair value of the warrants represent the Company’s best estimates; however, these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and different assumptions are used, the warrant liability and the change in estimated fair value could be materially different. Stock-Based Payment Arrangements Generally, all forms of stock-based payments, including stock option grants, warrants, restricted stock grants and stock appreciation rights are measured at their fair value on the awards’ grant date typically using a Black-Scholes pricing model, based on the estimated number of awards that are ultimately expected to vest. Stock-based compensation awards issued to non-employees for services rendered are recorded at either the fair value of the services rendered or the fair value of the stock-based payment, whichever is more readily determinable and are re-measured over the corresponding vesting period. The expense resulting from stock-based payments is recorded in research and development expense or general and administrative expense in the Consolidated Statement of Operations, depending on the nature of the services provided. Derivative Instruments The warrants issued in conjunction with the registered direct offering in October 2014 include a provision, that if the Company were to enter into a certain transaction, as defined in the agreement, the warrants would be purchased from the holder at a premium. The warrants issued in conjunction with the public offering of the Company’s securities in November 2016 include a provision, that if the Company were to enter into a certain transaction, as defined in the warrant agreement, the warrants would be purchased from the holder for cash. The provisions of these warrants preclude equity accounting treatment under ASC 815. Accordingly, the Company is required to record the warrants as liabilities at their fair value upon issuance and re-measure the fair value at each period end with the change in fair value recorded in the Statement of Operations. When the warrants are exercised or cancelled, they are reclassified to equity. The Company uses the Monte Carlo simulation options pricing model to estimate the fair value of the warrants. Synthetic Biologics, Inc. and Subsidiaries 3. Summary of Significant Accounting Policies - (continued) Income Taxes The Company recognizes deferred tax liabilities and assets based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities, using enacted tax rates in effect in the years the differences are expected to reverse. Deferred income tax benefit (expense) results from the change in net deferred tax assets or deferred tax liabilities. A valuation allowance is recorded when it is more likely than not that some or all deferred tax assets will not be realized. Management assesses the need to accrue or disclose uncertain tax positions for proposed potential adjustments from various federal and state authorities who regularly audit the Company in the normal course of business. In making these assessments, management must often analyze complex tax laws of multiple jurisdictions. The Company records the related interest expense and penalties, if any, as tax expense in the tax provision. At December 31, 2016 and 2015, respectively, the Company did not record any liabilities for uncertain tax positions. Recent Accounting Pronouncements and Developments In August 2016, the FASB issued ASU 2016-15 to clarify whether the following items should be categorized as operating, investing or financing in the statement of cash flows: (i) debt prepayments and extinguishment costs, (ii) settlement of zero-coupon debt, (iii) settlement of contingent consideration, (iv) insurance proceeds, (v) settlement of corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) policies, (vi) distributions from equity method investees, (vii) beneficial interests in securitization transactions, and (viii) receipts and payments with aspects of more than one class of cash flows. Accordingly, ASU No. 2016-015 is effective for public business entities for fiscal years beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the impact of the adoption of this standard on its consolidated financial statements. In March 2016, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2016-09, Compensation - Stock Compensation (Topic 718), which is part of the FASB's Simplification Initiative. The updated guidance simplifies the accounting for share-based payment transactions. The amended guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, with early adoption permitted. The Company is currently evaluating the impact of the adoption of this standard on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) , which establishes a new lease accounting model for lessees. The updated guidance requires an entity to recognize assets and liabilities arising from a lease for both financing and operating leases, along with additional qualitative and quantitative disclosures. The amended guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the impact of the adoption of this standard on its consolidated financial statements. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers , to provide guidance on revenue recognition. ASU No. 2014-09 requires a company to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under today’s guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date , which provided for the adoption of the new standard for fiscal years beginning after December 15, 2017. Accordingly, ASU No. 2014-09 is effective for the Company in the first quarter of 2018. Early adoption up to the first quarter of 2017 is permitted. Upon adoption, ASU No. 2014-09 can be applied retrospectively to all periods presented or only to the most current period presented with the cumulative effect of changes reflected in the opening balance of retained earnings in the most current period presented. The FASB has also issued the following standards which clarify ASU No. 2014-09 and have the same effective date as the original standard: ·ASU No. 2016-10, Identifying Performance Obligations and Licensing (Topic 606); · ASU No. 2016-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting; and · ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients. ·ASU No. 2016-20, Technical Correction and Improvements. ·ASU No. 2016-20, Technical correction and improvements to Topic 606, Revenue form Contracts with Customers. The adoption of ASU 2014-09 may have a material effect on the recognition of future revenues. ASU 2014-09 differs from the current accounting standard in many respects, such as in the accounting for variable consideration, including milestone payments. Accordingly, we expect that our evaluation of the accounting for collaboration agreements under the new revenue standard could identify material changes from the current accounting treatment. The new accounting standard will require entities to determine an appropriate attribution method using either output or input methods and does not include a presumption that entities would default to a ratable attribution approach for upfront non-refundable fees. These factors could materially impact the amount and timing of our revenue recognition from our license and collaboration agreements under the new revenue standard. The Company will need to evaluate the impact of adoption ASU No. 2014-09 on its results of operations, cash flows and financial position. Synthetic Biologics, Inc. and Subsidiaries 4. Selected Balance Sheet Information Prepaid expenses and other current assets (in thousands): The Intrexon prepaid research and development expenses were classified as a current asset at December 31, 2015. As of December 31, 2016, the Company had applied all of the Intrexon prepaid research and development expenses to research and development expenses. Prepaid clinical research organization expense is classified as a current asset. The Company makes payments to the clinical research organizations based on agreed upon terms that includes payments in advance of study services. The Company anticipates that the majority of the prepaid clinical research organization expenses will be applied to research and development expenses during 2017. Property and equipment (in thousands): Accrued expenses (in thousands): Synthetic Biologics, Inc. and Subsidiaries 5. Stock-Based Compensation Stock Incentive Plan During 2001, the Company’s Board of Directors and stockholders adopted the 2001 Stock Incentive Plan (the “2001 Stock Plan”). The total number of shares of stock with respect to which stock options and stock appreciation rights may be granted to any one employee of the Company or a subsidiary during any one-year period under the 2001 Stock Plan shall not exceed 250,000. All awards pursuant to the 2001 Stock Plan shall terminate upon the termination of the grantee’s employment for any reason. Awards include options, restricted shares, stock appreciation rights, performance shares and cash-based awards (the “Awards”). The 2001 Stock Plan contains certain anti-dilution provisions in the event of a stock split, stock dividend or other capital adjustment, as defined in the plan. The 2001 Stock Plan provides for a Committee of the Board to grant awards and to determine the exercise price, vesting term, expiration date and all other terms and conditions of the awards, including acceleration of the vesting of an award at any time. As of December 31, 2016, there were 228,773 options issued and outstanding under the 2001 Stock Plan. On March 20, 2007, the Company’s Board of Directors approved the 2007 Stock Incentive Plan (the “2007 Stock Plan”) for the issuance of up to 2,500,000 shares of common stock to be granted through incentive stock options, nonqualified stock options, stock appreciation rights, dividend equivalent rights, restricted stock, restricted stock units and other stock-based awards to officers, other employees, directors and consultants of the Company and its subsidiaries. This plan was approved by stockholders on November 2, 2007. The exercise price of stock options under the 2007 Stock Plan is determined by the compensation committee of the Board of Directors, and may be equal to or greater than the fair market value of the Company’s common stock on the date the option is granted. The total number of shares of stock with respect to which stock options and stock appreciation rights may be granted to any one employee of the Company or a subsidiary during any one-year period under the 2007 plan shall not exceed 250,000. Options become exercisable over various periods from the date of grant, and generally expire ten years after the grant date. As of December 31, 2016, there were 659,988 options issued and outstanding under the 2007 Stock Plan. On November 2, 2010, the Board of Directors and stockholders adopted the 2010 Stock Incentive Plan (“2010 Stock Plan”) for the issuance of up to 3,000,000 shares of common stock to be granted through incentive stock options, nonqualified stock options, stock appreciation rights, dividend equivalent rights, restricted stock, restricted stock units and other stock-based awards to officers, other employees, directors and consultants of the Company and its subsidiaries. On October 22, 2013, the stockholders approved and adopted an amendment to the Company’s 2010 Incentive Stock Plan to increase the number of shares of Company’s common stock reserved for issuance under the Plan from 3,000,000 to 6,000,000. On May 15, 2015, the stockholders approved and adopted an amendment to the Company’s 2010 Incentive Stock Plan to increase the number of shares of the Company’s common stock reserved for issuance under the Plan from 6,000,000 to 8,000,000. On August 25, 2016, the stockholders approved and adopted an amendment to the 2010 Stock Plan to increase the number of shares of the Company’s common stock reserved for issuance under the 2010 Stock Plan from 8,000,000 to 14,000,000. The exercise price of stock options under the 2010 Stock Plan is determined by the compensation committee of the Board of Directors, and may be equal to or greater than the fair market value of the Company’s common stock on the date the option is granted. Options become exercisable over various period from the date of grant, and expire between five and ten years after the grant date. As of December 31, 2016, there were 10,747,466 options issued and outstanding under the 2010 Stock Plan. In the event of an employee’s termination, the Company will cease to recognize compensation expense for that employee. There is no deferred compensation recorded upon initial grant date, instead, the fair value of the stock-based payment is recognized ratably over the stated vesting period. The Company has applied fair value accounting for all share based payment awards since inception. The fair value of each option or warrant granted is estimated on the date of grant using the Black-Scholes option pricing model. The Black-Scholes assumptions used in the years ended December 31, 2016, 2015 and 2014 are as follows: The Company records stock-based compensation based upon the stated vested provisions in the related agreements. The vesting provisions for these agreements have various terms as follows: Synthetic Biologics, Inc. and Subsidiaries 5. Stock-Based Compensation - (continued) ·immediate vesting, · half vesting immediately and remaining over three years, · quarterly over three years, · annually over three years, · one-third immediate vesting and remaining annually over two years, · one-half immediate vesting and remaining over nine months, · one-quarter immediate vesting and remaining over three years, · one-quarter immediate vesting and remaining over 33 months; and · monthly over three years. During the years ended December 31, 2016, 2015 and 2014 the Company granted 3,861,425, 3,781,666 and 2,382,500 options to employees and directors having an approximate fair value of $3.1 million, $8.0 million and $5.0 million based upon the Black-Scholes options pricing model, respectively. Stock-based compensation expense included in general and administrative expenses and research and development expenses relating to stock options issued to employees for the years ended December 31, 2016, 2015 and 2014 was $3.4 million, $2.3 million and $2.1 million, respectively. Stock-based compensation expense included in general and administrative expenses and research and development expenses relating to stock options issued to consultants for the years ended December 31, 2016, 2015 and 2014 were $603,000, $888,000 and $380,000, respectively. A summary of stock option activities for the years ended December 31, 2016, 2015 and 2014, is as follows: Synthetic Biologics, Inc. and Subsidiaries 5. Stock-Based Compensation - (continued) The options outstanding and exercisable at December 31, 2016 are as follows: The options outstanding and exercisable at December 31, 2015 are as follows: The options outstanding and exercisable at December 31, 2014 are as follows: Synthetic Biologics, Inc. and Subsidiaries 5. Stock-Based Compensation - (continued) The following is a summary of the Company’s non-vested stock options at December 31, 2016: As of December 31, 2016, total unrecognized stock-based compensation expense related to stock options was $6.4 million, which is expected to be expensed through January 2019. FASB’s guidance for stock-based payments requires cash flows from excess tax benefits to be classified as a part of cash flows from financing activities. Excess tax benefits are realized tax benefits from tax deductions for exercised options in excess of the deferred tax asset attributable to stock compensation costs for such options. The Company did not record any excess tax benefits in 2016, 2015 or 2014. Cash received from option exercises under the Company’s stock-based compensation plans for the years ended December 31, 2016, 2015 and 2014 was $814,000, $41,000 and $4,000, respectively. Stock Warrants On November 18, 2016, the Company completed a public offering of 25 million shares of common stock in combination with accompanying warrants to purchase an aggregate of 50,000,000 shares of the common stock. The stock and warrants were sold in combination, with two warrants for each share of common stock sold, a Series A warrant and a Series B warrant, each representing the right to purchase one share of common stock. The purchase price for each share of common stock and accompanying warrants was $1.00. The shares of common stock were immediately separable from the warrants and will be issued separately. The initial per share exercise price of the Series A warrants is $1.43 and the per share exercise price of the Series B warrants is $1.72, each subject to adjustment as specified in the Warrants. The Series A and Series B warrants may be exercised at any time on or after the date of issuance. The Series A warrants are exercisable until the four year anniversary of the issuance date. The Series B warrants are exercisable until December 31, 2017. The warrants include a provision, that if the Company were to enter into a certain transaction, as defined in the agreement, the warrants would be purchased from the holder for cash. Accordingly, the Company recorded the warrants as a liability at their estimated fair value on the issuance date, which was $15.7 million, and changes in estimated fair value will be recorded as non-cash income or expense in the Company’s Statement of Operations at each subsequent period. At December 31, 2016, the fair value of the warrant liability was $12.7 million, which resulted in non-cash income of $3.0 million in 2016. In accordance with authoritative accounting guidance, the warrants were valued on the date of grant using the Monte Carlo Simulation valuation model. The assumptions used by the Company are summarized in the following table: On October 10, 2014, the Company raised net proceeds of $19.1 million through the sale of 14,059,616 units at a price of $1.47 per unit to certain institutional investors in a registered direct offering. Each unit consisted of one share of the Company’s common stock and a warrant to purchase 0.5 shares of common stock. The warrants, exercisable for an aggregate of 7,029,808 shares of common stock, have an exercise price of $1.75 per share and a life of five years. The warrants vested immediately and expire October 10, 2019. The warrants issued in conjunction with the registered direct offering in October 2014 include a provision, that if the Company were to enter into a certain transaction, as defined in the agreement, the warrants would be purchased from the holder at a premium. Accordingly, the Company recorded the warrants as a liability at their estimated fair value on the issuance date, which was $7.4 million, and changes in estimated fair value will be recorded as non-cash income or expense in the Company’s statement of operations at each subsequent period. At December 31, 2016, the fair value of the warrant liability was $2.1 million, which resulted in non-cash income of $8.5 million in 2016. At December 31, 2015, the fair value of the warrant liability was $10.6 million, which resulted in non-cash income of $3.8 million in 2015. In accordance with authoritative accounting guidance, the warrants were valued on the date of grant using the Black-Scholes valuation model which approximates the value derived using the Monte Carlo Simulation valuation model. The assumptions used by the Company are summarized in the following table: Synthetic Biologics, Inc. and Subsidiaries 5. Stock-Based Compensation - (continued) The following table summarizes the estimated fair value of the warrant liability (in thousands) : As of December 31, 2016, all of the warrants remained outstanding. On October 25, 2012, the Company entered into a Common Stock Purchase Agreement with certain accredited investors. As part of this agreement, the Company issued warrants to purchase 635,855 shares of common stock to the placement agent, or its permitted assigns. The warrants have an exercise price of $1.60 and a life of five years. The warrants vested immediately and expire October 25, 2017. Since these warrants were granted as part of an equity raise, the Company has treated them as a direct offering cost. The result of the transaction has no affect to equity. As of December 31, 2016, 311,834 of these warrants remained outstanding. A summary of warrant activity for the Company for the years ended December 31, 2016 and 2015 is as follows: There was no stock-based compensation expense included in general and administrative expenses relating to warrants issued to consultants for the years ended December 31, 2016, 2015 and 2014. A summary of all outstanding and exercisable warrants as of December 31, 2016 is as follows: Synthetic Biologics, Inc. and Subsidiaries 6. Stockholders’ Equity Year Ended December 31, 2016 On November 18, 2016, the Company completed a public offering of 25 million shares of common stock in combination with accompanying warrants to purchase an aggregate of 50,000,000 shares of the common stock. The stock and warrants were sold in combination, with two warrants for each share of common stock sold, a Series A warrant and a Series B warrant, each representing the right to purchase one share of common stock. The purchase price for each share of common stock and accompanying warrants was $1.00. The shares of common stock are immediately separable from the warrants and were issued separately. The initial per share exercise price of the Series A warrants was $1.43 and the per share exercise price of the Series B warrants was $1.72, each subject to adjustment as specified in the warrants. The Series A and Series B warrants may be exercised at any time on or after the date of issuance. The Series A warrants are exercisable until the four year anniversary of the issuance date. The Series B warrants are exercisable until December 31, 2017. Net proceeds, after deducting underwriting discounts and estimated expenses were approximately $23.3 million. On August 5, 2016, the Company entered into the FBR Sales Agreement with FBR Capital Markets & Co., which enables the Company to offer and sell shares of the Company’s common stock with an aggregate sales price of up to $40.0 million, from time to time through FBR Capital Markets & Co. as the Company’s sales agent. Sales of common stock under the FBR Sales Agreement are made in sales deemed to be “at-the-market” equity offerings as defined in Rule 415 promulgated under the Securities Act, as amended. FBR Capital Markets & Co. is entitled to receive a commission rate of up 3.0% of gross sales in connection with the sale of the Company’s common stock sold on the Company’s behalf. From August 11, 2016 through December 31, 2016, the Company had sold through the FBR Sales Agreement an aggregate of 900,628 shares of the Company's common stock, and received gross proceeds of approximately $1,550,197, before deducting issuance expenses. Also, during the year ended December 31, 2016, the Company issued 445,334 shares of common stock, in connection with the exercise of stock options and warrants, for proceeds of approximately $814,000. Year Ended December 31, 2015 On August 29, 2015, the Company, SYN Biomics, a majority-owned subsidiary, and Mark Pimentel, M.D. entered into an amendment to the Stock Purchase Agreement dated December 3, 2013, which accelerated the date upon which Dr. Pimentel could exchange his shares of common stock in SYN Biomics for shares of the Company’s common stock. On August 29, 2015, Dr. Pimentel notified the Company of his intent to exchange all of the shares of common stock in SYN Biomics owned by him for 1,350,000 shares of the Company’s common stock in accordance with the terms of the Stock Purchase Agreement, as amended. On August 31, 2015, the Company issued 1,350,000 shares of the Company’s common stock to Dr. Pimentel in exchange for all of the shares of common stock of SYN Biomics held by Dr. Pimentel. On August 10, 2015, the Company expanded its relationship with Intrexon Corporation (“Intrexon”) and entered into an Exclusive Channel Collaboration Agreement with Intrexon that governs a “channel collaboration” arrangement in which the Company will use Intrexon’s technology relating to the development and commercialization of novel biotherapeutics for the treatment of patients with PKU. The Company paid Intrexon a technology access fee by the issuance of 937,500 shares of common stock, having a value equal to $3.0 million, which has been recorded as research and development expense. In July 2015, the Company completed a public offering of 15,333,333 shares of common stock, including the fully exercised over-allotment option by the underwriters covering 2.0 million shares, at an offering price of $3.00 per share. The total gross proceeds of the offering, including the exercise in full of the over-allotment option, were approximately $46.0 million. Net proceeds to the Company, after deducting the underwriters’ discount and other estimated expenses, were approximately $42.6 million. The Company paid direct offering costs of $3.4 million. In addition, during the year ended December 31, 2015, the Company issued 655,321 shares of common stock to Prev ABR LLC, with a fair value of $1,350,000, that was recorded as research and development expense, in consideration for achieving the first three milestones as set forth in the Asset Purchase Agreement dated November 28, 2012. In lieu of receiving any cash payment for achieving the first three milestones, Prev ABR LLC exercised its option to receive the milestone payments in shares of the Company’s common stock. The number of shares of common stock issued upon achievement of each milestone was based upon the average of the opening and closing prices of the Company’s stock on the date each milestone was achieved as specified in the Asset Purchase Agreement. Also, during the year ended December 31, 2015, the Company issued 35,006 shares of common stock, in connection with the exercise of stock options and warrants, for proceeds of approximately $41,000. Year Ended December 31, 2014 On October 10, 2014, the Company completed a registered direct offering of 14,059,616 units, with each unit consisting of one share of the Company’s common stock at a closing price of $1.47 for gross proceeds of $20.7 million and net proceeds of $19.1 million. The Company paid direct offering costs of $1.6 million. During the year ended December 31, 2014, the Company issued 6,583 shares of common stock, in connection with the exercise of stock options, for proceeds of approximately $4,000. The Company also issued 232,619 shares of common stock, in connection with cashless warrant exercises for the year ended December 31, 2014. Synthetic Biologics, Inc. and Subsidiaries 7. Non-controlling Interest On August 29, 2015, the Company, SYN Biomics and Mark Pimentel, M.D. entered into an amendment to the Pimentel Stock Purchase Agreement dated December 3, 2013, which accelerated the date upon which Dr. Pimentel could exchange his shares of common stock in SYN Biomics for shares of the Company’s common stock. On August 29, 2015, Dr. Pimentel notified the Company of his intent to exchange all of the shares of common stock in SYN Biomics, 8.5%, owned by him for 1,350,000 shares of the Company’s common stock in accordance with the terms of the Stock Purchase Agreement, as amended. On August 31, 2015, the Company issued 1,350,000 shares of the Company’s common stock to Dr. Pimentel in exchange for all of the shares of common stock of SYN Biomics held by Dr. Pimentel. The Company’s non-controlling interest is accounted for under ASC 810, Consolidation (“ASC 810”) and represents the minority shareholder’s ownership interest related to the Company’s subsidiary, SYN Biomics. In accordance with ASC 810, the Company reports its non-controlling interest in subsidiaries as a separate component of equity in the Condensed Consolidated Balance Sheets and reports both net loss attributable to the non-controlling interest and net loss attributable to the Company’s common shareholders on the face of the Consolidated Statements of Operations. After Dr. Pimentel’s transaction, the Company’s equity interest in SYN Biomics is 88.5% and the non-controlling stockholder’s interest is 11.5%. As of December 31, 2016, the accumulated net loss attributable to the non-controlling interest is $1.6 million that includes $1 million of prior year losses attributable to minority stockholders includingthe reversal of Dr. Pimentel’s 2015 losses of $505,000 associated with the exchange of his shares of common stock in SYN Biomics for shares of the Company’s common stock, and current year losses of $548,000 attributable to minority stockholders. Management considers the amounts which should have been recorded in prior years to be immaterial. 8. License, Collaborative and Employment Agreements and Commitments License and Collaborative Agreements As described below, the Company has entered into several license and collaborative agreements for the right to use research, technology and patents. Some of these license and collaborative agreements may contain milestones. The specific timing of such milestones cannot be predicted and are dependent on future developments as well as regulatory actions which cannot be predicted with certainty (including actions which may never occur). Further, under the terms of certain licensing agreements, the Company may have the obligation to pay certain milestones contingent upon the achievement of specific levels of sales. Due to the long-range nature of such commercial milestone amounts, they are neither probable at this time nor predictable and consequently are not included in this disclosure. Cedars-Sinai Medical Center (“CSMC”) Agreement On December 5, 2013, the Company, through its newly formed, majority owned subsidiary, SYN Biomics entered into a worldwide exclusive License Agreement with CSMC for the development of new treatment approaches to target non-bacterial intestinal microorganism life forms known as archaea that are associated with intestinal methane production and chronic diseases such as irritable bowel syndrome (IBS), obesity and type 2 diabetes. As part of the terms of the License Agreement the Company issued 334,911 unregistered shares of Company common stock to CSMC, paid $150,000 for the initial license fee and $220,000 for patent reimbursement fees. The License Agreement also provides that commencing on the second anniversary of the License Agreement, SYN Biomics will pay an annual maintenance fee, which payment shall be creditable against annual royalty payments owed under the License Agreement. In addition to royalty payments which are a percentage of Net Sales of licensed and technology products, SYN Biomics is obligated to pay CMSC a percentage of any non-royalty sublicense revenues, as well as additional consideration upon the achievement of milestones (the first two of which are payable in cash or unregistered shares of Company stock at the Company’s option). On December 5, 2013, the Company also entered into an option agreement with CSMC, which expired unexercised on December 31, 2014. Synthetic Biologics, Inc. and Subsidiaries 8. License, Collaborative and Employment Agreements and Commitments - (continued) The License Agreement terminates: (i) automatically if SYN Biomics enters into a liquidating bankruptcy or other specified bankruptcy event or if the performance of any term, covenant, condition or provision of the License Agreement will jeopardize the licensure of CMSC, its participation in certain reimbursement programs, its full accreditation by the Joint Commission of Accreditation of Healthcare Organizations or any similar state organizations, its tax exempt status or is deemed illegal; (ii) upon 30 days notice from CMSC if SYN Biomics fails to make a payment or use commercially reasonable efforts to exploit the patent rights; (iii) upon 60 days notice from CMSC if SYN Biomics fails to cure any breach or default of any material obligations under the License Agreement; or (iv) upon 90 days notice from SYN Biomics if CMCS fails to cure any breach or default of any material obligations under the License Agreement. SYN Biomics also has the right to terminate the License Agreement without cause upon six months notice to CSMC; however, upon such termination, SYN Biomics is obligated to pay a termination fee with the amount of such fee reduced: (i) if such termination occurs after an Investigational New Drug submission to the FDA but prior to completion of a Phase 2 clinical trial, (ii) reduced further if such termination occurs after completion of Phase 2 clinical trial but prior to completion of a Phase 3 clinical trial; and (iii) reduced to zero if such termination occurs after completion of a Phase 3 clinical trial. Prior to the execution of the CSMC License Agreement, SYN Biomics issued shares of common stock of SYN Biomics to each of CSMC and Mark Pimentel, M.D. (the primary inventor of the intellectual property), representing 11.5% and 8.5%, respectively, of the outstanding shares of SYN Biomics (the “SYN Biomics Shares”). The Stock Purchase Agreements for the SYN Biomics Shares provide for certain anti-dilution protection until such time as an aggregate of $3.0 million in proceeds from equity financings are received by SYN Biomics as well as a right, under certain circumstances in the event that the SYN Biomics Shares are not then freely tradable, and subject to NYSE MKT, LLC approval, as of the 18 and 36 month anniversary date of the effective date of the Stock Purchase Agreements, for each of CSMC and the Dr. Pimentel to exchange up to 50% of their SYN Biomics shares for unregistered share of the Company’s common stock, with the rate of exchange based upon the relative contribution of the valuation of SYN Biomics to the public market valuation of us at the time of each exchange. The Stock Purchase Agreements also provide for tag-along rights in the event of the sale by the Company of its shares of SYN Biomics. On August 29, 2015, the Company, SYN Biomics and Mark Pimentel, M.D. entered into an amendment to the Pimentel Stock Purchase Agreement, which accelerated the date upon which Dr. Pimentel can exchange his shares of common stock in SYN Biomics for shares of the Company’s common stock. On August 29, 2015, Dr. Pimentel notified the Company of his intent to exchange all of the shares of common stock in SYN Biomics owned by him for 1,350,000 shares of the Company’s common stock in accordance with the terms of the Pimentel Stock Purchase Agreement, as amended. On August 31, 2015, the Company issued 1,350,000 shares of the Company’s common stock to Dr. Pimentel in exchange for all of the shares of common stock of SYN Biomics held by Dr. Pimentel. University of Texas Austin Agreement On December 19, 2012, the Company entered into a License Agreement with The University of Texas at Austin (the “University”) for the exclusive license of the right to use, develop, manufacture, market and commercialize certain research and patents related to pertussis antibodies. The License Agreement provides that the University is entitled to payment of past patent expenses, an annual payment of $50,000 per year commencing on the effective date through December 31, 2014 and a $25,000 payment on December 31, 2015 and milestone payments of $50,000 upon commencement of Phase 1 clinical trials, $100,000 upon commencement of Phase 3 clinical trials, $250,000 upon NDA submission in the U.S., $100,000 upon European Medicines Agency approval and $100,000 upon regulatory approval in an Asian country. In addition, the University is entitled to a running royalty upon net sales. The License Agreement terminates upon the expiration of the patent rights; provided, however that the License Agreement is subject to early termination by the Company in its discretion and by the University for a breach of the License Agreement by the Company. Synthetic Biologics, Inc. and Subsidiaries 8. License, Collaborative and Employment Agreements and Commitments - (continued) In connection with the License Agreement, the Company and the University also entered into a Sponsored Research Agreement pursuant to which the University will perform certain research work related to pertussis. The Sponsored Research Agreement may be renewed annually, in the sole discretion of the Company, after the first year for two additional one year terms with a fixed fee for the first year of $303,287. The Sponsored Research Agreement was renewed for the second and third years for a fixed fee of $316,438 and $328,758 respectively, all payable in quarterly installments. The Sponsored Research Agreement was to expire on December 31, 2015; provided, however, the Sponsored Research Agreement is subject to early termination upon the written agreement of the parties, a default in the material obligations under the Research Agreement which remain uncured for sixty days after receipt of notice, automatically upon the Company’s bankruptcy or insolvency and by the Company in its sole discretion at any time after the one year anniversary of the date of execution thereof upon no less than 90 days notice. On October 22, 2015, the Company and the University amended the Sponsored Research Agreement to extend the termination date to January 15, 2017 and again on September 2, 2016 to extend the agreement until January 15, 2018. All other terms and conditions of the Sponsored Research Agreement remain unchanged. No further or additional payments will be made to the University as a result of this amendment. Prev ABR LLC (“Prev”) Agreement On November 28, 2012, the Company entered into an agreement (“Prev Agreement”) to acquire the C. diff program assets of Prev, including pre-Investigational New Drug (IND) package, Phase 1 and Phase 2 clinical data, manufacturing process data and all issued and pending U.S. and international patents. Upon execution and closing of the Prev Agreement, the Company paid Prev cash payments of $235,000 and issued 625,000 unregistered shares of its common stock to Prev. As set forth in the Prev Agreement, Prev may be entitled to receive additional consideration upon the achievement of certain milestones including: (i) commencement of an IND; (ii) commencement of a Phase 1 clinical trial; (iii) commencement of a Phase 2 clinical trial; (iv) commencement of a Phase 3 clinical trial; (v) filing a Biologic License Application (BLA) in the U.S. and for territories outside of the U.S. (as defined in the Prev Agreement); and (vi) approval of a BLA in the U.S. and for territories outside the-U.S. With exception of the first milestone payment, the remaining milestones are payable 50% in cash and 50% in our stock, however, at Prev’s option the entire milestone may be payable in shares of our stock. Under the Prev Agreement, the Company may be required to the return all of assets acquired from Prev if on or prior to the Prev Agreement execution date (i) the Company has not initiated toxicology studies in non-rodent models within 30 months, or (ii) within 36 months the Company has not filed a C. Diff program IND and such failure is not due to action or inaction of Prev or breach of its representations or warranties or covenants or if there is a change of control as defined in the Prev Agreement and after such change of control the assets are not further developed; provided however that such 30 and 36 month periods can be extended by the Company for an additional 12 months upon payment of a cash milestone payment. As of December 31, 2015, the first three milestones have been met, and at Prev’s option, Prev elected to receive 655,321 shares of the Company’s common stock. No milestones were achieved or such payments were made during the year ended December 31, 2016. Intrexon Exclusive Channel Collaboration On August 6, 2012, the Company expanded its relationship with Intrexon and entered into an Exclusive Channel Collaboration (“ECC”) (“Infectious Disease ECC”) with Intrexon that governs an “exclusive channel collaboration” arrangement in which the Company will use Intrexon’s technology relating to the identification, design and production of human antibodies and DNA vectors for the development and commercialization of a series of monoclonal antibody therapies for the treatment of certain serious infectious diseases. Pursuant to the terms of the Second Stock Issuance Agreement with Intrexon, which was approved by the Company’s stockholders on October 5, 2012, the Company issued 3,552,210 shares of its common stock, $0.001 par value, which issuance is also deemed paid in consideration for the execution and delivery of the Infectious Disease ECC, dated August 6, 2012, between the Company and Intrexon. The fair value of this transaction was $7.8 million and was charged to research and development expense for the year ended December 31, 2012, in accordance with the Company’s accounting policy. In connection with the transactions contemplated by the Second Stock Issuance Agreement, and pursuant to the First Amendment to Registration Rights Agreement (the “First Amendment to Registration Rights Agreement”) executed and delivered by the parties at the closing, which was declared effective on May 5, 2013. The Company filed a “resale” registration statement registering the resale of the shares issued under the Second Stock Issuance Agreement. Synthetic Biologics, Inc. and Subsidiaries 8. License, Collaborative and Employment Agreements and Commitments - (continued) Subject to certain expense allocations and other offsets provided in the Infectious Disease ECC, the Company will pay Intrexon royalties on annual net sales of the Synthetic Products, calculated on a Synthetic Product-by-Synthetic Product basis. The Company has likewise agreed to pay Intrexon a percentage of quarterly revenue obtained from a sublicensor in the event of a sublicensing arrangement. No such payments were made during the year ended December 31, 2016. The Company also agreed upon the filing of an IND application with the FDA for a Synthetic Product, or alternatively the filing of the first equivalent regulatory filing with a foreign regulatory agency (both as applicable, the “IND Milestone Event”), to pay Intrexon either (i) $2.0 million in cash, or (ii) that number of shares of Common Stock (the “IND Milestone Shares”) having a fair market value equaling $2.0 million where such fair market value is determined using published market data of the share price for Common Stock at the close of market on the business day immediately preceding the date of public announcement of attainment of the IND Milestone Event. Upon the first to occur of either first commercial sale of a Synthetic Product in a country or the granting of the regulatory approval of that Synthetic Product (both as applicable, the “Approval Milestone Event”), the Company agreed to pay to Intrexon either (i) $3.0 million in cash, or (ii) that number of shares of Common Stock (the “Approval Milestone Shares”) having a fair market value equaling $3.0 million where such fair market value is determined using published market data of the share price for Common Stock at the close of market on the business day immediately preceding the date of public announcement of attainment of the Approval Milestone Event. The Company also agreed that it will pay an optional and varying fee whereby the Company remits a payment, in cash or equity at our sole discretion, to Intrexon calculated as a multiple of the number of targets in excess of three total that the Company desires to elect (the “Field Expansion Fee”). The Field Expansion Fee must be paid completely in either Common Stock or cash, and will comprise either (i) $2.0 million in cash for each target in excess of three total that the Company elects, or (ii) that number of shares of Common Stock (the “Field Expansion Fee Shares”) having a fair market value equaling $2.0 million for each such target that the Company elects in excess of three where such fair market value is determined using published market data establishing the volume-weighted average price for a share of Common Stock over the 30 day period immediately preceding the date of the Field Expansion Fee Closing. No milestones were achieved or such payments were made during the year ended December 31, 2016. On August 10, 2015, the Company expanded our relationship with Intrexon and entered into an Exclusive Channel Collaboration Agreement (the “Channel Agreement”) with Intrexon that governs a “channel collaboration” arrangement in which the Company will use Intrexon’s technology relating to the development and commercialization of novel biotherapeutics (a “Collaboration Product”) for the treatment of patients with PKU. On September 2, 2015, in accordance with the terms of the Intrexon Stock Issuance Agreement that that the Company entered into in connection with the Channel Agreement, the Company paid Intrexon a technology access fee by the issuance of 937,500 shares of common stock, having a value equal to $3 million as of August 7, 2015. Synthetic Biologics, Inc. and Subsidiaries 8. License, Collaborative and Employment Agreements and Commitments - (continued) In addition, upon the achievement of certain milestones, the Company agreed to pay Intrexon milestone payments of up to $27 million for each product developed as follows: (i) $2 million upon first dosing of a patient in a Phase 1 clinical trial upon commencement of an IND, payable in stock or cash at our option; (ii) a payment 30 days after achievement of the first commercial sale of a Collaboration Product in the United States or approval of a New Drug Application and/or Biologics License Application for a Collaboration Product by the U.S. Food and Drug Administration; and (iii) a payment 30 days after achievement of the first commercial sale of a Collaboration Product in a nation subject to the authority of the European Medicines Agency (EMA) or approval of a Marketing Authorization Application for a Collaboration Product by the EMA. The Company will pay Intrexon royalties on annual net sales of Collaboration Products, calculated on a product-by-product basis, equal to a percent of net sales (ranging from mid-single digits on the first $100 million of net sales to mid-teen digits on net sales in excess of $750 million). The Company likewise agreed to pay Intrexon a percentage of quarterly revenue obtained from a sublicensor in the event of a sublicensing arrangement. Pursuant to the Second Amendment to Registration Rights Agreement, the Company filed a “resale” registration statement to register the shares issued under the Intrexon Stock Issuance Agreement, which was declared effective by the SEC on October 15, 2015. During December 2012, the Company paid Intrexon a prepayment of research and development expenses of $2.5 million for research and development goods and services to be provided in the future and has been recorded on the Company’s consolidated balance sheets in prepaid expenses and other current assets. Related research and development expenses of $643,000, $424,000 and $293,000 were recorded against this prepayment for the years ended December 31, 2016, 2015 and 2014, respectively. At December 31, 2016, there is no remaining balance of the Intrexon prepayment of research and development expenses. Employment Agreements Effective February 3, 2012, Jeffrey Riley was appointed to serve as the Company’s Chief Executive Officer and President. In connection with his appointment, Mr. Riley entered into a three-year employment agreement with the Company (the “Original Riley Agreement”). Pursuant to the Original Riley Employment Agreement, Mr. Riley was entitled to an annual base salary of $348,000 and was eligible for discretionary performance and transactional bonus payments. Additionally, Mr. Riley was granted options to purchase 750,000 shares of the Company’s common stock with an exercise price equal to the per share market price on the date of issue. These options will vest pro rata, on a monthly basis, over 36 months. The Company measured the fair value of the stock options at approximately $1.7 million using a Black-Scholes valuation model. Effective March 18, 2015, the Company entered into a new two-year employment agreement with Mr. Riley (the “Riley Employment Agreement”). Pursuant to the new Riley Employment Agreement Mr. Riley’s annual base salary remained at $385,000. Beginning in 2015 and for each full calendar year thereafter, Mr. Riley is eligible for an annual performance bonus of up to seventy-five percent (75%) of his base salary. The annual bonus will be based upon the Board’s assessment of Mr. Riley’s performance. The Employment Agreement also includes confidentiality obligations, inventions assignments by Mr. Riley as well as change in control, non-solicitation and non-competition provisions. Effective December 4, 2015, the Company entered into an amendment to the Riley Employment Agreement dated March 18, 2015, to increase Mr. Riley’s annual base salary to $550,000. On April 28, 2015, the Company entered into a two-year employment agreement with Steven A. Shallcross (the “Shallcross Employment Agreement”), who was appointed to serve as the Company’s Chief Financial Officer, Treasurer and Secretary, effective June 1, 2015. Pursuant to the Employment agreement, Mr. Shallcross is entitled to an annual base salary of $315,000. Additionally, Mr. Shallcross was granted options to purchase 900,000 shares of the Company’s common stock with an exercise price equal to the per share market price on the date of issue. These options vest pro rata, on a monthly basis, over 36 months. The Company measured the fair value of the stock options at approximately $1.9 million using a Black-Scholes valuation model. In 2015 and for each full calendar year thereafter, Mr. Shallcross will be eligible for an annual performance bonus of up to seventy-five percent (75%) of his base salary. The annual bonus is to be based upon the Board’s assessment of Mr. Shallcross’ performance. The Employment Agreement also includes confidentiality obligations and inventions assignments by Mr. Shallcross and non-solicitation and non-competition provisions. Synthetic Biologics, Inc. and Subsidiaries 8. License, Collaborative and Employment Agreements and Commitments - (continued) Effective November 30, 2016, the Company entered into an amendment to Shallcross Employment Agreement dated April 28, 2015, to increase Mr. Shallcross’ annual base salary to $346,500. The Riley Employment Agreement and the Shallcross Employment Agreement each have a stated term of two years but may be terminated earlier pursuant to their terms. If either Mr. Riley’s or Mr. Shallcross’ (each an “Executive”) employment is terminated for any reason, he or his estate as the case may be, will be entitled to receive the accrued base salary, vacation pay, expense reimbursement and any other entitlements accrued by him to the extent not previously paid (the “Accrued Obligations”); provided , however , that if his employment is terminated (1) by the Company without Cause or by the Executive for Good Reason (as each is defined below) then in addition to paying the Accrued Obligations, (x) the Company will continue to pay his then current base salary and continue to provide benefits at least equal to those which were provided at the time of termination for a period of twelve (12) months and (y) he shall have the right to exercise any vested equity awards until the earlier of six (6) months after termination or the remaining term of the awards, or (2) by reason of his death or Disability (as defined in the Riley Employment Agreement and the Shallcross Employment Agreement), then in addition to paying the Accrued Obligations, he would have the right to exercise any vested options until the earlier of six (6) months after termination or the remaining term of the awards. In such event, if the Executive commenced employment with another employer and becomes eligible to receive medical or other welfare benefits under another employer-provided plan, the medical and other welfare benefits to be provided by The Company as described herein will terminate. The Riley Employment Agreement and the Shallcross Employment Agreement each provide that upon the closing of a “Change in Control” (as defined below), the time period that the Executive will have to exercise all vested stock options and other awards that the Executive may have will be equal to the shorter of: (i) six (6) months after termination, or (ii) the remaining term of the award(s). Upon the closing of a Change in Control, all of Mr. Shallcross’ unvested options shall immediately vest. If within one year after the occurrence of a Change in Control, the Executive terminates his employment for “Good Reason” or the Company terminates the Executive’s employment for any reason other than death, Disability or Cause, the Executive will be entitled to receive: (i) the portion of his base salary for periods prior to the effective date of termination accrued but unpaid (if any); (ii) all unreimbursed expenses (if any); (iii) an aggregate amount (the “Change in Control Severance Amount”) equal to two times the sum of the base salary plus an amount equal to the bonus that would be payable if the “target” level performance were achieved under the Company’s annual bonus plan (if any) in respect of the fiscal year during which the termination occurs (or the prior fiscal year if bonus levels have not yet been established for the year of termination); and (iv) the payment or provision of any other benefits. The Change in Control Severance Amount is to be paid in a lump sum, if the Change in Control event constitutes a “change in the ownership” or a “change in the effective control” of the Company or a “change in the ownership of a substantial portion of a corporation’s assets” (each within the meaning of Section 409A of the Internal Revenue Code), or in 48 substantially equal payments, if the Change in Control event does not so comply with Section 409A. Upon the termination of employment for Good Reason by the Executive or upon the involuntary termination of employment of Executive for any reason other than death, Disability or Cause, in either case within two years commencing after the occurrence of a Change in Control, the Executive will be entitled to receive for a period of two years commencing on the date of such termination medical, dental, life and disability coverage for himself and his family members which is not less favorable than the coverage carried by the Company at the time of termination. Synthetic Biologics, Inc. and Subsidiaries 8. License, Collaborative and Employment Agreements and Commitments - (continued) For the purposes of the Riley Employment Agreement and the Shallcross Employment Agreement “Change in Control” is defined as: (i) any person or entity becoming the beneficial owner, directly or indirectly, of our securities representing fifty (50%) percent of the total voting power of all its then outstanding voting securities; (ii) a merger or consolidation of us in which our voting securities immediately prior to the merger or consolidation do not represent, or are not converted into securities that represent, a majority of the voting power of all voting securities of the surviving entity immediately after the merger or consolidation; or (iii) a sale of substantially all of our assets or our liquidation or dissolution. For purpose of the Riley Employment Agreement and the Shallcross Employment Agreement, “Good Reason” is defined as the occurrence of any of the following events without the respective Executive’s consent: (i) a material reduction in the Executive’s base salary (other than an across-the-board decrease in base salary applicable to all executive officers of the Company); (ii) a material breach of the employment agreement by the Company; (iii) a material reduction in the Executive’s duties, authority and responsibilities relative to the Executive’s duties, authority, and responsibilities in effect immediately prior to such reduction; or (iv) the relocation of the Executive’s principal place of employment, without the Executive’s consent, in a manner that lengthens his one-way commute distance by fifty (50) or more miles from his then-current principal place of employment immediately prior to such relocation. For purposes of the Riley Employment Agreement and the Shallcross Employment Agreement, “Cause” is defined as that the Executive shall have engaged in any of the following acts or that any of the following events shall have occurred, all as determined by the Board of Directors of the Company in its sole and absolute discretion: (i) gross insubordination, acts of embezzlement or misappropriation of funds, fraud, dereliction of fiduciary obligations; (ii) conviction of a felony or other crime involving moral turpitude, dishonesty or theft (including entry of a nolo contendere plea); (iii) willful unauthorized disclosure of confidential information belonging to the Company or entrusted to the Company by a client; (iv) material violation of any provision of the Executive’s employment agreement, of any Company policy, and/or of a confidentiality agreement, which, to the extent it is curable by the Executive, is not cured by the Executive within thirty (30) days of receiving written notice of such violation by the Company; (v) being under the influence of drugs (other than prescription medicine or other medically related drugs to the extent that they are taken in accordance with their directions) during the performance of the Executive’s duties; (vi) engaging in behavior that would constitute grounds for liability for harassment (as proscribed by the U.S. Equal Employment Opportunity Commission Guidelines or any other applicable state or local regulatory body) or other egregious conduct that violates laws governing the workplace; or (vii) willful failure to perform his written assigned tasks, where such failure is attributable to the fault of the Executive which, to the extent it is curable by the Executive, is not cured by Executive within thirty (30) days of receiving written notice of such violation by the Company. Operating Lease During 2012, the Company entered into a twelve month operating lease for office space in Ann Arbor, Michigan. In September 2015, this lease was amended to extend the term of the lease to December 31, 2016, for annual lease payments of $40,000. This lease was not renewed. In August 2015, the Company also entered into a sixty-six month operating lease that may be renewed for one additional term of five years, for office space in Rockville, Maryland, for annual lease payments of $142,172. The Company’s lease provides for fixed monthly rent for the term of the lease, with monthly rent increasing every 12 months subsequent to the first 12 months of the lease. In March 2016, the Company amended the Rockville, Maryland lease to increase the leased space and extend the lease term of the August 2015 lease conterminous with the lease amendment to sixty-nine months for annual lease payments of $285,843. During the years ended December 31, 2016, 2015 and 2014, the Company recognized rent expense of $145,000, $108,000 and $77,000, respectively. The following table summarizes the Company’s future minimum lease payments as of December 31, 2016 (in thousands): Synthetic Biologics, Inc. and Subsidiaries 9. Income Taxes There was no income tax expense for the years ended December 31, 2016 and 2015 due to the Company’s net losses. The Company’s tax expense differs from the “expected” tax expense for the years ended December 31, 2016 and 2015 (computed by applying the Federal Corporate tax rate of 34% to loss before taxes and 3.96% for blended state income tax rate, the blended rate used was 37.96%), as follows ( in thousands ): The effects of temporary differences that gave rise to significant portions of deferred tax assets at December 31, 2016 and 2015 are as follows ( in thousands ): At December 31, 2016, the Company has a net operating loss carry-forward of approximately $133.3 million available to offset future taxable income expiring through 2035. However, utilization of these net operating losses may be limited due to potential ownership changes under Section 382 of the Internal Revenue Code. The valuation allowance at December 31, 2015 was approximately $42.9 million. The net change in valuation allowance during the year ended December 31, 2016 was an increase of approximately $14.7 million. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred income tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on consideration of these items, management has determined that enough uncertainty exists relative to the realization of the deferred income tax asset balances to warrant the application of a full valuation allowance as of December 31, 2016. ASC 740-10 “ Accounting for Uncertain Tax Positions ” prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. As of December 31, 2016 and 2015, the Company had no unrecognized tax benefits and no adjustments to liabilities or operations were required under ASC 740-10. The Company’s practice was and continues to be to recognize interest and penalty expenses related to uncertain tax positions in income tax expense, which was zero for the years ended December 31, 2016 and 2015. The Company files United States federal and various state income tax returns. The Company does not anticipate that it is reasonably possible that unrecognized tax benefits as of December 31, 2016 will significantly change within the next 12 months. Synthetic Biologics, Inc. and Subsidiaries 10. Related Party Transactions In August 2015, the Company expanded its relationship with Intrexon and entered into an Exclusive Channel Collaboration Agreement with Intrexon. In connection with the Channel Agreement, the Company paid Intrexon a technology access fee by the issuance of 937,500 shares of common stock, having a value equal to $3 million as of August 7, 2015. In August 2012, the Company entered into an Infectious Disease ECC with Intrexon and issued 3,552,210 shares of common stock as consideration, having a fair value of $7.8 million ($2.20 per share), based on the quoted closing trading price on October 5, 2012. In November 2011, the Company entered into its initial ECC with Intrexon and issued 3,123,558 shares of common stock as consideration, having a fair value of $1.7 million ($0.54 per share), based on the quoted closing trading price. In connection with the November 2011 and August 2012 ECCs, the Company paid Intrexon approximately $2.9 million during 2012, including a prepayment of research and development expenses of $2.5 million for research and development goods and services to be provided in the future which has been recorded on the Company’s balance sheet in prepaid expenses and other current assets as described in Note 4. In October 2012, the Company consummated its October 2012 Private Placement and entered into a stock purchase agreement with several investors, including NRM VII Holdings I, LLC, an entity affiliated with Intrexon. Randal J. Kirk, directly and through certain affiliates, has voting and dispositive power over a majority of the outstanding capital of Intrexon Corporation, and controls NRM VII Holdings I, LLC. Mr. Kirk disclaims beneficial ownership of the shares held by Intrexon Corporation and NRM VII Holdings I, LLC, except to the extent of any pecuniary interest therein. In December 2013, through the Company’s subsidiary, Synthetic Biomics, Inc., the Company entered into a worldwide exclusive license agreement with Cedars-Sinai Medical Center “CSMC” and acquired the rights to develop products for therapeutic and prophylactic treatments of acute and chronic diseases, including the development of SYN-010 to target IBS-C. The Company licensed from CSMC a portfolio of intellectual property comprised of several U.S. and foreign patents and pending patent applications for various fields of use, including IBS-C, obesity and diabetes. An investigational team led by Mark Pimentel, M.D. at CSMC discovered that these products may reduce the production of methane gas by certain GI microorganisms. During the year ended December 31, 2016, the Company paid Cedars-Sinai Medical Center $350,000 for milestone payments related this license agreement. There were no milestone payments made during year ended December 31, 2015. On November 18, 2016, Scott Tarriff acquired 300,000 shares of the Company’s common stock together with a Series A warrant to purchase 300,000 shares of the Company’s common stock at an exercise price of $1.43 and a Series B warrant to purchase 300,000 shares of the Company’s common stock at an exercise price of $1.72 for an aggregate purchase price of $300,000. The shares of stock and warrants were acquired in the Company’s public offering that was consummated on November 18, 2016. The Series A warrant may be exercised until the four year anniversary of the date of its issuance and the Series B warrant may be exercised until December 31, 2017. 11. Selected Quarterly Financial Data (Unaudited) (In thousands, except per share amounts) 12. Subsequent Events On January 17, 2017, the Company entered into a two-year employment agreement with Dr. Joseph Sliman (the “Sliman Employment Agreement”), who was promoted at the Company from the position of Senior Vice President-Clinical & Regulatory Affairs to the position of Chief Medical Officer. The terms of the Employment Agreement are set forth below. Pursuant to the terms of the Employment Agreement, Dr. Sliman is entitled to an annual base salary of $385,000 and an annual performance bonus of up to seventy five percent (75%) of his annual base salary. The annual bonus will be based upon the assessment of the Company’s Board of Directors (the “Board”) of Dr. Sliman’s performance. Dr. Sliman was also granted a seven (7) year incentive stock option to purchase at an exercise price equal to the per share market price on the date of issue, one hundred and eighty-eight thousand nine hundred and twenty-seven (188,927) shares of the Company’s common stock, vesting pro rata on a monthly basis over a three (3) year period. The Employment Agreement also includes confidentiality obligations and inventions assignments by Dr. Sliman and non-solicitation and non-competition provisions. Effective February 27, 2017, the Company entered into a new two-year employment agreement with Mr. Riley (the “Riley Employment Agreement”), which replaced the prior two -year employment agreement that the Company had entered into on March 18, 2015 with Mr. Riley which was due to expire on March 17, 2017. Pursuant to the Riley Employment Agreement, Mr. Riley’s annual base salary remained at $550,000. Beginning in 2017 and for each full calendar year thereafter, Mr. Riley is eligible for an annual performance bonus of up to seventy-five percent (75%) of his base salary. The annual bonus will be based upon the Board’s assessment of Mr. Riley’s performance. The Riley Employment Agreement also includes confidentiality obligations, inventions assignments by Mr. Riley as well as change in control, non-solicitation and non-competition provisions.
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Summary of Financial Statement:
The financial statement indicates significant financial challenges:
Profit/Loss:
- Experiencing ongoing operational losses
- Substantial doubt about the company's ability to continue operating
Financial Position:
- Insufficient capital to fund operations for the next 12 months
- Limited cash and cash equivalents (approximately $1.7 in money market accounts)
- Potential inability to secure additional debt or equity capital
Key Risks:
- Uncertain future funding
- Potential need to adjust asset recoverability and liability classifications
- Ongoing financial instability
Management Outlook:
- Seeking ways to address capital needs
- Planned Phase 2 operations may be at risk due to financial constraints
Overall, the financial statement suggests the company is in a precarious financial position with significant uncertainty about its ability to continue operations.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM To the Board of Directors and Shareholders of Franklin Covey Co. Salt Lake City, Utah We have audited the internal control over financial reporting of Franklin Covey Co. (the “Company”) as of August 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of August 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended August 31, 2016 of the Company and our report dated November 14, 2016 expressed an unqualified opinion on those financial statements and included an explanatory paragraph regarding the Company’s early adoption of Financial Accounting Standards Board Accounting Standards Update No. 2015-17, “Balance Sheet Classification of Deferred Taxes,” as of August 31, 2016 on a prospective basis. /s/ Deloitte & Touche LLP Salt Lake City, Utah November 14, 2016 ACCOUNTING FIRM To the Board of Directors and Shareholders of Franklin Covey Co. Salt Lake City, Utah We have audited the accompanying consolidated balance sheet of Franklin Covey Co. (the "Company") as of August 31, 2016, and the related consolidated statements of income and comprehensive income, shareholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Franklin Covey Co. as of August 31, 2016, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the consolidated financial statements, the Company early adopted the Financial Accounting Standards Board Accounting Standards Update No. 2015-17, “Balance Sheet Classification of Deferred Taxes,” as of August 31, 2016 on a prospective basis. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of August 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 14, 2016 expressed an unqualified opinion on the Company's internal control over financial reporting. /s/ Deloitte & Touche LLP Salt Lake City, Utah November 14, 2016 REPORT OF THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Franklin Covey Co. We have audited the accompanying consolidated balance sheets of Franklin Covey Co. as of August 31, 2015, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the two years in the period ended August 31, 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Franklin Covey Co. at August 31, 2015, and the consolidated results of its operations and its cash flows for each of the two years in the period ended August 31, 2015, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Salt Lake City, Utah November 12, 2015 FRANKLIN COVEY CO. CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. FRANKLIN COVEY CO. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME See accompanying notes to consolidated financial statements. FRANKLIN COVEY CO. CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. FRANKLIN COVEY CO. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY See accompanying notes to consolidated financial statements. FRANKLIN COVEY CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Franklin Covey Co. (hereafter referred to as we, us, our, or the Company) is a global company specializing in performance improvement. We help individuals and organizations achieve results that require a change in human behavior and our mission is to “enable greatness in people and organizations everywhere.” Our expertise is in the following seven areas: Leadership, Execution, Productivity, Trust, Sales Performance, Customer Loyalty, and Educational improvement. Our offerings are described in further detail at www.franklincovey.com and elsewhere in this report. We have some of the best-known offerings in the training industry, including a suite of individual-effectiveness and leadership-development training and products based on the best-selling books, The 7 Habits of Highly Effective People, The Speed of Trust, The Leader In Me, and The Four Disciplines of Execution, and proprietary content in the areas of Execution, Sales Performance, Productivity, Customer Loyalty, and Educational improvement. Through our organizational research and curriculum development efforts, we seek to consistently create, develop, and introduce new services and products that help individuals and organizations achieve their own great purposes. Fiscal Year The Company utilizes a modified 52/53-week fiscal year that ends on August 31 of each year. Corresponding quarterly periods generally consist of 13-week periods that ended on November 28, 2015, February 27, 2016, and May 28, 2016 during fiscal 2016. Unless otherwise noted, references to fiscal years apply to the 12 months ended August 31 of the specified year. Basis of Presentation The accompanying consolidated financial statements include the accounts of the Company and our wholly-owned subsidiaries, which consist of Franklin Development Corp., and our offices in Japan, the United Kingdom, and Australia. Intercompany balances and transactions are eliminated in consolidation. Pervasiveness of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Reclassifications Certain reclassifications have been made to prior period financial statements to conform to the current period presentation. These reclassifications were made to separately disclose deferred revenue on our consolidated balance sheets and the change in deferred revenue on our consolidated statements of cash flows. Deferred revenue amounts were previously classified as a component of accrued liabilities. These reclassifications did not impact our results of operations, current liabilities, or net cash flows in the periods presented. Cash and Cash Equivalents Some of our cash is deposited with financial institutions located throughout the United States of America and at banks in foreign countries where we operate subsidiary offices, and at times may exceed insured limits. We consider all highly liquid debt instruments with a maturity date of three months or less to be cash equivalents. We did not hold a significant amount of investments that would be considered cash equivalent instruments at August 31, 2016 or 2015. Inventories Inventories are stated at the lower of cost or market, cost being determined using the first-in, first-out method. Elements of cost in inventories generally include raw materials and direct labor. Cash flows from the sale of inventory are included in cash flows provided by operating activities in our consolidated statements of cash flows. Our inventories are comprised primarily of training materials, books, and related accessories, and consisted of the following (in thousands): Provision is made to reduce excess and obsolete inventories to their estimated net realizable value. In assessing the valuation of inventories, we make judgments regarding future demand requirements and compare these estimates with current and committed inventory levels. Inventory requirements may change based on projected customer demand, training curriculum life-cycle changes, and other factors that could affect the valuation of our inventories. Property and Equipment Property and equipment are recorded at cost. Depreciation expense, which includes depreciation on our corporate campus that is accounted for as a financing obligation (Note 5), and the amortization of assets recorded under capital lease obligations, is calculated using the straight-line method over the lesser of the expected useful life of the asset or the contracted lease period. We generally use the following depreciable lives for our major classifications of property and equipment: Our property and equipment were comprised of the following (in thousands): Leasehold improvements are amortized over the lesser of the useful economic life of the asset or the contracted lease period. We expense costs for repairs and maintenance as incurred. Gains and losses resulting from the sale of property and equipment are recorded in operating income. Impairment of Long-Lived Assets Long-lived tangible assets and definite-lived intangible assets are reviewed for possible impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We use an estimate of undiscounted future net cash flows of the assets over the remaining useful lives in determining whether the carrying value of the assets is recoverable. If the carrying values of the assets exceed the anticipated future cash flows of the assets, we recognize an impairment loss equal to the difference between the carrying values of the assets and their estimated fair values. Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent from other groups of assets. The evaluation of long-lived assets requires us to use estimates of future cash flows. If forecasts and assumptions used to support the realizability of our long-lived tangible and definite-lived intangible assets change in the future, significant impairment charges could result that would adversely affect our results of operations and financial condition. For more information regarding our impaired asset charges in fiscal 2015 and fiscal 2014, refer to Note 11. Indefinite-Lived Intangible Assets and Goodwill Intangible assets that are deemed to have an indefinite life and acquired goodwill are not amortized, but rather are tested for impairment on an annual basis or more often if events or circumstances indicate that a potential impairment exists. The Covey trade name intangible asset has been deemed to have an indefinite life. This intangible asset is tested for impairment using qualitative factors or the present value of estimated royalties on trade name related revenues, which consist primarily of training seminars and work sessions, international licensee sales, and related products. Based on the fiscal 2016 evaluation of the Covey trade name, we believe the fair value of the Covey trade name substantially exceeds its carrying value. No impairment charges were recorded against the Covey trade name during the fiscal years ended August 31, 2016, 2015, or 2014. Goodwill is recorded when the purchase price for an acquisition exceeds the estimated fair value of the net tangible and identified intangible assets acquired. We tested goodwill for impairment at August 31, 2016 at the reporting unit level using a quantitative approach. The first step of the goodwill impairment testing process (Step 1) involves determining whether the estimated fair value of the reporting unit exceeds its respective book value. In performing Step 1, we compare the carrying amount of the reporting unit to its estimated fair value. If the fair value exceeds the book value, goodwill of that reporting unit is not impaired. The estimated fair value of each reporting unit was calculated using a combination of the income approach (discounted cash flows) and the market approach (using market multiples derived from a set of companies with comparable market characteristics). The estimated fair values of the reporting units from these approaches were weighted in the determination of the total fair value. If the Step 1 result concludes that the fair value does not exceed the book value of the reporting unit, goodwill may be impaired and additional analysis is required (Step 2). Step 2 of the goodwill impairment test compares the implied fair value of a reporting unit’s goodwill to its carrying value. The implied fair value of goodwill is derived by performing a hypothetical purchase price allocation for the reporting unit as of the measurement date, allocating the reporting unit’s estimated fair value to its assets and liabilities, including any recognizable intangible assets. The residual amount from performing this allocation represents the implied fair value of goodwill. To the extent this amount is below the carrying value of goodwill, an impairment loss is recorded. On an interim basis, we consider whether events or circumstances are present that may lead to the determination that goodwill may be impaired. These circumstances include, but are not limited to, the following: · significant underperformance relative to historical or projected future operating results; · significant change in the manner of our use of acquired assets or the strategy for the overall business; · significant change in prevailing interest rates; · significant negative industry or economic trend; · significant change in market capitalization relative to book value; and/or · significant negative change in market multiples of the comparable company set. If, based on events or changing circumstances, we determine it is more likely than not that the fair value of a reporting unit does not exceed its carrying value, we would be required to test goodwill for impairment. Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. In addition, we make certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values for each of our reporting units. The timing and frequency of our goodwill impairment tests are based on an ongoing assessment of events and circumstances that would indicate a possible impairment. Based on the results of our goodwill impairment testing during fiscal 2016, we determined that no impairment existed at August 31, 2016 and 2015, as each reportable operating segment’s estimated fair value substantially exceeded its carrying value. We will continue to monitor our goodwill and intangible assets for impairment and conduct formal tests when impairment indicators are present. For more information regarding our intangible assets and goodwill, refer to Note 3. Capitalized Curriculum Development Costs During the normal course of business, we develop training courses and related materials that we sell to our clients. Capitalized curriculum development costs include certain expenditures to develop course materials such as video segments, course manuals, and other related materials. Our capitalized curriculum development spending in fiscal 2016, which totaled $2.2 million, was primarily for offerings related to The Leader In Me and the All Access Pass, as well as various other offerings. During fiscal 2015, our capital spending included significant revisions to the Speed of Trust offering. In fiscal 2014, the majority of our capital spending on curriculum was for our re-created The 7 Habits of Highly Effective People - Signature Edition, which is our best-selling offering throughout the world. Generally, curriculum costs are capitalized when there is a major revision to an existing course that requires a significant re-write of the course materials or curriculum. Costs incurred to maintain existing offerings are expensed when incurred. In addition, development costs incurred in the research and development of new curriculum and software products to be sold, leased, or otherwise marketed are expensed as incurred until economic and technological feasibility has been established. Capitalized development costs are amortized over three- to five-year useful lives, which are based on numerous factors, including expected cycles of major changes to our content. Capitalized curriculum development costs are reported as a component of other long-term assets in our consolidated balance sheets and totaled $8.9 million and $10.5 million at August 31, 2016 and 2015. Amortization of capitalized curriculum development costs is reported as a component of cost of sales. Accrued Liabilities Significant components of our accrued liabilities were as follows (in thousands): Contingent Consideration for Business Acquisitions Acquisitions may include contingent consideration payments based on future financial measures of an acquired company. Contingent consideration is required to be recognized at fair value as of the acquisition date. We estimate the fair value of these liabilities based on financial projections of the acquired company and estimated probabilities of achievement. At each reporting date, the contingent consideration obligation is revalued to estimated fair value and changes in fair value subsequent to the acquisition date are reflected in selling, general, and administrative expense in our consolidated income statements, and could have a material impact on our operating results. Changes in the fair value of contingent consideration obligation may result from changes in discount periods or rates, changes in the timing and amount of earnings estimates, and changes in probability assumptions with respect to the likelihood of achieving various payment criteria. Foreign Currency Translation and Transactions The functional currencies of our foreign operations are the reported local currencies. Translation adjustments result from translating our foreign subsidiaries’ financial statements into United States dollars. The balance sheet accounts of our foreign subsidiaries are translated into United States dollars using the exchange rate in effect at the balance sheet date. Revenues and expenses are translated using average exchange rates for each month during the fiscal year. The resulting translation differences are recorded as a component of accumulated other comprehensive income in shareholders’ equity. Foreign currency transaction losses totaled $0.3 million, $1.1 million, and $0.1 million for the fiscal years ended August 31, 2016, 2015, and 2014, respectively, and are included as a component of selling, general, and administrative expenses in our consolidated income statements. Sales Taxes We collect sales tax on qualifying transactions with customers based upon applicable sales tax rates in various jurisdictions. We account for sales taxes collected using the net method; accordingly, we do not include sales taxes in net sales reported in our consolidated income statements. Revenue Recognition We recognize revenue when: 1) persuasive evidence of an arrangement exists, 2) delivery of product has occurred or services have been rendered, 3) the price to the customer is fixed or determinable, and 4) collectability is reasonably assured. For training and service sales, these conditions are generally met upon presentation of the training seminar or delivery of the consulting services based upon daily rates. For most of our product sales, these conditions are met upon shipment of the product to the customer. At times, our customers may request access to our intellectual property for the flexibility to print certain training materials or to have access to certain training videos and other training aids at their convenience. For intellectual property license sales, the revenue recognition conditions are generally met at the later of delivery of the curriculum to the client or the effective date of the arrangement. Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted for as separate units of accounting, and if so, the fair value for each of the elements. A deliverable constitutes a separate unit of accounting when it has standalone value to our clients. We routinely enter into arrangements that can include various combinations of multiple training curriculum, consulting services, and intellectual property licenses. The timing of delivery and performance of the elements typically varies from contract to contract. Generally, these items qualify as separate units of accounting because they have value to the customer on a standalone basis. When the Company’s training and consulting arrangements contain multiple deliverables, consideration is allocated at the inception of the arrangement to all deliverables based on their relative selling prices at the beginning of the agreement, and revenue is recognized as each curriculum, consulting service, or intellectual property license is delivered. We use the following selling price hierarchy to determine the fair value to be used for allocating revenue to the elements: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence (TPE), and (iii) best estimate of selling price (BESP). Generally, VSOE is based on established pricing and discounting practices for the deliverables when sold separately. In determining VSOE, we require that a substantial majority of the selling prices fall within a narrow range. When VSOE cannot be established, judgment is applied with respect to whether a selling price can be established based on TPE, which is determined based on competitor prices for similar offerings when sold separately. Our products and services normally contain a significant level of differentiation such that the comparable pricing of services with similar functionality cannot be obtained. When we are unable to establish a selling price using VSOE or TPE, BESP is used in our allocation of arrangement consideration. BESPs are established as best estimates of what the selling price would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining BESPs requires judgment and considers multiple factors, such as market conditions, type of customer, geographies, stage of product lifecycle, internal costs, and gross margin objectives. These factors may vary over time depending upon the unique facts and circumstances related to each deliverable. However, we do not expect the effect of changes in the selling price or method or assumptions used to determine selling price to have a significant effect on the allocation of arrangement consideration. Our multiple-element arrangements generally do not include performance, cancellation, termination, or refund-type provisions. Our international strategy includes the use of licensees in countries where we do not have a wholly-owned direct office. Licensee companies are unrelated entities that have been granted a license to translate our content and offerings, adapt the content and curriculum to the local culture, and sell our content in a specific country or region. Licensees are required to pay us royalties based upon a percentage of their sales to clients. We recognize royalty income each period based upon the sales information reported to us from our licensees. Licensee royalty revenues are included as a component of training sales and totaled $14.4 million, $13.7 million, and $13.8 million for the fiscal years ended August 31, 2016, 2015, and 2014. Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts and product returns. Stock-Based Compensation We record the compensation expense for all stock-based payments to employees and non-employees, including grants of stock options and the compensatory elements of our employee stock purchase plan, in our consolidated income statements based upon their fair values over the requisite service period. For more information on our stock-based compensation plans, refer to Note 10. Shipping and Handling Fees and Costs All shipping and handling fees billed to customers are recorded as a component of net sales. All costs incurred related to the shipping and handling of products are recorded in cost of sales. Advertising Costs Costs for advertising are expensed as incurred. Advertising costs included in selling, general, and administrative expenses totaled $6.6 million, $7.4 million, and $7.5 million for the fiscal years ended August 31, 2016, 2015, and 2014. Income Taxes Our income tax provision has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred income taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The income tax provision represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred income taxes result from differences between the financial and tax bases of our assets and liabilities and are adjusted for tax rates and tax laws when changes are enacted. A valuation allowance is provided against deferred income tax assets when it is more likely than not that all or some portion of the deferred income tax assets will not be realized. Interest and penalties related to uncertain tax positions are recognized as components of income tax expense in our consolidated income statements. We may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement. We provide for income taxes, net of applicable foreign tax credits, on temporary differences in our investment in foreign subsidiaries, which consist primarily of unrepatriated earnings. Comprehensive Income Comprehensive income includes changes to equity accounts that were not the result of transactions with shareholders. Comprehensive income is comprised of net income or loss and other comprehensive income and loss items. Our other comprehensive income and losses generally consist of changes in the cumulative foreign currency translation adjustment, net of tax. Accounting Pronouncements Issued and Adopted In November 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This guidance requires all deferred tax assets and liabilities to be classified as non-current in the statement of financial position. The provisions of ASU No. 2015-17 are effective for annual periods beginning after December 15, 2016, including interim periods within that reporting period. We have elected, as permitted by the guidance, to early adopt ASU No. 2015-17 on a prospective basis as of August 31, 2016 and prior periods were not restated. The adoption of this standard did not have a material effect on our consolidated balance sheet at August 31, 2016. Accounting Pronouncements Issued Not Yet Adopted On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. This new standard was issued in conjunction with the International Accounting Standards Board (IASB) and is designed to create a single, principles-based process by which all businesses calculate revenue. The new standard replaces numerous individual, industry-specific revenue rules found in U.S. generally accepted accounting principles and is required to be adopted in fiscal years beginning after December 15, 2017 and for interim periods therein. The new standard may be applied using the “full retrospective” or “modified retrospective” approach. As of August 31, 2016, we have not yet determined the method of adoption nor the impact that ASU No. 2014-09 will have on our reported revenue or results of operations. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606) - Identifying Performance Obligations and Licensing. The guidance in ASU 2016-10 clarifies aspects of Topic 606 related to identifying performance obligations and the licensing implementation guidance, while retaining the related core principles for those areas. The effective date and transition requirements for ASU 2016-10 are the same as the effective date and transition requirements for Topic 606 (ASU 2014-09) discussed above. While we do not expect the adoption of ASU 2016-10 to have a material effect on our business, we are evaluating the potential impact that adoption of ASU 2016-10 may have on our financial position, results of operations, and cash flows. On February 25, 2016, the FASB issued ASU No. 2016-02, Leases. The new lease accounting standard is the result of a collaborative effort with the IASB (similar to the new revenue standard described above), although some differences remain between the two standards. This new standard will affect all entities that lease assets and will require lessees to recognize a lease liability and a right-of-use asset for all leases (except for short-term leases that have a duration of less than one year) as of the date on which the lessor makes the underlying asset available to the lessee. For lessors, accounting for leases is substantially the same as in prior periods. For public companies, the new lease standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted for all entities. For leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, lessees and lessors must apply a modified retrospective transition approach. While we expect the adoption of this new standard will increase reported assets and liabilities, as of August 31, 2016, we have not yet determined the full impact that the adoption of ASU 2016-02 will have on our financial statements. In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment Accounting. The guidance in ASU 2016-09 simplifies several aspects of the accounting for stock-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification of items on the statement of cash flows. ASU 2016-09 is effective for public companies' annual periods, including interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted subject to certain requirements, and the method of application (i.e., retrospective, modified retrospective or prospective) depends on the transaction area that is being amended. Following adoption, the primary impact on our consolidated financial statements will be the recognition of excess tax benefits in the provision for income taxes rather than additional paid-in capital, which will likely result in increased volatility in the reported amounts of income tax expense and net income. As of August 31, 2016, we have not completed our evaluation of the impact of ASU 2016-09 on our results of operations or cash flows. In June 2014, the FASB issued ASU No. 2014-12, Compensation - Stock Compensation (Topic 718). The guidance in ASU No. 2014-12 addresses accounting for share-based payments when the terms of an award provide that a performance target could be achieved after the requisite service period. ASU 2014-12 indicates that, in such situations, the performance target should be treated as a performance condition and, accordingly, the performance target should not be reflected in estimating the grant-date fair value of the award. Instead, compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved. The guidance in ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. We do not expect the adoption of ASU 2014-12 in fiscal 2017 will have a material effect on our financial position, results of operations, or cash flows. 2. ACCOUNTS RECEIVABLE Accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents our best estimate of the amount of probable credit losses in the existing accounts receivable balance, and we review the adequacy of the allowance for doubtful accounts on a regular basis. We determine the allowance for doubtful accounts using historical write-off experience based on the age of the receivable balances and current economic conditions in general. Receivable balances past due over 90 days, which exceed a specified dollar amount, are reviewed individually for collectability. As we increase sales to governmental organizations, including school districts, and offer longer payment terms on certain contracts (which are still within our normal payment terms), our collection cycle may increase in future periods. If the risk of non-collection increases for such receivable balances, there may be additional charges to expense to increase the allowance for doubtful accounts. We classify receivable amounts as current or long-term based on expected payment and record long-term accounts receivable at their net present value. During the fourth quarter of fiscal 2015, we became aware of financial difficulties at a contracting partner from whom we receive payment for services rendered on a large federal government contract. Subsequent to August 31, 2015 we received a $1.8 million payment from this entity and entered into discussions to convert the remaining receivable, which totaled $2.9 million, into a note receivable. Based on expected payment terms as of August 31, 2015, we reclassified this amount to other assets and other long-term assets on the consolidated balance sheet based on expected principal payments. The note receivable is payable over a three-year period and bears interest at 5.0 percent per year. At August 31, 2016, the contracting partner is current on their payments to us. While we believe the remaining amounts due are collectible within the terms of the note receivable, the failure of the contracting partner to pay us may have an adverse impact on our cash flows, financial position, and liquidity. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. We do not have any off-balance sheet credit exposure related to our customers nor do we generally require collateral or other security agreements from our customers. The increase in our account write offs during fiscal 2016 was primarily due to a large Education practice contract that was written off and from uncollectible receivables due from a large sporting goods retailer that went bankrupt in fiscal 2016. Activity in our allowance for doubtful accounts was comprised of the following for the periods indicated (in thousands): Deductions on the foregoing table represent the write-off of amounts deemed uncollectible during the fiscal year presented. Recoveries of amounts previously written off were insignificant for the periods presented. 3. INTANGIBLE ASSETS AND GOODWILL Our intangible assets were comprised of the following (in thousands): Our intangible assets are amortized over the estimated useful life of the asset. The range of remaining estimated useful lives and weighted-average amortization period over which we are amortizing the major categories of definite-lived intangible assets at August 31, 2016 were as follows: Our aggregate amortization expense from definite-lived intangible assets totaled $3.3 million, $3.7 million, and $4.0 million for the fiscal years ended August 31, 2016, 2015, and 2014. Amortization expense from our intangible assets over the next five years is expected to be as follows (in thousands): Our goodwill balance at August 31, 2016 was generated from the fiscal 2009 acquisition of CoveyLink Worldwide, LLC (CoveyLink), the fiscal 2013 acquisition of Ninety Five 5, LLC (Ninety Five 5), and the fiscal 2014 acquisition of Red Tree, Inc. The previous owners of CoveyLink, which includes a brother of one of our executive officers, were entitled to earn annual contingent payments based upon earnings growth over the subsequent five years. These contingent payments were classified as goodwill on our consolidated balance sheets when paid according to previously existing business combination guidance. During fiscal 2015, we made a $0.3 million final payment based on the results of a reassessment of the terms and conditions of the CoveyLink acquisition. Our consolidated goodwill changed as follows during fiscal 2016 and 2015 (in thousands): In connection with the reorganization or our internal reporting structure during fiscal 2016, we allocated our goodwill to the new reportable operating segments based on their relative fair values as follows (in thousands): The goodwill generated by the Red Tree and Ninety Five 5 acquisitions are primarily attributable to the organization, methodologies, and curriculums that complement our existing practices and content. All of the goodwill generated from the acquisition of Red Tree and Ninety Five 5 is expected to be deductible for income tax purposes. 4. REVOLVING LINE OF CREDIT AND TERM NOTES PAYABLE During fiscal 2011, we entered into an amended and restated secured credit agreement (the Restated Credit Agreement) with our existing lender. The Restated Credit Agreement provides us with a revolving line of credit facility and the ability to borrow on other instruments, such as term loans. We generally renew the Restated Credit Agreement on a regular basis to maintain the long-term availability of this credit facility. On May 24, 2016, we entered into the Fifth Modification Agreement to the Restated Credit Agreement. The primary purposes of the Fifth Modification Agreement were to (i) obtain a term loan for $15.0 million (the Term Loan); (ii) increase the maximum principal amount of the revolving line of credit from $30.0 million to $40.0 million; (iii) extend the maturity date of the Restated Credit Agreement from March 31, 2018 to March 31, 2019; (iv) permit the Company to convert balances outstanding from time to time under the revolving line of credit to term loans; and (v) adjust the fixed charge coverage ratio from 1.40 to 1.15. In connection with the Fifth Modification Agreement, we entered into a promissory note, a security agreement, repayment guaranty agreements, and a pledge and security agreement. These agreements pledge substantially all of our assets located in the United States to the lender as collateral for borrowings under the Restated Credit Agreement and subsequent amendments. Revolving Line of Credit The key terms and conditions of the revolving line of credit under the Fifth Modification Agreement are as follows: · Available Credit - The maximum available credit is $40.0 million. The amount of available credit may be reduced by additional term loans (refer to discussion below) obtained during the life of Restated Credit Agreement. · Maturity Date - The maturity date of the Revolving Line of Credit is March 31, 2019. · Interest Rate - The effective interest rate continues to be LIBOR plus 1.85 percent per annum and the unused credit fee on the line of credit remains 0.25 percent per annum. · Financial Covenants - The Restated Credit Agreement requires us to be in compliance with specified financial covenants, including (a) a funded debt to EBITDAR (earnings before interest, taxes, depreciation, amortization, and rental expense) ratio of less than 3.00 to 1.00; (b) a fixed charge coverage ratio greater than 1.15 to 1.0; (c) an annual limit on capital expenditures (not including capitalized curriculum development) of $8.0 million; and (d) outstanding borrowings on the Revolving Line of Credit may not exceed 150 percent of consolidated accounts receivable. In the event of noncompliance with these financial covenants and other defined events of default, the lender is entitled to certain remedies, including acceleration of the repayment of any amounts outstanding on the Restated Credit Agreement. At August 31, 2016, we believe that we were in compliance with the terms and covenants applicable to the Fifth Modification Agreement. The effective interest rate on our Revolving Line of Credit and term notes payable (refer to discussion below) was 2.3 percent at August 31, 2016 and 2.0 percent August 31, 2015. We did not have any borrowings on the revolving line of credit at August 31, 2016 or 2015. Term Notes Payable In connection with the Fifth Modification Agreement, we obtained a $15.0 million term loan and have the ability to obtain additional term loans in increments of $5.0 million up to a maximum of $40.0 million. Each additional term loan will reduce the amount available to borrow on the revolving line of credit facility on a dollar-for-dollar basis. Interest on the term loans is payable monthly at LIBOR plus 1.85 percent per annum and each term loan matures in three years. Interest is payable monthly and principal payments are due and payable on the first day of each January, April, July, and October. Principal payments are equal to the original amount of the term loan divided by 16 and any remaining principal at the maturity date is immediately payable. The proceeds from each term loan may be used for general corporate purposes and each term loan may be repaid sooner than the maturity date at our discretion. Principal payments by fiscal year through the maturity dates of the term loans are as follows (in thousands): Subsequent to August 31, 2016, we obtained an additional term loan with a principal amount of $5.0 million. This additional term loan has the same terms and conditions as described above and the first principal payment is due on October 1, 2016. 5. FINANCING OBLIGATION In connection with the sale and leaseback of our corporate headquarters facility located in Salt Lake City, Utah, we entered into a 20-year master lease agreement with the purchaser, an unrelated private investment group. The 20-year master lease agreement also contains six five-year renewal options that will allow us to maintain our operations at the current location for up to 50 years. Although the corporate headquarters facility was sold and the Company has no legal ownership of the property, under applicable accounting guidance we were prohibited from recording the transaction as a sale since we have subleased a significant portion of the property that was sold. Accordingly, we account for the sale as a financing transaction, which requires us to continue reporting the corporate headquarters facility as an asset and to record a financing obligation for the sale price. The financing obligation on our corporate campus was comprised of the following (in thousands): Future principal maturities of our financing obligation were as follows at August 31, 2016 (in thousands): Our remaining future minimum payments under the financing obligation in the initial 20-year lease term are as follows (in thousands): The $1.3 million difference between the carrying value of the financing obligation and the present value of the future minimum financing obligation payments represents the carrying value of the land sold in the financing transaction, which is not depreciated. At the conclusion of the master lease agreement, the remaining financing obligation and carrying value of the land will be offset and written off of our consolidated financial statements. 6. OPERATING LEASES Lease Expense In the normal course of business, we lease office space and warehouse and distribution facilities under non-cancelable operating lease agreements. We rent office space, primarily for international and domestic regional sales administration offices, in commercial office complexes that are conducive to sales and administrative operations. We also rent warehousing and distribution facilities that are designed to provide secure storage and efficient distribution of our training products, books, and accessories. These operating lease agreements often contain renewal options that may be exercised at our discretion after the completion of the base rental term. In addition, many of the rental agreements provide for regular increases to the base rental rate at specified intervals, which usually occur on an annual basis. At August 31, 2016, we had operating leases with remaining terms ranging from less than one year to approximately seven years. The following table summarizes our future minimum lease payments under operating lease agreements at August 31, 2016 (in thousands): We recognize lease expense on a straight-line basis over the life of the lease agreement. Contingent rent expense is recognized as it is incurred and was insignificant for the periods presented. Total rent expense recorded in selling, general, and administrative expense from operating lease agreements was $2.2 million, $2.3 million, and $2.2 million for the fiscal years ended August 31, 2016, 2015, and 2014. Lease Income We have subleased the majority of our corporate headquarters campus located in Salt Lake City, Utah to multiple, unrelated tenants as well as to FC Organizational Products (FCOP, refer to Note 17). We recognize sublease income on a straight-line basis over the life of the sublease agreement. The cost basis of the office space available for lease was $35.8 million, which had a carrying value of $9.6 million at August 31, 2016. The following future minimum lease payments due to us from our sublease agreements at August 31, 2016 include lease income of approximately $0.7 million per year from FCOP. The majority of contracted lease income after fiscal 2021 is from FCOP (in thousands): Sublease revenue totaled $4.4 million, $4.4 million, and $3.9 million during the fiscal years ended August 31, 2016, 2015, and 2014. 7. COMMITMENTS AND CONTINGENCIES Information Systems and Warehouse Outsourcing Contract Prior to July 2016, we had an outsourcing contract with HP Enterprise Services (HPE) to provide information technology system support and product warehousing and distribution services. Effective July 1, 2016, we entered into a new warehousing services agreement with HPE to provide product kitting, warehousing, and order fulfillment services at an HPE facility in Des Moines, Iowa. Under the terms of the new contract, we pay HPE a fixed charge of $18,000 per month for account management services and variable charges for other warehousing services based on specified activities, including shipping charges. The warehouse charges may be increased each year of the contract based upon changes in the Employment Cost Index. The new warehousing contract with HPE expires on June 30, 2019. During fiscal years 2016, 2015, and 2014, we expensed $3.8 million, $4.9 million, and $5.2 million for services provided under the terms of the HPE outsourcing contract. The total amount expensed each year under the HPE contract includes freight charges, which are billed to the Company based upon activity. Freight charges included in our HPE outsourcing costs totaled $1.8 million, $1.9 million, and $2.2 million during the fiscal years ended August 31, 2016, 2015, and 2014. Because of the variable component of the agreement, our payments to HPE may fluctuate in future periods based upon sales and levels of specified activities. Purchase Commitments During the normal course of business, we issue purchase orders to various vendors for products and services. At August 31, 2016, we had open purchase commitments totaling $5.2 million for products and services to be delivered primarily in fiscal 2017. The increase over the previous year is primarily due to purchase orders related to our new enterprise resource planning system that is expected to be placed in service during mid-fiscal 2017 and other information system infrastructure projects. Other purchase commitments for materials, supplies, and other items incidental to the ordinary conduct of business were immaterial, both individually and in aggregate, to the Company’s operations at August 31, 2016. Letters of Credit At August 31, 2016 and 2015, we had standby letters of credit totaling $0.1 million. These letters of credit were primarily required to secure commitments for certain insurance policies and expire in January 2017. No amounts were outstanding on the letters of credit at either August 31, 2016 or August 31, 2015. Legal Matters and Loss Contingencies We are the subject of certain legal actions, which we consider routine to our business activities. At August 31, 2016, we believe that, after consultation with legal counsel, any potential liability to us under these other actions will not materially affect our financial position, liquidity, or results of operations. 8. SHAREHOLDERS’ EQUITY Preferred Stock We have 14.0 million shares of preferred stock authorized for issuance. At August 31, 2016 and 2015, no shares of preferred stock were issued or outstanding. Treasury Stock Open Market Purchases On January 23, 2015, our Board of Directors approved a new plan to repurchase up to $10.0 million of the Company’s outstanding common stock. All previously existing common stock repurchase plans were canceled and the new common share repurchase plan does not have an expiration date. On March 27, 2015, our Board of Directors increased the aggregate value of shares of Company common stock that may be purchased under the January 2015 plan to $40.0 million so long as we have either $10.0 million in cash and cash equivalents or have access to debt financing of at least $10.0 million. Through August 31, 2016, we have purchased 1,291,347 shares of our common stock for $22.3 million under the terms of this expanded common stock repurchase plan. The actual timing, number, and value of common shares repurchased under this plan will be determined at our discretion and will depend on a number of factors, including, among others, general market and business conditions, the trading price of our common shares, and applicable legal requirements. The Company has no obligation to repurchase any common shares under the authorization, and the repurchase plan may be suspended, discontinued, or modified at any time for any reason. The cost of common stock purchased for treasury as shown on our consolidated statement of cash flows for the year ending August 31, 2016 includes 2,260 shares withheld for minimum statutory taxes on stock-based compensation awards issued to participants during the year. The withheld shares were valued at the market price on the date the shares were distributed to participants, which totaled approximately $38,000. For the year ended August 31, 2015, we withheld 17,935 shares for minimum statutory taxes on stock-based compensation awards, which had a total value of $0.3 million. Fiscal 2016 Tender Offer On December 8, 2015, we announced that our Board of Directors approved a modified Dutch auction tender offer for up to $35.0 million in value of shares of our common stock at a price within (and including) the range of $15.50 to $17.75 per share. The tender offer commenced on December 14, 2015, and expired at 11:59 p.m. Eastern time, on January 12, 2016. The tender offer was fully subscribed and we acquired 1,971,832 shares of our common stock at $17.75 per share. Including fees to complete the tender offer, the total cost of the tendered shares was $35.3 million, which was financed by existing cash and proceeds from our revolving line of credit facility. For further information regarding the terms and conditions of this completed tender offer, refer to information in the Tender Offer Statement on Schedule TO filed with Securities and Exchange Commission on December 14, 2015 and subsequent amendments thereto. 9. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. The accounting standards related to fair value measurements include a hierarchy for information and valuations used in measuring fair value that is broken down into the following three levels based on reliability: · Level 1 valuations are based on quoted prices in active markets for identical instruments that the Company can access at the measurement date. · Level 2 valuations are based on inputs other than quoted prices included in Level 1 that are observable for the instrument, either directly or indirectly, for substantially the full term of the asset or liability including the following: a. quoted prices for similar, but not identical, instruments in active markets; b. quoted prices for identical or similar instruments in markets that are not active; c. inputs other than quoted prices that are observable for the instrument; or d. inputs that are derived principally from or corroborated by observable market data by correlation or other means. · Level 3 valuations are based on information that is unobservable and significant to the overall fair value measurement. The book value of our financial instruments at August 31, 2016 and 2015 approximated their fair values. The assessment of the fair values of our financial instruments is based on a variety of factors and assumptions. Accordingly, the fair values may not represent the actual values of the financial instruments that could have been realized at August 31, 2016 or 2015, or that will be realized in the future, and do not include expenses that could be incurred in an actual sale or settlement. The following methods and assumptions were used to determine the fair values of our financial instruments, none of which were held for trading or speculative purposes: Cash, Cash Equivalents, and Accounts Receivable - The carrying amounts of cash, cash equivalents, and accounts receivable approximate their fair values due to the liquidity and short-term maturity of these instruments. Other Assets - Our other assets, including notes receivable, were recorded at the net realizable value of estimated future cash flows from these instruments. Debt Obligations - At August 31, 2016, our debt obligations consisted of variable-rate term notes payable and a variable-rate revolving line of credit. The term notes payable and revolving line of credit (Note 4) are negotiated components of our Restated Credit Agreement, which is renewed on a regular basis to maintain the long-term borrowing capability of the agreement. Accordingly, the applicable interest rates on the term loans and revolving line of credit are reflective of current market conditions, and the carrying value of term loan and revolving line of credit obligations approximate their fair value. Contingent Consideration Liability - During fiscal 2013, we acquired Ninety Five 5, LLC. The purchase price included contingent consideration payments to the former owners up to a maximum of $8.5 million, based on cumulative earnings before interest, income taxes, depreciation, and amortization (EBITDA) as set forth in the purchase agreement. We reassess the fair value of expected contingent consideration and the corresponding liability each period using the Probability Weighted Expected Return Method, which is consistent with the initial measurement of the expected liability. This fair value measurement is considered a Level 3 measurement because we estimate projected earnings during the earn out period utilizing various potential pay-out scenarios. Probabilities were applied to each potential scenario and the resulting values were discounted using a rate that considered Ninety Five 5’s weighted average cost of capital as well as a specific risk premium associated with the riskiness of the contingent consideration itself, the related projections, and the overall business. Contingent consideration is payable in increments of $2.2 million based on the actual and projected financial results during the measurement period, which ends on August 31, 2017. As a result of significantly improved EBITDA from the sales performance group during the first half of fiscal 2016, we paid the first contingent earn out payment of $2.2 million in the third quarter of fiscal 2016 and may have to pay additional contingent earn out payments in fiscal 2017. We currently believe that projected financial results indicate one more additional payment may be earned during fiscal 2017. However, financial results would need to increase significantly to reach the third payment threshold and we do not currently believe that a third $2.2 million payment is probable. The contingent consideration liability is classified as a component of other long-term liabilities in our consolidated balance sheets. During the fiscal years ended August 31, 2016 and 2015, the contingent consideration liability changed as follows (in thousands): Changes to the estimated liability are reflected in selling, general, and administrative expenses in our consolidated income statements. 10. STOCK-BASED COMPENSATION PLANS Overview We utilize various stock-based compensation plans as integral components of our overall compensation and associate retention strategy. Our shareholders have approved various stock incentive plans that permit us to grant performance awards, unvested share awards, stock options, and employee stock purchase plan (ESPP) shares. In addition, our Board of Directors and shareholders may, from time to time, approve fully vested stock awards. The Organization and Compensation Committee of the Board of Directors (the Compensation Committee) has responsibility for the approval and oversight of our stock-based compensation plans. On January 23, 2015, our shareholders approved the 2015 Omnibus Incentive Plan (the 2015 Plan), which authorized an additional 1.0 million shares of common stock for issuance to employees and members of the Board of Directors as stock-based payments. We believe that the 2015 Plan will provide sufficient available shares to grant awards over the next several years, based on current expectations of grants in future periods. A more detailed description of the 2015 Plan is set forth in the Company’s Proxy Statement filed with the SEC on December 22, 2014. At August 31, 2016, the 2015 Plan had approximately 705,000 shares available for future grants and our ESPP had approximately 440,000 shares remaining for purchase by plan participants. The total compensation expense of our stock-based compensation plans was as follows (in thousands): The compensation expense of our stock-based compensation plans was included in selling, general, and administrative expenses in the accompanying consolidated income statements, and no stock-based compensation was capitalized during fiscal years 2016, 2015, or 2014. During fiscal 2016, we issued 81,757 shares of our common stock from shares held in treasury for various stock-based compensation plans. Certain of our stock-based compensation plans allow recipients to have shares withheld from the award to pay minimum statutory tax liabilities. We withheld 2,260 shares of our common stock for minimum statutory taxes during fiscal 2016. The following is a description of our stock-based compensation plans. Performance Awards In fiscal 2015, the Compensation Committee approved a modification to exclude the effects of foreign exchange on the measurement of performance criteria on the outstanding tranches of our long-term incentive plan (LTIP) awards. Accordingly, we calculated incremental compensation expense based upon the fair value of (closing price) our common stock on the modification date, which totaled $0.7 million. We recognized $0.5 million of the incremental compensation expense during fiscal 2015 for service provided in the current and previous fiscal years associated with the modification. Each of the LTIP performance awards described below have a maximum life of six years and compensation expense is recognized as we determine it is probable that the shares will vest. Adjustments to compensation expense to reflect the timing of and the number of shares expected to be awarded are made on a cumulative basis at the date of the adjustment. No tranches of performance awards vested to participants during fiscal 2016. Fiscal 2016 LTIP Award - On November 12, 2015, the Compensation Committee granted new performance-based awards for our executive officers and members of senior management. A total of 231,276 shares may be awarded to the participants based on six individual vesting conditions that are divided into two performance measures, trailing four-quarter adjusted earnings before interest, taxes, depreciation, and amortization (Adjusted EBITDA) and increased sales of Organizational Development Suite (OD Suite) offerings as shown below. The OD Suite is defined as Leadership, Productivity, and Trust practice sales. Fiscal 2015 LTIP Award - During fiscal 2015, the Compensation Committee granted a new performance-based award for our executive officers and certain members of senior management. A total of 112,464 shares may be awarded to the participants based on six individual vesting conditions that are divided into two performance measures, trailing four-quarter Adjusted EBITDA and increased sales of OD Suite sales as shown below. Fiscal 2014 LTIP Award - During the first quarter of fiscal 2014, the Compensation Committee granted new performance-based equity awards for our executive officers. A total of 89,418 shares may be awarded to the participants based on six individual vesting conditions that are divided into two performance measures, trailing four-quarter Adjusted EBITDA and trailing four-quarter increased sales of courses related to The 7 Habits of Highly Effective People (the 7 Habits). The following information applies to the fiscal 2014 LTIP award as of August 31, 2016. Fiscal 2013 LTIP Award - During the first quarter of fiscal 2013, the Compensation Committee granted a new performance-based equity award for the Chief Executive Officer (CEO), Chief Financial Officer (CFO), and the Chief People Officer (CPO). A total of 68,085 shares may be issued to the participants based on six individual vesting conditions that are divided into two performance measures, trailing four-quarter Adjusted EBITDA and Productivity Practice sales. The following information applies to the fiscal 2013 LTIP award as of August 31, 2016. Fiscal 2012 LTIP Award - During fiscal 2012, the Compensation Committee granted a performance-based equity award for the CEO, CFO, and CPO similar to the fiscal 2013 executive award described above. A total of 106,101 shares may be issued to the participants based on six individual vesting conditions that are divided into two performance measures, Adjusted EBITDA and Productivity Practice sales. The following information applies to the fiscal 2012 LTIP award as of August 31, 2016. Common Stock Price Performance Award - On July 15, 2011, the Compensation Committee approved a stock-based compensation plan that would allow certain members of our management team to receive shares of the Company’s common stock if the closing price of our common stock averaged specified levels over a five-day period. If the price of our common stock achieved the specified levels within three years of the grant date, 100 percent of the awarded shares would vest. If the price of our common stock reached the specified levels between three and five years from the grant date, only 50 percent of the performance shares would vest. No shares would vest to participants if the specified price targets were met after five years from the grant date. This award was designed to grant approximately one-half of the total award shares in fiscal 2011, approximately one-fourth of the award shares in fiscal 2012, and approximately one-fourth in fiscal 2013. Additional supplemental awards were made to three employees during fiscal 2014 as shown on the table below. This award program was designed to increase shareholder value as shares would only be awarded to participants if our share price increased significantly over a relatively short period of time. During fiscal 2014, the specified common share prices for all grants were achieved and all tranches of the award as described below vested to the participants. Since this performance award had market-based vesting conditions, the fair value and derived service periods of the grants within this award were determined using Monte Carlo simulation valuation models. The following table presents key information related to the tranches granted in this award. The April 2014 grant shown above included 9,557 shares with a vesting price of $18.05 per share (equal to the fiscal 2012 grant vesting price) and 3,920 shares with a $22.00 per share vesting price. Since our share price on the grant date was greater than the vesting price for the 9,557 shares granted, the fair value of these shares was determined by multiplying the number of shares by the grant date price per share, which resulted in $0.2 million of stock-based compensation expense. The $0.2 million of compensation expense for these shares was recorded on the summary stock-based compensation table above as a component of fully vested share award expense. Unvested Stock Awards The annual Board of Director unvested stock award, which is administered under the terms of the Franklin Covey Co. 2015 Omnibus Incentive Plan, is designed to provide our non-employee directors, who are not eligible to participate in our employee stock purchase plan, an opportunity to obtain an interest in the Company through the acquisition of shares of our common stock. Each eligible director is entitled to receive a whole-share grant equal to $75,000 with a one-year vesting period, which is generally granted in January (following the Annual Shareholders’ Meeting) of each year. Shares granted under the terms of this annual award are ineligible to be voted or participate in any common stock dividends until they are vested. Under the terms of this program, we issued 25,032 shares, 24,210 shares, and 14,616 shares of our common stock to eligible members of the Board of Directors during the fiscal years ended August 31, 2016, 2015, and 2014. The fair value of shares awarded to the directors was $0.5 million in each of fiscal years 2016 and 2015, and $0.3 million in fiscal 2014 as calculated on the grant date of the awards. The corresponding compensation cost is recognized over the vesting period of the awards, which is one year. The cost of the common stock issued from treasury for these awards was $0.3 million, $0.3 million, and $0.2 million for the fiscal years ended August 31, 2016, 2015, and 2014. The following information applies to our unvested stock awards for the fiscal year ended August 31, 2016: At August 31, 2016, there was $0.2 million of unrecognized compensation cost related to unvested stock awards, which is expected to be recognized over the remaining weighted-average vesting period of approximately three months. The total recognized tax benefit from unvested stock awards totaled $0.1 million for each of the fiscal years ended August 31, 2016, 2015, and 2014, respectively. The intrinsic value of our unvested stock awards at August 31, 2016 was $0.4 million. Stock Options We have an incentive stock option plan whereby options to purchase shares of our common stock may be issued to key employees at an exercise price not less than the fair market value of the Company’s common stock on the date of grant. Information related to our stock option activity during the fiscal year ended August 31, 2016 is presented below: During fiscal 2014, we had 43,750 stock options exercised on a net share basis, which had an aggregate intrinsic value of $0.5 million. At August 31, 2016, there was no remaining unrecognized compensation expense related to our stock options and no options were exercised during fiscal 2016 or 2015. The following additional information applies to our stock options outstanding at August 31, 2016: Fully Vested Stock Awards Client Partner and Consultant Award - During fiscal 2011, we implemented a new fully vested stock-based award program that is designed to reward our client partners and training consultants for exceptional long-term performance. The program grants shares of our common stock with a total value of $15,000 to each client partner who has sold over $20.0 million in cumulative sales or training consultant who has delivered over 1,500 days of training during their career. During fiscal 2016, four individuals qualified for this award; in fiscal 2015, five individuals earned this award; and 12 individuals qualified for the award in fiscal 2014. In the fourth quarter of fiscal 2015, the Compensation Committee approved a fully vested award equal to $10,000 for each general manager or area director that achieved a specified sales goal. Five individuals achieved their sales goals and qualified for the award. This award was only for fourth quarter fiscal 2015 sales performance and no additional awards may be granted under the terms of this award. Employee Stock Purchase Plan The Company has an employee stock purchase plan that offers qualified employees the opportunity to purchase shares of our common stock at a price equal to 85 percent of the average fair market value of our common stock on the last trading day of each quarter. We issued a total of 49,375 shares, 42,687 shares, and 36,761 shares to ESPP participants during the fiscal years ended August 31, 2016, 2015, and 2014, which had a corresponding cost basis of $0.7 million, $0.6 million, and $0.5 million, respectively. We received cash proceeds for these shares from ESPP participants totaling $0.7 million, $0.7 million, and $0.6 million during the fiscal years ended August 31, 2016, 2015, and 2014. 11. IMPAIRED ASSETS Our impaired asset charges consisted of the following (in thousands): The following is a description of the circumstances regarding the impairment of these long-lived assets. Long-Term Receivables From FCOP - During the third quarter of fiscal 2015, we determined that the operating agreements between the Company and FCOP allow us to collect reimbursement for certain rental expenses prior to the annual required distribution of earnings to FCOP’s creditors. Such rents were previously treated as lower in priority and therefore, were considered long-term receivables. Although this determination is expected to improve our cash flows and collections of rents receivable from FCOP in the short term, it reduces the amount of cash we are expecting to receive from the required distribution of earnings to pay long-term receivable balances. After this determination was made, the present value of our previously recorded long-term receivables was more than the present value of expected corresponding cash flows. Accordingly, we recalculated our discount on the long-term receivables and impaired the remaining balance. Subsequent to August 31, 2014, we received new cash flow and earnings projections from FCOP that reflected weaker sales of certain accessory products, which had a significant adverse impact on expected cash flows and earnings in future periods. Accordingly, we determined that an additional $0.6 million discount and a corresponding $0.4 million impairment charge were needed to reduce the long-term receivable from FCOP to its net realizable value and net present value. Capitalized Curriculum - During fiscal 2015, we determined that it would be beneficial to discontinue a component of one of our existing offerings and we received legal notice that another offering contained names trademarked by another entity. Since the Company currently offers a similar program, the decision was made to discontinue the offering rather than modify the curriculum as required by applicable trademark law. Accordingly, we impaired the remaining unamortized carrying value of these offerings. These items were classified as components of other long-term assets on our consolidated balance sheets. Investment in Cost Method Subsidiary - In the fourth quarter of fiscal 2015, we became aware of financial difficulties at an entity in which we had an investment accounted for under the cost method. Based on discussions with management of the entity, we determined that the investment in this subsidiary would not be recoverable in future periods due to going concern considerations. Accordingly, we impaired the carrying value of the investment in this entity. The investment in this entity was previously classified as a component of other long-term assets in our consolidated balance sheets. Prepaid Expenses and Other Long-Term Assets - In connection with a component of one of our offerings that was discontinued (as described above), we had prepaid royalties to an unrelated developer. Based on the decision to impair the curriculum, we determined that the probability of receiving cash flows sufficient to recover the prepaid royalties was remote and we expensed the carrying value of these prepaid assets. Approximately $60,000 of this balance was previously included in other long-term assets. 12. RESTRUCTURING COSTS Fiscal 2016 Restructuring Costs In the fourth quarter of fiscal 2016, we restructured the operations of certain of our domestic sales offices. The cost of this restructuring was $0.4 million and was primarily comprised of employee severance costs, which were paid in August and September 2016. During the second quarter of fiscal 2016, we restructured the operations of our Australian office. The restructuring was designed to reduce ongoing operating costs by closing the sales offices in Brisbane, Sydney, and Melbourne, and by reducing headcount for administrative and certain sales support functions. Our remaining sales and support personnel in Australia will work from home offices, similar to many of our sales personnel located in the U.S. and Canada. The Australia office restructure cost $0.4 million and was primarily comprised of office closure costs, including remaining lease expense on the offices that were closed, and for employee severance costs. The severance costs included the restructuring charge totaled less than $40,000. Remaining accrued restructuring costs totaled $0.2 million at August 31, 2016 and were included as a component of accrued liabilities in our consolidated balance sheet. Fiscal 2015 Restructuring Costs During the fourth quarter of fiscal 2015, we realigned our regional sales offices that serve the United States and Canada. As a result of this realignment, we closed our northeastern regional sales office located in Pennsylvania and created new geographic sales regions. In connection with this restructuring, we incurred costs related to involuntary severance and office closure costs. The restructuring charge taken during the fiscal year ended August 31, 2015 was comprised of the following (in thousands): The majority of these costs were paid prior to August 31, 2015 and the remaining restructuring liability totaled $0.1 million at August 31, 2015 and was included as a component of accrued liabilities in our consolidated balance sheet. All of the remaining accrued severance at August 31, 2015 was paid during September 2015. 13. EMPLOYEE BENEFIT PLANS Profit Sharing Plans We have defined contribution profit sharing plans for our employees that qualify under Section 401(k) of the Internal Revenue Code. These plans provide retirement benefits for employees meeting minimum age and service requirements. Qualified participants may contribute up to 75 percent of their gross wages, subject to certain limitations. These plans also provide for matching contributions to the participants that are paid by the Company. The matching contributions, which were expensed as incurred, totaled $1.9 million, $1.7 million, and $1.6 million during each of the fiscal years ended August 31, 2016, 2015, and 2014. We do not sponsor or participate in any defined-benefit pension plans. Deferred Compensation Plan We had a non-qualified deferred compensation (NQDC) plan that provided certain key officers and employees the ability to defer a portion of their compensation until a later date. Deferred compensation amounts used to pay benefits were held in a “rabbi trust,” which invested in insurance contracts, various mutual funds, and shares of our common stock as directed by the plan participants. However, due to legal changes resulting from the American Jobs Creation Act of 2004, we determined to cease compensation deferrals to the NQDC plan after December 31, 2004. Following the cessation of deferrals to the NQDC plan, the number of participants remaining in the plan declined steadily, and our Board of Directors decided to partially terminate the NQDC plan. Following this decision, all of the plan’s assets were liquidated, the plan’s liabilities were paid, and the only remaining items in the NQDC plan are shares of our common stock owned by the remaining plan participants. At August 31, 2016 and 2015, the cost basis of the shares of our common stock held by the rabbi trust was $0.4 million. 14. INCOME TAXES Our provision for income taxes consisted of the following (in thousands): The allocation of our total income tax provision is as follows (in thousands): Income before income taxes consisted of the following (in thousands): The differences between income taxes at the statutory federal income tax rate and the consolidated income tax rate reported in our consolidated income statements were as follows: In prior fiscal years, we elected to take deductions on our U.S. federal income tax returns for foreign income taxes paid, rather than claiming foreign tax credits. During those years we either generated or used net operating loss carryforwards and were therefore unable to utilize foreign tax credits. In fiscal 2011, we began claiming foreign tax credits on our U.S. federal income tax returns. Although we could not utilize the credits we claimed for fiscal 2012 and fiscal 2011 in those respective years, we concluded it was more likely than not that these foreign tax credits will be utilized in the future. Our overall U.S. taxable income and foreign source income for fiscal 2014 and 2013 were sufficient to utilize all of the foreign tax credits generated during those fiscal years, plus additional credits generated in prior years. Accordingly, we amended our U.S. federal income tax returns from fiscal 2003 through fiscal 2010 to claim foreign tax credits instead of foreign tax deductions. The net tax benefit resulting from claiming these additional foreign tax credits, which was recorded in the period the decision was made to amend the related returns, totaled $4.2 million in fiscal 2014. In fiscal 2015, we finalized the calculations of the impact of amending previously filed federal income tax returns to realize foreign tax credits previously treated as expired under the tax positions taken in the original returns. The income tax benefit recognized from these foreign tax credits totaled $0.6 million in fiscal 2015. We recognized tax benefits from deductions for stock-based compensation in excess of the corresponding expense recorded for financial statement purposes. Instead of reducing our income tax expense for these benefits, we recorded $0.1 million and $2.5 million for the fiscal years ending August 31, 2015 and 2014. Tax expense related to stock-based compensation recorded in additional paid-in capital for fiscal 2016 was insignificant. The significant components of our deferred tax assets and liabilities were comprised of the following (in thousands): Deferred income tax amounts are recorded as follows in our consolidated balance sheets (in thousands): As of August 31, 2016, we have utilized all of our U.S. federal net operating loss carryforwards. The Company still has U.S. state net operating loss carryforwards generated in various jurisdictions that expire primarily between September 1, 2016 and August 31, 2029. Our U.S. foreign income tax credit carryforwards were comprised of the following at August 31, 2016 (in thousands): We amended our U.S. federal income tax returns from fiscal 2003 through fiscal 2010 to claim foreign tax credits instead of the foreign tax deductions that were previously claimed. The additional taxable income from claiming these foreign tax credits results in the complete utilization of our remaining net operating loss carryforwards in fiscal 2012, as well as the ability to utilize all of the foreign tax credit generated in fiscal 2012. During the year ended August 31, 2016, we determined it was more likely than not that deferred tax assets of a foreign subsidiary would not be realized. Accordingly, we recorded a $0.3 million valuation allowance against these deferred tax assets. We have determined that projected future taxable income is adequate to allow for realization of all deferred tax assets, except for the assets subject to the valuation allowance. We considered sources of taxable income, including future reversals of taxable temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards, and reasonable, practical tax-planning strategies to generate additional taxable income. Based on the factors described above, we concluded that realization of our deferred tax assets, except those subject to the valuation allowance, is more likely than not at August 31, 2016. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in thousands): The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate is $2.1 million at August 31, 2016 and $2.2 million at August 31, 2015. Included in the ending balance of gross unrecognized tax benefits at August 31, 2016 is $2.7 million related to individual states’ net operating loss carryforwards. Interest and penalties related to uncertain tax positions are recognized as components of income tax expense. The net accruals and reversals of interest and penalties increased income tax expense by an insignificant amount in each of fiscal 2016, fiscal 2015 and fiscal 2014. The balance of interest and penalties included on our consolidated balance sheets at August 31, 2016 and 2015 was $0.3 million each year. During the next 12 months we expect a decrease in unrecognized tax benefits totaling $0.3 million related to foreign tax credits upon the lapse of the applicable statute of limitations. We also expect a decrease of $0.2 million in unrecognized tax benefits relating to state net operating loss deductions upon the lapse of the applicable statute of limitations. We file United States federal income tax returns as well as income tax returns in various states and foreign jurisdictions. The tax years that remain subject to examinations for our major tax jurisdictions are shown below. 15. EARNINGS PER SHARE The following is a reconciliation from basic earnings per share (EPS) to diluted EPS (in thousands, except per-share amounts). Other securities, including performance stock-based compensation instruments, may have a dilutive effect on our EPS calculation in future periods if our financial results reach specified targets (Note 10). 16. SEGMENT INFORMATION Reportable Segments Our revenues are primarily obtained from the sale of training and consulting services and related products. Effective September 1, 2015, we reorganized our internal reporting structure to include four new divisions and a corporate services group. A brief description of these new divisions follows: · Direct Offices - This division includes our geographic sales offices that serve the United States and Canada; our international sales offices located in Japan, the United Kingdom, and Australia; and our public programs group. · Strategic Markets - This division includes our government services office, the Sales Performance practice, the Customer Loyalty practice, and a new “Global 50” group, which is specifically focused on sales to large, multi-national organizations. · Education practice - This division includes our domestic and international Education practice operations, which are centered on sales to educational institutions. · International Licensees - This division is primarily comprised of our international licensees’ royalty revenues. We determined that the new divisions are reportable segments under the applicable accounting guidance. Additionally, we determined that the Company’s chief operating decision maker is the CEO, and the primary measurement tool used in business unit performance analysis is Adjusted EBITDA, which may not be calculated as similarly titled amounts calculated by other companies. For reporting purposes, our consolidated Adjusted EBITDA can be calculated as our income or loss from operations excluding stock-based compensation, restructuring charges, depreciation expense, amortization expense, and certain other charges such as impaired asset charges and adjustments for changes in the fair value of contingent earn out liabilities from previous business acquisitions. Our operations are not capital intensive and we do not own any manufacturing facilities or equipment. Accordingly, we do not allocate assets to the divisions for analysis purposes. Interest expense and interest income are primarily generated at the corporate level and are not allocated. Income taxes are likewise calculated and paid on a corporate level (except for entities that operate in foreign jurisdictions) and are not allocated for analysis purposes. All prior period segment information has been revised to conform to our current organizational structure, assigned responsibilities, and primary internal reports. We account for our segment information on the same basis as the accompanying consolidated financial statements. A reconciliation of Adjusted EBITDA to consolidated net income is provided below (in thousands): Geographic Information Our revenues are derived primarily from the United States. However, we also operate wholly owned offices or contract with licensees to provide our services in various countries throughout the world. Our consolidated revenues were derived from the following countries (in thousands): During the periods presented in this report, there were no customers that accounted for more than ten percent of our consolidated revenues. At August 31, 2016 and 2015, we had wholly owned direct offices in Australia, Japan, and the United Kingdom. Our long-lived assets, excluding intangible assets, goodwill, and the long-term portion of the FCOP receivable were held in the following locations for the periods indicated (in thousands): Inter-segment sales were immaterial and were eliminated in consolidation. 17. RELATED PARTY TRANSACTIONS Knowledge Capital Investment Group Knowledge Capital Investment Group (Knowledge Capital) held a warrant to purchase 5.9 million shares of our common stock, exercised its warrant at various dates according to the terms of a fiscal 2011 exercise agreement, and received a total of 2.2 million shares of our common stock from shares held in treasury. Two members of our Board of Directors, including our CEO, have an equity interest in Knowledge Capital. Pursuant to a fiscal 2011 warrant exercise agreement with Knowledge Capital, we filed a registration statement with the SEC on Form S-3 to register shares held by Knowledge Capital. This registration statement was declared effective on January 26, 2015. On May 20, 2015, Knowledge Capital sold 400,000 shares of our common stock on the open market and we did not purchase any of these shares. At each of August 31, 2016 and 2015, Knowledge Capital held 2.8 million shares of our common stock. FC Organizational Products During the fourth quarter of fiscal 2008, we joined with Peterson Partners to create a new company, FC Organizational Products, LLC. This new company purchased substantially all of the assets of our consumer solutions business unit with the objective of expanding the worldwide sales of FCOP as governed by a comprehensive license agreement between us and FCOP. On the date of the sale closing, we invested approximately $1.8 million to purchase a 19.5 percent voting interest in FCOP, and made a $1.0 million priority capital contribution with a 10 percent return. At the time of the transaction, we determined that FCOP was not a variable interest entity. As a result of FCOP’s structure as a limited liability company with separate owner capital accounts, we determined that our investment in FCOP is more than minor and that we are required to account for our investment in FCOP using the equity method of accounting. We have not recorded our share of FCOP’s losses in the accompanying consolidated income statements because we have impaired and written off investment balances, as defined within the applicable accounting guidance, in previous periods in excess of our share of FCOP’s losses through August 31, 2016. Based on changes to FCOP’s debt agreements and certain other factors in fiscal 2012, we reconsidered whether FCOP was a variable interest entity as defined under FASC 810, and determined that FCOP was a variable interest entity. Although the changes to the debt agreements did not modify the governing documents of FCOP, the changes were substantial enough to raise doubts regarding the sufficiency of FCOP’s equity investment at risk. We further determined that we are not the primary beneficiary of FCOP because we do not have the ability to direct the activities that most significantly impact FCOP’s economic performance, which primarily consist of the day-to-day sale of planning products and related accessories, and we do not have an obligation to absorb losses or the right to receive benefits from FCOP that could potentially be significant. Our voting rights and management board representation approximate our ownership interest and we are unable to exercise control through voting interests or through other means. Our primary exposures related to FCOP are from amounts owed to us by FCOP. We receive reimbursement from FCOP for certain operating costs, some of which are billed to us by third-party providers. The operations of FCOP are primarily financed by the sale of planning products and accessories in the normal course of business. We classify our receivables from FCOP based upon expected payment. Long-term receivable balances are discounted at 15 percent, which was the estimated risk-adjusted borrowing rate of FCOP. This rate was based on a variety of factors including, but not limited to, current market interest rates for various qualities of comparable debt, discussions with FCOP’s lenders, and an evaluation of the realizability of FCOP’s future cash flows. In fiscal 2013, we began to accrete this long-term receivable and the majority of our interest income from fiscal 2014 through fiscal 2016 is attributable to the accretion of interest on long-term receivables. Throughout fiscal 2014 we were optimistic about FCOP’s improving financial condition, as they increased their cash flows and did not request any working capital advances during calendar 2014. However, subsequent to August 31, 2014, we received new projected earnings and cash flow information that reflected weaker sales of accessory products, which were expected to have a significant adverse impact on expected earnings and cash flows in future periods. Accordingly, we determined that an additional $0.6 million discount charge and a corresponding $0.4 million impairment charge were needed to reduce the long-term receivable from FCOP to its net realizable value and ultimate net present value. During fiscal 2015, we determined that we will receive payment from FCOP for certain rent expenses earlier than previously estimated and we recognized additional leasing revenues from FCOP totaling $0.2 million due to the change in the priority of the payment of these items. Although we were able to record additional leasing revenues and our cash flows on current related party receivables will improve in the short term, the present value of our share of cash distributions to cover remaining long-term receivables was reduced and was less than the present value of the receivables previously recorded and accordingly, the Company recalculated its discount on the long-term receivables and impaired the remaining balance, which totaled $0.5 million. At August 31, 2016 and 2015, we had $3.2 million (net of $0.8 million discount) and $4.0 million (net of $1.0 million discount) receivable from FCOP, which have been classified in current assets and long-term assets in our consolidated balance sheets based on expected payment dates. We also owed FCOP $0.1 million and $50,000 at August 31, 2016 and 2015, respectively, for items purchased in the ordinary course of business. These liabilities were classified in accounts payable in the accompanying consolidated balance sheets. If FCOP is unable to pay us for these receivables, our liquidity, financial position, and cash flows will be adversely affected. CoveyLink Acquisition and Contingent Earn Out Payments During fiscal 2009, we acquired the assets of CoveyLink Worldwide, LLC (CoveyLink). CoveyLink conducts training and provides consulting based upon the book The Speed of Trust by Stephen M.R. Covey, who is the brother of one of our executive officers. We accounted for the acquisition of CoveyLink using the guidance found in Statement of Financial Accounting Standards No. 141, Business Combinations. The purchase price was $1.0 million in cash plus or minus an adjustment for specified working capital and the costs necessary to complete the transaction, which resulted in a total initial purchase price of $1.2 million. The previous owners of CoveyLink, which includes Stephen M.R. Covey, were also entitled to earn annual contingent payments based upon earnings growth during the five years following the acquisition. During the fiscal year ended August 31, 2014, we paid $3.5 million in cash to the former owners of CoveyLink for a contractual annual contingent payment. During fiscal 2015, we completed a review of the contingent earn out payments and determined that we owed the former owners of CoveyLink an additional $0.3 million for performance during the earn out measurement period. We do not anticipate any further payments related to the acquisition of CoveyLink. The annual contingent payments were classified as goodwill in our consolidated balance sheets under the accounting guidance applicable at the time of the acquisition. Prior to the acquisition date, CoveyLink had granted us a non-exclusive license for content related to The Speed of Trust book and related training courses for which we paid CoveyLink specified royalties. As part of the CoveyLink acquisition, an amended and restated license of intellectual property was signed that granted us an exclusive, perpetual, worldwide, transferable, royalty-bearing license to use, reproduce, display, distribute, sell, prepare derivative works of, and perform the licensed material in any format or medium and through any market or distribution channel. We are required to pay the brother of one of our executive officers royalties for the use of certain intellectual property developed by him. The amount expensed for these royalties totaled $1.4 million, $1.4 million, and $1.5 million during the fiscal years ended August 31, 2016, 2015, and 2014. As part of the acquisition of CoveyLink, we signed an amended license agreement as well as a speaker services agreement. Based on the provisions of the speakers’ services agreement, we pay the brother of one of our executive officers a portion of the speaking revenues received for his presentations. We expensed $1.3 million, $1.0 million, and $1.0 million for payment on these presentations during fiscal years 2016, 2015 and 2014. We had $0.7 million accrued for these royalties and speaking fees at each of August 31, 2016 and 2015, which were included as components of accrued liabilities in our consolidated balance sheets. Red Tree Acquisition On April 10, 2014, we acquired the assets of Red Tree, Inc. (Red Tree), a company that provides training, consulting, and coaching designed to help organizations effectively manage and engage the “Millennial Generation” in their workforces. We determined that this acquisition met the definition of an acquisition of a business under applicable accounting guidance. The purchase price totaled $0.5 million in cash, which was paid at the closing of the purchase agreement. During the 12 months ended December 31, 2013, Red Tree had revenues of $1.3 million (unaudited) and a net loss of $0.1 million (unaudited). The acquisition of Red Tree had an immaterial impact on our consolidated financial statements during the fiscal year ended August 31, 2014 and was determined to be “not significant” as defined by Regulation S-X. The following table summarizes the estimated fair values of the assets acquired from Red Tree (in thousands): Based on the initial purchase price allocation, we acquired the following intangible assets, which are being amortized over five years (in thousands): The acquisition costs associated with the purchase of Red Tree were insignificant and are included with our selling, general, and administrative expenses in fiscal 2014. The goodwill generated from this transaction is primarily attributable to the methodologies and processes acquired, and is expected to be deductible for income tax purposes. The former owners of Red Tree are related to one of our Named Executive Officers and are currently employed by us. Other Related Party Transactions We pay an executive officer of the Company a percentage of the royalty proceeds received from the sales of certain books authored by him in addition to his annual salary. During the fiscal years ended August 31, 2016, 2015, and 2014, we expensed $0.3 million, $0.2 million, and $0.2 million for these royalties and we had $0.2 million accrued at each of August 31, 2016 and 2015 as payable under the terms of these arrangements. These amounts are included as a component of accrued liabilities in our consolidated balance sheets. We pay the estate of the late Dr. Stephen R. Covey a percentage of the royalty proceeds received from the sale of certain books that were authored by him. During fiscal 2016, 2015, and 2014, we expensed $0.1 million, $0.1 million, and $0.3 million for royalties under these agreements. At August 31, 2016 and 2015, we had $0.2 million and $0.1 million accrued, respectively, for payment to the estate of the former Vice-Chairman under these royalty agreements. Amounts payable to the estate of Dr. Stephen R. Covey are included as components of accrued liabilities in our consolidated balance sheets.
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Here's a summary of the financial statement excerpt:
Financial Reporting Highlights:
1. Asset Impairment:
- Long-lived tangible and intangible assets are reviewed for potential impairment
- Impairment is assessed by estimating undiscounted future net cash flows
- If carrying values exceed anticipated cash flows, an impairment loss is recognized
- Future changes in cash flow forecasts could result in significant impairment charges
2. Financial Reporting Practices:
- Made reclassifications to prior period financial statements for better presentation
- Reclassifications included separately disclosing deferred revenue
- These changes did not impact overall financial results or cash flows
3. Cash Management:
- Cash deposited in financial institutions in the United States and foreign countries
- Cash deposits may occasionally exceed insured limits
- Considers highly liquid debt instruments with 3-month or less maturity as cash equival
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Claude
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Financial Statements The management of the Company has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles in the United States of America. The consolidated financial statements include amounts that are based on management’s best estimates and judgments. Management also prepared other information in the annual report and is responsible for its accuracy and consistency with the financial statements. The Company’s 2016 consolidated financial statements have been audited by Crowe Horwath LLP, an independent registered public accounting firm. ACCOUNTING FIRM Audit Committee Kentucky Bancshares, Inc. Paris, Kentucky We have audited the accompanying consolidated balance sheets of Kentucky Bancshares, Inc. as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/Crowe Horwath LLP Crowe Horwath LLP Louisville, Kentucky March 30, 2017 KENTUCKY BANCSHARES, INC. Paris, Kentucky CONSOLIDATED FINANCIAL STATEMENTS December 31, 2016, 2015 and 2014 CONSOLIDATED BALANCE SHEETS December 31 See accompanying notes. CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31 See accompanying notes. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31 See accompanying notes. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Years Ended December 31, 2016, 2015 and 2014 See accompanying notes. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 See accompanying notes. NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation: The consolidated financial statements include the accounts of Kentucky Bancshares, Inc. (the Company), its wholly-owned subsidiaries, Kentucky Bank (the Bank) and KBI Insurance Company, Inc., a captive insurance subsidiary, and the Bank’s wholly-owned subsidiary, KB Special Assets Unit, LLC. Intercompany transactions and balances have been eliminated in consolidation. Nature of Operations: The Bank operates under a state bank charter and provides full banking services, including trust services, to customers located in Bourbon, Clark, Elliot, Fayette, Harrison, Jessamine, Madison, Rowan, Scott, Woodford and adjoining counties in Kentucky. As a state bank, the Bank is subject to regulation by the Kentucky Department of Financial Institutions and the Federal Deposit Insurance Corporation (FDIC). The Company, a bank holding company, is regulated by the Federal Reserve. KBI Insurance Company, Inc., a captive insurance subsidiary, is regulated by the State of Nevada Division of Insurance. Estimates in the Financial Statements: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash Flows: For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and certain short-term investments with maturities of less than three months. Generally, federal funds are sold for one-day periods. Net cash flows are reported for loan, deposit and short-term borrowing transactions. Interest Bearing Time Deposits: Interest bearing time deposits in other financial institutions have original maturities between one and three years and are carried at cost. Securities: The Company is required to classify its securities portfolio into one of three categories: trading securities, securities available for sale and securities held to maturity. Fair value adjustments are made to the securities based on their classification with the exception of the held to maturity category. The Company has no investments classified as held to maturity. Securities available for sale and trading securities are carried at fair value. Unrealized holding gains and losses for securities which are classified as available for sale are reported in other comprehensive income, net of deferred tax. Unrealized holding gains and losses for securities which are classified as trading securities are reported in other income. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the settlement date and determined using the specific identification method. Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings. Loans Held for Sale: Loans held for sale are carried at the lower of cost or fair value as determined by outstanding commitments from investors or current secondary market prices, calculated on the aggregate loan basis. The Company also provides for any losses on uncovered commitments to lend or sell. Loans are generally sold with servicing rights retained but with some exceptions. Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity are stated at the amount of unpaid principal, net of deferred loan origination fees and costs and acquired purchase premiums and discounts, reduced by an allowance for loan losses. Interest income on loans is recognized on the accrual basis except for those loans on a nonaccrual status. Interest income on real estate mortgage (1-4 family residential and multi-family residential) and consumer loans is discontinued at the time the loan is 90 days delinquent, and interest income on real estate construction, non-farm and non-residential mortgage, agricultural and commercial loans is discontinued at the time the loan is 120 days delinquent, unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield on the related loan. Recorded investment is the outstanding loan balance, excluding accrued interest receivable. When interest accrual is discontinued, interest income received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Typically, the Company seeks to establish a payment history of at least six consecutive payments made on a timely basis before returning a loan to accrual status. Consumer and credit card loans are typically charged off no later than 120 days past due. Loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Concentration of Credit Risk: Most of the Company’s business activity is with customers located within Bourbon, Clark, Elliott, Fayette, Harrison, Jessamine, Madison, Rowan, Scott, Woodford and surrounding counties located in Kentucky. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in these counties. Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Adjustments are made to the historical loss experience ratios based on the qualitative factors as outlined in the regulatory Interagency Policy Statement on the Allowance for Loan and Lease Losses. These qualitative factors include the nature and volume of portfolio, economic and business conditions, classification, past due and non-accrual trends. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance for loan losses is evaluated at the portfolio segment level using the same methodology for each segment. The recent historical actual net losses is the basis for the general reserve for each segment which is then adjusted for qualitative factors as outlined above (i.e., nature and volume of portfolio, economic and business conditions, classification, past due and non-accrual trends) specifically evaluated at individual segment levels. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors for non-classified loans and a migration analysis for classified loans. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties and has been granted a concession, are considered troubled debt restructurings and classified as impaired. Loans are charged off when available information confirms that loans, or portions thereof, are uncollectible. While management considers the number of days a loan is past due in its evaluation process, we also consider a variety of other factors. Factors considered by management in evaluating the charge-off decision include collateral value, availability of current financial information for both borrower and guarantor, and the probability of collecting contractual principal and interest payments. These considerations may result in loans being charged off before they are 90 days or more past due. This evaluation framework for determining charge-offs is consistently applied to each segment. From time to time, the Company will charge-off a portion of impaired and non-performing loans. Loans that meet the criteria under ASC 310 are evaluated individually for impairment. Management considers payment status, collateral value, availability of current financial information for the borrower and guarantor, actual and expected cash flows, and probability of collecting amounts due. If a loan’s collection status is deemed to be collateral dependent or foreclosure is imminent, the loan is charged down to the fair value of the collateral, less selling costs. In circumstances where the loan is not deemed to be collateral dependent, but we believe, after completing our evaluation process, that probable loss has been incurred, we will provide a specific allocation on that loan. The impact of recording partial charge-offs is a reduction of gross loans and a reduction of the loan loss reserve. The net loan balance is unchanged in instances where the loan had a specific allocation as a component of the allowance for loan losses. The allowance as a percentage of total loans may be lower as the allowance no longer needs to include a component for the loss, which has now been recorded, and net charge-off amounts are increased as partial charge-offs are recorded. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Commercial and real estate construction and real estate mortgage loans (multi-family residential, and non-farm and non-residential mortgage) over $200 thousand are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and 1-4 family residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent 5 years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. A “portfolio segment” is defined as the level at which an entity develops and documents a systematic methodology to determine its allowance for loan losses. The Company has identified the following portfolio segments: commercial, real estate construction, real estate mortgage, agricultural, consumer (credit cards and other consumer) and other (overdrafts). Commercial: These loans to businesses do not have real estate as the underlying collateral. Instead of real estate, collateral could be business assets such as equipment or accounts receivable or the personal guarantee of one or more guarantors. These loans generally present a higher level of risk than loans secured by commercial real estate because in the event of default by the borrower, the business assets must be liquidated and/or guarantors pursued for deficit funds. Business assets are worth more while they are in use to produce income for the business and worth significantly less if the business is no longer in operation. Real estate construction: Real estate construction consist of loans secured by real estate for additions or alterations to existing structures, as well as constructing new structures. They include fixed and floating rate loans. Real estate construction loans generally present a higher level of risk than loans secured by 1-4 family residential real estate primarily because of the length of the construction period and the potential change in prices of construction materials. Real Estate Mortgage: 1-4 family residential: Loans secured by 1-4 family residential real estate represent the lowest risk of loans for the Company. They include fixed and floating rate loans as well as loans for commercial purposes or consumer purposes. The Company generally does not hold subprime residential mortgages. Borrowers with loans in this category, whether for commercial or consumer purposes, tend to make their payments timely as they do not want to risk foreclosure and loss of property. Multifamily residential: Loans secured by multifamily residential real estate consist primarily of loans secured by apartment buildings and can be either fixed or floating rate loans. Multi-family residential real estate loans generally present a higher level of risk than loans secured by 1-4 family residential real estate because the borrower’s repayment ability typically comes from rents from tenants. Local economic and employment fluctuations impact rent rolls and potentially the borrower’s repayment ability. Non-farm & non-residential: Loans secured by non-farm non-residential real estate consist of loans secured by commercial real estate that is not owner occupied. These loans generally consist of loans collateralized by property whereby rents received from commercial tenants of the borrower are the source of repayment. These loans generally present a higher level of risk than loans secured by owner occupied commercial real estate because repayment risk is expanded to be dependent on the success of multiple businesses which are paying rent to the borrower. If multiple businesses fail due to deteriorating economic conditions or poor business management skills, the borrower may not have enough rents to cover their monthly payment. Repayment risk is also increased depending on the level of surplus available commercial lease space in the local market area. Agricultural: These loans to agricultural businesses do not have real estate as the underlying collateral. Instead of real estate, collateral could be assets such as equipment or accounts receivable or the personal guarantee of one or more guarantors. These loans generally present a higher level of risk than loans secured by real estate because in the event of default by the borrower, the assets must be liquidated and/or guarantors pursued for deficit funds. Farm assets are worth more while they are in use to produce income and worth significantly less if the farm is no longer in operation. Consumer: Consumer loans are generally loans to borrowers for non-business purposes. They can be either secured or unsecured. Consumer loans are generally small in the individual amount of principal outstanding and are repaid from the borrower’s private funds earned from employment. Consumer lending risk is very susceptible to local economic trends. If there is a consumer loan default, any collateral that may be repossessed is generally not well maintained and has a diminished value. For this reason, consumer loans tend to have higher overall interest rates to cover the higher cost of repossession and charge-offs. However, due to their smaller average balance per borrower, consumer loans are collectively evaluated for impairment in determining the appropriate allowance for loan losses. Other: All other loan types are aggregated together for credit risk evaluation due to the varying nature but small number of the remaining types of loans in the Company’s loan portfolio. Loans in this segment include but are not limited to overdrafts. Due to their smaller balance, other loans are collectively evaluated for impairment in determining the appropriate allowance for loan losses. Due to the overall high level of real estate mortgage loans within the loan portfolio as a whole, as compared to other portfolio segments, for risk assessment and allowance purposes this segment was segregated into more granular pools by collateral property type. Real estate construction loans have the highest qualitative adjustments for economic and other credit risk factors, such as the incomplete status of the collateral and the effect of the recent economic downturn on these types of properties. The non-farm non-residential and the multi-family real estate mortgage loan portfolio segments had the next highest level of qualitative adjustments due to the effects of local markets and economies on the underlying collateral property values, as well as for industry concentrations and risks related to the this type of property. Within the commercial portfolio, risk analysis is performed primarily based on the individual loan type. Mortgage Servicing Rights: The Bank has sold certain residential mortgage loans to the Federal Home Loan Mortgage Corporation (FHLMC) while retaining the servicing rights. Servicing rights are recognized separately when they are acquired through sales of loans. When mortgage loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of mortgage loans. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into loan service fee income, net, included in non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses. Servicing fee income, which is reported on the income statement as loan service income, net, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights and valuation allowance are netted against loan servicing fee income. Servicing fees totaled $510 thousand, $486 thousand, and $471 thousand for the years ended December 31, 2016, 2015 and 2014 and are included in loan service fee income in the income statement. Late fees and ancillary fees related to loan servicing are not material. Federal Home Loan Bank (FHLB) Stock: The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. Bank Premises and Equipment: Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 40 years. Furniture, fixtures and equipment are depreciated using the straight-line (or accelerated) method with useful lives ranging from 3 to 10 years. Real Estate Owned: Real estate acquired through foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. The value of the underlying loan is written down to the fair value of the real estate to be acquired by a charge to the allowance for loan losses, if necessary. Any subsequent write-downs are charged to operating expenses. Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in other expenses. Investments in Limited Partnerships: Investments in limited partnerships represent the Company’s investments in affordable housing projects for the primary purpose of available tax benefits. The Company is a limited partner in these investments and as such, the Company is not involved in the management or operation of such investments. These investments are accounted for using the equity method of accounting. Under the equity method of accounting, the Company records its share of the partnership’s earnings or losses in its income statement and adjusts the carrying amount of the investments on the balance sheet. These investments are evaluated for impairment when events indicate the carrying amount may not be recoverable. The investment recorded at December 31, 2016 was $4.7 million and $4.0 million at December 31, 2015, respectively, and is included with other assets in the balance sheet. Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance. Stock-Based Compensation: Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest related to income tax matters as interest expense and penalties related to income tax matters as other expense. Retirement Plans: Employee 401(k) and profit sharing plan expense is the amount of matching contributions. Goodwill and Intangible Assets: Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Company has selected December 31 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet. Intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on either an accelerated or straight-line basis, over ten or fifteen years. Purchased Credit Impaired Loans: As part of the Madison Financial Corporation acquisition, the Company purchased loans, some of which have shown evidence of credit deterioration since origination. These purchased credit impaired loans are recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses. Such purchased credit impaired loans are accounted for individually. The Company estimated the amount and timing of expected cash flows for each loan and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan. The excess of the loan's contractual principal and interest over expected cash flows is not recorded (non-accretable difference). Over the life of the loan, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income. Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Earnings Per Common Share: Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and dividends through the date of issuance of the financial statements. Comprehensive Income (Loss): Comprehensive income consists of net income and other comprehensive income. Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale, which are also recognized as a separate component of equity. Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. Operating Segments: While the Company’s chief decision makers monitor the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company’s operations are considered by management to be aggregated into one reportable operating segment: banking. Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior yet net income or stockholders’ equity. Adoption of New Accounting Standards ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” Issued in August 2016, ASU 2016-15 provides guidance to reduce the diversity in practice of how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments of ASU 2016-15 provide guidance on eight specific cash flow: (i) debt prepayment or debt extinguishment costs; (ii) settlement of zero-coupon bonds; (iii) contingent consideration payments made after a business combination; (iv) proceeds from the settlement of insurance claims; (v) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (vi) distributions received from equity method investees; (vii) beneficial interests in securitization transactions and (viii) separately identifiable cash flows and application of the predominance principle. The amendments of ASU 2016-15 are effective for interim and annual periods beginning after December 15, 2017. Management has evaluated the amendments of ASU 2016-15 and does not believe that adoption of this ASU will impact Kentucky Bancshares existing presentation of the applicable cash receipts and cash payments on its consolidated statements of cash flows. ASU 2016-13, “Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” Issued in June 2016, ASU 2016-13 will add FASB ASC Topic 326, “Financial Instruments-Credit Losses” and finalizes amendments to FASB ASC Subtopic 825-15, “Financial Instruments-Credit Losses.” The amendments of ASU 2016-13 are intended to provide financial statement users with more decision-useful information related to expected credit losses on financial instruments and other commitments to extend credit by replacing the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to determine credit loss estimates. The amendments of ASU 2016-13 eliminate the probable initial recognition threshold and, in turn, reflect an entity’s current estimate of all expected credit losses. ASU 2016-13 does not specify the method for measuring expected credit losses, and an entity is allowed to apply methods that reasonably reflect its expectations of the credit loss estimate. Additionally, the amendments of ASU 2016-13 require that credit losses on available for sale debt securities be presented as an allowance rather than as a write-down. The amendments of ASU 2016-13 are effective for interim and annual periods beginning after December 15, 2019. Earlier application is permitted for interim and annual periods beginning after December 15, 2018. Kentucky Bancshares plans to adopt the amendments of ASU 2016-13 during the first quarter of 2020. Kentucky Bancshares has established a steering committee which includes the appropriate members of Management to evaluate the impact this ASU will have on the Company’s financial position, results of operations and financial statement disclosures and determine the most appropriate method of implementing the amendments in this ASU as well as any resources needed to implement the amendments. ASU 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” Issued in March 2016, ASU 2016-09 seeks to reduce complexity in accounting standards by simplifying several aspects of the accounting for share-based payment transactions. The amendments of ASU 2016-09 include: (i) requiring all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement; (ii) requiring excess tax benefits to be classified along with other income tax cash flows as an operating activity on the statement of cash flow; (iii) allowing an entity to make an entity-wide accounting policy election to either estimate the number of awards that expect to vest or account for forfeitures when they occur; (iv) change the threshold to qualify for equity classification to permit withholding up to the maximum statutory tax rates in the applicable jurisdictions; and (v) requiring that cash paid by an employer when directly withholding shares for tax-withholding purposes to be classified as a financing activity on the statement of cash flows. The amendments of ASU 2016-09 became effective for Kentucky Bancshares on January 1, 2017 and did not have a material impact on Kentucky Bancshares consolidated financial statements. The Company has made an entity-wide accounting policy election to account for forfeitures of stock awards as they occur. Changes to Kentucky Bancshares consolidated statement of cash flows required by the amendments of ASU 2016-09 will be presented in the Quarterly Report on Form 10-Q for the three month period ending March 31, 2017. ASU 2016-02, “Leases (Topic 842).” Issued in February 2016, ASU 2016-02 was issued by the FASB to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and by disclosing key information about leasing arrangements. ASU 2016-02 will, among other things, require lessees to recognize a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2016-02 does not significantly change lease accounting requirements applicable to lessors; however, the ASU contains some targeted improvements that are intended to align, where necessary, lessor accounting with the lessee accounting model and with the updated revenue recognition guidance issued in 2014. The amendments of ASU 2016-02 are effective for interim and annual periods beginning after December 15, 2018. Kentucky Bancshares plans to adopt the amendments of ASU 2016-02 beginning in the first quarter of 2019. At adoption, Kentucky Bancshares will recognize a lease asset and a corresponding lease liability on its consolidated balance sheet for its total lease obligation measured on a discounted basis. As of December 31, 2016, all leases in which Kentucky Bancshares was the lessee were classified as operating leases. Kentucky Bancshares does not anticipant any material impact to its consolidated statements of income as a result of the adoption of this ASU. The Company has an immaterial amount of leases in which it is the lessor. Based on Management’s evaluation to date, the Company does not expect the amendments of ASU 2016-02 to have any material impact to these leases or the related income. Management will continue to evaluate the impact this ASU will have on the Company’s consolidated financial statements; however, the adoption of ASU 2016-02 is not expected to have a material impact on Kentucky Bancshares consolidated financial statements. ASU 2016-01, “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (An Amendment of the FASB Accounting Standards Codification).” Issued in January 2016, ASU 2016-01 is intended to enhance the reporting model for financial instruments to provide users of financial statements with improved decision-making information. The amendments of ASU 2016-01 include: (i) requiring equity investments, except those accounted for under the equity method of accounting or those that result in the consolidation of an investee, to be measured at fair value with changes in fair value recognized in net income; (ii) requiring a qualitative assessment to identify impairment of equity investments without readily determinable fair values; (iii) eliminating the requirement to disclose the method and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet; (iv) requiring the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (v) requiring an entity that has elected the fair value option to measure the fair value of a liability to present separately in other comprehensive income the portion of the change in the fair value resulting from a change in the instrument-specific credit risk; (vi) requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (vii) clarifying that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available for sale securities in combination with the entity’s other deferred tax assets. The amendments of ASU 2016-01 are effective for interim and annual periods beginning after December 15, 2017. Kentucky Bancshares plans to adopt the amendments of ASU 2016-01 during the first quarter of 2018. Management has evaluated the impact this ASU will have on the Company’s consolidated financial statements. Through this evaluation, Management has determined that the principal areas impacted by the amendments of ASU 2016-01 will be Kentucky Bancshares investment in member bank stock, which are equity securities that do not have readily determinable fair values, and various fair value related disclosures. See Note 1 - Significant Accounting Policies, “Federal Home Loan Bank (FHLB): for information regarding Kentucky Bancshares investment in member bank stock. The adoption of ASU 2016-01 is not expected to have a material impact on the Company’s consolidated financial statements. ASU 2014-09, “Revenue from Contracts with Customers (Topic 606).” Issued in May 2014, ASU 2014-09 will add FASB ASC Topic 606, “Revenue from Contracts with Customers,” and will supersede revenue recognition requirements in FASB ASC Topic 605, “Revenue Recognition,” as well as certain cost guidance in FASB ASC Topic 605-35, “Revenue Recognition - Construction-Type and Production-Type Contracts.” ASU 2014-09 provides a framework for revenue recognition that replaces the existing industry and transaction specific requirements under the existing standards. ASU 2014-09 requires an entity to apply a five-step model to determine when to recognize revenue and at what amount. The model specifies that revenue should be recognized when (or as) an entity transfers control of goods or services to a customer at the amount in which the entity expects to be entitled. Depending on whether certain criteria are met, revenue should be recognized either over time, in a manner that depicts the entity’s performance, or at a point in time, when control of the goods or services are transferred to the customer. ASU 2014-09 provides that an entity should apply the following steps: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, the entity satisfies a performance obligation. In addition, the existing requirements for the recognition of a gain or loss on the transfer of non-financial assets that are not in a contract with a customer are amended to be consistent with the guidance on recognition and measurement in ASU 2014-09. The amendments of ASU 2014-09 may be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application. If the transition method of application is elected, the entity should also provide the additional disclosures in reporting periods that include the date of initial application of (1) the amount by which each financial statement line item is affected in the current reporting period, as compared to the guidance that was in effect before the change, and (2) an explanation of the reasons for significant changes. ASU 2015-14, “Revenue from Contracts with Customers (Topic 606)-Deferral of the Effective Date,” issued in August 2015, defers the effective date of ASU 2014-09 by one year. ASU 2015-14 provides that the amendments of ASU 2014-09 become effective for interim and annual periods beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. All subsequently issued ASUs which provide additional guidance and clarifications to various aspects of FASB ASC Topic 606 will become effective when the amendments of ASU 2014-09 become effective. Kentucky Bancshares plans to adopt these amendments during the first quarter of 2018. Management is continuing to evaluate the impact ASU 2014-09 will have on Kentucky Bancshares consolidated financial statements as well as the most appropriate transition method of application. Based on this evaluation to date, Management has determined that the majority of the revenues earned by Kentucky Bancshares are not within the scope of ASU 2014-09. Management also believes that for most revenue streams within the scope of ASU 2014-09, the amendments will not change the timing of when the revenue is recognized. Management will continue to evaluate the impact the adoption of ASU 2014-09 will have on Kentucky Bancshares consolidated financial statements, focusing on noninterest income sources within the scope of ASU 2014-09 as well as new disclosures required by these amendments; however, the adoption of ASU 2014-09 is not expected to have a material impact on Kentucky Bancshares consolidated financial statements. NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS Included in cash and due from banks are certain interest bearing deposits that are held at the Federal Reserve or maintained in vault cash in accordance with average balance requirements specified by the Federal Reserve Board of Governors. The reserve requirement was $2.3 million at December 31, 2016 and $0 at December 31, 2015. NOTE 3 - SECURITIES AVAILABLE FOR SALE The following table summarizes the amortized cost and fair value of the securities at December 31, 2016 and 2015 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows: The amortized cost and fair value of securities at December 31, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity are shown separately. Trading assets totaling $5.6 million are excluded from securities available for sale and consist primarily of municipal securities which are generally held for a minimal period of time. Proceeds from sales of securities during 2016, 2015 and 2014 were $23.9 million, $21.7 million and $74.0 million. Gross gains of $317 thousand, $425 thousand, and $1.4 million and gross losses of $30 thousand, $13 thousand and $400 thousand, were realized on those sales, respectively. The tax provision related to these realized gains and losses was $98 thousand, $140 thousand and $328 thousand, respectively. Securities with an approximate carrying value of $252.4 million and $246.2 million at December 31, 2016 and 2015, were pledged to secure public deposits, trust funds, securities sold under agreements to repurchase and for other purposes as required or permitted by law. Securities with unrealized losses at year end 2016 and 2015 not recognized in income are as follows: The Company evaluates securities for other than temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. Unrealized losses on securities have not been recognized into income because the issues are of high credit quality, management does not intend to sell and it is more likely than not that management would be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates. The fair value is expected to recover as the securities approach maturity. At December 31, 2016, eleven U.S. government agency securities have unrealized losses of 1.1% from their amortized cost, seventy mortgage-backed securities have unrealized losses of 1.6% from their amortized cost basis, and fifty two states and municipals have unrealized losses of 1.8% from their amortized cost basis. Management believes the declines in fair value from these and other securities are largely due to changes in interest rates. The Company believes there is no other than temporary impairment and does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. NOTE 4 - LOANS Loans at year-end were as follows: As discussed under Footnote 23 “Acquisition”, the above loan balances include loans purchased in the acquisition of Madison Financial Corporation. All loan balances acquired in the Madison Financial Corporation acquisition have no allocated allowance for loan losses. The composition of loans acquired, as of December 31, 2016 and December 31, 2015, is as follows: The following table presents the activity in the allowance for loan losses by portfolio segment for the years ending December 31, 2016, 2015 and 2014 (in thousands): Purchased Credit Impaired Loans: The Company has purchased loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. The carrying amount of those loans totaled $1.9 million at December 31, 2016 and $3.5 million at December 31, 2015. There was no associated allowance for loan losses as of December 31, 2016 or December 31, 2015 for purchased credit impaired loans. The contractually required payments of these loans were $2.6 million at December 31, 2016. Accretable yield, or income expected to be collected, is as follows (in thousands): The following tables present the balance in the allowance for loan losses and the recorded investment (excluding accrued interest receivable amounting to $2.4 million and $2.3 million) in loans by portfolio segment and based on impairment method as of December 31, 2016 and December 31, 2015 (in thousands): The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2016 The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality. The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2015. The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality. The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2014 The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality. Nonperforming loans include impaired loans and smaller balance homogeneous loans, such as residential mortgage and consumer loans, that are collectively evaluated for impairment. Nonaccrual loans secured by real estate make up 96.9% of the total nonaccrual loans. The following tables present the recorded investment in nonaccrual loans, loans past due over 90 days still on accrual, and troubled debt restructurings, excluding purchase credit impaired loans, by class of loans as of December 31, 2016 and 2015 (in thousands): The following tables present the aging of the recorded investment in past due and non-accrual loans as of December 31, 2016 and 2015 by class of loans (in thousands): Troubled Debt Restructurings: At December 31, 2016 and 2015, the Company had a recorded investment in troubled debt restructurings of $2.1 million and $2.2 million. The Company has allocated $40 thousand and $101 thousand in reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2016 and 2015. The Company has not committed to lend additional amounts as of December 31, 2016 and 2015 to customers with outstanding loans that are classified as troubled debt restructurings. During the years ending December 31, 2016 and 2015, no loans were modified that met the definition of troubled debt restructuring. The allowance for loan losses for loans classified as troubled debt restructurings decreased $61 thousand for the year ending December 31, 2016 and increased $101 thousand for the year ending December 31, 2015. Loans classified as troubled debt restructurings resulted in no charge offs during the periods ending December 31, 2016 and 2015. For the years ending December 31, 2016, 2015 and 2014, no loans modified as troubled debt restructurings had defaulted on payment. Credit Quality Indicators: The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes primarily non-homogeneous loans with an outstanding balance greater than $200 thousand such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings: Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date. Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. The following tables present the risk category of loans by class of loans, based on the most recent analysis performed, as of December 31, 2016 and 2015 (in thousands): For consumer loans, the Company evaluates the credit quality based on the aging of the recorded investment in loans, which was previously presented. Non-performing consumer loans are loans which are greater than 90 days past due or on non-accrual status, and total $8 thousand at December 31, 2016 and $44 thousand at December 31, 2015. Non-consumer loans with an outstanding balance less than $200 thousand are evaluated similarly to consumer loans. Loan performance is evaluated based on delinquency status. Both are reviewed at least quarterly and credit quality grades are updated as needed. Certain directors and executive officers of the Company and companies in which they have beneficial ownership were loan customers of the Bank during 2016 and 2015. An analysis of the activity with respect to all director and executive officer loans is as follows (in thousands): Loan Servicing Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage loans serviced for others were approximately $206.8 million and $196.2 million at December 31, 2016 and 2015. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $935 thousand and $890 thousand at December 31, 2016 and 2015. Activity for mortgage servicing rights and the related valuation allowance follows (in thousands): The fair value of servicing rights was $1.8 million and $1.7 million at year-end 2016 and 2015. Fair value at year-end 2016 was determined using a discount rate of 12.0%, prepayment speeds ranging from 8.5% to 45.0%, depending on the stratification of the specific right, and default rates ranging from 0.1% to 0.9%. Fair value at year-end 2015 was determined using a discount rate of 12.0%, prepayment speeds ranging from 8.1% to 21.0%, depending on the stratification of the specific right, and default rates ranging from 0.1% to 0.9%. The weighted average amortization period is 16.3 years. Estimated amortization expense for each of the next five years is (in thousands): NOTE 5 - REAL ESTATE OWNED Activity in real estate owned was as follows (in thousands): Activity in the valuation allowance was as follows (in thousands): Expenses related to foreclosed assets include (in thousands): NOTE 6 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows (in thousands): Depreciation expense was $1.3 million, $1.4 million and $1.3 million in 2016, 2015, and 2014. Certain premises, not included in premises and equipment above, are leased under operating leases. Minimum rental payments are as follows (in thousands): NOTE 7 - GOODWILL AND INTANGIBLE ASSETS The change in balance for goodwill during the year is as follows (in thousands): Goodwill is not amortized but instead evaluated periodically for impairment. Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of our single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. We determined the fair value of our reporting unit and compared it to its carrying amount. If the carrying amount of a reporting unit exceeds its fair value, we are required to perform a second step to the impairment test. Our annual impairment analysis as of December 31, 2016 and 2015 indicated that the Step 2 analysis was not necessary. If needed, Step 2 of the goodwill impairment test is performed to measure the impairment loss. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. Acquired intangible assets were as follows at year-end (in thousands): Aggregate amortization expense was $244 thousand, $205 thousand and $140 thousand for 2016, 2015 and 2014. Estimated amortization expense for each of the next five years (in thousands): NOTE 8 - DEPOSITS Time deposits of $250 thousand or more were $74.3 million and $61.2 million at year-end 2016 and 2015, respectively. At December 31, 2016, the scheduled maturities of time deposits for the next five years are as follows (in thousands): Certain directors and executive officers of the Company and companies in whom they have beneficial ownership are deposit customers of the Bank. The amount of these deposits was approximately $5.8 million and $7.3 million at December 31, 2016 and 2015. NOTE 9 - REPURCHASE AGREEMENTS AND OTHER BORROWINGS Securities sold under agreements to repurchase are secured by U.S. Government securities and mortgage-backed securities with a total carrying amount of $29.4 million and $18.5 million at year-end 2016 and 2015. Repurchase agreements range in maturities from 1 day to 41 months. The securities underlying the agreements are maintained in a third-party custodian’s account under a written custodial agreement. Information concerning repurchase agreements for 2016, 2015 and 2014 is summarized as follows (in thousands): On July 20, 2015, the Company borrowed $5 million which had an outstanding balance of $4.1 million at December 31, 2016 and $4.8 million at December 31, 2015. The term loan has a fixed interest rate of 5.02%, requires quarterly principal and interest payments, matures July 20, 2025 and is collateralized by the Company’s stock. The maturity schedule for the term loan as of December 31, 2016 is as follows: At December 31, 2015 the Company had a $5 million revolving promissory note with a maturity date of July 19, 2016. Upon maturity, the Company renewed the revolving promissory note. The new note has similar terms as the original note and matures July 18, 2017. The Company had no outstanding balances related to this promissory note at December 31, 2016 or 2015. NOTE 10 - FEDERAL HOME LOAN BANK ADVANCES At year-end, advances from the Federal Home Loan Bank were as follows (in thousands): Advances are paid either on a monthly basis or at maturity. All advances require a prepayment penalty, and are secured by the Federal Home Loan Bank stock and substantially all first-mortgage residential, multi-family and farm real estate loans. Scheduled principal payments due on advances during the years subsequent to December 31, 2016 are as follows (in thousands): NOTE 11 - SUBORDINATED DEBENTURES In August 2003, the Company formed Kentucky Bancshares, Statutory Trust I (“Trust”). The Trust issued $217 thousand of common securities to the Company and $7 million of trust preferred securities as part of a pooled offering of such securities. The Company issued $7.2 million subordinated debentures to the Trust in exchange for the proceeds of the offering, which debentures represent the sole asset of the Trust. The debentures paid interest quarterly at 7.06% for the first 5 years. Starting September 2008, the rate converted to three-month LIBOR plus 3.00% adjusted quarterly, which was 4.00% at year-end 2016. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. The Company may redeem the subordinated debentures, in whole or in part, beginning September 2008 at a price of 100% of face value. The subordinated debentures must be redeemed no later than 2033. The Company has the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years. The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations. NOTE 12 - INCOME TAXES Income tax expense was as follows (in thousands): Year-end deferred tax assets and liabilities were due to the following (in thousands). No valuation allowance for the realization of deferred tax assets is considered necessary. Effective tax rates differ from federal statutory rates applied to financial statement income due to the following: Federal income tax laws provided the First Federal Savings Bank, acquired by the Company in 2003, with additional bad debt deductions through 1987, totaling $1.3 million. Accounting standards do not require a deferred tax liability to be recorded on this amount, which otherwise would total a $441 thousand liability at December 31, 2016. The Company’s acquisition of First Federal Savings Bank did not require the recapture of the bad debt reserve. However, if Kentucky Bank was liquidated or otherwise ceased to be a bank, or if tax laws were to change, the $441 thousand would be recorded as expense. Unrecognized Tax Benefits The Company does not have any beginning and ending unrecognized tax benefits. The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. There were no interest and penalties recorded in the income statement or accrued for the years ended December 31, 2016 and 2015. The Company and its subsidiaries file a consolidated U.S. Corporation income tax return and a corporate income tax return in the state of Kentucky. The Company is no longer subject to examination by taxing authorities for years before 2013. NOTE 13 - EARNINGS PER SHARE The factors used in the earnings per share computation follow (in thousands): Stock options of 1,200 shares common stock from 2016, 2,400 shares common stock from 2015 and 12,625 shares common stock from 2014 were excluded from diluted earnings per share because their impact was antidilutive. No restricted stock grants for 2016, 2015 and 2014 were excluded from diluted earnings per share because their impact was antidilutive. NOTE 14 - RETIREMENT PLAN The Company has a qualified profit sharing plan which covers substantially all employees and includes a 401(k) provision. Profit sharing contributions, excluding the 401(k) provision, are at the discretion of the Company’s Board of Directors. Expense recognized in connection with the plan was $925 thousand, $815 thousand and $729 thousand in 2016, 2015 and 2014. NOTE 15 - STOCK BASED COMPENSATION The Company has four share based compensation plans as described below. Total compensation cost that has been charged against income for those plans was $153 thousand, $133 thousand, and $111 thousand for 2016, 2015 and 2014. Two Stock Option Plans Under the expired 1993 Non-Employee Directors Stock Ownership Incentive Plan, the Company had also granted certain directors stock option awards which vest and become fully exercisable immediately and provided for issuance of up to 20,000 options. The exercise price of each option, which has a ten year life, was equal to the market price of the Company’s stock on the date of grant. The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses various assumptions. Expected volatilities are based on historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. No options were granted in 2016, 2015 or 2014. Summary of activity in the two expired stock option plans for 2016 follows: Options outstanding at year-end 2016 were as follows: As of December 31, 2016, there was $0 of total unrecognized compensation cost related to nonvested stock options granted under the Plan. Since both stock option plans have expired, as of December 31, 2016, neither plan allows for additional options to be issued. 2005 Restricted Stock Grant Plan Under its expired 2005 Restricted Stock Grant Plan, total shares issuable under the plan were 50,000. There were no shares issued during 2016 and 5,385 shares issued during 2015. There were 916 shares forfeited during 2016 and 88 shares forfeited during 2015. A summary of changes in the Company’s nonvested shares for the year follows: As of December 31, 2016, there was $160 thousand of total unrecognized compensation cost related to nonvested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of 2.4 years. The total grant-date fair value of shares vested during the years ended December 31, 2016, 2015 and 2014 was $128 thousand, $105 thousand and $88 thousand. The vesting-date fair value of shares vested during 2016, 2015 and 2014 is immaterially different when compared to the grant-date fair value. Since the plan has expired, as of December 31, 2016, no additional restricted stock share awards will be issued. 2009 Stock Award Plan On May 13, 2009, the Company’s stockholders approved a stock award plan that provides for the granting of both incentive and nonqualified stock options and other share based awards. Total shares issuable under the plan are 150,000. There were 6,170 shares issued during 2016 and 1,465 shares issued during 2015. There were 265 shares forfeited during 2016 and none during 2015. A summary of changes in the Company’s nonvested shares for the year follows: As of December 31, 2016 there was $172 thousand of total unrecognized compensation cost related to nonvested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of 3.9 years. The total grant-date fair value of shares vested during the years ended December 31, 2016, 2015 and 2014 was $15 thousand, $6 thousand and $4. The vesting-date fair value of shares vested during 2016, 2015 and 2014 is immaterially different when compared to the grant-date fair value. As of December 31, 2016, the 2009 stock award plan allows for additional restricted stock share awards of up to 142 thousand shares. NOTE 16 - LIMITATION ON BANK DIVIDENDS The Company’s principal source of funds is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid by the Bank without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, as defined, combined with the retained net profits of the preceding two years. During 2017 the Bank could, without prior approval, declare dividends on any 2017 net profits retained to the date of the dividend declaration plus $5.6 million. NOTE 17 - FAIR VALUE Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. Level 2 - Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. The Company used the following methods and significant assumptions to estimate the fair value: Securities Available for Sale and Trading Assets: The fair values for investment securities and trading assets are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted in accordance with the allowance policy. Other Real Estate Owned: Assets acquired through, or instead of, loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly. Loan Servicing Rights: Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income, resulting in a Level 3 classification. Assets and Liabilities Measured on a Recurring Basis Available for sale investment securities are the Company’s only balance sheet item that meet the disclosure requirements for instruments measured at fair value on a recurring basis. Disclosures are as follows in the tables below. There were no transfers between level 1 and level 2 during 2016 or 2015. Assets measured at fair value on a non-recurring basis are summarized below: Impaired loans measured for impairment using the fair value of the collateral had a net carrying amount of $3.9 million, with a valuation allowance of $502 thousand at December 31, 2016. During 2016, four new loans became impaired resulting in an additional provision for loan losses of $427 thousand. The total allowance for specific impaired loans decreased $107 thousand for the year ending December 31, 2016. At December 31, 2015, impaired loans measured for impairment using the fair value of the collateral had a net carrying amount of $825 thousand, with a valuation allowance of $170 thousand, resulting in an additional provision for loan losses of $170 thousand for the year ending December 31, 2015. Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $1.2 million, which is made up of the outstanding balance of $2.0 million, net of a valuation allowance of $803 thousand at December 31, 2016. Write-downs of other real estate totaled $187 thousand for the year ending December 31, 2016. At December 31, 2015, other real estate owned measured at fair value less costs to sell, had a net carrying amount of $1.5 million, which was made up of the outstanding balance of $2.1 million, net of a valuation allowance of $616 thousand at December 31, 2015. Write-downs of other real estate totaled $252 thousand for the year ending December 31, 2015. Certain impaired loan servicing rights, which are carried at lower of cost or fair value, were carried at their fair value of $1.1 million, which is made up of the outstanding balance of $1.2 million, net of a valuation allowance of $125 thousand at December 31, 2016. Net write-downs for the loan servicing rights totaled $105 thousand for the year ending December 31, 2016. At December 31, 2015, impaired loan servicing rights were carried at their fair value of $87 thousand, which is made up of the outstanding balance of $106 thousand, net of a valuation allowance of $20 thousand at December 31, 2015. Net Recoveries for prior write-downs were recorded in the amount of $59 thousand for the year ending December 31, 2015. The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2016 and 2015: Fair Value of Financial Instruments The carrying amounts and estimated fair values of financial instruments, at December 31, 2016 and December 31, 2015 are as follows: December 31, 2016: December 31, 2015: The methods and assumptions, not previously presented, used to estimate fair value are described as follows: Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, accrued interest receivable and payable, demand deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully. The methods for determining the fair values for securities were described previously. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk (including consideration of widening credit spreads). The method used to determine the fair value of loans does not necessarily represent an exit price. Fair value of debt is based on current rates for similar financing. It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability. The fair value of off-balance sheet items is not considered material. NOTE 18 - OFF-BALANCE SHEET ACTIVITIES AND COMMITMENTS Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. Financial instruments with off-balance sheet risk were as follows at year-end (in thousands): Unused lines of credit are substantially all at variable rates. Commitments to make loans are generally made for a period of 60 days or less and are originated at current market rates ranging from 2.88% to 6.78% with maturities ranging up to 30 years. NOTE 19 - CAPITAL REQUIREMENTS The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and Bank capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors. The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for US banks (Basel III rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under the Basell III rules, the Company must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2016 is 0.625%. The net unrealized gain or loss on available for sale securities is not included in computing regulatory capital. Management believes as of December 31,2016, the Company and the Bank meet all capital adequacy requirements to which they are subject. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). Management believes, as of December 31, 2016 and 2015, that the Bank meets all capital adequacy requirements to which they are subject. The most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum Total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the institution’s category. The Company’s and the Bank’s actual amounts and ratios, exclusive of the capital conservation buffer, are presented in the table below: NOTE 20 - PARENT COMPANY FINANCIAL STATEMENTS Condensed Balance Sheets December 31 Condensed Statements of Income and Comprehensive Income Years Ended December 31 Condensed Statements of Cash Flows Years Ended December 31 NOTE 21 - QUARTERLY FINANCIAL DATA (UNAUDITED) (in thousands, except per share data) The Company recorded an additional $747 in other income during the second quarter of 2015 for the settlement of a legal matter. NOTE 22 - ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following is changes in Accumulated Other Comprehensive Income (Loss) by component, net of tax, for the years ending December 31, 2016 and 2015 (in thousands): NOTE 23 - ACQUISITION OF MADISON FINANCIAL CORPORATION On July 24, 2015, the Company acquired Madison Financial Corporation and its wholly-owned subsidiary, Madison Bank, both of which were headquartered in Richmond, Kentucky. As a result of the acquisition the Company expanded its presence into central Kentucky with minimal overlap of its existing market footprint and generate long-term value for the Company shareholders. Madison Bank had $116.1 million in total assets and operated three financial centers. The total purchase price for Madison Financial Corporation was $7.9 million net of capital stock issuance costs, consisting of $3 thousand cash for fractional shares and the issuance of 263,361 shares of the Company’s common stock valued at $7.9 million net of capital stock issuance costs. The acquisition was accounted for under the acquisition method of accounting. Accordingly, the Company recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values, while approximately $858 thousand of transaction and integration costs associated with the acquisition were expensed as incurred. Of the total purchase price, $884 thousand was allocated to goodwill which is not considered deductible for tax purposes. Based on management’s valuation of the fair value of tangible and intangible assets acquired and liabilities assumed, the purchase price for the Madison Financial Corporation acquisition is allocated as follows (in thousands): The fair value of net assets acquired includes fair value adjustments to certain loan receivables that were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows. However, the Company believes that all contractual cash flows related to these loans will be collected. As such, these loan receivables were not considered impaired at the acquisition date and were not subject to the guidance relating to purchase credit impaired loans, which have shown evidence of credit deterioration since origination. Loan receivables acquired that were not subject to these requirements include non-impaired loans with a fair value and gross contractual amounts receivable of $73.6 million and $74.7 million as of the date of acquisition.
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Here's a summary of the financial statement:
Key Financial Points:
1. Securities Classification & Treatment:
- Available for sale securities: Losses reported in other comprehensive income (net of deferred tax)
- Trading securities: Unrealized gains/losses reported in other income
- No held to maturity investments
2. Cash & Equivalents:
- Includes cash on hand, amounts due from banks, federal funds sold
- Short-term investments with maturities under 3 months
- Federal funds typically sold for one-day periods
3. Interest Bearing Time Deposits:
- Original maturities between 1-3 years
- Carried at cost
4. Asset Information:
- Company operated three financial centers
- Purchase price for Madison Financial Corporation was $7.9 (units not specified)
5. Securities Management:
- OTTI evaluations conducted quarterly at minimum
- More frequent evaluations when economic conditions warrant
- Specific criteria for impairment recognition and splitting
6. Accounting Methods:
- Level-yield method used for premium/discount amortization
- Specific identification method used for sales gains/losses
- Settlement date recording for gains/losses
This statement shows a structured approach to securities management with clear guidelines for classification, valuation, and impairment assessment.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM To the Board of Directors of ONEOK Partners GP, L.L.C. as General Partner of ONEOK Partners, L.P. and to the Unitholders: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, changes in equity and cash flows present fairly, in all material respects, the financial position of ONEOK Partners, L.P. and its subsidiaries (the Partnership) at December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Partnership maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Partnership’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Partnership’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP Tulsa, Oklahoma February 28, 2017 See accompanying . See accompanying . See accompanying . See accompanying . See accompanying . ONEOK PARTNERS, L.P. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Nature of Operations - On January 31, 2017, we and ONEOK entered into the Merger Agreement, by and among ONEOK, Merger Sub, ONEOK Partners and ONEOK Partners GP, our general partner, pursuant to which ONEOK will acquire all of our outstanding common units representing limited partner interests in us not already directly or indirectly owned by ONEOK. Upon the terms and conditions set forth in the Merger Agreement, Merger Sub will be merged with and into ONEOK Partners, with ONEOK Partners continuing as a wholly owned subsidiary of ONEOK, in a taxable transaction to our common unitholders. For additional information on this transaction, see Note B. ONEOK Partners, L.P. is a publicly traded master limited partnership, organized under the laws of the state of Delaware, that was formed in 1993. Our equity consists of a 2 percent general partner interest and a 98 percent limited partner interest. Our limited partner interests are represented by our common units, which are listed on the NYSE under the trading symbol “OKS,” and our Class B limited partner units. We are managed under the direction of the Board of Directors of our sole general partner, ONEOK Partners GP. ONEOK Partners GP is a wholly owned subsidiary of ONEOK. ONEOK and its subsidiaries owned a 41.2 percent aggregate equity interest in us at December 31, 2016. Our operations include gathering and processing of natural gas produced from crude oil and natural gas wells. We gather and process natural gas in the Mid-Continent region, which includes the NGL-rich STACK and SCOOP areas in the Anadarko Basin and the Cana-Woodford Shale, Woodford Shale, Springer Shale, Meramec, Granite Wash and Mississippian Lime formations of Oklahoma and Kansas, and the Hugoton and Central Kansas Uplift Basins in Kansas. We also gather and/or process natural gas in two producing basins in the Rocky Mountain region: the Williston Basin, which spans portions of North Dakota and Montana and includes the oil-producing, NGL-rich Bakken Shale and Three Forks formations; and the Powder River Basin located in Wyoming, which includes the NGL-rich Niobrara Shale and Frontier, Turner and Sussex formations in Wyoming. Our natural gas liquids assets consist of facilities that gather, fractionate and treat NGLs and store NGL products primarily in Oklahoma, Kansas, Texas, New Mexico and the Rocky Mountain region where we provide midstream services to producers of NGLs. We own or have an ownership interest in FERC-regulated natural gas liquids gathering and distribution pipelines in Oklahoma, Kansas, Texas, New Mexico, Montana, North Dakota, Wyoming and Colorado, and terminal and storage facilities in Missouri, Nebraska, Iowa and Illinois. We also own FERC-regulated natural gas liquids distribution and refined petroleum products pipelines in Kansas, Missouri, Nebraska, Iowa, Illinois and Indiana that connect our Mid-Continent assets with Midwest markets, including Chicago, Illinois. We own and operate truck- and rail-loading and -unloading facilities that interconnect with our NGL fractionation and pipeline assets. We operate interstate and intrastate natural gas transmission pipelines and natural gas storage facilities. Our FERC-regulated interstate natural gas pipeline assets transport natural gas through pipelines in North Dakota, Minnesota, Wisconsin, Illinois, Indiana, Kentucky, Tennessee, Oklahoma, Texas and New Mexico. Our intrastate natural gas pipeline assets in Oklahoma transport natural gas throughout the state and have access to the major natural gas producing areas in the Mid-Continent region, which include the emerging STACK and SCOOP areas in the Anadarko Basin and the Cana-Woodford Shale, Woodford Shale, Springer Shale, Meramec, Granite Wash and Mississippian Lime formations. The Roadrunner pipeline transports natural gas from the Permian Basin in West Texas to the Mexican border near El Paso, Texas, and is fully subscribed with 25-year firm demand charge, fee-based agreements. We own underground natural gas storage facilities in Oklahoma and Texas that are connected to our intrastate natural gas pipeline assets. We also have underground natural gas storage facilities in Kansas. Consolidation - Our consolidated financial statements include our accounts and the accounts of our subsidiaries over which we have control or are the primary beneficiary. All significant intercompany balances and transactions have been eliminated in consolidation. Investments in unconsolidated affiliates are accounted for using the equity method if we have the ability to exercise significant influence over operating and financial policies of our investee. Under this method, an investment is carried at its acquisition cost and adjusted each period for contributions made, distributions received and our share of the investee’s comprehensive income. For the investments we account for under the equity method, the premium or excess cost over underlying fair value of net assets is referred to as equity-method goodwill. Impairment of equity investments is recorded when the impairments are other than temporary. These amounts are recorded as investments in unconsolidated affiliates on our accompanying Consolidated Balance Sheets. See Note L for disclosures of our unconsolidated affiliates. Distributions paid to us from our unconsolidated affiliates are classified as operating activities on our Consolidated Statements of Cash Flows until the cumulative distributions exceed our proportionate share of income from the unconsolidated affiliate since the date of our initial investment. The amount of cumulative distributions paid to us that exceeds our cumulative proportionate share of income in each period represents a return of investment and is classified as an investing activity on our Consolidated Statements of Cash Flows. Use of Estimates - The preparation of our consolidated financial statements and related disclosures in accordance with GAAP requires us to make estimates and assumptions with respect to values or conditions that cannot be known with certainty that affect the reported amount of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements. These estimates and assumptions also affect the reported amounts of revenue and expenses during the reporting period. Items that may be estimated include, but are not limited to, the economic useful life of assets, fair value of assets, liabilities and equity-method investments, provisions for uncollectible accounts receivable, unbilled revenues and cost of goods sold, expenses for services received but for which no invoice has been received, the results of litigation and various other recorded or disclosed amounts. We evaluate these estimates on an ongoing basis using historical experience, consultation with experts and other methods we consider reasonable based on the particular circumstances. Nevertheless, actual results may differ significantly from the estimates. Any effects on our financial position or results of operations from revisions to these estimates are recorded in the period when the facts that give rise to the revision become known. Fair Value Measurements - We define fair value as the price that would be received from the sale of an asset or the transfer of a liability in an orderly transaction between market participants at the measurement date. We use market and income approaches to determine the fair value of our assets and liabilities and consider the markets in which the transactions are executed. We measure the fair value of a group of financial assets and liabilities consistent with how a market participant would price the net risk exposure at the measurement date. While many of the contracts in our derivative portfolio are executed in liquid markets where price transparency exists, some contracts are executed in markets for which market prices may exist, but the market may be relatively inactive. This results in limited price transparency that requires management’s judgment and assumptions to estimate fair values. For certain transactions, we utilize modeling techniques using NYMEX-settled pricing data and implied forward LIBOR curves. Inputs into our fair value estimates include commodity-exchange prices, over-the-counter quotes, historical correlations of pricing data, data obtained from third-party pricing services and LIBOR and other liquid money-market instrument rates. We validate our valuation inputs with third-party information and settlement prices from other sources, where available. In addition, as prescribed by the income approach, we compute the fair value of our derivative portfolio by discounting the projected future cash flows from our derivative assets and liabilities to present value using interest-rate yields to calculate present-value discount factors derived from LIBOR, Eurodollar futures and the LIBOR interest-rate swaps market. We also take into consideration the potential impact on market prices of liquidating positions in an orderly manner over a reasonable period of time under current market conditions. We consider current market data in evaluating counterparties’, as well as our own, nonperformance risk, net of collateral, by using specific and sector bond yields and monitoring the credit default swap markets. Although we use our best estimates to determine the fair value of the derivative contracts we have executed, the ultimate market prices realized could differ from our estimates, and the differences could be material. The fair value of our forward-starting interest-rate swaps are determined using financial models that incorporate the implied forward LIBOR yield curve for the same period as the future interest-rate swap settlements. Fair Value Hierarchy - At each balance sheet date, we utilize a fair value hierarchy to classify fair value amounts recognized or disclosed in our financial statements based on the observability of inputs used to estimate such fair value. The levels of the hierarchy are described below: • Level 1 - fair value measurements are based on unadjusted quoted prices for identical securities in active markets, including NYMEX-settled prices. These balances are comprised predominantly of exchange-traded derivative contracts for natural gas and crude oil. • Level 2 - fair value measurements are based on significant observable pricing inputs, such as NYMEX-settled prices for natural gas and crude oil, and financial models that utilize implied forward LIBOR yield curves for interest-rate swaps. • Level 3 - fair value measurements are based on inputs that may include one or more unobservable inputs, including internally developed natural gas basis and NGL price curves that incorporate observable and unobservable market data from broker quotes, third-party pricing services, market volatilities derived from the most recent NYMEX close spot prices and forward LIBOR curves, and adjustments for the credit risk of our counterparties. We corroborate the data on which our fair value estimates are based using our market knowledge of recent transactions, analysis of historical correlations and validation with independent broker quotes. These balances categorized as Level 3 are comprised of derivatives for natural gas and NGLs. We do not believe that our Level 3 fair value estimates have a material impact on our results of operations, as the majority of our derivatives are accounted for as hedges for which ineffectiveness has not been material. Determining the appropriate classification of our fair value measurements within the fair value hierarchy requires management’s judgment regarding the degree to which market data is observable or corroborated by observable market data. We categorize derivatives for which fair value is determined using multiple inputs within a single level, based on the lowest level input that is significant to the fair value measurement in its entirety. See Note C for discussion of our fair value measurements. Cash and Cash Equivalents - Cash equivalents consist of highly liquid investments, which are readily convertible into cash and have original maturities of three months or less. Revenue Recognition - Our reportable segments recognize revenue when services are rendered or product is delivered. Our Natural Gas Gathering and Processing segment records revenues when natural gas is gathered or processed through our facilities. Our Natural Gas Liquids segment records revenues based upon contracted services and volumes exchanged or stored under service agreements in the period services are provided. A portion of our revenues for our Natural Gas Pipelines segment and our Natural Gas Liquids segment are recognized based upon contracted capacity and contracted volumes transported and stored under service agreements in the period services are provided. We disaggregate revenue on the Consolidated Statements of Income as follows: • Commodity sales - Commodity sales represent the sale of NGLs, condensate and residue natural gas. We generally purchase a supplier’s raw natural gas or unfractionated NGLs, which we process into marketable commodities and condensate, then we sell these commodities and condensate to downstream customers. Commodity sales are recognized upon delivery or title transfer to the customer, when revenue recognition criteria are met. • Service revenue - Service revenue represents the fees generated from the performance of our services. We enter into a variety of contract types that provide commodity sales and service revenue. We provide services primarily under the following types of contracts: • Fee-based - Under fee-based arrangements, we receive a fee or fees for one or more of the following services: gathering, compression, processing, transmission and storage of natural gas; and gathering, transportation, fractionation and storage of NGLs. The revenue we earn from these arrangements generally is directly related to the volume of natural gas and NGLs that flow through our systems and facilities, and is not normally directly dependent on commodity prices. However, to the extent a sustained decline in commodity prices results in a decline in volumes, our revenues from these arrangements would be reduced. In addition, many of our arrangements provide for fixed fee, minimum volume or firm demand charges. Fee-based arrangements are reported as service revenue on the Consolidated Statements of Income. • Percent-of-proceeds - Under POP arrangements in our Natural Gas Gathering and Processing segment, we generally purchase the producer’s raw natural gas which we process into natural gas and natural gas liquids, then we sell these commodities and condensate to downstream customers. We remit sales proceeds to the producer according to the contractual terms and retain our portion. Typically, our POP arrangements also include a fee-based component. In many cases, our Natural Gas Gathering and Processing segment provides services under contracts that contain a combination of the arrangements described above. When services are provided (in addition to raw natural gas purchased) under POP with fee contracts, we record such fees as service revenue on the Consolidated Statements of Income. The terms of our contracts vary based on natural gas quality conditions, the competitive environment when the contracts are signed and customer requirements. Cost of Sales and Fuel - Cost of sales and fuel primarily includes (i) the cost of purchased commodities, including NGLs, natural gas and condensate, (ii) fees incurred for third-party transportation, fractionation and storage of commodities, and (iii) fuel and power costs incurred to operate our own facilities that gather, process, transport and store commodities. Operations and Maintenance - Operations and maintenance primarily includes (i) payroll and benefit costs, (ii) third-party costs for operations, maintenance and integrity management, regulatory compliance and environmental and safety, and (iii) other business related service costs. Accounts Receivable - Accounts receivable represent valid claims against nonaffiliated customers for products sold or services rendered, net of allowances for doubtful accounts. We assess the creditworthiness of our counterparties on an ongoing basis and require security, including prepayments and other forms of collateral, when appropriate. Outstanding customer receivables are reviewed regularly for possible nonpayment indicators, and allowances for doubtful accounts are recorded based upon management’s estimate of collectability at each balance sheet date. At December 31, 2016 and 2015, our allowance for doubtful accounts was not material. Inventory - The values of current natural gas and NGLs in storage are determined using the lower of weighted-average cost or market method. Noncurrent natural gas and NGLs are classified as property and valued at cost. Materials and supplies are valued at average cost. Commodity Imbalances - Commodity imbalances represent amounts payable or receivable for NGL exchange contracts and natural gas pipeline imbalances and are valued at market prices. Under the majority of our NGL exchange agreements, we physically receive volumes of unfractionated NGLs, including the risk of loss and legal title to such volumes, from the exchange counterparty. In turn, we deliver NGL products back to the customer and charge them gathering, fractionation and transportation fees. To the extent that the volumes we receive under such agreements differ from those we deliver, we record a net exchange receivable or payable position with the counterparties. These net exchange receivables and payables are settled with movements of NGL products rather than with cash. Natural gas pipeline imbalances are settled in cash or in-kind, subject to the terms of the pipelines’ tariffs or by agreement. Derivatives and Risk Management - We utilize derivatives to reduce our market-risk exposure to commodity price and interest-rate fluctuations and to achieve more predictable cash flows. We record all derivative instruments at fair value, with the exception of normal purchases and normal sales transactions that are expected to result in physical delivery. Commodity price and interest-rate volatility may have a significant impact on the fair value of derivative instruments as of a given date. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, the reason for holding it. The table below summarizes the various ways in which we account for our derivative instruments and the impact on our consolidated financial statements: To reduce our exposure to fluctuations in natural gas, NGLs and condensate prices, we periodically enter into futures, forward purchases and sales, options or swap transactions in order to hedge anticipated purchases and sales of natural gas, NGLs and condensate. Interest-rate swaps are used from time to time to manage interest-rate risk. Under certain conditions, we designate our derivative instruments as a hedge of exposure to changes in fair values or cash flows. We formally document all relationships between hedging instruments and hedged items, as well as risk-management objectives and strategies for undertaking various hedge transactions, and methods for assessing and testing correlation and hedge ineffectiveness. We specifically identify the forecasted transaction that has been designated as the hedged item in a cash flow hedge relationship. We assess the effectiveness of hedging relationships quarterly by performing an effectiveness analysis on our fair value and cash flow hedging relationships to determine whether the hedge relationships are highly effective on a retrospective and prospective basis. We also document our normal purchases and normal sales transactions that we expect to result in physical delivery and that we elect to exempt from derivative accounting treatment. The realized revenues and purchase costs of our derivative instruments not considered held for trading purposes and derivatives that qualify as normal purchases or normal sales that are expected to result in physical delivery are reported on a gross basis. Cash flows from futures, forwards and swaps that are accounted for as hedges are included in the same category as the cash flows from the related hedged items in our Consolidated Statements of Cash Flows. See Notes C and D for more discussion of our fair value measurements and risk-management and hedging activities using derivatives. Property, Plant and Equipment - Our properties are stated at cost, including AFUDC and capitalized interest. In some cases, the cost of regulated property retired or sold, plus removal costs, less salvage, is charged to accumulated depreciation. Gains and losses from sales or transfers of nonregulated properties or an entire operating unit or system of our regulated properties are recognized in income. Maintenance and repairs are charged directly to expense. The interest portion of AFUDC and capitalized interest represent the cost of borrowed funds used to finance construction activities for regulated and nonregulated projects, respectively. We capitalize interest costs during the construction or upgrade of qualifying assets. These costs are recorded as a reduction to interest expense. The equity portion of AFUDC represents the capitalization of the estimated average cost of equity used during the construction of major projects and is recorded in the cost of our regulated properties and as a credit to the allowance for equity funds used during construction. Our properties are depreciated using the straight-line method over their estimated useful lives. Generally, we apply composite depreciation rates to functional groups of property having similar economic circumstances. We periodically conduct depreciation studies to assess the economic lives of our assets. For our regulated assets, these depreciation studies are completed as a part of our rate proceedings or tariff filings, and the changes in economic lives, if applicable, are implemented prospectively when the new rates are billed. For our nonregulated assets, if it is determined that the estimated economic life changes, the changes are made prospectively. Changes in the estimated economic lives of our property, plant and equipment could have a material effect on our financial position or results of operations. Property, plant and equipment on our Consolidated Balance Sheets includes construction work in process for capital projects that have not yet been placed in service and therefore are not being depreciated. Assets are transferred out of construction work in process when they are substantially complete and ready for their intended use. See Note E for disclosures of our property, plant and equipment. Impairment of Goodwill and Long-Lived Assets, Including Intangible Assets - We assess our goodwill for impairment at least annually on July 1, unless events or changes in circumstances indicate an impairment may have occurred before that time. As the commodity price environment has remained relatively low since 2015, we elected to perform a quantitative assessment, or Step 1 analysis, to test our goodwill for impairment. The assessment included our current commodity price assumptions, expected contractual terms, anticipated operating costs and volume estimates. Our goodwill impairment analysis performed as of July 1, 2016, did not result in an impairment charge nor did our analysis reflect any reporting units at risk. In each reporting unit, the fair value substantially exceeded the carrying value. Subsequent to that date, no event has occurred indicating that the implied fair value of each of our reporting units is less than the carrying value of its net assets. As part of our impairment test, we may first assess qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors and overall financial performance) to determine whether it is more likely than not that the fair value of each of our reporting units is less than its carrying amount. If further testing is necessary or a quantitative test is elected, we perform a two-step impairment test for goodwill. In the first step, an initial assessment is made by comparing the fair value of a reporting unit with its book value, including goodwill. If the fair value is less than the book value, an impairment is indicated, and we must perform a second test to measure the amount of the impairment. In the second test, we calculate the implied fair value of the goodwill by deducting the fair value of all tangible and intangible net assets of the reporting unit from the fair value determined in step one of the assessment. If the carrying value of the goodwill exceeds the implied fair value of the goodwill, we will record an impairment charge. To estimate the fair value of our reporting units, we use two generally accepted valuation approaches, an income approach and a market approach, using assumptions consistent with a market participant’s perspective. Under the income approach, we use anticipated cash flows over a period of years plus a terminal value and discount these amounts to their present value using appropriate discount rates. Under the market approach, we apply EBITDA multiples to forecasted EBITDA. The multiples used are consistent with historical asset transactions. The forecasted cash flows are based on average forecasted cash flows for a reporting unit over a period of years. We assess our long-lived assets, including intangible assets with finite useful lives, for impairment whenever events or changes in circumstances indicate that an asset’s carrying amount may not be recoverable. An impairment is indicated if the carrying amount of a long-lived asset exceeds the sum of the undiscounted future cash flows expected to result from the use and eventual disposition of the asset. If an impairment is indicated, we record an impairment loss equal to the difference between the carrying value and the fair value of the long-lived asset. For the investments we account for under the equity method, the impairment test considers whether the fair value of the equity investment as a whole, not the underlying net assets, has declined and whether that decline is other than temporary. Therefore, we periodically reevaluate the amount at which we carry our equity-method investments to determine whether current events or circumstances warrant adjustments to our carrying values. See Notes E, F and L for our long-lived assets, goodwill and intangible assets and investments in unconsolidated affiliates disclosures. Regulation - Our intrastate natural gas transmission and natural gas liquids pipelines are subject to the rate regulation and accounting requirements of the OCC, KCC, RRC and various municipalities in Texas. Our interstate natural gas and natural gas liquids pipelines are subject to regulation by the FERC. In Kansas and Texas, natural gas storage may be regulated by the state and the FERC for certain types of services. Accordingly, portions of our Natural Gas Liquids and Natural Gas Pipelines segments follow the accounting and reporting guidance for regulated operations. In our Consolidated Financial Statements and our , regulated operations are defined pursuant to Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 980, Regulated Operations. During the rate-making process for certain of our assets, regulatory authorities set the framework for what we can charge customers for our services and establish the manner that our costs are accounted for, including allowing us to defer recognition of certain costs and permitting recovery of the amounts through rates over time as opposed to expensing such costs as incurred. Certain examples of types of regulatory guidance include costs for fuel and losses, acquisition costs, contributions in aid of construction, charges for depreciation, and gains or losses on disposition of assets. This allows us to stabilize rates over time rather than passing such costs on to the customer for immediate recovery. Actions by regulatory authorities could have an effect on the amount recovered from rate payers. Any difference in the amount recoverable and the amount deferred is recorded as income or expense at the time of the regulatory action. A write-off of regulatory assets and costs not recovered may be required if all or a portion of the regulated operations have rates that are no longer: • established by independent, third-party regulators; • designed to recover the specific entity’s costs of providing regulated services; and • set at levels that will recover our costs when considering the demand and competition for our services. At December 31, 2016 and 2015, we recorded regulatory assets of approximately $5.5 million and $5.8 million, respectively, which are currently being recovered and are expected to be recovered from our customers. Regulatory assets are being recovered as a result of approved rate proceedings over varying time periods up to 50 years. These assets are reflected in other assets on our Consolidated Balance Sheets. Income Taxes - We are not a taxable entity for federal income tax purposes. As such, we do not directly pay federal income tax. For our operations in Texas, we are subject to the Texas franchise tax, which is included in income tax expense in our consolidated statements of income. Our taxable income or loss, which may vary substantially from the net income or loss reported in our Consolidated Statements of Income, is included in the federal income tax returns of each partner. The aggregate difference in the basis of our net assets for financial and income tax purposes cannot be readily determined, as we do not have access to all information about each partner’s tax attributes related to us. Our corporate subsidiaries are required to pay federal and state income taxes. Deferred income taxes are provided for the difference between the financial statement and income tax basis of assets and liabilities and carryforward items based on income tax laws and rates existing at the time the temporary differences are expected to reverse. Generally, the effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date of the rate change. For regulated companies, the effect on deferred tax assets and liabilities of a change in tax rates is recorded as regulatory assets and regulatory liabilities in the period that includes the enactment date, if, as a result of an action by a regulator, it is probable that the effect of the change in tax rates will be recovered from or returned to customers through future rates. We utilize a more-likely-than-not recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position that is taken or expected to be taken in a tax return. We reflect penalties and interest as part of income tax expense as they become applicable for tax provisions that do not meet the more-likely-than-not recognition threshold and measurement attribute. During 2016, 2015 and 2014, our tax positions did not require an establishment of a material reserve. We file numerous consolidated and separate income tax returns with federal tax authorities of the United States along with the tax authorities of several states. There are no United States federal audits or statute waivers at this time. See Note K for additional discussion of income taxes. Asset Retirement Obligations - Asset retirement obligations represent legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset. Certain of our natural gas gathering and processing, natural gas liquids and natural gas pipeline facilities are subject to agreements or regulations that give rise to our asset retirement obligations for removal or other disposition costs associated with retiring the assets in place upon the discontinued use of the assets. We recognize the fair value of a liability for an asset retirement obligation in the period when it is incurred if a reasonable estimate of the fair value can be made. We are not able to estimate reasonably the fair value of the asset retirement obligations for portions of our assets, primarily certain pipeline assets, because the settlement dates are indeterminable given our expected continued use of the assets with proper maintenance. We expect our pipeline assets, for which we are unable to estimate reasonably the fair value of the asset retirement obligation, will continue in operation as long as supply and demand for natural gas and natural gas liquids exists. Based on the widespread use of natural gas for heating and cooking activities for residential users and electric-power generation for commercial users, as well as use of natural gas liquids by the petrochemical industry, we expect supply and demand to exist for the foreseeable future. For our assets that we are able to make an estimate, the fair value of the liability is added to the carrying amount of the associated asset, and this additional carrying amount is depreciated over the life of the asset. The liability is accreted at the end of each period through charges to operating expense. If the obligation is settled for an amount other than the carrying amount of the liability, we will recognize a gain or loss on settlement. The depreciation and accretion expense are immaterial to our consolidated financial statements. In accordance with long-standing regulatory treatment, we collect, through rates, the estimated costs of removal on certain regulated properties through depreciation expense, with a corresponding credit to accumulated depreciation and amortization. These removal costs collected through rates include legal and nonlegal removal obligations; however, the amounts collected in excess of the asset removal costs incurred are accounted for as a regulatory liability for financial reporting purposes. Historically, the regulatory authorities that have jurisdiction over our regulated operations have not required us to quantify this amount; rather, these costs are addressed prospectively in depreciation rates and are set in each general rate order. We have made an estimate of our regulatory liability using current rates since the last general rate order in each of our jurisdictions; however, for financial reporting purposes, significant uncertainty exists regarding the ultimate disposition of this regulatory liability pending, among other issues, clarification of regulatory intent. We continue to monitor regulatory requirements, and the liability may be adjusted as more information is obtained. Contingencies - Our accounting for contingencies covers a variety of business activities, including contingencies for legal and environmental exposures. We accrue these contingencies when our assessments indicate that it is probable that a liability has been incurred or an asset will not be recovered and an amount can be estimated reasonably. We expense legal fees as incurred and base our legal liability estimates on currently available facts and our estimates of the ultimate outcome or resolution. Accruals for estimated losses from environmental remediation obligations generally are recognized no later than completion of a remediation feasibility study. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. Our expenditures for environmental evaluation, mitigation, remediation and compliance to date have not been significant in relation to our financial position or results of operations, and our expenditures related to environmental matters had no material effect on earnings or cash flows during 2016, 2015 and 2014. Actual results may differ from our estimates resulting in an impact, positive or negative, on earnings. See Note N for additional discussion of contingencies. Recently Issued Accounting Standards Update - Changes to GAAP are established by the FASB in the form of ASUs to the FASB Accounting Standards Codification. We consider the applicability and impact of all ASUs. ASUs not listed below were assessed and determined to be either not applicable or clarifications of ASUs listed below. The following tables provide a brief description of recent accounting pronouncements and our analysis of the effects on our financial statements: B. ACQUISITION OF ONEOK PARTNERS On January 31, 2017, we and ONEOK entered into the Merger Agreement in which ONEOK will acquire all of our outstanding common units representing limited partner interests in us not already directly or indirectly owned by ONEOK in an all stock-for-unit transaction at a ratio of 0.985 of ONEOK common shares per common unit of ONEOK Partners, in a taxable transaction to our common unitholders. Following completion of the Merger Transaction, all of our outstanding common units will be owned by ONEOK and will no longer be publicly traded. All of our outstanding debt is expected to remain outstanding. We and ONEOK expect to enter into a cross guarantee agreement whereby each party to the agreement unconditionally guarantees and becomes liable for the indebtedness of each other party to the agreement. A Special Committee of the Board of Directors of ONEOK, the Conflicts Committee of the Board of Directors of our general partner and the Board of Directors of our general partner each unanimously approved the Merger Agreement. Subject to customary approvals and conditions, the Merger Transaction is expected to close in the second quarter of 2017. The Merger Transaction is subject to the approval of our common unitholders and the approval by ONEOK shareholders of the issuance of ONEOK common shares in the Merger Transaction. The Merger Agreement contains certain termination rights, including the right for either us or ONEOK, as applicable, to terminate the Merger Agreement if the closing of the transactions contemplated by the Merger Agreement has not occurred on or before September 30, 2017. In the event of termination of the Merger Agreement under certain circumstances, we may be required to pay ONEOK a termination fee of (up to, in certain instances, $300 million in cash) and, under other certain circumstances, ONEOK may be required to pay us a termination fee in the form of a temporary reduction in incentive distributions (up to, in certain instances, $300 million). C. FAIR VALUE MEASUREMENTS Recurring Fair Value Measurements - The following tables set forth our recurring fair value measurements for the periods indicated: (a) - Derivative assets and liabilities are presented in our Consolidated Balance Sheets on a net basis. We net derivative assets and liabilities when a legally enforceable master-netting arrangement exists between the counterparty to a derivative contract and us. At December 31, 2016, we held no cash and posted $67.7 million of cash with various counterparties, including $51.6 million of cash collateral that is offsetting derivative net liability positions under master-netting arrangements in the table above. The remaining $16.1 million of cash collateral in excess of derivative net liability positions is included in other current assets in our Consolidated Balance Sheets. (b) - Included in other current assets, other assets or other current liabilities in our Consolidated Balance Sheets. (a) - Derivative assets and liabilities are presented in our Consolidated Balance Sheets on a net basis. We net derivative assets and liabilities when a legally enforceable master-netting arrangement exists between the counterparty to a derivative contract and us. At December 31, 2015, we held $34.4 million of cash from various counterparties that is offsetting derivative net asset positions in the table above under master-netting arrangements and had no cash collateral posted. (b) - Included in other current assets or other current liabilities in our Consolidated Balance Sheets. The following table sets forth a reconciliation of our Level 3 fair value measurements for the periods indicated: (a) - Included in commodity sales revenues in our Consolidated Statements of Income. Realized/unrealized gains (losses) include the realization of our derivative contracts through maturity. During the years ended December 31, 2016 and 2015, gains or losses included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at the end of each reporting period were not material. We recognize transfers into and out of the levels in the fair value hierarchy as of the end of each reporting period. During the years ended December 31, 2016 and 2015, there were no transfers between levels. Other Financial Instruments - The approximate fair value of cash and cash equivalents, accounts receivable, accounts payable and short-term borrowings is equal to book value, due to the short-term nature of these items. Our cash and cash equivalents are comprised of bank and money market accounts and are classified as Level 1. Our short-term borrowings are classified as Level 2 since the estimated fair value of the short-term borrowings can be determined using information available in the commercial paper market. The estimated fair value of the aggregate of our senior notes outstanding, including current maturities, was $7.1 billion and $6.2 billion at December 31, 2016 and 2015, respectively. The book value of the aggregate of our senior notes outstanding, including current maturities, was $6.7 billion and $6.8 billion at December 31, 2016 and 2015, respectively. The estimated fair value of the aggregate of our senior notes outstanding was determined using quoted market prices for similar issues with similar terms and maturities. The estimated fair value of our long-term debt is classified as Level 2. During 2015 and 2014, we recorded noncash impairment charges primarily related to our equity investments in the dry natural gas area of the Powder River Basin. The valuation of these investments required use of significant unobservable inputs. We used an income approach to estimate the fair value of our investments. Our discounted cash flow analysis included the following inputs that are not readily available: a discount rate reflective of our cost of capital and estimated contract rates, volumes, operating and maintenance costs and capital expenditures. The estimated fair value of these investments is classified as Level 3. See Note L for additional information about our equity investments and the impairment charges. D. RISK-MANAGEMENT AND HEDGING ACTIVITIES USING DERIVATIVES Risk-Management Activities - We are sensitive to changes in natural gas, crude oil and NGL prices, principally as a result of contractual terms under which these commodities are processed, purchased and sold. We use physical-forward purchases and sales and financial derivatives to secure a certain price for a portion of our natural gas, condensate and NGL products; to reduce our exposure to commodity price and interest-rate fluctuations; and to achieve more predictable cash flows. We follow established policies and procedures to assess risk and approve, monitor and report our risk-management activities. We have not used these instruments for trading purposes. We are also subject to the risk of interest-rate fluctuation in the normal course of business. Commodity price risk - Commodity price risk refers to the risk of loss in cash flows and future earnings arising from adverse changes in the price of natural gas, NGLs and condensate. We use the following commodity derivative instruments to mitigate the near-term commodity price risk associated with a portion of the forecasted sales of these commodities: • Futures contracts - Standardized contracts to purchase or sell natural gas and crude oil for future delivery or settlement under the provisions of exchange regulations; • Forward contracts - Nonstandardized commitments between two parties to purchase or sell natural gas, crude oil or NGLs for future physical delivery. These contracts are typically nontransferable and can only be canceled with the consent of both parties; • Swaps - Exchange of one or more payments based on the value of one or more commodities. These instruments transfer the financial risk associated with a future change in value between the counterparties of the transaction, without also conveying ownership interest in the asset or liability; and • Options - Contractual agreements that give the holder the right, but not the obligation, to buy or sell a fixed quantity of a commodity at a fixed price within a specified period of time. Options may either be standardized and exchange-traded or customized and nonexchange-traded. We may also use other instruments including collars to mitigate commodity price risk. A collar is a combination of a purchased put option and a sold call option, which places a floor and a ceiling price for commodity sales being hedged. In our Natural Gas Gathering and Processing segment, we are exposed to commodity price risk as a result of retaining a portion of the commodity sales proceeds associated with our POP with fee contracts. Under certain POP with fee contracts, our fee revenues may increase or decrease if production volumes, delivery pressures or commodity prices change relative to specified thresholds. We also are exposed to basis risk between the various production and market locations where we receive and sell commodities. As part of our hedging strategy, we use the previously described commodity derivative financial instruments and physical-forward contracts to reduce the impact of price fluctuations related to natural gas, NGLs and condensate. In our Natural Gas Liquids segment, we are exposed to location price differential risk, primarily as a result of the relative value of NGL purchases at one location and sales at another location. We are also exposed to commodity price risk resulting from the relative values of the various NGL products to each other, NGLs in storage and the relative value of NGLs to natural gas. We utilize physical-forward contracts and commodity derivative financial instruments to reduce the impact of price fluctuations related to NGLs. In our Natural Gas Pipelines segment, we are exposed to commodity price risk because our intrastate and interstate natural gas pipelines retain natural gas from our customers for operations or as part of our fee for services provided. When the amount of natural gas consumed in operations by these pipelines differs from the amount provided by our customers, our pipelines must buy or sell natural gas, or store or use natural gas from inventory, which can expose us to commodity price risk depending on the regulatory treatment for this activity. To the extent that commodity price risk in our Natural Gas Pipelines segment is not mitigated by fuel cost-recovery mechanisms, we may use physical-forward sales or purchases to reduce the impact of price fluctuations related to natural gas. At December 31, 2016 and 2015, there were no financial derivative instruments with respect to our natural gas pipeline operations. Interest-rate risk - We manage interest-rate risk through the use of fixed-rate debt, floating-rate debt and interest-rate swaps. Interest-rate swaps are agreements to exchange interest payments at some future point based on specified notional amounts. In January 2016, we entered into forward-starting interest-rate swaps with notional amounts totaling $1 billion to hedge the variability of our LIBOR-based interest payments, all of which were active swaps as of December 31, 2016. In addition, in June 2016, we entered into forward-starting interest rate swaps with notional amounts totaling $750 million to hedge the variability of interest payments on a portion of our forecasted debt issuances that may result from changes in the benchmark interest rate before the debt is issued, resulting in total notional amounts of this type of interest-rate swap of $1.2 billion at December 31, 2016, compared with $400 million at December 31, 2015. All of our interest-rate swaps are designated as cash flow hedges. Upon our debt issuance in March 2015, we settled $500 million of our interest-rate swaps and realized a loss of $55.1 million, which is included in accumulated other comprehensive loss and will be amortized to interest expense over the term of the related debt. Fair Values of Derivative Instruments - The following table sets forth the fair values of our derivative instruments presented on a gross basis for the periods indicated: Notional Quantities for Derivative Instruments - The following table sets forth the notional quantities for derivative instruments held for the periods indicated: These notional amounts are used to summarize the volume of financial instruments; however, they do not reflect the extent to which the positions offset one another and consequently do not reflect our actual exposure to market or credit risk. Cash Flow Hedges - At December 31, 2016, our Consolidated Balance Sheet reflected a net loss of $161.5 million in accumulated other comprehensive loss. The portion of accumulated other comprehensive loss attributable to our commodity derivative financial instruments is an unrealized loss of $63.4 million, which will be realized within the next 24 months as the forecasted transactions affect earnings. If commodity prices remain at the current levels, we will realize approximately $61.5 million in net losses over the next 12 months and approximately $1.9 million in net losses thereafter. The amount deferred in accumulated other comprehensive loss attributable to our settled interest-rate swaps is a loss of $125.9 million, which will be recognized over the life of the long-term, fixed-rate debt, including losses of $16.6 million that will be reclassified into earnings during the next 12 months as the hedged items affect earnings. The remaining amounts in accumulated other comprehensive loss are attributable primarily to forward-starting interest-rate swaps with future settlement dates, which will be amortized to interest expense over the life of long-term, fixed-rate debt upon issuance of the debt. The following table sets forth the unrealized effect of cash flow hedges recognized in other comprehensive income (loss) for the periods indicated: The following table sets forth the effect of cash flow hedges in our Consolidated Statements of Income for the periods indicated: Credit Risk - We monitor the creditworthiness of our counterparties and compliance with policies and limits established by our Risk Oversight and Strategy Committee. We maintain credit policies with regard to our counterparties that we believe minimize overall credit risk. These policies include an evaluation of potential counterparties’ financial condition (including credit ratings, bond yields and credit default swap rates), collateral requirements under certain circumstances and the use of standardized master-netting agreements that allow us to net the positive and negative exposures associated with a single counterparty. We have counterparties whose credit is not rated, and for those customers, we use internally developed credit ratings. From time to time, we may enter into financial derivative instruments that contain provisions that require us to maintain an investment-grade credit rating from S&P and/or Moody’s. If our credit ratings on our senior unsecured long-term debt were to decline below investment grade, the counterparties to the derivative instruments could request collateralization on derivative instruments in net liability positions. There were no financial derivative instruments with contingent features related to credit risk as of December 31, 2016. The counterparties to our derivative contracts consist primarily of major energy companies, financial institutions and commercial and industrial end users. This concentration of counterparties may affect our overall exposure to credit risk, either positively or negatively, in that the counterparties may be affected similarly by changes in economic, regulatory or other conditions. Based on our policies, exposures, credit and other reserves, we do not anticipate a material adverse effect on our financial position or results of operations as a result of counterparty nonperformance. At December 31, 2016, the net credit exposure from our derivative assets is primarily with investment-grade companies in the financial services sector. E. PROPERTY, PLANT AND EQUIPMENT The following table sets forth our property, plant and equipment by property type, for the periods indicated: The average depreciation rates for our regulated property are set forth, by segment, in the following table for the periods indicated: We incurred costs for construction work in process that had not been paid at December 31, 2016, 2015 and 2014, of $83.0 million, $115.7 million and $187.2 million, respectively. Such amounts are not included in capital expenditures (less AFUDC and capitalized interest) on the Consolidated Statements of Cash Flows. Impairment Charges - Due to the continued and greater than expected decline in volumes gathered in the dry natural gas area of the Powder River Basin, we evaluated our long-lived assets and equity investments in this area in 2015 and made the decision to cease operations of our wholly owned coal-bed methane natural gas gathering system in 2016. This resulted in a $63.5 million noncash impairment charge to long-lived assets in 2015 in our Natural Gas Gathering and Processing segment. In addition, we recorded noncash impairment charges of approximately $20.2 million for previously idled assets in the Natural Gas Gathering and Processing and Natural Gas Liquids segments in 2015, as our expectation for future use of these assets changed. F. GOODWILL AND INTANGIBLE ASSETS Goodwill - The following table sets forth our goodwill, by segment, for the periods indicated: Intangible Assets - Our intangible assets relate primarily to contracts acquired through acquisitions in our Natural Gas Gathering and Processing and Natural Gas Liquids segments, which are being amortized over periods of 20 to 40 years. Amortization expense for intangible assets for 2016, 2015 and 2014 was $11.9 million, $11.9 million and $11.8 million, respectively, and the aggregate amortization expense for each of the next five years is estimated to be approximately $11.9 million. The following table reflects the gross carrying amount and accumulated amortization of intangible assets for the periods presented: G. DEBT The following table sets forth our debt for the periods indicated: (a) - We had $14 million of letters of credit issued at December 31, 2016 and 2015. (b) - Individual issuances of commercial paper under our $2.4 billion commercial paper program generally mature in 90 days or less. However, these issuances are supported by and reduce the borrowing capacity under our Partnership Credit Agreement. Partnership Credit Agreement - In January 2016, we extended the term of our Partnership Credit Agreement by one year to January 2020. Our Partnership Credit Agreement is a $2.4 billion revolving credit facility and includes a $100 million sublimit for the issuance of standby letters of credit and a $150 million swingline sublimit. Our Partnership Credit Agreement is available for general partnership purposes and had available capacity of approximately $1.3 billion at December 31, 2016. Our Partnership Credit Agreement contains provisions for an applicable margin rate and an annual facility fee, both of which adjust with changes in our credit rating. Under the terms of the Partnership Credit Agreement, based on our current credit ratings, borrowings, if any, will accrue interest at LIBOR plus 117.5 basis points, and the annual facility fee is 20 basis points. Our Partnership Credit Agreement is guaranteed fully and unconditionally by the Intermediate Partnership. Borrowings under our Partnership Credit Agreement are nonrecourse to ONEOK. Following the completion of the Merger Transaction described in Note B, we and ONEOK expect to enter into a cross guarantee agreement whereby each party to the agreement unconditionally guarantees and becomes liable for the indebtedness of each other party to the agreement. Our Partnership Credit Agreement contains certain financial, operational and legal covenants. Among other things, these covenants include maintaining a ratio of indebtedness to adjusted EBITDA (EBITDA, as defined in our Partnership Credit Agreement, adjusted for all noncash charges and increased for projected EBITDA from certain lender-approved capital expansion projects) of no more than 5.0 to 1. If we consummate one or more acquisitions in which the aggregate purchase price is $25 million or more, the allowable ratio of indebtedness to adjusted EBITDA will increase to 5.5 to 1 for the quarter in which the acquisition was completed and the two following quarters. If we were to breach certain covenants in our Partnership Credit Agreement, amounts outstanding under our Partnership Credit Agreement, if any, may become due and payable immediately. At December 31, 2016, our ratio of indebtedness to adjusted EBITDA was 4.1 to 1, and we were in compliance with all covenants under our Partnership Credit Agreement. Senior Unsecured Obligations - All notes are senior unsecured obligations, ranking equally in right of payment with all of our existing and future unsecured senior indebtedness, and are structurally subordinate to any of the existing and future debt and other liabilities of any nonguarantor subsidiaries. Issuances and maturities - In January 2016, we entered into the $1.0 billion senior unsecured Term Loan Agreement with a syndicate of banks. The Term Loan Agreement matures in January 2019 and bears interest at LIBOR plus 130 basis points based on our current credit ratings. At December 31, 2016, the interest rate was 2.04 percent. The Term Loan Agreement contains an option, which may be exercised up to two times, to extend the term of the loan, in each case, for an additional one-year term, subject to approval of the banks. The Term Loan Agreement allows prepayment of all or any portion outstanding without penalty or premium. During the first quarter 2016, we drew the full $1.0 billion available under the agreement and used the proceeds to repay $650 million of senior notes at maturity, to repay amounts outstanding under our commercial paper program and for general partnership purposes. We repaid our $450 million, 6.15 percent senior notes at maturity in October 2016, with a combination of cash on hand and short-term borrowings. In March 2015, we completed an underwritten public offering of $800 million of senior notes, consisting of $300 million, 3.8 percent senior notes due 2020, and $500 million, 4.9 percent senior notes due 2025. The net proceeds, after deducting underwriting discounts, commissions and offering expenses, were approximately $792.3 million. We used the proceeds to repay amounts outstanding under our commercial paper program and for general partnership purposes. The aggregate maturities of long-term debt outstanding as of December 31, 2016, for the years 2017 through 2021 are shown below: Covenants - Our Term Loan Agreement contains substantially the same covenants as our Partnership Credit Agreement. Our senior notes are governed by an indenture, dated as of September 25, 2006, between us and Wells Fargo Bank, N.A., the trustee, as supplemented. The indenture does not limit the aggregate principal amount of debt securities that may be issued and provides that debt securities may be issued from time to time in one or more additional series. The indenture contains covenants including, among other provisions, limitations on our ability to place liens on our property or assets and to sell and lease back our property. The indenture includes an event of default upon acceleration of other indebtedness of $100 million or more. Such events of default would entitle the trustee or the holders of 25 percent in aggregate principal amount of any of our outstanding senior notes to declare those notes immediately due and payable in full. We may redeem our senior notes due 2019, 2036 and 2037, in whole or in part, at any time prior to their maturity at a redemption price equal to the principal amount, plus accrued and unpaid interest and a make-whole premium. The redemption price will never be less than 100 percent of the principal amount of the respective note plus accrued and unpaid interest to the redemption date. We may redeem our senior notes due 2017 and our senior notes due 2022 at par starting one month and three months, respectively, before their maturity dates. We may redeem our senior notes due 2041 at a redemption price equal to the principal amount, plus accrued and unpaid interest, starting six months before its maturity date. Prior to that date, we may redeem these notes, in whole or in part, at a redemption price equal to the principal amount, plus accrued and unpaid interest and a make-whole premium. We may redeem our senior notes due 2018, 2020, 2023, 2025, and 2043 at par, plus accrued and unpaid interest to the redemption date, starting one month, one month, three months, three months, and six months, respectively, before their maturity dates. Prior to these dates, we may redeem these notes, in whole or in part, at a redemption price equal to the principal amount, plus accrued and unpaid interest and a make-whole premium. The redemption price will never be less than 100 percent of the principal amount of the respective note plus accrued and unpaid interest to the redemption date. ONEOK Partners Debt Guarantee - Our senior notes are guaranteed fully and unconditionally on a senior unsecured basis by the Intermediate Partnership. The guarantee ranks equally in right of payment to all of the Intermediate Partnership’s existing and future unsecured senior indebtedness. See Note R for additional information on the guarantee. Our long-term debt is nonrecourse to our general partner. Neither we nor ONEOK guarantees the debt or other similar commitments of unaffiliated parties. ONEOK does not guarantee the debt, commercial paper borrowings under the Partnership Credit Agreement or other similar commitments of ONEOK Partners, and ONEOK Partners does not guarantee the debt or other similar commitments of ONEOK. Following the completion of the Merger Transaction, we and ONEOK expect to enter into a cross guarantee agreement whereby each party to the agreement unconditionally guarantees and becomes liable for the indebtedness of each other party to the agreement. Guardian Pipeline Senior Notes - These senior notes were issued under a master shelf agreement dated November 8, 2001, with certain financial institutions. Principal payments are due quarterly through 2022. Guardian Pipeline’s senior notes contain financial covenants that require the maintenance of certain financial ratios as defined in the master shelf agreement based on Guardian Pipeline’s financial position and results of operations. Upon any breach of these covenants, all amounts outstanding under the master shelf agreement may become due and payable immediately. At December 31, 2016, Guardian Pipeline was in compliance with its financial covenants. Other - We amortize premiums, discounts and expenses incurred in connection with the issuance of long-term debt consistent with the terms of the respective debt instrument. H. EQUITY ONEOK - ONEOK and its affiliates owned all of the Class B units, 41.3 million common units and the entire 2 percent general partner interest in us, which together constituted a 41.2 percent ownership interest in us at December 31, 2016. Equity Issuances - We have an “at-the-market” equity program for the offer and sale from time to time of our common units, up to an aggregate amount of $650 million. The program allows us to offer and sell our common units at prices we deem appropriate through a sales agent. Sales of common units are made by means of ordinary brokers’ transactions on the NYSE, in block transactions or as otherwise agreed to between us and the sales agent. We are under no obligation to offer and sell common units under the program. At December 31, 2016, we had approximately $138 million of registered common units available for issuance through our “at-the-market” equity program. During the year ended December 31, 2016, we sold no common units through our “at-the-market” equity program. In August 2015, we completed a private placement of 21.5 million common units at a price of $30.17 per unit with ONEOK. Additionally, we completed a concurrent sale of approximately 3.3 million common units at a price of $30.17 per unit to funds managed by Kayne Anderson Capital Advisors in a registered direct offering, which were issued through our existing “at-the-market” equity program. The combined offerings generated net cash proceeds of approximately $749 million. In conjunction with these issuances, ONEOK Partners GP contributed approximately $15.3 million in order to maintain its 2 percent general partner interest in us. We used the proceeds for general partnership purposes, including capital expenditures and repayment of commercial paper borrowings. During the year ended December 31, 2015, we sold 10.5 million common units through our “at-the-market” equity program, including the units sold to funds managed by Kayne Anderson Capital Advisors in the offering discussed above. The net proceeds, including ONEOK Partners GP’s contribution to maintain its 2 percent general partner interest in us, were approximately $381.6 million, which were used for general partnership purposes, including repayment of commercial paper borrowings. In May 2014, we completed an underwritten public offering of 13.9 million common units at a public offering price of $52.94 per common unit, generating net proceeds of approximately $714.5 million. In conjunction with this issuance, ONEOK Partners GP contributed approximately $15.0 million in order to maintain its 2 percent general partner interest in us. We used the proceeds for general partnership purposes, including capital expenditures and repayment of commercial paper borrowings. During the year ended December 31, 2014, we sold 7.9 million common units through our “at-the-market” equity program. The net proceeds, including ONEOK Partners GP’s contribution to maintain its 2 percent general partner interest in us, were approximately $402.1 million, which were used for general partnership purposes. Partnership Agreement - Available cash, as defined in our Partnership Agreement generally will be distributed to our general partner and limited partners according to their partnership percentages of 2 percent and 98 percent, respectively. Our general partner’s percentage interest in quarterly distributions is increased after certain specified target levels are met during the quarter. Under the incentive distribution provisions, as set forth in our Partnership Agreement, our general partner receives: • 15 percent of amounts distributed in excess of $0.3025 per unit; • 25 percent of amounts distributed in excess of $0.3575 per unit; and • 50 percent of amounts distributed in excess of $0.4675 per unit. Cash Distributions - The following table sets forth the quarterly cash distribution declared and paid on each of our common and Class B units during the periods indicated: The following table shows our distributions paid during the periods indicated: Distributions are declared and paid within 45 days of the completion of each quarter. The following table shows our distributions declared for the periods indicated: Our Class B limited partner units are entitled to receive increased quarterly distributions equal to 110 percent of the distributions paid with respect to our common units. ONEOK, as the sole holder of our Class B limited partner units, has waived its right to receive the increased quarterly distributions on the Class B units. ONEOK retains the option to withdraw its waiver of increased distributions on Class B units at any time by giving us no less than 90 days advance notice. Any such withdrawal of the waiver will be effective with respect to any distribution on the Class B units declared or paid on or after the 90 days following delivery of the notice. The Class B units are eligible to convert into common units on a one-for-one basis at ONEOK’s option. If our common unitholders vote at any time to remove ONEOK or its affiliates as our general partner, quarterly distributions payable on the Class B limited partner units would increase to 123.5 percent of the distributions payable with respect to the common units, and distributions payable upon liquidation of the Class B limited partner units would increase to 123.5 percent of the distributions payable with respect to the common units. Our income is allocated to the general partner and the limited partners in accordance with their respective partnership percentages, after giving effect to any priority income allocations for incentive distributions that are allocated to the general partner. Noncontrolling Interest - In November 2014, we completed the acquisition of an 80 percent interest in the WTLPG. We consolidate WTLPG and record noncontrolling interests in consolidated subsidiaries in our consolidated financial statements to recognize the portion of WTLPG that we do not own. I. ACCUMULATED OTHER COMPREHENSIVE LOSS The following table sets forth the balance in accumulated other comprehensive loss for the periods indicated: The following table sets forth the effect of reclassifications from accumulated other comprehensive loss in our Consolidated Statements of Income for the periods indicated: J. LIMITED PARTNERS’ NET INCOME PER UNIT Limited partners’ net income per unit is computed by dividing net income attributable to ONEOK Partners, L.P., after deducting the general partner’s allocation as discussed below, by the weighted-average number of outstanding limited partner units, which includes our common and Class B limited partner units. Because ONEOK has conditionally waived its right to increased quarterly distributions, until it gives 90 days notice of the withdrawal of the waiver, currently each Class B and common unit share equally in the earnings of the Partnership, and neither has any liquidation or other preferences. ONEOK Partners GP owns the entire 2 percent general partnership interest in us, which entitles it to incentive distribution rights that provide for an increasing proportion of cash distributions from the Partnership as the distributions made to limited partners increase above specified levels. For purposes of our calculation of limited partners’ net income per unit, net income attributable to ONEOK Partners, L.P. is allocated to the general partner as follows: (i) an amount based upon the 2 percent general partner interest in net income attributable to ONEOK Partners, L.P.; and (ii) the amount of the general partner’s incentive distribution rights based on the total cash distributions declared for the period. The amount of incentive distributions allocated to our general partner totaled $402.2 million, $382.8 million and $326.0 million for 2016, 2015 and 2014, respectively. The terms of our Partnership Agreement limit the general partner’s incentive distribution to the amount of available cash calculated for the period. As such, incentive distribution rights are not allocated on undistributed earnings. For additional information regarding our general partner’s incentive distribution rights, see “Partnership Agreement” in Note H. K. INCOME TAXES The following table sets forth our provision for income taxes for the periods indicated: The following table is a reconciliation of our income tax provision for the periods indicated: The following table sets forth the tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and liabilities for the periods indicated: L. UNCONSOLIDATED AFFILIATES Investments in Unconsolidated Affiliates - The following table sets forth our investments in unconsolidated affiliates for the periods indicated: (a) - Equity-method goodwill (Note A) was $40.1 million at December 31, 2016 and 2015, respectively. Equity in Net Earnings from Investments and Impairments - The following table sets forth our equity in net earnings from investments for the periods indicated: Unconsolidated Affiliates Financial Information - The following tables set forth summarized combined financial information of our unconsolidated affiliates for the periods indicated: (a) Includes long-lived asset impairment charges in 2015 and 2014. We incurred expenses in transactions with unconsolidated affiliates of $140.3 million, $104.7 million and $62.0 million for 2016, 2015 and 2014, respectively, primarily related to Overland Pass Pipeline Company and Northern Border Pipeline. Accounts payable to our equity-method investees at December 31, 2016 and 2015, was $11.1 million and $8.0 million, respectively. Northern Border Pipeline - The Northern Border Pipeline partnership agreement provides that distributions to Northern Border Pipeline’s partners are to be made on a pro rata basis according to each partner’s percentage interest. The Northern Border Pipeline Management Committee determines the amount and timing of such distributions. Any changes to, or suspension of, the cash distribution policy of Northern Border Pipeline requires the unanimous approval of the Northern Border Pipeline Management Committee. Cash distributions are equal to 100 percent of distributable cash flow as determined from Northern Border Pipeline’s financial statements based upon EBITDA less interest expense and maintenance capital expenditures. Loans or other advances from Northern Border Pipeline to its partners or affiliates are prohibited under its credit agreement. Overland Pass Pipeline Company - The Overland Pass Pipeline Company limited liability company agreement provides that distributions to Overland Pass Pipeline Company’s members are to be made on a pro rata basis according to each member’s percentage interest. The Overland Pass Pipeline Company Management Committee determines the amount and timing of such distributions. Any changes to, or suspension of, the cash distributions from Overland Pass Pipeline Company requires the unanimous approval of the Overland Pass Pipeline Management Committee. Cash distributions are equal to 100 percent of available cash as defined in the limited liability company agreement. Roadrunner Gas Transmission - In March 2015, we entered into a 50-50 joint venture with a subsidiary of Fermaca, a Mexico City-based natural gas infrastructure company, to construct the Roadrunner pipeline to transport natural gas from the Permian Basin in West Texas to the Mexican border near El Paso, Texas. We contributed approximately $65 million and $30 million to Roadrunner in 2016 and 2015, respectively. The Roadrunner limited liability agreement provides that distributions to members are made on a pro rata basis according to each member’s ownership interest. The Roadrunner Management Committee determines the amount and timing of such distributions. Cash distributions are equal to 100 percent of available cash, as defined in the limited liability company agreement. Impairment Charges - Due to the continued and greater than expected decline in volumes gathered in the dry natural gas area of the Powder River Basin, we evaluated our long-lived assets and equity investments in this area in 2015 and made the decision to cease operations of our wholly owned coal-bed methane natural gas gathering system in 2016. Bighorn Gas Gathering, in which we own a 49 percent equity interest, and Fort Union Gas Gathering, in which we own a 37 percent equity interest, are both partially supplied with volumes from our wholly owned coal-bed methane natural gas gathering system. We own a 35 percent equity interest in Lost Creek Gathering Company, which also is located in a dry natural gas area. We reviewed our Bighorn Gas Gathering, Fort Union Gas Gathering and Lost Creek Gathering Company equity investments and recorded noncash impairment charges of $180.6 million in 2015. The remaining net book value of our equity investments in this dry natural gas area is $31.1 million as of December 31, 2016. In 2014, Bighorn Gas Gathering recorded an impairment of its underlying assets when the operator determined that the volume decline would be sustained for the foreseeable future. As a result, we reviewed our equity investment in Bighorn Gas Gathering for impairment and recorded noncash impairment charges of $76.4 million in 2014. M. RELATED-PARTY TRANSACTIONS On January 31, 2017, we and ONEOK entered into the Merger Agreement in which ONEOK will acquire all of our outstanding common units representing limited partner interests in us not already directly or indirectly owned by ONEOK. For additional information on this transaction, see Note B. Under the Services Agreement with ONEOK and ONEOK Partners GP (the Services Agreement), our operations and the operations of ONEOK and its affiliates can combine or share certain common services in order to operate more efficiently and cost effectively. Under the Services Agreement, ONEOK provides to us similar services that it provides to its affiliates, including those services required to be provided pursuant to our Partnership Agreement. ONEOK Partners GP may purchase services from ONEOK and its affiliates pursuant to the terms of the Services Agreement. ONEOK Partners GP has no employees and utilizes the services of ONEOK to fulfill its operating obligations. ONEOK and its affiliates provide a variety of services to us under the Services Agreement, including cash management and financial services, employee benefits provided through ONEOK’s benefit plans, legal and administrative services, insurance and office space leased in ONEOK’s headquarters building and other field locations. Where costs are incurred specifically on behalf of one of our affiliates, the costs are billed directly to us by ONEOK. In other situations, the costs may be allocated to us through a variety of methods, depending upon the nature of the expense and activities. Beginning in the second quarter 2014, ONEOK allocates substantially all of its general overhead costs to us as a result of ONEOK’s separation of its natural gas distribution business and the wind down of its energy services business in the first quarter 2014. For the first quarter 2014, it is not practicable to determine what these general overhead costs would have been on a stand-alone basis. All costs directly charged or allocated to us are included in our Consolidated Statements of Income. Commodity sales and services revenues for transactions with ONE Gas prior to its separation from ONEOK on January 31, 2014, are reflected as affiliate transactions. Transactions with ONE Gas that occurred after the separation are reflected as unaffiliated, third-party transactions. On March 31, 2014, ONEOK completed the wind down of ONEOK Energy Services Company, a subsidiary of ONEOK. For the first quarter 2014, we had transactions with ONEOK Energy Services Company, which are reflected as affiliate transactions. The following table sets forth the transactions with related parties for the periods indicated: ONEOK Partners GP made additional general partner contributions to us of approximately $21.0 million and $23.2 million in 2015 and 2014, respectively, to maintain its 2 percent general partner interest in connection with the issuances of common units. See Note H for additional information about cash distributions paid to ONEOK for its general partner and limited partner interests. We have an operating agreement with Roadrunner that provides for reimbursement or payment to us for management services and certain operating costs. Charges to Roadrunner included in operating income in our Consolidated Statements of Income for 2016 and 2015 were $7.7 million and $5.4 million, respectively. N. COMMITMENTS AND CONTINGENCIES Commitments - Operating leases represent future minimum lease payments under noncancelable leases covering office space and pipeline equipment. Rental expense in 2016, 2015 and 2014 was not material. We have no material operating leases. Firm transportation and storage contracts are fixed-price contracts that provide us with firm transportation and storage capacity. The following table sets forth our firm transportation and storage contract payments for our continuing operations for the periods indicated: Environmental Matters and Pipeline Safety - The operation of pipelines, plants and other facilities for the gathering, processing, transportation and storage of natural gas, NGLs, condensate, and other products is subject to numerous and complex laws and regulations pertaining to health, safety and the environment. As an owner and/or operator of these facilities we must comply with United States laws and regulations at the federal, state and local levels that relate to air and water quality, hazardous and solid waste management and disposal, and other environmental matters. The cost of planning, designing, constructing and operating pipelines, plants and other facilities must incorporate compliance with environmental laws and regulations and safety standards. Failure to comply with these laws and regulations may trigger a variety of administrative, civil and potentially criminal enforcement measures, including citizen suits, which can include the assessment of monetary penalties, the imposition of remedial requirements and the issuance of injunctions or restrictions on operation. Management believes that, based on currently known information, compliance with these laws and regulations will not have a material adverse effect on our results of operations, financial condition or cash flows. Legal Proceedings - We are a party to various litigation matters and claims that have arisen in the normal course of our operations. While the results of these litigation matters and claims cannot be predicted with certainty, we believe the reasonably possible losses from such matters, individually and in the aggregate, are not material. Additionally, we believe the probable final outcome of such matters will not have a material adverse effect on our consolidated results of operations, financial position or cash flows. O. ACQUISITIONS In November 2014, we completed the acquisition of an 80 percent interest in WTLPG and a 100 percent interest in the Mesquite Pipeline for approximately $800 million from affiliates of Chevron Corporation, and we became the operator of both pipelines. Financing to close this transaction came from available cash on hand and borrowings under our existing commercial paper program. We accounted for the West Texas LPG acquisition as a business combination which, among other things, requires assets acquired and liabilities assumed to be measured at their acquisition-date fair values. The final purchase price allocation and assessment of the fair value of the assets acquired as of the acquisition date were as follows: Beginning November 29, 2014, the results of operations for West Texas LPG are included in our Natural Gas Liquids segment. We consolidate WTLPG and have recorded noncontrolling interests in consolidated subsidiaries on our Consolidated Statements of Income and Consolidated Balance Sheets to recognize the portion of WTLPG that we do not own. The portion of the assets and liabilities of WTLPG acquired attributable to noncontrolling interests was accounted for as noncash activity. The fair value of the noncontrolling interest of WTLPG was estimated by applying a market approach. Revenues and earnings related to West Texas LPG have been included within the Consolidated Statements of Income since the acquisition date. Supplemental pro forma revenue and earnings reflecting this acquisition as if it had occurred as of January 1, 2014, are not materially different from the information presented in the accompanying Consolidated Statements of Income and are, therefore, not presented. The limited partnership agreement of WTLPG provides that cash distributions to the partners are to be made on a pro rata basis according to each partner’s ownership interest. Cash distributions are equal to 100 percent of distributable cash as defined in the limited partnership agreement of WTLPG. Any changes to, or suspension of, the cash distributions from WTLPG requires the approval of a minimum of 90 percent of the ownership interest and a minimum of two general partners of WTLPG. P. SEGMENTS Segment Descriptions - Our operations are divided into three reportable business segments, as follows: • our Natural Gas Gathering and Processing segment gathers, treats and processes natural gas; • our Natural Gas Liquids segment gathers, treats, fractionates and transports NGLs and stores, markets and distributes NGL products; and • our Natural Gas Pipelines segment operates regulated interstate and intrastate natural gas transmission pipelines and natural gas storage facilities. Accounting Policies - The accounting policies of the segments are described in Note A. Our chief operating decision-maker reviews the financial performance of each of our three segments, as well as the financial performance of the Partnership as a whole, on a regular basis. Beginning in 2016, adjusted EBITDA by segment is utilized in this evaluation. We believe this financial measure is useful to investors because it and similar measures are used by many companies in our industry as a measurement of financial performance and are commonly employed by financial analysts and others to evaluate our financial performance and to compare financial performance among companies in our industry. Adjusted EBITDA for each segment is defined as net income adjusted for interest expense, depreciation and amortization, noncash impairment charges, income taxes, allowance for equity funds used during construction and other noncash items. This calculation may not be comparable with similarly titled measures of other companies. Prior period segment disclosures have been recast to reflect this change. As a result of ONEOK’s separation of its natural gas distribution business into a stand-alone publicly traded company called ONE Gas on January 31, 2014, transactions with ONE Gas subsequent to the separation are reflected as sales to unaffiliated customers. Customers - The primary customers of our Natural Gas Gathering and Processing segment are crude oil and natural gas producers, which include both large integrated and independent exploration and production companies. Our Natural Gas Liquids segment’s customers are primarily NGL and natural gas gathering and processing companies; large integrated and independent crude oil and natural gas production companies; propane distributors; ethanol producers; and petrochemical, refining and NGL marketing companies. Our Natural Gas Pipelines segment’s customers are primarily local natural gas distribution companies, electric-generation companies, large industrial companies, municipalities, irrigation customers and marketing companies. For each of the years ended December 31, 2016, 2015 and 2014, we had no single customer from which we received 10 percent or more of our consolidated revenues. See Note M for additional information about our sales to affiliated customers. Operating Segment Information - The following tables set forth certain selected financial information for our operating segments for the periods indicated: (a) - Our Natural Gas Liquids segment has regulated and nonregulated operations. Our Natural Gas Liquids segment’s regulated operations had revenues of $1.2 billion, of which $992.8 million related to sales within the segment, cost of sales and fuel of $458.7 million and operating income of $467.9 million. (b) - Our Natural Gas Pipelines segment has regulated and nonregulated operations. Our Natural Gas Pipelines segment’s regulated operations had revenues of $238.7 million, cost of sales and fuel of $30.0 million and operating income of $100.8 million. (a) - Our Natural Gas Liquids segment has regulated and nonregulated operations. Our Natural Gas Liquids segment’s regulated operations had revenues of $954.8 million, of which $770.1 million related to sales within the segment, cost of sales and fuel of $412.6 million and operating income of $306.9 million. (b) - Our Natural Gas Pipelines segment has regulated and nonregulated operations. Our Natural Gas Pipelines segment’s regulated operations had revenues of $266.9 million, cost of sales and fuel of $31.1 million and operating income of $103.7 million. (a) - Our Natural Gas Liquids segment has regulated and nonregulated operations. Our Natural Gas Liquids segment’s regulated operations had revenues of $695.9 million, of which $598.1 million related to sales within the segment, cost of sales and fuel of $309.4 million and operating income of $196.1 million. (b) - Our Natural Gas Pipelines segment has regulated and nonregulated operations. Our Natural Gas Pipelines segment’s regulated operations had revenues of $290.0 million, cost of sales and fuel of $47.7 million and operating income of $106.5 million. Q. QUARTERLY FINANCIAL DATA (UNAUDITED) The fourth quarter 2015 includes noncash impairment charges of $264.3 million related to long-lived assets and equity investments. R. SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIAL INFORMATION We have no significant assets or operations other than our investment in our wholly owned subsidiary, the Intermediate Partnership. The Intermediate Partnership holds all our partnership interests and equity in our subsidiaries, as well as a 50 percent interest in Northern Border Pipeline. Our Intermediate Partnership guarantees our senior notes and borrowings, if any, under the Partnership Credit Agreement. The Intermediate Partnership’s guarantee of our senior notes and of any borrowings under the Partnership Credit Agreement are full and unconditional, subject to certain customary automatic release provisions. For purposes of the following footnote: • we are referred to as “Parent”; • the Intermediate Partnership is referred to as “Guarantor Subsidiary”; and • the “Non-Guarantor Subsidiaries” are all subsidiaries other than the Guarantor Subsidiary. The following supplemental condensed consolidating financial information is presented on an equity-method basis reflecting the Parent’s separate accounts, the Guarantor Subsidiary’s separate accounts, the combined accounts of the Non-Guarantor Subsidiaries, the combined consolidating adjustments and eliminations and the Parent’s consolidated amounts for the periods indicated. Condensed Consolidating Statements of Income Condensed Consolidating Statements of Comprehensive Income Condensed Consolidating Balance Sheets Condensed Consolidating Statements of Cash Flows
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Based on the provided financial statement excerpt, here's a summary of the key financial points:
1. Business Operations:
- The company deals with NGL (Natural Gas Liquids) products
- They provide gathering, fractionation, and transportation services
- They use derivative instruments to manage market risks
2. Key Financial Practices:
- Uses derivative instruments for hedging against commodity price and interest-rate fluctuations
- Records derivative instruments at fair value
- Uses straight-line depreciation method for properties
- Conducts regular depreciation studies
- Performs annual goodwill impairment assessment (July 1)
3. Risk Management:
- Employs futures, forward purchases/sales, options, and swap transactions
- Uses interest-rate swaps to manage interest rate risk
- Maintains formal documentation of hedging relationships
- Performs quarterly effectiveness analyses of hedging relationships
4. Valuation Methods:
- Uses market and income approaches for fair value determination
- Validates valuations with third-party information
- Employs a fair value hierarchy for financial statements
- Considers market data in evaluating counterparty risks
5. Notable Event:
- Mentions a pending Merger Transaction expected to close in second quarter 2017
- Includes a cross guarantee agreement between the company and ONEOK
The statement appears to be focused more on explaining accounting methodologies and risk management practices rather than providing specific financial figures.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ACCOUNTING FIRM To the Board of Directors and Stockholders of Algae Dynamics Corp. We have audited the accompanying balance sheets of Algae Dynamics Corp. as of March 31, 2016 and 2015, and the related statements of operations, stockholders’ (deficiency), and cash flows for each of the years in the two year period ended March 31, 2016. Algae Dynamics Corp.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Algae Dynamics Corp. as of March 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the two year period ended March 31, 2016, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that Algae Dynamics Corp. will continue as a going concern. As discussed in Note 1 to the financial statements, Algae Dynamics Corp.’s operating losses, and negative working capital and an accumulated deficit as at March 31, 2016 raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Toronto, Canada June 29, 2016 ALGAE DYNAMICS CORP. Balance Sheets (Stated in Canadian Dollars) Going Concern (Note 1) Commitments and Contingencies (Note 11) These financial statements are approved by the Directors: The accompanying notes are an integral part of these financial statements ALGAE DYNAMICS CORP. Statements of Operations (Stated in Canadian Dollars) The accompanying notes are an integral part of these financial statements ALGAE DYNAMICS CORP. Statements of Stockholders' (Deficiency) (Stated in Canadian Dollars) The accompanying notes are an integral part of these financial statements ALGAE DYNAMICS CORP. Statements of Cash Flows (Stated in Canadian Dollars) The accompanying notes are an integral part of these financial statements Algae Dynamics Corp. (Formerly Converted Carbon Technologies Corp.) Notes to Financial Statements (Stated in Canadian Dollars) March 31, 2016 and 2015 1.) Nature of the Business and Going Concern Algae Dynamics Corp. (the “Company”) was incorporated under the Canada Business Corporations Act on October 7, 2008 as Converted Carbon of Canada Corp. On November 19, 2010, the Company amended its Articles of Incorporation to change its name to Converted Carbon Technologies Corp. and a further amendment was approved by the shareholders on August 28, 2014 to change the name to Algae Dynamics Corp. The Company is a nutrient ingredient company and has developed a scalable Pure-BioSilo™ for sanitary cultivation of microalgae targeted to the functional food and beverage additives and supplement markets. The Company’s planned principal operations are the design, engineering and manufacturing of a proprietary algae cultivation system for the high volume production of pure contaminant-free algae biomass. The Company is currently conducting research and development activities to operationalize certain technology currently in the allowed patent application stage, so it can produce pure contaminate-free algae biomass. During the year ended March 31, 2014, the Company secured a research facility in Mississauga, Ontario, which houses all of its employees and research and development activities. The Company is also in the process of raising additional equity capital to support the completion of its development activities to begin production of pure contaminate-free algae biomass as soon as possible. The Company filed a Form S-1 registration Statement with the U.S Securities and Exchange Commission (SEC) as an initial registration of common shares. The registration was declared effective by the SEC on November 21, 2014. The Company’s stock began trading on September 17, 2015. The Company’s activities are subject to significant risks and uncertainties, including failing to obtain patents and failing to secure additional funding to operationalize the Company’s current technology before another company develops similar technology. These financial statements have been prepared on the basis of a going concern, which contemplates the realization of assets and the settlement of liabilities in the normal course of business. The Company is in the development stage and has not yet realized profitable operations and has relied on non-operational sources to fund operations. The Company has suffered recurring losses and additional future losses are anticipated as the Company has not yet been able to generate revenue. In addition, as of March 31, 2016, the Company has a working capital deficiency of $765,356 (2015 - $845,406) and an accumulated deficit of $3,723,368 (2015 - $1,809,373). The Company’s ability to continue as a going concern is dependent on successfully executing its business plan, which includes the raising of additional funds. The Company will continue to seek additional forms of debt or equity financing, but it cannot provide assurances that it will be successful in doing so. These circumstances raise substantial doubt as to the ability of the Company to meet its obligations as they come due and accordingly, the appropriateness of the use of accounting principles applicable to a going concern. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. Such adjustments could be material. 2.) Presentation of Financial Statements Basis of Presentation The financial statements have been prepared in accordance with U.S Generally Accepted Accounting Principles (“US GAAP”). All adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows as of March 31, 2016 have been included. The Company’s financial statements are prepared using the accrual basis of accounting in accordance with US GAAP and the Company’s functional and reporting currency is the Canadian dollar. In June 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2014-10 “ASU 2014-10” to eliminate certain financial reporting requirements for development stage entities. The amendments in ASU 2014-10 remove the incremental financial reporting requirements from US GAAP for development stage entities, including the presentation of inception-to-date information in the statements of income, cash flows and shareholder equity, and disclosure of the financial statements as those of a development stage entity. The Company has chosen to early adopt these amendments effective for its fiscal year ended March 31, 2013 and onwards. Use of Estimates and Assumptions The preparation of the financial statements in accordance with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual amounts could materially differ from these estimates. The significant areas requiring the use of management estimates are related to provision for doubtful accounts, accrued liabilities, contingencies, the valuation of deferred taxes, stock based compensation, warrants, convertible debt and intangible assets. Although these estimates are based on management’s knowledge of current events and actions management may undertake in the future, actual results may ultimately differ materially from those estimates. 3.) Summary of Significant Accounting Policies Cash and Cash Equivalents Cash and cash equivalents include cash on hand, and all highly liquid debt instruments purchased with an original maturity of three months or less. As at March 31, 2016 and 2015 there were no cash equivalents. Prepaid Expenses Prepaid expenses consist of services paid, for which the Company has not yet received the benefit. 3.) Summary of Significant Accounting Policies (continued) Equipment and Leasehold Improvements Equipment and leasehold improvements are stated at cost less accumulated amortization and accumulated impairment losses. Cost includes expenditures that are directly attributable to the acquisition of the asset. Subsequent costs are included in the asset’s carrying amount or recognized as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Company and the cost can be measured reliably. The carrying amount of an asset is derecognized when replaced. Repairs and maintenance costs are charged to the statements of operations, during the year in which they are incurred. Amortization is provided for over the estimated useful life of the asset as follows: Computer equipment 30% on a declining balance Production equipment 20% on a declining balance Leasehold improvements are amortized over the term of the lease or useful life of the improvements, whichever is shorter, which is currently 5 years. Useful lives and residual values are reviewed and adjusted, if appropriate, at the end of each reporting period. An asset’s carrying amount is written down immediately to its recoverable amount if the asset’s carrying amount is greater than its estimated recoverable amount. The cost and accumulated amortization of assets retired or sold are removed from the respective accounts and any gain or loss is recognized in operations. Intangible Assets Intangible assets are comprised of patents. Patents represent capitalized legal costs incurred in connection with applications for patents which have a probable future economic benefit. In-process patents are not amortized. All patents subject to amortization are amortized on a straight line basis over an estimated useful life. The Company regularly evaluates patents and patent applications for impairment or abandonment, at which point the Company charges the remaining net book value to expenses. Impairment of Long-Lived Assets The Company reviews its long-lived assets for impairment whenever events and circumstances indicate that the carrying value of an asset might not be recoverable. An impairment loss, measured as the amount by which the carrying amount exceeds the fair value, is recognized if the carrying amount exceeds estimated undiscounted future cash flows. 3.) Summary of Significant Accounting Policies (continued) Research and Development Research and development costs include costs directly attributable to the conduct of research and development programs, including the cost of consulting fees, materials, supplies, and the maintenance of research equipment. All costs associated with research and development are expensed as incurred. The approved refundable portion of tax credits are netted against the related expenses. Non-refundable investment tax credits are recorded in the period when reasonable assurance exists that the Company has complied with the terms and conditions required for approval of the tax credit and it is more likely than not that the Company will realize the benefits of these tax credits against the deferred taxes. Refundable investment tax credits are recorded in the period when reasonable assurance exists that the Company has complied with the terms and conditions required for approval of the tax credit and it is more likely than not that the Company will collect it. Stock-based Compensation The Company uses the fair value based method of accounting for all its stock-based compensation in accordance with FASB Accounting Standards Codification ("ASC") ASC 718 “Compensation - Stock Compensation”. The estimated fair value of the options and warrants that are ultimately expected to vest based on performance related conditions, as well as the options and warrants that are expected to vest based on future service, is recorded over the instrument’s requisite service period and charged to stock-based compensation. In determining the amount of options and warrants that are expected to vest, the Company takes into account, voluntary termination behavior as well as trends of actual option and warrant forfeitures. Stock options and warrants which are indexed to a factor which is not a market, performance or service condition, in addition to the Company’s share price, are classified as liabilities and re-measured at each reporting date based on the Black-Scholes option pricing model with a charge to operations, until the date of settlement. Income Taxes Income taxes are accounted for under the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax liabilities and assets are recognized for the estimated future tax consequences attributable to differences between the amounts reported in the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply when the asset is realized or the liability is settled. The effect of a change in income tax rates on deferred tax liabilities and assets is recognized in income in the period in which the change occurs. Deferred tax assets are recognized to the extent that they are considered more likely than not to be realized. FASB issued ASC 740-10 “Accounting for Uncertainty in Income Taxes”. ASC 740-10 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. This standard requires a company to determine whether it is more likely than not that a tax position will be sustained upon examination based upon the technical merits of the position. If the more-likely-than-not threshold is met, a company must measure the tax position to determine the amount to recognize in the financial statements. 3.) Summary of Significant Accounting Policies (continued) Fair Value of Financial Instruments ASC 820 “Fair Value Measurement” defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value as follows: Level 1 - unadjusted quoted prices in active markets for identical assets or liabilities; Level 2 - inputs other than quoted prices that are observable for the asset or liability or indirectly; and Level 3 - inputs that are not based on observable market data. The carrying amounts of the Company’s financial instruments including cash, amounts receivable, accounts payable and accrued liabilities and advances from shareholders approximate their fair values due to their short-term nature. Management is of the opinion that the Company is not exposed to significant interest, credit or currency risks from these financial instruments. The Company’s equity-linked financial instruments reflected as warrant liability on the balance sheet represent financial liabilities classified as Level 3 as per ASU 2009-05. As required by the guidance, assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The fair value of the warrant liability which is not traded in an active market has been determined using the Black-Scholes option pricing model based on assumptions that are not supported by observable market conditions. Foreign Currency Transactions and Translation Monetary assets and liabilities are translated into Canadian dollars, which is the functional currency of the Company, at the year-end exchange rate, while foreign currency expenses are translated at the exchange rate in effect on the date of the transaction. The resultant gains or losses are included in the statement of operations. Non-monetary items are translated at historical rates. Loss per Share Basic loss per share is calculated by dividing the net loss available to common shareholders by the weighted average number of common shares outstanding during the year. Diluted loss per share is calculated using the treasury stock method and reflects the potential dilution of securities by including warrants and contingently issuable shares, if any, in the weighted average number of common shares outstanding for a year, if dilutive. In a loss year, dilutive common shares are excluded from the loss per share calculation as the effect would be anti-dilutive. Accordingly, for the years ended March 31, 2016 and 2015, the basic loss per share was equal to diluted loss per share as there were no dilutive securities. Comprehensive Income (Loss) ASC 220 “Comprehensive Income” establishes standards for reporting and display of comprehensive income, its components and accumulated balances. The net loss is equivalent to the comprehensive loss for the periods presented. 3.) Summary of Significant Accounting Policies (continued) New Accounting Pronouncements In June 2014, FASB issued Accounting Standards Update (“ASU”) ASU No. 2014-12, “Compensation - Stock Compensation (Topic 718); Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period”. The amendments in this ASU apply to all reporting entities that grant their employees share-based payments in which the terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period. The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718 as it relates to awards with performance conditions that affect vesting to account for such awards. For all entities, the amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. The Company is currently evaluating the impact this guidance will have on its financial statements. In April 2015, the FASB issued ASU 2015-03, Interest - Imputation of Interest (Subtopic 835-30). This guidance is to simplify the presentation of debt issuance costs by recognizing debt issuance costs related to a debt liability in the balance sheet as a direct deduction from that debt liability consistent with the presentation of a debt discount. The amendments in this update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. The Company is currently evaluating the impact of the new requirements on its financial statements. In February 2016, the FASB issued ASU 2016-02 Leases (ASC 842), which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract (i.e. lessees and lessors). The new standard requires lessors to account for leases using an approach that is substantially equivalent to existing guidance for sales-type leases, direct financing leases and operating leases. The new standard requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. ASC 842 supersedes the previous leases standard, ASC 840 Leases. The amendments in this update are effective for fiscal years beginning after December 15, 2018, which is our fiscal 2020, beginning on April 1, 2019. The Company is currently evaluating the impact this guidance will have on its financial statements. In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The ASU includes multiple provisions intended to simplify various aspects of the accounting for share-based payments. The amendments in this update are effective for annual periods beginning after December 15, 2016, which is the Company’s fiscal 2018, which will begin on April 1, 2017. The Company is currently evaluating the impact of the new requirements on its financial statements. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s financial statements upon adoption. 4.) Equipment and Leasehold Improvements During the year ended March 31, 2016, the Company recorded total amortization of $20,198 (2015 - $20,338) which was recorded to amortization expense on the statements of operations. 5.) Intangible Assets The Company has patents and patents pending with a cost of $Nil as at March 31, 2016 (2015 - $15,970) that are not currently being amortized and accordingly, the Company did not record amortization expense relating to its intangible assets for the years ended March 31, 2016 and 2015. During the year ended March 31, 2016, the Company reported an impairment of $15,970 with respect to its intangible assets. 6.) Advances from Shareholders and Related Parties As at March 31, 2016, the Company had received cumulative working capital advances in the amount of $383,990 (2015 - $367,267) from two shareholders who are also officers and directors of the Company and a related party who is a family member of one of the officers. The advances from shareholders are unsecured, non-interest bearing and payable upon demand. During the year ended March 31, 2016, advances of $75,846 (including interest of $8,721) were settled with 49,371 shares to be issued valued at (USD$1.72) $2.38 per share based on the quoted market value. The total value of consideration provided in exchange for the extinguishment of debt was $117,527, which resulted in a loss on extinguishment of debt of $41,681, which was recorded on the statement of operations. The advances from the related party are unsecured, payable upon demand and bear interest at 20% per annum. 7.) Term Loan On May 6, 2015, the Company agreed to a one year term loan (maturing May 5, 2016) with a family member of an officer. The loan bore interest at 12% per annum paid quarterly. The face value of the loan was $33,000. The carrying value of the loan was recorded net of $3,000 of transaction costs. The term loan plus the accrued interest of $2,604 was settled on December 31, 2015 with 23,094 shares to be issued valued at (USD$1.72) $2.38 per share based on the quoted market value. The total value of consideration provided in exchange for the extinguishment of debt was $54,975, which resulted in a loss on extinguishment of debt of $19,371, which was recorded on the statement of operations. 8.) Convertible Note On September 2, 2015, the Company entered into a convertible note with an arm’s length third party with a principal amount of USD$25,000 ($32,400). The convertible note matures on September 1, 2016 and accrues interest at the rate of 12% per annum. The convertible note is convertible at any time after six months, in whole or in part, at the holder’s option into common shares of the Company’s capital stock at a variable conversion price equal to a 45% discount from the lowest trading price in the twenty (20) trading days prior to the day that the holder requests conversion. The beneficial conversion feature was recognized separately at issuance by allocating a portion of the proceeds equal to the intrinsic value of that feature to additional paid-in capital in accordance with ASC 470-20. The intrinsic value at issuance was $27,227. The issuance of convertible debt with a beneficial conversion feature results in a tax basis difference. The recognition of deferred taxes for the temporary difference of the convertible debt with a beneficial conversion feature is recorded as an adjustment to additional paid-in capital. A deferred income tax liability of $7,215 was recognized upon the issuance of the convertible note. The discount to the carrying value of the convertible note was amortized as a non-cash interest expense over the term of the convertible note using the effective interest rate method. During the year ended March 31, 2016, the Company accreted $12,563 (2015 - $Nil) in non-cash accretion expense in connection with the convertible note, which is included in accretion expense on the statements of operations. 8.) Convertible Note (continued) The convertible loan plus the accrued interest was converted into 29,609 common shares on February 17, 2016 at a 45% discount to the market price (USD$0.89) $1.23 based on the terms of the convertible note. 9.) Capital Stock (a) Common Shares Authorized The Company is authorized to issue an unlimited number of common shares with no par value. Issued and Outstanding On June 6, 2014, the Company closed a private placement for gross proceeds of $647,860 of which $328,180 was received as at March 31, 2014 and reflected as equity to be issued. Pursuant to the private placement, the Company issued 556,118 units at $1.12 per unit for gross proceeds of $622,860 and 44,642 units at $0.56 per unit for gross proceeds of $25,000, with each unit comprised of one common share and one-half of one (1/2) common share purchase warrant. Each whole warrant is exercisable at $1.68 per share within the first twelve months of the close of the private placement and $2.24 per share for the second twelve month period to expiration. Immediate family members of management subscribed for 57,000 units for gross proceeds of $63,840 pursuant to this private placement. On October 22, 2014, a consultant was issued 6,700 units in settlement of debt owed in the amount of USD$10,050 ($11,256), each unit comprised of one common share and one-half of one (1/2) common share purchase warrant. Each whole warrant is exercisable at USD$1.50 ($1.94) per share until October 22, 2016. On November 24, 2014, the Company closed a further private placement for gross proceeds of $30,000. Pursuant to the private placement, the Company issued 17,700 units at USD$1.50 ($1.695) per unit for gross proceeds of $30,000, each unit comprising one common share and one-half of one (1/2) common share purchase warrant. Each whole warrant is exercisable at USD$2.00 ($2.59) per share until November 30, 2016. Additionally, on November 22, 2014, 25,000 common share purchase warrants were exercised at USD$0.04 ($0.046) per warrant for total cash proceeds of USD$1,000 ($1,113). On June 25, 2015, 12,500 common share purchase warrants were exercised at USD$0.04 ($0.048) per warrant for total cash proceeds of USD$500 ($620). On September 10, 2015, a consultant was issued 50,000 common shares for services rendered in the amount of $67,195, this amount has been recorded as professional fees on the statement of operations. 9.) Capital Stock (continued) (a) Common Shares (continued) On November 5, 2015, 31,000 common share purchase warrants were exercised at USD$0.04 ($0.052) per warrant for total cash proceeds of USD$1,240 ($1,632). On December 18, 2015, 51,600 common share purchase warrants were exercised at USD$0.04 ($0.054) per warrant for total cash proceeds of USD$2,064 ($2,834). On December 22, 2015, 31,000 common share purchase warrants were exercised at USD$0.04 ($0.056) per warrant for total cash proceeds of USD$1,240 ($1,735). On December 31, 2015, 48,400 common share purchase warrants were exercised at USD$0.04 ($0.055) per warrant for total cash proceeds of USD$1,936 ($2,683). On December 31, 2015, a private placement was completed to issue 31,532 common shares at USD$1.11 ($1.54) per share for gross proceeds of USD$35,000 ($48,441). The shares were subscribed for by a family member of an officer. On December 31, 2015, a consultant was issued 10,000 common shares for services rendered in the amount of USD$17,200 ($23,805). Another consultant was issued 93,000 common shares for services rendered in the amount of USD$159,960 ($221,385) (see Note 11), these amounts have been recorded as professional fees on the statement of operations. On January 4, 2016, 31,000 common share purchase warrants were exercised at USD$0.04 ($0.056) per warrant for total cash proceeds of USD$1,240 ($1,732). On February 25, 2016, 25,000 common share purchase warrants were exercised at USD$0.04 ($0.056) per warrant for total cash proceeds of USD$1,000 ($1,378). Shares to be issued On December 31, 2015, the term loan described in Note 7 was converted into shares to be issued at a value of $54,975 based upon an estimated fair market value of USD$1.72 ($2.38) per share at the time of conversion. On December 31, 2015, advances from related parties described in Note 6 were converted into shares to be issued at a value of $117,526 based upon a fair market value of USD$1.72 ($2.38) per share at the time of conversion. On December 31, 2015, the Company agreed to issue 45,000 compensatory shares to three officers of the Company with a fair market value of USD$1.72 ($2.38) per share for a total value of $107,123. This expense was recorded as stock based compensation on the statements of operations. On December 31, 2015, a consulting firm was granted 13,874 shares to be issued for services rendered in the amount of USD$22,500 ($31,140), these amounts have been recorded as professional fees on the statement of operations. These shares were issued subsequent to March 31, 2016. 9.) Capital Stock (continued) On March 31, 2016, a consulting firm was granted 15,264 shares to be issued for services in the amount of USD$22,500 ($29,185). This amount has been recorded as professional fees on the statement of operations. Equity Purchase Agreement (“EPA”) On September 10, 2015 the Company entered into the EPA. The holder of the EPA is committed to purchase up to USD$750,000 worth of the Company’s common shares (the “Put Shares”) over the 12 month term of the EPA. The Company paid to the holder of the EPA a commitment fee for entering into the EPA equal to 50,000 restricted common shares of the Company, valued at $67,195, based on the stock price in the most recent private placement as the Company’s shares had not yet begun to trade on a public market. From time to time over the EPA, commencing on the trading day immediately following the date on which the registration statement covering the resale of the Put Shares (the “Registration Statement”) is declared effective by the Securities and Exchange Commission (the ”Commission”), the Company may, in its sole discretion, draw upon the EPA periodically during the term by the Company’s delivery to the holder of the EPA, a written notice requiring the holder to purchase a dollar amount in common shares (the “Draw Down Notice”). The shares issuable pursuant to a Draw Down Notice, when aggregated with the shares then held by the holder on the date of the draw down may not exceed the lessor of (i) 4.99% of the Company’s outstanding common shares, (ii) USD$62,500 in any 30 days period or (iii) 100% of the aggregate trading volume for the 10 trading days immediately preceding the date of the Draw Down Notice without the prior written consent of the holder. The purchase price per common share purchased under the EPA shall equal 65% of the lowest closing bid for the 10 days immediately preceding the date of the Draw Down Notice. The Registration Statement was filed with the Commission on October 1, 2015 and was declared effective by the Commission on March 3, 2016. See Note 14. 9.) Capital Stock (continued) (b) Warrants As at March 31, 2016, the following warrants were outstanding: * Expired unexercised subsequent to the year-ended March 31, 2016. i) In connection with a private placement offering completed during the year ended March 31, 2015, the Company granted an aggregate of 300,383 share purchase warrants each exercisable into one common share at $1.68 during the first year and at $2.24 during the second year. The fair value of the warrants at the date of grant of $170,908 was estimated using the Black-Scholes option pricing model, based on the following weighted average assumptions: expected dividend yield of 0%; expected volatility of 173%; risk free interest rate of 1.06%; and expected term of 2 years. ii) In connection with a second private placement offering completed during the year ended March 31, 2015, the Company granted an aggregate of 8,850 share purchase warrants each exercisable into one common share at USD$2.00 ($2.59) until November 30, 2016. The fair value of the warrants at the date of grant of $6,213 was estimated using the Black-Scholes option pricing model, based on the following weighted average assumptions: expected dividend yield of 0%; expected volatility of 124%; risk free interest rate of 1.02%; and expected term of 2 years. iii) During the year ended March 31, 2015, the Company also issued 27,500 warrants of the Company valued at $19,290 for services rendered of which 22,500 warrants were granted to an officer of the Company. The compensation expense has been included in professional fees on the statements of operations. Each warrant entitles the holder to purchase one common share at an exercise price of $1.12 for a period ranging from 2.15 to 3 years after the date of issuance. The fair value of the warrants at the date of grant of $19,290 was estimated using the Black-Scholes option pricing model, based on the following weighted average assumptions: expected dividend yield of 0%; risk free interest rate of 1.14%; expected volatility of 182%; and expected term of 2.85 years. 9.) Capital Stock (continued) (b) Warrants (continued) iv) In connection with the unit issuance completed October 22, 2014 in settlement of debt, the Company granted 3,350 share purchase warrants exercisable into one common share at USD$1.50 ($1.95) per share for a period of 2 years from the date of issuance. The fair value of the warrants at the date of grant of $2,060 was estimated using the Black-Scholes option pricing model, based on the following assumptions: expected dividend yield of 0%; expected volatility of 123%; risk free interest rate of 0.99%; and expected term of 2 years. v) In connection with a consulting agreement (see Note 11), the Company granted 625,000 common share purchase warrants with each warrant entitling the grantee to acquire one common share in the capital of the Company at an exercise price of USD$0.04 ($0.052) at any time prior to April 1, 2017. Of the warrants granted, 300,000 vested on September 3, 2014 with the unvested portion vesting pro-rata for each USD$250,000 ($324,275) raised in an offering, fully vesting upon USD$1,500,000 ($1,945,650) being raised. The fair value of the 625,000 warrants at the date of grant of $500,000 was estimated using the Black-Scholes option pricing model, based on the following assumptions: expected dividend yield of 0%; expected volatility of 159%; risk free interest rate of 1.25%; and expected term of 3 years For the year ended March 31, 2016, the Company recorded $Nil (2015 - $240,000) as compensation expense for warrants issued to a consultant for services, plus a market adjustment for the year ended March 31, 2016 of $171,655 (2015 - $149,280). This expense was recorded as professional fees on the statement of operations. ASC 815 "Derivatives and Hedging" indicates that warrants with exercise prices denominated in a currency other than an entity's functional currency should not be classified as equity. As a result, warrants with a USD exercise price have been treated as derivatives and recorded as liabilities carried at their fair value, with period-to-period changes in the fair value recorded as a gain or loss in the statements of operations. The continuity of warrants for the years ended March 31, 2015 and 2016 is as follows: As at March 31, 2016, the fair value of the 381,700 (2015 - 612,200) warrants exercisable in US dollars, remaining after the exercise of 230,500 warrants (2015 - 25,000), was $222,803 (2015 - $786,403) which was estimated using the Black-Scholes option pricing model based on the following weighted average assumptions: expected dividend yield of 0% (2015 - 0%); expected volatility of 150% (2015 - 118%); risk-free interest rate of 0.54% (2015 - 0.52%) and expected term of 0.99 years (2015 - 2 years). Of this amount, $27,479 (2015 - $364,878) was reflected as a liability as at March 31, 2016, representing the percentage of the fair value of the warrants that is equal to the percentage of the requisite service that has been rendered at March 31, 2016. The warrant liability is classified as Level 3 within the fair value hierarchy (See Note 13). The Company’s computation of expected volatility during the years ended March 31, 2016 and 2015 is based on the market close price of comparable public entities over the period equal to the expected life of the warrants. The Company’s computation of expected life is calculated using the contractual life. 9.) Capital Stock (continued) (c) Stock-based compensation The Company’s stock-based compensation program (the "Plan") includes stock options in which some options vest based on continuous service. For those equity awards that vest based on continuous service, compensation expense is recorded over the service period from the date of grant. The total number of options outstanding as at March 31, 2016 was 930,000 (2015 - 505,000). The weighted average grant date fair value of options granted during the year ended March 31, 2016 was $2.21 (2015 - $1.18). The maximum number of options that may be issued under the Plan is floating at an amount equivalent to 15% of the issued and outstanding common shares, or 1,455,158 as at March 31, 2016 (2015 - 1,388,461). During the year ended March 31, 2015, 505,000 options were granted to officers, employees and consultants of the Company. The exercise price of these options is $1.73. Of this grant, 420,000 options vest as to one-third on the date of grant and one-third vest on each of the first anniversary and the second anniversary of the grant date; 60,000 options vest as to one quarter on the date of grant and one quarter vesting at 90 days, 180 days and 270 days from the grant date; and 25,000 options vested immediately. Since stock-based compensation is recognized only for those awards that are ultimately expected to vest, the Company has applied an estimated forfeiture rate (based on historical experience and projected employee turnover) to unvested awards for the purpose of calculating compensation expense. The grant date fair value of these options was estimated as $1.18 using the Black-Scholes option pricing model, based on the following assumptions: expected dividend yield of 0%; expected volatility of 144%; expected risk free interest rate of 1.39%; and expected term of 5 years. During the year ended March 31, 2016, 425,000 options were granted to officers and consultants of the Company. The exercise price of these options is $2.43. Of this grant, 340,000 options vest as to one-third on the grant date and one-third vesting on each of the first anniversary and the second anniversary of the grant date; 85,000 options vest as to one quarter on the date of grant and one quarter vesting at 90 days, 180 days and 270 days from the grant date. Since stock-based compensation is recognized only for those awards that are ultimately expected to vest, the Company has applied an estimated forfeiture rate (based on historical experience and projected employee turnover) to unvested awards for the purpose of calculating compensation expense. The grant date fair value of these options was estimated as $2.21 using the Black-Scholes option pricing model, based on the following assumptions: expected dividend yield of 0%; expected volatility of 157%; expected risk free interest rate of 0.66%; and expected term of 5 years. 9.) Capital Stock (continued) (c) Stock-based compensation (continued) The Company’s computation of expected volatility during the years ended March 31, 2016 and 2015 is based on the market close price of comparable public entities over the period equal to the expected life of the options. The Company’s computation of expected life is calculated using the contractual life. For the year ended March 31, 2016, the Company recorded $701,849 (2015 - $324,916) as Additional Paid in Capital for options issued to directors, officers and consultants based on continuous service. This expense was recorded as stock based compensation on the statements of operations. Additionally, for the year ended March 31, 2016, the Company recorded $372,709 (2015 - Nil) as professional fees for 153,000 common shares issued and 29,138 shares to be issued to consultants for services rendered. The expense was recorded as professional fees on the statements of operations. The activities in options outstanding are as noted below: The following table presents information relating to stock options outstanding and exercisable at March 31, 2016. 10.) Income Taxes The following table reconciles the income tax benefit at the Canadian statutory rate to income tax benefit at the Company’s effective tax rates. Deferred taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities and their respective tax bases for financial reporting purposes. Deferred tax assets as at March 31, 2016 and 2015 are comprised of the following: The Company has net operating loss carry forwards of approximately $2,262,000 (2015 - $913,000) which may be carried forward to apply against future year income for Canadian income tax purposes, subject to final determination by taxing authorities, expiring in the following years: 10.) Income Taxes (continued) The deferred tax assets have not been recognized because at this stage of the Company’s development, it is not determined that future taxable profits will be available against which the Company can utilize such deferred tax assets. Tax years 2010 through 2016 remain open to examination by the taxing jurisdictions to which the Company is subject. The Company has not been notified by any taxing jurisdictions of any proposed or planned examination. The Company has non-refundable tax credits as at March 31, 2016 of $5,449 (2015 - $5,449) which expire in the year 2031. 10.) Commitments and Contingencies The Company entered into a five (5) year operating lease for office and production facilities. The lease commenced on December 1, 2013 and expires on November 30, 2018. The base monthly rental is $1,362 plus the Company’s estimated portion of property taxes and operating expenses which are currently $810 per month. The future commitments pursuant to this lease arrangement, including property taxes and operating expenses for the fiscal periods ending March 31 are: 2017 $26,066 2018 $26,400 2019 $17,600 For the year ended March 31, 2016, occupancy costs related to this lease were $26,015 (2015 - $25,732). On March 11, 2014, and as amended on July 18, September 3, 2014, September 5, 2014 and again on December 31, 2015, the Company entered into a consulting agreement with Connectus, Inc. to assist and advise the Company in matters concerning corporate finance and the Company’s current and proposed financing activities for the period commencing April 1, 2014 and ending December 31, 2014. On December 31, 2015, the Company extended the contract to December 31, 2016. In consideration of the contract extension, the Company issued 93,000 common shares to Connectus, Inc. as compensation, which has been recorded as professional fees on the statements of loss. Pursuant to this agreement, the Company agreed to issue to this consulting corporation (the “Consultant”), 625,000 warrants of the Company. Each warrant is exercisable at USD$0.04 ($0.052) per share for a period of three years. Of the warrants granted, 300,000 vested on September 3, 2014 with the unvested portion vesting pro-rata for each USD$250,000 ($324,275) raised in an offering, fully vesting upon USD$1,500,000 ($1,945,650) being raised. During the year ended March 31, 2015, the President of the Consultant became a director of the Company. 11.) Commitments and Contingencies (continued) On April 23, 2014, the Company entered into employment agreements with three officers of the Company effective July 1, 2014. The initial contracts contain minimum aggregate commitments of approximately $427,000 per year for three years and additional contingent payments of up to approximately $600,000 in aggregate upon the occurrence of a change of control. As a triggering event has not taken place, the contingent payments have not been reflected in these financial statements. If employment is terminated by the Company other than upon a change of control or for just cause, the officers will be entitled to an amount equal to twelve months compensation including benefits, which shall be increased by one month for each full year of service completed. The employment agreements were amended whereby any salary from the commencement of the employment agreements has been waived until such a time when the Company is able to raise additional financing. Salaries will be earned based upon the Company’s success in raising future capital in accordance with the following schedule: 1 Cumulative funds raised is inclusive of all sources including without limitation capital raised, grants received, revenue recorded, debt raised, and assets sold. On September 24, 2015, the Company signed a consulting agreement with an investor relations firm with terms commencing immediately and ending on September 30, 2016. Consideration payable under the consulting agreement include a monthly fee of USD$7,500 ($9,728) payable in a combination of cash and restricted stock. 12.) Related Party Transactions Included in accounts payable and accrued liabilities as at March 31, 2016 is $52,030 (2015 - $52,030) owing to two directors who are also officers and significant shareholders of the Company for unpaid management fees. This balance is unsecured, non-interest bearing and due on demand. See also Notes 6, 7, 9(a), 9(b) and 9(c), 11 and 14. Amounts receivable from officer as at March 31, 2016 of $21,064 (2015 - $29,967) is owing from a shareholder, who is also a director and officer of the Company for funds advanced under the employment agreement (See Note 11). The amount receivable is unsecured, non-interest bearing and repayable upon demand. Management fees and consulting fees in the amount of $427,000 (2015 - $363,750) were waived by the officers of the Company during the year ended March 31, 2016. 13.) Financial Instruments (a) Liquidity risk Liquidity risk is the risk that the Company will not have sufficient cash resources to meet its financial obligations as they come due. The Company’s liquidity and operating results may be adversely affected if its access to the capital market is hindered, whether as a result of a downturn in stock market conditions generally or matters specific to the Company. The Company generates cash flow primarily from its financing activities and advances from shareholders. As at March 31, 2016, the Company had cash of $173 (2015 - $3,084) to settle current liabilities of $809,347 (2015 - $894,022). All of the Company's financial liabilities other than the warrant liability of $27,479 (2015 - $364,878) have contractual maturities of less than 30 days and are subject to normal trade terms. The Company regularly evaluates its cash position to ensure preservation and security of capital as well as liquidity. In the normal course of business, management considers various alternatives to ensure that the Company can meet some of its operating cash flow requirements through financing activities, such as private placements of common stock, preferred stock offerings and offerings of debt and convertible debt instruments as well as through merger or acquisition opportunities. Management may also consider strategic alternatives, including strategic investments and divestitures. As future operations may be financed out of funds generated from financing activities, the ability to do so is dependent on, among other factors, the overall state of capital markets and investor appetite for investments in the green technology industry and the Company’s securities in particular. Should the Company elect to satisfy its cash commitments through the issuance of securities, by way of either private placement or public offering or otherwise, there can be no assurance that the efforts to obtain such additional funding will be successful, or achieved on terms favorable to the Company or its existing shareholders. If adequate funds are not available on favorable terms, the Company may have to reduce substantially or eliminate expenditures or obtain funds through other sources such as divestiture or monetization of certain assets or sublicensing (where permitted) of certain rights to certain of the Company’s technologies or products. 13.) Financial Instruments (continued) (b) Concentration of credit risk Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash deposits. Cash deposits with a major Canadian chartered bank are insured by the Canadian Deposit Insurance Corporation up to $100,000. As at March 31, 2016, the Company held $173 (2015 - $3,084) with a major Canadian chartered bank. (c) Foreign exchange risk The Company principally operates within Canada. The Company’s functional currency is the Canadian dollar and major purchases are transacted in Canadian dollars. Management believes the foreign exchange risk derived from currency conversions is negligible and therefore does not hedge its foreign exchange risk. See also Note 13 (e). (d) Interest rate risk As at March 31, 2016, the Company does not have any interest-bearing debt. The Company invests any cash surplus to its operational needs in investment-grade short-term deposit certificates issued by highly rated Canadian banks. The Company periodically assesses the quality of its investments and is satisfied with the credit rating of the bank. (e) Derivative liability-warrant liability In connection with a consulting agreement, the Company granted warrants to purchase up to 625,000 common shares of the Company as disclosed in Note 9(b). The warrants have an exercise price of USD$0.04 ($0.052). The warrants are exercisable at any time prior to April 1, 2017. The warrants are accounted for as derivative liabilities because the exercise price is denominated in a currency other than the Company’s functional currency. In connection with the settlement of a vendor’s account, the Company granted warrants to purchase up to 3,350 common shares of the Company. The warrants have an exercise price of USD$1.50 ($1.95). The warrants are exercisable at any time prior to October 22, 2016. The warrants are accounted for as derivative liabilities because the exercise price is denominated in a currency other than the Company’s functional currency. In connection with a private placement, the Company granted warrants to purchase up to 8,850 common shares of the Company. The warrants have an exercise price of USD$2.00 ($2.59). The warrants are exercisable at any time prior to November 30, 2016. The warrants are accounted for as derivative liabilities because the exercise price is denominated in a currency other that the Company’s functional currency. 13.) Financial Instruments (continued) The table below summarizes the fair value of the Company’s financial liabilities measured at fair value: The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial liabilities (warrant derivative liability) for the periods ended March 31, 2016 and 2015: These instruments were valued using pricing models that incorporate the price of a share of common stock (based upon the price of the most recent private placement), expected volatility, risk free rate, expected dividend rate and expected estimated life. The Company estimated the value of the warrants using the Black-Scholes model. There were no transfers of assets or liabilities between Level 1, Level 2, or Level 3 during the years ended March 31, 2016 and 2015. The following are the key weighted average assumptions used in connection with the estimation of fair value as at March 31, 2016: 13.) Subsequent Events Subsequent to March 31, 2016, the Company entered into various agreements pursuant to which it has committed to issue up to 1,100,000 common shares of the Company to October 24, 2016, as compensation for services to be rendered. Within these agreements the commitment to Directors and Executive Officers totals 250,000 shares and the other significant commitments are to Tradersmasterpro.com, Inc for 750,000 shares and Midtown Partners & Co., LLC for 100,000 shares. On May 4, 2016 the Board approved a term loan in the amount of $40,000 for bridge financing with a relative of one of the officers of the Company. The terms of the loan are that it is to be repaid on August 28, 2016 at a 30% premium. On May 18, 2016, 44,500 warrants were exercised at USD$0.04 ($0.52) for gross proceeds of USD$1,780 ($2,164). On June 23, 2016, the Company agreed in conjunction with RY Capital Group, LLC and GHS Investments, LLC to assign the EPA to GHS Investments, LLC. The changes made to the EPA include increasing the share purchase price per common share to 80% from 65% of the lowest closing bid for the 10 days immediately preceding the date of the draw down notice, increasing the upper limit on individual draws to USD$75,000 from USD$62,500 and including a True-Up feature whereby if the lowest volume-weighted average price (“VWAP”) for the ten trading days following a draw down (the ‘Trading Period”) is less than 85% of the purchase price of the common shares issued in connection with a draw down, then the Company shall issue such additional common shares as maybe necessary to adjust the purchase price for such draw down to equal the VWAP during the Trading Period. See Note 9(b) regarding expiration of warrants subsequent to March 31, 2016.
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Based on the provided excerpt, here's a summary of the financial statement:
The company is currently in the development stage and is experiencing significant financial challenges:
1. Financial Status:
- Ongoing losses
- Negative working capital
- Accumulated deficit
- No profitable operations to date
2. Operational Challenges:
- Relying on non-operational funding sources
- Anticipating continued future losses
- Unable to generate revenue
3. Financial Uncertainty:
- Substantial doubt about the company's ability to meet financial obligations
- Seeking potential debt or equity financing
- No assurance of successfully securing additional funding
4. Going Concern Warning:
- Significant risk of being unable to continue operations
- Financial statements do not include potential adjustments if the company cannot sustain itself
- Potential material financial adjustments may be necessary
The statement suggests the company is in a precarious financial position with significant risks of financial instability
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Claude
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[THE REST OF THIS PAGE INTENTIONALLY LEFT BLANK] ACCOUNTING FIRM The Board of Directors and Shareholders of Graybar Electric Company, Inc. We have audited the accompanying consolidated balance sheets of Graybar Electric Company, Inc. and Subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Graybar Electric Company, Inc. and Subsidiaries at December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP St. Louis, Missouri March 10, 2017 Graybar Electric Company, Inc. and Subsidiaries Consolidated Statements of Income (A)Adjusted for the declaration of a 5% stock dividend in December 2016, shares related to which were issued in February 2017. Prior to the adjustment, the average common shares outstanding were 16,364 and 16,244 for the years ended December 31, 2015 and 2014, respectively. The accompanying are an integral part of the Consolidated Financial Statements. Graybar Electric Company, Inc. and Subsidiaries Consolidated Statements of Comprehensive Income The accompanying are an integral part of the Consolidated Financial Statements. Graybar Electric Company, Inc. and Subsidiaries Consolidated Balance Sheets The accompanying are an integral part of the Consolidated Financial Statements. Graybar Electric Company, Inc. and Subsidiaries Consolidated Statements of Cash Flows The accompanying are an integral part of the Consolidated Financial Statements. Graybar Electric Company, Inc. and Subsidiaries Consolidated Statements of Changes in Shareholders’ Equity The accompanying are an integral part of the Consolidated Financial Statements. Graybar Electric Company, Inc. and Subsidiaries as of December 31, 2016 and 2015 and for the Years Ended December 31, 2016, 2015, and 2014 (Stated in thousands, except share and per share data) 1. DESCRIPTION OF THE BUSINESS Graybar Electric Company, Inc. (“Graybar”, “Company”, "we", "our", or "us") is a New York corporation, incorporated in 1925. We are engaged in the distribution of electrical and communications and data networking products and are a provider of related supply chain management and logistics services. We primarily serve customers in the construction, industrial & utility, and commercial, institutional and government ("CIG") vertical markets, with products and services that support new construction, infrastructure updates, building renovation, facility maintenance, repair and operations ("MRO"), and original equipment manufacturers ("OEM"). All products sold by us are purchased by us from others, and we neither manufacture nor contract to manufacture any products that we sell. Our business activity is primarily with customers in the United States (“U.S.”). We also have subsidiary operations with distribution facilities in Canada and Puerto Rico. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Our accounting policies conform to generally accepted accounting principles in the U.S. ("GAAP”) and are applied on a consistent basis among all years presented. Significant accounting policies are described below. Principles of Consolidation The consolidated financial statements include the accounts of Graybar and its subsidiary companies. All material intercompany balances and transactions have been eliminated. The ownership interests that are held by owners other than the Company in subsidiaries consolidated by the Company are accounted for and reported as noncontrolling interests. Estimates The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. Actual results could differ from these estimates. Reclassifications Certain reclassifications have been made to prior years' financial information to conform to the December 31, 2016 presentation. Subsequent Events We have evaluated subsequent events through the time of the filing of this Annual Report on Form 10-K with the Commission. No material subsequent events have occurred since December 31, 2016 that require recognition or disclosure in our financial statements. Revenue Recognition Revenue is recognized when evidence of a customer arrangement exists, prices are fixed and determinable, product title, ownership and risk of loss transfers to the customer, and collectability is reasonably assured. Revenues recognized are primarily for product sales, but also include freight and handling charges. Our standard shipping terms are FOB shipping point, under which product title passes to the customer at the time of shipment. We also earn revenue for services provided to customers for supply chain management and logistics services. Service revenue, which accounts for less than 1% of net sales, is recognized when services are rendered and completed. Revenue is reported net of all taxes assessed by governmental authorities as a result of revenue-producing transactions, primarily sales tax. Outgoing Freight Expenses We record certain outgoing freight expenses as a component of selling, general and administrative expenses. These costs totaled $50,949, $51,100, and $49,622 for the years ended December 31, 2016, 2015, and 2014, respectively. Cash and Cash Equivalents We account for cash on hand, deposits in banks, and other short-term, highly liquid investments with an original maturity of three months or less as cash and cash equivalents. Allowance for Doubtful Accounts We perform ongoing credit evaluations of our customers, and a significant portion of our trade receivables is secured by mechanic’s lien or payment bond rights. We maintain allowances to reflect the expected uncollectability of trade receivables based on past collection history and specific risks identified in the receivables portfolio. Although actual credit losses have historically been within management’s expectations, additional allowances may be required if the financial condition of our customers were to deteriorate. Merchandise Inventory Our inventory is stated at the lower of cost (determined using the last-in, first-out (“LIFO”) cost method) or market. LIFO accounting is a method of accounting that, compared with other inventory accounting methods, generally provides better matching of current costs with current sales. We make provisions for obsolete or excess inventories as necessary to reflect reductions in inventory value. Vendor Allowances Our agreements with many of our suppliers provide for us to earn volume incentives based on purchases during the agreement period. Based on the provisions of our vendor agreements, we develop vendor accrual rates by estimating the point at which we will have completed our performance under the agreement and the deferred amounts will be earned. We perform analyses and review historical trends to ensure the deferred amounts earned are appropriately recorded. Certain vendor agreements contain purchase volume incentives that provide for increased funding when graduated purchase volumes are met. Amounts accrued throughout the year are based on estimates of future activity levels, and could be materially impacted if actual purchase volumes differ. Changes in the estimated amount of incentives are treated as changes in estimate and are recognized in earnings in the period in which the change in estimate occurs. In the event that the operating performance of our suppliers were to decline, however, there can be no assurance that amounts earned would be paid or that the volume incentives would continue to be included in future agreements. Property and Depreciation Property, plant and equipment are recorded at cost. Depreciation is expensed on a straight-line basis over the estimated useful lives of the related assets. Interest costs incurred to finance expenditures for major long-term construction projects are capitalized as part of the asset's historical cost and included in property, plant and equipment, then depreciated over the useful life of the asset. Leasehold improvements are amortized over the term of the lease or the estimated useful life of the improvement, whichever is shorter. Expenditures for maintenance and repairs are charged to expense when incurred, while the costs of significant improvements, which extend the useful life of the underlying asset, are capitalized. Credit Risk Financial instruments that potentially expose us to concentrations of credit risk consist primarily of trade receivables. We perform ongoing credit evaluations of our customers, and a significant portion of our trade receivables may be protected by mechanic’s lien or payment bond rights. We maintain allowances for potential credit losses, and such losses historically have been within management’s expectations. Fair Value We endeavor to utilize the best available information in measuring fair value. GAAP has established a fair value hierarchy, which prioritizes the inputs used in measuring fair value. The tiers in the hierarchy include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own data inputs and assumptions. We have used fair value measurements to value our pension plan assets. Foreign Currency Exchange Rate The functional currency for our Canadian subsidiary is the Canadian dollar. Accordingly, its balance sheet amounts are translated at the exchange rates in effect at the end of each reporting period and its statements of income amounts are translated at the average rates of exchange prevailing during the current period. Currency translation adjustments are included in accumulated other comprehensive loss. Goodwill Our goodwill is not amortized, but rather tested annually for impairment. Goodwill is reviewed annually in the fourth quarter and/or when circumstances or other events might indicate that impairment may have occurred. We first perform a qualitative assessment of goodwill impairment. The qualitative assessment considers several factors including the excess fair value over carrying value as of the last quantitative impairment test, the length of time since the last fair value measurement, the current carrying value, market conditions, actual performance compared to forecasted performance, and the current business outlook. If the qualitative assessment indicates that it is more likely than not that goodwill is impaired, the reporting unit is then quantitatively tested for impairment. If a quantitative assessment is required, the fair value is determined using a variety of assumptions including estimated future cash flows of the reporting unit using applicable discount rates. Definite Lived Intangible Assets The cost of intangible assets with determinable useful lives is amortized to reflect the pattern of economic benefits consumed, either on a straight-line or accelerated basis over the estimated periods benefited. Customer relationships, trade names and other non-contractual intangible assets with determinable lives are amortized over periods generally ranging from 5 to 20 years. Intangible assets are tested for impairment if events or circumstances occur indicating that the respective asset might be impaired. Income Taxes We recognize deferred tax assets and liabilities to reflect the future tax consequences of events that have been recognized in the financial statements or tax returns. Uncertainty exists regarding tax positions taken in previously filed tax returns still subject to examination and positions expected to be taken in future returns. A deferred tax asset or liability results from the temporary difference between an item’s carrying value as reflected in the financial statements and its tax basis, and is calculated using enacted applicable tax rates. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, a valuation allowance is established. Changes in the valuation allowance, when recorded, are included in the provision for income taxes in the consolidated financial statements. We classify interest expense and penalties as part of our provision for income taxes based upon applicable federal and state interest/underpayment percentages. Other Postretirement Benefits We account for postretirement benefits other than pension by accruing the costs of benefits to be provided over the employees’ periods of active service. These costs are determined on an actuarial basis. Our consolidated balance sheets reflect the funded status of postretirement benefits. Pension Plan We sponsor a noncontributory defined benefit pension plan accounted for by accruing the cost to provide the benefits over the employees’ periods of active service. These costs are determined on an actuarial basis. Our consolidated balance sheets reflect the funded status of the defined benefit pension plan. New Accounting Standards No new accounting standards that were issued or became effective during 2016 have had or are expected to have a material impact on our consolidated financial statements except those noted below. In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update (“ASU” or “Update”) 2016-02, “Leases (Topic 842)”. The core principle of Topic 842 requires that a lessee should recognize the assets and liabilities on the balance sheet and disclose key information about leasing arrangements. The amendments in ASU 2016-02 are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The guidance is required to be adopted at the earliest period presented using a modified retrospective approach. We are currently evaluating the impact the provisions will have on our consolidated financial statements but have decided we will not adopt the guidance early. In April 2015, FASB issued ASU 2015-05, "Intangibles-Goodwill and Other-Internal-use Software: Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement". This Update provides guidance about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract and expensed as services are received. The Update is effective for fiscal years beginning after December 15, 2015 and interim periods. We adopted this Update on January 1, 2016. The adoption of this standard did not have a material impact on our results of operation, financial position, or cash flows. In February 2015, FASB issued ASU 2015-02, "Consolidation". The amendments in this Update affect reporting entities that are required to evaluate whether they should consolidate certain legal entities. All legal entities are subject to reevaluation under the revised consolidation model. This ASU is effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015. We adopted this Update on January 1, 2016. The adoption of this standard did not have a material impact on our results of operation, financial position, or cash flows. In May 2015, the FASB issued ASU 2015-07, "Fair Value Measurement (Topic 820) - Disclosures for Investments in Certain Entities That Calculate Net Asset Value Per Share (or Its Equivalent)". The Update removes the requirement to include within the fair value hierarchy leveling table those investments that measure fair value using the practical expedient available for investments that calculate a net asset value per share (or NAV equivalent, for example member units or an ownership interest in partners’ capital to which a proportionate share of net assets is attributed). Even though these investments are removed from the fair value hierarchy, entities should provide or disclose the total amount of investments measured using the net asset value per share (or its equivalent) practical expedient in order to permit reconciliation of fair value of investments included in the fair value hierarchy to the line items disclosed. The guidance contained in the ASU is effective for public business entities for fiscal years beginning after December 15, 2015. The adoption of this standard has been applied retrospectively. In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” ("ASU 2014-09"), which provides guidance on a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes current revenue recognition guidance, including industry-specific guidance. In July 2015, the FASB deferred the effective date of the Update for one year. The Update will now be effective for public business entities for annual reporting periods, including interim reporting periods, beginning after December 15, 2017. The new standard provides for two alternative implementation methods. The first is to apply the new standard retrospectively to each prior reporting period presented. This method allows the use of certain practical expedients. The second method is to apply the new standard retrospectively in the year of initial adoption and record a cumulative effect adjustment for the impact of adjusting contracts open at the date of adoption. Under this transition method, we would apply this guidance retrospectively only to contracts that are not completed contracts at the date of initial application, which for us will be January 1, 2018. We would then recognize the cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings. This method also requires us to disclose comparative information for the year of adoption. In March 2016, FASB issued ASU 2016-08 "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)". The amendments in this Update do not change the core principle of the guidance stated in ASU 2014-09. Instead, the amendments in this ASU are intended to further clarify the implementation guidance on principal versus agent considerations. ASU 2016-08 will have the same effective date and transition requirements as the new revenue standard issued in ASU 2014-09. Our primary source of revenues is from customer purchase orders in the construction, industrial & utility, and CIG markets for electrical and comm/data products. Revenue is currently recognized when evidence of a customer arrangement exists, prices are fixed and determinable, product title, ownership and risk of loss transfers to the customer, and collectability is reasonably assured. We are currently assessing our revenue streams and reporting disclosures to determine the potential impact related to the adoption of ASU 2014-09. We do however believe that, upon adoption of ASU 2014-09, the timing of revenue related to our sales will remain relatively consistent with current practices. At the time of this filing, we believe we will be adopting ASU 2014-09 under the modified retrospective approach. 3. CASH DISCOUNTS AND DOUBTFUL ACCOUNTS The following table summarizes the activity in the allowances for cash discounts and doubtful accounts: 4. INVENTORY Our inventory is stated at the lower of cost (determined using the LIFO cost method) or market. Inventories valued using the LIFO method comprised 90% and 93% of the total inventories at December 31, 2016 and 2015, respectively. Had the first-in, first-out (“FIFO”) method been used, merchandise inventory would have been $147,091 and $136,143 greater than reported under the LIFO method at December 31, 2016 and 2015, respectively. In 2016, we liquidated portions of previously-created LIFO layers, resulting in decreases in cost of merchandise sold of $131. We did not liquidate any portion of previously-created LIFO layers in 2015 and 2014. Reserves for excess and obsolete inventories were $6,553 and $4,912 at December 31, 2016 and 2015, respectively. The change in the reserve for excess and obsolete inventories, included in cost of merchandise sold, was $1,641, $495, and $670 for the years ended December 31, 2016, 2015, and 2014, respectively. 5. PROPERTY AND DEPRECIATION We provide for depreciation and amortization using the straight-line method over the following estimated useful asset lives: Classification Estimated Useful Asset Life Buildings 42 years Leasehold improvements Over the shorter of the asset’s life or the lease term Furniture, fixtures, equipment and software 3 to 14 years Assets held under capital leases Over the shorter of the asset’s life or the lease term Depreciation expense was $39,332, $38,588, and $35,040 in 2016, 2015, and 2014, respectively. At the time property is retired or otherwise disposed of, the asset and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is credited or charged to other income, net. Assets held under capital leases, consisting primarily of information technology equipment, are recorded in property with the corresponding obligations carried in long-term debt. The amount capitalized is the present value at the beginning of the lease term of the aggregate future minimum lease payments. Assets held under leases which were capitalized during the year ended December 31, 2016 and 2015 were $427 and $7,354, respectively. We capitalize interest expense on major construction and development projects while in progress. There was no interest capitalized in 2016. Interest capitalized in 2015 and 2014 was $225 and $102, respectively. Where applicable, we will capitalize qualifying internal and external costs incurred to develop or obtain software for internal use during the application development stage. Costs incurred during the pre-application development and post- implementation stages are expensed as incurred. We capitalized software and software development costs of $3,542 and $4,559 in 2016 and 2015, respectively, and the amounts are recorded in furniture and fixtures. We consider properties to be assets held for sale when all of the following criteria are met: (i) a formal commitment to a plan to sell a property has been made and exercised; (ii) the property is available for sale in its present condition; (iii) actions required to complete the sale of the property have been initiated; (iv) sale of the property is probable and we expect the sale will occur within one year; and (v) the property is being actively marketed for sale at a price that is reasonable given its current market value. Upon designation as an asset held for sale, we record the carrying value of each property at the lower of its carrying value or its estimated fair value, less estimated costs to sell, and depreciation of the property ceases. The net book value of assets held for sale was $464 and $58 at December 31, 2016 and 2015, respectively, and is recorded in net property in the consolidated balance sheet. During 2016 and 2015, we sold assets classified as held for sale with net book values of $148 and $7,669, respectively, and recorded net gains on the assets held for sale of $2,004 and $4,691, respectively in other income, net. We review long-lived assets held and used for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. For assets classified as to be held and used, impairment may occur if projected undiscounted cash flows are not adequate to cover the carrying value of the assets. In such cases, additional analysis is conducted to determine the amount of the loss to be recognized. The impairment loss is calculated as the difference between the carrying amount of the asset and its estimated fair value. The analysis requires estimates of the amount and timing of projected cash flows and, where applicable, selection of an appropriate discount rate. Such estimates are critical in determining whether any impairment charge should be recorded and the amount of such charge if an impairment loss is deemed necessary. For assets held for sale, impairment occurs whenever the net book value of the property listed for sale exceeds the expected selling price less estimated selling expenses. There were no impairment charges recorded during 2016 and 2015. 6. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill The changes in the carrying amount of goodwill, included in other non-current assets in our consolidated balance sheets, for the year ended December 31, 2016 and 2015 were as follows: In 2016 and 2015, goodwill increased due to the acquisitions of Cape Electrical Supply LLC ("Cape Electric") and Advantage Industrial Automation, Inc. ("Advantage"), respectively. See Note 15, "Acquisitions", for further information on the acquisitions. As of December 31, 2016, we have completed our annual impairment test and concluded that there is no impairment of our goodwill. Other Intangible Assets Other intangible assets, included in other non-current assets in our consolidated balance sheets, consist of the following: In 2016 and 2015, other intangible assets were acquired in the acquisitions of Cape Electric and Advantage, respectively. See Note 15, "Acquisitions", for further information on the acquisitions. Amortization expense for other intangible assets was $1,647 and $522 in 2016 and 2015, respectively. Estimated future amortization expense related to our intangible assets for the years ending December 31 are as follows: We did not incur impairment losses related to our other intangible assets during the year ended December 31, 2016. 7. INCOME TAXES We determine our deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of our assets and liabilities calculated using enacted applicable tax rates. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. Changes in the valuation allowance, when recorded, are included in the provision for income taxes in the consolidated financial statements. Our unrecognized tax benefits of $1,755, $2,247, and $3,104 as of December 31, 2016, 2015, and 2014, respectively, are uncertain tax positions that would impact our effective tax rate if recognized. We are periodically engaged in tax return examinations, reviews of statute of limitations periods, and settlements surrounding income taxes. We do not anticipate a material change in unrecognized tax benefits during the next twelve months. Our uncertain tax benefits, and changes thereto, during 2016, 2015, and 2014 were as follows: We classify interest expense and penalties as part of our provision for income taxes based upon applicable federal and state interest/underpayment percentages. We have accrued $650 and $907 in interest and penalties at December 31, 2016 and 2015, respectively. Interest was computed on the difference between the provision for income taxes recognized in accordance with GAAP and the amount of benefit previously taken or expected to be taken in our federal, state, and local income tax returns. Our federal income tax returns for the tax years 2013 and forward are available for examination by the United States Internal Revenue Service (“IRS”). The statute of limitation for the 2013 federal return will expire on September 15, 2017, unless extended by consent. Our state income tax returns for 2012 through 2016 remain subject to examination by various state authorities with the latest period closing on December 31, 2021. We have not extended the statutes of limitations in any state jurisdictions with respect to years prior to 2012. The IRS concluded examinations of the Company's 2008-2011 federal income tax returns. In May 2014, we formalized settlement of the IRS audit for each of these four years. Collectively, including interest, we settled the assessments for $907. This closure has been recorded in our federal income tax expense for 2014. A reconciliation between the “statutory” federal income tax rate and the effective tax rate in the consolidated statements of income is as follows: The components of income before taxes and the provision for income taxes recorded in the consolidated statements of income are as follows: Deferred income taxes are provided based upon differences between the financial statement and tax bases of assets and liabilities. The following deferred tax assets (liabilities) were recorded at December 31: Deferred income taxes included in non-current assets (liabilities) at December 31 were: We adopted FASB's ASU 2015-17, "Balance Sheet Classification of Deferred Taxes”, which required entities with a classified balance sheet to present all deferred tax assets and liabilities as non-current, retrospectively beginning January 1, 2015 resulting in a change in presentation of prior periods. Deferred tax assets included in other current assets decreased by $2,777 as of December 31, 2014 with a corresponding increase to deferred tax assets included in other non-current assets. Deferred tax liabilities included in other current liabilities of $365 as of December 31, 2014, were reclassified to other non-current liabilities. Operating loss carryforwards included in net deferred tax assets at December 31 were: (1)Expires in 2024 (2)Expire between 2020 and 2030 Due to uncertainties regarding the utilization of our foreign and state net operating losses, a partial valuation allowance has been applied against the deferred tax benefit at December 31, 2016. We have undistributed earnings of non-U.S. subsidiaries of $78,767 and $72,488 as of December 31, 2016 and 2015, respectively. We have not made a provision for U.S. federal and state income taxes on these accumulated but undistributed earnings, as such earnings are considered to be indefinitely reinvested outside the U.S. 8. CAPITAL STOCK Our common stock is 100% owned by active and retired employees, and there is no public trading market for our common stock. Since 1928, substantially all of the issued and outstanding shares of common stock have been held of record by voting trustees under successive voting trust agreements. Under applicable New York law, a voting trust may not have a term greater than ten years. Accordingly, a new Voting Trust Agreement was established effective March 3, 2017, which expires on March 1, 2027. At December 31, 2016, approximately 84% of the common stock was held in a voting trust that expired on March 3, 2017. The participation of shareholders in the voting trust is voluntary at the time the voting trust is created, but is irrevocable during its term. Shareholders who elect not to participate in the voting trust hold their common stock as shareholders of record. Shareholders may elect to participate in the voting trust at any time during the term of the voting trust. As of March 3, 2017, 4,661 shareholders owning 14,011,446 shares of common stock, or approximately 80% of the total shares outstanding, have agreed to deposit their shares into the new Voting Trust Agreement. No holder of our common stock or voting trust interests representing our common stock ("common stock", "common shares", or "shares") may sell, transfer or otherwise dispose of any shares without first offering us the option to purchase those shares at the price at which they were issued. Additionally, a shareholder is entitled to any cash dividends, if any, accrued for the quarter in which the purchase offer is made, adjusted pro rata for the number of days such shares were held prior to the dividend record date. We also have the option to purchase at the issue price the common shares of any shareholder who ceases to be an employee for any reason other than death or retirement on a pension (except a deferred pension), and on the first anniversary of any holder's death. In the past, we have always exercised these purchase options and we expect to continue to do so in the foreseeable future. However, we can make no assurance that we will continue to exercise our purchase option in the future. All outstanding shares have been issued at $20.00 per share. During 2016, eligible employees and qualified retirees subscribed for 896,456 shares totaling $17,929. Subscribers under the Plan elected to make payments under one of the following options: (i) all shares subscribed for on or before January 13, 2017; or (ii) all shares subscribed for in installments paid through payroll deductions (or in certain cases where a subscriber is no longer on our payroll, through direct monthly payments) over an eleven-month period. Common shares were delivered to subscribers as of January 13, 2017, in the case of shares paid for prior to January 13, 2017. Shares will be issued and delivered to subscribers on a quarterly basis, as of the tenth day of March, June, September, and December, to the extent full payments for shares are made in the case of subscriptions under the installment method. Shown below is a summary of shares purchased and retired by the Company during the three years ended December 31: We also have authorized 10,000,000 shares of Delegated Authority Preferred Stock (“preferred stock”), par value one cent ($0.01). The preferred stock may be issued in one or more series, with the designations, relative rights, preferences, and limitations of shares of each such series being fixed by a resolution of our Board of Directors. There were no shares of preferred stock outstanding at December 31, 2016 and 2015. On December 8, 2016, our Board of Directors declared a 5% common stock dividend. Each shareholder was entitled to one share of common stock for every twenty shares held as of December 19, 2016. The stock was issued on February 3, 2017. On December 10, 2015, our Board of Directors declared a 2.5% common stock dividend. Each shareholder was entitled to one share of common stock for every forty shares held as of December 18, 2015. The stock was issued on February 1, 2016. There was no common stock dividend declared by our Board of Directors in 2014. 9. NET INCOME PER SHARE OF COMMON STOCK The computation of net income per share of common stock is based on the average number of common shares outstanding during each year, adjusted in all periods presented for the declaration of a 5% stock dividend declared in 2016 and a 2.5% stock dividend declared in 2015. There was no stock dividend declared in 2014. The average number of shares used in computing net income per share of common stock at December 31, 2016, 2015, and 2014 was 17,385,952, 17,182,663, and 17,056,076, respectively. 10. DEBT The carrying amount of our outstanding long-term, fixed-rate debt exceeded its fair value by $984 and $1,243 at December 31, 2016 and 2015, respectively. The fair value of the long-term is estimated by calculating future cash flows at interpolated Treasury yields with similar maturities, plus an estimate of our credit risk spread. The fair value of our variable-rate short- and long-term debt approximates its carrying value at December 31, 2016 and 2015, respectively. Revolving Credit Facility On December 31, 2016 and December 31, 2015, we along with Graybar Canada Limited, our Canadian operating subsidiary (“Graybar Canada”), had an unsecured, five-year, $550,000 revolving credit agreement maturing in June 2019 with Bank of America, N.A. and other lenders named therein (the "Credit Agreement"), which includes a combined letter of credit subfacility of up to $50,000, a U.S. swing line loan facility of up to $50,000, and a Canadian swing line loan facility of up to $20,000. The Credit Agreement includes a $100,000 sublimit (in U.S. or Canadian dollars) for borrowings by Graybar Canada and contains an accordion feature, which allows us to request increases in the aggregate borrowing commitments of up to $300,000. Borrowings of Graybar Canada may be in U.S. dollars or Canadian dollars. The obligations of Graybar Canada are secured by the guaranty of Graybar and any material domestic subsidiaries of Graybar (as defined in the Credit Agreement). Under no circumstances will Graybar Canada use its borrowings to benefit Graybar or its operations, including without limitation to repay any of Graybar’s obligations under the facility. Interest on our borrowings under the Credit Agreement are based on, at the borrower’s election, either (A) (i) the base rate (as defined in the Credit Agreement), or (ii) LIBOR (in the case of Graybar as borrower) or (B) (i) the base rate (as defined in the agreement) or (ii) CDOR (in the case of Graybar Canada as borrower), in each case plus an applicable margin, as determined by the pricing grid set forth in the Credit Agreement. In connection with such a borrowing, the applicable borrower also selects the term of the loan, up to six months. Swing line loans, which are daily loans, bear interest at a rate based on, at the borrower’s election, either (i) the base rate or (ii) the daily floating Eurodollar rate (or CDOR, in the case of Graybar Canada). In addition to interest payments, there are also certain fees and obligations associated with borrowings, swing line loans, letters of credit and other administrative matters. The Credit Agreement provides for a quarterly commitment fee ranging from 0.25% to 0.40% per annum, subject to adjustment based upon the consolidated leverage ratio for a fiscal quarter, and letter of credit fees ranging from 1.00% to 1.60% per annum payable quarterly, subject to such adjustment. Borrowings can be either base rate loans plus a margin ranging from 0.00% to 0.60% or Eurodollar rate loans plus a margin ranging from 1.00% to 1.60%, subject to adjustment based upon our consolidated leverage ratio. Availability under the Credit Agreement is subject to the accuracy of representations and warranties and absence of a default and, in the case of Canadian borrowings denominated in Canadian dollars, the absence of a material adverse change in the national or international financial markets, which would make it impracticable to lend Canadian dollars. The Credit Agreement contains customary affirmative and negative covenants for credit facilities of this type, including limitations on us and our subsidiaries with respect to indebtedness, liens, changes in the nature of our business, investments, mergers and acquisitions, issuance of equity securities, dispositions of assets and dissolution of certain subsidiaries, transactions with affiliates, restricted payments (subject to incurrence tests, with certain exceptions), as well as securitizations, factoring transactions, and transactions with sanctioned parties or in violation of certain U.S. or Canadian anti-corruption laws. There are also maximum leverage ratio and minimum interest coverage ratio financial covenants that we are subject to during the term of the Credit Agreement. The Credit Agreement also provides for customary events of default, including a failure to pay principal, interest or fees when due, the fact that any representation or warranty made by any of the credit parties is materially incorrect, failure to comply with covenants, the occurrence of an event of default under certain other indebtedness by us and our subsidiaries, the commencement of certain insolvency or receivership events affecting any of the credit parties, certain actions under Employee Retirement Income Security Act ("ERISA") and the occurrence of a change in control of any of the credit parties (subject to certain permitted transactions as described in the Credit Agreement). Upon the occurrence of an event of default, the commitments of the lenders may be terminated and all outstanding obligations of the credit parties under the Credit Agreement may be declared immediately due and payable. We had total letters of credit of $5,244 and $4,994 outstanding, of which none were issued under the $550,000 revolving credit facility at December 31, 2016 and December 31, 2015, respectively. The letters of credit are used primarily to support certain workers' compensation insurance policies. Short-term borrowings of $140,465 and $104,978 outstanding at December 31, 2016 and 2015, respectively, were drawn under the revolving credit facility. Short-term borrowings outstanding during the years ended December 31, 2016 and 2015 ranged from a minimum of $105,014 and $35,981 to a maximum of $311,506 and $184,188, respectively. The average daily amount of borrowings outstanding under short-term credit agreements during 2016 and 2015 amounted to approximately $185,000 and $119,000 at weighted-average interest rates of 1.52% and 1.31%, respectively. The weighted-average interest rate for amounts outstanding at December 31, 2016 was 1.83%. At December 31, 2016, we had available unused committed lines of credit amounting to $409,535, compared to $445,022 at December 31, 2015. These lines are available to meet our short-term cash requirements, and certain committed lines of credit have annual fees of up to 40 basis points (0.40%) of the committed lines of credit as of December 31, 2016 and 2015. The Credit Agreement contains various affirmative and negative covenants. We are also required to maintain certain financial ratios as defined in the Credit Agreement. We were in compliance with all covenants as of December 31, 2016 and 2015. Private Placement Shelf Agreements On December 31, 2016 and December 31, 2015, we had an uncommitted $100,000 private placement shelf agreement with Prudential Investment Management, Inc. (the "Prudential Shelf Agreement"). Subject to the terms and conditions set forth below, the Prudential Shelf Agreement allows us to issue senior promissory notes to affiliates of Prudential at fixed rate terms to be agreed upon at the time of any issuance during a three year issuance period ending in September 2017. At December 31, 2016 and 2015, no notes had been issued under the Prudential Shelf Agreement. On September 22, 2016, we entered into an uncommitted $100,000 private placement shelf agreement (the “MetLife Shelf Agreement”) with Metropolitan Life Insurance Company and MetLife Investment Advisors, LLC and each other affiliate of MetLife that becomes a party to the agreement (collectively, “MetLife”). Subject to the terms and conditions set forth below, the MetLife Shelf Agreement is expected to allow the Company to issue senior promissory notes to MetLife at fixed or floating rate economic terms to be agreed upon at the time of any issuance during a three-year issuance period ending in September 2019. Floating rate note interest rates will be based on London Interbank Offered Rate ("LIBOR") plus a spread. No notes have been issued under the MetLife Shelf Agreement, which ranks equally with the Company’s Credit Agreement and Prudential Shelf Agreement. Under these shelf agreements, the term of each note issuance will be selected by us and will not exceed 12 years and will have such other particular terms as shall be set forth, in the case of any series of notes, in the Confirmation of Acceptance with respect to such series. Any notes issued under the Prudential Shelf Agreement or under the MetLife Shelf Agreement will be guaranteed by our material domestic subsidiaries, if any, as described in the Prudential Shelf Agreement and the MetLife Shelf Agreement. Any future proceeds of any issuance under the facilities will be used for general corporate purposes, including working capital and capital expenditures, to refinance existing indebtedness and/or to fund potential acquisitions. Each shelf agreement contains customary representations and warranties of the Company and the applicable lender. Each shelf agreement also contains customary events of default, including: a failure to pay principal, interest or fees when due; a failure to comply with covenants; the fact that any representation or warranty made by any of the credit parties is incorrect when given; the occurrence of an event of default under the Credit Agreement or certain other indebtedness of us and our subsidiaries; the commencement of certain insolvency or receivership events affecting any of the credit parties; certain actions under ERISA; and the occurrence of a change in control of Graybar (subject to certain permitted transactions as described in the Credit Agreement). All outstanding obligations of Graybar under one or both of these agreements may be declared immediately due and payable upon the occurrence of an event of default. Each shelf agreement contains customary affirmative and negative covenants for facilities of this type, including limitations on us and our subsidiaries with respect to indebtedness, liens, changes in the nature of our business, investments, mergers and acquisitions, issuance of equity securities, dispositions of assets and dissolution of certain subsidiaries, transactions with affiliates, restricted payments (subject to incurrence tests, with certain exceptions), as well as securitizations, factoring transactions, and transactions with sanctioned parties or in violation of certain U.S. or Canadian anti-terrorism laws. There are also maximum leverage ratio and minimum interest coverage ratio financial covenants that we are subject to during the term of the shelf agreements. We were in compliance with all covenants as of December 31, 2016 and 2015. In addition, we have agreed to a most favored lender clause which is designed to ensure that any notes issued in the future under the Prudential Shelf Agreement and MetLife Shelf Agreement in the future will continue to be of equal ranking with indebtedness under our Credit Agreement. 11. PENSION AND OTHER POSTRETIREMENT BENEFITS We have a noncontributory defined benefit pension plan covering substantially all employees first hired prior to July 1, 2015 after the completion of one year of service and 1,000 hours of service. The plan provides retirement benefits based on an employee’s average earnings and years of service. These employees become 100% vested after three years of service, regardless of age. A supplemental benefit plan provides nonqualified benefits for compensation in excess of the IRS compensation limits applicable to the plan. Our plan funding policy is to make contributions provided that the total annual contributions will not be less than ERISA and the Pension Protection Act of 2006 minimums or greater than the maximum tax-deductible amount, to review the contribution and funding strategy on a regular basis, and to allow discretionary contributions to be made by us from time to time. The assets of the defined benefit pension plan are invested primarily in fixed income investments and equity securities. We pay nonqualified pension benefits when they are due according to the terms of the supplemental benefit plan. We provide certain postretirement healthcare and life insurance benefits to retired employees. Substantially all of our employees hired or rehired prior to 2014 may become eligible for postretirement medical benefits if they reach the age and service requirements of the retiree medical plan and retire on a pension (except a deferred pension) under the defined benefit pension plan. Medical benefits are self-insured and claims are administered through an insurance company. The cost of coverage is determined based on the annual projected plan costs. The participant's premium or cost is determined based on Company guidelines. Postretirement life insurance benefits are insured through an insurance company. We fund postretirement benefits as incurred, and accordingly, there were no assets held in the postretirement benefits plan at December 31, 2016 and 2015. The following table sets forth information regarding the funded status of our pension and other postretirement benefits as of December 31, 2016 and 2015: (1) Includes $1,634 and $1,537 paid from our assets for unfunded nonqualified benefits in fiscal years 2016 and 2015, respectively. The accumulated benefit obligation for our defined benefit pension plan was $592,810 and $551,662 at December 31, 2016 and 2015, respectively. Amounts recognized in the consolidated balance sheet for the years ended December 31 consist of the following: Amounts recognized in accumulated other comprehensive loss for the years ended December 31, net of tax, consist of the following: Amounts estimated to be amortized from accumulated other comprehensive loss into net periodic benefit costs in 2017, net of tax, consist of the following: Weighted-average assumptions used to determine the actuarial present value of the pension and postretirement benefit obligations as of December 31 are: For measurement of the postretirement benefit obligation, a 6.0% annual rate of increase in the per capita cost of covered healthcare benefits was assumed at December 31, 2016. This rate is assumed to decline to 5.0% at January 1, 2019 and remain at that level thereafter. A one percent increase or decrease in the assumed healthcare cost trend rate would not have had a material effect on the postretirement benefit obligations as of December 31, 2016 and 2015. The net periodic benefit cost for the years ended December 31, 2016, 2015, and 2014 included the following components: Weighted-average assumptions used to determine net periodic benefit cost for the years ended December 31 were: The expected return on plan assets assumption for the defined benefit pension plan is a long-term assumption and was determined after evaluating input from both the plan’s actuary and pension fund investment advisors, consideration of historical rates of return on plan assets, and anticipated current and long-term rates of return on the various classes of assets in which the plan invests. For measurement of the postretirement benefits net periodic cost, a 6.5% annual rate of increase in per capita cost of covered healthcare benefits was assumed for 2016. The rate was assumed to decline to 5.0% in 2019 and to remain at that level thereafter. A one percent increase or decrease in the assumed healthcare cost trend rate would not have had a material effect on 2016, 2015 and 2014 net periodic benefit cost. We expect to make contributions totaling $60,000 to our defined benefit pension plan and fund $1,589 for non-qualified benefits during 2017. Estimated future defined benefit pension and other postretirement benefit plan payments to plan participants for the years ending December 31 are as follows: The investment objective of our defined benefit pension plan is to ensure that there are sufficient assets to fund regular pension benefits payable to employees over the long-term life of the plan. Our defined benefit pension plan seeks to allocate plan assets in a manner that is closely duration-matched with the actuarial projected cash flow liabilities, consistent with prudent standards for preservation of capital, tolerance of investment risk, and maintenance of liquidity. Assets of the qualified pension plan are held by Comerica Bank (the "Trustee"). Our defined benefit pension plan utilizes a liability-driven investment (“LDI”) approach to help meet these objectives. The LDI strategy employs a structured fixed-income portfolio designed to reduce volatility in the plan's future funding requirements and funding status. This is accomplished by using a blend of corporate fixed-income securities, long duration government, and quasi-governmental, as well as appropriate levels of equity and alternative investments designed to optimize the plan's liability hedge ratio. In practice, the value of an asset portfolio constructed primarily of fixed income securities is inversely correlated to changes in market interest rates, at least partially offsetting changes in the value of the pension benefit obligation caused by changes in the interest rate used to discount plan liabilities. Asset allocation information for the defined benefit pension plan at December 31, 2016 and 2015 is as follows: The following is a description of the valuation methodologies used for assets held by the defined benefit pension plan measured at fair value: Equity securities - U.S. Equity securities - U.S. consist of investments in U.S. corporate stocks and U.S. equity mutual funds. U.S. equity mutual funds include publicly traded mutual funds and a bank collective fund for ERISA plans. U.S. corporate stocks and U.S. equity mutual funds are primarily large-capitalization stocks (defined as companies with market capitalization of more than $10 billion). U.S. corporate stocks and publicly traded mutual funds are valued at the closing price reported on the active public market in which the individual securities are traded and are classified as Level 1. The bank collective fund for ERISA plans is valued at the net asset value ("NAV") of units of the fund. The NAV, as provided by the Trustee, is used as a practical expedient to estimate fair value. The NAV is based on the fair value of the underlying investments held by the fund. Equity securities - International Equity securities - International consist of investments in international corporate stocks and publicly traded mutual funds and are both primarily investments within developed and emerging markets. Both are valued at the closing price reported on the active public market in which the individual securities are traded and are classified as Level 1. Fixed income investments - U.S. Fixed income investments - U.S. consist of U.S. corporate bonds, government and government agency bonds, as well as a publicly traded mutual fund and commingled funds, both of which invest in corporate and government debt securities within the U.S. U.S. corporate bonds, government and government agency bonds, and the publicly traded mutual fund are valued at the closing price reported on the active market in which they are traded and thus are classified as Level 1. The commingled funds are valued at the NAV of units of the fund. The NAV, as provided by the Trustee, is used as a practical expedient to estimate fair value. The NAV is based on the fair value of the underlying investments held by the fund. Fixed income investments - International Fixed income investments - International consist of international corporate bonds. International corporate bonds are valued at the closing price reported on the active market in which they are traded and thus are classified as Level 1. Absolute return Absolute return consists of investments in various hedge funds structured as fund-of-funds (defined as a single fund that invests in multiple funds). The hedge funds use various investment strategies in an attempt to generate non-correlated returns. A fund-of-funds is designed to help diversify and reduce the risk of the overall portfolio. The hedge funds are valued at the NAV of units of the fund. The NAV, as provided by the Trustee, is used as a practical expedient to estimate fair value. The NAV is based on the fair value of the underlying investments held by the fund. Audited financial statements are produced on an annual basis for the hedge funds. Real assets Real assets consists of natural resource fund (oil, gas and forestry) and a real estate investment trust ("REIT"). The natural resource fund is owned by a limited partnership ("LP"). The LP is generally characterized as requiring a long-term commitment with limited liquidity. The value of the LP is not publicly available and thus, is classified as Level 3. The REIT is a commingled trust. The commingled trust is valued at the NAV of units of the trust. The NAV, as provided by the Trustee, is used as a practical expedient to estimate fair value. The NAV is based on the fair value of the underlying investments held by the fund. Audited financial statements are produced on an annual basis for the LP and REIT. Private equity Private equity is an asset class that is generally characterized as requiring long-term commitments and where liquidity is typically limited. Private equity does not have an actively traded market with readily observable prices. The investments are limited partnerships structured as fund-of-funds. The investments are diversified across typical private equity strategies including: buyouts, co-investments, secondary offerings, venture capital, and special situations. Valuations are developed using a variety of proprietary model methodologies. Valuations may be derived from publicly available sources as well as information obtained from each fund's general partner based upon public market conditions and returns. All private equity investments are classified as Level 3. Audited financial statements are produced on an annual basis for the private equity investments. Short-term investments Short-term investments consist of cash and cash equivalents in a short-term fund which is valued at the NAV of units of the fund. The NAV, as provided by the Trustee, is used as a practical expedient to estimate fair value. The NAV is based on the fair value of the underlying investments held by the fund. The methods described above may produce fair value calculations that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we believe our defined benefit pension plan valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. There have been no changes in the methodologies for determining fair value at December 31, 2016 or 2015. The following tables set forth, by level within the fair value hierarchy, the defined benefit pension plan assets measured at fair value as of December 31, 2016 and 2015: The tables below set forth a summary of changes in the fair value of the defined benefit pension plan's Level 3 assets for the years ended December 31, 2016 and 2015: 12. PROFIT SHARING AND SAVINGS PLAN We provide a defined contribution profit sharing and savings plan covering substantially all of our eligible employees with an individual account for each participant. Employees may make voluntary before-tax and/or after-tax contributions, ranging from 2% to 50% of pay, to the savings portion of the plan subject to limitations imposed by federal tax law, ERISA, and the Pension Protection Act of 2006. Effective July 1, 2015, all employees hired or rehired after July 1, 2015, are eligible to receive a Company matching contribution beginning the first month after the completion of one year of service and 1,000 hours of service. The Company match is equal to 50% of an eligible employee's before-tax contribution, up to 6% of pay, with a maximum match of 3%. The matching contribution expense recognized by us was $363 for the year ended December 31, 2016. Annual contributions made by us to the profit-sharing portion of the plan are determined by the Board of Directors at their discretion, are generally based on the profitability of the Company. Expense recognized by us under the profit-sharing portion of the plan was $41,365, $40,020, and $56,709 for the years ended December 31, 2016, 2015 and 2014, respectively. 13. COMMITMENTS AND CONTINGENCIES Rental expense was $25,133, $22,685, and $21,891 in 2016, 2015, and 2014, respectively. Future minimum rental payments required under operating leases that have either initial or remaining noncancelable lease terms in excess of one year as of December 31, 2016 are as follows: Graybar and our subsidiaries are subject to various claims, disputes, and administrative and legal matters incidental to our past and current business activities. As a result, contingencies arise resulting from an existing condition, situation, or set of circumstances involving an uncertainty as to the realization of a possible loss. Estimated loss contingencies are accrued only if the loss is probable and the amount of the loss can be reasonably estimated. With respect to a particular loss contingency, it may be probable that a loss has occurred but the estimate of the loss is a wide range. If we deem an amount within the range to be a better estimate than any other amount within the range, that amount will be accrued. However, if no amount within the range is a better estimate than any other amount, the minimum amount of the range is accrued. While we believe that none of these claims, disputes, administrative, and legal matters will have a material adverse effect on our financial position, these matters are uncertain and we cannot at this time determine whether the financial impact, if any, of these matters will be material to our results of operations in the period in which such matters are resolved or a better estimate becomes available. 14. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The components of accumulated other comprehensive income (loss) as of December 31 are as follows: The following table represents amounts reclassified from accumulated other comprehensive income (loss) for the years ended December 31, 2016 and 2015: The following table represents the activity included in accumulated other comprehensive income (loss) for the years ended December 31, 2016 and 2015: 15. ACQUISITIONS On July 1, 2016, we purchased Cape Electric, a regional distributor serving electrical contractors and large engineering construction firms, as well as industrial, institutional and utility customers, for approximately $59,946 in cash, net of cash acquired. The purchase price allocation resulted in $16,377 and $23,586 of tax deductible goodwill and other intangible assets, respectively. In April 2015, we acquired 100% of the outstanding capital stock of Advantage, which provides control and automation solutions to industrial users, OEMs and system integrators, for $18,093 in cash, net of cash acquired. The purchase price allocation resulted in $7,057 and $8,283 of tax deductible goodwill and other intangible assets, respectively. Since the date of acquisition, Cape Electric and Advantage results are reflected in our Consolidated Financial Statements. Pro forma results of these acquisitions were not material; therefore, they are not presented. 16. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following tables set forth selected quarterly financial data for the years ended December 31, 2016 and 2015: (A)All periods adjusted for a 5% stock dividend declared in December 2016. Prior to these adjustments, the average common shares outstanding for the first, second, third, and fourth quarters of 2016 were 16,537,536, 16,569,408, 16,573,041, and 16,558,984, respectively. (A)All periods adjusted for a 5% stock dividend declared in December 2016 and a 2.5% stock dividend declared in December 2015. Prior to these adjustments, the average common shares outstanding for the first, second, third, and fourth quarters of 2015 were 16,023,053, 15,986,695, 15,942,178, and 15,927,663, respectively.
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Based on the provided text, which appears to be fragments of a financial statement, here's a summary:
Revenue Recognition:
- Revenues primarily come from product sales
- Includes freight and handling charges
- Standard shipping terms are FOB shipping point (title transfers at shipment)
- Earn additional revenue from supply chain and logistics services
- Service revenue is less than 1% of total revenue
Financial Reporting:
- Uses estimates for financial reporting
- Actual results may differ from estimates
- Some reclassifications made to prior years' financial information to ensure consistency
The text seems incomplete and lacks specific numerical details about profits, losses, assets, liabilities, or expenses. A full financial statement would typically provide more comprehensive information about the company's financial performance.
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Claude
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ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM To the Partners of Atlas Resources Series 28-2010 L.P. We have audited the accompanying balance sheets of Atlas Resources Series 28-2010 L.P. (a Delaware Limited Partnership) (the “Partnership”) as of December 31, 2016 and 2015, and the related statements of operations, comprehensive loss, changes in partners’ capital, and cash flows for each of the two years in the period ended December 31, 2016. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States) and in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Partnership’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Atlas Resources Series 28-2010 L.P. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As disclosed in Note 1 to the financial statements, as of December 31, 2016, the Partnership’s Managing General Partner was in violation of certain debt covenants under its credit agreements and there are uncertainties regarding its liquidity and capital resources. The ability of the Managing General Partner to continue as a going concern also raises substantial doubt regarding the Partnership’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ GRANT THORNTON LLP Cleveland, Ohio April 17, 2017 ATLAS RESOURCES SERIES 28-2010 L.P. BALANCE SHEETS DECEMBER 31, 2016 AND 2015 See accompanying notes to financial statements. ATLAS RESOURCES SERIES 28-2010 L.P. STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2016 AND 2015 See accompanying notes to financial statements. ATLAS RESOURCES SERIES 28-2010 L.P. STATEMENTS OF COMPREHENSIVE LOSS YEARS ENDED DECEMBER 31, 2016 AND 2015 See accompanying notes to financial statements. ATLAS RESOURCES SERIES 28-2010 L.P. STATEMENTS OF CHANGES IN PARTNERS’ CAPITAL YEARS ENDED DECEMBER 31, 2016 AND 2015 See accompanying notes to financial statements. ATLAS RESOURCES SERIES 28-2010 L.P. STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2016 AND 2015 See accompanying notes to financial statements. ATLAS RESOURCES SERIES 28-2010 L.P. NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 2016 AND 2015 NOTE 1-BASIS OF PRESENTATION Atlas Resources Series 28-2010 L.P. (the “Partnership”) is a Delaware limited partnership, formed on April 1, 2010 with Atlas Resources, LLC serving as its Managing General Partner and Operator (“Atlas Resources” or the “MGP”). Atlas Resources is an indirect subsidiary of Titan Energy, LLC (“Titan”). Titan is an independent developer and producer of natural gas, crude oil, and natural gas liquids, with operations in basins across the United States. Titan also sponsors and manages tax-advantaged investment partnerships, in which it co-invests to finance a portion of its natural gas and oil production activities. As discussed further below, Titan is the successor to the business and operations of Atlas Resource Partners, L.P. (“ARP”), a Delaware limited partnership organized in 2012. Unless the context otherwise requires, references below to “the Partnership,” “we,” “us,” “our” and “our company”, refer to Atlas Resources Series 28-2010 L.P. Atlas Energy Group, LLC (“Atlas Energy Group”; OTCQX: ATLS) is a publicly traded company and manages Titan and the MGP through a 2% preferred member interest in Titan. The Partnership has drilled and currently operates wells located in Pennsylvania, Indiana and Colorado. We have no employees and rely on our MGP for management, which in turn, relies on Atlas Energy Group for administrative services. The Partnership’s operating cash flows are generated from its wells, which produce natural gas. Produced natural gas is then delivered to market through affiliated and/or third-party gas gathering systems. The Partnership intends to produce its wells until they are depleted or become uneconomical to produce at which time they will be plugged and abandoned or sold. The Partnership does not expect to drill additional wells and expects no additional funds will be required for drilling. The economic viability of the Partnership’s production is based on a variety of factors including proved developed reserves that it can expect to recover through existing wells with existing equipment and operating methods or in which the cost of additional required extraction equipment is relatively minor compared to the cost of a new well; and through currently installed extraction equipment and related infrastructure which is operational at the time of the reserves estimate (if the extraction is by means not involving drilling, completing or reworking a well). There are numerous uncertainties inherent in estimating quantities of proven reserves and in projecting future net revenues. The prices at which the Partnership’s natural gas will be sold are uncertain and the Partnership is not guaranteed a specific price for the sale of its production. Changes in natural gas prices have a significant impact on the Partnership’s cash flow and the value of its reserves. Lower natural gas prices may not only decrease the Partnership’s revenues, but also may reduce the amount of natural gas that the Partnership can produce economically. ARP Restructuring and Chapter 11 Bankruptcy Proceedings On July 25, 2016, ARP and certain of its subsidiaries, including the MGP, and Atlas Energy Group, solely with respect to certain sections thereof, entered into a restructuring support agreement with ARP’s lenders (the “Restructuring Support Agreement”) to support ARP’s restructuring that reduced debt on its balance sheet (the “Restructuring”) pursuant to a pre-packaged plan of reorganization (the “Plan”). On July 27, 2016, ARP and certain of its subsidiaries, including the MGP, filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code (“Chapter 11”) in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). The cases commenced thereby were being jointly administered under the caption “In re: ATLAS RESOURCE PARTNERS, L.P., et al.” ARP and the MGP operated the Partnership’s businesses as “debtors in possession” under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of Chapter 11 and the orders of the Bankruptcy Court. Under the Plan, all suppliers, vendors, employees, royalty owners, trade partners and landlords were unimpaired and were satisfied in full in the ordinary course of business, and the MGP’s existing trade contracts and terms were maintained. To assure ordinary course operations, ARP and the MGP obtained interim approval from the Bankruptcy Court on a variety of “first day” motions, including motions seeking authority to use cash collateral on a consensual basis, pay wages and benefits for individuals who provide services to the Partnership, and pay vendors, oil and gas obligations and other creditor claims in the ordinary course of business. The Partnership was not a party to the Restructuring Support Agreement. The ARP Restructuring did not materially impact the MGP’s ability to perform as the managing general partner and operator of the Partnership’s operations. In June 2016, the MGP transferred $380,900 of funds to the Partnership based on projected monthly distributions to its limited partners over the next several months to ensure accessible distribution funding coverage in accordance with the Partnership’s operations and partnership agreements in the event the MGP experienced a prolonged restructuring period as the MGP performs all administrative and management functions for the Partnership. As of December 31, 2016, the Partnership has used these funds for distributions. On July 26, 2016, the MGP adopted certain amendments to our partnership agreement, in accordance with the MGP’s ability to amend our partnership agreement to cure an ambiguity in or correct or supplement any provision of our partnership agreement as may be inconsistent with any other provision, to provide that bankruptcy and insolvency events, such as the MGP’s Chapter 11 filing, with respect to the managing general partner would not cause the managing general partner to cease to serve as the managing general partner of the Partnership nor cause the termination of the Partnership. Atlas Energy Group was not a party to the ARP Restructuring. Atlas Energy Group remains controlled by the same ownership group and management team and thus, the ARP Restructuring did not have a material impact on the ability of Atlas Energy Group management to operate ARP or the other Atlas Energy Group businesses. On August 26, 2016, an order confirming ARP’s Plan was entered by the Bankruptcy Court. On September 1, 2016, ARP’s Plan became effective and ARP emerged as Titan. Liquidity, Capital Resources and Ability to Continue as a Going Concern The Partnership is generally limited to the amount of funds generated by the cash flow from its operations to fund its obligations and make distributions, if any, to its partners. Historically, there has been no need to borrow funds from the MGP to fund operations as the cash flow from the Partnership’s operations had been adequate to fund its obligations and distributions to its partners. Prices for oil and natural gas began to decline significantly during the fourth quarter of 2014 and continued to remain low in 2016. These lower commodity prices have negatively impacted the Partnership’s revenues, earnings and cash flows. Sustained low commodity prices will have a material and adverse effect on the Partnership’s liquidity position and may make it uneconomical for the Partnership to produce its wells until they are depleted as the Partnership originally intended. In addition, the Partnership has experienced significant downward revisions of its natural gas and oil reserves volumes and values due to the declines in commodity prices. The MGP continues to implement various cost saving measures to reduce the Partnership’s operating and general and administrative costs, including renegotiating contracts with contractors, suppliers and service providers, reducing the number of staff and contractors and deferring and eliminating discretionary costs. The MGP will continue to be strategic in managing the Partnership’s cost structure and, in turn, liquidity to meet its operating needs. To the extent commodity prices remain low or decline further, or the Partnership experiences other disruptions in the industry, the Partnership’s ability to fund its operations and make distributions may be further impacted, and could result in the liquidation of the Partnership’s operations. The uncertainties of Titan’s and the MGP’s liquidity and capital resources (as further described below) raise substantial doubt about Titan’s and the MGP’s ability to continue as a going concern, which also raises substantial doubt about the Partnership’s ability to continue as a going concern. If Titan is unsuccessful in taking actions to resolve its liquidity issues (as further described below), the MGP’s ability to continue the Partnership’s operations may be further impacted and may make it uneconomical for the Partnership to produce its wells until they are depleted as originally intended. If the Partnership is not able to continue as a going concern, the Partnership will liquidate. If the Partnership’s operations are liquidated, a valuation of the Partnership’s assets and liabilities would be determined by an independent expert in accordance with the partnership agreement. It is possible that based on such determination, the Partnership would not be able to make any liquidation distributions to its limited partners. A liquidation could result in the transfer of the post-liquidation assets and liabilities of the Partnership to the MGP and would occur without any further contributions from or distributions to the limited partners. The financial statements have been prepared on a going concern basis of accounting, which contemplates continuity of operations, realization of assets, and satisfaction of liabilities and commitments in the normal course of business. The financial statements do not include any adjustments that might result from the outcome of the going concern uncertainty. If the Partnership cannot continue as a going concern, adjustments to the carrying values and classification of the Partnership’s assets and liabilities and the reported amounts of income and expenses could be required and could be material. MGP’s Liquidity, Capital Resources, and Ability to Continue as a Going Concern The MGP’s primary sources of liquidity are cash generated from operations, capital raised through its drilling partnership program, and borrowings under Titan’s credit facilities. The MGP’s primary cash requirements are operating expenses, payments to Titan for debt service including interest, and capital expenditures. The MGP has historically funded its operations, acquisitions and cash distributions primarily through cash generated from operations, amounts available under Titan’s credit facilities and equity and debt offerings. The MGP’s future cash flows are subject to a number of variables, including oil and natural gas prices. Prices for oil and natural gas began to decline significantly during the fourth quarter of 2014 and continued to remain low in 2016. These lower commodity prices have negatively impacted the MGP’s revenues, earnings and cash flows. Sustained low commodity prices could have a material and adverse effect on the MGP’s liquidity position. In addition, challenges with the MGP’s ability to raise capital through its drilling partnership program, either as a result of downturn in commodity prices or other difficulties affecting the fundraising channel, have negatively impacted Titan’s and the MGP’s ability to remain in compliance with the covenants under its credit facilities. Titan was not in compliance with certain of the financial covenants under its credit facilities as of December 31, 2016, as well as the requirement to deliver audited financial statements without a going concern qualification. Titan and the MGP do not currently have sufficient liquidity to repay all of Titan’s outstanding indebtedness, and as a result, there is substantial doubt regarding Titan’s and the MGP’s ability to continue as a going concern. Titan expects to finalize an amendment to its first lien credit facility on April 19, 2017 in an attempt to ameliorate some of its liquidity concerns, subject to receiving the remaining lenders’ consent. The amendment is expected to provide for, among other things, waivers of non-compliance, increases in certain financial covenant ratios and scheduled decreases in Titan’s borrowing base. In addition, Titan expects that it will sell a significant amount of non-core assets in the near future to comply with the requirements of its expected first lien credit facility amendment and to attempt to enhance its liquidity. The lenders’ waivers are subject to revocation in certain circumstances, including the exercise of remedies by junior lenders (including pursuant to Titan’s second lien credit facility), the failure to extend the standstill period under the intercreditor agreement at least 15 business days prior to its expiration, and the occurrence of additional events of default under the first lien credit facility. Unless Titan is able to obtain an amendment or waiver, the lenders under Titan’s second lien credit facility may declare a default with respect to Titan’s failure to comply with financial covenants and deliver audited financial statements without a going concern qualification. However, pursuant to the intercreditor agreement, the lenders under Titan’s second lien credit facility are restricted in their ability to pursue remedies for 180 days from any such notice of default. As of the date hereof, the lenders under Titan’s second lient credit facility have not yet given notice of any default. Titan continually monitors the capital markets and the MGP’s capital structure and may make changes to its capital structure from time to time, with the goal of maintaining financial flexibility, preserving or improving liquidity, strengthening its balance sheet, meeting its debt service obligations and/or achieving cost efficiency. For example, Titan could pursue options such as refinancing, restructuring or reorganizing its indebtedness or capital structure or seek to raise additional capital through debt or equity financing to address its liquidity concerns and high debt levels. Titan is evaluating various options, but there is no certainty that Titan will be able to implement any such options, and cannot provide any assurances that any refinancing or changes in its debt or equity capital structure would be possible or that additional equity or debt financing could be obtained on acceptable terms, if at all, and such options may result in a wide range of outcomes for Titan’s stakeholders. In addition, Titan expects that it will sell a significant amount of non-core assets in the near future to comply with the requirements of its expected first lien credit facility amendment and to attempt to enhance its liquidity. However, there is no guarantee that the proceeds Titan receives for any asset sale will satisfy the repayment requirements under its first lien credit facility. NOTE 2-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates The preparation of the Partnership’s financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities that exist at the date of the Partnership’s financial statements, as well as the reported amounts of revenue and costs and expenses during the reporting periods. The Partnership’s financial statements are based on a number of significant estimates, including revenue and expense accruals, depletion, depreciation and amortization, asset impairments, fair value of derivative instruments, and the probability of forecasted transactions. The oil and gas industry principally conducts its business by processing actual transactions as many as 60 days after the month of delivery. Consequently, the most recent two months’ financial results were recorded using estimated volumes and contract market prices. Actual results could differ from those estimates. Receivables Accounts receivable trade-affiliate on the balance sheets consist solely of the trade accounts receivable associated with the Partnership’s operations. In evaluating the realizability of its accounts receivable, the MGP performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current creditworthiness, as determined by management’s review of the credit information. The Partnership extends credit on sales on an unsecured basis to many of their customers. At December 31, 2016 and 2015, the Partnership had recorded no allowance for uncollectible accounts receivable on its balance sheets. Asset retirement receivable - affiliate on the balance sheets consist solely of the net amount withheld from distributions for the purpose of establishing a fund to cover the estimated costs of plugging and abandoning the Partnership’s wells less any amounts used for the plugging and abandonment of the Partnership’s wells. As amounts are withheld, they are paid to the MGP and held until the Partnership’s wells are plugged and abandoned, at which time, the funds are used to cover the actual expenditures incurred. The total amount withheld from distributions will not exceed the MGP’s estimate of the costs to plug and abandon the Partnership’s wells. The following is a reconciliation of the Partnerships’ asset retirement receivable - affiliate for the years indicated: Gas Properties Gas properties are stated at cost. Maintenance and repairs that generally do not extend the useful life of an asset for two years or more through the replacement of critical components are expensed as incurred. Major renewals and improvements that generally extend the useful life of an asset for two years or more through the replacement of critical components are capitalized. The Partnership follows the successful efforts method of accounting for gas producing activities. The Partnership’s depletion expense is determined on a field-by-field basis using the units-of-production method. Depletion rates for lease, well and related equipment costs are based on proved developed reserves associated with each field. Depletion rates are determined based on reserve quantity estimates and the capitalized cost of developed producing properties. The Partnership also considers the estimated salvage value in the calculation of depletion. Upon the sale or retirement of a complete field of a proved property, the Partnership eliminates the cost from the property accounts and the resultant gain or loss is reclassified to the Partnership’s statements of operations. Upon the sale or retirement of an individual well, the Partnership reclassifies the costs associated with the well and credits the proceeds to accumulated depletion and impairment within its balance sheets. Impairment of Long-Lived Assets The Partnership reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If it is determined that an asset’s estimated future cash flows will not be sufficient to recover its carrying amount, an impairment charge will be recorded to reduce the carrying amount of that asset to its estimated fair value if such carrying amount exceeds the fair value (see Note 4). The review of the Partnership’s gas properties is done on a field-by-field basis by determining if the historical cost of proved properties less the applicable accumulated depletion and impairment is less than the estimated expected undiscounted future cash flows including salvage. The expected future cash flows are estimated based on the Partnership’s plans to continue to produce and develop proved reserves. Expected future cash flow from the sale of the production of reserves is calculated based on estimated future prices. The Partnership estimates prices based upon current contracts in place, adjusted for basis differentials and market related information, including published futures prices. The estimated future level of production is based on assumptions surrounding future prices and costs, field decline rates, market demand and supply and the economic and regulatory climates. If the carrying value exceeds the expected future cash flows, an impairment loss is recognized for the difference between the estimated fair market value and the carrying value of the assets. The determination of natural gas reserve estimates is a subjective process, and the accuracy of any reserve estimate depends on the quality of available data and the application of engineering and geological interpretation and judgment. Estimates of economically recoverable reserves and future net cash flows depend on a number of variable factors and assumptions that are difficult to predict and may vary considerably from actual results. In addition, reserve estimates for wells with limited or no production history are less reliable than those based on actual production. Estimated reserves are often subject to future revisions, which could be substantial, based on the availability of additional information which could cause the assumptions to be modified. The Partnership cannot predict what reserve revisions may be required in future periods. Derivative Instruments The Partnership’s MGP entered into certain financial contracts to manage the Partnership’s exposure to movement in commodity prices (See Note 6). The derivative instruments recorded on the balance sheets were measured as either an asset or liability at fair value. Changes in a derivative instrument’s fair value are recognized currently in the Partnership’s statements of operations unless specific hedge accounting criteria are met. On January 1, 2015, the Partnership discontinued hedge accounting through de-designation for all of its existing commodity derivatives which were qualified as hedges. As such, subsequent changes in fair value after December 31, 2014 of these derivatives are recognized immediately within gain (loss) on mark-to-market derivatives in the Partnership’s statements of operations, while the fair values of the instruments recorded in accumulated other comprehensive income as of December 31, 2014 were reclassified to the statements of operations in the periods in which the respective derivative contracts settled. Prior to discontinuance of hedge accounting, the fair value of these commodity derivative instruments was recognized in accumulated other comprehensive income (loss) within partners’ capital on the Partnership’s balance sheets and reclassified to the Partnership’s statements of operations at the time the originally hedged physical transactions affected earnings. Asset Retirement Obligations The Partnership recognizes an estimated liability for the plugging and abandonment of its gas wells and related facilities (See Note 5). The Partnership recognizes a liability for its future asset retirement obligations in the current period if a reasonable estimate of the fair value of that liability can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. Income Taxes The Partnership is not subject to U.S. federal and most state income taxes. The partners of the Partnership are liable for income tax in regard to their distributive share of the Partnership’s taxable income. Such taxable income may vary substantially from net income reported in the financial statements. The federal and state income taxes related to the Partnership were immaterial to the financial statements and are recorded in pre-tax income on a current basis only. Accordingly, no federal or state deferred income tax has been provided for in the financial statements. The Partnership evaluates tax positions taken or expected to be taken in the course of preparing the Partnership’s tax returns and disallows the recognition of tax positions not deemed to meet a “more-likely-than-not” threshold of being sustained by the applicable tax authority. The Partnership’s management does not believe it has any tax positions taken within its financial statements that would not meet this threshold. The Partnership’s policy is to reflect interest and penalties related to uncertain tax positions, when and if they become applicable. However, the Partnership has not recognized any potential interest or penalties in its financial statements as of December 31, 2016 and 2015. The Partnership files Partnership Returns of Income in the U.S. and various state jurisdictions. With few exceptions, the Partnership is no longer subject to income tax examinations by major tax authorities for years prior to 2012. The Partnership is not currently being examined by any jurisdiction and is not aware of any potential examinations as of December 31, 2016. Environmental Matters The Partnership is subject to various federal, state, and local laws and regulations relating to the protection of the environment. Management has established procedures for the ongoing evaluation of the Partnership’s operations, to identify potential environmental exposures and to comply with regulatory policies and procedures. Environmental expenditures that relate to current operations are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations and do not contribute to current or future revenue generation are expensed. Liabilities are recorded when environmental assessments and/or clean-ups are probable, and the costs can be reasonably estimated. The Partnership maintains insurance which may cover in whole or in part certain environmental expenditures. The Partnership had no environmental matters requiring specific disclosure or requiring the recognition of a liability for the years ended December 31, 2016 and 2015. Concentration of Credit Risk The Partnership sells natural gas under contracts to various purchasers in the normal course of business. For the year ended December 31, 2016, the Partnership had two customers that individually accounted for approximately 73% and 22% of the Partnership’s natural gas revenues, excluding the impact of all financial derivative activity. For the year ended December 31, 2015, the Partnership had two customers that individually accounted for approximately 53% and 43%, of the Partnership’s natural gas combined revenues, excluding the impact of all financial derivative activity. Revenue Recognition The Partnership generally sells natural gas at prevailing market prices. Generally, the Partnership’s sales contracts are based on pricing provisions that are tied to a market index, with certain fixed adjustments based on proximity to gathering and transmission lines and the quality of its natural gas. Generally, the market index is fixed two business days prior to the commencement of the production month. Revenue and the related accounts receivable are recognized when produced quantities are delivered to a custody transfer point, persuasive evidence of a sales arrangement exists, the rights and responsibility of ownership pass to the purchaser upon delivery, collection of revenue from the sale is reasonably assured and the sales price is fixed or determinable. Revenues from the production of natural gas in which the Partnership has an interest with other producers, are recognized on the basis of its percentage ownership of the working interest and/or overriding royalty. The MGP and its affiliates perform all administrative and management functions for the Partnership including billing revenues and paying expenses. Accounts receivable trade-affiliate on the Partnership’s balance sheets includes the net production revenues due from the MGP. The Partnership accrues unbilled revenue due to timing differences between the delivery of natural gas and condensate and the receipt of a delivery statement. These revenues are recorded based upon volumetric data from the Partnership’s records and management estimates of the related commodity sales and transportation and compression fees which are, in turn, based upon applicable product prices. The Partnership had unbilled revenues at December 31, 2016 and 2015 of $858,800 and $750,000, respectively, which were included in accounts receivable trade-affiliate within the Partnership’s balance sheets. Loss on Abandonment of Well During the year ended December 31, 2015, the Partnership plugged and abandoned the remaining Michigan well. The remaining net asset value recorded in the Partnership’s gas properties prior to plugging and abandonment was $300. This net asset value was written off as part of the net loss on abandonment of well in the Partnership’s statement of operations for the year ended December 31, 2015 and also removed from gas properties on the Partnership’s balance sheet. Plugging and abandonment costs incurred through December 31, 2015 total $557,800, of which $269,600 had been previously recorded as an asset retirement obligation, resulting in a net loss on abandonment of well of $288,200. Comprehensive Income (Loss) Comprehensive income (loss) includes net income (loss) and all other changes in the equity of a business during a period from transactions and other events and circumstances from non-owner sources that, under U.S. GAAP, have not been recognized in the calculation of net income (loss). These changes, other than net income (loss), are referred to as “other comprehensive income (loss)” on the Partnership’s financial statements and, at December 31, 2016, only include changes in the fair value of unsettled derivative contracts which, prior to January 1, 2015, were accounted for as cash flow hedges (See Note 6). The Partnership does not have any other type of transaction which would be included within other comprehensive income (loss). Recently Issued Accounting Standards In August 2014, the FASB updated the accounting guidance related to the evaluation of whether there is substantial doubt about an entity’s ability to continue as a going concern. The updated accounting guidance requires an entity’s management to evaluate whether there are conditions or events that raise substantial doubt about its ability to continue as a going concern within one year from the date the financial statements are issued and provide footnote disclosures, if necessary. The updated guidance is effective as of December 15, 2016 and the Partnership is currently in the process of determining the impact of providing the enhanced disclosures, as applicable, within its financial statements. In May 2014, the FASB updated the accounting guidance related to revenue recognition. The updated accounting guidance provides a single, contract-based revenue recognition model to help improve financial reporting by providing clearer guidance on when an entity should recognize revenue, and by reducing the number of standards to which an entity has to refer. In July 2015, the FASB voted to defer the effective date by one year to December 15, 2017 for annual reporting periods beginning after that date. The updated accounting guidance provides companies with alternative methods of adoption. We are evaluating the impact of this updated accounting guidance on our financial statements. This accounting guidance will require that our revenue recognition policy disclosures include further detail regarding our performance obligations as to the nature, amount, timing, and estimates of revenue and cash flows generated from our contracts with customers. We are still in the process of determining whether or not we will use the retrospective method or the modified retrospective approach to implementation. NOTE 3-PARTICIPATION IN REVENUES AND COSTS Working Interest The Partnership Agreement establishes that revenues and expenses will be allocated to the MGP and limited partners based on their ratio of capital contributions to total contributions (“working interest”). The MGP is also provided an additional working interest of 10% as provided in the Partnership Agreement. Due to the time necessary to complete drilling operations and accumulate all drilling costs, estimated working interest percentage ownership rates are utilized to allocate revenues and expense until the wells are completely drilled and turned on-line into production. Once the wells are completed, the final working interest ownership of the partners is determined and any previously allocated revenues based on the estimated working interest percentage ownership are adjusted to conform to the final working interest percentage ownership. At December 31, 2016 and 2015, $0 and $5,600, respectively, of net earnings resulting from the working interest adjustment were reclassified from the MGP’s capital account to the limited partners’ capital account. The MGP and the limited partners generally participated in revenues and costs in the following manner: (1) Subject to the MGP’s subordination obligation, substantially all partnership revenues will be shared in the same percentage as capital contributions are to the total partnership capital contributions, except that the MGP will receive an additional 10% of the partnership revenues. (2) These costs will be charged to the partners in the same ratio as the related production revenues are credited. NOTE 4-PROPERTY, PLANT AND EQUIPMENT The following is a summary of natural gas properties at the dates indicated: The Partnership recorded depletion expense on natural gas properties of $1,898,700 and $2,361,600 for the years ended December 31, 2016 and 2015, respectively. Upon the sale or retirement of a complete or partial unit of a proved property, the cost is eliminated from the property accounts, and the resultant gain or loss is reclassified to accumulated depletion. During the years ended December 31, 2016 and 2015, the Partnership recognized $212,400 and $6,420,500, respectively, of impairment related to gas properties. These impairments relate to the carrying amount of these gas properties being in excess of the Partnership’s estimate of their fair value at December 31, 2016 and 2015. At December 31, 2016, the MGP redetermined estimated salvage values to be lower than previous estimates. This redetermination resulted in the impairment of gas and oil properties. At December 31, 2015, the estimate of fair value of these gas properties was impacted by, among other factors, the deterioration of natural gas prices at the date of measurement. NOTE 5-ASSET RETIREMENT OBLIGATIONS The Partnership recognizes an estimated liability for the plugging and abandonment of its gas wells and related facilities. It also recognizes a liability for future asset retirement obligations if a reasonable estimate of the fair value of that liability can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The estimated liability is based on the MGP’s historical experience in plugging and abandoning wells, estimated remaining lives of those wells based on reserve estimates, external estimates as to the cost to plug and abandon the wells in the future and federal and state regulatory requirements. The liability is discounted using an assumed credit-adjusted risk-free interest rate. Revisions to the liability could occur due to changes in cost estimates, remaining lives of the wells or if federal or state regulators enact new plugging and abandonment requirements. The Partnership has no assets legally restricted for purposes of settling asset retirement obligations. Except for the Partnership’s gas properties, the Partnership determined that there were no other material retirement obligations associated with tangible long-lived assets. The MGP’s historical practice and continued intention is to retain distributions from the limited partners as the wells within the Partnership near the end of their useful life. On a partnership-by-partnership basis, the MGP assesses its right to withhold amounts related to plugging and abandonment costs based on several factors including commodity price trends, the natural decline in the production of the wells and current and future costs. Generally, the MGP’s intention is to retain distributions from the limited partners as the fair value of the future cash flows of the limited partners’ interest approaches the fair value of the future plugging and abandonment cost. Upon the MGP’s decision to retain all future distributions to the limited partners of the Partnership, the MGP will assume the related asset retirement obligations of the limited partners. As of December 31, 2016 and 2015, the MGP withheld $110,000 and $40,400, respectively, of net production revenue for future plugging and abandonment costs. A reconciliation of the Partnership’s asset retirement obligation liability for well plugging and abandonment costs for the periods indicated is as follows: NOTE 6-DERIVATIVE INSTRUMENTS The MGP, on behalf of the Partnership, used a number of different derivative instruments, principally swaps and options, in connection with the Partnership’s commodity price risk management activities. Management used financial instruments to hedge forecasted commodity sales against the variability in expected future cash flows attributable to changes in market prices. Swap instruments are contractual agreements between counterparties to exchange obligations of money as the underlying commodities are sold. Under commodity-based swap agreements, the Partnership receives or pays a fixed price and receives or remits a floating price based on certain indices for the relevant contract period. To manage the risk of regional commodity price differences, the Partnership occasionally enters into basis swaps. Basis swaps are contractual arrangements that guarantee a price differential for a commodity from a specified delivery point price and the comparable national exchange price. For natural gas basis swaps, which have negative differentials to NYMEX, the Partnership receives or pays a payment from the counterparty if the price differential to NYMEX is greater or less than the stated terms of the contract. Commodity-based put option instruments are contractual agreements that require the payment of a premium and grant the purchaser of the put option the right, but not the obligation, to receive the difference between a fixed, or strike price, and a floating price based on certain indices for the relevant contract period, if the floating price is lower than the fixed price. The put option instrument sets a floor price for commodity sales being hedged. The Partnership entered into derivative contracts with various financial institutions, utilizing master contracts based upon the standards set by the International Swaps and Derivatives Association, Inc. These contracts allow for rights of offset at the time of settlement of the derivatives. Due to the right of offset, derivatives are recorded on the Partnership’s balance sheets as assets or liabilities at fair value on the basis of the net exposure to each counterparty. Potential credit risk adjustments are also analyzed based upon the net exposure to each counterparty. Premiums paid for purchased options are recorded on the Partnership’s balance sheets as the initial value of the options. The Partnership reflected net derivative assets on its balance sheets of $0 and $799,500 at December 31, 2016 and 2015, respectively. The following table summarizes the gains or losses recognized within the statements of operations for derivative instruments previously designated as cash flow hedges for the periods indicated: Put Premiums Payable During June 2012, a premium (“put premium”) was paid to purchase the contracts and will be allocated to natural gas production revenues generated over the contractual term of the purchased hedging instruments. At December 31, 2016 and 2015, the put premiums were recorded as short-term payables to affiliate of $0 and $162,700, respectively. The MGP has a secured hedge facility agreement with a syndicate of banks under which the Partnership has the ability to enter into derivative contracts to manage its exposure to commodity price movements. Under the MGP’s revolving credit facility the Partnership is required to utilize this secured hedge facility for future commodity risk management activity. The Partnership’s obligations under the facility are secured by mortgages on its gas properties and first priority security interests in substantially all of its assets and by a guarantee of the MGP. The MGP administers the commodity price risk management activity for the Partnership under the secured hedge facility. The secured hedge facility agreement contains covenants that limit the Partnership’s ability to incur indebtedness, grant liens, make loans or investments, make distributions if a default under the secured hedge facility agreement exists or would result from the distribution, merge into or consolidate with other persons, enter into commodity or interest rate swap agreements that do not conform to specified terms or that exceed specified amounts, or engage in certain asset dispositions including a sale of all or substantially all of its assets. As of December 31, 2016, only the Partnership’s natural gas swaps are included in the secured hedge facility. NOTE 7-FAIR VALUE OF FINANCIAL INSTRUMENTS The Partnership has established a hierarchy to measure its financial instruments at fair value, which requires it to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs represent market data obtained from independent sources, whereas unobservable inputs reflect the Partnership’s own market assumptions, which are used if observable inputs are not reasonably available without undue cost and effort. The hierarchy defines three levels of inputs that may be used to measure fair value: Level 1 - Unadjusted quoted prices in active markets for identical, unrestricted assets and liabilities that the reporting entity has the ability to access at the measurement date. Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset and liability or can be corroborated with observable market data for substantially the entire contractual term of the asset or liability. Level 3 - Unobservable inputs that reflect the entity’s own assumptions about the assumptions market participants would use in the pricing of the asset or liability and are consequently not based on market activity but rather through particular valuation techniques. Assets and Liabilities Measured at Fair Value on a Recurring Basis The Partnership uses a market approach fair value methodology to value the assets and liabilities for its outstanding derivative contracts (See Note 6). The Partnership manages and reports the derivative assets and liabilities on the basis of its net exposure to market risks and credit risks by counterparty. The Partnership’s commodity derivative contracts are valued based on observable market data related to the change in price of the underlying commodity and are therefore defined as Level 2 assets and liabilities within the same class of nature and risk. The fair values of these derivative instruments are calculated by utilizing commodity indices, quoted prices for futures and options contracts traded on open markets that coincide with the underlying commodity, expiration period, strike price (if applicable) and the pricing formula utilized in the derivative instrument. Information for assets and liabilities measured at fair value was as follows: Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis The Partnership estimates the fair value of its asset retirement obligations based on discounted cash flow projections using numerous estimates, assumptions and judgments regarding factors at the date of establishment of an asset retirement obligation such as: amounts and timing of settlements, the credit-adjusted risk-free rate of the Partnership and estimated inflation rates (See Note 5). The Partnership estimates the fair value of its long-lived assets in conjunction with the review of assets for impairment or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, using estimates, assumptions, and judgments regarding such events or circumstances. For the years ended December 31, 2016 and 2015, the Partnership recognized $212,400 and $6,420,500, respectively, of impairment of long-lived assets which were defined as Level 3 fair value measurements (See Note 4: Property, Plant and Equipment). NOTE 8-CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS The Partnership has entered into the following significant transactions with the MGP and its affiliates as provided under its Partnership Agreement. Administrative costs, which are included in general and administrative expenses in the Partnership’s statements of operations, are payable at $75 per well per month. Monthly well supervision fees which are included in production expenses in the Partnership’s statements of operations are payable at $975 per well per month for Marcellus wells, $1,500 per well per month for New Albany wells, $600 per well per month for horizontal Antrim Shale wells and for Colorado wells a fee of $400 is charged per well per month for operating and maintaining the wells. Well supervision fees are proportionately reduced to the extent the Partnership does not acquire 100% of working interest in a well. Transportation fees are included in production expenses in the Partnership’s statements of operations and are generally payable at 16% of the natural gas sales price. Direct costs, which are included in production and general administrative expenses in the Partnership’s statements of operations, are payable to the MGP and its affiliates as reimbursement for all costs expended on the Partnership’s behalf. The following table provides information with respect to these costs and the periods incurred. The MGP and its affiliates perform all administrative and management functions for the Partnership, including billing revenues and paying expenses. Accounts receivable trade-affiliate on the Partnership’s balance sheets includes the net production revenues due from the MGP. Subordination by Managing General Partner Under the terms of the Partnership Agreement, the MGP may be required to subordinate up to 50% of its share of net production revenues of the Partnership to the benefit of the limited partners for an amount equal to at least 12% of their net subscriptions in the first 12-month subordination period, 10% of their net subscriptions in each of the next three 12-month subordination periods, and 8% of their net subscriptions in the fifth 12-month subordination period determined on a cumulative basis, in each of the first five years of Partnership operations, commencing with the first distribution to the limited partners (March 2011) and expiring 60 months from that date. The MGP subordinated $126,600 and $731,200 of its net production revenues to the limited partners for the years ended December 31, 2016 and 2015, respectively. NOTE 9-COMMITMENTS AND CONTINGENCIES General Commitments Subject to certain conditions, investor partners may present their interests beginning in 2015 for purchase by the MGP. The purchase price is calculated by the MGP in accordance with the terms of the partnership agreement. The MGP is not obligated to purchase more than 5% of the total outstanding units in any calendar year. In the event that the MGP is unable to obtain the necessary funds, it may suspend its purchase obligation. Beginning one year after each of the Partnership’s wells has been placed into production, the MGP, as operator, may retain $200 per month per well to cover estimated future plugging and abandonment costs. As of December 31, 2016 and 2015, the MGP withheld $110,000 and $40,400, respectively, of net production revenue for future plugging and abandonment costs. Legal Proceedings The Partnership is a party to various routine legal proceedings arising out of the ordinary course of its business. Management believes that none of these actions, individually or in the aggregate, will have a material adverse effect on the Partnership’s financial condition or results of operations. Affiliates of the MGP and their subsidiaries are party to various routine legal proceedings arising in the ordinary course of their respective businesses. The MGP’s management believes that none of these actions, individually or in the aggregate, will have a material adverse effect on the MGP’s financial condition or results of operations. NOTE 10-SUBSEQUENT EVENTS Management has considered for disclosure any material subsequent events through the date the financial statements were issued. NOTE 11-SUPPLEMENTAL GAS INFORMATION (UNAUDITED) Gas Reserve Information. The preparation of the Partnership’s natural gas reserve estimates was completed in accordance with our MGP’s prescribed internal control procedures by its reserve engineers. For the periods presented, Wright & Company, Inc., an independent third-party reserve engineer, was retained to prepare a report of proved reserves related to the Partnership. The reserve information for the Partnership includes natural gas reserves which are all located in the United States. The independent reserves engineer’s evaluation was based on more than 40 years of experience in the estimation of and evaluation of petroleum reserves, specified economic parameters, operating conditions, and government regulations. The MGP’s internal control procedures include verification of input data delivered to its third-party reserve specialist, as well as a multi-functional management review. The preparation of reserve estimates was overseen by our MGP’s Director of Reservoir Engineering, who is a member of the Society of Petroleum Engineers and has more than 18 years of natural gas industry experience. The reserve estimates were reviewed and approved by the MGP’s senior engineering staff and management, with final approval by the MGP’s President. The reserve disclosures that follow reflect estimates of proved developed reserves net of royalty interests, of natural gas owned at year end. Proved developed reserves are those reserves that can be expected to be recovered through existing wells with existing equipment and operating methods or in which the cost of the required equipment is relatively minor compared to the cost of a new well; and through installed extraction equipment and infrastructure operational at the time of the reserves estimate if the extraction is by means not involving a well. The proved reserves quantities and future net cash flows were estimated using an unweighted 12-month average pricing based on the prices on the first day of each month during the years ended December 31, 2016 and 2015, including adjustments related to regional price differentials and energy content. There are numerous uncertainties inherent in estimating quantities of proven reserves and in projecting future net revenues and the timing of development expenditures. The reserve data presented represents estimates only and should not be construed as being exact. In addition, the standardized measures of discounted future net cash flows may not represent the fair market value of gas reserves included within the Partnership or the present value of future cash flows of equivalent reserves, due to anticipated future changes in gas prices and in production and development costs and other factors, for their effects have not been proved. Reserve quantity information and a reconciliation of changes in proved reserve quantities included within the Partnership are as follows (unaudited): (1) The downward revision in natural gas forecasts is primarily due to a decrease in SEC base pricing from the prior year, resulting in shorter economic life. (2) We experienced significant downward revisions of our natural gas reserves volumes and values in 2015 and 2016 due to the significant declines in commodity prices. The proved reserves quantities and future net cash flows were estimated under the SEC’s standardized measure using an unweighted 12-month average pricing based on the gas prices on the first day of each month during the years ended December 31, 2016 and 2015, including adjustments related to regional price differentials and energy content. The SEC’s standardized measure of reserve quantities and discounted future net cash flows may not represent the fair market value of the Partnership’s gas equivalent reserves due to anticipated future changes in gas commodity prices. Accordingly, such information should not serve as a basis in making any judgment on the potential value of recoverable reserves or in estimating future results of operations. (3) The downward revision in natural gas forecasts is primarily due to forecast adjustments in order to reflect actual production. Capitalized Costs Related to Gas Producing Activities. The components of capitalized costs related to gas producing activities of the Partnership during the periods indicated were as follows: Results of Operations from Gas Producing Activities. The results of operations related to the Partnership’s gas producing activities during the periods indicated were as follows: Standardized Measure of Discounted Future Cash Flows. The following schedule presents the standardized measure of estimated discounted future net cash flows relating to the Partnership’s proved gas reserves. The estimated future production was priced at a twelve-month average for the years ended December 31, 2016 and 2015 adjusted only for regional price differentials and energy content. The resulting estimated future cash inflows were reduced by estimated future costs to produce the proved reserves based on year-end cost levels and includes the effect on cash flows of settlement of asset retirement obligations on gas properties. The future net cash flows were reduced to present value amounts by applying a 10% discount factor. The standardized measure of future cash flows was prepared using the prevailing economic conditions existing at the dates presented and such conditions continually change. Accordingly, such information should not serve as a basis in making any judgment on the potential value of recoverable reserves or in estimating future results of operations: (1) We experienced significant downward revisions of our natural gas reserves volumes and values in 2015 due to the recent significant declines in commodity prices. The proved reserves quantities and future net cash flows were estimated under the SEC’s standardized measure using an unweighted 12-month average pricing based on the gas prices on the first day of each month during the year ended December 31, 2015, including adjustments related to regional price differentials and energy content. The SEC’s standardized measure of reserve quantities and discounted future net cash flows may not represent the fair market value of the Partnership’s gas equivalent reserves due to anticipated future changes in gas commodity prices. Accordingly, such information should not serve as a basis in making any judgment on the potential value of recoverable reserves or in estimating future results of operations. ITEM 9:
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Based on the financial statement excerpt, here's a summary:
Financial Condition Overview:
- The Partnership is experiencing significant financial uncertainty
- Revenue is highly dependent on unpredictable natural gas prices
- Lower gas prices could reduce both revenues and economically viable production
Key Financial Challenges:
- Potential inability to make liquidation distributions to limited partners
- Uncertainty about continuing as a going concern
- Possible need for material adjustments to asset and liability valuations
Liquidity and Resources:
- Primary liquidity sources include:
1. Cash from operations
2. Capital raised through drilling partnership program
3. Borrowings under credit facilities
Financial Risks:
- Oil and natural gas prices declined significantly in Q4 2014
- Debt covenants and liquidity uncertainties
- Substantial doubt about the Partnership's and Managing General Partner's ability to continue operations
Auditor's Note:
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CONTENTS Page Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Stockholders’ Deficit Consolidated Statements of Cash Flows Notes to the Consolidated Financial Statements ACCOUNTING FIRM To the Board of Directors and Stockholders of Music of Your Life, Inc. I have audited the accompanying consolidated balance sheets of Music of Your Life, Inc. (the “Company”) as of May 31, 2016 and 2015 and the related consolidated statements of operations, stockholders’ deficit, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. My responsibility is to express an opinion on these financial statements based on my audits. I conducted my audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that I plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. I believe that my audits provide a reasonable basis for my opinion. In my opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Music of Your Life, Inc. as of May 31, 2016 and 2015 and the consolidated results of their operations and cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. The accompanying financial statements referred to above have been prepared assuming that the Company will continue as a going concern. As discussed in Note 12 to the financial statements, the Company’s present financial situation raises substantial doubt about its ability to continue as a going concern. Management’s plans in regard to this matter are also described in Note 12. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Michael T. Studer CPA P.C. Michael T. Studer CPA P.C. Freeport, New York September 13, 2016 MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 NOTE 1 - ORGANIZATION Music of Your Life, Inc. (the “Company”) was incorporated under the laws of the State of Florida on January 30, 2008 under the name of “Zhong Sen International Tea Company”. From January 2008 to May 2013, the Company operated with the principal business objective of providing sales and marketing consulting services to small to medium sized Chinese tea producing companies who wished to export and distribute high quality Chinese tea products worldwide. On May 31, 2013 (the “Closing Date”), the Company entered into a Merger Agreement (the “Merger Agreement”) by and among the Company, Music of Your Life, Inc., a Nevada corporation (“MYL Nevada”) incorporated October 10, 2012, and Music of Your Life Merger Sub, Inc., a Utah corporation ("Merger Sub"), pursuant to which MYL Nevada merged with Merger Sub. Each shareholder of MYL Nevada received ten (10) shares of common stock of the Company for every one (1) share of MYL Nevada held as of May 31, 2013. In accordance with the terms of the merger agreement, all of the shares of MYL Nevada held by MYL Nevada shareholders were cancelled and 100 shares of MYL Nevada were issued to the Company. 34,860,000 shares of common stock of the Company were issued to the MYL Nevada shareholders. As a result of the merger, MYL Nevada became a wholly-owned subsidiary of the Company, and on July 26, 2013, the Company changed its name to Music of Your Life, Inc., and is now operating a multi-media entertainment company, producing live concerts, television shows and radio programming. On May 20, 2014 the Company acquired 100% of the outstanding stock of iRadio, Inc., a Utah corporation. A total of 20,000,000 shares were issued to the shareholders of iRadio. The Company was the surviving corporation. iRadio was an entity related to the Company by common ownership. NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES This summary of significant accounting policies of the Company is presented to assist in understanding the Company’s financial statements. The financial statements and notes are representations of the Company’s management who are responsible for their integrity and objectivity. These accounting policies conform to accounting principles generally accepted in the United States of America and have been consistently applied in the preparation of the financial statements. The following policies are considered to be significant: a. Accounting Method The Company recognizes income and expenses based on the accrual method of accounting. The Company has elected a May 31 year-end. b. Cash and Cash Equivalents Cash equivalents are generally comprised of certain highly liquid investments with original maturities of less than three months. c. Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 d. Basic and Fully Diluted Net Loss per Share of Common Stock In accordance with Financial Accounting Standards No. ASC 260, “Earnings per Share,” basic net loss per common share is based on the weighted average number of shares outstanding during the periods presented. Diluted earnings per share is computed using the weighted average number of common shares plus dilutive common share equivalents outstanding during the period. Dilutive instruments (such as convertible notes payable and common stock purchase warrants) have not been included and calculated for the year end computations as their effect is antidilutive. e. Revenue Recognition Revenue is recognized upon completion of services or delivery of goods where the sales price is fixed or determinable and collectability is reasonably assured. Advance customer payments are recorded as deferred revenue until such time as they are recognized. The Company does not offer any cash rebates. Returns or discounts, if any, are netted against gross revenues. f. Recent Accounting Pronouncements We have reviewed accounting pronouncements issued and have adopted any that are applicable to the Company. We have determined that none had a material impact on our financial position, results of operations, or cash flows for the years ended May 31, 2016 and 2015. Certain other accounting pronouncements have been issued by the FASB and other standard setting organizations which are not yet effective and therefore have not yet been adopted by the Company. The impact on the Company’s financial position and results of operations from adoption of these standards is not expected to be material. g. Income Taxes The Financial Accounting Standards Board (FASB) has issued FASB ASC 740-10 (Prior authoritative literature: Financial Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109 (FIN 48)). FASB ASC 740-10 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with prior literature FASB Statement No. 109, Accounting for Income Taxes. This standard requires a company to determine whether it is more likely than not that a tax position will be sustained will be sustained upon examination based upon the technical merits of the position. If the more-likely-than- not threshold is met, a company must measure the tax position to determine the amount to recognize in the financial statements. As a result of the implementation of this standard, the Company performed a review of its material tax positions in accordance with recognition and measurement standards established by FASB ASC 740-10. Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 At May 31, 2016, the Company had net operating loss carryforwards of approximately $1,696,755 which may be offset against future taxable income through 2036. No tax benefit has been reported in the financial statements because the potential tax benefits of the net operating loss carryforwards are offset by a valuation allowance of the same amount. Due to the change in ownership provisions of the Tax Reform Act of 1986, net operating loss carryforwards for Federal income tax reporting purposes are subject to annual limitations. Should a change in ownership occur, net operating loss carryforwards may be limited as to future use. Net deferred tax assets consist of the following components as of May 31, 2016 and 2015: The income tax provision differs from the amount of income tax determined by applying the U.S. federal and state income tax rates of 34% to pretax income for the years ended May 31, 2016 and 2015 due to the following: MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: At May 31, 2016, the Company had no unrecognized tax benefits that, if recognized, would affect the effective tax rate. The Company did not have any tax positions for which it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months. The Company includes interest and penalties arising from the underpayment of income taxes in the consolidated statements of operations in the provision for income taxes. As of May 31, 2016, the Company had no accrued interest or penalties related to uncertain tax positions. h. Concentrations of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risks consist of cash and cash equivalents. The Company places cash and cash equivalents at well known quality financial institutions. Cash and cash equivalents at banks are insured by the Federal Deposit Insurance Corporation for up to $250,000. The Company did not have any cash or cash equivalents in excess of this amount at May 31, 2016. i. Principles of Consolidation The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and include the Company and its wholly-owned subsidiary. All inter-company accounts and transactions have been eliminated. j. Advertising Advertising costs, which are expensed as incurred, were $13,709 and $19,060 for the years ended May 31, 2016 and 2015, respectively. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 NOTE 3 - FINANCIAL INSTRUMENTS The Company has adopted FASB ASC 820-10-50, “Fair Value Measurements.” This guidance defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosure requirements for fair value measures. The three levels are defined as follows: Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 inputs to valuation methodology are unobservable and significant to the fair measurement. The carrying amounts reported in the balance sheets for the cash and cash equivalents, receivables and current liabilities each qualify as financial instruments and are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and their current market rate of interest. NOTE 4 - LOANS RECEIVABLE - RELATED PARTY During the year ended May 31, 2013, the Company loaned $174,950 to the Company’s current chief executive in anticipation of the merger agreement described in Note 1. The loans are non-interest bearing and due on demand. Effective May 31, 2015, the Company agreed to waive collection of $100,000 of the remaining $115,950 loans receivable balance in exchange for the chief executive officer’s agreement to waive payment of the $100,000 accrued consulting fees balance due him at May 31, 2015 (see Note 10). As of May 31, 2016, the balance due on this loan was $15,950. NOTE 5 - DEPOSITS FOR ACQUISITION OF INTANGIBLE ASSETS During the years ended May 31, 2016 and 2015 the Company paid $59,000 and $158,000, respectively, to the wife of the chief executive officer as deposits for certain trademarks and other intellectual property to be assigned to the Company. Under the agreement, if the Company failed to pay a total of $250,000 by December 31, 2015, the Company was to forfeit all rights, title and interest in the trademarks and intellectual property unless extended by her. As of the date of this filing, the agreement has not been extended but the Company continues to use the intangible assets and is in negotiations to extend the agreement. At May 31, 2016, it is not certain whether the intangible assets will ultimately be assigned to the Company. Further, it is not more likely than not that the Company will be able to generate sufficient future cash flows from these assets to recover any or all of the $243,000 deposits balance. Accordingly, the Company recognized a provision for impairment expense of $243,000 at May 31, 2016 and reduced the net carrying balance of the deposits for acquisition of intangible assets to $-0-. NOTE 6 - MUSIC INVENTORY The Company purchases digital music to broadcast over the radio and internet. During the year ended May 31, 2016, the Company purchased $3,874 worth of music inventory. The amount of music inventory held at May 31, 2016 was $8,019. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 NOTE 7 - NOTES PAYABLE Notes payable consisted of the following: MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 (A) On August 15, 2014, the Company issued a $50,000 Promissory Note with a stated interest amount of $15,000 due at maturity on October 14, 2014. The Company also issued 350,000 shares of common stock, valued at $52,500, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $25,610. This amount was amortized over the 60 days life of the promissory note. (B) On April 22, 2015, the Company issued a $25,000 Promissory Note, non-interest bearing (interest at 24% per annum after May 22, 2015), due at maturity on May 22, 2015. The Company also agreed to issue 500,000 shares of common stock, valued at $50,000 on April 22, 2015, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $16,667. This amount was amortized over the 30 days life of the promissory note. (C) On June 23, 2015, the Company issued a $25,000 Promissory Note, non-interest bearing, due at maturity on August 23, 2015. The Company also agreed to issue 500,000 shares of common stock, valued at $20,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $11,111. This amount was amortized over the 60 days life of the promissory note. (D) On July 24, 2015, the Company issued a $50,000 Promissory Note to Kodiak Capital Group, LLC (“Kodiak”) for services rendered in association with the Equity Purchase Agreement (See Note 8). As amended and restated January 4, 2016, the note is non-interest bearing and is due on February 1, 2016. (E) On July 31, 2015, the Company issued a $25,000 Promissory Note with a stated interest amount of $2,500 due at maturity on October 31, 2015. The Company also issued 1,000,000 shares of common stock, valued at $38,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $15,079. This amount was amortized over the 90 days life of the promissory note. (F) On July 31, 2015, the Company issued a second $25,000 Promissory Note with a stated interest amount of $2,500 due at maturity on October 31, 2015. The Company also issued 1,000,000 shares of common stock, valued at $38,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $15,079. This amount was amortized over the 90 days life of the promissory note. (G) On August 6, 2015, the Company issued a $50,000 Promissory Note with a stated interest amount of $5,000 due at maturity on October 21, 2015. The Company also agreed to issue 2,000,000 shares of common stock, valued at $76,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $30,159. This amount was amortized over the 75 days life of the promissory note. (H) On August 21, 2015, the Company issued a $50,000 Promissory Note with a stated interest amount of $5,000 due at maturity on November 6, 2015. The Company also agreed to issue 2,000,000 shares of common stock, valued at $60,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $27,273. This amount was amortized over the 75 days life of the promissory note. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 (I) On September 21, 2015, the Company issued a $25,000 Promissory Note with a stated interest amount of $2,500 due at maturity on December 20, 2015. The Company also agreed to issue 1,000,000 shares of common stock, valued at $30,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $13,636. This amount was amortized over the 90 days life of the promissory note. In the event that all principal and interest are not paid to the lender by January 20, 2016, the Company is obligated to issue another 1,000,000 shares of common stock to the lender and for interest to accrue at a rate of 24% per annum commencing on January 21, 2016. (J) On September 25, 2015, the Company issued a $55,750 Convertible Promissory Note to a lender for net loan proceeds of $45,000. The note bears interest at a rate of 10% per annum (24% per annum default rate), is due on June 25, 2016, and is convertible at the option of the lender into shares of the Company common stock at a Conversion Price equal to the lesser of (a) 55% of the lowest Trading Price during the 25 Trading Day period prior to the Conversion Date or (b) $.00605 per share. See Note 9 (Derivative Liability). (K) On November 13, 2015, the Company issued a $25,000 Promissory Note with a stated interest amount of $2,500 due at maturity on December 18, 2015. The Company also agreed to issue 200,000 shares of common stock, valued at $6,000, as part of the note agreement. The proceeds of the note were allocated between the principal and the market value of the stock resulting in the Company recording a discount on the debt of $4,839. This amount was amortized over the 35 days life of the promissory note. In the event that all principal and interest are not paid to the lender by December 18, 2015, the Company is obligated to pay late fees of 5,000 shares of common stock per day for the first 60 days after December 18, 2015, and beginning with the 61st day after December 18, 2015, any balance owed shall accrue interest at a rate of 10% per annum. (L) On December 22, 2015, the Company issued a $20,000 Convertible Promissory Note to a lender for net loan proceeds of $15,000. The note bears interest at a rate of 12% per annum, is due on December 22, 2016, and is convertible at the option of the lender into shares of the Company common stock at a Conversion Price equal to 50% of the lowest closing bid price during the 30 Trading Day period prior to the Conversion Date. See Note 9 (Derivative Liability). (M) On December 29, 2015, the Company issued a $20,000 Convertible Promissory Note to a lender for net loan proceeds of $15,000. The note bears interest at a rate of 12% per annum, is due on December 22, 2016, and is convertible at the option of the lender into shares of the Company common stock at a Conversion Price equal to 50% of the lowest closing bid price during the 30 Trading Day period prior to the Conversion Date. See Note 9 (Derivative Liability). (N) On February 12, 2016, the Company issued a $35,500 Convertible Promissory Note to a lender for net loan proceeds of $27,000. The note bears interest at a rate of 10% per annum (24% per annum default rate), is due on November 12, 2016, and is convertible at the option of the lender into shares of the Company common stock at a Conversion Price equal to the lesser of (a) 55% of the lowest Trading Price during the 25 Trading Day period prior to the Conversion Date or (b) $.00605 per share. See Note 9 (Derivative Liability). (O) On March 17, 2016, the Company issued a $44,000 Convertible Promissory Note to a lender for net loan proceeds of $30,000. The note bears interest at a rate of 10% per annum (24% per annum default rate), is due on September 17, 2016, and is convertible at the option of the lender into shares of the Company common stock at a Conversion Price equal to the lesser of (a) 65% of the lowest Trading MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 Price during the 30 Trading Day period prior to the Conversion Date or (b) 65% of the lowest Market Price during the 30 day Trading Day period prior to the Conversion Date. See Note 9 (Derivative Liability). NOTE 8 - NOTES PAYABLE - RELATED PARTIES Notes payable - related parties consisted of the following: In December 2015, the $150,000 note payable (and $75,000 accrued interest) was satisfied from the foreclosure of property securing the February 2013 Promissory Note. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 NOTE 9 - DERIVATIVE LIABILITY The derivative liability at May 31, 2016 consisted of: The above convertible notes contain a variable conversion feature based on the future trading price of the Company common stock. Therefore, the number of shares of common stock issuable upon conversion of the notes is indeterminate. Accordingly, we have recorded the fair value of the embedded conversion features as a derivative liability at the respective issuance dates of the notes ($823,405 total for the year ended May 31, 2016) and charged the applicable amounts to debt discounts ($175,250 total for the year ended May 31, 2016) and the remainder to other expense ($648,155 total for the year ended May 31, 2016). The increase (decrease) in the fair value of the derivative liability from the respective issuance dates of the notes to the measurement date ($553,107 total decrease for the year ended May 31, 2016) is charged (credited) to other expense (income). The fair value of the derivative liability of the notes is measured at the respective issuance dates and quarterly thereafter using the Black Scholes option pricing model. Assumptions used for the calculations of the derivative liability of the notes at May 31, 2016 include (1) stock price of $0.0023 per share, (2) exercise prices ranging from $0.0010 to $0.0013 per share, (3) terms ranging from 25 days to 212 days, (4) expected volatility of 445% and (5) risk free interest rates ranging from 0.27% to 0.49%. NOTE 10 - EQUITY TRANSACTIONS During the year ended May 31, 2015, the Company issued an aggregate of 9,400,000 shares of common stock for cash in the aggregate amount of $267,500. During the year ended May 31, 2015, the Company issued an aggregate of 594,559 shares of common stock for the conversion of notes payable and interest in the aggregate amount of $70,378. On October 14, 2014, the Company issued 350,000 shares of common stock to an accredited investor in consideration of the investor making a $50,000 loan to the Company (see Note 7). On April 22, 2015, the Company agreed to issue 500,000 shares of common stock to an accredited investor in consideration of the investor making a $25,000 loan to the Company (see Note 7). MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 During the year ended May 31, 2016, the Company issued an aggregate of 7,700,000 shares of common stock to accredited investors in consideration of loans made to the Company. During the year ended May 31, 2016, the Company issued an aggregate of 1,000,000 shares of common stock for consulting services rendered to the Company and was recorded as consulting fees on the statement of operations in the amount of $33,000. During the year ended May 31, 2016, the Company issued 1,000,000 shares of common stock for late fees on promissory notes. During the year ended May 31, 2016, the Company issued an aggregate of 10,164,933 shares of common stock for the conversion of notes payable and interest in the aggregate amount of $12,560. During the year ended May 31, 2016, the Company issued an aggregate of 20,900,000 shares of common stock for cash in the aggregate amount of $112,600. On March 4, 2016, the Company issued 200 shares of Series A Preferred Stock to our chief executive officer for consulting services rendered to the Company and was recorded as consulting fees on the statement of operations in the amount of $10,000. Each share of Series A Preferred Stock is entitled to 2,000,000 votes. The Series A Preferred Stock has no conversion, liquidation, or dividend rights. During the years ended May 31, 2016 and 2015, 360,000 and 652,000 warrants (which were exercisable at $1.00 per share) respectively, expired without being exercised. At May 31, 2016, there are no stock options or warrants outstanding. NOTE 11 - COMMITMENTS AND CONTINGENCIES Service Agreements On November 5, 2012, the Company executed a General Services Agreement with the Company’s chief executive officer. The agreement provided for monthly compensation of $10,000 and was to remain in full force and effect until either party provided 30 days notice of termination to the other party. Effective May 31, 2015, the chief executive officer agreed to waive payment of the $100,000 accrued consulting fees balance due him at May 31, 2015 in exchange for the Company’s agreement to waive collection of $100,000 of the remaining $115,950 loans receivable balance due from the chief executive officer at May 31, 2015 before this transaction (see Note 4). As of May 31, 2015, this agreement has been terminated. On November 15, 2012 and June 3, 2013, the Company executed General Services Agreements with two other service providers. The agreements provided for monthly compensation of $1,000 and $500, respectively, and were to remain in full force and effect until either party provided 90 days and 30 days, respectively, notice of termination to the other party. Effective September 1, 2015, these two agreements were replaced by Consulting Agreements to provide for monthly compensation of $5,000 to each of the two service providers. The term of the agreements is from September 1, 2015 to December 31, 2016 and thereafter on a month-to-month basis. The Company may terminate both of these Consulting Agreements at any time without cause. Effective September 1, 2015, the Company entered into a Consulting Agreement with another service provider. The agreement provides for monthly compensation of $1,000 for a term from September 1, 2015 to December 31, 2016 and thereafter on a month-to-month basis. The Company may terminate this Consulting Agreement at any time without cause. MUSIC OF YOUR LIFE, INC. Notes to the Consolidated Financial Statements May 31, 2016 Equity Purchase Agreement On July 24, 2015, the Company executed an Equity Purchase Agreement and a Registration Rights Agreement with Kodiak Capital Group, LLC (“Kodiak”) and issued a Promissory Note to Kodiak with a $50,000 face value for services rendered in association with the Equity Purchase Agreement (see Note 7). The Equity Purchase Agreement (which expires July 24, 2016) provides for Kodiak to purchase up to $1,000,000 of the Company’s common stock to be sold at a 30% discount to market. The Company is required to file and have declared effective a Registration Statement with the SEC relating to these shares. The Company initially filed a Registration Statement with the SEC on October 9, 2015; the amended Registration Statement was declared effective on February 17, 2016. NOTE 12 - GOING CONCERN The accompanying financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has an accumulated deficit at May 31, 2016 of $2,375,737 and has experienced periodic cash flow difficulties, all of which raise substantial doubt regarding the Company’s ability to continue as a going concern. To date the Company has funded its operations through a combination of loans and sales of common stock. The Company anticipates another net loss for the fiscal year ended May 31, 2017 and with the expected cash requirements for the coming year, there is substantial doubt as to the Company’s ability to continue operations. The Company is attempting to improve these conditions by way of financial assistance through issuances of additional equity and by generating revenues through sales of products and services. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. NOTE 13 - SUBSEQUENT EVENTS On July 22, 2016, the Company increased its authorized common stock from 500,000,000 shares to 2,000,000,000 shares and reduced the par value of the common stock from $0.001 to $0.0001 per share. From June 1, 2016 to September 9, 2016, the Company issued an aggregate of 20,000,000 shares of its common stock to certain consulting personnel for services provided. From June 1, 2016 to September 9, 2016, the Company issued an aggregate of 141,944,553 shares of its common stock for the conversion of notes payable and interest.
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt. It contains some accounting terminology and references to a company called "MUSIC OF YOUR LIFE, INC.", but lacks clear, comprehensive financial information that would allow for a meaningful summary.
The text seems to include:
- A partial reference to accounting standards (ASC 260)
- A mention of financial estimates and potential variations
- A note about current liabilities being considered financial instruments
- A date of May 31 (year not specified)
To provide a proper summary, I would need a more complete financial statement with clear revenue, expense, profit/loss, and balance sheet details.
Would you like to share the full financial statement?
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Claude
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Financial Statements. SEAFARER EXPLORATION CORP. FINANCIAL STATEMENTS DECEMBER 31, 2016 AND 2015 ACCOUNTING FIRM To the Board of Directors and Shareholders of Seafarer Exploration Corp. We have audited the accompanying balance sheet of Seafarer Exploration Corp. as of December 31, 2015, and the related statements of operations, stockholders’ deficit, and cash flows for the year then ended. Seafarer Exploration Corp.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Seafarer Exploration Corp. as of December 31, 2015, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has incurred net losses and negative cash flows since inception. These conditions raise substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters also are described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion on the financial statements is not modified with respect to this matter. /s/ Accell Audit & Compliance, P.A. Tampa, Florida April 7, 2016 ACCOUNTING FIRM To the Board of Directors and Stockholders of Seafarer Exploration Corp. Tampa, Florida We have audited the accompanying balance sheet of Seafarer Exploration Corp. (the “Company”) at December 31, 2016, and the related statements of operations, changes in stockholders’ equity and cash flows for the year ended December 31, 2016. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Seafarer Exploration Corp. at December 31, 2016, and the results of its operations and its cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As described in Note 2 to the financial statements, the Company has sustained recurring losses from operations and has working capital and accumulated deficits that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter. /s/ Daszkal Bolton LLP Fort Lauderdale, Florida March 31, 2017 SEAFARER EXPLORATION CORP. BALANCE SHEETS DECEMBER 31, 2016 AND 2015 See accompanying notes to the financial statements. SEAFARER EXPLORATION CORP. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2016 AND See accompanying notes to the financial statements. SEAFARER EXPLPLORATION CORP. STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT FOR THE YEARS ENDED DECEMBER 31, 2016 AND See accompanying notes to the financial statements. SEAFARER EXPLORATION CORP. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2016 AND See accompanying notes to the financial statements. SEAFARER EXPLORATION CORP. (A Development Stage Company) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - DESCRIPTION OF BUSINESS Seafarer Exploration Corp. (the “Company”), formerly Organetix, Inc. (“Organetix”), was incorporated on May 28, 2003 in the State of Delaware. The principal business of the Company is to engage in the archaeologically-sensitive exploration, documentation, and recovery of historic shipwrecks with the objective of exploring and discovering Colonial-era shipwrecks for future generations to be able to appreciate and understand. NOTE 2 - GOING CONCERN These financial statements have been prepared on a going concern basis, which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future. The Company has incurred net losses since inception, which raises substantial doubt about the Company’s ability to continue as a going concern. Based on its historical rate of expenditures, the Company expects to expend its available cash in less than one month from April 3, 2017. Management's plans include raising capital through the equity markets to fund operations and, eventually, the generation of revenue through its business. The Company does not expect to generate any revenues for the foreseeable future. Failure to raise adequate capital and generate adequate revenues could result in the Company having to curtail or cease operations. The Company’s ability to raise additional capital through the future issuances of the common stock is unknown. Additionally, even if the Company does raise sufficient capital to support its operating expenses and generate adequate revenues, there can be no assurances that the revenue will be sufficient to enable it to develop to a level where it will generate profits and cash flows from operations. These matters raise substantial doubt about the Company's ability to continue as a going concern; however, the accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. These financial statements do not include any adjustments relating to the recovery of the recorded assets or the classifications of the liabilities that might be necessary should the Company be unable to continue as a going concern. This summary of significant accounting policies of the Company is presented to assist in understanding the Company’s financial statements. The financial statements and notes are representations of the Company’s management, who are responsible for their integrity and objectivity. These accounting policies conform to accounting principles generally accepted in the United States of America, and have been consistently applied in the preparation of the financial statements. NOTE 3 - SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents For purposes of the statement of cash flows, the Company considers all highly liquid investments and short-term debt instruments with original maturities of three months or less to be cash equivalents. There are no cash equivalents at December 31, 2016 and 2015. Earnings Per Share The Company has adopted the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 260-10 which provides for calculation of "basic" and "diluted" earnings per share. Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted average common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Basic and diluted losses per share were the same at the reporting dates, as the inclusion of outstanding common stock equivalents would have been anti-dilutive, as of December 31, 2016 and 2015. Components of loss per share for the respective years are as follows: Fair Value of Financial Instruments Effective January 1, 2008, fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception of the application of the statement to non-recurring, non-financial assets and liabilities, as permitted. Fair value is defined in the authoritative guidance as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows: ● Level 1 - Valuation based on unadjusted quoted market prices in active markets for identical assets or liabilities. ● Level 2 - Valuation based on, observable inputs (other than level one prices), quoted market prices for similar assets such as at the measurement date; quoted prices in the market that are not active; or other inputs that are observable, either directly or indirectly. ● Level 3 - Valuation based on unobservable inputs that are supported by little or no market activity, therefore requiring management’s best estimate of what market participants would use as fair value. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. The valuation of the Company’s derivative liability is determined using Level 1 inputs, which consider (i) time value, (ii) current market and (iii) contractual prices. The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, receivables, accounts payable, notes payable and other payables, approximate their fair values because of the short maturity of these instruments. Property and Equipment and Depreciation Fixed assets are recorded at historical cost. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets. Property and equipment, net consist of the following at December 31: Depreciation expense for the years ended December 31, 2016 and 2015 amounted to $33,984. Impairment of Long-Lived Assets In accordance with ASC 360-10, the Company, on a regular basis, reviews the carrying amount of long-lived assets for the existence of facts or circumstances, both internally and externally, that suggest impairment. ASC 360-10 provides guidance on accounting for property, plant, and equipment, and the related accumulated depreciation on those assets. ASC 360-10 also includes guidance on the impairment or disposal of long-lived assets. ASC 360-10 notes that long-lived tangible assets include land and land improvements, buildings, machinery and equipment, and furniture and fixtures. The Company determines if the carrying amount of a long-lived asset is impaired based on anticipated undiscounted cash flows, before interest, from the use of the asset. In the event of impairment, a loss is recognized based on the amount by which the carrying amount exceeds the fair value of the asset. Fair value is determined based on appraised value of the assets or the anticipated cash flows from the use of the asset, discounted at a rate commensurate with the risk involved. The Company has determined there has been no impairment in the carrying value of its long-lived assets at December 31, 2016 and 2015, respectively. Use of Estimates The process of preparing financial statements in conformity with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions regarding certain types of assets, liabilities, revenues, and expenses. Such estimates primarily relate to unsettled transactions and events as of the date of the financial statements. Accordingly, upon settlement, actual results may differ from estimated amounts. Revenue Recognition The Company plans to recognize revenue on arrangements in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” and No. 104, “Revenue Recognition”. In all cases, revenue will be recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed and collectability is reasonably assured. For the years ended December 31, 2016 and 2015, the Company did not report any revenues. Convertible Notes Payable The Company accounts for conversion options embedded in convertible notes in accordance with ASC 815. ASC 815 provides comprehensive guidance on derivative and hedging transactions. It sets forth the definition of a derivative instrument and specifies how to account for such instruments, including derivatives embedded in hybrid instruments. In addition, ASC 815 establishes when reporting entities, in certain limited, well-defined circumstances, may apply hedge accounting to a relationship involving a designated hedging instrument and hedged exposure. Hedge accounting provides an alternative, special way of accounting for such relationships. ASC 815 also provides guidance on how reporting entities determine whether an instrument is (1) indexed to the reporting entity’s own stock and (2) considered to be settled in the reporting entity’s own stock. Such a determination will dictate whether an instrument should be accounted for as debt or equity and the appropriate accounting for the instrument. Finally, ASC 815 addresses the accounting for non-exchange-traded weather derivatives. ASC 815 generally requires companies to bifurcate conversion options embedded in convertible notes from their host instruments and to account for them as free standing derivative financial instruments. ASC 815 provides for an exception to this rule when convertible notes, as host instruments, are deemed to be conventional, as defined by ASC 815-40. As of December 31, 2016, all of the Company’s convertible notes payable were classified as conventional instruments. The Company accounts for convertible notes deemed conventional and conversion options embedded in non-conventional convertible notes which qualify as equity under ASC 815, in accordance with the provisions of ASC 470-20, which provides guidance on accounting for convertible securities with beneficial conversion features. ASC 470-10 addresses classification determination for specific obligations, such as short-term obligations expected to be refinanced on a long-term basis, due-on-demand loan arrangements, callable debt, sales of future revenue, increasing rate debt, debt that includes covenants, revolving credit agreements subject to lock-box arrangements and subjective acceleration clauses, indexed debt. Accordingly, the Company records, as a discount to convertible notes, the intrinsic value of such conversion options based upon the differences between the fair value of the underlying common stock at the commitment date of the note transaction and the effective conversion price embedded in the note. Debt discounts under these arrangements are amortized over the term of the related debt. Fair Value of Financial Instruments Effective January 1, 2008, fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception of the application of the statement to non-recurring, non-financial assets and liabilities, as permitted. Fair value is defined in the authoritative guidance as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows: Level 1 - Valuation based on unadjusted quoted market prices in active markets for identical assets or liabilities. Level 2 - Valuation based on, observable inputs (other than level one prices), quoted market prices for similar assets such as at the measurement date; quoted prices in the market that are not active; or other inputs that are observable, either directly or indirectly. Level 3 - Valuation based on unobservable inputs that are supported by little or no market activity, therefore requiring management’s best estimate of what market participants would use as fair value. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. The valuation of the Company’s notes recorded at fair value is determined using Level 3 inputs, which consider (i) time value, (ii) current market and (iii) contractual prices. The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, receivables, accounts payable, notes payable and other payables, approximate their fair values because of the short maturity of these instruments. The following table represents the Company’s assets and liabilities by level measured at fair value on a recurring basis at December 31, 2015: The following assets and liabilities are measured on the balance sheets at fair value on a recurring basis utilizing significant unobservable inputs or Level 3 assumptions in their valuation. The following tables provide a reconciliation of the beginning and ending balances of the liabilities: The change in the notes payable at fair value for the year ended December 31, 2016 is as follows: The change in the notes payable at fair value for the year ended December 31, 2015 is as follows: All gains and losses on assets and liabilities measured at fair value on a recurring basis and classified as Level 3 within the fair value hierarchy were recognized in interest income or expense in the accompanying financial statements. The significant unobservable inputs used in the fair value measurement of the liabilities described above present value of the future interest payments. Recent Accounting Pronouncements Recent accounting pronouncements issued by the FASB, including its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements. NOTE 4 - CAPITAL STOCK Our total authorized capital stock consists of 2,900,000,000 shares of common stock, $0.0001 par value per share. Preferred Stock The Company is authorized to sell or issue 50,000,000 shares of preferred stock. Series A Preferred Stock At December 31, 2016 and 2015, the Company had seven shares of Series A preferred stock issued and outstanding. Each share of Series A preferred stock has the right to convert into 214,289 shares of the Company’s common stock. Series B Preferred Stock On February 10, 2014, the Board of Directors of the Company under the authority granted under Article V of the Articles of Incorporation, defined and created a new preferred series of shares from the 50,000,000 authorized preferred shares. Pursuant to Article V, the Board of Directors has the power to designate such shares and all powers and matters concerning such shares. Such share class shall be designated Preferred Class B. The preferred class was created for 60 Preferred Class B shares. Such shares each have a voting power equal to one percent of the outstanding shares issued (totaling 60%) at the time of any vote action as necessary for share votes under Florida law, with or without a shareholder meeting. Such shares are non-convertible to common stock of the Company and are not considered as convertible under any accounting measure. Such shares shall only be held by the Board of Directors as a Corporate body, and shall not be placed into any individual name. Such shares were considered issued at the time of this resolution’s adoption, and do not require a stock certificate to exist, unless selected to do so by the Board for representational purposes only. Such shares are considered for voting as a whole amount, and shall be voted for any matter by a majority vote of the Board of Directors. Such shares shall not be divisible among the Board members, and shall be voted as a whole either for or against such a vote upon the vote of the majority of the Board of Directors. In the event that there is any vote taken which results in a tie of a vote of the Board of Directors, the vote of the Chairman of the Board shall control the voting of such shares. Such shares are not transferable except in the case of a change of control of the Corporation when such shares shall continue to be held by the Board of Directors. Such shares have the authority to vote for all matters that require a share vote under Florida law and the Articles of Incorporation. Warrants and Options At December 31, 2016 the Company had warrants to purchase a total of 126,631,818 shares of its restricted common stock outstanding: Warrants Issued During the Year Ended December 31, During the year ended December 31, 2015 the Company issued a total of 63,745,834 warrants to purchase shares of restricted common stock at prices ranging from $0.0030 to $0.01, 38,412,500 warrants were issued under equity subscription agreements and 25,333,334 under convertible promissory notes. The warrants issued under equity subscription agreements were valued using the Black-Scholes model. Warrants Issued During the Year Ended December 31, During the year ended December 31, 2016 the Company issued a total of 98,681,818 warrants to purchase shares of restricted common stock at prices ranging from $0.002 to $0.005, 44,681,818 warrants were issued under equity subscription agreements and 54,000,000 under convertible promissory notes. The warrants issued under convertible promissory note agreements were valued using the Black-Scholes model. NOTE 5 - INCOME TAXES At December 31, 2016 and 2015, the Company had available Federal and state net operating loss carry forwards to reduce future taxable income. The amounts available were approximately $12,300,000 and $11,000,000 for Federal purposes. The Federal carry forwards begin to expire in 2033. Given the Company’s history of net operating losses, management has determined that it is more likely than not that the Company will not be able to realize the tax benefit of the carryforwards. Accordingly, the Company has not recognized a deferred tax asset for this benefit. The Company adopted FASB guidelines that address the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under this guidance, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. This guidance also provides guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. As of December 31, 2016 and 2015, the Company did not have a liability for unrecognized tax benefits. The Company’s policy is to record interest and penalties on uncertain tax provisions as income tax expense. As of December 31, 2016 and 2015, the Company has not accrued interest or penalties related to uncertain tax positions. Additionally, tax years 2010 through 2016 remain open to examination by the major taxing jurisdictions to which the Company is subject. The Company is currently in the process of filing tax returns for past years, due to the Company’s lack of revenue since inception management does not believe that there is any income tax liability for past years. There are currently no open federal or state tax years under audit. Upon the attainment of taxable income by the Company, management will assess the likelihood of realizing the tax benefit associated with the use of the carry forwards and will recognize a deferred tax asset at that time. The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes are as follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. As of December 31, 2016 and 2015, the Company’s only significant deferred income tax asset was a cumulative estimated net tax operating loss of $12,300,000 and $11,000,000, respectively that is available to offset future taxable income, if any, in future periods, subject to expiration and other limitations imposed by the Internal Revenue Service. Management has considered the Company's operating losses incurred to date and believes that a full valuation allowance against the deferred tax assets is required as of December 31, 2016 and 2015. NOTE 6 - LEASE OBLIGATION Corporate Office The Company leases 823 square feet of office space located at 14497 North Dale Mabry Highway, Suite 209-N, Tampa, Florida 33618. The Company entered into an amended lease agreement commencing on July 1, 2015 through June 30, 2017. Under the amended lease agreement the base monthly rent is $1,215 from July 1, 2015 through June 30, 2016 and $1,251 from July 1, 2016 to June 30, 2017. There may be additional monthly charges for pro-rated maintenance, late fees, etc. As of December 31, 2016, future minimum rental payments required under this non-cancelable operating lease total $7,510 for the year for the year ending December 31, 2017. Operations House The Company has an operating lease for a house located in Palm Bay, Florida. The Company uses the house to store equipment and gear and to provide temporary work-related living quarters for its divers, personnel, consultants and independent contractors involved in its exploration and recovery operations. The term of the lease agreement commenced on October 1, 2015 and expires on October 31, 2016. The Company pays $1,300 per month to lease the operations house. The term of the lease expired in October 2016, the Company is leasing the operations house on a month-to-month basis and anticipates continuing to lease the house for the foreseeable future. NOTE 7 - CONVERTIBLE NOTES PAYABLE AND NOTES PAYABLE Upon inception, the Company evaluates each financial instrument to determine whether it meets the definition of “conventional convertible” debt under paragraph 4 of EITF 00-19, which was superseded by ASC 815, and EITF 05-02, which was superseded by ASC 470. Convertible Notes Payable The following table reflects the convertible notes payable as of December 31, 2016, other than the notes that have been remeasured to fair value which are discussed later in Note 7: Notes Payable The following table reflects the notes payable as of December 31, 2015 and 2014: Convertible Notes Payable Between January 1, 2015 and December 31, 2015, the Company issued four (4) convertible notes payable totaling $109,000. The notes include interest at 6%. Between January 1, 2016 and December 31, 2016, the Company issued 12 convertible notes payable totaling $104,150. The notes include interest at 6%. The principal amount of the notes and interest is payable on the maturity date. The notes and accrued interest are convertible into common stock at fixed conversion prices. The conversion prices and maturity dates of these notes are detailed in the table in the preceding page. The Company has evaluated the terms and conditions of the convertible notes under the guidance of ASC 815 and other applicable guidance. The conversion feature of four of the notes met the definition of conventional convertible for purposes of applying the conventional convertible exemption. The definition of conventional contemplates a limitation on the number of shares issuable under the arrangement. The note is convertible into a fixed number of shares and there are no down round protection features contained in the contracts. Since the convertible notes achieved the conventional convertible exemption, the Company was required to consider whether the hybrid contracts embody a beneficial conversion feature. The calculation of the effective conversion amount did result in a beneficial conversion feature. The following tables reflect the aggregate allocation as of December 31: The discounts on the convertible notes arose from the allocation of basis to the beneficial conversion feature. The discount is amortized through charges to interest expense over the term of the debt agreement. For the twelve months ended December 31, 2016 and 2015, the Company recorded interest expense related to the amortization of debt discounts in the amount of approximately $80,600 and $116,000, respectively. At December 31, 2016 and 2015, combined accrued interest on the convertible notes payable, notes payable and stockholder loans was $154,790 and $135,581, respectively, and included in accounts payable and accrued expenses on the accompanying balance sheets. Note Conversions A lender who had a convertible promissory note outstanding with a remaining principal balance of $38,000 elected to convert a portion of the principal balance of $14,348 of the note plus accrued interest and late fees of $6,652 into 12,750,000 shares of the Company’s common stock. The remaining principal balance of this note was $23,652 at December 31, 2016. A lender elected to convert the entire principal balance of $15,000 of a convertible promissory note into 30,000,000 shares of the Company’s common stock. The remaining principal balance of this note was $0 at December 31, 2016. A lender agreed to accept 7,000,000 shares of common stock to settle the remaining principal balance of $7,000 of a promissory note. As of December 31, 2016 the remaining principal balance of this note was $0 and no accrued interest was due to the lender. Convertible Notes Payable and Notes Payable, in Default The Company does not have additional sources of debt financing to refinance its convertible notes payable and notes payable that are currently in default. If the Company is unable to obtain additional capital, such lenders may file suit, including suit to foreclose on the assets held as collateral for the obligations arising under the secured notes. If any of the lenders file suit to foreclose on the assets held as collateral, then the Company may be forced to significantly scale back or cease its operations which would more than likely result in a complete loss of all capital that has been invested in or borrowed by the Company. The fact that the Company is in default of several promissory notes held by various lenders makes investing in the Company or providing any loans to the Company extremely risky with a very high potential for a complete loss of capital. The convertible notes that have been issued by the Company are convertible at the lender’s option. These convertible notes represent significant potential dilution to the Company’s current shareholders as the convertible price of these notes is generally lower than the current market price of the Company’s shares. As such when these notes are converted into shares of the Company’s common stock there is typically a highly dilutive effect on current shareholders and very possible that such dilution may significantly negatively affect the trading price of the Company’s common stock. Shareholder Loans At December 31, 2016 the Company had three loans outstanding to its CEO totaling $22,683, consisting of a loan with a remaining principal balance of 19,983 with a 6% annual rate of interest, a loan in the amount of $1,200 at 6% rate of interest and an option to convert the loan into restricted shares of the Company’s common stock at $0.002, and a loan in the amount of $1,500 at a rate of 2% interest. Convertible Notes Payable and Notes Payable, in Default Convertible Notes Payable at Fair Value Convertible Note Payable Dated August 28, 2015 at Fair Value On August 28, 2015 the Company entered into a convertible note payable with a corporation. The note payable, with a face value of $44,000, including a $4,000 of original issue discount, bears interest at 12.0% per annum and is due on August 28, 2016. The convertible note payable is convertible, at the holder’s option, into the Company’s common shares at the Variable Conversion Price. The Variable Conversion Price is defined as 62% multiplied by the lowest closing bid price for the Company’s common stock during the twenty (20) trading day period including the day the notice of conversion is received by the Company. If the Company’s market capitalization is less than $1,000,000 on the day immediately prior to the date of the notice of conversion, then the conversion price shall be 25% multiplied by the lowest closing price as of the date notice of conversion is given and if the closing price of the Company’s common stock on the day immediately prior to the date of the notice of conversion is less than $0.00075 then the conversion price shall be 25% multiplied by the lowest closing price as of the date a notice of conversion is given. The conversion feature is subject to full-ratchet, anti-dilution protection if the Company sells shares or share-indexed financing instruments at less than the conversion price. In the evaluation of the financing arrangement, the Company concluded that the conversion feature did not meet the conditions set forth in current accounting standards for equity classification. Since equity classification is not available for the conversion feature, it requires bifurcation and liability classification, at fair value. The Company elected to account for this hybrid contract under the guidance of ASC 815-15-25-4. In connection with the issuance of the convertible note payable, the Company recognized day-one derivative loss totaling $76,210 related to the recognition of (i) the hybrid note and (ii) the derivative instrument arising from the fair value measurement due to the fair value of the hybrid note and embedded derivative exceeding the proceeds that the Company received from the arrangement. Therefore, the Company was required to record a $76,210 loss on the derivative financial instrument. In addition, the fair value will change in future periods, based upon changes in the Company’s common stock price and changes in other assumptions and market indicators used in the valuation techniques. These future changes will be currently recognized in interest expense or interest income on the Company’s statement of operations. The conversion of the note into shares of the Company’s common stock is potentially highly dilutive to current shareholders. If the note holder elects to sell the shares that it has acquired as a result of converting the note into shares of common stock, then any such sales may result in a significant decrease in the market price of the Company’s shares. During the period ended December 31, 2016, the principal balance and accrued interest was converted into 54,561,311 shares of common stock. Convertible Note Payable Dated September 3, 2015 at Fair Value On September 3, 2015 the Company entered into a convertible note payable with a corporation. The note payable in the amount of $38,500, including a $3,500 original issue discount, and bears interest at 12.0% per annum and is due on September 3, 2017. According to the terms of the note, the Company was eligible to utilize up to $200,000 of credit under the note, with potential proceeds received of $180,000, however at the time the Company elected to borrow only the $38,500. Any additional amount borrowed under this note would require approval of both the Company and the lender. The convertible note payable is convertible, at the holder’s option, into the Company’s common shares at the Variable Conversion Price. The Variable Conversion Price is defined as 65% multiplied by the lowest trade price for the Company’s common stock in the twenty-five (25) trading day period previous to the conversion. The conversion feature is subject to full-ratchet, anti-dilution protection if the Company sells shares or share-indexed financing instruments at less than the conversion price. In the evaluation of the financing arrangement, the Company concluded that the conversion feature did not meet the conditions set forth in current accounting standards for equity classification. Since equity classification is not available for the conversion feature, it requires bifurcation and liability classification, at fair value. The Company elected to account for this hybrid contract under the guidance of ASC 815-15-25-4. In connection with the issuance of the convertible note payable, the Company recognized day-one derivative loss totaling $42,308 related to the recognition of (i) the hybrid note and (ii) the derivative instrument arising from the fair value measurement due to the fair value of the hybrid note and embedded derivative exceeding the proceeds that the Company received from the arrangement. Therefore, the Company was required to record a $29,789 loss on the derivative financial instrument. In addition, the fair value will change in future periods, based upon changes in the Company’s common stock price and changes in other assumptions and market indicators used in the valuation techniques. These future changes will be currently recognized in interest expense or interest income on the Company’s statement of operations. The conversion of the note into shares of the Company’s common stock is potentially highly dilutive to current shareholders. If the note holder elects to sell the shares that it has acquired as a result of converting the note into shares of common stock, then any such sales may result in a significant decrease in the market price of the Company’s shares. During the period ended December 31, 2016, the principal balance and accrued interest was converted into 86,597,589 shares of common stock. Convertible Note Payable Dated September 8, 2015 at Fair Value On September 8, 2015, the Company entered into a convertible note payable with a corporation. The convertible note payable, with a face value of $27,000, bears interest at 8.0% per annum and is due on September 8, 2016. The note payable is convertible, at the holder’s option, into the Company’s common shares at the Variable Conversion Price. The Variable Conversion Price is defined as 65% multiplied by the lowest closing bid price for the Company’s common stock during the fifteen (15) trading day period including the day the notice of conversion is received by the Company. The conversion feature is subject to full-ratchet, anti-dilution protection if the Company sells shares or share-indexed financing instruments at less than the conversion price. In the evaluation of the financing arrangement, the Company concluded that the conversion feature did not meet the conditions set forth in current accounting standards for equity classification. Since equity classification is not available for the conversion feature, it requires bifurcation and liability classification, at fair value. The Company elected to account for this hybrid contract under the guidance of ASC 815-15-25-4. In connection with the issuance of the convertible note payable, the Company recognized day-one derivative loss totaling $16,690 related to the recognition of (i) the hybrid note and (ii) the derivative instrument arising from the fair value measurement due to the fair value of the hybrid note and embedded derivative exceeding the proceeds that the Company received from the arrangement. Therefore, Company was required to record a $16,690 loss on the derivative financial instrument. In addition, the fair value will change in future periods, based upon changes in the Company’s common stock price and changes in other assumptions and market indicators used in the valuation techniques. These future changes will be currently recognized in interest expense or interest income on the Company’s statement of operations. The conversion of the note into shares of the Company’s common stock is potentially highly dilutive to current shareholders. If the note holder elects to sell the shares that it has acquired as a result of converting the note into shares of common stock, then any such sales may result in a significant decrease in the market price of the Company’s shares. During the period ended December 31, 2016, the principal balance and accrued interest was converted into 50,268,153 shares of common stock. Convertible Note Payable Dated December 15, 2015 at Fair Value On December 15, 2015 the Company entered into a convertible note payable with a corporation. The note payable in the amount of $27,500, including a $2,500 original issue discount, and bears interest at 12.0% per annum and is due on September 3, 2017. The convertible note payable is convertible, at the holder’s option, into the Company’s common shares at the Variable Conversion Price. The Variable Conversion Price is defined as 65% multiplied by the lowest trade price for the Company’s common stock in the twenty-five (25) trading day period previous to the conversion. The conversion feature is subject to full-ratchet, anti-dilution protection if the Company sells shares or share-indexed financing instruments at less than the conversion price. In the evaluation of the financing arrangement, the Company concluded that the conversion feature did not meet the conditions set forth in current accounting standards for equity classification. Since equity classification is not available for the conversion feature, it requires bifurcation and liability classification, at fair value. The Company elected to account for this hybrid contract under the guidance of ASC 815-15-25-4. In connection with the issuance of the convertible note payable, the Company recognized day-one derivative loss totaling $29,789 related to the recognition of (i) the hybrid note and (ii) the derivative instrument arising from the fair value measurement due to the fair value of the hybrid note and embedded derivative exceeding the proceeds that the Company received from the arrangement. Therefore, the Company was required to record a $29,789 loss on the derivative financial instrument. In addition, the fair value will change in future periods, based upon changes in the Company’s common stock price and changes in other assumptions and market indicators used in the valuation techniques. These future changes will be currently recognized in interest expense or interest income on the Company’s statement of operations. The conversion of the note into shares of the Company’s common stock is potentially highly dilutive to current shareholders. If the note holder elects to sell the shares that it has acquired as a result of converting the note into shares of common stock, then any such sales may result in a significant decrease in the market price of the Company’s shares. During the period ended December 31, 2016, the principal balance and accrued interest was converted into 53,181,384 shares of common stock. Convertible Note Payable Dated March 24, 2016 at Fair Value On March 24, 2016 the Company entered into a convertible note payable with a corporation. The note payable, with a face value of $33,000, including a $3,000 of original issue discount, bears interest at 12.0% per annum and is due on March 24, 2017. The convertible note payable is convertible, at the holder’s option, into the Company’s common shares at the Variable Conversion Price. The Variable Conversion Price is defined as 62% multiplied by the lowest closing bid price for the Company’s common stock during the twenty-five (25) trading day period including the day the notice of conversion is received by the Company. If the Company’s market capitalization is less than $1,000,000 on the day immediately prior to the date of the notice of conversion, then the conversion price shall be 25% multiplied by the lowest closing price as of the date notice of conversion is given and if the closing price of the Company’s common stock on the day immediately prior to the date of the notice of conversion is less than $0.0009 then the conversion price shall be 25% multiplied by the lowest closing price as of the date a notice of conversion is given. The conversion feature is subject to full-ratchet, anti-dilution protection if the Company sells shares or share-indexed financing instruments at less than the conversion price. In the evaluation of the financing arrangement, the Company concluded that the conversion feature did not meet the conditions set forth in current accounting standards for equity classification. Since equity classification is not available for the conversion feature, it requires bifurcation and liability classification, at fair value. The Company elected to account for this hybrid contract under the guidance of ASC 815-15-25-4. In connection with the issuance of the convertible note payable, during the three month period ended March 31, 2016 the Company recognized day-one derivative loss totaling $32,210 related to the recognition of (i) the hybrid note and (ii) the derivative instrument arising from the fair value measurement due to the fair value of the hybrid note and embedded derivative exceeding the proceeds that the Company received from the arrangement. Therefore, during the three month period ended March 31, 2016 the Company was required to record a $102,882 loss on the derivative financial instrument and is included in interest expense. In addition, the fair value will change in future periods, based upon changes in the Company’s common stock price and changes in other assumptions and market indicators used in the valuation techniques. These future changes will be currently recognized in interest expense or interest income on the Company’s statement of operations. The conversion of the note into shares of the Company’s common stock is potentially highly dilutive to current shareholders. If the note holder elects to sell the shares that it has acquired as a result of converting the note into shares of common stock, then any such sales may result in a significant decrease in the market price of the Company’s shares. During the period ended December 31, 2016, the principal balance and accrued interest was converted into 69,091,471 shares of common stock. NOTE 8 - MATERIAL AGREEMENTS Agreement to Explore a Shipwreck Site Located off of Brevard County, Florida On March 1, 2014, Seafarer entered into a partnership and ownership with Marine Archaeology Partners, LLC, with the formation of Seafarer’s Quest, LLC. Such LLC was formed in the State of Florida for the purpose of permitting, exploration and recovery of artifacts from a designated area on the east coast of Florida. Such site area is from a defined, contracted area by a separate entity, which a portion of such site is designated from a previous contracted holding through the State of Florida. Under such agreement, Seafarer is responsible for costs of permitting, exploration and recovery, and is entitled to 60% of such artifact recovery. Seafarer has a 50% ownership, with designated management of the LLC coming from Seafarer. Exploration Permit with the Florida Division of Historical Resources for an Area off of Melbourne Beach, Florida On July 28, 2014, Seafarer’s Quest, LLC, received a 1A-31 Permit (the “Permit”) from the Florida Division of Historical Resources for an area identified off of Melbourne Beach, Florida. The Permit is active for three years from the date of issuance. Exploration Permit with the Florida Division of Historical Resources for an Area off of Melbourne Beach, Florida On July 6, 2016, Seafarer’s Quest, LLC, received a 1A-31 Permit (the “Permit”) from the Florida Division of Historical Resources for a second area identified off of Melbourne Beach, Florida. The Permit is active for three years from the date of issuance. Certain Other Agreements In January of 2016 the Company entered into a consulting agreement with an individual under which the individual agreed to provide corporate communications services and shareholder notification and awareness services. The term of the agreements is for twelve months and the Company agreed to pay the consultant 4,000,000 shares of restricted common stock to perform the services. In April of 2016, the Company entered into agreements with seven separate individuals to either join or rejoin the Company’s advisory council. Under the advisory council agreements all of the advisors agreed to provide various advisory services to the Company, including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect to the Company's business, and providing such other advisory or consulting services as may be appropriate from time to time. The term of each of the advisory council agreements is for one year. In consideration for the performance of the advisory services, the Company agreed to issue the advisors shares of the Company’s restricted common stock including 4,000,000 shares each to three of the advisors, 3,000,000 shares each to three of the advisors and 2,000,000 shares to one of the advisors, an aggregate total of 23,000,000 restricted shares. According to the agreements each of the advisors’ shares vest at a rate of 1/12th of the amount per month over the term of the agreement. If any of the advisors or the Company terminates the advisory council agreements prior to the expiration of the one year terms, then each of the advisors whose agreement has been terminated has agreed to return to the Company for cancellation any portion of their shares that have not vested. Under the advisory council agreements, the Company has agreed to reimburse the advisors for preapproved expenses. In April of 2016, the Company entered into a consulting agreement with a limited liability company under which the consultant agreed to provide diving services, assist in maintaining Seafarer’s vessels and equipment, and provide operational and project management services for Seafarer’s exploration and recovery diving operations. The term of the consulting agreement is from April 1, 2016 to March 31, 2017 and at the end of the term the consulting agreement may be renegotiated. The consultant reports directly to the CEO of Seafarer. The Company agreed to pay $125 per day to the consultant plus an initial $25 per day for operational and site management services. The Company also agreed to pay $700 per month to the consultant for campground and electrical services while the consultant is on site providing services to the Company The Company also agreed to pay 4,000,008 shares of restricted common stock to the consultant for the services. The shares vest at a rate of 333,334 shares per month over a twelve month period. If the Company or the consultant terminates the agreement prior to the end of the term of the agreement then any of the shares that have not yet vested will be cancelled. The Company, in its sole discretion, may pay the consultant additional compensation or bonuses. In April of 2016, the Company paid 2,880,000 shares of restricted common stock to an individual for providing past project management services related to the Company’s dive operations. In April of 2016 the Company entered into a consulting agreement with a corporation under which the corporation agreed to provide various services including business development, mergers and acquisitions, business strategy and analysis of business opportunities in the historic shipwreck exploration business in Panama. The consultant will not negotiate on behalf of the Company or provide any market making or listing services. The term of the agreement is open ended and will continue until the completion of the consulting services. The Company agreed to pay the consultant a total of 2,000,000 shares of restricted common stock. In April of 2016 the Company entered into a consulting agreement with a corporation under which the corporation agreed to provide various services including business development, mergers and acquisitions and business. The consultant will not negotiate on behalf of the Company or provide any market making or listing services. The term of the agreement is open ended and will continue until the completion of the consulting services. The Company agreed to pay the consultant a total of 1,000,000 shares of restricted common stock. In May of 2016, the Company entered into an agreement with an individual to rejoin the Company’s advisory council. Under the advisory council agreement the advisor agreed to provide various advisory services to the Company, including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect to the Company's business, and providing such other advisory or consulting services as may be appropriate from time to time. The term of each of the advisory council agreement is for one year. In consideration for the performance of the advisory services, the Company agreed to issue the advisor 2,000,000 shares of restricted common stock. According to the agreements the advisor’s shares vest at a rate of 1/12th of the amount per month over the term of the agreement. If the advisor or the Company terminates the advisory council agreement prior to the expiration of the one year term, the advisor has agreed to return to the Company for cancellation any portion of the shares that have not vested. Under the advisory council agreement, the Company has agreed to reimburse the advisor for preapproved expenses. In May of 2016, the Company extended the term of a previous agreement with an individual who is related to the Company’s CEO to continue serving as a member of the Company’s Board of Directors. Under the agreement, the Director agreed to provide various services to the Company including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect for one year and may be terminated by either the Company or the Director by providing written notice to the other party. The agreement also terminates automatically upon the death, resignation or removal of the Director. Under the terms of the agreement, the Company agreed to pay the Director 20,000,000 shares of restricted common stock and to negotiate future compensation on a year-by-year basis. The Company also agreed to reimburse the Director for preapproved expenses. In May of 2016, the Company extended the term of a previous agreement with an individual who is related to the Company’s CEO to continue serving as a member of the Company’s Board of Directors. Under the agreement, the Director agreed to provide various services to the Company including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect for one year and may be terminated by either the Company or the Director by providing written notice to the other party. The agreement also terminates automatically upon the death, resignation or removal of the Director. Under the terms of the agreement, the Company agreed to pay the Director 20,000,000 shares of restricted common stock and to negotiate future compensation on a year-by-year basis. The Company also agreed to reimburse the Director for pre-approved expenses. In May of 2016, the Company issued a consultant 5,000,000 shares of restricted common stock for providing various project management services related to the Company’s shipwreck exploration and recovery services. The Company believes that the consultant has provided services at below market rates of compensation and the shares were paid both to more fairly compensate the consultant and as a bonus and inducement for the consultant to continue to provide services to the Company. In June of 2016, the Company entered into a consulting agreement with two individuals under which the individuals agreed to provide various consulting services including website development to include a storefront, and business strategy relating to business development for the Company’s digital storefront and Internet merchandising site. The term of the agreement is open ended and will continue until the completion of the services. The Company agreed to pay each consultant 2,000,000 shares of its restricted common stock, a total of 4,000,000 shares of restricted common stock. In June of 2016, the Company entered into a consulting agreement with an individual who is related to the Company’s CEO under which the individual agreed to provide various consulting services including business development, photography, custom logo design and development, developing corporate identity materials such as business cards, editing, art illustrations, and working with the Company and other consultants to develop its future digital storefront and Internet merchandise site. The term of the agreement is open ended and will continue until the completion of the services. The Company agreed to pay the consultant a total of 5,000,000 shares of restricted common stock. In July of 2016, the Company entered into a consulting agreement with a corporation under which the corporation agreed to provide various services including business development, mergers and acquisitions and business. The consultant will not negotiate on behalf of the Company or provide any market making or listing services. The term of the agreement is open ended and will continue until the completion of the consulting services. The Company agreed to pay the consultant a total of 5,000,000 shares of restricted common stock. In July of 2016, the Company issued 4,732,000 shares of restricted common stock to a consultant to reimburse the consultant for travel expenses and time incurred for setting up various meetings. In July of 2016, the Company entered into a consulting agreement with an individual under which the individual agreed to provide various consulting services including website development to include business development, assistance with other consultants in developing and maintaining a digital store front, film editing, and for other Web based consulting relating to the Company’s efforts to develop Internet merchandising opportunities. The term of the agreement is open ended and will continue until the completion of the services. The Company agreed to pay the consultant 2,500,000 shares of its restricted common stock. In July of 2016, the Company entered into a consulting agreement with an individual under which the individual agreed to provide various consulting services including media, business development related to television and motion pictures, and general consulting related to media and entertainment. The term of the agreement is open ended and will continue until the completion of the services. The Company agreed to pay the consultant 2,000,000 shares of its restricted common stock. In September of 2016 the Company issued 5,000,000 shares of restricted common stock to one of its legal advisors. The shares were issued as a retention bonus for the advisor’s past legal services rendered, as well to induce the advisor to continue to provide services on favorable terms to the Company. In September of 2016 the Company issued 1,500,000 shares of restricted common stock to one of its consultants. The shares were issued as retention bonus as well to induce the consultant to continue to provide services on favorable terms to the Company. In September of 2016 the Company issued 15,000,000 shares of restricted common stock to one of its business advisory consultants. The shares were issued as retention bonus as well to induce the consultant to continue to provide services on favorable terms to the Company. In September of 2016 the Company issued a total of 13,000,000 shares of restricted common stock to nine independent contractor consultants who provide various services relating to the Company’s diving operations. The shares were issued as retention bonus as well to induce the consultant to continue to provide services on favorable terms to the Company. In December of 2016, the Company entered into an agreement with an individual to join the Company’s advisory council. Under the advisory council agreement the advisor agreed to provide various advisory services to the Company, including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect to the Company's business, and providing such other advisory or consulting services as may be appropriate from time to time. The term of each of the advisory council agreement is for one year. In consideration for the performance of the advisory services, the Company agreed to issue the advisor 2,000,000 shares of restricted common stock. According to the agreements the advisor’s shares vest at a rate of 333,333 shares per month over the term of the agreement. If the advisor or the Company terminates the advisory council agreement prior to the expiration of the one year term, the advisor has agreed to return to the Company for cancellation any portion of the shares that have not vested. Under the advisory council agreement, the Company has agreed to reimburse the advisor for preapproved expenses. The Company has a verbal agreement with a limited liability company that is controlled by a person who is related to the Company’s CEO to pay the related party consultant $3,000 per month to provide general business consulting and assessing the Company's business and to advise management with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions, perform period background research including background checks and provide investigative information on individuals and companies and to occasional assist as an administrative specialist to perform various administrative duties and clerical services including reviewing the Company’s agreements and books and records During the year ended December 31, 2016 the company paid the related party consultant a total of $32,950 for consulting services. The consultant provides the services under the direction and supervision of the Company’s CEO. At December 31, 2016, the Company owed the related party limited liability company $2,736. The Company has an ongoing agreement with a limited liability company that is owned and controlled by a person who is related to the Company’s CEO to provide stock transfer agency services. During the period ended December 31, 2016 the Company paid the related party consultant $12,000 in fees for transfer agency services and entered into a debt settlement agreement with a related party vendor to settle a total of $32,213 of outstanding debt related to transfer agent fees and legal fees incurred by the related party vendor due to a lawsuit against the Company in which suit the related party vendor was also named as a defendant due to its position as the Company’s stock transfer agency. The Company issued 32,212,790 shares of its restricted common stock to this vendor as satisfaction for the outstanding debt. The agreement between the Company and the vendor stipulated that should the transfer agency realize less than $32,213from the sale of the stock, then the consultant is entitled to receive up to an additional 11,000,000 shares of common stock or a cash payment until the balance is paid in full. At December 31, 2016, the Company owed the related party limited liability company $2,736. The Company has an ongoing agreement to pay a limited liability company a monthly fee of $3,500 in cash or $5,000 per month in restricted stock for archeological services and the review of historic shipwreck research consulting services. The Company has an ongoing agreement to pay an individual a monthly fee of $1,500 per month for archeological consulting services. The Company has an ongoing consulting agreement to pay a limited liability company a minimum of $5,000 per month for business advisory, strategic planning and consulting services, assistance with financial reporting, IT management, and administrative services. The Company also agreed to reimburse the consultant for expenses. The agreement is verbal and may be terminated by the Company or the consultant at any time. NOTE 9 - LEGAL PROCEEDINGS On March 23, 2016 the Board of Directors signed a universal settlement agreement with the Plaintiffs in the litigation matters of Micah Eldred, et al., v. Seafarer Exploration, et al., Hillsborough County, Florida, Case No. 09-CA-30763, and Micah Eldred v. Seafarer Exploration Corp., et al., Hillsborough County, Florida, Case No. 14-CA-5360, and in the matter of Seafarer Exploration, et al. v. Micah Eldred, et al., Hillsborough County, Florida, Court of Appeals Case No. 14-2884, specifically: Micah Eldred, Michael Daniels, Diane J. Harrison, James Eldred, Mary R. Eldred, Michole Eldred, Nathan Eldred, Toni A. Eldred, Toni A. Eldred FBO Jordan Gratton, Toni A. Eldred FBO Justin Gratton, Vanessa A Verbosh, Oksana Savchenko, Matthew J. Presy, Olessia Kritskaia, Ekaterina Messinger, Abby Lord, Ioulia Hess, Anna Krokhina, George Linder, Christine Zitman, Carl Dilley, Heather Dilley, Robert Lizzano, Elizabeth Lizzano, Karen Lizzano, Susan Miller, Jillian Mally, Michael Mona, Alan Wolper, Sarah Wolper, Alan Wolper FBO Michael Wolper, Spartan Securities Group, Ltd., and Am Asia Consulting entered into the settlement agreement with Seafarer. An earlier named party, CADEF, The Childhood Autism Foundation, Inc., had previously entered into a settlement agreement, stating they had no knowledge of the suit or parties and had not agreed to sue Seafarer, and is no longer a party in the Litigation. The settlement called for both cases to be dismissed, with prejudice, and the Plaintiffs in case number 09-CA-30763 agreed to surrender and cancel all of their 32,300,000 shares of restricted common stock which were returned to the treasury of the Corporation. All such shares have been returned for cancellation. On March 23, 2016 Seafarer CEO signed the resolution to cancel the 32,300,000 shares and instructed the transfer agent ClearTrust LLC to cancel the shares and return them to treasury for the benefit of Seafarer thus reducing the number of outstanding shares by 32,300,000 shares. At the present time the dismissal has been filed and the case closed, with all shares cancelled. On June 18, 2013, Seafarer began litigation against Tulco Resources, LLC, in a lawsuit filed in the Circuit Court in and for Hillsborough County, Florida. Such suit was filed for against Tulco based upon for breach of contract, equitable relief and injunctive relief. Tulco was the party holding the rights under a permit to a treasure site at Juno Beach, Florida. Tulco and Seafarer had entered into contracts in March 2008, and later renewed under an amended agreement on June 11, 2010. Such permit was committed to by Tulco to be an obligation and contractual duty to which they would be responsible for payment of all costs in order for the permit to be reissued. Such obligation is contained in the agreement of March 2008 which was renewed in the June 2010 agreement between Seafarer and Tulco. Tulco made the commitment to be responsible for payments of all necessary costs for the gaining of the new permit. Tulco never performed on such obligation, and Seafarer during the period of approximately March 2008 and April 2012 had endeavored and even had to commence a lawsuit to gain such permit which was awarded in April 2012. Seafarer alleges in their complaint the expenditure of large amounts of shares and monies for financing and for delays due to Tulco’s non-performance. Seafarer seeks monetary damages and injunctive relief for the award of all rights held by Tulco to Seafarer Seafarer gained a default and final Judgment on such matter on July 23, 2014. Seafarer is now working with the State for the renewed permit to be in Seafarer’s name and rights only, with Tulco removed per the Order of the Court. On March 4, 2015, the Court awarded full rights to the Juno sight to Seafarer Exploration, erasing all rights of Tulco Resources. The company has currently filed an Admiralty Claim over such sight in the United States District Court which is pending final ruling. On October 21, 2016 a hearing on the Admiralty Claim in the United States District Court for the Southern District of Florida was held, where the Court Ordered actions to take place for ongoing admiralty claim, which will occur during the month of November 2016. The Court subsequently entered and Order directing the arrest warrant for such site, and such arrest warrant has been issued by the Clerk of Court. Such warrant entry is now in process by the Company. On September 3, 2014, the Company filed a lawsuit against Darrel Volentine, of California. Mr. Volentine was sued in two counts of libel per se under Florida law, as well as a count for injunction against Volentine to exclude and prohibit internet postings. Such lawsuit was filed in the Circuit Court in Hillsborough County, Florida. Such suit is based upon Internet postings on www.investorshub.com. On or about October 15, 2015, the Company and Volentine entered into a stipulation whereby Volentine admitted to his tortious conduct, however the stipulated damages of 10,300,000 agreed to were questioned by the Court, and the Company proceeded to trial on damages against Volentine in a non-jury trial on December 1, 2015. Volentine is the subject of a contempt of court motion which was heard on April 7, 2016, whereby the Court found a violation and modified the injunction against Volentine, and imposed other matters of potential penalties against Volentine. The Court also awarded attorney’s fees against Volentine on behalf of Seafarer for such motion. Volentine subsequently attempted to have such ruling, evidence and testimony attacked through a motion heard before the Court on October 24, 2016. Volentine lost, The Court dismissed Volentine’s motion after presentation of Volentine’s case at the hearing. The Plaintiff has set the matter for entry of the attorney’s fees amount due from Volentine for hearing in December 2016. As well the Plaintiff has set for hearing its motion for sanctions in the form of attorney’s fees for frivolous filing of the October 24th motion, which motion was also set for hearing in December 2016. The Plaintiff filed a renewed and amended motion for punitive damages in the case on September 11, 2016, which has not been set for hearing. Volentine had also filed a motion for summary judgment on the matter of notice entitlement pre-suit, was denied by the Court and Volentine lost again. The Plaintiff filed a motion for sanctions against Volentine for the motion for summary judgment being frivolous under existing law, and such motion is pending ruling on the motion. Discovery is ongoing on such case. On December 7, 2016, the Court held a hearing on Volentine’s motion for sanctions, and essentially attempting to rehear the motion for contempt against Volentine. The Court dismissed Volentine’s motions, and renewed the ability of the Company to seek attorney’s fees on such matter, which hearing has not been set at present. On February 28, 2017, the Court entered an Order denying Volentine’s motion for summary judgment. The Company has a pending motion for sanctions related to Volentine’s filing of the motion for summary judgment which has not been set for hearing. The Company will be attempting to set such matter for trial during 2017. NOTE 10 - RELATED PARTY TRANSACTIONS In January of 2016, the Company entered into a convertible promissory note agreement in the amount of $5,000 with an individual who is related to the Company’s CEO. This loan pays interest at a rate of 6% per annum and the principle and accrued interest was due on or before July 12, 2016. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.002 per share. In January of 2016 a shareholder who is related to the Company’s CEO provided a loan in the amount of $260 to the Company. This loan pays 0% interest. In February 2016, the Company’s CEO provided a loan to the Company in the amount of $4,000. This loan pays interest at a rate of 6% per annum and if the loan and accrued interest are not repaid within 90 days from February 10, 2016 then the lender is entitled to receive 500,000 shares of the Company’s restricted common stock which has not been issued. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.002 per share. In May of 2016, the Company’s CEO provided a loan to the Company in the amount of $1,200. This loan was repaid during the year ended December 31, 2016, no interest was paid. In May of 2016, the Company extended the term of a previous agreement with an individual who is related to the Company’s CEO to continue serving as a member of the Company’s Board of Directors. Under the agreement, the Director agreed to provide various services to the Company including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect for one year and may be terminated by either the Company or the Director by providing written notice to the other party. The agreement also terminates automatically upon the death, resignation or removal of the Director. Under the terms of the agreement, the Company agreed to pay the Director 20,000,000 restricted shares of its common stock and to negotiate future compensation on a year-by-year basis. The Company also agreed to reimburse the Director for preapproved expenses. In May of 2016, the Company extended the term of a previous agreement with an individual who is related to the Company’s CEO to continue serving as a member of the Company’s Board of Directors. Under the agreement, the Director agreed to provide various services to the Company including making recommendations for both the short term and the long term business strategies to be employed by the Company, monitoring and assessing the Company's business and to advise the Company’s Board of Directors with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions and identifying and evaluating alternative courses of action, making suggestions to strengthen the Company's operations, identifying and evaluating external threats and opportunities to the Company, evaluating and making ongoing recommendations to the Board with respect for one year and may be terminated by either the Company or the Director by providing written notice to the other party. The agreement also terminates automatically upon the death, resignation or removal of the Director. Under the terms of the agreement, the Company agreed to pay the Director 20,000,000 restricted shares of its common stock and to negotiate future compensation on a year-by-year basis. The Company also agreed to reimburse the Director for preapproved expenses. In May of 2016, the Company entered into a convertible promissory note agreement in the amount of $5,000 with an individual who is related to the Company’s CEO. This loan pays interest at a rate of 6% per annum and the principle and accrued interest are due on or before November 10, 2016. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.0005 per share. The related party lender received 2,500,000 warrants to purchase shares of the Company’s common stock at a price of $0.002. This note remains unpaid. In May of 2016, the Company entered into a convertible promissory note agreement in the amount of $5,000 with an individual who is related to the Company’s CEO. This loan pays interest at a rate of 6% per annum and the principle and accrued interest are due on or before November 10, 2016. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.0005 per share. The related party lender received 2,500,000 warrants to purchase shares of the Company’s common stock at a price of $0.002. This note remains unpaid. In May of 2016, the Company entered into a convertible promissory note agreement in the amount of $5,000 with an individual who is related to the Company’s CEO. This loan pays interest at a rate of 6% per annum and the principle and accrued interest are due on or before November 20, 2016. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.0005 per share. The related party lender received 10,000,000 warrants to purchase shares of the Company’s common stock at a price of $0.002. This note remains unpaid. In June of, 2016, the Company entered into a consulting agreement with an individual who is related to the Company’s CEO under which the individual agreed to provide various consulting services including business development, photography, custom logo design and development, developing corporate identity materials such as business cards, editing, art illustrations, and working with the Company to develop its future digital storefront and Internet merchandise site. The term of the agreement is open ended and will continue until the completion of the services. The Company agreed to pay the consultant a total of 5,000,000 million shares of its restricted common stock. On various dates in July of 2016 the Company repaid a total of $3,180 of the principal balance of several loans owed to a related party. No interest or financing fees were paid to the related party in conjunction with the repayment of the loans. In July of 2016, the Company entered into a convertible promissory note agreement in the amount of $2,400 with an individual who is related to the Company’s CEO. This loan pays interest at a rate of 6% per annum and the principle and accrued interest are due on or before January 12, 2017. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.0006 per share. The related party lender received 4,000,000 warrants to purchase shares of the Company’s common stock at a price of $0.002. In August of 2016, the Company entered into a debt settlement agreement with a related party vendor to settle a total of $32,213 of outstanding debt related to transfer agent fees and legal fees incurred by the related party vendor due to a lawsuit against the Company in which suit the related party vendor was also named as a defendant due to its position as the Company’s stock transfer agency. The Company issued 32,212,790 shares of its restricted common stock to this vendor as satisfaction for the outstanding debt. The agreement between the Company and the vendor stipulated that should the transfer agency realize less than $32,213from the sale of the stock, then the consultant is entitled to receive up to an additional 11,000,000 shares of common stock or a cash payment until the balance is paid in full. In September of 2016, the Company agreed to pay a related party to the Company’s CEO, 25,000,000 shares of its restricted common stock for the purchase of a magnetometer owned by the related party. The related party had previously purchased the magnetometer and agreed to rent the equipment to the Company in 2015, however the Company and the related party never agreed to a specific rental price and the Company never made any rental payments or paid any fees for use of the equipment. The agreement specifically states that the Company does not owe the related party any past fees for rental or equipment charges for use of the magnetometer. In December of 2016, the Company’s CEO provided a loan to the Company in the amount of $1,500. This loan has an interest rate 2%. After six months from December 16, 2016 the lender has the right to convert the loan in to shares of the Company’s common stock at a rate of $0.005 per share. On various dates during the period ended December 31, 2016 the Company repaid a total of $8,500 to its CEO in order to repay loans the CEO had previously provided to the Company. The Company has a verbal agreement with a limited liability company that is controlled by a person who is related to the Company’s CEO to pay the related party consultant $3,000 per month to provide general business consulting and assessing the Company's business and to advise management with respect to an appropriate business strategy on an ongoing basis, commenting on proposed corporate decisions, perform period background research including background checks and provide investigative information on individuals and companies and to occasional assist as an administrative specialist to perform various administrative duties and clerical services including reviewing the Company’s agreements and books and records. During the year ended December 31, 2016 the company paid the related party consultant a total of $32,950 for consulting services. At December 31, 2016 the Company owed the consultant a total of $5,950. The consultant provides the services under the direction and supervision of the Company’s CEO. The Company has an agreement with a limited liability company that is owned and controlled by a person who is related to the Company’s CEO to provide stock transfer agency services. During the year ended December 31, 2016 the company paid the related party consultant a total of $2,000 for consulting services. At December 31, 2016, the Company owed the related party limited liability company $2,736 for transfer agency services rendered and for the reimbursement of legal fees. At December 31, 2016 the following promissory notes and shareholder loans were outstanding to related parties: A convertible note payable dated January 9, 2009 due to a person related to the Company’s CEO with a face amount of $10,000. This note bears interest at a rate of 10% per annum with interest payments to be paid monthly and is convertible at the note holder’s option into the Company’s common stock at $0.015 per share. The convertible note payable was due on or before January 9, 2010 and is secured. This note is currently in default due to non-payment of principal and interest. A convertible note payable dated January 25, 2010 in the principal amount of $6,000 with a person who is related to the Company’s CEO. This loan pays interest at a rate of 6% per annum and the principle and accrued interest were due on or before January 25, 2011. The note is not secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.005 per share. This note is currently in default due to non-payment of principal and interest. A note payable dated February 24, 2010 in the principal amount of $7,500 with a corporation. The Company’s CEO was a director of the corporation. The loan is not secured and pays interest at a rate of 6% per annum and the principle and accrued interest were due on or before February 24, 2011. This note is currently in default due to non-payment of principal and interest. A convertible note payable dated January 18, 2012 in the amount of $50,000 with two individuals who are related to the Company’s CEO. This loan pays interest at a rate of 8% per annum and the principle and accrued interest were due on or before July 18, 2012. The note is secured and is convertible at the lender’s option into shares of the Company’s common stock at a rate of $0.004 per share. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated January 19, 2013 due to a person related to the Company’s CEO with a face amount of $15,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.004 per share. The convertible note payable was due on or before July 30, 2013 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated July 26, 2013 due to a person related to the Company’s CEO with a face amount of $10,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.01 per share. The convertible note payable was due on or before January 26, 2014 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated January 17, 2014 due to a person related to the Company’s CEO with a face amount of $31,500. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.006 per share. The convertible note payable is due on or before July 17, 2015 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated May 27, 2014 due to a person related to the Company’s CEO with a face amount of $7,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.007 per share. The convertible note payable was due on or before November 27, 2014 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated July 21, 2014 due to a person related to the Company’s CEO with a face amount of $17,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.008 per share. The convertible note payable was due on or before January 25, 2015 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated October 16, 2014 due to a person related to the Company’s CEO with a face amount of $21,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0045 per share. The convertible note payable was due on or before April 16, 2015 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated July 14, 2015 due to a person related to the Company’s CEO with a face amount of $9,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0030 per share. The convertible note payable was due on or before January 14, 2016 and is not secured. The note is currently in default due to non-payment of principal and interest. A note payable dated October 6, 2015 in the principal amount of $10,000 due to one of the Company’s Directors. The loan is not secured and pays interest at a rate of 6% per annum and the principle and accrued interest was due on or before November 11, 2015. This note is currently in default due to non-payment of principal and interest. A loan in the amount of $19,983 due to the Company’s CEO. The loan is not secured and pays interest at a 6% per annum and the principal and accrued interest and was due on or before June 14, 2016. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated January 12, 2016 due to a person related to the Company’s CEO with a face amount of $5,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0020 per share. The convertible note payable was due on or before July 12, 2016 and is not secured. The note is currently in default due to non-payment of principal and interest. A loan in the amount with the remaining principal balance of $1,200 due to the Company’s CEO. The loan is not secured and pays interest at a 6% per annum. The lender is entitled to receive 500,000 shares of the Company’s restricted common stock due to the loan not being repaid within 90 days from February 10, 2016. A convertible note payable dated May 10, 2016 due to a person related to the Company’s CEO with a face amount of $5,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0005 per share. The convertible note payable was due on or before November 10, 2016 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated May 10, 2016 due to a person related to the Company’s CEO with a face amount of $5,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0005 per share. The convertible note payable was due on or before November 10, 2016 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated May 20, 2016 due to a person related to the Company’s CEO with a face amount of $5,000. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0005 per share. The convertible note payable was due on or before November 20, 2016 and is not secured. The note is currently in default due to non-payment of principal and interest. A convertible note payable dated July 12, 2016 due to a person related to the Company’s CEO with a face amount of $2,400. This note bears interest at a rate of 6% per annum with accrued interest to be paid at the time that the principal balance is repaid or the note is converted into shares of the Company’s common stock. The note is convertible at the note holder’s option into the Company’s common stock at $0.0006 per share. The convertible note payable is due on or before January 12, 2017 and is not secured. A loan in the amount of $1,500 due to the Company’s CEO. The loan is not secured and pays interest at a 2% per annum. After the loan has aged for six months from December 16, 2016 the lender has the right to convert the loan into shares of the Company’s restricted common shares at a rate of $0.005 per share. NOTE 11 - SUBSEQUENT EVENTS Per the Company’s filing on Form 8-K filed on March 10, 2017, on February 24, 2017 the Board of Directors, pursuant to Section 607.0704, Florida Statutes, the Board of Directors, acting as shareholders of the Preferred Shares and pursuant to their own resolution, voted to increase the authorized shares of the Corporation from 2,500,000,000 common shares to 2,900,000,000 common shares. Such filing was processed to be effective with the State of Florida on March 2, 2017. Subsequent to December 31, 2016, through March 31, 2017, the Company sold or issued shares of its common stock as follows (unaudited): (i) sales of 57,000,000 shares of common stock for proceeds of $80,000, used for general working capital purposes. (ii) issuance of 51,524,000 shares of common stock for services valued in the aggregate amount of $175,800. (iii) issuance of 26,524,000 shares of common stock for conversion and satisfaction of debt in the amount of $26,524; and (iv) issuance of 89,212,790 shares not previously issued due to an administrative time lag.
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Here's a summary of the financial statement:
The company is experiencing significant financial challenges:
1. Profitability: Consistent losses and negative cash flows since inception
2. Financial Viability: Substantial doubt about the company's ability to continue operating
3. Cash Position: Expected to exhaust available cash within one month (as of April 3)
4. Assets: Fixed assets recorded at historical cost, using straight-line depreciation
5. Liabilities: No cash equivalents as of December 31
6. Management is aware of these issues and has plans to address them (referenced in Note 2)
Overall, the financial statement indicates the company is in a precarious financial position with limited resources and ongoing operational losses.
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Claude
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. COTIVITI HOLDINGS, INC. Index to Consolidated Financial Statements Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Cotiviti Holdings, Inc.: We have audited the accompanying consolidated balance sheets of Cotiviti Holdings, Inc. and subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income (loss), stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. In connection with our audits of the consolidated financial statements, we also have audited Schedule I and II. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial and financial statement schedules based on our audits. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cotiviti Holdings, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when consideration in relation to basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG LLP New York, New York February 23, 2017 Cotiviti Holdings, Inc. Consolidated Balance Sheets (In thousands, except share and per share amounts) See accompanying notes to consolidated financial statements. Cotiviti Holdings, Inc. Consolidated Statements of Comprehensive Income (Loss) (In thousands, except share and per share amounts) See accompanying notes to consolidated financial statements. Cotiviti Holdings, Inc. Consolidated Statements of Stockholders’ Equity (In thousands, except shares) Cotiviti Holdings, Inc. Consolidated Statements of Cash Flows (In thousands) See accompanying notes to consolidated financial statements Cotiviti Holdings, Inc. Notes to the Financial Statements (In thousands, except shares and per share amounts) Note 1. Description of Business Cotiviti Holdings, Inc. (collectively with its subsidiaries, “we,” “our,” “Cotiviti” or the “Company”) is a leading provider of analytics-driven payment accuracy solutions, focused primarily on the healthcare sector. Our integrated solutions help clients enhance payment accuracy in an increasingly complex healthcare environment. We leverage our robust technology platform, configurable analytics, proprietary information assets and expertise in healthcare reimbursement to help our clients enhance their claims payment accuracy. We help our healthcare clients identify and correct payment inaccuracies. We work with over 40 healthcare organizations, including 20 of the 25 largest U.S. commercial, Medicaid and Medicare managed health plans, as well as CMS. We are also a leading provider of payment accuracy solutions to over 35 retail clients, including eight of the ten largest retailers in the United States. We were founded as Connolly in 1979 as a provider of payment accuracy solutions to the retail industry and launched our retrospective claims accuracy solutions to the healthcare industry in 1998. Connolly was acquired by the funds managed by Advent in 2012. In May 2014, Connolly merged with iHealth Technologies which was founded in 2001. At the time of the merger, Connolly was a leading provider of retrospective claims accuracy solutions to U.S. healthcare providers and retailers and iHealth Technologies was a leading provider of prospective claims accuracy solutions to U.S. healthcare providers. As a result of the Connolly iHealth Merger, iHT and all of its wholly owned subsidiaries became our wholly owned subsidiaries. The results of operations for iHT are included in our consolidated financial statements as of and since May 14, 2014. Accordingly, comparability to other periods presented is impacted by the timing of the Connolly iHealth Merger. We have adopted a holding company structure and our primary domestic operations are performed through our wholly owned operating subsidiaries. We have international operations in Canada, the United Kingdom and India. We rebranded our company as “Cotiviti” in September 2015. Note 2. Summary of Significant Accounting Policies Basis of Presentation The accompanying consolidated financial statements include our accounts and our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation. Use of Estimates The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions affecting the reported amounts in our consolidated financial statements and accompanying notes. These estimates are based on information available as of the date of the Consolidated Financial Statements; therefore, actual results could differ from those estimates. Foreign Currency Translation Assets and liabilities of our foreign subsidiaries with a functional currency other than the U.S. Dollar are translated into U.S. Dollars using applicable exchange rates at the balance sheet date. Revenue and expenses are translated at average exchange rates effective during the year. The resulting foreign currency translation gains and losses are included as a component of accumulated other comprehensive (loss) income within stockholders’ equity on our Consolidated Balance Sheets. Assets and liabilities of our foreign subsidiaries for which the functional currency is the U.S. Dollar are re-measured into U.S. Dollars using applicable exchange rates at the balance sheet date, except nonmonetary assets and liabilities, which are re-measured at the historical exchange rates prevailing when acquired. Revenue and expenses are re-measured at average exchange rates effective during the year. Foreign currency translation gains and losses from re-measurement are included in other non-operating (income) expense in the accompanying Consolidated Statements of Comprehensive Income (Loss). The amounts of net gain (loss) on foreign currency re-measurement recognized were immaterial for all periods presented. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Revenue Recognition, Unbilled Receivables and Estimated Liability for Refunds and Appeals We provide services under contracts that contain various fee structures, including performance fee-based contracts and fixed fee arrangements. Revenue is recognized when a contract exists, services have been provided to the client, the fee is fixed and determinable and collectability is reasonably assured. We recognize revenue on performance fee-based contracts based upon the specific terms of the underlying contract. The contract terms generally specify: (a) time periods covered by the work to be performed; (b) nature and extent of services we are to provide; (c) the client’s duties in assisting and cooperating with us; and (d) fees payable to us. Our fees are most often expressed as a percentage of our findings. Generally, our services are rendered when our clients realize the economic benefits from our services. Our clients realize economic benefits when they take credits against their existing accounts payable based on when we identify cost savings, when they receive refund checks based on overpayments, or when they acknowledge payment reductions based on cost savings. We derive a relatively small portion of revenue on contracts with fixed fee arrangements. We recognize revenue on these contracts ratably over the contract term and once all of the above criteria have been satisfied. Historically, there has been a certain amount of revenue with respect to which, even though we had met the requirements of our revenue recognition policy, the claim is ultimately rejected. In such cases, our clients may request a refund or offset if their providers or vendors ultimately reject the payment inaccuracies we find or if our clients determine not to pursue reimbursement from their providers or vendors even though we may have collected fees. We record any such refund as a reduction of revenue. We record an estimate for refund liabilities at any given time based on actual historical refund data by client type. We satisfy such refund liabilities either by offsets to accounts receivable or by cash payments to clients. In addition to the refund liabilities, we calculate client specific reserves when we determine an additional reserve may be necessary. The estimated liability for refunds and appeals representing our estimate of claims that may be overturned related to revenue which had already been received was $62,539 and $67,775 at December 31, 2016 and December 31, 2015, respectively. The estimated allowance for refunds and appeals representing our estimate of claims that may be overturned related to amounts in accounts receivable was $41,020 and $33,406 at December 31, 2016 and December 31, 2015, respectively. Under the Medicare Recovery Audit Program, in which we are one of the four Medicare RACs for CMS, healthcare providers have the right to appeal a claim and may pursue additional appeals if the initial appeal is found in favor of CMS. We accrue an estimated liability for appeals based on the amount of fees that are subject to appeals, closures or other adjustments and those which we estimate are probable of being returned to CMS following a successful appeal by the providers. Our estimates are based on our historical experience with the Medicare RAC appeal process. This estimated liability for Medicare RAC appeals is an offset to revenue in our Consolidated Statements of Comprehensive Income (Loss). The liability is included in the estimated liability for refunds and appeals on our Consolidated Balance Sheets. See Note 8 for further information regarding the estimated liability for appeals related to the Medicare RAC program. Unbilled receivables represent revenue recognized related to claims for which clients have received economic value that were not invoiced at the balance sheet date. Unbilled receivables were approximately $51,643 and $51,799 as of December 31, 2016 and December 31, 2015, respectively and are included in accounts receivable on our Consolidated Balance Sheets. Certain unbilled receivables arise when a portion of our earned fee is deferred at the time of the initial invoice. At a later date (which can be up to a year after original invoice, and at other times during the year after completion of the Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) audit period based on contractual terms or as agreed with our client), we invoice the unbilled receivable amount. Notwithstanding the deferred due date, our clients acknowledge we have earned this unbilled receivable at the time of the original invoice, but we have agreed to defer billing the client for the related services. Unbilled receivables of this nature were approximately $6,137 and $6,431 as of December 31, 2016 and December 31, 2015, respectively, and are included in accounts receivable on our Consolidated Balance Sheets. We record periodic changes in unbilled receivables and refund liabilities as adjustments to revenue. Cost of Revenue Cost of revenue is a direct cost associated with generating revenue. Cost of revenue related to compensation includes the total cost of payroll, related benefits and stock compensation expense for employees in roles that serve to provide direct revenue generating services to clients. Other cost of revenue primarily includes expenses related to the use of certain subcontractors and professional service firms, costs associated with the retrieval of medical records and facilities related costs associated with locations that are used strictly for revenue generating activities. Cost of revenue does not include depreciation and amortization, which is stated separately in our Consolidated Statements of Comprehensive Income (Loss). Selling, General and Administrative (“SG&A”) Compensation within SG&A includes the total cost of payroll, related benefits and stock compensation expense for employees who do not have a direct role associated with revenue generation including those involved with developing new service offerings. Other SG&A expenses include all general operating costs. These costs include, but are not limited to, rent and occupancy costs for facilities associated with locations that are used for employees not serving in revenue generating roles, telecommunications costs, information technology infrastructure costs, software licensing costs, advertising and marketing expenses, costs associated with developing new service offerings and expenses related to the use of certain subcontractors and professional services firms. Selling, general and administrative expenses do not include depreciation and amortization, which is stated separately in our Consolidated Statements of Comprehensive Income (Loss). Advertising Costs Advertising costs are expensed as incurred and included in other selling, general and administrative expenses on our Consolidated Statements of Comprehensive Income (Loss). Advertising expense was $1,345, $1,241 and $1,294 for the years ended December 31, 2016, 2015 and 2014, respectively. Cash and Cash Equivalents Cash and cash equivalents include all cash balances and highly liquid investments with an original maturity of 90 days or less from the date of purchase. Restricted Cash In connection with providing services to certain clients, we maintain a series of lockbox accounts with certain financial institutions. These lockbox accounts exist to receive funds we collect on behalf of our clients resulting from services provided. When client funds are received and deposited into the lockbox accounts, we record a corresponding customer deposit liability. These funds are included as both restricted cash in current assets and customer deposits in current liabilities on our Consolidated Balance Sheets. Accounts Receivable Trade accounts receivable are recorded at the invoiced amount and do not bear interest. We accrue an allowance against accounts receivable related to fees yet to be collected, based on historical losses adjusted for current market Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) conditions, our clients’ financial condition, the amount of any receivables in dispute, the current receivables aging and current payment patterns. We record changes in our estimate to the allowance for doubtful accounts through bad debt expense and relieve the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Write offs for all periods presented have not been significant. We do not have any off balance sheet credit exposure related to our clients. Investments Investments, which were historically purchased on behalf of our nonqualified profit sharing incentive compensation plan (See Note 19), consisted of money market securities and were classified as available-for-sale securities. Available-for-sale securities are reported at fair values (based primarily on quoted prices and market observable inputs) using the specific identification method, with the unrealized gains and losses included in accumulated other comprehensive (loss) income on our Consolidated Balance Sheets. Investments are included in prepaid expenses and other current assets on our Consolidated Balance Sheets (See Note 3). Realized gains and losses and interest and dividends on available-for-sale securities are included in other non-operating (income) expense on the Consolidated Statements of Comprehensive Income (Loss). Property and Equipment Property and equipment is stated at cost, net of accumulated depreciation. Depreciation on property and equipment is calculated using the straight-line method over the estimated useful lives of the assets and is included in depreciation and amortization of property and equipment in our Consolidated Statements of Comprehensive Income (Loss). The estimated useful lives of our property and equipment are as follows: We have asset retirement obligations (“AROs”) arising from contractual requirements to perform specified activities at the time of disposition of certain leasehold improvements and equipment at some of our facilities. We record a liability for the estimated costs of these AROs. The liabilities are included in other long-term liabilities on our Consolidated Balance Sheets and are initially measured at fair value and subsequently are adjusted for accretion expense and any changes in the amount or timing of the estimated cash flows. Internally Developed Software Costs Capitalization of costs incurred in connection with software developed for internal use commences when both the preliminary project stage is completed and management has authorized further funding for the project, based on a determination that it is probable the project will be completed and used to perform the function intended. Capitalized costs are limited to (i) external direct costs of materials and services consumed in developing or obtaining internal use software and (ii) payroll and payroll related costs for employees who are directly associated with and devote time to the internal use software project. Capitalization of such costs ceases no later than the point at which the project is substantially complete and ready for its intended use. All other costs to develop software for internal use are expensed as incurred. We capitalized approximately $21,580 and $7,239 for the years ended December 31, 2016 and 2015, respectively. Amortization of software and software development costs is calculated on a straight-line basis over the expected economic life of the software, generally estimated to be five years and is included in depreciation and amortization of property and equipment on our Consolidated Statements of Comprehensive Income (Loss). Amortization expense for internal use software was $2,992, $2,287 and $722 for the years ended December 31, 2016, 2015 and 2014, respectively. Amortization expense for the year ended December 31, 2015 includes the write off of approximately $975 related to software that is no longer being used. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Intangible Assets Our intangible assets with definite lives include customer relationships and acquired software. Intangible assets with indefinite lives include a trademark, which is not being amortized and is tested for impairment on an annual basis or when events or changes in circumstances necessitate an evaluation for impairment. Intangible assets with definite lives are initially recorded at fair value and are amortized on a basis consistent with the timing and pattern of expected cash flows used to value the intangibles, generally on a straight-line basis over useful lives ranging from 6 to 14 years. Amortization expense is included in amortization of intangible assets in our Consolidated Statements of Comprehensive Income (Loss). Impairment of Long-Lived Assets Long-lived assets, including property and equipment and intangible assets with definite lives, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. If circumstances require the asset or asset group be tested for possible impairment, we first compare undiscounted cash flows expected to be generated by the asset or asset group to its carrying value. If the carrying value of the asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment loss is recognized to the extent the carrying value exceeds its fair value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third party independent appraisals, as necessary. Intangible assets with indefinite lives are tested for impairment on an annual basis as of October 1, of each year or more frequently whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of these assets is measured by a comparison of the carrying amounts to the future discounted cash flows the assets are expected to generate. We recognized a $27,826 impairment charge on our trademark assets during the year ended December 31, 2015 due to a change in the estimated fair value of the trademark. We recognized a $74,034 impairment charge for the year ended December 31, 2014 due to the change in the estimated fair value of our CMS customer relationship intangible asset associated with the Medicare RAC. See Note 6 for further detail. Goodwill Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination which are not individually identified and separately recognized. We do not amortize goodwill. Goodwill is reviewed for impairment on an annual basis as of October 1, of each year or more frequently if a triggering event occurs. These tests are performed at the reporting unit level. We have two reporting units, Healthcare and Global Retail and Other. We are permitted to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two step impairment test as required in ASC 350, Intangibles-Goodwill and Other. If we can support the conclusion that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then we would not need to perform the two step impairment test. If we cannot support such a conclusion, or we do not elect to perform the qualitative assessment, then the first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The fair value of each reporting unit is determined using a discounted cash flow analysis. Acquisitions We account for acquisitions using the accounting for business combinations. The purchase price is allocated to the identifiable net assets acquired, including intangible assets and liabilities assumed, based on estimated fair values at the date of the acquisition. The excess of the purchase price over the amount allocated to the identifiable assets and liabilities, if any, is recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires significant judgment, including the selection of valuation methodologies, estimates of future revenue and cash flows and discount rates. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Under the acquisition method of accounting for business combinations, any changes to acquired balances in tax accounts, including adjustments to deferred tax asset valuation allowances or liabilities related to uncertain tax positions, which are recorded during the measurement period, and are determined to be attributable to facts and circumstances that existed as of the acquisition date, are considered a measurement period adjustment and will result in an offsetting increase or decrease to goodwill. All other changes to deferred tax asset valuation allowances and liabilities related to uncertain tax positions will result in an increase or decrease to income tax expense. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as for tax attributes such as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We recognize net deferred tax assets to the extent that we believe these assets are more likely than not to be realized. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies, and results of recent operations. In the event we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we reduce the deferred tax asset valuation allowance and record a benefit in our provision for income taxes in our Consolidated Statements of Comprehensive Income (Loss). We record liabilities related to uncertain tax positions in accordance with ASC 740, Income Taxes (“ASC 740”), on the basis of a two step process whereby (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. We recognize interest and penalties related to unrecognized tax benefits within the income tax provision in the accompanying Consolidated Statements of Comprehensive Income (Loss). Accrued interest and penalties are included within accounts payable and accrued other expenses in the Consolidated Balance Sheets. Derivative Instruments Our derivative instruments consist entirely of interest rate cap agreements, are stated at fair value and are included in accounts payable and accrued other expenses and other long-term liabilities on our Consolidated Balance Sheets. Changes in the fair value of derivatives that are designated as cash flow hedges are deferred in accumulated other comprehensive loss (income) on our Consolidated Balance Sheets until the underlying hedged transactions are recognized in earnings, at which time any deferred hedging gains or losses are also recorded in earnings. See Note 10 for more information. Stock-Based Compensation Our policy is to issue new shares for purchases under our equity incentive plans as described in Note 15. Stock-based compensation expense is estimated at the grant date based on an award’s fair value. The determination of the stock-based compensation expense related to stock options is calculated using a Black-Scholes-Merton option pricing model and is affected by our stock price, expected stock price volatility over the term of the awards, expected term, risk free interest rate and expected dividends. We record forfeitures as they occur. We recognize stock-based compensation expense for service-based equity awards using the straight-line attribution method over the requisite service period. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) We have awarded performance-based equity awards to certain employees and directors. Performance-based awards vested in accordance with the specific performance criteria espoused in the executed award agreements. Consistent with the service-based equity awards, the vesting of performance-based equity awards was dependent upon the participant’s continued employment through the date the performance criteria were achieved. The criteria associated with our outstanding performance-based stock options as defined in the terms of the award agreements, was satisfied as of September 30, 2016 and therefore these stock options all became vested and exercisable. As such, we recorded stock-based compensation expense during the year ended December 31, 2016 based on the grant date fair value of the performance-based awards. Commitments and Contingencies Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. See Note 8 for further detail on loss contingency related to the Medicare RAC. Fair Value of Financial Instruments The carrying values for cash and cash equivalents, restricted cash, accounts receivable, accounts payable, and other accrued liabilities reasonably approximate fair market value due to their nature and the short term maturity of these financial instruments. We measure assets and liabilities at fair value based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market. When considering market participant assumptions in fair value measurements, we use a consistent fair value hierarchy framework as defined in ASC 820, Fair Value Measurement. Refer to Note 11 for more information regarding management’s fair value estimates. Recently Issued Accounting Standards In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment (“ASU 2017-04”), which is intended to simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of the goodwill. Instead, an entity should compare the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value and should not exceed the total amount of goodwill allocated to that reporting unit. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2019, and interim periods within those annual periods. Early adoption is permitted. We are evaluating this new guidance and do not believe it will have a material impact on our consolidated financial statements and related disclosures as the fair values of our reporting units exceed their carrying values. In November 2016, the FASB issued ASU 2016-18, Restricted Cash (“ASU 2016-18”), which requires that restricted cash be included with cash and cash equivalents when reconciling the beginning and end of period total amounts shown on the statement of cash flows. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted. We are evaluating this guidance and its impact on our consolidated financial statements and related disclosures and expect the adoption of this ASU could impact the disclosure of our cash flows from operations. In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which addresses eight specific cash flow issues in order to reduce diversity in practice. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted. We are evaluating this guidance and its impact on our consolidated financial statements and related disclosures. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplifies several aspects of the accounting for share based compensation. ASU 2016-09 changes several aspects of the accounting for share based payment award transactions, including 1) accounting for income taxes, 2) classification of excess tax benefits on the statement of cash flows, 3) forfeitures, 4) minimum statutory tax withholding requirements and 5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. We early adopted ASU 2016-09 during the third quarter of 2016, which did not result in any significant changes to our current or prior period consolidated financial statements. As a result of this adoption, we recorded an excess tax benefit of approximately $4,000 during the fourth quarter of 2016 related to stock option exercises. In conjunction with adopting ASU 2016-09, we also made an accounting policy election to account for forfeitures as they occur. In February 2016, the FASB issued ASU 2016-02, Leases (“ASU 2016-02”), which changes the accounting recognition, measurement and disclosure for leases in order to increase transparency. ASU 2016-02 requires lease assets and liabilities to be recognized on the balance sheet and key information about leasing arrangements to be disclosed. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We are evaluating this new guidance and its impact on our consolidated financial statements and related disclosures. In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which changes the current financial instruments model primarily impacting the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The guidance is effective for public companies with annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. We are evaluating this new guidance and do not believe it will have a material impact on our consolidated financial statements and related disclosures. In November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes, (“ASU 2015-17”), which requires entities with a classified balance sheet to present all deferred tax assets and liabilities as noncurrent. The guidance is effective for public companies with annual and interim periods beginning after December 15, 2016. We early adopted the provisions of ASU 2015-17 as of December 31, 2016 and prior period amounts have been reclassified to conform to the current period presentation. As of December 31, 2015, $32,919 of current deferred tax assets have been reclassified to long-term deferred tax liabilities in the consolidated balance sheet. The adoption of ASU 2015-17 did not materially impact our consolidated financial position, results of operations or cash flows, but did reduce our calculation of working capital. In April 2015, the FASB issued ASU 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement (“ASU 2015-05”), which established guidance regarding the accounting for software licenses. ASU 2015-05 was effective for annual reporting periods, including interim periods, beginning after December 15, 2015. We prospectively adopted the provisions of ASU 2015-05 as of January 1, 2016 and have not yet had any material contracts that were impacted by this new guidance. In April 2015, the FASB issued ASU 2015-03, Simplifying the Presentation of Debt and Issuance Costs (“ASU 2015-03”), which establishes guidance to simplify the presentation of debt issuance costs by requiring debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that liability, consistent with debt discounts. Prior to the issuance of ASU 2015-03, debt issuance costs were required to be presented as an asset in the balance sheet. The guidance is effective for annual reporting periods beginning after December 15, 2015, and interim periods within that reporting period. We adopted the provisions of ASU 2015-03 as of January 1, 2016 and prior period amounts have been reclassified to conform to the current period presentation. As of December 31, 2015, $20,975 of debt issuance costs were reclassified in the consolidated balance sheet from debt issuance costs, net to long-term debt. The adoption of ASU 2015-03 did not materially impact our consolidated financial position, results of operations or cash flows. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which supersedes existing revenue recognition guidance and provides clarification of principles for recognizing revenue from contracts with customers. ASU 2014-09 sets forth a five-step model for determining when and how revenue is recognized. The core principle of the new standard is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. Additional disclosures will be required to describe the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. The two permitted transition methods under ASU 2014-09 are the full retrospective method, in which case the new guidance would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of the initial application. The guidance is effective for public companies with annual periods beginning after December 15, 2017 and interim periods within that reporting period. The FASB will permit companies to adopt the new standard early, but not before the original effective date of annual reporting periods beginning after December 15, 2016. We have formed an internal team to evaluate and quantify the potential impact of this new revenue guidance. As of the date of this filing, we have made significant progress on our contract reviews and policy drafting. We will continue to evaluate this new guidance and plan to provide additional information about our method of adoption and the impact, if any, on our consolidated financial statements and related disclosures in future filings. Note 3. Investments Investments in marketable securities, all of which were classified as available-for-sale and included in prepaid expenses and other current assets, were as follows: There were no investments in marketable securities as of December 31, 2016. Note 4. Acquisition On May 14, 2014, we acquired the stock of iHealth Technologies resulting in the Connolly iHealth Merger. The Connolly iHealth Merger brought two market leaders together to offer clients a broad suite of claims accuracy solutions. This merger and related transaction expenses were funded through a cash investment by us and our stockholders as well as by additional borrowings. In addition to the cash funding related to the Connolly iHealth Merger, certain members of management received $69,957 in equity by rolling over a portion of their former equity interests in iHealth Technologies or incentive compensation that was owed to them as of the date of the merger. As part of the Connolly iHealth Merger, we allocated the purchase price to the identifiable net assets acquired, including intangible assets and liabilities assumed, based on the estimated fair values at the date of acquisition. The excess of the purchase price over the amount allocated to the identifiable assets and liabilities was recorded as goodwill. Goodwill represents the value of the acquired assembled workforce, specialized processes and procedures and operating synergies, none of which qualify as separate intangible assets. We believe these specialized processes and procedures and operating synergies will enhance our long history of innovation in improving our existing solutions, developing new solutions and expanding the scope of our services at both legacy companies. As a result of the Connolly iHealth Merger, we have cross sell opportunities across more than half of our healthcare client base and are actively engaging with existing clients to cross sell our solutions. We determined the estimated fair values of intangible assets acquired using estimates of future discounted cash flows to be generated by the business over the estimated duration of those cash flows. We based the estimated cash flows Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) on our projections of future revenue, operating expenses, capital expenditures, working capital needs and tax rates. We estimated the duration of the cash flows based on the projected useful lives of the assets acquired. The discount rate was determined based on specific business risk, cost of capital and other factors. The estimated fair values of the assets acquired and liabilities assumed, after the effect of final adjustments related to the accounting for business combinations within the measurement period as described below, at the date of the Connolly iHealth Merger were as follows: The $543,200 of acquired intangible assets are subject to a weighted average useful life of approximately 13.3 years. These definite lived intangible assets include a registered trademark of $8,600 (11 year useful life), customer relationships of $486,700 (14 year useful life) and acquired software of $47,900 (7 year useful life). For federal income tax purposes, the Connolly iHealth Merger was treated as a stock acquisition. The goodwill recognized is not deductible for income tax purposes. In connection with the acquisition, a preliminary liability of $21,291 was recorded in accounts payable and accrued other expenses on the Consolidated Balance Sheets as of December 31, 2014 for payments due to the former stockholders of iHealth Technologies These amounts were finalized and no other adjustments were made to the estimated fair values of the assets acquired and liabilities assumed during the measurement period in 2015 as additional information was received by management resulting in a total liability due to the former stockholders of iHealth Technologies of $22,270 and a corresponding increase to goodwill of $979. The payment in full was made to the former stockholders during the year ended December 31, 2015. We recorded $5,745 of transaction costs primarily related to professional services associated with the Connolly iHealth Merger as transaction-related expenses within our Consolidated Statements of Comprehensive Income (Loss) during the year ended December 31, 2014. We consolidated the results of operations of the acquired business as of and from May 14, 2014. The following are unaudited pro forma results of operations for the year ended December 31, 2014 as if the acquisition had occurred on January 1, 2014, and does not give effect to any estimated and potential cost savings or other operating efficiencies that may result from the Connolly iHealth Merger. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) These unaudited pro forma results are for comparative purposes only and may not be indicative of the results that would have occurred had this acquisition been completed on January 1, 2014 or the results that would be attained in the future. Note 5. Property and Equipment Property and equipment by major asset class for the periods presented consisted of the following: In December 2015, we purchased a perpetual software license, which is included in the software total above. We are paying for this software over a two year period ending in January 2018. As such, there is approximately $3,351 and $2,952 included in accounts payable and accrued other expenses and $3,225 and $6,340 included in other long-term liabilities on our Consolidated Balance Sheets as of December 31, 2016 and 2015, respectively. The amounts included in other long-term liabilities represents the present value of payments that will ultimately be made. Total depreciation and amortization expense related to property and equipment, including capitalized software costs, was $20,151, $12,695 and $7,416 for the years ended December 31, 2016, 2015 and 2014, respectively. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Note 6. Intangible Assets Intangible asset balances by major asset class for the periods presented were as follows: Amortization expense was $60,818, $61,467 and $52,355 for the years ended December 31, 2016, 2015 and 2014, respectively. As a result of our rebranding in September 2015, we recorded an impairment of intangible assets of $27,826 related to our legacy trademarks during the year ended December 31, 2015. The remaining trademark value as of December 31, 2016 of $4,200 is related to our retail business that we continue to operate as Connolly, a division of Cotiviti. As of December 31, 2016 amortization expense for the next 5 years is expected to be: Note 7. Goodwill Total goodwill in our Consolidated Balance Sheets was $1,196,024 and $1,197,044 as of December 31, 2016 and December 31, 2015, respectively. Changes in the carrying amount of goodwill for the years ended December 31, 2016 and 2015 as allocated to each of our Healthcare and Global Retail and Other segments was as follows: There was no impairment related to goodwill for any period presented. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Note 8. Commitments and Contingencies Operating Leases We are obligated under non cancellable lease agreements for certain facilities and equipment, which frequently include renewal options and escalation clauses. For leases that contain predetermined fixed escalations, we recognize the related rent expense on a straight-line basis and record the difference between the recognized rent expense and amounts payable under the lease as lease obligations. Lease obligations due within one year are included in accounts payable and accrued other expenses on our Consolidated Balance Sheets. We lease certain facilities and equipment under non cancelable leases that expire at various points through 2029. Rent expense was $10,529, $8,826 and $7,202 for the years ended December 31, 2016, 2015 and 2014, respectively. Future minimum payments under non cancelable operating lease agreements as of December 31, 2016 were as follows: Legal and Other Matters We may be involved in various legal proceedings and litigation arising in the ordinary course of business. While any legal proceeding or litigation has an element of uncertainty, management believes the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, results of operations, or liquidity. Medicare RAC Contract Contingency In August 2014, CMS announced it would allow providers to remove all eligible claims currently pending in the appeals process by offering to pay hospitals 68% of the original claim amount. This settlement was offered to the providers and it was unknown what, if any, impact there would be for the Medicare RACs. On July 1, 2015, CMS issued a Technical Direction Letter to the Medicare RACs, including us, indicating that Medicare RACs will only be entitled to the contract contingency fee on the settled amounts of the claims, or 32% of the original inpatient claim amounts. Based on the initial lists of finalized settlements provided by CMS, we would be required to refund CMS approximately $22,308 due to the related adjustments in Medicare RAC contingency fees. CMS further advised that as the hospital settlement project continues, additional settlement lists will be matched to Medicare RAC claims which may result in updated refund amounts to those initially provided. While there are uncertainties in any dispute resolution and results are uncertain, we have disputed CMS’s findings based on our interpretation of the terms of the Medicare RAC contract and our belief that the backup data provided by CMS is inaccurate and/or incomplete. Our liability for estimated refunds and appeals includes amounts for these settled claims based on our best estimates of the amount we believe will be ultimately payable to CMS based on our interpretation of the terms of the Medicare RAC contract. We believe that it is possible that we could be required to pay an additional amount up to approximately $13,000 in excess of the amount we accrued as of December 31, 2016 based on the claims data we have received from CMS to date. As CMS completes its settlement process with the providers and updated files are provided to us, the potential amount owed by us may change. On September 28, 2016, CMS announced a second settlement process to allow eligible providers to settle their inpatient Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) claims currently under appeal beginning December 1, 2016. This second settlement process could result in additional amounts owed to CMS. The amount of any such additional claims cannot presently be determined. Asset Retirement Obligations We have AROs arising from contractual requirements to perform specified activities at the time of disposition of certain leasehold improvements and equipment at some of our facilities. Changes in the carrying amount of AROs were as follows: Note 9. Long-term Debt In September 2016, we entered into and executed the Restated Credit Agreement, which replaced our then outstanding Initial Secured Credit Facilities, lowered total debt outstanding by $22,700 and provided for lower applicable interest rates. The Restated Credit Agreement consists of (a) the First Lien Term A Loan in the amount of $250,000, (b) the First Lien Term B Loan in the amount of $550,000 and (c) the Revolver in the amount of up to $100,000. As a result of this refinancing, we recognized a loss on extinguishment of debt of $9,349 during the year ended December 31, 2016, which is included in our Consolidated Statements of Comprehensive Income (Loss). In June 2016, we repaid $223,000 in outstanding principal under our then outstanding Initial Second Lien Credit Facility using proceeds from our IPO. We also made a voluntary prepayment of $13,100 of outstanding principal under the Initial Second Lien Credit Facility. As a result of these repayments, we recognized a loss on extinguishment of debt of $7,068 during the year ended December 31, 2016, which is included in our Consolidated Statements of Comprehensive Income (Loss). In May 2015, we entered into and executed the First and Second Amendments to the then outstanding Initial First Lien Credit Facilities, which, among other things, provided for lower applicable interest rates associated with the Initial First Lien Credit Facilities by 50 basis points. As a result, we recorded a loss on extinguishment of debt of $4,084 during the year ended December 31, 2015, which is included in our Consolidated Statements of Comprehensive Income (Loss). Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Long-term debt for the periods presented was as follows: (a) The First Lien Term A Loan matures on September 28, 2021 and requires quarterly principal payments of $3,125 for the fourth quarter of 2016, $3,125 per quarter in 2017 and 2018, $4,688 per quarter in 2019, $6,250 per quarter in 2020 and $9,375 per quarter for the first two quarters of 2021. The remainder of the outstanding First Lien Term A Loan borrowings are due on September 28, 2021. Any mandatory or voluntary prepayment will be applied against the remaining scheduled installments of principal payments in direct order of maturity, unless other direction of application is provided by us. Based on our periodic election, borrowings under the First Lien Term A Loan bear interest at either (a) the ABR plus, based on our Secured Leverage Ratio (as defined in the Restated Credit Agreement), 1.25% - 2.00% for ABR loans or (b) LIBOR plus, based on our Secured Leverage Ratio, 2.25% to 3.00% for LIBOR loans. The ABR is equal to the highest of (i) the New York Federal Reserve Bank rate in effect on such date plus 0.50%, (ii) the LIBOR plus 1.00% and (iii) the prime commercial lending rate of the administrative agent as in effect on the relevant day. The interest period applicable to any LIBOR borrowing is one, two, three or six months, at the election of the borrower. Interest on LIBOR loans is payable the last day of the applicable interest period and, in the case of an interest period of more than three months’ duration, each day on which interest would have been payable had successive interest periods of three months’s duration been applicable to such borrowing. The interest rate in effect was 3.75% at December 31, 2016. (b) The First Lien Term B Loan matures on September 28, 2023 and requires quarterly principal payments of $1,375 with all remaining borrowings due on September 28, 2023. Based on our periodic election, borrowings under the First Lien Term B Loan bear interest at either (a) the ABR plus 1.75% for ABR loans or (b) LIBOR plus 2.75% for LIBOR loans. The ABR is equal to the highest of (i) the New York Federal Reserve Bank rate in effect on such date plus 0.50%, (ii) LIBOR plus 1.00%, (iii) the prime commercial lending rate of the administrative agent as in effect on the relevant day and (iv) 1.75%. LIBOR is equal to the higher of (a) the published LIBOR or (b) 0.75%. If our corporate credit rating from Moody’s Investor Service, Inc. is Ba3 or better and our corporate family rating from Standard & Poor’s Financial Services, LLC is BB- or better, the margin will be reduced by 0.25% per annum for as long as such ratings are maintained. The interest period applicable to any LIBOR borrowing is one, two, three or six months, at the election of the borrower. Interest on LIBOR loans is payable the last day of the applicable interest period and, in the case of an interest period of more than three months’ duration, each day on which interest would have been payable had successive interest periods of three months’s duration been applicable to such borrowing. The interest rate in effect was 3.75% at December 31, 2016. (c) The Revolver expires on September 28, 2021. Interest for any borrowings under the Revolver is payable over one, two, three or six months at our election. A commitment fee is payable quarterly based on the unused portion of the Revolver commitment which ranges from 0.30% to 0.50% per annum based on certain financial tests. Based on our periodic election, borrowings under the Revolver bear interest at either (a) ABR plus, based on our Secured Leverage Ratio, 1.25% - 2.00% for ABR loans or (b) LIBOR plus, based on our Secured Leverage Ratio, 2.25% to 3.00% for LIBOR loans. The ABR is equal to the highest of (i) the New York Federal Reserve Bank rate in effect on such date plus 0.50%, (ii) LIBOR plus 1.00% and (iii) the prime commercial lending rate of the administrative agent as in effect on the relevant day. There were no borrowings outstanding under the Revolver as of December 31, 2016. The interest rate in effect was 3.75% at December 31, 2016. (d) The Initial First Lien Term Loan, as amended, expired May 2021 and required quarterly principal payments of $2,025. The quarterly principal payment could be reduced by any amounts of mandatory prepayment. Any mandatory prepayment would be applied against the remaining scheduled installments of principal payments in direct order of maturity, unless other direction of application was provided by us. Interest on the Initial First Lien Term Loan was payable over periods of one, two, three or six months at the election of the borrower. Based on our periodic election, borrowings under the Initial First Lien Term Loan bore Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) interest at either (a) ABR plus 2.50% for ABR Loans, or (b) LIBOR plus 3.50% for LIBOR Loans. The ABR was equal to the higher of (a) the Federal Funds Effective Rate plus 0.50%; (b) the published one month LIBOR plus 1.00%; (c) the Prime Rate; or (d) 2.00%. The LIBOR was equal to the higher of (a) LIBOR or (b) 1.00%. The interest rate in effect was 4.50% at December 31, 2015. Following the IPO, borrowings under the Initial First Lien Term Loan bore interest at either (a) ABR plus 2.25%, or (b) LIBOR plus 3.25%. (e) The Initial Second Lien Credit Facility expired May 2022 with the total principal balance due at maturity. Interest on the Initial Second Lien Credit Facility was payable over periods of one, two, three, or six months at the election of the borrower. Based on our periodic election, borrowings under the Initial Second Lien Credit Facility bore interest at either (a) ABR plus 6.00% for ABR Loans or (b) LIBOR plus 7.00% for LIBOR Loans. The ABR was equal to the higher of (a) the Federal Funds Effective Rate plus 0.50% (b) the published one month LIBOR plus 1.00%; (c) the Prime Rate; or (d) 2.00%. The LIBOR was equal to the higher of (a) LIBOR or (b) 1.00%. The interest rate in effect was 8.00% at December 31, 2015. Following the IPO, borrowings under the Initial Second Lien Credit Facility bore interest at either (a) ABR plus 5.75% for ABR Loans, or (b) LIBOR plus 6.75% for LIBOR Loans. (f) The Initial First Lien Revolver expired May 2019 with interest payable over periods of one, two, three or six months at the election of the borrower. A commitment fee was payable quarterly based on the daily unused portion of the Initial First Lien Revolver balance which ranged from an annual rate of 0.375% to 0.50% based on certain financial tests. The commitment fee was 0.375% at December 31, 2015. Based on our periodic election, borrowings under the Initial First Lien Revolver bore interest at either (a) ABR plus 1.75% to 2.25% for ABR Loans based on certain financial tests or (b) LIBOR plus 2.75% to 3.25% for LIBOR Loans based on certain financial tests. The ABR was equal to the higher of (a) the Federal Funds Effective Rate plus 0.50%; (b) the published one month LIBOR plus 1.00%; or (c) the Prime Rate. The LIBOR was equal to the higher of (a) the LIBOR or (b) 1.00%. The interest rate in effect was 4.00% at December 31, 2015. At December 31, 2015 we had $3,526 letters of credit outstanding which reduce the amount available for borrowing. There were no borrowings outstanding under the Initial First Lien Revolver as of December 31, 2015. The Restated Credit Agreement includes certain binding affirmative and negative covenants, including delivery of financial statements and other reports, maintenance of existence and transactions with affiliates. The negative covenants restrict our ability, among other things, to incur indebtedness, grant liens, make investments, sell or otherwise dispose of assets or enter into a merger, pay dividends or repurchase stock. As a result of these restrictions, approximately 80% of the subsidiary net assets are deemed restricted as of December 31, 2016. Refer to Schedule I Condensed Financial Information of Parent. Beginning December 31, 2016, there is a required financial covenant applicable only to the Revolver and the First Lien Term A Loan, pursuant to which we agree not to permit our Secured Leverage Ratio (as defined in the Restated Credit Agreement) to exceed 5.50:1.00 through September 2018, 5.25:1.00 through September 2019 and 5.00:1.00 through June 2021. In addition, the Restated Credit Agreement includes certain events of default including payment defaults, failure to perform affirmative covenants, failure to refrain from actions or omissions prohibited by negative covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults and a change of control default. We were in compliance with all such covenants as of December 31, 2016 and similar affirmative and negative covenants applicable to our then outstanding credit facilities as of December 31, 2015. The Restated Credit Agreement requires mandatory prepayments based upon annual excess cash flows commencing with the year ended December 31, 2017. The mandatory prepayment is contingently payable based on an annual excess cash flow calculation as defined within the Restated Credit Agreement. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) As of December 31, 2016, the expected aggregate maturities of long-term debt for each of the next five years are as follows: Note 10. Derivative Instruments We are exposed to fluctuations in interest rates on our long-term debt. We manage our exposure to fluctuations in the 3-month LIBOR through the use of interest rate cap agreements designated as cash flow hedges. We are meeting our objective by hedging the risk of changes in cash flows related to changes in LIBOR by capping the interest on our floating rate debt linked to LIBOR to approximately 3%. We do not utilize derivatives for speculative or trading purposes. As of December 31, 2016 and December 31, 2015, we had $540,000 and $630,000, respectively, in notional debt outstanding related to these interest rate caps, which cover quarterly interest payments through September 2019. The notional amount decreases over time. Refer to Note 9 for more information regarding the debt outstanding related to these agreements. All of our outstanding interest rate cap contracts qualify for cash flow hedge accounting treatment in accordance with ASC 815, Derivatives and Hedging. Cash flow hedge accounting treatment allows for gains and losses on the effective portion of qualifying hedges to be deferred in accumulated other comprehensive (loss) income until the underlying transaction occurs, rather than recognizing the gains and losses on these instruments in earnings during each period they are outstanding. When the actual interest payments are made on our variable rate debt as described in Note 9 and the related derivative contract settles, any effective portion of realized interest rate hedging derivative gains and losses previously recorded in accumulated other comprehensive (loss) income is recognized in interest expense. We recognized interest expense of $283 and $105 during the years ended December 31, 2016 and 2015, respectively. We did not recognize any interest expense related to interest rate caps during the year ended December 31, 2014. Ineffectiveness results, in certain circumstances, when the change in total fair value of the derivative instrument differs from the change in the fair value of our expected future cash outlays for the related interest payment and is recognized immediately in interest expense. There was no ineffectiveness recorded during the years ended December 31, 2016, 2015 and 2014, respectively. Likewise, if the hedge does not qualify for hedge accounting, the periodic changes in its fair value are recognized in the period of the change in interest expense. All cash flows related to our interest rate cap agreements are classified as operating cash flows. Any outstanding derivative instruments expose us to credit loss in the event of nonperformance by the counterparties to the agreements, but we do not expect that the counterparty will fail to meet their obligations. The amount of such credit exposure is generally the positive fair value of our outstanding contracts. To manage credit risks, we select counterparties based on credit assessments, limit our overall exposure to any single counterparty and monitor the market position of any counterparty. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) The table below reflects quantitative information related to the fair value of our derivative instruments and where these amounts are recorded in our consolidated financial statements as of the period presented: We record deferred hedge premiums which are being paid over the life of the hedge in accumulated other comprehensive (loss) income until the related hedge ultimately settles and interest payments are made on the underlying debt. As of December 31, 2016, we have made payments of $2,581 related to these deferred premiums. We expect to pay an additional $3,813 in deferred premiums through 2019 related to our outstanding interest rate cap agreements which is reflected in the fair value of these derivatives in the table above. Comprehensive (loss) income includes changes in the fair value of our interest rate cap agreements which qualify for hedge accounting. Changes in other comprehensive (loss) income for the periods presented related to derivative instruments classified as cash flow hedges were as follows: Note 11. Fair Value Measurements We measure assets and liabilities at fair value based on assumptions market participants would use in pricing an asset or liability in the principal or most advantageous market. Authoritative guidance on fair value measurements establishes a consistent framework for measuring fair value whereby inputs are assigned a hierarchical level. The hierarchical levels are: Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the reporting entity at the measurement date. Level 2: Observable prices, other than quoted prices included in Level 1 inputs for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability. Level 3: Unobservable inputs for the asset or liability used to measure fair value to the extent observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at measurement date. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) The following table summarizes our financial instruments measured at fair value within the Consolidated Balance Sheets: Investments are classified as available-for-sale and carried at fair value in the accompanying Consolidated Balance Sheets. As of December 31, 2015, our investments consisted of money market securities valued using quoted market prices for identical assets in active markets. As of December 31, 2016, we did not hold any investments in available-for-sale securities. The fair value of our private debt is determined based on fluctuations in current interest rates, the trends in market yields of debt instruments with similar credit ratings, general economic conditions and other quantitative and qualitative factors. The carrying value of our debt approximates its fair value. The fair value of the interest rate cap agreements is determined using the market standard methodology of discounting the future expected variable cash receipts that would occur if interest rates rose above the strike rate of the caps. The analysis reflects the contractual terms of the derivatives, including period to maturity and remaining deferred premium payments, and uses observable market-based inputs, including interest rates and implied volatilities. The variable cash receipts are based on an expectation of future interest rates (forward curves) derived from observable market interest rates. As such, the estimated fair values of these liabilities are classified as Level 2 in the fair value hierarchy. Note 12. Income Taxes Total income tax expense (benefit) for the years ended December 31, 2016, 2015 and 2014 was as follows: For the years ended December 31, 2016, 2015 and 2014, income (loss) from continuing operations before income taxes includes the following components: Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) The income tax expense (benefit) that is attributable to income (loss) from continuing operations before income taxes included in our Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2016, 2015 and 2014 consisted of the following: The factors accounting for the variation in our overall effective tax rates from continuing operations compared to U.S. statutory income tax rates for the years ended December 31, 2016, 2015 and 2014 were as follows: Our effective income tax rate from continuing operations was 30.0%, 52.0% and 39.4% for the years ended December 31, 2016, 2015 and 2014, respectively. The decrease in the effective tax rate for the year ended December 31, 2016 compared to December 31, 2015 is primarily due to a $1,300 tax benefit related to the settlement of an uncertain tax position recorded in a prior period, a $4,000 excess tax benefit related to stock option exercises resulting from the early adoption of ASU 2016-09 and a $1,122 tax benefit from the implementation of certain tax planning. The increase in the effective tax rate for the year ended December 31, 2015 compared to December 31, 2014 is primarily due to changes in uncertain tax positions, an increase in non-deductible costs, an increase in the valuation allowance and the impact of a state deferred tax remeasurement as a result of new statutory regulations. In general, it is our practice and intention to reinvest the earnings of our non branch foreign subsidiaries in those operations on an indefinite basis. Such amounts may become subject to U.S. taxation upon the remittance of dividends and under certain other circumstances. Due to our intent to reinvest such amounts indefinitely, the taxation of these amounts in the U.S. is not expected to occur in the foreseeable future and therefore no deferred tax liability has been recorded. For the years ended December 31, 2016, 2015 and 2014 the amounts considered indefinitely reinvested were $8,065, $5,910 and $4,610, respectively. If the earnings were not considered indefinitely reinvested under current law, the tax on such earnings would be approximately $1,891, $1,386 and $1,081 for the years ended December 31, 2016, 2015 and 2014, respectively. The net deferred taxes below are included on our Consolidated Balance Sheets as a long-term net deferred tax liability of $120,533 at December 31, 2016 and a long-term net deferred tax liability of $129,284 at December 31, 2015. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) The components of our deferred tax assets and liabilities as of December 31, 2016 and 2015 are as follows: We have federal net operating loss carryforwards of $1,297 which will expire in 2029. In addition, we have a foreign net operating loss of $1,183 with an unlimited carryforward. All state net operating losses were utilized in the prior year. As of December 31, 2016 and 2015, a valuation allowance of $199 and $440, respectively, has been recorded to reflect the portion of the deferred tax asset that is not more likely than not to be realized. The decrease in the valuation allowance relates to changes from statutory tax filings for the year ended December 31, 2015. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period are reduced or increased or if objective negative evidence in the form of cumulative losses is no longer present and additional weight may be given to subjective evidence such as our projections for growth. Due to change of ownership provisions in the Internal Revenue Code, use of a portion of our domestic net operating loss and tax credit carryforwards will be limited in future periods. Further, a portion of the carryforwards may expire before being applied to reduce future income tax liabilities. ASC 740 clarifies the accounting and reporting for uncertainties in income tax law. This interpretation prescribes a comprehensive model for financial statement recognition measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. ASC 740 requires that the tax effects of an uncertain tax position be recognized only if it is “more likely than not” to be sustained by the taxing authority as of the reporting date. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) A reconciliation of the beginning and ending amount of unrecognized tax benefits at December 31, 2016 and 2015 is as follows: The majority of the balance of unrecognized tax benefits as of December 31, 2016 and 2015, would affect the effective tax rate if recognized. The total uncertain tax positions expected to reverse in the next 12 months is approximately $2,301 and $194 as of December 31, 2016 and 2015, respectively, due to lapse of statute of limitations. The current year change in uncertain tax positions is primarily the result of the settlement of an uncertain tax position recorded during a prior period. The total penalty and interest incurred, relating to uncertain tax positions, for years ended December 31, 2016, 2015 and 2014, was $424, $920 and $583, respectively. We include interest and penalties as tax expense in the Consolidated Statements of Comprehensive Income (Loss). We file income taxes with the U.S. federal government and various state and foreign jurisdictions. We are currently under audit with the Internal Revenue Service for the tax year ended December 31, 2014. In addition we are currently under audit for iHealth Technologies for the tax years ended December 31, 2012, December 31, 2013 and May 13, 2014. We operate in a number of state and local jurisdictions and as such are subject to state and local income tax examinations based upon various statutes of limitations in each jurisdiction. We are currently under audit by the State of New York for the tax year ended December 31, 2014 and for iHealth Technologies for the tax years ended December 31, 2012, December 31, 2013 and May 13, 2014. Note 13. Stockholders’ Equity Issuance of Common Stock On May 13, 2016 our certificate of incorporation was amended and the number of shares of common stock authorized to be issued by Cotiviti Holdings, Inc. was increased from 122,000,000 to 600,000,000. On May 25, 2016 we consummated our IPO in which we issued and sold a total of 12,936,038 shares of common stock, including a portion of the underwriter overallotment, at a public offering price of $19.00 per share. We received net proceeds of approximately $226,963 after deducting underwriting discounts and commissions and other offering expenses of approximately $18,822. In May 2014, a total of 32,790,321 shares of common stock were issued for a total fair value of $435,144 in connection with the Connolly iHealth Merger. Of this amount, $365,187 was received in cash and $69,957 was issued to certain members of the former iHealth Technologies management as they either rolled over a portion of their former equity interests in iHealth Technologies or received equity in lieu of incentive compensation that was owed to them as of the date of the merger. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) A summary of the current rights and preferences of holders of our common stock are as follows: Voting Common stockholders are entitled to one vote per share of common stock held on all matters on which such common stockholder is entitled to vote. Dividends Common stockholders are eligible to receive dividends on common stock held when funds are available and as approved by the Board. The Restated Credit Agreement contains certain negative covenants that may restrict our ability to pay dividends. In addition, Delaware law may restrict the Board’s ability to declare dividends. Liquidation Rights In the event of liquidation or dissolution, common stockholders are entitled to receive all assets available for distribution to stockholders. Registration Rights The Second Amended and Restated Stockholders Agreement entered into as of June 1, 2016 in connection with our IPO contains (i) demand registration rights for Advent, subject to a cap of two requests in any 12 month period; (ii) piggy-back registration rights for any stockholder holding at least $500 worth of shares (each, a “Holder”), subject to a pro rata reduction if the total amount of shares requested to be included exceeds the amount of securities which in the opinion of the underwriters can be sold; and (iii) shelf registration rights for Holders, subject to a required anticipated aggregate offering price, net of selling expenses, of $5,000 subject to a cap of two requests for shelf registrations, for all Holders in the aggregate, in any 12 month period. Holders that are capable of selling all of their registrable securities pursuant to Rule 144 under the Securities Act in a single transaction without timing or volume limitations do not have piggy-back registration rights. We will be responsible for fees and expenses in connection with the registration rights, other than underwriters’ discounts and brokers’ commissions, if any, relating to any such registration and offering. Common Stock Split On May 13, 2016 we effected a 6.1-for-1 stock split of all outstanding shares of our common stock. All share, option and per share information presented in the accompanying consolidated financial statements and notes thereto have been adjusted to reflect the stock split on a retroactive basis for all periods presented and all share information is rounded up to the nearest whole share after reflecting the stock split. Common Stock Dividends On May 25, 2016 we paid a Special Cash Dividend of $150,000, or $1.94 per share of common stock outstanding prior to the IPO, to holders of record of our common stock on the dividend record date. In connection with the Special Cash Dividend we lowered the exercise price of then outstanding stock options by $1.94 per share in order to preserve the intrinsic value of the options giving effect to the Special Cash Dividend. Note 14. Earnings per Share Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period. For all periods presented, potentially dilutive outstanding shares consisted solely of our stock-based awards. Our potential common shares consist of the incremental common shares issuable upon the exercise of the options and vesting of restricted stock Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) units. The dilutive effect of outstanding stock-based awards is reflected in diluted earnings per share by application of the treasury stock method. For all periods presented, all outstanding common stock consisted of a single-class. Basic and diluted earnings (loss) per share are computed as follows: Employee stock options and RSUs that were excluded from the calculation of diluted earnings per share because their effect is anti-dilutive for the periods presented were as follows: The criteria associated with all of our outstanding performance-based stock options as defined in the terms of the applicable award agreements, were satisfied as of September 30, 2016 and, as a result, outstanding performance-based stock options were included in the calculation of diluted earnings per share for the year ended December 31, 2016. Performance-based stock options of 2,794,910 and 2,487,275 as of December 31, 2015 and 2014, respectively, were not included in the calculation of diluted earnings per share as the vesting conditions had not yet been satisfied. Note 15. Stock-Based Compensation Equity Incentive Plans In 2012, we adopted the 2012 Plan pursuant to which our Board of Directors (or committee as designated by the Board of Directors) may grant options to purchase shares of our stock, restricted stock and certain other equity awards to directors, officers and key employees. We only granted stock options that can be settled in shares of our common stock under the 2012 Plan. The 2012 Plan had a total of 7,243,330 shares authorized for issuance. Upon completion of the IPO in May 2016, issuances under the 2012 Plan were suspended. At that time we adopted the 2016 Plan (collectively with the 2012 Plan, the “Equity Plans”), pursuant to which our Board of Directors (or a committee or sub-committee designated by the Board of Directors) may grant options to purchase shares of our stock, restricted stock and certain other equity awards to directors, officers and key employees. The 2016 Plan was established with the authorization for grants of up to 5,490,000 shares of authorized but unissued shares of common stock. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) No stock options were granted under the 2012 Plan after December 31, 2015. Awards granted under the 2012 Plan will remain outstanding until the earlier of exercise, forfeiture, cancellation or expiration. To the extent outstanding options under the 2012 Plan are forfeited, cancelled or terminated, the common stock subject to such options will be available for future issuance under the 2016 Plan. As of December 31, 2016, there are no shares available for future issuance under the 2012 Plan as it was discontinued upon adoption of the 2016 Plan. As of December 31, 2016 the total number of shares available for future issuance under the 2016 Plan is 5,277,451. Stock Options Under the terms of the 2016 Plan, we may issue options to purchase shares of our common stock at a price equal to 100% of the market price on the date of grant. Issuances under the 2012 Plan, prior to its suspension, were under terms similar to issuances under the 2016 Plan. Stock options granted are subject to either time of service (service-based awards) or performance (performance-based awards) criteria. Service-based awards typically vest ratably over a five year service period from the date of grant under the 2012 Plan and typically vest ratably over a four year service period from the date of grant under the 2016 Plan. In the event of a change in control, any outstanding, unvested service-based awards will vest immediately. Performance-based awards vest in accordance with the specific performance criteria espoused in the executed award agreements. The term of any stock option shall not exceed ten years from the date of grant. However, an incentive stock option granted to an employee who, at the time of grant, owns stock possessing more than 10% of the total combined voting power of all classes of our stock may not have a term exceeding five years from the date of grant. The following is a summary of stock option activity under the Equity Plans: The criteria associated with 2,746,592 of our outstanding performance-based stock options as defined in the terms of the award agreements, was satisfied as of September 30, 2016 and therefore these stock options all became vested and exercisable. Aggregate intrinsic value represents the difference between our estimated fair value of common stock and the exercise price of outstanding in the money options. The fair value per share of common stock was $34.40 as of December 31, 2016 based upon the closing price of our common stock on the NYSE. The total intrinsic value of options exercised was $15,521 for the year ended December 31, 2016 and was insignificant for the year ended Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) December 31, 2015. The total fair value of stock options vested was $22,453, $2,450 and $2,000 during the years ended December 31, 2016, 2015 and 2014, respectively. Restricted Stock Units RSUs provide participants the right to receive a payment based on the value of a share of common stock. RSUs may be subject to vesting requirements, restrictions and conditions to payment. Such requirements may be based on the continued service for a specified time period or on the attainment of specified performance goals as specified in the award agreements. RSUs are payable in cash or in shares or a combination of both. Under the terms of the Equity Plans, RSUs have a grant date fair value equal to the closing price of our stock on the grant date. The units typically vest ratably over a four year service period. We began issuing RSUs upon adoption of the 2016 Plan; no RSUs were issued under the 2012 Plan. The following is a summary of RSU activity under the 2016 Plan: Stock Compensation Expense The fair value of each stock option award is estimated on the date of grant using a Black-Scholes-Merton option pricing model. The expected term of the option represents the period the stock-based awards are expected to be outstanding. We use the simplified method under the provisions of ASC 718, Compensation - Stock Compensation, for estimating the expected term of the options. Since our shares were not publicly traded until May 2016 and were rarely traded privately, at the time of each grant, there was insufficient volatility data available. Accordingly, we calculate expected volatility using comparable peer companies with publicly traded shares over a term similar to the expected term of the options issued. We do not intend to pay dividends on our common shares, therefore, the dividend yield percentage is zero. The risk-free interest rate is based on the U.S. Treasury constant maturity interest rate whose term is consistent with the expected life of our stock options. We used the following weighted average assumptions to estimate the fair value of stock options granted for the periods presented as follows: We recorded total stock-based compensation expense of $22,954, $3,399 and $2,492 for the years ended December 31, 2016, 2015 and 2014, respectively. Stock-based compensation expense during the year ended December 31, 2016 includes $15,898 related to the vesting of all outstanding performance-based stock options. Stock-based compensation expense during the year ended December 31, 2016 also includes $2,257 related to the accelerated vesting Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) of certain stock options as the result of our IPO. We had not previously adjusted stock-based compensation expense for estimated forfeitures as there has been insignificant forfeiture activity to date. Based on the adoption of ASU 2016-09, we will account for forfeitures as they occur. As of December 31, 2016, we had total unrecognized compensation cost related to 1,784,212 unvested service-based stock options and RSUs under the Equity Plans of $13,319 which we expect to recognize over the next 3.1 years. Note 16. Related Party Transactions In connection with the Connolly iHealth Merger, a preliminary liability of $21,291 was recorded in accounts payable and accrued other expenses on the Consolidated Balance Sheets as of December 31, 2014 for payments due to the former stockholders of iHealth Technologies. See Note 4 for more information regarding the Connolly iHealth Merger. These amounts were finalized during 2015 and $22,270 was paid to the former stockholders of iHealth Technologies in September 2015. Note 17. Segment and Geographic Information Operating segments are components of an enterprise for which separate financial information is available that is evaluated regularly by our Chief Operating Decision Maker in deciding how to allocate resources and in assessing financial performance. We conduct our business through two reportable business segments: Healthcare and Global Retail and Other. Through our Healthcare segment, we offer prospective and retrospective claims accuracy solutions to healthcare payers in the United States. We also provide analytics-based solutions unrelated to our healthcare payment accuracy solutions, on a limited basis in the United States. Through our Global Retail and Other segment, we provide retrospective claims accuracy solutions to retailers primarily in the United States, Canada and the United Kingdom, as well as solutions that improve efficiency and effectiveness of payment networks for a limited number of clients. We evaluate the performance of each segment based on segment net revenue and segment operating income. Operating income is calculated as net revenue less operating expenses and is not affected by other expense (income) or by income taxes. Indirect costs are generally allocated to the segments based on the segments’ proportionate share of revenue and expenses directly related to the operation of the segment. We do not allocate interest expense, other non-operating (income) expense or the provision for income taxes, since these items are not considered in evaluating the segment’s overall operating performance. Our Chief Operating Decision Maker does not receive or utilize asset information to evaluate performance of operating segments. Accordingly, asset-related information has not been presented. Our operating segment results for the periods presented were as follows: Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Operating segment net revenue by product type for the periods presented was as follows: Geographic Information Geographic net revenue and long-lived assets are attributed to the geographic regions based on the geographic location of each of our subsidiaries/locations. Our operations are primarily within the continental United States. We also operate in Canada and the United Kingdom. Net revenue generated in the United States accounted for approximately 98%, 98%, and 95% of total net revenue for the years ended December 31, 2016, 2015 and 2014, respectively. Remaining net revenue was generated in the rest of the world. Long-lived assets are primarily based in the United States with over 99% of total consolidated long-lived assets. Less than 1% of total consolidated long-lived assets are foreign. Note 18. Client Concentration The list of our largest clients changes periodically and was further impacted by the Connolly iHealth Merger. Our significant clients accounted for the following percentages of total net revenue: In many instances, we provide our services pursuant to agreements which have auto renewal clauses and may be periodically subject to a competitive reprocurement process. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) Note 19. Employee Benefit Plans Contributions expensed and included in compensation on our Consolidated Statements of Comprehensive Income (Loss) for employee benefit plans are detailed below: (a) We sponsor defined contribution retirement plans in accordance with Section 401(k) of the Internal Revenue Code, which cover substantially all U.S. employees, subject to certain minimum age and service requirements. The plans provide for a contribution based on a percentage of eligible employee contributions. (b) We had a nonqualified profit sharing incentive compensation plan for certain eligible employees. Contributions were made within 90 days following the last day of the plan to a brokerage account in an amount determined at our discretion for employees who had completed 1,000 hours of service and were employed at the time of the contribution. This plan was discontinued after the 2014 plan year, with the final payout occurring in June 2016 and therefore we did not have a liability under the plan as of December 31, 2016. Our liability under the plan was $893 at December 31, 2015, which is included in accrued compensation costs in the accompanying Consolidated Balance Sheets. (c) Eligible employees of our subsidiary located in India are covered by the Provident Fund, contributions which are based on a percentage of eligible employees’ salaries, and the Indian Payment of Gratuity Act, which provides for benefits to be paid to eligible employees upon termination of employment (collectively, the “India Plan”). Benefits under the India Plan are administered by the Indian Government. As of December 31, 2016 and 2015 we had an accrued benefit obligation relating to the India Plan of $763 and $535, respectively. Note 20. Discontinued Operations In February 2015, we received payment on a $900 note receivable related to a business that was disposed of in 2012. Since the date of sale, we had elected to fully reserve the note receivable as the collectability was determined to be uncertain. This gain from the collection of the note receivable, net of tax, is reflected as a gain on discontinued operations on our Consolidated Statements of Comprehensive Income (Loss). The estimated impact to diluted EPS as a result of this gain on discontinued operations was $0.01 per diluted share for the year ended December 31, 2015. Note 21. Selected Quarterly Financial Data (Unaudited) Historically, there has been a seasonal pattern to our healthcare revenue with the revenues in the first quarter generally lower than the other quarters and revenues in the fourth quarter generally being higher than the other quarters. Accordingly, the comparison of revenue from quarter to quarter may fluctuate and is dependent on various factors, including, but not limited to, reset of member liability, timing of special projects and timing of inaccurate payments being prevented or recovered as well as the aforementioned seasonal considerations. Consequently, you should not rely on our revenue for any one quarter as an indication of our future performance. Cotiviti Holdings, Inc. Notes to the Financial Statements (continued) (In thousands, except shares and per share amounts) The following table summarizes our unaudited quarterly operating results for the last two years: (1) During the second quarter 2016, we generated approximately $5,000 in healthcare revenue from special projects that did not reoccur in the second half of the year. (2) During the second quarter 2016, stock-based compensation expense includes $2,257 related to the accelerated vesting of certain stock options as the result of our IPO. During the third quarter 2016, stock-based compensation expense includes $15,898 related to the vesting of all outstanding performance-based stock options (see Note 15). (3) During the second quarter 2016, we made a voluntary prepayment on our Initial Second Lien Credit Facility which resulted in a $7,068 loss on extinguishment of debt. During the third quarter 2016, as a result of refinancing our long-term debt, we recorded a loss on extinguishment of $9,349 (see Note 9). (4) During the second quarter 2015, as a result of repricing our Initial First Lien Credit Facilities, we recorded a loss on extinguishment of debt of $4,084 (see Note 9). (5) As a result of our rebranding in September 2015, as discussed in Note 1, we recorded an impairment of intangible assets of $27,826 related to our trademarks (see Note 6). (6) During the first quarter 2015, we received payment on a $900 note receivable related to a business that was disposed of in 2012. Since the date of sale, we had elected to fully reserve the note receivable as the collectability was determined to be uncertain. This collection of the note receivable resulted in a gain on discontinued operations, net of tax, of $559 (see Note 20).
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From the provided financial statement excerpt, here's a summary of the key points:
1. Revenue:
- Primary operations are in the United States (98% of net revenue)
- Revenue recognition is based on performance fee-based contracts and fixed fee arrangements
- Revenue is recognized when contracts exist, services are provided, fees are fixed, and collection is reasonably assured
2. Operating Structure:
- Operating income = Net revenue - Operating expenses
- Indirect costs are allocated based on proportionate share of revenue and expenses
- Interest expense, non-operating income/expense, and income taxes are not allocated to segments
3. Geographic Presence:
- Main operations in continental United States
- Additional operations in Canada and United Kingdom
- Foreign currency transactions are translated to USD
4. Key Financial Practices:
- Estimated liability for refunds and appeals was $62,539 thousand
- Accounts receivable are recorded at invoice amount (non-interest bearing)
- Allowance for doubtful accounts is maintained based on historical losses
- Write-offs have not been significant
5. Notable Features:
- Asset information is not used for evaluating operating segment performance
- Foreign currency translation gains/losses are included in stockholders' equity
- No significant off-balance sheet credit exposure to clients
The statement appears to be from Cotiviti Holdings, Inc., and shows a financially stable organization with strong domestic presence and established financial control mechanisms.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ACCOUNTING FIRM To the Board of Directors and Stockholders of Metaldyne Performance Group Inc. Southfield, MI We have audited the accompanying consolidated balance sheet of Metaldyne Performance Group Inc. and subsidiaries (the "Company") as of December 31, 2016, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for the year ended December 31, 2016. Our audit also included the financial statement schedule for the year ended December 31, 2016 listed in the Index at These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Metaldyne Performance Group Inc. and subsidiaries as of December 31, 2016, and the results of their operations and their cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 2, 2017 expressed an unqualified opinion on the Company's internal control over financial reporting. /s/ Deloitte & Touche LLP Detroit, MI March 2, 2017 ACCOUNTING FIRM The Board of Directors Metaldyne Performance Group, Inc. We have audited the accompanying consolidated balance sheet of Metaldyne Performance Group Inc. and subsidiaries as of December 31, 2015 and the related consolidated statements of operations, comprehensive income, stockholders’ equity (deficit) and cash flows for each of the years in the two-year period ended December 31, 2015. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedule II: Valuation and Qualifying Accounts for each of the years in the two-year period ended December 31, 2015. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Metaldyne Performance Group, Inc. and subsidiaries as of December 31, 2015 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule for each of the years in the two-year period ended December 31, 2015, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Detroit, Michigan February 29, 2016, except for the effects of the retrospective application of ASU 2015-03, Interest - Imputation of Interest (Topic 835-30), as disclosed in Note 4, to which the date is March 2, 2017 METALDYNE PERFORMANCE GROUP INC. CONSOLIDATED BALANCE SHEETS (In millions, except per share data) See accompanying notes to consolidated financial statements. METALDYNE PERFORMANCE GROUP INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except per share amounts) See accompanying notes to consolidated financial statements. METALDYNE PERFORMANCE GROUP INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) See accompanying notes to consolidated financial statements. METALDYNE PERFORMANCE GROUP INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions) See accompanying notes to consolidated financial statements. METALDYNE PERFORMANCE GROUP INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) See accompanying notes to consolidated financial statements. METALDYNE PERFORMANCE GROUP INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Description of the Business Metaldyne Performance Group Inc. is a leading provider of components for use in engine, transmission and driveline (“Powertrain”) and chassis, suspension, steering and brake component (“Safety-Critical”) Platforms for the global light, commercial and industrial vehicle markets. We produce these components using complex metal-forming manufacturing technologies and processes for a global customer base of vehicle original equipment manufacturers (“OEMs”) and tier I suppliers (“Tier I suppliers”). Our components help OEMs meet fuel economy, performance and safety standards. Our metal-forming manufacturing technologies and processes include aluminum casting (“Aluminum Die Casting”), cold, warm or hot forging (“Forging”), iron casting (“Iron Casting”), and powder metal forming (“Powder Metal Forming”), as well as value-added precision machining and assembly (“Advanced Machining and Assembly”). These technologies and processes are used to create a wide range of customized Powertrain and Safety-Critical components that address requirements for power density (increased component strength to weight ratio), power generation, power / torque transfer, strength and Noise, Vibration and Harshness (“NVH”). Metaldyne Performance Group Inc. is organized and operated as three operating segments: the HHI segment, the Metaldyne segment and the Grede segment. (2) Basis of Presentation and Consolidation Basis of Presentation Metaldyne Performance Group Inc. was formed through the reorganization of ASP HHI Holdings, Inc. (together with its subsidiaries, “HHI”), ASP MD Holdings, Inc. (together with its subsidiaries, “Metaldyne”) and ASP Grede Intermediate Holdings LLC (together with its subsidiaries, “Grede”) on August 4, 2014 (the “Combination”). The Combination occurred through mergers with three separate wholly owned merger subsidiaries of Metaldyne Performance Group Inc. (“MPG,” the “Company,” “we,” “our” and “us” and similar terms refer to Metaldyne Performance Group Inc. and all of its subsidiaries, including HHI, Metaldyne and Grede). In connection with the Combination, 13.4 million shares of MPG common stock were issued in exchange for the outstanding shares of HHI, Metaldyne and Grede. On November 18, 2014, the outstanding shares of MPG common stock were split at a 5-to-1 ratio (the “Stock Split”). After the Stock Split, 67.1 million shares were outstanding. The number of authorized shares was increased to 400.0 million. Consolidation The Combination has been accounted for as a reorganization of entities under common control in a manner similar to a pooling of interests, that is, the bases of accounting of HHI, Metaldyne and Grede were carried over to MPG. These financial statements reflect the retrospective application of the MPG capital structure and the Stock Split for all periods presented. All intercompany balances and transactions have been eliminated in consolidation. (3) Significant Accounting Policies The financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) as defined by the Financial Accounting Standards Board (“FASB”) within the FASB Accounting Standards Codification. Use of Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported therein. Use of significant estimates and judgments are inherent in the accounting for acquisitions, stock-based compensation, income taxes and employee benefit plans, as well as in the testing of goodwill and long-lived assets for potential impairment. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be based upon amounts that differ from these estimates. Revenue Recognition Revenue is recognized when there is evidence of a sale, delivery has occurred or services have been rendered, the sales price is fixed or determinable and the collectability of receivables is reasonably assured. The Company has ongoing adjustments to its pricing arrangements with customers based on the related content and cost of its products. These adjustments are accrued as products are shipped to customers. Such pricing accruals are adjusted periodically and as they are settled with the customers. The Company has agreements allowing the pass-through of changes in the prices of raw materials referred to as material surcharges. Material surcharges are recognized as revenue when an agreement is reached, delivery of the goods has occurred and the amount of the material surcharge is determinable. Cash and Cash Equivalents All highly liquid investments with an initial maturity of three months or less are considered to be cash and cash equivalents. A cash pooling strategy is in place with certain foreign operations. Checks issued but not presented to banks may result in book overdraft balances for accounting purposes and such book overdrafts are classified within accounts payable and the change as a component of operating cash flows. Receivables Accounts receivable are stated at amounts estimated by management to be the net realizable value. An allowance for doubtful accounts is recorded when it is probable that amounts will not be collected based on specific identification of customer circumstances, age of the receivable and other pertinent information. Account balances are charged against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Valuation allowances for doubtful accounts, pricing accruals and anticipated customer deductions and returns are recorded based upon current information. Agreements are in place with international factoring companies to sell customer accounts receivable from locations in France, Germany, the Czech Republic, and the United Kingdom (“U.K.”) on a nonrecourse basis. The Company collects payment and remits such collections to the factoring companies for a portion of the sold receivables. The Company has no continuing involvement with all sold receivables. A commission is paid to the factoring company plus interest calculated from the date the receivables are sold to either the customer’s due date or a specified number of days thereafter or until the receivable is deemed uncollectible. Inventories Inventories are stated at the lower of cost or market value. Cost is determined using the first-in, first-out method and includes the cost of materials, direct labor and the applicable share of manufacturing overhead. To the extent management determines it is holding excess or obsolete inventory, the inventory is written down to its net realizable value. Pre-production Costs on Long-term Supply Arrangements Pre-production engineering, research and development costs related to products made for customers under long-term supply agreements are expensed as incurred. Pre-production tooling costs related to products made for customers under long-term supply agreements are expensed when reimbursement is not contractually guaranteed by the customer or where the customer has not provided a noncancelable right to use the tooling. Long-lived assets Long-lived assets other than goodwill are evaluated for impairment if adverse events or changes in circumstances indicate it is more likely than not that the assets are impaired. For each asset group affected by such impairment indicators, the recoverability of the carrying value of that asset group is determined by comparing the forecasted undiscounted cash flows related to that asset group to the asset group’s carrying value. Property and equipment, net: Property and equipment additions, including significant improvements, are recorded at cost, less accumulated depreciation. Upon retirement or disposal of property and equipment, the cost and accumulated depreciation are removed from the accounts and any gain or loss is included in cost of sales. Repair and maintenance costs are charged to expense as incurred. Depreciation is provided for using the straight-line method over the estimated useful lives of the related assets. Assets held under capital lease are included in property and equipment, net and the depreciation of these assets is included in accumulated depreciation. Capital lease assets are depreciated over the lesser of the lease term or their useful lives. Amortizable intangible assets, net: The useful lives of intangible assets are determined based on consideration of multiple factors including the Company’s expected use of the assets, the expected useful life of related assets and other external factors that may limit the useful life. Amortization is provided for using the straight-line method over the estimated useful lives for intangible assets with definite useful lives. Goodwill Impairment Testing Goodwill is evaluated for impairment annually or more often if a triggering event occurs between annual tests. The annual tests are performed in the fourth quarter. For each reporting unit to which goodwill has been assigned, the evaluation for impairment entails a quantitative analysis of the fair value of the reporting unit compared to the carrying value of the reporting unit. The Company may opt to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount prior to performing the quantitative assessment. Foreign Currency Translation The financial statements of foreign subsidiaries are translated to U.S. dollars at end-of-period exchange rates for assets and liabilities and an average monthly exchange rate for revenues and expenses. Translation adjustments are recorded as a component of accumulated other comprehensive loss within equity. Transaction gains and losses arising from fluctuations in foreign currency exchange rates on transactions denominated in currencies other than a subsidiary’s functional currency are recognized in other expense, net. Stock-based Compensation Stock-based compensation is measured based on the grant-date fair value of the award, and is recognized as expense over the requisite service period. To measure compensation cost of stock options, we determined fair value using a Black-Scholes pricing model. To measure compensation cost of restricted stock awards, we use the market value of the Company’s common stock as of the grant date. Employee Benefit Plans Annual net periodic benefit expense and benefit liabilities under defined benefit pension plans and statutory retirement benefits are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Pensions and other postretirement employee benefit costs and related liabilities and assets are dependent upon assumptions used in calculating such amounts. These assumptions include discount rates, expected returns on plan assets, health care cost trends, compensation and other factors. Each year end, actual experience is compared to the more significant assumptions used and the assumptions are adjusted, if warranted. Discount rates are based upon an expected benefit payments duration analysis and the equivalent average yield rate for high quality fixed income investments. Certain pension benefits are funded through investments held with trustees and the expected long-term rate of return on fund assets is based on actual historical returns modified for known changes in the market and any expected change in investment policy. Actual results that differ from the assumptions used are accumulated and amortized over future periods and, accordingly, generally affect recognized expense in future periods. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The effect of income tax positions are recognized only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. Interest and penalties related to unrecognized tax benefits are recorded in income tax expense. Noncontrolling Interests The accumulated amount of noncontrolling interests is classified in the consolidated balance sheets as a component of total stockholders’ equity and noncontrolling interests are reflected in the consolidated statements of comprehensive income and stockholders’ equity. Fair Value Measurements The fair values of assets and liabilities disclosed are categorized based on a fair value hierarchy giving the highest priority to the quoted prices in active markets for identical assets and liabilities and lowest priority to unobservable inputs. The various levels of the fair value hierarchy are described as follows: Level 1 Financial assets and liabilities whose values are based on quoted market prices for identical assets and liabilities in an active market that the Company has the ability to access. Level 2 Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable for substantially the full term of the asset or liability. Level 3 Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. (4) Recently Issued Accounting Standards In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). This guidance will supersede most current revenue recognition guidance, including industry-specific guidance. The underlying principle is that an entity will recognize revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. The guidance provides a five-step analysis of transactions to determine when and how revenue is recognized. Other major provisions include capitalization of certain contract costs, consideration of time value of money in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. The guidance also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from an entity’s contracts with customers. The guidance, as agreed to by the FASB, is effective for the interim and annual periods beginning on or after December 15, 2017. Early adoption is permitted on January 1, 2017. The guidance permits the use of either a retrospective or cumulative effect transition method. We have not yet selected a transition method and are currently evaluating the impact of the guidance on the consolidated financial statements. In April 2015, the FASB issued ASU 2015-03, Interest-Imputation of Interest (Topic 835-30). This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. This guidance is effective for fiscal years and interim periods beginning after December 15, 2015, and requires retrospective application. We adopted this guidance as of April 3, 2016, using retrospective application. Upon adoption of this guidance, the debt and total assets presented on our consolidated balance sheet were reduced by net debt issuance costs, which totaled $19.6 million as of December 31, 2015. In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes (Subtopic 740-10). ASU 2015-17 simplifies the presentation of deferred income taxes by eliminating the requirement for companies to present deferred tax liabilities and assets as current and non-current on the Consolidated Balance Sheets. Instead, companies will be required to classify all deferred tax assets and liabilities as non-current. This guidance is effective for annual and interim periods beginning after December 15, 2016 and early adoption is permitted. We elected to early adopt ASU 2015-17 prospectively, on December 31, 2015. The adoption of ASU 2015-17 did not have a material impact on our consolidated financial position, and had no impact on our results of operations or cash flows. No prior periods were retrospectively adjusted. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The primary focus of the standard addresses the accounting of lessees. It requires all lessees to recognize a right-of-use asset and a lease liability for virtually all leases (other than leases that meet the definition of a short-term lease) on the balance sheet. The recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from previous GAAP. Operating leases will result in straight-line expense while finance leases will result in depreciation expense recorded on the right-of-use asset and interest expense recorded on the lease liability. Quantitative and qualitative disclosures are required to provide insight into the extent of revenue and expense recognized and expected to be recognized from leasing arrangements. This guidance becomes effective January 1, 2019. Early adoption is permitted. We are currently evaluating the impact this guidance will have on our consolidated financial statements. In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (Topic 718). This guidance updates several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Specific changes include that all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) should be recognized as income tax expense or benefit in the income statement. The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. An entity would also recognize excess tax benefits regardless of whether the benefit reduces taxes payable in the current period. Excess tax benefits would be classified along with other income tax cash flows as an operating activity in the consolidated statement of cash flows. Also, an entity can make an accounting policy election to either estimate the number of awards that are expected to vest (current GAAP) or account for forfeitures when they occur. This ASU also amends guidance for the calculation of earnings per share under the treasury stock method by removing excess tax benefits as an assumed proceed from the exercise of options. This guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted in any interim or annual period. We did not early adopt this guidance and are currently evaluating the impact on the consolidated financial statements. (5) Acquisitions Brillion Transaction On September 2, 2016, the Grede segment acquired 100% of the equity of Brillion Iron Works, Inc. (“Brillion”) from its parent company Accuride Corporation (NYSE: ACW). Brillion was a reportable segment for Accuride Corporation and consists of a foundry located in Brillion, Wisconsin, (the “Brillion Facility”) which supplies castings to the industrial machinery, construction, agricultural equipment and oil and gas markets, including flywheels, pump housings, valve body housings, small engine components, and other industrial components. The purchase price for the acquisition was $14.0 million of cash consideration. Under the acquisition method of accounting, all assets acquired and liabilities assumed were recorded in the consolidated financial statements at estimated fair value. The allocation of purchase price paid resulted in receivables of $8.1 million, inventory of $3.8 million, property, plant, and equipment of $15.9 million, assumed liabilities of $12.8 million, and a gain on bargain purchase of $1.0 million. The $1.0 million gain on bargain purchase is recorded within other, net on the consolidated statement of operations for the year ended December 31, 2016. On September 12, 2016, the Company announced its plan to close the Brillion Facility and to consolidate substantially all of Brillion’s business into Grede’s existing locations. As of December 31, 2016, the Brillion Facility had ceased operations. Grede Transaction On June 2, 2014 (the “Acquisition Date”), a subsidiary of American Securities, ASP Grede Intermediate Holdings LLC (together with its subsidiaries, “Grede”), purchased 97.1% of the membership interests in Grede Holdings LLC (the “Grede Transaction”). Management and outside investors purchased the remaining membership interests. Upon completion of the Combination, 100% of Grede was owned by the Company. Purchase Accounting The Grede Transaction was a cash purchase and was accounted for under the acquisition method. The accounting for the acquisition has been pushed-down to the financial statements of the Company. All assets acquired and liabilities assumed were recorded in the consolidated financial statements at estimated fair value. The purchase price for the acquisition, net of cash and cash equivalents, was $829.7 million. The acquisition was funded by cash from capital contributions ($251.1 million from affiliates of American Securities, $6.5 million from certain members of the Grede management team and $1.0 million from outside investors) and the issuance of term loan debt. The Grede Transaction was recorded, as revised for updated valuation information, in the accounts of the Company as follows: The valuation method used to estimate the fair value of assets acquired and liabilities assumed entailed a cost approach, a market approach, an income approach or a combination of those approaches based on the nature of the asset or liability being valued. The estimated value of property and equipment was determined using a cost approach, relying on estimated replacement costs. Within amortizable intangible assets, customer relationships and platforms were valued using an income approach, relying on estimated multi-period excess earnings attributable to the relationship or platform. Goodwill recognized was primarily attributable to potential operational synergies related to overhead cost reductions and the assembled workforce. None of the goodwill recognized is expected to be deductible for tax purposes. Additional details of the assets recognized were as follows: The estimated fair value of inventories was $4.4 million higher than the carrying value at the time of the acquisition. The entire amount of this step-up in value was expensed in cost of sales during 2014 based on an analysis of Grede’s inventory turns. Grede has estimated a remaining useful life of 10 years for the customer relationships and platforms due to the strong and longstanding relationships with our customers, which include many of the leading global OEMs and Tier 1 Suppliers. Grede has estimated a remaining useful life of 15 years for the trade names based on the nature of the industry, the length of time it has been in business and the relative strength of the name in the marketplace. Included within other long-term liabilities are obligations for noncontributory defined benefit plans maintained by Grede for certain employees covered by collective bargaining agreements. The obligations for these plans were measured as of the acquisition date. The funded status as of the Acquisition Date was as follows: A weighted average discount rate of 4.04% was used to determine the projected benefit obligation. The rate of compensation increase is not applicable due to the fact that the plans’ benefits are based on credited years of service. The plans’ assets are composed primarily of pooled separate accounts in which the underlying securities are primarily publicly traded domestic equities and government debt securities. The amount of Grede revenues and earnings included in the consolidated statements of operations subsequent to the Grede Transaction was as follows: Grede Transaction-related expenses incurred in 2014 were $13.0 million, which were recorded within acquisition costs, of which $8.3 million was paid to related parties. Supplemental Pro Forma Information (Unaudited) The following table presents the revenues and earnings of MPG on a pro forma basis as if the Grede Transaction had occurred on January 1, 2013: These results do not purport to be indicative of the results of operations which actually would have resulted had the Grede Transaction occurred on January 1, 2013, or of the future results of operations of the Company. (6) Receivables Receivables as of December 31 were stated net of the following allowances: Receivables available for sale and sold under agreements with international factoring companies as of December 31 were as follows: (7) Inventories Inventories as of December 31 were as follows: (8) Property and Equipment The carrying amount, accumulated depreciation and useful lives of property and equipment as of December 31 were as follows: Property and equipment are depreciated on a straight-line basis. Depreciation expense was $151.4 million for 2016 $159.4 million for 2015, and $155.0 million for 2014. Included in property and equipment are gross carrying values for assets under capital lease of $2.7 million and $13.8 mllion as of December 31, 2016 and 2015, respectively; related accumulated depreciation was $0.6 million and $9.0 million as of December 31, 2016 and 2015, respectively. In June 2015, the Company announced plans to close its Berlin, Wisconsin facility included within the Grede segment. In conjunction with this announcement, the Company recorded a $4.0 million asset impairment charge within cost of sales to reduce the carrying value of Berlin’s assets to their estimated fair value based on level 3 valuation inputs. The closure, which is primarily a result of the industrial market slowdown, was completed in fiscal 2015. In May 2016, the Company announced plans to close its Bessemer, Alabama facility included within the Grede segment. The closure, which is primarily due to declines in heavy truck and industrial equipment markets, was completed in fiscal 2016. In conjunction with this announcement, the Company recorded a $2.3 million asset impairment charge within cost of sales to reduce the carrying value of Bessemer’s assets to their estimated fair value based on level 3 valuation inputs. (9) Goodwill The carrying values of goodwill by segment throughout fiscal years ended December 31, 2016 and 2015 were as follows: In conjunction with our 2014 annual impairment test, the Company concluded that the goodwill assigned to a reportable unit within the HHI segment (the “Unit”) was no longer recoverable. The Unit manufactures wheel bearings for a large OEM customer at our facility in Sandusky, Ohio (the “Sandusky facility”). In our assessment of the recoverability of the Unit’s goodwill, the Company estimated the fair value of the Unit using an income method based on discounted cash flows, which resulted in a fair value below the carrying value. Key factors impacting a lower fair value included the scheduled attrition of programs for the OEM customer and the expiration of labor subsidies in September 2015. An impairment loss of $11.8 million was recognized in the fourth quarter of 2014, representing the full amount of goodwill assigned to the Unit. (10) Amortizable Intangible Assets The carrying amount and accumulated amortization of intangible assets as of December 31 were as follows: Amortization expense was $69.9 million for 2016, $69.9 million for 2015, and $54.8 million for 2014. As of December 31, 2016, the weighted-average amortization period of customer relationships and platforms was 12 years. Other intangible assets primarily consist of patented and unpatented technology, and trade names and trademarks, which have weighted-average amortization periods of 13 and 15 years, respectively. Estimated amortization expense for the next five years is $69.9 million for 2017, $68.4 million for 2018 and 2019, $68.3 million for 2020, and $68.2 for 2021. (11) Debt The carrying value of debt as of December 31 was as follows: Credit Facilities In October 2014, MPG Holdco I Inc., the Company’s wholly owned subsidiary (“Holdco”) entered into a senior secured credit facility (the “Senior Credit Facilities”) consisting of a $1,350.0 million term loan (“Term Loan Facility”), maturing in 2021, and a $250.0 million revolving credit facility (“Revolving Credit Facility”), maturing in 2019. Interest on the Term Loan Facility accrued at a rate equal to the London Interbank Offered Rate (“LIBOR”) rate (bearing a LIBOR floor of 1.00%) plus an applicable margin of 3.25% or a base rate that is the higher of the Federal Funds Rate (plus 0.50%), the U.S. prime rate as published in The Wall Street Journal, or LIBOR (plus 1.00%), plus an applicable margin of 2.25%, at Holdco’s option. Prior to the Company’s initial public offering on December 12, 2014, the applicable margin was 3.50% for LIBOR rate loans and 2.50% for base rate loans. The interest rate in effect as of December 31, 2014 was 4.25%. The Term Loan Facility was payable in quarterly installments of $3.375 million beginning in March 2015. On May 8, 2015, the Company amended its Senior Credit Facilities to reduce the applicable interest rate on the Term Loan Facility and to refinance the outstanding balance of the Term Loan Facility with new term loans (the “Refinanced Term Loan Facility”). The Refinanced Term Loan consists of a $1,072.6 million U.S. Dollar denominated term loan (the “USD Term Loan”) and a €225.0 million Euro denominated term loan (the “Euro Term Loan”). The USD Term Loan was issued at par and accrues interest at LIBOR, bearing a 1.00% floor, plus an applicable margin of 2.75%. The Euro Term Loan was issued at an original issuance discount of 0.50%, or $1.3 million, and accrues interest at the Euro Interbank Offer Rate (“EURIBOR”), bearing a 1.00% floor, plus an applicable margin of 2.75%. At December 31, 2016, the effective interest rate on both the USD Term Loan and Euro Term Loan was 3.75%. Principal repayments on the USD Term Loan and Euro Term Loan are payable in quarterly installments equal to 0.25% of the original loan balances. All other terms of the amended Senior Credit Facilities remain substantially unchanged. In connection with amending the Senior Credit Facilities, the Company paid fees to third parties totaling $1.8 million, of which $1.6 million was expensed. During 2015, the Company made $10.0 million in voluntary prepayments on the previous Term Loan Facility and $45.0 million in voluntary prepayments on the Refinanced Term Loan Facility. Interest on the Revolving Credit Facility is accrued at a rate equal to the LIBOR rate plus an applicable margin of 3.25% or a base rate that is the higher of the Federal Funds Rate (plus 0.50%), the U.S. prime rate as published in The Wall Street Journal, or LIBOR (plus 1.00%), plus an applicable margin of 2.25%, at Holdco’s option. The applicable margin is based on a leverage ratio grid. As of December 31, 2016, zero was outstanding under the Revolving Credit Facility and $236.8 million was available after giving effect to outstanding letters of credit. Holdco pays fees with respect to the Revolving Credit Facility, including (i) an unused commitment fee of 0.50% or 0.375% based on a leverage ratio, (ii) fixed fees with respect to letters of credit of 3.25% per annum on the stated amount of each letter of credit outstanding during each month and (iii) customary administrative fees. The agreement governing the Senior Credit Facilities contains certain covenants that, among other things, require MPG Holdco to maintain a leverage ratio once revolver borrowings and letters of credit exceed 35% of aggregate revolving credit commitments as defined under the terms of the Senior Credit Facilities and to comply with customary affirmative and negative covenants. In addition to scheduled maturities, the Refinanced Term Loan Facility is subject to customary mandatory prepayments, including an excess cash flow sweep based on leverage ratio step downs and a mandatory prepayment for certain asset sales. The Company is required to prepay a portion of the Term Loan Facility in an amount equal to a percentage of the preceding fiscal year’s excess cash flow, as defined, with such percentage based on our leverage ratio, as defined. No mandatory prepayments are due as of December 31, 2016. The agreements governing the Senior Credit Facilities and the Registered Notes restrict the payment of dividends except (i) to pay reasonable estimated amount of taxes as long as not prohibited by applicable laws, (ii) to pay legal, accounting, and reporting expenses, (iii) to pay general administrative costs and expenses, and reasonable directors fees, and expenses; (iv) to repurchase stock owned by employees, (v) for management or similar fees, (vi) to pay franchise or similar taxes to maintain corporate existence, (vii) permitted tax distributions, and (viii) to pay dividends up to $30.0 million or 6% of the net cash proceeds from an underwritten public offering of our common stock. The Senior Credit Facilities are guaranteed by MPG and certain of its direct and indirect existing and future domestic subsidiaries and are secured on a first priority basis by all or substantially all of our assets, the assets of Holdco and each guarantor’s assets, including a pledge of capital stock of our U.S. subsidiaries that hold domestic assets and a portion of the capital stock of the first tier foreign subsidiaries of MPG and each guarantor. The Registered Notes are guaranteed by MPG and certain of its direct and indirect existing and future domestic subsidiaries. The Registered Notes are pari passu in right of payment with the Senior Credit Facilities, but are effectively subordinated to the Senior Credit Facilities to the extent of the value of the assets securing such indebtedness. Registered Notes In October 2014, Holdco issued $600.0 million of senior notes (“Senior Notes”). The Senior Notes mature in 2022, and bear interest at a rate of 7.375%, payable semi-annually on April 15 and October 15 per the terms of the indenture governing the Senior Notes. In May, 2015, the Company launched an offer to exchange notes registered with the SEC (the “Registered Notes”) for its existing Senior Notes that were not registered with the SEC. The Registered Notes have substantially identical terms as the Senior Notes. The exchange offer was made pursuant to a prospectus included in a Registration Statement on Form S-4 filed with the SEC on May 1, 2015, and declared effected by the SEC on May 8, 2015. The exchange offer was completed on June 8, 2015, and all outstanding original Senior Notes were tendered and exchanged for Registered Notes. The indenture governing the Senior Notes contains certain covenants, including a covenant that restricts the payment of dividends except (i) to pay reasonable estimated amount of taxes as long as not prohibited by applicable laws, (ii) to pay legal, accounting, and reporting expenses, (iii) to pay general and administrative costs and expenses, and reasonable directors fees, and expenses, (iv) to repurchase stock owned by employees, (v) for management or similar fees, (vi) to pay franchise or similar taxes to maintain corporate existence and (vii) to pay dividends up to $30.0 million or 6% of the net cash proceeds from an underwritten public offering of our common stock. Scheduled Maturities of Long-term Debt As of December 31, 2016, the Company’s scheduled principal payments of long-term debt for the five succeeding years were $13.1 million for 2017, $13.1 million for 2018, $13.1 million for 2019, $13.1 million for 2020 and $1,192.4 million for 2021, and $600.0 million thereafter. The scheduled principal payments are exclusive of potential required prepayments. (12) Lease Commitments The Company leases certain property and equipment under capital and operating lease arrangements that expire at various dates through 2036. Most of the operating leases provide the option, after the initial lease term, either to purchase the property or renew its lease at the then fair value. Future minimum lease payments by the Company under capital and operating leases that have initial or remaining noncancelable terms in excess of one year as of December 31, 2016 are as follows: Rental expense for operating leases was $14.5 million for 2016, $12.9 million for 2015, and $12.4 million for 2014. (13) Equity, Dividends and Change in Accumulated Other Comprehensive Loss Equity On August 4, 2014, in connection with the Combination, the issued and outstanding shares of HHI, Metaldyne and Grede were converted to shares of MPG. The number of MPG shares issued upon conversion was determined based on the relative fair value of each entity to the overall fair value of MPG at the time of the Combination. Upon completion of the Combination, 13.4 million shares of MPG common stock were issued and outstanding. On November 18, 2014, MPG common stock was split at a 5-to-1 ratio, with each stockholder receiving four additional shares for each share held. Upon completion of the Stock Split, 67.1 million shares were outstanding. The number of authorized shares was increased to 400 million. The Combination and the Stock Split have been retrospectively applied to the Successor Period financial statements. On December 12, 2014, American Securities sold 10,000,000 shares of the Company’s common stock under an IPO, for which no proceeds were received by the Company. The Company recognized costs directly attributable to the IPO of $5.6 million within paid-in capital. On January 15, 2015, the underwriters of the IPO exercised their option to purchase additional shares of our common stock from American Securities. After selling these additional shares, American Securities owned 78.5% of our common stock. Dividends In 2016 and 2015, the Company declared the following cash dividends on its common stock, totaling $25.4 million and $18.5 million, respectively. As of December 31, 2016, the Company had accrued dividends of $0.6 million on unvested Restricted Shares, which are to be paid upon vesting. In 2014, prior to the Combination, HHI paid dividends to its stockholders totaling $111.3 million, which was primarily funded by an incremental term loan. Share Repurchases On February 24, 2016, our board of directors authorized a share repurchase program (the “Share Repurchase Program”). The Share Repurchase Program, as amended on August 3, 2016, authorized the Company to purchase shares of its common stock for an aggregate repurchase price not to exceed $35.0 million. Subject to applicable rules and regulations, shares could be repurchased through open market purchases, privately negotiated transactions, or otherwise. On November 3, 2016, the Company suspended the Share Repurchase Program due to the pending merger with American Axle & Manufacturing Holdings, Inc. As of December 31, 2016, cumulative shares repurchased totaled 1,898,261 shares at an average purchase price per share of $15.56. The repurchased shares are presented as common stock held in treasury, at cost, on the consolidated balance sheets. Changes in Accumulated Other Comprehensive Loss Attributable to Stockholders, Net of Tax (14) Net Income Per Share Attributable to Stockholders (“EPS”) The Company’s basic and diluted EPS were calculated as follows: For 2014, the weighted average shares outstanding were retrospectively adjusted to reflect MPG common stock outstanding upon completion of the Combination and the Stock Split; the equivalent shares for outstanding stock-based compensation awards were retrospectively adjusted to reflect the conversion of those awards into options to purchase shares of Common Stock of MPG and the Stock Split. The number of equivalent shares excluded from the calculation as they were anti-dilutive was 0.1 million for 2016, de minimis for 2015, and 0.8 million for 2014. (15) Other, net (16) Stock-based Compensation In August 2014, the Board of Directors of MPG approved an equity incentive plan (the “MPG Plan”) for officers, key employees and non-employees. The MPG Plan permits the grant of equity awards to purchase up to 5.9 million shares of MPG common stock. All awards granted on or after August 4, 2014 were issued under the MPG Plan. Restricted Shares The Company has granted restricted stock awards and restricted stock unit awards to certain employees and nonemployee directors (collectively the “Restricted Shares”). The following table summarizes the terms of the Restricted Shares: The Restricted Shares are being expensed based on their grant-date fair values on a straight-line basis over the requisite service period for the entire award. The grant-date fair values were determined using the fair value of the Company’s common stock as of the grant date. Changes in the number of Restricted Shares outstanding for the years ended December 31, 2016 and 2015 were as follows: Options The Company has granted options to certain employees to purchase shares of its common stock with the following terms: All options are being expensed on their grant-date fair values on a straight-line basis over the requisite service period for the entire award. The grant-date fair values of the options were determined using a Black-Scholes valuation model based on the following weighted average assumptions: The risk-free rate was determined based on U.S. Treasury yield curves of securities matching the expected term of the awards or a blend of securities with similar terms. The expected term was determined using the simplified method as the Company did not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term. Expected volatility was estimated based on historical volatility of comparable companies within our industry. The expected dividend yield was determined based on the expected annual dividend amount divided by the common stock price as of the grant date. Options Outstanding Changes in the number of Options outstanding for the years ended December 31, 2016 and 2015 were as follows: Proceeds and tax benefit realized from the exercise of stock options during the years ended December 31, 2016, 2015 and 2014 were as follows: Stock-based Compensation Expense Compensation expense associated with the outstanding stock-based awards was recognized within selling, general and administrative expenses. Total unrecognized compensation cost related to non-vested awards as of December 31, 2016 was approximately $31.0 million, which is expected to be recognized ratably over the remaining vesting terms. In 2015, the Company modified 297,378 restricted shares and 1,387,087 options in connection with employee separation agreements. In accordance with these agreements, all non-vested awards vested immediately at the date of separation. In addition, the terms of the options were modified from the original term to exercise of 30 days after separation to a term of three or five years based on the respective separation agreement. The modification, which affected five participants, resulted in additional compensation expense related to restricted shares and options of approximately $4.1 million and $7.6 million, respectively, for the year ended December 31, 2015. In August 2014, in conjunction with the Combination, all outstanding stock-based compensation awards were converted (the “Conversion”) to options to acquire MPG common stock. The Conversion was accounted for as a modification resulting from an equity restructuring. The terms of the original awards were modified to eliminate and replace performance-based vesting with time-based vesting over the remaining vesting periods as set forth in the original option agreements. The modification, which affected fifty-nine option holders, resulted in no incremental compensation cost to the Company. The number of options issued upon conversion and the exercise price of those options were determined based on the relative fair values of the underlying stock of HHI, Metaldyne, or Grede to the overall fair value of MPG common stock at the time of the Combination. Prior to the Combination and Conversion, Grede had issued 970,395 equity awards in 2014, HHI and Metaldyne had issued 39,885 and 1,991,305 equity awards in 2013, respectively, and, as of the beginning of 2013, HHI had 1,888,450 equity awards issued and outstanding. (17) Income Taxes The components of deferred taxes as of December 31 were as follows: The balance sheet presentation of net deferred tax liability follows: The following is a reconciliation of tax computed at the U.S. federal statutory rate to the provision for income taxes allocated to income from continuing operations: As of December 31, 2016, the Company has not made a provision for U.S. or additional foreign withholding taxes on approximately $265 million of the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries that is indefinitely reinvested. Such amounts could become taxable upon the sale or liquidation of these foreign subsidiaries or upon dividend repatriation. If a U.S. deferred tax liability were to be recorded on those basis differentials, the estimated tax liability would approximate $24.8 million. For those wholly owned foreign subsidiaries where basis differentials are not indefinitely reinvested, the Company provides deferred income taxes on the basis differentials. As of December 31, 2016 and 2015, this deferred income tax liability totaled $3.9 million and $2.2 million, respectively. The Protecting Americans from Tax Hikes Act of 2015 extended the “look-through” rule under subpart F of the U.S. Internal Revenue Code through 2019. The “look-through rule” provides an exception to the U.S. taxation of certain income generated by foreign subsidiaries. As a result of this change in law, the Company recorded a $3.2 million income tax benefit in 2015, to derecognize a portion of the deferred tax liabilities previously recorded. In the fourth quarter of 2014, MPG made the assertion that the earnings of certain foreign subsidiaries within the Metaldyne segment are indefinitely reinvested. This determination resulted from the Refinancing in October 2014 and the IPO in December 2014, which added significant flexibility to the Company’s capital structure. The assertion is also supported by the operational and investing needs of the Company’s foreign locations. As a result of this change, the Company recorded a $31.6 million deferred tax benefit for the year ended December 31, 2014 to derecognize a portion of the deferred tax liabilities previously recorded. As of December 31, 2016 and 2015, certain foreign subsidiaries have NOL carryforward balances totaling $57.6 million and $40.2 million, respectively. Of the December 31, 2016 balance, foreign NOL carryforwards totaling $5.4 million will expire in various years ranging from 2018 through 2025, while the remaining balance of $52.3 million has no expiration date. The Company continues to maintain a valuation allowance related to its net deferred tax assets in multiple jurisdictions. As of December 31, 2016 and 2015, the Company had valuation allowances of $15.3 million and $11.8 million, respectively, primarily related to tax loss and credit carryforwards. For its U.S. federal income tax provision, the Company has recorded a research and experimentation tax credit of $2.4 million and $1.3 million for the year ended December 31, 2016 and 2015, respectively. A reconciliation of the total amounts of unrecognized tax benefits for the years ended December 31 follows: The reserve for unrecognized tax benefits totaled $4.1 million and $4.5 million as of December 31, 2016 and 2015, respectively. This reserve primarily consists of foreign tax contingencies related to ongoing tax audits. Additionally, as of December 31, 2015, deferred tax assets related to net operating losses were reduced by $2.7 million. The deferred tax assets were re-established during the year ended December 31, 2016 due to a favorable resolution of an audit issue for one of the Company’s foreign subsidiaries. All of the Company’s unrecognized tax benefits would, if recognized, reduce its effective tax rate. In connection with the Metaldyne Transaction, the former owner’s stockholders have indemnified Metaldyne for certain pre-closing taxes. An indemnification asset of $4.7 million and $7.6 million related to the foreign tax contingencies, including interest and penalties, is recorded in receivables, net as of December 31, 2016 and 2015, respectively. The Company recognizes both interest and penalties accrued with respect to an underpayment of income taxes as income tax expense. Related to the unrecognized tax benefits noted above, the amount of interest and penalty expense was $0.1 million, $0.2 million, and $0.2 million for the years ended December 31, 2016, 2015, and 2014, respectively. The accrued liability for penalties and interest as of December 31, 2016, 2015 and 2014 was $1.4 million, $1.3 million and $1.1 million, respectively. The Company has open tax years from 2004 to 2016 with varying taxing jurisdictions where taxes remain subject to examination including, but not limited to, the United States of America, Spain, France, Germany, and India. All necessary adjustments for the anticipated outcomes of ongoing examinations have been properly addressed or accrued. As of December 31, 2016 and 2015, since existing examinations remain pending, it is not possible to reasonably estimate the expected change to the total amount of unrecognized tax benefits over the next twelve months. (18) Employee Benefit Plans The Company sponsors employee benefit plans for certain of its employees. Defined Benefit Pension Plans The Company sponsors defined benefit pension plans, including certain unfunded supplemental retirement plans, covering certain active and retired employees for its operations in the U.S., U.K., Germany, Mexico, France and Korea (the “Defined Benefit Pension Plans”). The straight-line method is used to amortize prior service amounts and unrecognized net actuarial (gains) losses. Changes in projected benefit obligations and plan assets for the years ended December 31 were as follows: Amounts recognized on the consolidated balance sheets as of December 31 were as follows: The current portion of the above retirement benefit liabilities is recognized in accrued liabilities and the noncurrent portion is recognized in other long-term liabilities. Changes in accumulated other comprehensive income for the years ended December 31 were as follows: The amounts in accumulated other comprehensive income that are expected to be recognized as components of net periodic benefit cost in 2017 are de minimis for the U.S. plans and $0.3 million for the non-U.S. plans. Weighted average assumptions used to determine the benefit obligations as of December 31 were as follows: Weighted average assumptions used to determine net periodic benefit cost for the periods ended of December 31 were as follows: The discount rate used was determined based upon available yields for high quality corporate and government bonds of the plan countries, utilizing similar durations/terms and currencies of the plan liabilities. The non-U.S. country specific rates are weighted by projected benefit obligation to arrive at a single weighted average rate. The expected long-term rate of return for the plans’ total assets is based on the expected return of each of the below asset categories, weighted based on the target allocation for each class. Equity securities and growth assets are expected to return 6% to 8% over the long-term, while debt securities and liability matching assets are expected to return between 2% and 4%. The rate of compensation increase for the U.S. plans is not applicable as the plans’ benefits are based upon credited years of service. Net periodic benefit cost for the periods ended of December 31 was as follows: The weighted average asset allocations as of December 31 were as follows: Certain policies are established to provide for growth of capital with a moderate level of volatility by investing assets per the target allocations. The plans’ asset allocation percentages at December 31, 2016 and 2015 approximated the target asset allocation ranges. The targeted asset allocations and the investment policies are reviewed periodically to determine if the policies should be changed. Fair value measurements for plan assets as of December 31, 2016 were as follows: Fair value measurements for plan assets as of December 31, 2015 were as follows: Level 1 assets include cash and cash equivalents and are valued at cost. Level 2 assets include investments in mutual funds and are valued using observable market inputs. Level 3 assets include investments in real estate and are valued using unobservable inputs that are significant to the overall fair value measurement. The following table summarizes the changes in Level 3 assets: Contributions to the U.S. plans and the non-U.S. plans in 2017 are estimated to be $0.3 and $0.8 million, respectively. Contributions are expected to meet or exceed the minimum funding requirements of the relevant governmental authorities. Contributions may be made in excess of the minimum funding requirements in response to the plans’ investment performance, to achieve funding levels required by defined benefit plan arrangements or when deemed to be financially advantageous to do so based on their other cash requirements. The following payments, which reflect expected future service, as appropriate, are expected to be paid by the plans: Defined Contribution Plans The Company sponsors a number of qualified defined contribution personal savings plans for U.S. hourly and salaried employees. These plans allow eligible employees to contribute a portion of their compensation into the plans and generally provide employer matching contributions. In addition to the employer match, for certain of the plans, a contribution is made for each participant based on a dollar amount per hour worked. Contributions were $6.4 million for 2016, $7.6 million for 2015, and $6.7 million for 2014 . (19) Fair Value Measurements The carrying value and fair value of the notes and term loans as of December 31 were as follows: The fair values of the Registered Notes and term loans were estimated using quoted market prices. As the markets for this debt are not active, the debt is categorized as Level 2 within the fair value hierarchy. The fair value of the Company’s other financial instruments, cash and cash equivalents, revolving lines of credit and other long-term debt, are estimated to equal their carrying values due to their short-term nature. (20) Commitments and Contingencies Various claims, lawsuits and administrative proceedings are pending or threatened against the Company or its subsidiaries, covering a wide range of matters that arise in the ordinary course of the Company’s business activities, primarily with respect to commercial, environmental and occupational and employment matters. Commercial disputes vary in nature and have historically been resolved by negotiations between the parties. Although the outcome of any of these matters cannot be predicted with certainty, the Company does not believe that any of these proceedings or matters in which the Company is currently involved will have a material adverse effect on the Company’s results of operations, financial position or cash flows. In addition, the Company is conducting remedial actions at certain of its facilities. A reserve estimate for each environmental matter is established using standard engineering cost estimating techniques on an undiscounted basis. In determining such costs, consideration is given to the professional judgment of Company environmental engineers. The Company believes any liability that may result from the resolution of environmental matters for which sufficient information is available to support these cost estimates will not have a material adverse effect on the Company’s results of operations, financial position or cash flows. The Company cannot predict the effect of compliance with environmental laws and regulations with respect to unknown environmental matters on the Company’s results of operations, financial position or cash flows or the possible effect of compliance with environmental requirements imposed in the future. Definitive Merger Agreement On November 3, 2016, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”), by and among the Company, American Axle & Manufacturing Holdings, Inc. (“American Axle”) and Alpha SPV I, Inc. (“Merger Sub”), a wholly owned subsidiary of American Axle, pursuant to which American Axle will acquire all of the outstanding equity of the Company. In accordance with and subject to the terms and conditions of the Merger Agreement, Merger Sub will merge with and into the Company (the “Merger”), with the Company surviving the Merger and continuing as a wholly-owned subsidiary of American Axle. Upon consummation of the transactions contemplated by the Merger Agreement, each outstanding share of common stock, par value $0.001 per share, of the Company will automatically be converted into the right to receive (i) $13.50 per share in cash (without interest) and (ii) 0.5 shares of common stock, par value $0.01 per share, of American Axle. The consummation of the Merger and the transactions contemplated by the Merger Agreement are subject to the satisfaction of customary closing conditions, including the receipt of Mexican antitrust approval, the approval of the Merger Agreement by the requisite vote of the Company’s stockholders and approval of the issuance of shares of common stock of American Axle to the Company’s stockholders in the Merger by the requisite vote of American Axle’s stockholders. (21) Related Party Transactions HHI, Metaldyne and Grede were parties to management services agreement with American Securities. Advisory and management fees and expenses totaling $14.7 million for 2014 were paid to American Securities under the agreements. These agreements were terminated upon completion of the initial public offering of the Company’s common stock on December 12, 2014. As of December 31, 2016 there were no amounts due to American Securities. As of December 31, 2016, affiliates of American Securities held 76.0% of the outstanding common stock of the Company. (22) Segment and Geographical Data The Company is organized and operated as three operating segments: the HHI segment, the Metaldyne segment and the Grede segment. The HHI segment manufactures highly-engineered metal-based products for the North American light vehicle market. These components are used in Powertrain and Safety-Critical applications, including transmission components, drive line components, wheel hubs, axle ring and pinion gears, sprockets, balance shaft gears, timing drive systems, VVT components, transfer case components and wheel bearings. The Metaldyne segment manufactures highly-engineered metal-based Powertrain products for the global light vehicle markets. These components include connecting rods, VVT components, balance shaft systems, and crankshaft dampers, differential gears, pinions and assemblies, valve bodies, hollow and solid shafts, clutch modules and assembled end covers. The Grede segment manufactures cast, machined and assembled components for the light, commercial and industrial (agriculture, construction, mining, rail, wind energy and oil field) vehicle and equipment end-markets. These components are used in Powertrain and Safety-Critical applications, including turbocharger housings, differential carriers and cases, scrolls and covers, brake calipers and housings, knuckles, control arms and axle components. The Company evaluates the performance of its operating segments based on external sales and Adjusted EBITDA. Adjusted EBITDA is calculated as net income (loss) before tax adjusted to exclude depreciation and amortization expense, interest expense, net and other income and expenses that are either non-recurring or non-cash by nature, as well as management fees paid to American Securities (“sponsor management fees”). Adjusted EBITDA may not be comparable to similarly titled measures reported by other companies. Segment information for 2016, 2015 and 2014 was as follows: Elimination and other above reflects the elimination of intercompany sales, payables and receivables and assets held by the parent company. Assets held by the parent company primarily consist of cash and cash equivalents, and deferred tax assets. Reconciliation of Adjusted EBITDA to income before tax follows: The following table presents total assets, long-lived assets and net assets by geographic area, attributed to each subsidiary’s continent of domicile as of December 31, 2016 and 2015. The following table presents the net sales by geographic area, attributed to each subsidiary’s continent of domicile: During 2016, direct sales to two customers accounted for 25% and 21% of net sales, respectively. (23) Summarized Quarterly Financial Information (Unaudited) (24) Guarantor Condensed Consolidating Financial Information The outstanding balances of the Senior Credit Facilities and Registered Notes, entered into and issued on October 20, 2014, are guaranteed by all of the Company’s existing and future domestic subsidiaries (“Guarantor Subsidiaries”). All of the Guarantor Subsidiaries are 100% owned by Metaldyne Performance Group Inc. (“Parent”) and Holdco (“Issuer”). The guarantee is full, unconditional, joint and several. The Company’s non-domestic subsidiaries have not guaranteed the Senior Credit Facilities or the Registered Notes (“Non-Guarantor Subsidiaries”). The accompanying supplemental condensed, consolidating financial information is presented using the equity method of accounting for all periods presented. Under this method, investments in subsidiaries are recorded at cost and adjusted for the Company’s share in the subsidiaries’ cumulative results of operations, capital contributions and distributions and other changes in equity. Elimination entries relate primarily to the elimination of investments in subsidiaries and associated intercompany balances and transactions. Condensed Consolidating Balance Sheet December 31, 2016 (In millions) Condensed Consolidating Balance Sheet December 31, 2015 (In millions) Condensed Consolidating Statements of Operations (In millions) Condensed Consolidating Statements of Operations (In millions) Condensed Consolidating Statements of Comprehensive Income (In millions) Condensed Consolidating Statements of Cash Flows (In millions) Condensed Consolidating Statements of Cash Flows (Continued) (In millions) (25) Subsequent Events On February 24, 2017, our board of directors declared a dividend of $0.0925 per share, payable March 24, 2017 to stockholders of record as of March 10, 2017.
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Here's a summary of the financial statement:
Key Financial Policies:
1. Asset Management:
- Depreciation uses straight-line method
- Capital lease assets are included in property/equipment
- Assets are depreciated over their useful life or lease term (whichever is shorter)
2. Intangible Assets & Goodwill:
- Useful lives determined by multiple factors
- Goodwill evaluated annually for impairment
- Testing performed in fourth quarter
3. Foreign Currency:
- Foreign subsidiaries' statements translated to USD
- Uses end-of-period rates for assets/liabilities
- Monthly average rates for revenues/expenses
4. Compensation & Benefits:
- Stock-based compensation measured at grant-date value
- Uses Black-Scholes model for stock options
- Pension benefits calculated actuarially
- Benefits dependent on various factors (discount rates, returns, healthcare costs)
5. Tax Management:
- Uses asset and liability method
- Deferred tax assets/liabilities recognized
- Tax positions recognized if >50% likely to be sustained
Notable Figures:
- Net debt issuance costs: $19.6 million (reduction in total assets)
The statement shows a comprehensive accounting framework focusing on asset valuation, employee benefits, and tax management, with specific attention to international operations and currency translation.
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Claude
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FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders West Coast Ventures Group Corp We have audited the accompanying balance sheets of West Coast Ventures Group Corp. as of April 30, 2016 and 2015and the related statement of operations, stockholder's deficit and cash flows for the years ended April 30, 2016 and 2015. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of West Coast Ventures Group Corp. as of April 30, 2016 and 2015 and the results of its operations and its cash flows for the years ended April 30, 2016 and 2015 in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the financial statements, the Company has incurred a loss since inception, had a net accumulated deficit and may be unable to raise further equity. These factors raise substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters are also described in Note 3. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Ankit Consulting Services, Inc. Certified Public Accountants Rancho Santa Margarita May 12, 2017 West Coast Ventures Group Corp. (Formerly Energizer Tennis Inc.) Consolidated Balance Sheets *Note: all shares presented have been retroactively adjusted for the effect of a 1 for 1,000 reverse stock split, approved by our Board of Directors on February 4, 2016. The accompanying notes are an integral part of these consolidated financial statements. West Coast Ventures Group Corp. (Formerly Energizer Tennis Inc.) Consolidated Statements of Operations *Note: all shares presented have been retroactively adjusted for the effect of a 1 for 1,000 reverse stock split, approved by our Board of Directors on February 4, 2016. The accompanying notes are an integral part of these consolidated financial statements. West Coast Ventures Group Corp. (Formerly Energizer Tennis Inc.) Consolidated Statement of Changes in Stockholders' Deficit *Note: all shares presented have been retroactively adjusted for the effect of a 1 for 1,000 reverse stock split, approved by our Board of Directors on February 4, 2016. The accompanying notes are an integral part of these consolidated financial statements. West Coast Ventures Group Corp. (Formerly Energizer Tennis Inc.) Consolidated Statements of Cash Flows The accompanying notes are an integral part of these consolidated financial statements. West Coast Ventures Group Corp. (Formerly Energizer Tennis Inc.). Notes to the Consolidated Financial Statements April 30, 2016 and 2015 NOTE 1 - BACKGROUND INFORMATION Organization and Business West Coast Ventures Group Corp. (“our”, “us”, “we” or the “Company”) was incorporated on June 16, 2011 in the State of Nevada for the purpose of developing, producing, and selling instructional tennis videos to the global tennis community Since April 30, 2015 the Company has focused on investing in and acquiring technology companies within the United States and abroad, as well as, discovering existing synergies that offer the opportunity to expand the company’s footprint in order to create revenues and profits. Through its wholly-owned subsidiary, GameRevz, Inc. ("GameRevz") the company has focused on the US based, online video gaming and entertainment industry. On February 4, 2016, Energizer Tennis, Corp. filed Articles of Merger with the Nevada Secretary of State whereby it entered into a statutory merger with its wholly-owned subsidiary, West Coast Ventures Group Corp. The effect of such merger is that the Company was the surviving entity and changed its name to “West Coast Ventures Group Corp.” NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying audited consolidated financial statements presented herein have been prepared pursuant to the rules and regulations of the SEC. The Financial Statements have been prepared using the accrual basis of accounting in accordance with Generally Accepted Accounting Principles (“GAAP”) of the United States (See Note 3 regarding the assumption that the Company is a “going concern”). Principles of Consolidation The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned subsidiary, GameRevz, Inc., a Nevada corporation. All significant intercompany balances and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and (iii) the reported amount of net revenues and expenses recognized during the periods presented. Adjustments made with respect to the use of estimates often relate to improved information not previously available. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of financial statements; accordingly, actual results could differ from these estimates. The Company’s most significant estimates relate to the valuation of its intangible assets and the valuation of its common stock. Fiscal Year End The Company has elected April 30 as its fiscal year end. Reclassifications Certain prior year amounts have been reclassified to conform with the current year presentation. Discontinued Operations The Company decided to discontinue the business of developing, producing and selling instructional tennis videos, hence the income and expenses related to such activities have been excluded from the Company’s Financial Statements. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents were $0 and $100 at April 30, 2016 and 2015, respectively. Commitments and Contingencies Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company's management and legal counsel assess such contingent liabilities, and such assessment inherently involves judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company's legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought. If the assessment of a contingency indicates it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company's financial statements. If the assessment indicates that a potential material loss contingency is not probable but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material would be disclosed. Loss contingencies considered to be remote by management are generally not disclosed unless they involve guarantees, in which case the guarantee would be disclosed. Risks and Uncertainties The Company is subject to risks from, among other things, competition associated with the industry in general, other risks associated with financing, liquidity requirements, rapidly changing customer requirements, limited operating history, foreign currency exchange rates and the volatility of public markets. Earnings (Loss) Per Share The Company computes basic and diluted earnings per share amounts in accordance with ASC Topic 260, Earnings per Share. Basic earnings per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the reporting period. Diluted earnings per share reflects the potential dilution that could occur if stock options and other commitments to issue common stock were exercised or equity awards vest resulting in the issuance of common stock that could share in the earnings of the Company. Diluted earnings per share is not presented separately since the effect of dilutive securities is anti-dilutive. There were no common stock equivalents as of April 30, 2016 and 2015. Loss per share as of April 30, 2016 and 2015 are as follows: Fair Value of Financial Instruments The Company’s balance sheet includes certain financial instruments. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization. FASB Accounting Standards Codification ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below: Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means. Level 3: Inputs that are both significant to the fair value measurement and unobservable. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of April 30, 2016. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. These financial instruments include prepaid expense, accounts payable and accrued expenses. The Company applied ASC 820 for all non-financial assets and liabilities measured at fair value on a non-recurring basis. Income Taxes The Company accounts for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under ASC 740, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. The Company files income tax returns in the United States which are subject to examination by tax authorities in these jurisdictions. Generally, three years of returns remain subject to examination by major tax jurisdictions. The state impact, if any, of any federal changes to prior year remains subject to examination for a period of up to five years after formal notification to the states. The Company has evaluated tax positions in accordance with ASC 740, “Income Taxes,” and has not identified any significant tax positions, other than those disclosed. Intangible Assets We account for intangible assets in accordance with ASC 350, “Intangibles-Goodwill and Other” ("ASC 350"). ASC 350 requires that intangibles with indefinite lives be tested for impairment annually or on an interim basis if events or circumstances indicate that the fair value of an asset has decreased below its carrying value. The cost of intangible assets with determinable useful lives is amortized to reflect the pattern of economic benefits consumed, either on a straight-line or accelerated basis over the estimated periods benefited. Patents, technology and other intangibles with contractual terms are generally amortized over their respective legal or contractual lives. When certain events or changes in operating conditions occur, an impairment assessment is performed and lives of intangible assets with determinable lives may be adjusted. We completed an evaluation of intangibles at April 30, 2016 and recognized an impairment loss of $160,208 during the year ended April 30, 2016. No impairment loss was recognized for the year ended April 30, 2015. Long-Lived Assets Long-lived assets are evaluated for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Each impairment test is based on a comparison of the undiscounted future cash flows to the recorded value of the asset. If impairment is indicated, the asset is written down to its estimated fair value. Foreign Currency The Company’s functional currency is the United States Dollar (USD) and its reporting currency is also the USD. Foreign currency transactions, from our prior operations, were primarily undertaken in the British Pound (GBP). The financial statements of the Company are translated to USD in accordance with ASC 830, “Foreign Currency Translation Matters.” Assets and liabilities are translated at the current exchange rate prevailing at the balance sheet date. Equity accounts are translated at historical amounts. Revenues and expenses are translated using average rates during the year. Related parties The Company follows ASC 850, “Related Party Disclosures,” for the identification of related parties and disclosure of related party transactions. Recent Accounting Pronouncements In August 2014, the FASB issued Accounting Standards Update No. 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (ASU 2014-15). The guidance in ASU 2014-15 sets forth management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern as well as required disclosures. ASU 2014-15 indicates that, when preparing financial statements for interim and annual financial statements, management should evaluate whether conditions or events, in the aggregate, raise substantial doubt about the entity’s ability to continue as a going concern for one year from the date the financial statements are issued or are available to be issued. This evaluation should include consideration of conditions and events that are either known or are reasonably knowable at the date the financial statements are issued or are available to be issued, as well as whether it is probable that management’s plans to address the substantial doubt will be implemented and, if so, whether it is probable that the plans will alleviate the substantial doubt. ASU 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods and annual periods thereafter. Early application is permitted. The Company is currently evaluating the impact of the adoption of this standard on its consolidated financial statements. In November 2015, the Financial Accounting Standards Board (FASB) issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes” (ASU 2015-17), which changes how deferred taxes are classified on the balance sheet and is effective for financial statements issued for annual periods beginning after December 15, 2016, with early adoption permitted. ASU 2015-17 requires all deferred tax assets and liabilities to be classified as non-current. The Company is currently evaluating the impact of the adoption of this standard on its consolidated financial statements. In January 2016, the FASB issued ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” (ASU 2016-01), which requires equity investments that are not accounted for under the equity method of accounting to be measured at fair value with changes recognized in net income and updates certain presentation and disclosure requirements. ASU 2016-01 is effective beginning after December 15, 2017. The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures. In February 2016, the FASB issued ASU No. 2016-02, “Leases,” which requires lessees to recognize right-of-use assets and lease liabilities, for all leases, with the exception of short-term leases, at the commencement date of each lease. This ASU requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. This ASU is effective for annual periods beginning after December 15, 2018 and interim periods within those annual periods. Early adoption is permitted. The amendments of this update should be applied using a modified retrospective approach, which requires lessees and lessors to recognize and measure leases at the beginning of the earliest period presented. The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures. In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting.” The guidance simplifies accounting for share-based payments, most notably by requiring all excess tax benefits and tax deficiencies to be recorded as income tax benefits or expense in the income statement and by allowing entities to recognize forfeitures of awards when they occur. This new guidance is effective for annual reporting periods beginning after December 15, 2016 and may be adopted prospectively or retroactively. The Company is currently evaluating the impact the adoption of this standard would have on its financial condition, results of operations and cash flows. In May 2016, the FASB issued ASU 2016-12, “Revenue from Contracts with Customers (Topic 606): Narrow- Scope Improvements and Practical Expedients” (“ASU 2016-12”), which amends the guidance in the new revenue standard on collectability, noncash consideration, presentation of sales tax, and transition. The amendments are intended to address implementation issues and provide additional practical expedients to reduce the cost and complexity of applying the new revenue standard. The new guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, which will be our interim period beginning January 1, 2018. Early adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods with that reporting period. The Company is currently evaluating the impact of adopting this standard on its consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, regarding ASC Topic 230 “Statement of Cash Flows.” This update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The new guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early adoption is permitted. The Company does not expect the adoption of this standard to have a significant effect on its consolidated financial statements. There were no other new accounting pronouncements during the year ended June 30, 2016 that we believe would have a material impact on our financial position or results of operations. NOTE 3 - GOING CONCERN The Company’s financial statements are prepared using accounting principles generally accepted in the United States of America applicable to a going concern which contemplates the realization of assets and liquidation of liabilities in the normal course of business. As of April 30, 2016, the Company does not have products available for sale or have established an ongoing source of revenue. As a result, the Company has a net loss, negative operating cash flow, and an accumulated deficit. The ability of the Company to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until it becomes profitable. If the Company is unable to obtain adequate capital, it could be forced to cease operations. Management’s plan to obtain such resources for the Company include, obtaining loans from management and stockholders to meet its minimal operating expenses and raising equity funding. However, management cannot provide any assurance that the Company will be successful in accomplishing any of its plans. There is no assurance that the Company will be able to obtain sufficient additional funds when needed or that such funds, if available, will be obtainable on terms satisfactory to the Company. In addition, profitability will ultimately depend upon the level of revenues received from business operations. However, there is no assurance that the Company will attain profitability. The accompanying financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. NOTE 4 - INTANGIBLES Intangibles consisted of: The intangible assets are amortized over an estimated useful life of 3 years. Amortization expenses were $83,333 and $0 for the years ended April 30, 2016 and 2015, respectively. We determined the implied fair value of intangibles was substantially below the carrying value being reported. Accordingly, we recognized an impairment loss of $160,208, for the year ended April 30, 2016. No impairment of intangibles was recognized for the year ended April 30, 2015. NOTE 5 - NOTES PAYABLE Promissory Notes During the period ended April 30, 2016, an unrelated party advanced funds in the amount of $46,975 to fund operations and provide working capital. Unpaid balances are due on demand and accrue an annual interest rate of 5%. During the year ended April 30, 2016, the Company acknowledged and agreed to issue the convertible note of $51,221 for payment of principal on the Promissory note of $51,221. At April 30, 2016 and 2015, the notes had accrued interest of $1,598 and $116, respectively. Note Payable On April 30, 2017, the Warwick Overseas, LLC, agreed to extend the note for an additional one year term to April 30, 2018. During the year ended April 30, 2016 and 2015, the company recognized interest expense on the note payable of $12,534 and $0, respectively. NOTE 6 - CONVERTIBLE NOTE On January 31, 2016, the Company issued convertible notes of $51,221 for the payment of promissory notes of $51,211 (note 5). Unpaid balances are due on January 31, 2018 and accrue an annual interest at the rate of 4%. The Holders have the right, at any time to convert any part of outstanding Principal balance of this note into shares of the Company’s common stock at a conversion rate of $0.01 per share. During the year ended April 30, 2016, the Company recorded as discount on the convertible note due to a beneficial conversion feature of $51,221 and amortized $6,403 as interest expense. NOTE 7 - SHAREHOLDERS’ EQUITY On February 4, 2016, the Company filed a Certificate of Amendment with the Nevada Secretary of State whereby it amended its Articles of Incorporation to increase the Company’s authorized number of shares of common stock from 100 million to 250 million and decrease all of its issued and outstanding shares of common stock at a ratio of one (1) share for every one thousand (1,000) shares held. All relevant information relating to numbers of shares and per share information have been retroactively adjusted to reflect the reverse stock split for all periods presented. Preferred Stock The authorized preferred stock of the Company consists of 10,000,000 shares with a par value of $0.001. The Company has not issued any shares of Class A Convertible Preferred Stock as of April 30, 2016. Common Stock The authorized common stock of the Company consists of 250,000,000 shares with a par value of $0.001. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. The Company did not issue any new common shares during the years ended April 30, 2016 and 2015 As at April 30, 2016 and 2015, there are 88,426 shares of common stock issued and outstanding. Pertinent Rights and Privileges Holders are not entitled to pre-emptive or referential rights to subscribe to unissued stock or other securities. Holders do not have cumulative voting rights. Preferred stockholders of Class A Convertible Preferred Stock do not have a right to vote their shares except as determined by the Board of Directors. Additional Paid In Capital During the year ended April 30, 2016, the Company recorded as discount on the convertible note due to a beneficial conversion feature of $51,221(Note 9). During the year ended April 30, 2015, the Company recorded additional paid in capital as follows; · Our former CEO contributed office space valued at $3,600. · A related party contributed accounting and tax services totaling $4,000 · On January 30, 2015, our former CEO and majority shareholder waived in full related party advances totaling $47,403 NOTE 8 - DISCONTINUED OPERATIONS As part of the Company's strategy to focus on businesses with greater global growth potential, the Company decided in the fourth quarter of 2015 to exit its plan of developing and marketing instructional tennis videos. On April 30, 2015, the Company, through its wholly-owned subsidiary GameRevz, completed the purchase of certain intellectual property in lieu of a promissory note for $250,000. During the year ended April 30, 2015, discontinued operations consist of the following: NOTE 9 - INCOME TAXES The Company has not recognized an income tax benefit for its operating losses generated based on uncertainties concerning its ability to generate taxable income in future periods. The tax benefit for the periods presented is offset by a valuation allowance established against deferred tax assets arising from the net operating losses and other temporary differences, the realization of which could not be considered more likely than not. In future periods, tax benefits and related deferred tax assets will be recognized when management considers realization of such amounts to be more likely than not. As of April 30, 2016, the Company has incurred net losses of approximately $429,536, resulting in a net operating loss (“NOL”) for income tax purposes. NOLs begin expiring in 2032. The loss results in a deferred tax asset of approximately $216,100 at the effective statutory rate of 35%. The deferred tax asset has been off-set by an equal valuation allowance. The tax effects of temporary differences and carry forwards that give rise to significant portions of the deferred income tax assets are as follows: The reconciliation of the effective income tax rate to the federal statutory rate is as follows: The utilization of these NOLs may become subject to limitations based on past and future changes in ownership of the company pursuant to Internal Revenue Code Section 382. The Company has no uncertain tax positions as of April 30, 2016. Tax returns for the years ended April 30, 2011 through April 30, 2016 remain open to examination. NOTE 10 - COMMITMENTS AND CONTINGENCIES Litigation The Company is not presently involved in any litigation. Lease Obligations At April 30, 2016, the Company does not have any capital leases. On January 3, 2016, the Company leased office space at $199 per month with no specified term. The lease is cancelable at any time by either party with 30 days’ notice. NOTE 11 - RELATED PARTY TRANSACTIONS Due from shareholders From time to time, stockholders of the Company advance funds to the Company for working capital purposes. Those advances are unsecured, non-interest bearing, and due on demand. During the year ended April 30, 2015, due from our former CEO/majority shareholder totaled $23,673. On January 30, 2015, our former CEO/majority shareholder waived in full, $47,403 of related party advances and which was recorded as additional paid in capital. As of April 30, 2016 and 2015, no amounts were owed. Other As of April 30, 2016 and 2015, the Company accrued salaries to officers and directors of $125,814 and $26,000, respectively. Our former CEO had provided office space without charge. Rental expense is recorded in the financial statements as additional paid-in capital and totaled $3,600 for the years ended April 30, 2015. NOTE 12 - SUBSEQUENT EVENTS Management has evaluated subsequent events through the date these financial statements were issued. Based on our evaluation no events have occurred requiring adjustment or disclosure to the financial statements. Subsequent to April 30, 2016, the Company issued each 7,500,000 shares of common stock to the company’s officer and board members for their ongoing service and accrued salaries. On December 30, 2016, the Company entered into a Definitive Share Exchange Agreement (the “Agreement”) with James M. Nixon (“Nixon”) and Nixon Restaurant Group, Inc., a Florida corporation (“NRG”) pursuant to which the Company will exchange 12,100,000 shares of its Common Stock, $0.001 par value per share, for 60,500,000 shares of NRG Common Stock, $0.0001 par value per share, which represents all of the issued and outstanding capital stock of NRG. In addition, the Company will issue 500,000 shares of the Company’s preferred stock to Nixon as compensation for completing the transaction. This preferred stock which shall be designated as Series A Preferred Stock shall have no dividend, liquidation, or conversion rights, but will have voting rights of 100,000 votes per share of Series A Preferred Stock, an aggregate equal to 500,000,000 shares of the Company’s Common Stock. The closing of transaction described in the Agreement is subject to several conditions precedent. Following closing of the transaction NRG will operate as wholly owned subsidiary of the Company.
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Here's a summary of the financial statement:
Financial Overview:
- Fiscal Year End: April 30
- Financial Status: Experiencing a loss since inception
- Accumulated Deficit: Significant, raising doubts about the company's ability to continue operations
Key Financial Characteristics:
1. Revenue and Expenses:
- Estimates and assumptions are used in financial reporting
- Actual results may differ from estimated figures
- Most significant estimates involve intangible asset and common stock valuation
2. Assets and Liabilities:
- Current assets and liabilities are valued close to fair market value
- Short time between instrument origination and expected realization
- Follows FASB Accounting Standards Codification ASC 820
Challenges:
- Potential difficulty in raising additional equity
- Substantial uncertainty about continuing as a going concern
- Management has plans to address these challenges (referenced in Note 3)
Overall,
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements ACCOUNTING FIRM To the Board of Directors and Stockholders of Virtu Financial, Inc.: We have audited the accompanying consolidated statements of financial condition of Virtu Financial, Inc. and Subsidiaries (the ‘‘Company’’) as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income, changes in equity, and cash flows for each of the three years in the period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Virtu Financial, Inc. and Subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the consolidated financial statements, the Company completed an initial public offering in April 2015. /s/ DELOITTE & TOUCHE LLP New York, NY March 13, 2017 Virtu Financial, Inc. and Subsidiaries Consolidated Statements of Financial Condition See accompanying notes to the consolidated financial statements. Virtu Financial, Inc. and Subsidiaries Consolidated Statements of Comprehensive Income See accompanying notes to the consolidated financial statements. Virtu Financial, Inc. and Subsidiaries Consolidated Statements of Changes in Equity See accompanying notes to the consolidated financial statements. Virtu Financial, Inc. and Subsidiaries Consolidated Statements of Cash Flows See accompanying notes to the consolidated financial statements. Virtu Financial, Inc. and Subsidiaries (dollars in thousands, except shares and per share amounts, unless otherwise noted) 1. Organization and Basis of Presentation Organization The accompanying consolidated financial statements include the accounts and operations of Virtu Financial, Inc. (“VFI” or, collectively with its wholly owned or controlled subsidiaries, the “Company”) beginning with its initial public offering (“IPO”) in April of 2015, along with the historical accounts and operations of Virtu Financial LLC (“Virtu Financial”) prior to the Company’s IPO. VFI is a Delaware corporation whose primary asset is its ownership of approximately 29.6% of the membership interests of Virtu Financial, which it acquired pursuant to and subsequent to certain reorganization transactions (the “Reorganization Transactions”) consummated in connection with its IPO. The Company is the sole managing member of Virtu Financial and operates and controls all of the businesses and affairs of Virtu Financial and, through Virtu Financial and its subsidiaries (the “Group”), continues to conduct the business now conducted by such subsidiaries. Virtu Financial was formed as a Delaware limited liability company on April 8, 2011 in connection with a corporate reorganization and acquisition of the outstanding equity interests of Madison Tyler Holdings, LLC (“MTH”), an electronic trading firm and market maker. In connection with the reorganization, the members of Virtu Financial’s predecessor entity, Virtu Financial Operating LLC (“VFO”), a Delaware limited liability company formed on March 19, 2008, exchanged their interests in VFO for interests in Virtu Financial and the members of MTH exchanged their interests in MTH for cash and/or interests in Virtu Financial. Virtu Financial’s principal subsidiaries include Virtu Financial BD LLC (“VFBD”), a self-clearing U.S. broker-dealer, Virtu Financial Capital Markets LLC (“VFCM”), an U.S. broker-dealer and customers, which self-clears its proprietary transactions and introduces the accounts of its affiliates and non-affiliated broker-dealers on an agency basis to other clearing firms that clear and settle transactions in those accounts; and which is also a designated market maker on the New York Stock Exchange (“NYSE”) and the NYSE MKT (formerly NYSE Amex), Virtu Financial Global Markets LLC (“VFGM”), a U.S. trading entity focused on futures and currencies, Virtu Financial Ireland Limited (“VFIL”), formed in Ireland, Virtu Financial Asia Pty Ltd (“VFAP”), formed in Australia, and Virtu Financial Singapore Pte. Ltd. (“VFSing”), formed in Singapore, each of which are trading entities focused on asset classes in their respective geographic regions. The Company is a technology-enabled market maker and liquidity provider. The Company has developed a single, proprietary, multi-asset, multi-currency technology platform through which it provides quotations to buyers and sellers in equities, commodities, currencies, options, fixed income and other securities on numerous exchanges, markets and liquidity pools in numerous countries around the world. The Company is managed and operated as one business. Accordingly, the Company operates under one reportable segment. Basis of Presentation These consolidated financial statements are presented in U.S. dollars and have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding financial reporting with respect to Form 10-K and accounting standards generally accepted in the United States of America (“U.S. GAAP”) promulgated in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC” or the “Codification”). The consolidated financial statements of the Company include its equity interests in Virtu Financial, and its subsidiaries. The Company operates and controls all business and affairs of Virtu Financial and its operating subsidiaries indirectly through its equity interest in Virtu Financial. Principles of Consolidation, including Noncontrolling Interests The consolidated financial statements include the accounts of the Company and its majority and wholly owned subsidiaries. As sole managing member of Virtu Financial, the Company exerts control over the Group’s operations. The Company consolidates Virtu Financial and its subsidiaries’ consolidated financial statements and records the interests in Virtu Financial that the Company does not own as noncontrolling interests. All intercompany accounts and transactions have been eliminated in consolidation. 2. Summary of Significant Accounting Policies Use of Estimates The Company's consolidated financial statements are prepared in conformity with U.S. GAAP, which require management to make estimates and assumptions regarding measurements including the fair value of trading assets and liabilities, goodwill and intangibles, compensation accruals, capitalized software, income tax, and other matters that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Accordingly, actual results could differ materially from those estimates. Earnings Per Share Earnings per share (“EPS”) calculated on both a basic and diluted basis. Basic EPS excludes dilution and is calculated by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS is calculated by dividing the net income available for common stockholders by the diluted weighted average shares outstanding for that period. Diluted EPS includes the determinants of the basic EPS and, in addition, reflects the dilutive effect of shares of common stock estimated to be distributed in the future under the Company’s share based compensation plans. The Company grants restricted stock units (“RSUs”), which entitle recipients to receive nonforfeitable dividends during the vesting period on a basis equivalent to the dividends paid to holders of common stock. As a result, the unvested RSUs meet the definition of a participating security requiring the application of the two-class method. Under the two-class method, earnings available to common shareholders, including both distributed and undistributed, are allocated to each class of common stock and participating securities according to dividends declared and participating rights in undistributed earnings, which may cause diluted EPS to be more dilutive than the calculation using the treasury stock method. Cash and Cash Equivalents The Company considers cash equivalents as highly liquid investments with original maturities of less than three months when acquired. The Company maintains cash in bank deposit accounts that, at times, may exceed federally insured limits. Securities Borrowed and Securities Loaned The Company conducts securities borrowing and lending activities with external counterparties. In connection with these transactions, the Company receives or posts collateral. These transactions are collateralized by cash or securities. In accordance with substantially all of its stock borrow agreements, the Company is permitted to sell or repledge the securities received. Securities borrowed or loaned are recorded based on the amount of cash collateral advanced or received. The initial cash collateral advanced or received generally approximates or is greater than 102% of the fair value of the underlying securities borrowed or loaned. The Company monitors the fair value of securities borrowed and loaned, and delivers or obtains additional collateral as appropriate. Receivables and payables with the same counterparty are not offset in the consolidated statements of financial condition. Interest received or paid by the Company for these transactions is recorded gross on an accrual basis under interest and dividends income or interest and dividends expense in the consolidated statements of comprehensive income. Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase In a repurchase agreement, securities sold under agreements to repurchase are treated as collateralized financing transactions and are recorded at contract value, plus accrued interest, which approximates fair value. It is the Company's policy that its custodian takes possession of the underlying collateral securities with a fair value approximately equal to the principal amount of the repurchase transaction, including accrued interest. For reverse repurchase agreements, the Company typically requires delivery of collateral with a fair value approximately equal to the carrying value of the relevant assets in the consolidated statements of financial condition. To ensure that the fair value of the underlying collateral remains sufficient, the collateral is valued daily with additional collateral obtained or excess collateral returned, as permitted under contractual provisions. The Company does not net securities purchased under agreements to resell transactions with securities sold under agreements to repurchase transactions entered into with the same counterparty. Interest received or paid by the Company for these transactions is recorded gross on an accrual basis under interest and dividends income or interest and dividends expense in the consolidated statements of comprehensive income. Receivables from/Payables to Broker-dealers and Clearing Organizations Amounts receivable from broker-dealers and clearing organizations may be restricted to the extent that they serve as deposits for securities sold, not yet purchased. At December 31, 2016 and 2015, receivables from and payables to broker-dealers and clearing organizations primarily represent amounts due for unsettled trades, open equity in futures transactions, securities failed to deliver or failed to receive, deposits with clearing organizations or exchanges and balances due from or due to prime brokers in relation to the Company’s trading. The Company presents its balances, including outstanding principal balances on all credit facilities, on a net by counterparty basis within receivable from and payable to broker-dealers and clearing organizations when the criteria for offsetting are met. In the normal course of business, substantially all of the Company’s securities transactions, money balances, and security positions are transacted with several brokers. The Company is subject to credit risk to the extent any broker with whom it conducts business is unable to fulfill contractual obligations on its behalf. The Company monitors the financial condition of such brokers and does not anticipate any losses from these counterparties. Financial Instruments Owned Including Those Pledged as Collateral and Financial Instruments Sold, Not Yet Purchased The Company records financial instruments owned, including those pledged as collateral, and financial instruments sold, not yet purchased at fair value. Gains and losses arising from financial instrument transactions are recorded net on a trade-date basis in trading income, net, in the consolidated statements of comprehensive income. Fair Value Measurements Fair value is defined as fair value as the price that would be received to sell an asset or would be paid to transfer a liability (i.e., the exit price) in an orderly transaction between market participants at the measurement date. Fair value measurements are not adjusted for transaction costs. The recognition of “block discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available in an active market is prohibited. The Company categorizes its financial instruments into a three level hierarchy which prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy level assigned to each financial instrument is based on the assessment of the transparency and reliability of the inputs used in the valuation of such financial instruments at the measurement date based on the lowest level of input that is significant to the fair value measurement. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurements). Financial instruments measured and reported at fair value are classified and disclosed in one of the following categories based on inputs: Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; Level 2 - Quoted prices in markets that are not active and financial instruments for which all significant inputs are observable, either directly or indirectly; Level 3 - Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. Transfers in or out of levels are recognized based on the beginning fair value of the period in which they occurred. Fair Value Option The fair value option election that allows entities to make an irrevocable election of fair value as the initial and subsequent measurement attribute for certain eligible financial assets and liabilities. Unrealized gains and losses on items for which the fair value option has been elected are recorded in other revenues (losses) in the consolidated statements of comprehensive income. The decision to elect the fair value option is determined on an instrument by instrument basis and must be applied to an entire instrument and is irrevocable once elected. Derivative Instruments Derivative instruments used for trading purposes, including economic hedges of trading instruments, which are carried at fair value include futures, forward contracts, and options. Unrealized gains or losses on these derivative instruments are recognized currently within trading income, net in the consolidated statement of comprehensive income. Fair values for exchange-traded derivatives, principally futures, are based on quoted market prices. Fair values for over-the-counter derivative instruments, principally forward contracts, are based on the values of the underlying financial instruments within the contract. The underlying instruments are currencies which are actively traded. The Company presents its derivatives balances on a net-by-counterparty basis when the criteria for offsetting are met. Property and Equipment Property and equipment are carried at cost, less accumulated depreciation, except for the assets acquired in connection with the acquisition of MTH which were recorded at fair value on the date of acquisition. Depreciation is provided using the straight-line method over estimated useful lives of the underlying asset. Routine maintenance, repairs and replacement costs are expensed as incurred and improvements that appreciably extend the useful life of the assets are capitalized. When property and equipment are sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in income. Property and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. Furniture, fixtures, and equipment are depreciated over three to seven years. Leasehold improvements are amortized over the lesser of the length of the lease term or seven years. Capitalized Software The Company capitalizes costs of materials, consultants, and payroll and payroll related costs for employees incurred in developing internal-use software. Costs incurred during the preliminary project and post-implementation stages are charged to expense. Management’s judgment is required in determining the point at which various projects enter the stages at which costs may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the estimated useful lives over which the costs are amortized. Capitalized software development costs and related accumulated amortization are included in property, equipment and capitalized software in the accompanying consolidated statements of financial condition and are amortized over a period of 1.4 to 2.5 years, which represents the estimated useful lives of the underlying software. Goodwill Goodwill represents the excess of the purchase price over the underlying net tangible and intangible assets of the Company’s acquisitions. Goodwill is not amortized but is tested for impairment on an annual basis and between annual tests whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Goodwill is tested at the reporting unit level, which is defined as an operating segment or one level below the operating segment. The Company operates as one operating segment, which is the Company’s only reporting unit. The Company tests goodwill for impairment on an annual basis on July 1 and on an interim basis when certain events or circumstances exist. In the impairment test as of July 1, 2016, the primary valuation method used to estimate the fair value of the Company’s reporting unit was the market capitalization approach based on the market price of its Class A Common Stock, which the Company’s management believes to be an appropriate indicator of its fair value. Based on the results of the annual impairment tests performed, no goodwill impairment was recognized during the years ended December 31, 2016, 2015, and 2014, respectively. Intangible Assets The Company amortizes finite-lived intangible assets over their estimated useful lives. Finite-lived intangible assets are tested for impairment annually or when impairment indicators are present, and if impaired, written down to fair value. Exchange Memberships and Stock Exchange memberships are recorded at cost or, if any other than temporary impairment in value has occurred, at a value that reflects management’s estimate of fair value. Exchange stock includes shares that entitle the Company to certain trading privileges. The shares are marked to market with the corresponding gain or loss recorded under operating and administrative in the consolidated statements of comprehensive income. The Company’s exchange memberships and stock are included in other assets in the consolidated statements of financial condition. Trading Income Trading income is comprised of changes in the fair value of trading assets and liabilities (i.e., unrealized gains and losses) and realized gains and losses on trading assets and liabilities. Trading gains and losses on financial instruments owned and financial instruments sold, not yet purchased are recorded on the trade date and reported on a net basis in the consolidated statements of comprehensive income. Interest and Dividends Income/Interest and Dividends Expense Interest income and interest expense are accrued in accordance with contractual rates. Interest income consists of interest earned on collateralized financing arrangements and on cash held by brokers. Interest expense includes interest expense from collateralized transactions, margin and related lines of credit. Dividends on financial instruments owned including those pledged as collateral and financial instruments sold, not yet purchased are recorded on the ex-dividend date and interest is recognized on the accrual basis. Technology Services Technology services revenues consist of technology licensing fees and agency commission fees. Technology licensing fees are earned from third parties for licensing of the Company’s proprietary risk management and trading infrastructure technology and provision of associated management and hosting services. These fees include both upfront and annual recurring fees. Revenue from technology services is recognized once persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is probable. Revenue is recognized ratably over the contractual service period. Agency commission fees are earned from agency trades executed by the Company on behalf of third parties and recognized on a trade date basis. Rebates Rebates consist of volume discounts, credits or payments received from exchanges or other market places related to the placement and/or removal of liquidity from the order flow in the marketplace. Rebates are recorded on an accrual basis and included net within brokerage, exchange and clearance fees in the accompanying consolidated statements of comprehensive income. Income Taxes Subsequent to consummation of the Reorganization Transactions and the IPO, the Company is subject to U.S. federal, state and local income taxes on its taxable income. The Company's subsidiaries are subject to income taxes in the respective jurisdictions (including foreign jurisdictions) in which they operate. Prior to the consummation of the Reorganization Transactions and the IPO, no provision for United States federal, state and local income tax was required, as Virtu Financial is a limited liability company and is treated as a pass-through entity for United States federal, state, and local income tax purposes. The provision for income tax is comprised of current tax and deferred tax. Current tax represents the tax on current year tax returns, using tax rates enacted at the balance sheet date. The deferred tax assets are recognized in full and then reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be recognized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the applicable taxing authority, including resolution of the appeals or litigation processes, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit for each such position that has a greater than fifty percent likelihood of being realized upon ultimate resolution. Many factors are considered when evaluating and estimating the tax positions and tax benefits. Such estimates involve interpretations of regulations, rulings, case law, etc. and are inherently complex. The Company’s estimates may require periodic adjustments and may not accurately anticipate actual outcomes as resolution of income tax treatments in individual jurisdictions typically would not be known for several years after completion of any fiscal year. The Company has determined that there are no uncertain tax positions that would have a material impact on the Company’s financial position as of December 31, 2016 and 2015 or the results of operations or cash flows for the years ended December 31, 2016, 2015, and 2014. Comprehensive Income and Foreign Currency Translation Comprehensive income consists of two components: net income and other comprehensive income (“OCI”). OCI is comprised of revenues, expenses, gains and losses that are reported in the comprehensive income section of the consolidated statements of comprehensive income, but are excluded from reported net income. The Company’s OCI is comprised of foreign currency translation adjustments. Assets and liabilities of operations having non-U.S. dollar functional currencies are translated at period-end exchange rates, and revenue and expenses are translated at weighted average exchange rates for the period. Gains and losses resulting from translating foreign currency financial statements, net of related tax effects, are reflected in accumulated other comprehensive income, a separate component of stockholders’ equity. Share-Based Compensation The fair value of awards issued for compensation prior to the Reorganization Transactions and the IPO was determined by management, with the assistance of an independent third party valuation firm, using a projected annual forfeiture rate, where applicable, on the date of grant. Share-based awards issued for compensation in connection with or subsequent to the Reorganization Transaction and the IPO pursuant to the VFI 2015 Management Incentive Plan (the “2015 Management Incentive Plan”) were in the form of stock options, Class A common stock and restricted stock units. The fair value of the stock option grants is determined through the application of the Black-Scholes-Merton model. The fair value of the Class A common stock and restricted stock units are determined based on the volume weighted average price for the three days preceding the grant, and with respect to the restricted stock units, a projected annual forfeiture rate. The fair value of share-based awards granted to employees is expensed based on the vesting conditions and are recognized on a straight line basis over the vesting period. The Company records as treasury stock shares repurchased from its employees for the purpose of settling tax liabilities incurred upon the issuance of common stock, the vesting of restricted stock units or the exercise of stock options. Recent Accounting Pronouncements Revenue - In May 2014, the FASB issued Accounting Standard Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers. ASU 2014-09 is a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. ASU 2014-09 also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. ASU No. 2015-14 defers the effective date of ASU No. 2014-09 by one year for public companies. ASU 2015-14 applies to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Early adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. In December 2016, FASB issued ASU 2016-20 Technical Correction and Improvement (Topic 606): Revenue from Contracts with Customers, which amends the guidance in ASU 2014-09. The effective date and transition requirements for the ASU are the same as ASU 2014-09. The Company is currently evaluating the potential effects of adoption of ASU 2014-09, ASU 2015-14, and ASU 2016-20 on the Company’s consolidated financial statements. Going Concern - In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The guidance requires management to assess an entity’s ability to continue as a going concern and to provide related footnote disclosures in certain circumstances. The new standard is effective in the first annual period ending after December 15, 2016. The Company adopted this ASU effective as of December 31, 2016, and it did not have an impact on the Company’s consolidated financial statements. Financial Assets and Liabilities - In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The update intends to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information and addresses certain aspects of the recognition, measurement, presentation, and disclosure of financial instruments. The new standard affects all entities that hold financial assets or owe financial liabilities and is effective for annual reporting periods (including interim periods) beginning after December 15, 2017. Early adoption of the ASU is not permitted, except for the amendments relating to the presentation of the change in the instrument-specific credit risk relating to a liability that an entity has elected to measure at fair value. The Company is currently evaluating the potential effects of the adoption of ASU 2016-01 on its consolidated financial statements. Leases - In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). Under the new ASU, a lessee will be required to recognize assets and liabilities for leases with lease terms of more than 12 months. The liability will be equal to the present value of lease payments. The asset, referred to as a “right-of-use asset” will be based on the liability, subject to adjustment, such as for initial direct costs. For income statement purposes, leases will be classified as either operating or finance. Operating leases will result in straight-line expense (similar to current operating leases) while finance leases will result in a front-loaded expense pattern (similar to current capital leases). Classification will be based on criteria that are largely similar to those applied in current lease accounting, but without explicit bright lines. New quantitative and qualitative disclosures, including significant judgments made by management, will be required to provide greater information regarding the extent of revenue and expense recognized and expected to be recognized from existing contracts. The standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating the potential effects of the adoption of ASU 2016-02 on the Company’s consolidated financial statements. Compensation - Stock Compensation - In March 2016, FASB issued ASU 2016-09, Employee Share-Based Payment Accounting Improvements. The ASU makes a number of changes to accounting for share based payment programs, including the following principal changes: providing that all excess tax benefits and tax deficiencies arising from share-based payment programs should be recognized as income tax expense or benefit in the income statement; allowing companies to make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest (as is provided under current GAAP) or account for forfeitures when they occur; and providing that partial cash settlement of an award for tax-withholding purposes would not result, by itself, in liability classification of the award provided the amount withheld does not exceed the maximum statutory tax rate (as opposed to the current requirement which specifies the minimum statutory tax rate) for an employee in the applicable jurisdictions. The ASU also provides guidance on the classification of various items related to share based payment programs in the statement of cash flows. The ASU is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted and an entity that elects early adoption must adopt all of the amendments in the same period. The Company has elected to early adopt this ASU effective as of December 31, 2016 and it did not have a material impact on the Company’s consolidated financial statements. Statement of Cash Flows - In August 2016, FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The ASU intended to reduce diversity in practice how certain transactions are classified in the statement of cash flows by mandating classification of certain activities. The ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted. An entity that elects early adoption must adopt all of the amendments in the same period. The Company is currently evaluating the potential effects of adoption of ASU 2016-15 on the Company’s consolidated financial statements. Income Taxes - In October 2016, FASB issued ASU 2016-16, Income Taxes (Topic 749): Intra-Entity Transfers of Assets Other Than Inventory. The ASU requires the reporting entity to recognize the tax expense from the sale of an asset in the seller’s tax jurisdiction when the transfer occurs, even though the pre-tax effects of the transactions are eliminated in consolidation. Any deferred tax asset that arises in the buyer’s jurisdiction would also be recognized at the time of the transfer. The ASU is effective for annual periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. The Company is currently evaluating the potential effects of adoption of ASU 2016-16 on the Company’s consolidated financial statements. Goodwill - In January, 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other (Topic 350), Simplifying the Test for Goodwill Impairment. To simplify the subsequent measurement of goodwill, the Company’s board of directors eliminated Step 2 from the goodwill impairment test. (In computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Instead, under the ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The Company’s board of directors also eliminated the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. The ASU is effective for public entities in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the potential effects of adoption of ASU 2017-04 on the Company’s consolidated financial statements. 3. Earnings per Share Historical earnings per share information is not applicable for reporting periods prior to the consummation of the Reorganization Transactions and the IPO because the ownership structure of the Company did not include a common unit of ownership. Net income available for common stockholders is based on the Company’s approximate 28.9% interest in Virtu Financial. The below table contains a reconciliation of net income before noncontrolling interest to net income available for common stockholders: The calculation of basic and diluted earnings per share is presented below: (1) The dilutive impact of unexercised stock options excludes from the computation of EPS 743,096 and 0 options for the years ended December 31, 2016 and 2015, respectively, because inclusion of the options would have been anti-dilutive. 4. Tax Receivable Agreements In connection with the IPO and the Reorganization Transactions, the Company entered into tax receivable agreements to make payments to certain Virtu Members, as defined in Note 13, that are generally equal to 85% of the applicable cash tax savings, if any, that the Company actually realizes as a result of favorable tax attributes that were and will continue to be available to the Company as a result of the Reorganization Transactions, exchanges of membership interests for Class A common stock or Class B common stock and payments made under the tax receivable agreements. Payments will occur only after the filing of the U.S. federal and state income tax returns and realization of the cash tax savings from the favorable tax attributes. The first payment is due 120 days after the filing of the Company’s tax return for the year ended December 31, 2015, which was due March 15, 2016, but the due date was extended until September 15, 2016. Future payments under the tax receivable agreements in respect of subsequent exchanges would be in addition to these amounts. As a result of (i) the purchase of equity interests in Virtu Financial from certain Virtu Members in connection with the Reorganization Transactions, (ii) the purchase of non-voting common interest units in Virtu Financial (the “Virtu Financial Units”) (along with the corresponding shares of Class C common stock) from certain of the Virtu Members in connection with the IPO, (iii) the purchase of Virtu Financial Units (along with the corresponding shares of Class C common stock) and the exchange of Virtu Financial Units (along with the corresponding shares of Class C common stock) for shares of Class A common stock in connection with the Secondary Offerings, the Company recorded a deferred tax asset of $210.1 million associated with the increase in tax basis that results from such events. Payments to certain Virtu Members in respect of the purchases are expected to aggregate to approximately $231.4 million, ranging from approximately $0.7 million to $20.8 million per year over the next 15 years. The corresponding deduction to additional paid-in capital was approximately $21.3 million for the difference between the tax receivable agreements liability and the related deferred tax asset. In connection with the September 2016 Secondary Offering (as defined below), the Company recorded an additional deferred tax asset of $9.3 million and payment liability pursuant to the tax receivable agreements of $7.6 million, with the $1.7 million difference recorded as an increase to additional paid-in capital. The amounts recorded as of December 31, 2016 and December 31, 2015 are based on best estimates available at the respective dates and may be subject to change after the filing of the Company’s U.S. federal and state income tax returns for the years in which tax savings were realized. During the year ended December 31, 2016, the Company filed its 2015 U.S. federal and state tax returns and recorded increases of $4.2 million in deferred tax assets, $5.4 million in payment liability pursuant to the tax receivable agreements and a corresponding reduction of $1.2 million to additional paid-in capital as a result of differences between the estimate and the tax returns. At December 31, 2016 and 2015, the Company’s remaining deferred tax assets were approximately $185.6 million and $187.0 million, respectively, the Company’s payment liability pursuant to the tax receivable agreements were approximately $231.4 million and $218.4 million, respectively. For the tax receivable agreements discussed above, the cash savings realized by the Company are computed by comparing the actual income tax liability of the Company to the amount of such taxes the Company would have been required to pay had there been (i) no increase to the tax basis of the assets of Virtu Financial as a result of the purchase or exchange of Virtu Financial Units, (ii) no tax benefit from the tax basis in the intangible assets of Virtu Financial on the date of the IPO and (iii) no tax benefit as a result of the Net Operating Losses (“NOLs”) and other tax attributes of Virtu Financial. Subsequent adjustments of the tax receivable agreements obligations due to certain events (e.g., changes to the expected realization of NOLs or changes in tax rates) will be recognized within operating expenses in the consolidated statements of comprehensive income. 5. Goodwill and Intangible Assets There were no changes in the carrying amount of goodwill and no goodwill impairment was recognized for the years ended December 31, 2016, 2015, and 2014. Acquired intangible assets consisted of the following as of December 31, 2016 and December 31, 2015: Amortization expense relating to finite-lived intangible assets was approximately $0.2 million, $0.2 million, and $0.2 million for the years ended December 31, 2016, 2015, and 2014, respectively. This is included in amortization of purchased intangibles and acquired capitalized software in the accompanying consolidated statements of comprehensive income. 6. Receivables from/Payables to Broker-Dealers and Clearing Organizations The following is a summary of receivables from and payables to brokers-dealers and clearing organizations at December 31, 2016 and December 31, 2015: Included as a deduction from “Due from prime brokers” and “Net equity with futures commission merchants” is the outstanding principal balance on all of the Company’s short-term credit facilities (described in Note 8) of approximately $309.1 million and $219.1 million as of December 31, 2016 and 2015, respectively. The loan proceeds from the credit facilities are available only to meet the initial margin requirements associated with the Company’s ordinary course futures and other trading positions, which are held in the Company’s trading accounts with an affiliate of the respective financial institutions. The credit facilities are fully collateralized by the Company’s trading accounts and deposit accounts with these financial institutions. “Securities failed to deliver” and “Securities failed to receive” include amounts with a clearing organization and other broker-dealers. 7. Collateralized Transactions The Company is permitted to sell or repledge securities received as collateral and use these securities to secure repurchase agreements, enter into securities lending transactions or deliver these securities to counterparties or clearing organizations to cover short positions. At December 31, 2016 and December 31, 2015, substantially all of the securities received as collateral have been repledged. The fair value of the collateralized transactions at December 31, 2016 and December 31, 2015 are summarized as follows: In the normal course of business, the Company pledges qualified securities with clearing organizations to satisfy daily margin and clearing fund requirements. Financial instruments owned and pledged, where the counterparty has the right to repledge, at December 31, 2016 and December 31, 2015 consisted of the following: 8. Borrowings Outstanding borrowings and financing capacity or unused available capacity under the Company’s borrowing arrangements were as follows: (1) Outstanding borrowings were included with receivable from broker-dealers and clearing organization within the consolidated statements of financial condition. Broker-Dealer Credit Facilities The Company is a party to two secured credit facilities with the same financial institution to finance overnight securities positions purchased as part of its ordinary course broker-dealer market making activities. One of the facilities (the “Uncommitted Facility”), is provided on an uncommitted basis and is available for borrowings by the Company’s broker-dealer subsidiaries up to a maximum amount of $125.0 million. In connection with this credit facility, the Company has entered into demand promissory notes dated February 20, 2013. The loans provided under the Uncommitted Facility are collateralized by the Company’s broker-dealer trading and deposit accounts with the same financial institution and, bear interest at a rate set by the financial institution on a daily basis equal to 1.66% at December 31, 2016 and 1.25% at December 31, 2015. The Company is party to another facility (the “Committed Facility”) with the same financial institution dated July 22, 2013 and subsequently amended on March 26, 2014, July 21, 2014, April 24, 2015, and July 18, 2016, which is provided on a committed basis and is available for borrowings by one of the Company’s broker-dealer subsidiaries up to a maximum of the lesser of $75.0 million or an amount determined based on agreed advance rates for pledged securities. The Committed Facility is subject to certain financial covenants, including a minimum tangible net worth, a maximum total assets to equity ratio, and a minimum excess net capital, each as defined. The Committed Facility bears interest at a rate per annum at the Company’s election equal to either an adjusted LIBOR rate or base rate, plus a margin of 1.25% per annum, and has a term of 364 days. Interest expense for the years ended December 31, 2016, 2015 and 2014 was approximately $1.2 million, $0.9 million, and $0.5 million, respectively. Interest expense is included within interest and dividends expense in the accompanying consolidated statements of comprehensive income. Short-Term Credit Facilities The Company maintains short term credit facilities with various prime brokers and other financial institutions from which it receives execution or clearing services. The proceeds of these facilities are used to meet margin requirements associated with the products traded by the Company in the ordinary course, and amounts borrowed are collateralized by the Company’s trading accounts with the applicable financial institution. Borrowings bore interest at a weighted average interest rate of 3.12% and 2.48% per annum, as of December 31, 2016 and 2015, respectively. Interest expense in relation to the facilities for the years ended December 31, 2016, 2015 and 2014 was approximately $6.3 million, $5.5 million, and $3.3 million, respectively. Interest expense is recorded within interest and dividends expense in the accompanying consolidated statements of comprehensive income. Long-Term Borrowings Senior Secured Credit Facility On July 8, 2011, Virtu Financial, its wholly owned subsidiary, VFH Parent LLC (“VFH”) and each of its unregulated domestic subsidiaries entered into the credit agreement (the “Credit Agreement”) among VFH, Virtu Financial, Credit Suisse AG, as administrative agent, and the other parties thereto. The senior secured credit facility funded a portion of the MTH acquisition with a term loan in the amount of $320.0 million to VFH. The senior secured credit facility was issued at a discount of 2.0% or $313.6 million, net of $6.4 million discount. The senior secured credit facility was initially subject to quarterly principal payments beginning on December 31, 2011 with the unpaid principal payable on maturity on July 8, 2016. Under the terms of the loan, VFH is subject to certain financial covenants, including a total net leverage ratio and an interest coverage ratio, as defined in the Credit Agreement. VFH is also subject to contingent principal payments based on excess cash flow, as defined in the Credit Agreement, and certain other triggering events. Borrowings are collateralized by substantially all the assets of the Company, other than the equity interests in and assets of its registered broker-dealer, regulated and foreign subsidiaries, but including 100% of the non-voting stock and 65% of the voting stock of Virtu Financial’s or its domestic subsidiaries’ direct foreign subsidiaries. The Credit Agreement was amended on February 5, 2013, May 1, 2013 and November 8, 2013. The amendments resulted in a decreased interest rate, changes in certain operating covenants, and increases in principal amount outstanding by $150.0 million on May 1, 2013 and $106.7 million on November 8, 2013, respectively. Additionally, the amendments reduced the annual minimum principal payments from 15% of the original principal amount to approximately 1% of the outstanding principal amount as of November 8, 2013, which was $510.0 million. The terms of the amended senior secured credit facility are otherwise substantially similar to the original senior secured credit facility, except as set forth below. On October 27, 2016, Virtu Financial and VFH entered into a third amended and restated credit agreement with JPMorgan Chase Bank, N.A. as administrative agent, lead arranger and bookrunner and BMO Capital Markets Corp., as syndication agent (the “Refinancing Transaction”). The third amended and restated credit agreement amends and restated in its entirety the existing Credit Agreement. Under the third amended and restated credit agreement (i) VFH’s existing term loan facility was replaced by a senior secured first lien term loan in an aggregate principal amount of $540.0 million, drawn in its entirety on the closing date and (ii) VFH’s existing senior secured first lien revolving facility with aggregate commitments of $100.0 million remains in effect. The term loan borrowings under the third amended and restated credit agreement will bear interest, at the Company’s election, at either (i) the greatest of (a) the prime rate in effect, (b) the federal funds effective rate plus 0.5%, (c) an adjusted LIBOR rate for a Eurodollar borrowing with an interest period of one month plus 1% and (d) 1.75%, plus, in each case, 2.50%, or (ii) the greater of (x) an adjusted LIBOR rate for the interest period in effect and (y) 0.75%, plus, in each case, 3.50%. In addition, the term loans were issued at a discount of 0.25%. Borrowings under the third amended and restated credit agreement continue to be secured by substantially all of VFH’s assets, other than the equity interests in and assets of its subsidiaries that are subject to, or potentially subject to, regulatory oversight, and its foreign subsidiaries, but including 100% of the non-voting stock and 65% of the voting stock of these subsidiaries. Under the terms of the third amended and restated credit agreement, term loans will mature on October 27, 2022, subject to certain exceptions and permitted extensions as set forth in the third amended and restated credit agreement. A portion of certain financing costs incurred in connection with the original credit facility that were scheduled to be amortized over the term of the loan, including original issue discount and underwriting and legal fees, were accelerated at the closing of the refinancing. The Company recognized $5.6 million expense on accelerated financing fees as a result of the refinancing, which is included within debt issue cost related to debt refinancing in the accompanying consolidated statement of comprehensive income. On April 15, 2015, the Company, Virtu Financial, and each unregulated domestic subsidiary of Virtu Financial, entered into an amendment agreement to the Credit Agreement, which provided for a revolving credit facility with aggregate commitments by revolving lenders of $100.0 million. The revolving credit facility is secured pari passu with the term loans outstanding under the Credit Agreement and is subject to the same financial covenants and negative covenants. Borrowings under the revolving facility bear interest, at the Company’s election, at either (i) the greatest of (a) the prime rate in effect, (b) the federal funds effective rate plus 0.5% (c) an adjusted LIBOR rate for a Eurodollar borrowing with an interest period of one month plus 1% and (d) 2.25%, plus, in each case, 2.0%, or (ii) the greater of (x) an adjusted LIBOR rate for the interest period in effect and (y) 1.25%, plus, in each case, 3.0%. The Company will also pay a commitment fee of 0.50% per annum on the average daily unused portion of the facility. Under the terms of the third amended and restated credit agreement, revolving commitments will terminate and outstanding revolving loans will mature on April 15, 2018, subject to certain exceptions and permitted extensions as set forth in the third amended and restated credit agreement. SBI Bonds On July 25, 2016, VFH issued Japanese Yen Bonds (collectively the “SBI Bonds”) in the aggregate principal amount of ¥3.5 billion ($33.1 million at issuance date) to SBI Life Insurance Co., Ltd. and SBI Insurance Co., Ltd. The proceeds from the SBI Bonds were used to partially fund the investment in SBI (as described in Note 9). The SBI Bonds were issued bearing interest at the rate per annum of 4.0% until their scheduled maturity on January 6, 2020. Following the consummation of the Refinancing Transaction (as described in Note 18) and in accordance with the terms and conditions of the SBI Bonds, the rate per annum was increased to 5.0% as of October 2016. The SBI Bonds are guaranteed by Virtu Financial. The SBI Bonds are subject to fluctuations on the Japanese Yen currency rates relative to the Company’s reporting currency (U.S. Dollar) with the changes reflected in other revenues (losses) in the consolidated statements of comprehensive income. The principal balance was ¥3.5 billion ($29.9 million) as of December 31, 2016 and the Company recorded a loss of $3.2 million due to the change in currency rates during the year ended December 31, 2016. Aggregate future required minimum principal payments based on the terms of the long-term borrowings at December 31, 2016 were as follows: The below table contains a reconciliation of the long-term borrowings principal amount to the secured credit facility recorded in the consolidated statements of financial condition: 9. Financial Assets and Liabilities At December 31, 2016 and December 31, 2015, substantially all of Company’s financial assets and liabilities, except for the long-term borrowings, short-term borrowings, securities borrowed and loaned, and certain exchange memberships which would all be categorized as Level 2, were carried at fair value based on published market prices and are marked to market daily or were short-term in nature and were carried at amounts that approximate fair value. The Company determined that the carrying value of the Company’s long-term borrowings approximates fair value as of December 31, 2016 and December 31, 2015 based on the recent transaction date of the SBI Bonds and the quoted over-the-counter market prices provided by the issuer of the senior secured credit facility, and would be categorized as Level 2. The fair value of equities, U.S. government obligations and exchange traded notes is estimated using recently executed transactions and market price quotations in active markets and are categorized as Level 1 with the exception of inactively traded equities which are categorized as Level 2. Fair value of the Company’s derivative contracts is based on the indicative prices obtained from broadly distributed bank and broker prices, as well as management’s own analyses. The indicative prices have been independently validated through the Company’s risk management systems, which are designed to check prices with information independently obtained from exchanges and venues where such financial instruments are listed or to compare prices of similar instruments with similar maturities for listed financial futures in foreign exchange. At December 31, 2016 and December 31, 2015, the Company’s derivative contracts and non-U.S. government obligations have been categorized as Level 2. In July 2016, the Company made an additional minority investment in SBI, a proprietary trading system based in Tokyo, which is further described later in this footnote. The Company elected the fair value option to account for this equity method investment because it believes that fair value is the most relevant measurement attribute for this investment, as well as to reduce operational and accounting complexity. This investment has been categorized as Level 3. The valuation process involved for Level 3 measurements is completed on a quarterly basis. The Company employs two valuation methodologies when determining the fair value of investments categorized as Level 3, market comparable analysis and discounted cash flow analysis. The market comparable analysis considers key financial inputs, recent public and private transactions and other available measures. The discounted cash flow analysis incorporates significant assumptions and judgments and the estimates of key inputs used in this methodology include the discount rate for the investment and assumed inputs used to calculate terminal values, such as price/earnings multiples. Upon completion of the valuations conducted using these methodologies, a weighting is ascribed to each method and the ultimate fair value recorded for a particular investment will generally be within a range suggested by the two methodologies. When determining the weighting ascribed to each valuation methodology, the Company considers, among other factors, the availability of direct market comparables, the applicability of a discounted cash flow analysis and the expected holding period. There were no transfers of financial instruments between levels during the years ended December 31, 2016 and 2015. Fair value measurements for those items measured on a recurring basis are summarized below as of December 31, 2016: Fair value measurements for those items measured on a recurring basis are summarized below as of December 31, 2015: Investment in SBI Japannext Co., Ltd. On July 27, 2016, the Company purchased an additional minority interest (29.4%) in SBI Japannext, a proprietary trading system based in Tokyo, for $38.8 million in cash. In connection with the investment, VFH issued bonds to certain affiliates of SBI Japannext and used the proceeds to finance the transaction (Note 8). Subsequent to the Company’s incremental investment, the Company reclassified $0.4 million (0.5% interest) of existing SBI shares held prior to the transaction, which were historically recorded at cost within other assets in the consolidated statements of financial condition, to Level 3. The Company’s initial fair value of SBI was determined using the discounted cash flow method, an income approach, with the discount rate of 15.9% applied to the cash flow forecasts. The Company also used a market approach based on 19x average price/earnings multiples of comparable companies to corroborate the income approach. The fair value of SBI at December 31, 2016 was determined to approximate the purchase price paid for the SBI investment, adjusted for the changes in the Japanese Yen currency rate, given the proximity to the transaction date and lack of significant events subsequent to the transaction date. The fair value measurement is highly sensitive to significant changes in the unobservable inputs and significant increases (decreases) in discount rate or decreases (increases) in price/earnings multiples would result in a significantly lower (higher) fair value measurement. Changes in the fair value of SBI are reflected in other revenues, net in the consolidated statements of comprehensive income. The following presents the changes in Level 3 financial instruments measured at fair value on a recurring basis: Offsetting of Financial Assets and Liabilities The Company does not net securities borrowed and securities loaned, or securities purchased under agreements to resell and securities sold under agreements to repurchase. These financial instruments are presented on a gross basis in the consolidated statements of financial condition. In the tables below, the amounts of financial instruments owned that are not offset in the consolidated statements of financial condition, but could be netted against financial liabilities with specific counterparties under legally enforceable master netting agreements in the event of default, are presented to provide financial statement readers with the Company’s estimate of its net exposure to counterparties for these financial instruments. The following tables set forth the gross and net presentation of certain financial assets and financial liabilities as of December 31, 2016 and 2015 Excluded from the fair value and offsetting tables above is net unsettled fair value on long and short futures contracts in the amounts of $18.0 million and $(8.1) million, which are included within receivables from broker-dealers and clearing organizations as of December 31, 2016 and 2015, respectively, and $(3.5) million and $(11.7) million, which are included within payables to broker-dealers and clearing organizations as of December 31, 2016 and 2015, respectively, and would be categorized as Level 1. The following table presents gross obligations for securities lending transactions by remaining contractual maturity and the class of collateral pledged. 10. Derivative Instruments The fair value of the Company’s derivative instruments on a gross basis consisted of the following at December 31, 2016 and December 31, 2015: Amounts included in receivables from and payables to broker-dealers and clearing organizations represent net variation margin on long and short futures contracts. The following table summarizes the net gain from derivative instruments not designated as hedging instruments, which are recorded in trading income, net in the accompanying consolidated statements of comprehensive income for the years ended December 31, 2016, 2015, and 2014. 11. Income Taxes Income before income taxes and noncontrolling interest is as follows for the years ended December 31, 2016, 2015 and 2014: The provision for income taxes consists of the following for the years ended December 31, 2016, 2015 and 2014. The reconciliation of the tax provision at the U.S. Federal Statutory Rate to the provision for income taxes for the years ended December 31, 2016, 2015 and 2014 is as follows: The components of the deferred tax assets and liabilities as of December 31, 2016 and 2015 are as follows: Prior to the consummation of the Reorganization Transactions and the IPO, the Company’s business was historically operated through a limited liability company that is treated as a partnership for U.S. federal income tax purposes, and as such most of its income is not subject to U.S. federal and certain state income taxes. Subsequent to consummation of the Reorganization Transactions and the IPO, the Company is subject to U.S. federal, state and local income tax at the rate applicable to corporations less the rate attributable to the noncontrolling interest in Virtu Financial. These noncontrolling interests are subject to U.S. taxation as partnerships. Accordingly, for years ended December 31, 2016, 2015 and 2014, the income attributable to these noncontrolling interests is reported in the consolidated statements of comprehensive income, but the related U.S. income tax expense attributable to these noncontrolling interests is not reported by the Company as it is the obligation of the individual partners. Income tax expense is also affected by the differing effective tax rates in foreign, state and local jurisdictions where certain of the Company’s subsidiaries are subject to corporate taxation. Deferred income taxes arise primarily due to the amortization of the deferred tax assets recognized in connection with the IPO (Note 4 and Note 13), differences in the valuation of financial assets and liabilities, and in connection with other temporary differences arising from the deductibility of compensation and depreciation expenses in different time periods for book and income tax return purposes. There are no expiration dates on the deferred tax assets. The provisions of ASC 740 require that carrying amounts of deferred tax assets be reduced by a valuation allowance if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Accordingly, the need to establish valuation allowances for deferred tax assets is assessed periodically with appropriate consideration given to all positive and negative evidence related to the realization of the deferred tax assets. A valuation allowance against deferred tax assets at the balance sheet date is not considered necessary because it is more likely than not the deferred tax asset will be fully realized. There are no unrecognized tax benefits as of December 31, 2016 and December 31, 2015. The Company is subject to taxation in U.S. federal, state, local and foreign jurisdictions. As of December 31, 2016, the Company’s tax years for 2013 through 2015 and 2010 through 2015 are subject to examination by U.S. and non-U.S. tax authorities, respectively. 12. Commitments, Contingencies and Guarantees At December 31, 2016, minimum rental commitments under non-cancellable leases are approximately as follows: Total operating lease expense, net of amortization expense related to landlord incentives, for the years ended December 31, 2016, 2015 and 2014 was approximately $2.4 million, $5.3 million, and $3.5 million, respectively. Occupancy lease expense for the years ended December 31, 2016, 2015 and 2014 of $1.3 million, $3.9 million and $1.7 million, respectively, is included within operations and administrative expenses in the consolidated statements of comprehensive income. Communication equipment lease expense for the years ended December 31, 2016, 2015 and 2014 of $1.1 million, $1.4 million and $1.8 million, respectively, is included within communication and data processing in the accompanying consolidated statements of comprehensive income. Employee Retention Plan In connection with the July 8, 2011 acquisition of MTH, the Company established an employee retention plan. Under the plan, approximately $21.5 million was paid to employees in five installments from July 8, 2011 through July 8, 2014. The Company recognized approximately $0, $0 and $2.6 million, respectively, in compensation expense related to the plan, for the years ended December 31, 2016, 2015 and 2014, in acquisition related retention bonus in the accompanying consolidated statements of comprehensive income. Litigation The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company has also been, is currently, and may in the future be, the subject of one or more governmental, regulatory or self-regulatory organization enforcement actions, including but not limited to targeted and routine regulatory inquiries and investigations involving Regulation NMS, Regulation SHO, capital requirements and other domestic and foreign securities rules and regulations which may from time to time result in the imposition of penalties or fines. The Company has also been the subject of requests for information and documents from the SEC and the State of New York Office of the Attorney General (“NYAG”). Certain of these matters may result, or have resulted, in adverse judgments, settlements, fines, penalties, injunctions or other relief, and the Company’s business or reputation could be negatively impacted if it were determined that disciplinary or other enforcement actions were required. The ultimate effect on the Company from the pending proceedings and claims, if any, is presently unknown. Where available information indicates that it is probable a liability had been incurred at the date of the consolidated financial statements and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income. In addition, in December 2015 the enforcement committee of the Autorité des marchés financiers (“AMF”) fined the Company’s European subsidiary in the amount of €5.0 million (approximately $5.4 million) based on its allegations that the subsidiary of MTH engaged in price manipulation and violations of the AMF General Regulation and Euronext Market Rules. In accordance with the foregoing, the Company has accrued an estimated loss of €5.0 million (approximately $5.4 million) in relation to the fine imposed by the AMF. The Company’s management believes that the relevant trading engaged in by the subsidiary of MTH was conducted in accordance with applicable French law and regulations and the Company is pursuing its rights of appeal. Subject to the foregoing, based on information currently available, management believes it is not probable that the resolution of any known matters will result in a material adverse effect on the Company’s financial position although they might be material for the Company’s results of operations or cash flows for any particular reporting period. Indemnification Arrangements Consistent with standard business practices in the normal course of business, the Company has provided general indemnifications to its managers, officers, employees, and agents against expenses, judgments, fines, settlements, and other amounts actually and reasonably incurred by such persons under certain circumstances as more fully disclosed in its operating agreement. The overall maximum amount of the obligations (if any) cannot reasonably be estimated as it will depend on the facts and circumstances that give rise to any future claims. 13. Capital Structure The Company has four classes of authorized common stock. The Class A common stock and the Class C common stock have one vote per share. The Class B common stock and the Class D common stock have 10 votes per share. Shares of the Company’s common stock generally vote together as a single class on all matters submitted to a vote of the Company’s stockholders. Initial Public Offering and Reorganization Transactions Prior to the IPO, the Company’s business was conducted through Virtu Financial and its subsidiaries. In a series of transactions that occurred in connection with the IPO, (i) the Company became the sole managing member of Virtu Financial and acquired Virtu Financial Units, (ii) certain direct or indirect equityholders of Virtu Financial acquired shares of the Company’s Class A common stock and (iii) certain direct or indirect equityholders of Virtu Financial had their interests reclassified into Virtu Financial Units and acquired shares of the Company’s Class C common stock or, in the case of the TJMT Holdings LLC (the “Founder Post-IPO Member”) only, shares of the Company’s Class D common stock (collectively, the “Virtu Members”). On April 21, 2015, the Company completed its IPO of 19,012,112 shares of its Class A common stock, par value $0.00001 per share, including 2,479,840 shares of Class A common stock sold in connection with the full exercise of the option to purchase additional shares granted to the underwriters, at a price to the public of $19.00 per share. The shares began trading on NASDAQ on April 16, 2015 under the ticker symbol “VIRT” and the offering was closed on April 21, 2015. In connection with the Reorganization Transactions, the Company sold 16,532,272 shares of Class A common stock. The Company used its net proceeds from its IPO to purchase shares of Class A common stock from an affiliate of Silver Lake Partners, purchase Virtu Financial Units and corresponding shares of Class C common stock from certain Virtu Members, and for working capital and general corporate purposes. 2015 Management Incentive Plan The Company’s board of directors and stockholders adopted the 2015 Management Incentive Plan, which became effective upon consummation of the IPO. The 2015 Management Incentive Plan provides for the grant of stock options, restricted stock units, and other awards based on an aggregate of 12,000,000 shares of Class A common stock, subject to additional sublimits, including limits on the total option grant to any one participant in a single year and the total performance award to any one participant in a single year. Secondary Offerings In November 2015, the Company and certain selling stockholders affiliated with Silver Lake Partners completed a public offering (the “November 2015 Secondary Offering”) of 6,473,371 shares of the Company’s Class A common stock. The selling stockholders sold 6,075,837 shares of Class A common stock and the Company sold 397,534 shares of Class A common stock at a price to the public of $22.15 per share. The selling stockholders received all of the net proceeds from the sale of shares of Class A common stock by them in the November 2015 Secondary Offering. The Company used its net proceeds from the offering to purchase Virtu Financial Units (together with corresponding shares of Class C common stock) from one of its non-executive employees at a net price equal to the price paid by the underwriters for shares of its Class A common stock. Following the November 2015 Secondary Offering, Silver Lake Partners no longer holds any equity interest in us. In September 2016, the Company completed a public offering (the “September 2016 Secondary Offering,” collectively with the November 2015 Secondary Offering, the “Secondary Offerings”) of 1,103,668 shares of the Company’s Class A common stock. The Company sold 1,103,668 shares of Class A common stock at a price to the public of $15.75 per share. The Company used the net proceeds from the September 2016 Secondary Offering to purchase Virtu Financial Units (together with corresponding shares of Class C common stock) from certain employees at a net price equal to the price paid by the underwriters for shares of its Class A common stock, which was the price at which the shares were offered to the public less underwriting discounts and commissions of $0.10 per share. As a result of the completion of the IPO, the Reorganization Transactions and the Secondary Offerings, the Company holds approximately 29.6% interest in Virtu Financial at December 31, 2016. Distributions in Connection with the IPO In connection with the IPO, the holders of the outstanding equity interests in Virtu Financial prior to the consummation of the Reorganization Transactions (the “Virtu Financial Pre-IPO Members”) authorized the Company as the managing member of Virtu Financial to make distributions to the Virtu Financial Pre-IPO Members in an aggregate amount up to $50.0 million and on such dates as the Company determined in its sole discretion. Since the IPO, the Virtu Financial Pre-IPO Members have received distributions of $20.0 million. The Company has not recorded a liability as there is no obligation to make any further distributions to the Virtu Financial Pre-IPO Members and any such discretionary distributions will be funded from cash on hand. 14. Share-based Compensation Share-based compensation prior to the Company’s Reorganization completed on April 15, 2015 and IPO commenced on April 16, 2015: Class A-2 profits interests were issued to Virtu Employee Holdco LLC (“Employee Holdco”), a holding company that holds the interests on behalf of certain key employees or stakeholders. During the years ended December 31, 2016, 2015 and 2014, the Company recorded expense relating to non-voting common interest units, which were originally granted as Class A-2 profits interests and were reclassified into non-voting common interest units in connection with the Reorganization Transactions. The non-voting common interest units are subject to the same vesting requirements as the prior Class A-2 profits interests, which were either fully vested upon issuance or vested over a period of up to four years, and in each case are subject to repurchase provisions upon certain termination events. These awards were accounted for as equity awards and were measured at fair value at the date of grant. The Company recognized compensation expense related to the vesting of non-voting common interest units (formerly Class A-2 profits interests) of $1.3 million, $1.5 million and $16.0 million for the years ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016 and 2015, total unrecognized share-based compensation expense related to unvested non-voting common interest units (formerly Class A-2 profits interests), was $0.8 million and $2.5 million, respectively; and this amount is expected to be recognized over a weighted average period of 0.8 years and 1.6 years, respectively. Activity in the non-voting members’ interests (formerly Class A-2 profits interests) is as follows: On July 8, 2011, 2,625,000 Class A-2 capital interests were contributed by Class A-2 members to Virtu East MIP LLC (“East MIP”). East MIP issued Class A interests to the members who contributed the Class A-2 capital interests, and Class B interests (“East MIP Class B interests”) to certain key employees. Additionally, Class B interests were issued to Employee Holdco on behalf of certain key employees and stakeholders on July 8, 2011, and on subsequent dates. East MIP Class B interests and Class B interests were each subject to time based vesting over four years and only fully vested upon the consummation of a qualifying capital transaction by the Company, including an IPO. In connection with the Reorganization Transactions, East MIP was liquidated and a portion of the Class A-2 capital interests held by East MIP were contributed to Virtu Employee Holdco on behalf of holders of East MIP Class B Interests (or, in the case of certain employees located outside the United States, contributed to a trust whose trustee is one of the Company’s subsidiaries), which Class A-2 capital interests were subsequently reclassified into non-voting common interest units. The Company recognized compensation expense in respect of non-voting common interest units (formerly Class B interests) vested of $1.1 million and $44.9 million for the years ended December 31, 2016 and 2015. The compensation expense related to non-voting common interest units (formerly Class B interests) was included within charges related to share based compensation at IPO in the consolidated statements of comprehensive income. As of December 31, 2016 and 2015, total unrecognized share-based compensation expense related to unvested non-voting common interest units (formerly Class B interests) was $0.8 million and $2.1 million, respectively; and this amount is expected to be recognized over a weighted average period of 1.0 years and 1.8 years, respectively. Additionally, in connection with the compensation charges related to non-voting common interest units (formerly Class B interests) mentioned above, the Company capitalized $0.09 million and $9.2 million for the years ended December 31, 2016 and 2015. The amortization costs related to these capitalized compensation charges and previously capitalized compensation charges related to East MIP Class B interests and Class B interests were approximately $0.7 million and $8.5 million for the years ended December 31, 2016 and 2015. The costs attributable to employees incurred in development of software for internal use were included within charges related to share based compensation at IPO in the consolidated statements of comprehensive income. The fair value of the Class A-2 profit, Class B and East MIP Class B interest was estimated by the Company using an option pricing methodology based on expected volatility, risk-free rates and expected life. Expected volatility is calculated based on companies in the same peer group as the Company. The weighted-average assumptions used by the Company in estimating the grant date fair values of Class A-2 profits, Class B and East MIP Class B interests for the years ended December 31, 2015 and 2014 are summarized below: In connection with the Reorganization Transactions, all Class A-2 profits interests, Class B and East MIP Class B interests were reclassified into non-voting common interest units. As of December 31, 2016 and 2015, there were 14,231,535 and 15,394,426 non-voting common interest units outstanding, respectively, and 1,162,891 and 57,106 non-voting common interest units and corresponding Class C common stock were exchanged into Class A common stock, forfeited or repurchased during years ended December 31, 2016 and 2015. Share-based compensation after the Company’s Reorganization completed on April 15, 2015 and IPO completed on April 16, 2015: Pursuant to 2015 Management Incentive Plan as described above (Note 13) and in connection with the IPO, non-qualified stock options to purchase shares of Class A common stock were granted, each of which vests in equal annual installments over a period of the four years from grant date and expires not later than 10 years from the date of grant. The following table summarizes activity related to stock options for the year ended December 31, 2016 and 2015: The fair value of the stock option grants in 2015 was determined through the application of the Black-Scholes-Merton model with the following assumptions: The expected life has been determined based on an average of vesting and contractual period. The risk-free interest rate was determined based on the yields available on U.S. Treasury zero-coupon issues. The expected stock price volatility was determined based on historical volatilities of comparable companies. The expected dividend yield was determined based on estimated future dividend payments divided by the IPO stock price. The Company recognized $5.6 million and $4.7 million of compensation expense in relation to the stock options issued and outstanding for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2016 and 2015, total unrecognized share-based compensation expense related to unvested stock options was $14.2 million and $22.4 million, respectively, and these amounts are to be recognized over a weighted average period of 2.3 years and 3.3 years, respectively. Class A common stock and Restricted Stock Units Pursuant to the 2015 Management Incentive Plan as described above (Note 13) subsequent to the IPO, shares of immediately vested Class A common stock and restricted stock units were granted, which vest over a period of up to 4 years. The fair value of the Class A common stock and restricted stock units was determined based on a volume weighted average price and will be recognized on a straight line basis over the vesting period. For the year ended December 31, 2016 and 2015, 656,019 and 576,693 shares of immediately vested Class A common stock were granted and the Company recorded compensation expense of $10.6 million and $13.2 million, respectively. The following table summarizes activity related to the restricted stock units for the years ended December 31, 2016 and 2015: The Company recognized $6.3 million and $0.5 million of compensation expense in relation to the restricted stock units for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2016 and 2015, total unrecognized share-based compensation expense related to unvested restricted stock units was $28.5 million and $20.9 million, respectively, and this amount is to be recognized over a weighted average period of 2.6 years and 3.0 years, respectively. 15. Property, Equipment and Capitalized Software Property, equipment and capitalized software consisted of the following at December 31, 2016 and 2015: Depreciation expense for property and equipment for the years ended December 31, 2016, 2015, and 2014 was approximately $19.6 million, $24.0 million and $20.0 million, respectively, and is included within depreciation and amortization expense in the accompanying consolidated statements of comprehensive income. The Company’s capitalized software development costs excluding the compensation charges recognized in relation to the IPO disclosed below were approximately $11.1 million, $10.1 million, and $9.8 million for years ended December 31, 2016, 2015 and 2014, respectively. The related amortization expense was approximately $10.1 million, $9.6 million, and $10.4 million for the years ended December 31, 2016, 2015, and 2014, respectively, and is included within depreciation and amortization expense in the accompanying consolidated statements of comprehensive income. Additionally, in connection with the compensation charges related to non-voting interest units (formerly Class B interests) recognized upon the IPO (Note 14), the Company capitalized approximately $0.09 million and $9.2 million for the years ended December 31, 2016 and 2015 respectively. The amortization costs related to these capitalized compensation charges and previously capitalized compensation charges related to East MIP Class B interests and Class B interests were approximately $0.7 million and $8.5 million for the years ended December 31, 2016 and 2015, respectively. 16. Regulatory Requirement As of December 31, 2016, two broker-dealer subsidiaries of the Company are subject to the SEC Uniform Net Capital Rule 15c3-1, which requires the maintenance of minimum net capital of $1.0 million for each of the two broker-dealer subsidiaries. At December 31 2016, the subsidiaries had net capital of approximately $74.5 million and $10.8 million, which was approximately $73.5 million and $9.8 million in excess of its required net capital of $1.0 million and $1.0 million, respectively. At December 31, 2015, the subsidiaries had net capital of approximately $64.2 million and $8.5 million, which was approximately $63.2 million and $7.5 million in excess of its required net capital of $1.0 million and $1.0 million, respectively. Pursuant to NYSE and NYSE MKT (formerly NYSE Amex) rules, one of the broker-dealer subsidiaries was also required to maintain $1.9 million and $1.9 million of capital in connection with the operation of its Designated Market Maker (“DMM”) business as of December 31, 2016 and 2015, respectively. The required amount is determined under the exchange rules as the greater of $1 million or 15% of the market value of 60 trading units for each symbol in which the broker-dealer subsidiary is registered as the DMM. 17. Geographic Information The Company operates its business in the U.S. and internationally, primarily in Europe and Asia. Significant transactions and balances between geographic regions occur primarily as a result of certain Company’s subsidiaries incurring operating expenses such as employee compensation, communications and data processing and other overhead costs, for the purpose of providing execution, clearing and other support services to affiliates. Charges for transactions between regions are designed to approximate full costs. Intra-region income and expenses and related balances have been eliminated in the geographic information presented below to accurately reflect the external business conducted in each geographical region. The revenues are attributed to countries based on the locations of the subsidiaries. The following table presents total revenues by geographic area for the years ended December 31, 2016, 2015, and 2014: 18. Related Party Transactions As of December 31, 2016, and December 31, 2015, the Company had a payable of $0.2 million and $0.2 million to its affiliates, respectively. In the ordinary course of business, the Company purchases network connections services from affiliates of Level 3 Communications (“Level 3”). Temasek Holdings (Private) Limted and its affiliates have a significant ownership interest in Level 3. During the years ended December 31, 2016, 2015 and 2014 the Company paid $2.4 million, $4.3 million, and $2.0 million, respectively, to Level 3 for these services. Finally, in the ordinary course of business, the Company purchases telecommunications services from Singapore Telecommunications Limited (“Singtel”). Temasek and its affiliates have a significant ownership interest in Singtel. During the years ended December 31, 2016, 2015, and 2014, the Company paid $0.2 million, $0.1 million, and $0.2 million, respectively, to Singtel for these purchases. The Company employed the son of the Company’s Founder and Executive Chairman, as a trader during the years ended December 31, 2015 and 2014. The Company paid approximately $0.8 million and $0.6 million of employee compensation for the years ended December 31, 2015 and 2014, respectively. This employee was also granted 60,000 stock options with respect to shares of the Company’s Class A common stock under the 2015 Management Incentive Plan. The Company had no such expense during the year ended December 31, 2016. The Company has engaged a member of the Board of Directors to provide leadership consulting services. The Company has paid approximately $0.03 million, $0.1 million and $0.1 million for such engagement for the years ended December 31, 2016, 2015, and 2014, respectively. Additionally, the Company entered into sublease arrangements with affiliates of the Company’s Founder and Executive Chairman for office space no longer used by the Company. For the years ended December 31, 2016 and 2015, the Company recognized $0.04 million and $0.1 million, respectively, pursuant to these arrangements. 19. Parent Company VFI is a managing member of Virtu Financial, which guarantees the indebtedness of its direct subsidiary under the senior secured facility (Note 8). VFI is limited to its ability to receive distributions (including for purposes of paying corporate and other overhead expenses and dividends) from Virtu Financial under our senior secured credit facility. The following financial statements (the “Parent Company Only Financial Statements”) should be read in conjunction with the consolidated financial statements of the Company and the foregoing. The condensed statements of financial condition as of December 31, 2016 and 2015 reflect the financial condition of VFI. The condensed statements of comprehensive income and of cash flows for the year ended December 31, 2015 reflect the condensed operating results and cash flows of Virtu Financial prior to April 15, 2015 and reflect the condensed operating results and cash flows of VFI from April 16, 2015 through December 31, 2015. Virtu Financial, Inc. (Parent Company Only) Condensed Statements of Financial Condition Virtu Financial, Inc. (Parent Company Only) Condensed Statements of Comprehensive Income Virtu Financial, Inc. (Parent Company Only) Condensed Statements of Cash Flows 20. Subsequent Events The Company has evaluated subsequent events for adjustment to or disclosure in its consolidated financial statements through the date of this report, and has not identified any recordable or disclosable events, not otherwise reported in these consolidated financial statements or the notes thereto, except for the following: On November 28, 2016, the Company agreed to acquire select strategic telecommunications assets from Teza Technologies. The closing of the transaction is pending regulatory approval. The Company anticipates that the transaction will close during the first half of 2017. On February 2, 2017, the Company’s board of directors declared a dividend of $0.24 per share of Class A common stock and Class B common stock and per Restricted Stock Unit that was paid on March 15, 2017 to holders of record as of March 1, 2017. SUPPLEMENTAL FINANCIAL INFORMATION Consolidated Quarterly Results of Operations (Unaudited)
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This appears to be a partial financial statement with some key components. Here's a summary of the main points:
1. Revenue: Organized by geographic area, reported annually as of December 31 (specific figures not provided)
2. Profit/Loss: Calculated using:
- Basic EPS (Earnings Per Share)
- Diluted EPS
- Uses two-class method for calculating earnings due to RSUs (Restricted Stock Units)
3. Cash & Equivalents:
- Includes highly liquid investments with <3 month maturities
- May exceed federally insured limits in bank deposits
4. Securities Operations:
- Company engages in borrowing/lending with external parties
- Transactions collateralized by cash or securities
- Collateral typically ≥102% of value
5. Assets:
- Includes total assets to equity ratio
- Committed Facility with LIBOR-based or base rate plus 1.25% margin
6. Expenses: Includes:
- Liabilities
- Goodwill and intangibles
- Compensation accruals
- Capitalized software
- Income tax
- Other operational costs
Note: This summary is limited as many specific financial figures are missing from the provided text.
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Claude
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Financial Statements. ACCOUNTING FIRM Board of Directors and Shareholders of Riverview Financial Corporation We have audited the accompanying consolidated balance sheet of Riverview Financial Corporation and subsidiaries (the “Company”) as of December 31, 2016, and the related consolidated statement of income and comprehensive income (loss), change in stockholders’ equity, and cash flows for the year ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Riverview Financial Corporation and subsidiaries as of December 31, 2016, and the results of their operations and their cash flows for the year ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. /s/ Dixon Hughes Goodman LLP Gaithersburg, Maryland March 29, 2017 ACCOUNTING FIRM To the Board of Directors and Shareholders of Riverview Financial Corporation Harrisburg, Pennsylvania We have audited the accompanying consolidated balance sheet of Riverview Financial Corporation and its wholly-owned subsidiary (the “Company”) as of December 31, 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended. Riverview Financial Corporation’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Riverview Financial Corporation and its wholly-owned subsidiary as of December 31, 2015, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Smith Elliott Kearns & Company, LLC SMITH ELLIOTT KEARNS & COMPANY, LLC Chambersburg, Pennsylvania March 30, 2016 Riverview Financial Corporation CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except share data) See notes to consolidated financial statements. Riverview Financial Corporation CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (LOSS) (Dollars in thousands, except per share data) See notes to consolidated financial statements Riverview Financial Corporation CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Dollars in thousands, except per share data) See notes to consolidated financial statements Riverview Financial Corporation CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands, except per share data) See notes to consolidated financial statements Riverview Financial Corporation NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) 1. Summary of significant accounting policies: Nature of Operations: Riverview Financial Corporation, (the “Company”), a bank holding company incorporated under the laws of Pennsylvania, provides a full range of financial services through its wholly-owned subsidiary, Riverview Bank (the “Bank”). Effective December 31, 2015, The Citizens National Bank of Meyersdale (“Citizens”) merged with and into Riverview Bank, with Riverview Bank surviving (the “Merger”). The Company’s financial results reflect the merger of Citizens with and into Riverview Bank under the purchase method of accounting, with the Company treated as the acquirer from an accounting standpoint. Riverview Bank, with sixteen full service offices and three limited purpose offices, is a full service commercial bank offering a wide range of traditional banking services and financial advisory, insurance and investment services to individuals, municipalities and small to medium sized businesses in its Central Pennsylvania market areas of Berks, Cumberland, Dauphin, Perry, Northumberland and Schuylkill counties as well as its Southwestern Pennsylvania market areas of Somerset, Cambria, Bedford and Westmoreland Counties. The Bank is state-chartered under the jurisdiction of the Pennsylvania Department of Banking and Securities and the Federal Deposit Insurance Corporation. The Bank’s primary product is loans to small- and medium-sized businesses. Other lending products include one-to-four family residential mortgages and consumer loans. The Bank primarily funds its loans by offering open time deposits to commercial enterprises and individuals. Other deposit product offerings include certificates of deposits and various demand deposit accounts. The Bank offers a broad range of financial advisory, investment and fiduciary services through its wealth management and trust operating divisions. The wealth management and trust divisions did not meet the quantitative thresholds for required segment disclosure in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The Bank’s sixteen community banking offices, all similar with respect to economic characteristics, share a majority of the following aggregation criteria: (i) products and services; (ii) operating processes; (iii) customer bases; (iv) delivery systems; and (v) regulatory oversight. Accordingly, they were aggregated into a single operating segment. The Company faces competition primarily from commercial banks, thrift institutions and credit unions within the Central and Southwestern Pennsylvania markets, many of which are substantially larger in terms of assets and capital. In addition, mutual funds and security brokers compete for various types of deposits, and consumer, mortgage, leasing and insurance companies compete for various types of loans and leases. Principal methods of competing for banking and permitted nonbanking services include price, nature of product, quality of service and convenience of location. The Company and the Bank are subject to regulations of certain federal and state regulatory agencies and undergo periodic examinations. Basis of presentation: The consolidated financial statements of the Company have been prepared in conformity with GAAP, Regulation S-X and reporting practices applied in the banking industry. All significant intercompany balances and transactions have been eliminated in consolidation. The Company also presents herein condensed parent company only financial information regarding Riverview Financial Corporation (“Parent Company”). Prior period amounts are reclassified when necessary to conform with the current year’s presentation. Such reclassifications had no effect on financial position or results of operations. The Company has evaluated events and transactions occurring subsequent to the balance sheet date of December 31, 2016, for items that should potentially be recognized or disclosed in these consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued. Estimates: The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates that are particularly susceptible to material change in the near term relate to the determination of the allowance for loan losses, fair value of financial instruments, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, the valuation of deferred tax assets, determination of other-than-temporary impairment losses on securities, impairment of goodwill and fair value of assets acquired and liabilities assumed in business combinations. Actual results could differ from those estimates. Investment securities: Investments securities are classified and accounted for as either held-to-maturity, available-for-sale, or trading account securities based on management’s intent at the time of acquisition. Management is required to reassess the appropriateness of such classifications at each reporting date. The Company classifies debt securities as held-to maturity when management has the positive intent and ability to hold such securities to maturity. Held-to-maturity securities are stated at cost, adjusted for amortization of premium and accretion of discount. Investment securities are designated as available-for-sale when they are to be held for indefinite periods of time as management intends to use such securities to implement asset/liability strategies or to sell them in response to changes in interest rates, prepayment risk, liquidity requirements, or other circumstances identified by management. Available-for-sale securities are reported at fair value, with unrealized gains and losses, net of income taxes, excluded from earnings and reported in a separate component of stockholders’ equity. All marketable equity securities are accounted for at fair value. Estimated fair values for investment securities are based on market prices from a national pricing service. Realized gains and losses are computed using the specific identification method and are included in noninterest income. Premiums are amortized and discounts are accreted using the interest method over the contractual lives of investment securities. Investment securities that are bought and held principally for the purpose of selling them in the near term, in order to generate profits from market appreciation, are classified as trading account securities. Trading account securities are carried at market value. Interest on trading account securities is included in interest income. Profits or losses on trading account securities are included in noninterest income. All of the Company’s investment securities were classified as available-for-sale in 2016 and 2015. Transfers of securities between categories are recorded at fair value at the date of the transfer, with the accounting treatment of unrealized gains or losses determined by the category into which the security is transferred. Management evaluates each investment security to determine if a decline in fair value below its amortized cost is an other-than-temporary impairment (“OTTI”) at least quarterly, and more frequently when economic or market concerns warrant an evaluation. Factors considered in determining whether an other-than-temporary impairment was incurred include: (i) the length of time and the extent to which the fair value has been less than amortized cost; (ii) the financial condition and near-term prospects of the issuer; (iii) whether a decline in fair value is attributable to adverse conditions specifically related to the security or specific conditions in an industry or geographic area; (iv) the credit-worthiness of the issuer of the security; (v) whether dividend or interest payments have been reduced or have not been made; (vi) an adverse change in the remaining expected cash flows from the security such that the Company will not recover the amortized cost of the security; (vii) whether management intends to sell the security; and (viii) if it is more likely than not that management will be required to sell the security before recovery. If a decline is judged to be other-than-temporary, the individual security is written-down to fair value with the credit related component of the write-down included in earnings and the non-credit related component included in other comprehensive income or loss. The assessment of whether an other-than-temporary impairment exists involves a high degree of subjectivity and judgment and is based on information available to management at a point in time. Loans held for sale: Loans held for sale consist of one-to-four family residential mortgages originated and intended for sale in the secondary market with servicing rights released. The loans are carried in aggregate at the lower of cost or estimated market value, based upon current delivery prices in the secondary mortgage market. Net unrealized losses are recognized through a valuation allowance by corresponding charges to income. Gains or losses on the sale of these loans are recognized in noninterest income at the time of sale using the specific identification method. Loan origination fees, net of certain direct loan origination costs, are included in net gains or losses upon the sale of the related mortgage loan. All loans are sold without recourse. As a result of the consolidation with Union Bancorp, Inc. (“Union”), the Bank continues to service loans that Union sold to the Federal Home Loan Bank of Pittsburgh (“FHLB-Pgh”), and has recorded the corresponding servicing rights. The Bank receives servicing fees of approximately 0.25% of the outstanding loan balances. As of December 31, 2016 and 2015, loans serviced for the benefit of others totaled $4,291 and $5,143, respectively. No loans were sold to the FHLB-Pgh for the years ended December 31, 2016 and 2015. Loans, net: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at their outstanding unpaid principal balances, net of deferred fees or costs. Interest income is accrued on the principal amount outstanding. Loan origination fees, net of certain direct origination costs, are deferred and recognized over the contractual life of the related loan as an adjustment to yield using the effective interest method. Premiums and discounts on purchased loans are amortized as adjustments to interest income using the effective interest method. Delinquency fees are recognized in income when chargeable, assuming collectability is reasonably assured. Transfers of financial assets, which include loan participation sales, are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (i) the assets have been isolated from the Company; (ii) the transferee obtains the right, free of conditions that constrain it from taking advantage of that right, to pledge or exchange the transferred assets and (iii) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. The loan portfolio is segmented into commercial and retail loans. Commercial loans consist of commercial and commercial real estate loans. Retail loans consist of residential real estate and other consumer loans. The Company makes commercial loans for real estate development and other business purposes required by the customer base. The Company’s credit policies determine advance rates against the different forms of collateral that can be pledged against commercial loans. Typically, the majority of loans will be limited to a percentage of their underlying collateral values such as real estate values, equipment, eligible accounts receivable and inventory. Individual loan advance rates may be higher or lower depending upon the financial strength of the borrower and/or term of the loan. The assets financed through commercial loans are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversion of assets. Commercial real estate loans include long-term loans financing commercial properties. Repayment of these loans is dependent upon either the ongoing cash flow of the borrowing entity or the resale of or lease of the subject property. Commercial real estate loans typically require a loan to value of not greater than 80% and vary in terms. Commercial and commercial real estate loans generally have higher credit risk compared to residential mortgage loans and consumer loans, as they typically involve larger loan balances concentrated with single borrowers or groups of borrowers. In addition, the payment expectations on loans secured by income-producing properties typically depend on the successful operations of the related business and thus may be subject to a greater extent to adverse conditions in the real estate market and in the general economy. Loans secured by commercial real estate generally have larger balances and involve a greater degree of risk than one-to-four family residential mortgage loans. Of primary concern in commercial real estate lending is the borrower’s and any guarantor’s creditworthiness and the feasibility and cash flow potential of the financed project. Additional considerations include: location, market and geographic concentrations, loan to value, strength of guarantors and quality of tenants. Payments on loans secured by income properties often depend on successful operation and management of the properties. As a result, repayment of such loans may be subject to a greater extent than residential real estate loans, to adverse conditions in the real estate market or the economy. To monitor cash flows on income properties, we require borrowers and loan guarantors, if any, to provide annual consolidated financial statements on commercial real estate loans and rent rolls where applicable. In reaching a decision on whether to make a commercial real estate loan, we consider and review a cash flow analysis of the borrower and guarantor, when applicable, and considers the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property. We have generally required that the properties securing these real estate loans have debt service coverage ratios , the ratio of earnings before debt service to debt service, of at least 1.2 times. An environmental report is obtained when the possibility exists that hazardous materials may have existed on the site, or the site may have been impacted by adjoining properties that handled hazardous materials. Residential mortgages, including home equity loans, are secured by the borrower’s residential real estate in either a first or second lien position. Residential mortgages have varying loan rates depending on the financial condition of the borrower and the loan to value ratio. Residential mortgages may have amortizations up to 30 years. Consumer loans include installment loans, car loans, and overdraft lines of credit. The majority of these loans are secured. Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as motor vehicles. In the latter case, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and a small remaining deficiency often does not warrant further substantial collection efforts against the borrower. Consumer loan collections depend on the borrower’s continuing financial stability, and therefore are likely to be adversely affected by various factors, including job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state insolvency laws, may limit the amount that can be recovered on such loans. Off-balance sheet financial instruments: In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit, unused portions of lines of credit and standby letters of credit. These financial instruments are recorded in the consolidated financial statements when they are funded. Fees on commercial letters of credit and on unused available lines of credit are recorded as service charges, fees and commissions and are included in noninterest income when earned. The Company records an allowance for off-balance sheet credit losses, if deemed necessary, separately as a liability. Nonperforming assets: Nonperforming assets consist of nonperforming loans and other real estate owned. Nonperforming loans include nonaccrual loans, troubled debt restructured loans and accruing loans past due 90 days or more. Past due status is based on contractual terms of the loan. Generally, a loan is classified as nonaccrual when it is determined that the collection of all or a portion of interest or principal is doubtful or when a default of interest or principal has existed for 90 days or more, unless the loan is well secured and in the process of collection. When a loan is placed on nonaccrual, interest accruals discontinue and uncollected accrued interest is reversed against income in the current period. Interest collections after a loan has been placed on nonaccrual status are credited to the principal balance. Interest earned that would have been recognized is credited to income over the remaining life of the loan using the effective yield method if the nonaccrual loan is returned to performing status. A nonaccrual loan is returned to performing status when the loan is current as to principal and interest and has performed according to the contractual terms for a minimum of six months. Troubled debt restructured loans are loans with original terms, interest rate, or both, that have been modified as a result of a deterioration in the borrower’s financial condition and a concession has been granted that the Company would not otherwise consider. Unless on nonaccrual, interest income on these loans is recognized when earned, using the interest method. The Company offers a variety of modifications to borrowers that would be considered concessions. The modification categories offered can generally fall within the following categories: • Rate Modification - A modification in which the interest rate is changed to a below market rate. • Term Modification - A modification in which the maturity date, timing of payments or frequency of payments is changed. • Interest Only Modification - A modification in which the loan is converted to interest only payments for a period of time. • Payment Modification - A modification in which the dollar amount of the payment is changed, other than an interest only modification described above. • Combination Modification - Any other type of modification, including the use of multiple categories above. The Company segments loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans are individually analyzed for credit risk by classifying them within the Company’s internal risk rating system. The Company’s risk rating classifications are defined as follows: • Pass - A loan to borrowers with acceptable credit quality and risk that is not adversely classified as Substandard, Doubtful, Loss nor designated as Special Mention. • Special Mention - A loan that has potential weaknesses that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the institution’s credit position at some future date. Special Mention loans are not adversely classified since they do not expose the Company to sufficient risk to warrant adverse classification. • Substandard - A loan that is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. • Doubtful - A loan classified as Doubtful has all the weaknesses inherent in one classified Substandard with the added characteristic that the weaknesses make the collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. • Loss - A loan classified as Loss is considered uncollectible and of such little value that its continuance as bankable loans is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future. Other real estate owned is comprised of properties acquired through foreclosure proceedings or in-substance foreclosures. A loan is classified as in-substance foreclosure when the Company has taken possession of the collateral regardless of whether formal foreclosure proceedings take place. Other real estate owned is included in other assets and recorded at fair value less cost to sell at the time of acquisition, establishing a new cost basis. Any excess of the loan balance over the recorded value is charged to the allowance for loan losses. Subsequent declines in the recorded values of the properties prior to their disposal and costs to maintain the assets are included in other expenses. Any gain or loss realized upon disposal of other real estate owned is included in noninterest expense. Allowance for loan losses: The allowance for loan losses represents management’s estimate of losses inherent in the loan portfolio as of the balance sheet date. The allowance for loan losses account is maintained through a provision for loan losses charged to earnings. Loans, or portions of loans, determined to be confirmed losses are charged against the allowance account and subsequent recoveries, if any, are credited to the account. A loss is considered confirmed when information available at the financial statement date indicates the loan, or a portion thereof, is uncollectible. Nonaccrual, troubled debt restructured and loans deemed impaired at the time of acquisition are reviewed monthly to determine if carrying value reductions are warranted or if these classifications should be changed. Consumer loans are considered losses and charged-off when they are 120 days past due. Management evaluates the adequacy of the allowance for loan losses account quarterly. This assessment is based on past charge-off experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available. Regulators, in reviewing the loan portfolio as part of the scope of a regulatory examination, may require the Company to increase its allowance for loan losses or take other actions that would require the Company to increase its allowance for loan losses. The allowance for loan losses is maintained at a level believed to be adequate to absorb probable credit losses related to specifically identified loans, as well as probable incurred losses inherent in the remainder of the loan portfolio as of the balance sheet date. The allowance for loan losses consists of an allocated element and an unallocated element. The allocated element consists of a specific allowance for impaired loans individually evaluated under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 310, “Receivables,” and a formula portion for loss contingencies on those loans collectively evaluated under FASB ASC 450, “Contingencies.” A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. All amounts due according to the contractual terms means that both the contractual interest and principal payments of a loan will be collected as scheduled in the loan agreement. Factors considered by management in determining impairment include payment status, ability to pay and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. The Company recognizes interest income on impaired loans, including the recording of cash receipts, for nonaccrual, restructured loans or accruing loans depending on the status of the impaired loan. Loans considered impaired under FASB ASC 310 are measured for impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. If the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent, is less than the recorded investment in the loan, a specific allowance for the loan will be established. The formula portion of the allowance for loan losses relates to large pools of smaller-balance homogeneous loans and those identified loans considered not individually impaired having similar characteristics as these loan pools. Loss contingencies for each of the major loan pools are determined by applying a total loss factor to the current balance outstanding for each individual pool. The total loss factor is comprised of a historical loss factor using a loss migration method plus qualitative factors, which adjusts the historical loss factor for changes in trends, conditions and other relevant factors that may affect repayment of the loans in these pools as of the evaluation date. Loss migration involves determining the percentage of each pool that is expected to ultimately result in loss based on historical loss experience. Historical loss factors are based on the ratio of net loans charged-off to loans, net, for each of the major groups of loans evaluated and measured for impairment under FASB ASC 450. The historical loss factor for each pool is an average of the Company’s historical net charge-off ratio for the most recent rolling eight quarters. Management adjusts these historical loss factors by qualitative factors that represent a number of environmental risks that may cause estimated credit losses associated with the current portfolio to differ from historical loss experience. These environmental risks include: (i) changes in lending policies and procedures including underwriting standards and collection, charge-off and recovery practices; (ii) changes in the composition and volume of the portfolio; (iii) changes in national, local and industry conditions, including the effects of such changes on the value of underlying collateral for collateral-dependent loans; (iv) changes in the volume and severity of classified loans, including past due, nonaccrual, troubled debt restructures and other loan modifications; (v) changes in the levels of, and trends in, charge-offs and recoveries; (vi) the existence and effect of any concentrations of credit and changes in the level of such concentrations; (vii) changes in the experience, ability and depth of lending management and other relevant staff; (viii) changes in the quality of the loan review system and the degree of oversight by the board of directors; and (ix) the effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the current loan portfolio. Each environmental risk factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a narrative accompanying the allowance for loan loss calculation. The unallocated element, if any, is used to cover inherent losses that exist as of the evaluation date, but which have not been identified as part of the allocated allowance using the above impairment evaluation methodology due to limitations in the process. One such limitation is the imprecision of accurately estimating the impact current economic conditions will have on historical loss rates. Variations in the magnitude of impact may cause estimated credit losses associated with the current portfolio to differ from historical loss experience, resulting in an allowance that is higher or lower than the anticipated level. Management establishes the unallocated element of the allowance by considering a number of environmental risks similar to the ones used for determining the qualitative factors. Management continually monitors trends in historical and qualitative factors, including trends in the volume, composition and credit quality of the portfolio. The reasonableness of the unallocated element is evaluated through monitoring trends in its level to determine if changes from period to period are directionally consistent with changes in the loan portfolio. Management believes the level of the allowance for loan losses was adequate to absorb probable credit losses as of December 31, 2016. Premises and equipment, net: Land is stated at cost. Premises, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. The cost of routine maintenance and repairs is expensed as incurred. The cost of major replacements, renewals and betterments is capitalized. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation and amortization are eliminated and any resulting gain or loss is reflected in noninterest income. Depreciation and amortization are computed principally using the straight-line method based on the following estimated useful lives of the related assets, or in the case of leasehold improvements, to the expected terms of the leases, if shorter: Premises and leasehold improvements 7 - 50 years Leasehold improvements 10 - 30 years Furniture, fixtures and equipment 3 - 10 years Business combinations, goodwill and other intangible assets, net: The Company accounts for its acquisitions using the purchase accounting method. Purchase accounting requires the total purchase price to be allocated to the estimated fair values of assets acquired and liabilities assumed, including certain intangible assets that must be recognized. Typically, this allocation results in the purchase price exceeding the fair value of net assets acquired, which is recorded as goodwill. Core deposit intangibles are a measure of the value of checking, money market and savings deposits acquired in business combinations accounted for under the purchase method. Core deposit intangibles and other identified intangibles with finite useful lives are amortized using the sum of the year’s digits over their estimated useful lives of up to ten years. Loans that the Company acquires in connection with acquisitions are recorded at fair value with no carryover of the related allowance for credit losses. Fair value of the loans involves estimating the amount and timing of principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest. The excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loan. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable discount. The non-accretable discount includes estimated future credit losses expected to be incurred over the life of the loan. Subsequent decreases to the expected cash flows will require the Company to evaluate the need for an additional allowance for credit losses. Subsequent improvement in expected cash flows will result in the reversal of a corresponding amount of the non-accretable discount which the Company will then reclassify as accretable discount that will be recognized into interest income over the remaining life of the loan. Acquired loans that met the criteria for nonaccrual of interest prior to the acquisition may be considered performing upon acquisition, regardless of whether the customer is contractually delinquent. As such, the Company may no longer consider the loan to be nonaccrual or nonperforming and may accrue interest on these loans, including the impact of any accretable discount. In addition, charge-offs on such loans would be first applied to the non-accretable difference portion of the fair value adjustment. The Company accounts for performing loans acquired in business combinations using the contractual cash flows method of recognizing discount accretion based on the acquired loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing loans. A provision for loan losses is recorded for any further deterioration in these loans subsequent to the acquisition. Customer list intangibles are also included in intangible assets as a result of the purchase of the wealth management companies. These intangible are amortized as an expense over ten years using the sum of the years’ amortization method. Goodwill and other intangible assets are tested for impairment annually or when circumstances arise indicating impairment may have occurred. In making this assessment that impairment has occurred, management considers a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of impairment. Changes in economic and operating conditions, as well as other factors, could result in impairment in future periods. Any impairment losses arising from such testing would be reported in the Consolidated Statements of Income and Comprehensive Income as a separate line item within operations. There were no impairment losses recognized as a result of periodic impairment testing in each of the two-years ended December 31, 2016. Restricted equity securities: As a member of the FHLB-Pgh and Atlantic Community Bankers Bank (“ACBB”), the Company is required to purchase and hold stock in these entities to satisfy membership and borrowing requirements. This stock is restricted in that it can only be redeemed by these entities or to another member institution and all redemptions of stock must be at par. As a result of these restrictions, restricted equity stock is unlike other investment securities as there is no trading market in it and the transfer price is determined by the FHLB-Pgh and ACBB membership rules and not by market participants. The carrying value of restricted stock is included in other assets. Bank owned life insurance: The Company invests in bank owned life insurance (“BOLI”) as a source of funding for employee benefit expenses. BOLI involves the purchasing of life insurance by the Bank on certain of its directors and employees. The Bank is the owner and beneficiary of the policies. This life insurance investment is carried at the cash surrender value of the underlying policies and is included in other assets. Income from increases in cash surrender value of the policies is included in noninterest income. Pension plans: As a result of the consolidation with Union and the merger with Citizens, the Company assumed control over Union’s and Citizens’ noncontributory defined benefit pensions plans, which covered substantially all of the Union and Citizens employees, respectively. The liabilities and annual income or expense of these pension plans are determined using methodologies that involve several actuarial assumptions, the most significant of which are the discount rate and the long-term rate of asset return, based on the market-related value of assets. The fair values of plan assets are determined based on prevailing market prices or estimated fair value for investments with no available quoted prices. Statements of Cash Flows: The Consolidated Statements of Cash Flows are presented using the indirect method. For purposes of cash flow, cash and cash equivalents include cash on hand, cash items in the process of collection, noninterest-bearing and interest-bearing deposits in other banks and federal funds sold. Fair value of financial instruments: The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosure under GAAP. Fair value estimates are calculated without attempting to estimate the value of anticipated future business and the value of certain assets and liabilities that are not considered financial. Accordingly, such assets and liabilities are excluded from disclosure requirements. In accordance with FASB ASC 820, “Fair Value Measurements and Disclosures,” fair value is the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets. In many cases, these values cannot be realized in immediate settlement of the instrument. Current fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction that is not a forced liquidation or distressed sale between participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions. In accordance with GAAP, the Company groups its assets and liabilities generally measured at fair value into three levels based on market information or other fair value estimates in which the assets and liabilities are traded or valued and the reliability of the assumptions used to determine fair value. These levels include: • Level 1: Unadjusted quoted prices of identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. • Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. • Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. The following methods and assumptions were used by the Company to construct the summary table in Note 13 containing the fair values and related carrying amounts of financial instruments: Cash and cash equivalents: The carrying values of cash and cash equivalents as reported on the balance sheet approximate fair value. Investment securities available-for-sale: The fair values of marketable equity securities are based on quoted market prices from active exchange markets. The fair values of debt securities are based on pricing from a matrix pricing model. Loans held for sale: The fair values of loans held for sale as reported on the balance sheet approximate fair value. Net loans: For adjustable-rate loans that reprice frequently and with no significant credit risk, fair values are based on carrying values. The fair values of other non-impaired loans are estimated using discounted cash flow analysis, using interest rates currently offered in the market for loans with similar terms to borrowers of similar credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis determined by the loan review function or underlying collateral values, where applicable. In conjunction with the merger, the loans purchased were recorded at their acquisition date fair value. In order to record the loans at fair value, management made three different types of fair value adjustments. A market rate adjustment was made to adjust for the movement in market interest rates, irrespective of credit adjustments, compared to the stated rates of the acquired loans. A credit adjustment was made on pools of homogeneous loans representing the changes in credit quality of the underlying borrowers from the loan inception to the acquisition date. The credit adjustment on distressed loans represents the portion of the loan balance that has been deemed uncollectible based on the management’s expectations of future cash flows for each respective loan. Accrued interest receivable: The carrying value of accrued interest receivable as reported on the balance sheet approximates fair value. Restricted equity securities: The carrying values of restricted equity securities approximate fair value, due to the lack of marketability for these securities. Deposits: The fair values of noninterest-bearing deposits and savings, NOW and money market accounts are the amounts payable on demand at the reporting date. The fair value estimates do not include the benefit that results from such low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. The carrying values of adjustable-rate, fixed-term time deposits approximate their fair values at the reporting date. For fixed-rate time deposits, the present value of future cash flows is used to estimate fair values. The discount rates used are the current rates offered for time deposits with similar maturities. Short-term borrowings: The carrying values of short-term borrowings approximate fair value. Long-term debt: The fair value of fixed-rate long-term debt is based on the present value of future cash flows. The discount rate used is the current rate offered for long-term debt with the same maturity. Accrued interest payable: The carrying value of accrued interest payable as reported on the balance sheet approximates fair value. Off-balance sheet financial instruments: The majority of commitments to extend credit, unused portions of lines of credit and standby letters of credit carry current market interest rates if converted to loans. Because such commitments are generally unassignable of either the Company or the borrower, they only have value to the Company and the borrower. None of the commitments are subject to undue credit risk. The estimated fair values of off-balance sheet financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of off-balance sheet financial instruments was not material at December 31, 2016 and December 31, 2015. Advertising: The Company follows the policy of charging marketing and advertising costs to expense as incurred. Advertising expense for the years ended December 31, 2016 and 2015 was $248 and $129, respectively. Income taxes: The Company accounts for income taxes in accordance with the income tax accounting guidance set forth in FASB ASC 740, “Income Taxes”. ASC 740 sets out a consistent framework to determine the appropriate level of tax reserves to maintain for uncertain tax positions. Deferred income taxes are provided on the balance sheet method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the effective date. A tax position is recognized as a benefit only if it is more likely than not that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that has a likelihood of being realized on examination of more than 50 percent. For tax positions not meeting the more likely than not threshold, no tax benefit is recorded. Under the more likely than not threshold guidelines, the Company believes no significant uncertain tax positions exist, either individually or in the aggregate, that would give rise to the non-recognition of an existing tax benefit. The Company had no material unrecognized tax benefits or accrued interest and penalties for any year in the three-year period ended December 31, 2016. As applicable, the Company recognizes accrued interest and penalties assessed as a result of a taxing authority examination through income tax expense. The Company files consolidated income tax returns in the United States of America and various states’ jurisdictions. With limited exception, the Company is no longer subject to federal and state income tax examinations by taxing authorities for years before 2013. Other comprehensive income (loss): The components of other comprehensive income (loss) and their related tax effects are reported in the Consolidated Statements of Income and Comprehensive Income (Loss). The accumulated other comprehensive income (loss) included in the Consolidated Balance Sheets relates to net unrealized gains and losses on investment securities available-for-sale and benefit plan adjustments. The components of accumulated other comprehensive income (loss) included in stockholders’ equity at December 31, 2016 and 2015 are as follows: Other comprehensive income (loss) and related tax effects for the years ended December 31, 2016 and 2015 are as follows: (1) Represents amounts reclassified out of accumulated comprehensive income and included in gains on sale of investment securities on the consolidated statements of income and comprehensive income. (2) Represents amounts reclassified out of accumulated comprehensive income and included in the computation of net periodic pension expense. Refer to Note 14 included in these consolidated financial statements. Earnings per share: Basic earnings per share represent income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. The following table provides reconciliation between the computation of basic earnings per share and diluted earnings per share for the years ended December 31, 2016 and 2015: Stock-based compensation: The Company recognizes all share-based payments to employees in the consolidated statement of operations based on their grant date fair values. The fair value of such equity instruments is recognized as an expense in the historical consolidated financial statements as services are performed. The Company uses the Black-Scholes Model to estimate the fair value of each option on the date of grant. The Black-Scholes Model estimates the fair value of employee stock options using a pricing model which takes into consideration the exercise price of the option, the expected life of the option, the current market price and its expected volatility, the expected dividends on the stock and the current risk-free interest rate for the expected life of the option. The Company typically grants stock options to employees with an exercise price equal to the fair value of the shares at the date of grant. The fair value of restricted stock is equivalent to the fair value on the date of grant and is amortized over the vesting period. Correction of an immaterial error in previously issued financial statements: In connection with the 2016 year-end audit process, the Company identified an error related to how the historical activity and ending balances of its common stock and capital surplus had been reflected on the consolidated balance sheets and consolidated statements of changes in stockholders’ equity from a change in the par value of its common stock and acquisition made in a previous year. Accordingly, on November 1, 2013, Riverview Financial Corporation and Union Bancorp, Inc. consolidated to form a new Pennsylvania corporation under the name of Riverview Financial Corporation (“Riverview”). The common stock of newly formed Riverview was issued with no par or stated value, thereby replacing the $0.50 par value common stock of the previously existing holding company. The nature of the error resulted from recording all of the amounts for the issuance of shares, with the exception of those related to stock based compensation, as capital surplus rather than common stock since November 1, 2013. The Company assessed the materiality of these errors for each period presented in accordance with the guidance in FASB ASC Topic 250, “Accounting Changes and Error Corrections,” ASC Topic 250-10-S99-1, “Assessing Materiality”, and determined that the errors were immaterial to the consolidated financial statements taken as a whole. Management corrected the errors in the applicable prior periods and revised its consolidated statements of changes in stockholders’ equity, as well as related footnotes as of and for the year ended December 31, 2016 with the cumulative effect of the adjustments on years prior to 2015 as a correction to common stock and capital surplus balances as of December 31, 2014, the beginning of the Company’s 2015 reporting year. The amount of the reclassifications from capital surplus to common stock totaled $53, $6,551, and $371 for each of the three years ended December 31, 2016 and did not have any impact on total stockholders’ equity or regulatory capital ratios for any of the periods presented. The Company will reflect these corrections in all future filings that contain such consolidated financial statements. Recent accounting standards: In February 2015, FASB issued ASU No. 2015-02, Consolidation (Topic 810): “Amendments to the Consolidation Analysis”, which changes the analysis that a reporting entity must perform to determine whether it should consolidate certain legal entities. The amendments in the standard affect limited partnerships and similar legal entities, evaluating fees paid to a decision maker or a service provider as a variable interest, the effect of fee arrangements on the primary beneficiary determination, the effect of related parties on the primary beneficiary determination, and certain investment funds. We adopted the amendments in this ASU effective January 1, 2016. The adoption of ASU No. 2015-02 did not have a material impact on our consolidated financial statements. In June 2015, FASB issued amendments to clarify the Accounting Standards Codification (ASC), correct unintended application of guidance, and make minor improvements to the ASC that are not expected to have a significant effect on current accounting practice or create a significant administrative cost to most entities. The amendments were effective upon issuance (June 12, 2015) for amendments that do not have transition guidance. Amendments that are subject to transition guidance were adopted effective January 1, 2016. The adoption of these amendments did not have a material effect on our consolidated financial statements. In September 2015, the FASB issued ASU No. 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments”. The new guidance requires that adjustments to provisional amounts identified during the measurement period of a business combination be recognized in the reporting period in which the adjustment amounts are determined. Furthermore, the income statement effects of such adjustments, if any, must be calculated as if the accounting had been completed at the acquisition date reflecting the portion of the amount recorded in current-period earnings that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. Under previous guidance, adjustments to provisional amounts identified during the measurement period are to be recognized retrospectively. ASU 2015-16 was effective for us on January 1, 2016 and did not have a significant impact on our consolidated financial statements. In January 2016, the FASB issued ASU No. 2016-01, “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The amendments in ASU 2016-01, among other things: requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requires separate presentation of financial assets and liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables); and eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2016-01 will have on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842).” Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is currently assessing the impact that ASU 2016-02 will have on its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-07, “Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting.” The amendments in this ASU eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The amendments require that the equity method investor add the cost of acquiring the additional interest in the investee to the current basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. Therefore, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. In addition, the amendments in this ASU require that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The amendments should be applied prospectively upon their effective date to increases in the level of ownership interest or degree of influence that result in the adoption of the equity method. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-07 to have a material impact on its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Shares-Based Payment Accounting”. The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: income tax consequences; classification of awards as either equity or liabilities; and classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company is currently assessing the impact that ASU 2016-09 will have on its consolidated financial statements. In June 2016, the FASB ASU No. 2016-13, “Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. ASU 2016-13 requires an entity to utilize a new impairment model known as the current expected credit loss (“CECL”) model to estimate its lifetime “expected credit loss” and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. The CECL model is expected to result in earlier recognition of credit losses. ASU 2016-13 also requires new disclosures for financial assets measured at amortized cost, loans and available-for-sale debt securities. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. We have dedicated staff and resources in place evaluating the Company’s options including evaluating the appropriate model options and collecting and reviewing loan data for use in these models. The Company is currently still assessing the impact that this new guidance will have on its consolidated financial statements. In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” The update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. This new accounting guidance will be effective for interim and annual reporting periods beginning after December 15, 2019. The Company does not expect the adoption of the new accounting guidance to have a material effect on the statement of cash flow. In December 2016, the FASB issued ASU No. 2016-20, “Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers”. ASU 2016-20 updates the new revenue standard by clarifying issues that have arisen from ASU 2014-09, but does not change the core principle of the new standard. The issues addressed in this ASU include: (i) Loan guarantee fees; (ii) Impairment testing of contract costs; (iii) Interaction of impairment testing with guidance in other topics; (iv) Provisions for losses on construction-type and production-type contracts; (v) Scope of Topic 606; (vi) Disclosure of remaining performance obligations; (vii) Disclosure of prior-period performance obligations; (viii) Contract modifications; (ix) Contract asset vs. receivable; (x) Refund liability; (xi) Advertising costs; (xii) Fixed-odds wagering contracts in the casino industry; and (xiii) Cost capitalization for advisors to private funds and public funds. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2017. The amendments can be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this new guidance recognized at the date of initial application. Our revenue is comprised of net interest income on financial assets and financial liabilities, which is explicitly excluded from the scope of ASU 2014-09, and non-interest income. ASU 2016-20 and 2014-09 could require us to change how we recognize certain revenue streams within non-interest income, however, we do not expect these changes to have a significant impact on our financial statements. We continue to evaluate the impact of ASU 2016-20 and 2014-09 on our Company and expect to adopt the standard in the first quarter of 2018 with a cumulative effect adjustment to opening retained earnings, if such adjustment is deemed to be significant. In January 2017, the FASB issued ASU No. 2017-03, “Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 323): Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings.” The ASU adds an SEC paragraph to ASUs 2014-09, 2016-02 and 2016-13 which specifies the SEC staff view that a registrant should evaluate ASUs that have not yet been adopted to determine the appropriate disclosure about the potential material effects of those ASUs on the financial statements when adopted. The guidance also specifies the SEC staff view on financial statement disclosures when the company does not know or cannot reasonably estimate the impact that adoption of the ASUs will have on the financial statements. The ASU also conforms to SEC guidance on accounting for tax benefits resulting from investments in affordable housing projects to the guidance in ASU 2014-01, Investments - Equity Method and Joint Ventures (Topic 323). The amendments in this update are effective upon issuance. The guidance did not have a significant impact on our consolidated financial statements. In January 2017, FASB issued ASU No. 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business”. The ASU clarifies the definition of a business to assist with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendments in this update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The guidance is not expected to have a significant impact on the Company’s financial positions, results of operations or disclosures. In January 2017, FASB issued ASU No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment”. The ASU simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. The Company should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value. The impairment charge is limited to the amount of goodwill allocated to that reporting unit. The amendments in this update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for goodwill impairment tests performed on testing dates after January 1, 2017. The guidance is not expected to have a significant impact on the Company’s financial positions, results of operations or disclosures. 2. Merger accounting: Riverview and Citizens entered into an Agreement and Plan of Merger, dated October 30, 2014, pursuant to which Citizens merged with and into Riverview Bank, with Riverview Bank surviving, effective December 31, 2015. In the Merger, each share of Citizens common stock that was outstanding was converted into either $38.46 in cash or 2.9586 shares of Riverview common stock, at the election of each Citizens shareholder, subject to proration in order to ensure that no more than 20% of the outstanding Citizens shares are converted into cash consideration. In accordance with the Merger Agreement, the Company issued a total of 492,178 shares. The following table summarizes the fair values of the assets acquired and the liabilities assumed as of the effective date of the consolidation. This transaction was accounted for using the purchase method of accounting in accordance with ASC No. 805, “Business Combinations”. Accordingly the purchase price was allocated to the respective assets acquired and liabilities assumed based upon their estimated fair values as of the effective date of the consolidation. The excess of purchase price over the fair value of net assets acquired is recorded as goodwill. The following table provides the calculation of the goodwill: The fair value of certain assets and certain liabilities were based on quoted prices from reliable market sources. When quoted market prices were not available, the estimated fair values were based upon the best information available, including, obtaining prices for similar assets and liabilities, and the results of using other valuation techniques. The prominent other valuation techniques used were the present value technique and appraisal/third party valuations. When the present value technique was employed, the associated cash flow estimates incorporated assumptions that marketplace participants would use in estimating fair values. In instances where reliable market information was not available, the Company assumed the historical book value of certain assets and liabilities represented a reasonable proxy for fair value. The Company determined that there were no other categories of identifiable intangible assets arising from the Citizens merger other than the core deposit intangible. No goodwill is expected to be deductible for tax purposes. The following presents the unaudited pro forma consolidated results of operations of the Company for the year ended December 31, 2015 as though Citizens merged with Riverview Bank on January 1, 2015. The information is for illustrative purposes only and is not necessarily indicative of the financial results of the combined companies if they actually completed the merger at the beginning of the period presented, nor does it indicate future results for any other interim or full year period. The proforma earnings per share were calculated using the Company’s actual weighted average shares outstanding for the period presented. The pro forma net income amount for the year ended 2015, includes pre-tax expenses of $448 associated with the merger. Net loss of Citizens that is included in the pro forma consolidated net income (loss) is $(141) for the year ended December 31, 2015. 3. Cash and due from banks: The Bank is required to maintain average reserve balances in cash or on deposit with the Federal Reserve Bank. The required reserve at December 31, 2016 and 2015 was $10,198 and $9,324, respectively. In addition, the Bank’s other correspondents may require average compensating balances as part of their agreements to provide services. The Bank maintains balances with correspondent banks that may exceed federal insured limits, which management considers to be a normal business risk. 4. Investment securities: The amortized cost and fair value of investment securities available-for-sale aggregated by investment category at December 31, 2016 and 2015 are summarized as follows: The Company had a net unrealized loss of $1,659, net of deferred income taxes of $854 at December 31, 2016, and a net realized gain of $461, net of deferred income taxes of $238 at December 31, 2015. Proceeds from the sale of investment securities available-for-sale amounted to $38,380 in 2016. Gross gains of $524 and gross losses of $40 were realized from the sale of securities in 2016. The income tax provision applicable to net realized gains amounted to $165 in 2016. The Company did not sell any securities during 2015. However, gross gains of $29 and gross losses of $46 were realized in 2015 as a result of called securities. The income tax benefit applicable to net realized losses amounted to $6 in 2015. The maturity distribution of the fair value, which is the net carrying amount of the debt securities classified as available-for-sale at December 31, 2016, is summarized as follows: Securities with a carrying value of $47,576 and $53,039 at December 31, 2016 and 2015, respectively, were pledged to secure public deposits as required or permitted by law. Securities and short-term investment activities are conducted with a diverse group of government entities, corporations and state and local municipalities. The counterparty’s creditworthiness and type of collateral is evaluated on a case-by-case basis. At December 31, 2016 and December 31, 2015, there were no significant concentrations of credit risk from any one issuer, with the exception of U.S. Government agencies and sponsored enterprises that exceeded 10.0 percent of stockholders’ equity. The fair value and gross unrealized losses of investment securities with unrealized losses for which an other-than-temporary impairment (“OTTI”) has not been recognized at December 31, 2016 and 2015, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, are summarized as follows: The Company had 80 investment securities, consisting of 49 taxable state and municipal obligations, seven tax-exempt municipal obligations, three U. S. Treasury bonds, four corporate obligations and 17 mortgage-backed securities that were in unrealized loss positions at December 31, 2016. Of these securities, one taxable state and municipal obligation was in a continuous unrealized loss position for twelve months or more. Management does not consider the unrealized losses on the debt securities, as a result of changes in interest rates, to be OTTI based on historical evidence that indicates the cost of these securities is recoverable within a reasonable period of time in relation to normal cyclical changes in the market rates of interest. Moreover, because there has been no material change in the credit quality of the issuers or other events or circumstances that may cause a significant adverse impact on the fair value of these securities, and management does not intend to sell these securities and it is unlikely that the Company will be required to sell these securities before recovery of their amortized cost basis, which may be maturity, the Company does not consider any of the unrealized losses to be OTTI at December 31, 2016. The Company had 13 investment securities, consisting of one tax-exempt state and municipal obligation, one taxable state and municipal obligation, eight mortgage-backed securities, two corporate debt obligations and one equity security that were in unrealized loss positions at December 31, 2015. Of these securities, one tax-exempt state and municipal security and one taxable state and municipal obligation were in a continuous unrealized loss position for twelve months or more. 5. Loans, net and allowance for loan losses: The major classifications of loans outstanding, net of deferred loan origination fees and costs at December 31, 2016 and 2015 are summarized as follows. Net deferred loan costs were $1,077 and $764 at December 31, 2016 and 2015, respectively. Loans outstanding to directors, executive officers, principal stockholders or to their affiliates totaled $8,778 and $9,878 at December 31, 2016 and 2015, respectively. Advances and repayments during 2016, totaled $2,240 and $3,340, respectively. There were no related party loans that were classified as nonaccrual, past due, or restructured or considered a potential credit risk at December 31, 2016 and 2015. At December 31, 2016, the majority of the Company’s loans were at least partially secured by real estate located in Central and Southwestern Pennsylvania. Therefore, a primary concentration of credit risk is directly related to the real estate market in these areas. Changes in the general economy, local economy or in the real estate market could affect the ultimate collectability of this portion of the loan portfolio. Management does not believe there are any other significant concentrations of credit risk that could affect the loan portfolio. The changes in the allowance for loan losses account by major classification of loan for the years ended December 31, 2016 and 2015 are summarized as follows: The allocation of the allowance for loan losses and the related loans by major classifications of loans at December 31, 2016 and December 31, 2015 is summarized as follows: The following tables present the major classification of loans summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system at December 31, 2016 and 2015: Information concerning nonaccrual loans by major classification at December 31, 2016 and 2015 is summarized as follows: The major classifications of loans by past due status at December 31, 2016 and 2015 are summarized as follows: The following tables summarize information concerning impaired loans as of and for the years ended December 31, 2016 and 2015, by major loan classification: For the years ended December 31, interest income, related to impaired loans, would have been $88 in 2016 and $159 in 2015 had the loans been current and the terms of the loans not been modified. Included in the commercial loan and commercial and residential real estate categories are troubled debt restructurings that are classified as impaired. Troubled debt restructurings totaled $6,208 at December 31, 2016 and $7,083 at December 31, 2015. The following tables present the number of loans and recorded investment in loans restructured and identified as troubled debt restructurings for the years ended December 31, 2016 and 2015, as well as the number and recorded investment in these loans that subsequently defaulted. Defaulted loans are those which are 30 days or more past due for payment under the modified terms. There were two loans modified as troubled debt restructurings for the year ended December 31, 2016. As of December 31, 2016, there were 24 restructured loans totaling $6,208 with 18 separate and unrelated borrowers who were experiencing financial difficulties. These loans were comprised of two commercial loans totaling $741, nine commercial real estate loans totaling $3,424 and 13 residential real estate loans totaling $2,044. The modifications on these loans included reductions in interest rates, extensions of maturity dates, lengthening of amortization schedules and provisions for interest only payments. These restructurings result in the collection of principal over a longer period than would have been received under the original contractual terms. At December 31, 2015, there were 32 restructured loans totaling $7,083 with 26 separate and unrelated borrowers. During 2016, there were no defaults on loans restructured. During 2015, there were two defaults on loans restructured. These loans were comprised of one residential real estate loan in the amount of $10 and one owner occupied commercial real estate loan in the amount of $147. Each of these loans defaulted as they were both more than 30 days past due as of December 31, 2015. The effect of these defaults on the allowance for loan losses was negligible as both loans were well secured and the delinquency was subsequently cured. Purchased loans are initially recorded at their acquisition date fair values. The carryover of the allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for purchased loans are based on a cash flow methodology that involves assumptions and judgments as to credit risk, default rates, loss severity, collateral values, discount rates, payment speeds, and prepayment risk. As part of its acquisition due diligence process, the Bank reviews the acquired institution’s loan grading system and the associated risk rating for loans. In performing this review, the Bank considers cash flows, debt service coverage, delinquency status, accrual status, and collateral for the loan. This process allows the Bank to clearly identify the population of acquired loans that had evidence of deterioration in credit quality since origination and for which it was probable, at acquisition, that the Bank would be unable to collect all contractually required payments. All such loans identified by the Bank are considered to be within the scope of ASC 310-30, Loan and Debt Securities Acquired with Deteriorated Credit Quality and are identified as “Purchased Credit Impaired Loans”. As a result of the merger with Citizens, effective December 31, 2015, the Bank identified ten purchased credit impaired (“PCI”) loans. As part of the consolidation with Union, effective November 1, 2013, the Bank identified fourteen PCI loans. For all PCI loans, the excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loan. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable discount. The non-accretable discount represents estimated future credit losses expected to be incurred over the life of the loan. Subsequent decreases to the expected cash flows require the Bank to evaluate the need for an allowance for loan losses on these loans. Subsequent improvements in expected cash flows result in the reversal of a corresponding amount of the non-accretable discount which the Bank then reclassifies as an accretable discount that is recognized into interest income over the remaining life of the loan. The Bank’s evaluation of the amount of future cash flows that it expects to collect is based on a cash flow methodology that involves assumptions and judgments as to credit risk, collateral values, discount rates, payment speeds, and prepayment risk. Charge-offs of the principal amount on purchased impaired loans are first applied to the non-accretable discount. For purchased loans that are not deemed impaired at acquisition, credit discounts representing principal losses expected over the life of the loans are a component of the initial fair value, and the discount is accreted to interest income over the life of the asset. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to originated loans, and if necessary, additional reserves are recognized in the allowance for loan losses. The following is a summary of the loans acquired in the Union merger as of November 1, 2013, the date of the consolidation: The unpaid principal balances and the related carrying amount of Union acquired loans as of December 31, 2016 and 2015 were as follows: As of the indicated dates, the changes in the accretable discount related to the purchased credit impaired loans were as follows: The following is a summary of the loans acquired in the Citizens’ merger as of December 31, 2015, the effective date of the merger: The unpaid principal balances and the related carrying amount of Citizens acquired loans as of December 31, 2016 and 2015 were as follows: As of the indicated dates, the changes in the accretable discount related to the purchased credit impaired loans were as follows: 6. Off-balance sheet financial instruments: The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, unused portions of lines of credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, unused portions of lines of credit and standby letters of credit is represented by the contractual amounts of those instruments. The Company follows the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. We record a valuation allowance for off-balance sheet credit losses, if deemed necessary, separately as a liability. The allowance was $81 and $43 at December 31, 2016 and 2015, respectively. The contractual amounts of off-balance sheet commitments at December 31, 2016 and 2015 are summarized as follows: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory and equipment. Unused portions of lines of credit, including home equity and overdraft protection agreements, are commitments for possible future extensions of credit to existing customers. Unused portions of home equity lines are collateralized and generally have fixed expiration dates. Overdraft protection agreements are uncollateralized and usually do not carry specific maturity dates. Unused portions of lines of credit ultimately may not be drawn upon to the total extent to which the Company is committed. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Generally, all standby letters of credit expire within twelve months. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending other loan commitments. The Company requires collateral supporting these standby letters of credit as deemed necessary. The carrying value of the liability for the Company’s obligations under guarantees for standby letters of credit was not material at December 31, 2016 and 2015. 7. Premises and equipment, net: Premises and equipment at December 31, 2016 and 2015 are summarized as follows: Depreciation and amortization included to noninterest expense amounted to $787 and $1,038 in 2016 and 2015, respectively. Pursuant to the terms of non-cancelable lease agreements in effect at December 31, 2016, pertaining to banking premises and equipment, future minimum annual rent commitments under various operating leases are summarized as follows: The leases contain options to extend for periods from one to ten years. The cost of such options is not included in the annual rental commitments. Rent expense for the years ended December 31, 2016 and 2015 amounted to $287 and $547, respectively. 8. Intangible assets, net: The gross carrying amount and accumulated amortization related to intangible assets at December 31, 2016 and 2015 are presented below: Amortization expense for intangible assets totaled $340 and $259 for the years ended 2016 and 2015, respectively. Riverview estimates the amortization expense for the core deposit and customer list intangibles as follows: 9. Other assets: The components of other assets at December 31, 2016 and 2015 are summarized as follows: 10. Deposits: The major components of interest-bearing and noninterest-bearing deposits at December 31, 2016 and 2015 are summarized as follows: The aggregate amount of time deposits that met or exceeded the FDIC insurance limit of $250 was $8,952 at December 31, 2016 and $7,566 at December 31, 2015. The aggregate amounts of maturities for all time deposits at December 31, 2016, are summarized as follows: The aggregate amount of deposits reclassified as loans was $15 at December 31, 2016, and $7 at December 31, 2015. Management evaluates transaction accounts that are overdrawn for collectability as part of its evaluation for credit losses. During 2016 and 2015, no deposits were received on terms other than those available in the normal course of business. 11. Short-term borrowings: Short-term borrowings consisting of FHLB-Pgh and ACBB generally represent overnight or less than 30-day borrowings at December 31, 2016 and 2015 are summarized as follows: The Bank has an agreement with the FHLB-Pgh which allows for borrowings up to its maximum borrowing capacity based on a percentage of qualifying collateral assets. At December 31, 2016, the Bank’s maximum borrowing capacity was $211,907 of which $36,500 was outstanding in borrowings. Advances with the FHLB-Pgh are secured under terms of a blanket collateral agreement by a pledge of FHLB-Pgh stock and certain other qualifying collateral, such as investments and mortgage-backed securities and mortgage loans. Interest accrues daily on the FHLB-Pgh advances based on rates of the FHLB-Pgh discount notes. This rate resets each day. The Bank also has an unsecured line of credit agreement with ACBB, where the line amount was $7,500 at December 31, 2016 and 2015. There were no amounts outstanding on this line of credit at December 31, 2016 and 2015. Interest on this borrowing accrues daily based on the daily federal funds rate. 12. Long-term debt: Long-term debt consisting of the following advances at December 31, 2016 and 2015 are as follows: Maturities of long-term debt, by contractual maturity, in years subsequent to December 31, 2016 are as follows: The $2,000 secured term loan agreement with ACNB Bank due March 31, 2031, was fixed at 3.25% until March 3, 2016, and thereafter, adjusted every three years and indexed to the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of three years, plus 3%, with a floor of 4.25%. Interest is payable monthly for a period of 18 months until March 3, 2016, and thereafter, 180 monthly payments of principal and interest in an amount sufficient to fully amortize the balance of the loan over 15 years. The $5,000 secured guidance line of credit with ACNB Bank consists of three separate draws of $350, $2,000, and $2,050. The aggregate outstanding balance of the line was $4,232 at December 31, 2016 and $2,350 at December 31, 2015. The maximum term of the facility is 42 months consisting of a non-revolving draw period followed by a principal repayment term. The interest was fixed at 3.99% until January 11, 2016. Thereafter, the interest rate will be adjusted every three years and indexed to the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of three years, plus 3%, rounded up to the nearest 0.125%, with a floor of 4.50% until July 11, 2016, and then a floor of 4.25% thereafter. Each advance under the loan will require monthly interest only payments until January 11, 2016. Thereafter, each advance shall require 180 monthly payments of principal including interest in an amount sufficient to fully amortize the balance of the loan over the term of the loan. Both the term loan and the guidance line of credit with ACNB Bank are subject to prepayment penalties equal to 2% of the amount prepaid if prepaid by a third party. If at any time either of these borrowing facilities is in default, all loans outstanding with ACNB Bank will be considered in default and all outstanding amounts will be immediately due and payable in full. 13. Fair value of financial instruments: Assets and liabilities measured at fair value on a recurring basis at December 31, 2016 and 2015 are summarized as follows: Assets and liabilities measured at fair value on a nonrecurring basis at December 31, 2016 and 2015 are summarized as follows: The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value: Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 Inputs which are not identifiable. Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses. The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal. The carrying and fair values of the Company’s financial instruments at December 31, 2016 and 2015 and their placement within the fair value hierarchy are as follows: Note 14. Employee Benefit Plans: Defined Contribution Plan: The Bank maintains a contributory 401(k) retirement plan for all eligible employees. Currently, the Bank’s policy is to match 100% of the employee’s voluntary contribution to the plan up to a maximum of 4% of the employees’ compensation. Additionally, the Bank may make discretionary contributions to the plan after considering current profits and business conditions. The amount charged to expense in 2016 and 2015 totaled $208 and $258, respectively. Of these amounts, no discretionary contributions were made in 2016 as compared with a discretionary contribution of $92 made in 2015. Director Emeritus Plan: Effective November 2, 2011, a Director Emeritus Agreement (the “Agreement”) was entered into by and between the Company, the Bank and the Directors. In order to promote orderly succession of the Company’s and Bank’s Board of Directors, the Agreement defines the benefits the Company is willing to provide upon the termination of service to those individuals who were Directors of the Company and Bank as of December 31, 2011, where the Company will pay the Director $15 per year for services performed as a Director Emeritus, which may be increased at the sole discretion of the Board of Directors. The benefit is paid over five years, in 12 monthly installments to a Director: • upon termination of service as a Director on or after the age of 65, provided the Director agrees to provide certain ongoing services for Riverview; • upon termination of service as a Director due to a disability prior to age 65; • upon a change of control; or • upon the death of a Director after electing to be a Director Emeritus. Expenses recorded under the terms of this agreement were $26 and $36 for the years ended December 31, 2016 and 2015, respectively. Deferred Compensation Agreements: The Bank maintains five Supplemental Executive Retirement Plan (“SERP”) agreements that provide specified benefits to certain key executives. The agreements were specifically designed to encourage key executives to remain as employees of the Bank. The agreements are unfunded, with benefits to be paid from the Bank’s general assets. After normal retirement, benefits are payable to the executive or his beneficiary in equal monthly installments for a period of 15 years for two of the executives and 20 years for three of the executives. There are provisions for death benefits should a participant die before his retirement date. These benefits are also subject to change of control and other provisions. The Bank maintains a “Director Deferred Fee Agreement” (“DDFA”) which allows electing directors to defer payment of their directors’ fees until a future date. In addition, the Bank maintains an “Executive Deferred Compensation Agreement” (“EDCA”) with two of its executives. This agreement, which was initiated in 2010, allows the executives of the Bank to defer payment of their base salary, bonus and performance based compensation until a future date. For both types of deferred fee agreements, the estimated present value of the future benefits is accrued over the effective dates of the agreements using an interest factor that is evaluated and approved by the compensation committee of the Board of Directors on an annual basis. The agreements are unfunded, with benefits to be paid from the Bank’s general assets. The accrued benefit obligations for all the plans total $2,189 at December 31, 2016 and $1,941 at December 31, 2015 and are included in other liabilities. Expenses relating to these plans totaled $174 and $176 in the years ended December 31, 2016 and 2015, respectively. Stock Option Plan: The Company has a nonqualified stock option plan to advance the development, growth and financial condition of the Company. This plan provides incentives through participation in the appreciation of its common stock in order to secure, retain and motivate directors, officers and key employees and align such person’s interests with those of its shareholders. A total of 350,000 shares are authorized under the stock option plan. The vesting schedule for all option grants is a seven year cliff, which means that the options are 100% vested in the seventh year following the grant date and the expiration date of all options is ten years following the grant date. The Plan states that upon the date of death of a participant, all awards granted pursuant to the agreement for that participant shall become fully vested and remain exercisable for the option grant’s remaining term. As of December 31, 2016, there were 159,500 option grants fully vested and exercisable. No options were granted or exercised during 2016. A summary of the status of the stock option plan as of December 31, 2016 and 2015 is as follows: The fair value of each option granted during 2015 is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions. Information pertaining to options outstanding at December 31, 2016 is as follows: There was intrinsic value associated with the 298,079 options outstanding at December 31, 2016, where the market value of the stock as of the close of business at year end was $11.60 per share as compared with the option exercise price of $10.60 for 147,000 options, $10.35 for 12,500 options, $9.75 for 34,579 options and $10.00 for 104,000 options. There was intrinsic value associated with the 338,500 options outstanding at December 31, 2015, where the market value of the stock as of the close of business at year end was $13.20 per share as compared with the option exercise price of $10.60 for 158,500 options, $10.35 for 6,750 options, $9.75 for 40,750 options, $10.00 for 107,200 options, $12.25 for 2,500 options and $13.05 for 22,800 options. The Company accounts for these options in accordance with GAAP, which requires that the fair value of the equity awards be recognized as compensation expense over the period during which the employee is required to provide service in exchange for such an award. The Company is amortizing compensation expense over the vesting period, or seven years. The Company recognized $40 and $32 of compensation expense for stock options in the years ended December 31, 2016 and 2015. As of December 31, 2016, the Company had $193 of unrecognized compensation expense associated with the stock options. Employee Stock Purchase Plan: The Company has an Employee Stock Purchase Plan (“ESPP”), whereby employees may purchase up to 170,000 shares of common stock of the Company, up to a 15% discount. On April 15, 2015, the Company filed a Registration Statement on Form S-8, to register 75,000 shares of common stock that the Company may issue to the ESPP. Common shares acquired through the ESPP totaled 8,725 shares in 2016 and 5,212 shares in 2015. Defined Benefit Pension Plan: As a result of the consolidation with Union, the Company took over Union’s noncontributory defined benefit pension plan, which substantially covered all Union employees. The plan benefits were based on average salary and years of service. Union elected to freeze all benefits earned under the plan effective January 1, 2007. The Company also assumed responsibility of Citizens’ noncontributory defined benefit pension plan effective as of the December 31, 2015 merger date. The plan substantially covered all Citizens employees and the plan benefits were based on average salary and years of service. Citizens elected to freeze all benefits earned under the plan effective January 1, 2013. The Company accounts for the defined benefit pension plan in accordance with FASB ASC Topic 715, “Compensation-Retirement Plans”. This guidance requires the Company to recognize the funded status, which is the difference between the fair value of the plan assets and the projected benefit obligation of the benefit plan. The following table presents the plans’ funded status and the amounts recognized in the Company’s consolidated financial statements for 2016 and 2015. The measurement date, for purposes of these valuations, was December 31, 2016 and 2015. Amounts related to the plan that have been recognized in accumulated other comprehensive loss but not yet recognized as a component of net periodic pension cost are as follows for the years ended December 31: The amount of net actuarial cost or (credit) expected to be amortized in 2017 is $8 for the Union pension and $(92) for the Citizens pension. Net periodic pension expense included the following components for the years ended December 31: The accumulated benefit obligation for Union was $4,283 at December 31, 2016 and $4,298 at December 31, 2015, while the accumulated benefit obligation for Citizens was $3,719 at December 31, 2016 and $3,951 at December 31, 2015. The following is a summary of actuarial assumptions used for the Company’s pension plan: The selected long-term rate of return on plan assets was primarily based on the asset allocation of the plan’s assets. Analysis of the historic returns on these asset classes and projections of expected future returns were considered in setting the long-term rate of return. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid: The Company’s pension plan asset allocations as of the year ends, by asset category, are as follows: The fair value of the Union’s pension plan assets at December 31, 2016 and 2015 by asset category are as follows: The fair value of the Citizens’ pension plan assets at December 31, 2016 and 2015 by asset category are as follows: The valuation used is based on quoted market prices provided by an independent third party. The Company does not expect to contribute to the plans in 2017. 15. Income taxes: The current and deferred amounts of the provision for income taxes expense (benefit) for each of the years ended December 31, 2016 and 2015 are summarized as follows: The components of the net deferred tax asset at December 31, 2016 and 2015 are summarized as follows: Management believes that future taxable income will be sufficient to utilize deferred tax assets. Core earnings of the Company will continue to support the recognition of the deferred tax asset based on future growth projections. A reconciliation between the amount of the effective income tax expense and the income tax expense that would have been provided at the federal statutory rate of 34.0 percent for the years ended December 31, 2016 and 2015 is summarized as follows: Note 16. Parent company financial statements: Condensed Balance Sheets Condensed Statements of Income and Comprehensive Income Condensed Statements of Cash Flows Note 17. Regulatory matters and shareholders’ equity: The ability of the Bank to transfer funds to the Company in the form of cash dividends, loans or advances is restricted by applicable regulations. Regulatory approval is required if the total of all dividends declared by a state-chartered bank in any calendar year exceeds net profits, as defined, for that year combined with the retained net profits for the two preceding years. At December 31, 2016, $1,929 of undistributed earnings of the Bank, included in consolidated shareholders’ equity, was available for distribution to the Company as dividends without prior regulatory approval. The amount of funds available for transfer from the Bank to the Company in the form of loans and other extensions of credit is also limited. Under Federal Regulation, transfers to any one affiliate are limited to 10.0 percent of capital and surplus. At December 31, 2016, the maximum amount available for transfer from the Bank to the Company in the form of loans amounted to $4,427. At December 31, 2016 and 2015, there were no loans outstanding, nor were any advances made during 2016 and 2015. The Federal Reserve Board ( the “Board”) approved a final rule in 2006 that expands the definition of a small bank holding company (“BHC”) under the Board’s Small Bank Holding Company Policy Statement and risk-based and leverage capital guidelines for bank holding companies. In 2015, the Board increased the asset limit to qualify as a small bank holding company from $500 million to $1 billion. Currently, the Company meets the eligibility criteria of a small BHC and is exempt from risk-based capital and leverage rules, including Basel III. The Bank is subject to certain regulatory capital requirements administered by the federal banking agencies, which are defined in Section 38 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”). Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s consolidated financial statements. In the event an institution is deemed to be undercapitalized by such standards, FDICIA prescribes an increasing amount of regulatory intervention, including the required institution of a capital restoration plan and restrictions on the growth of assets, branches or lines of business. Further restrictions are applied to the significantly or critically undercapitalized institutions including restrictions on interest payable on accounts, dismissal of management and appointment of a receiver. For well capitalized institutions, FDICIA provides authority for regulatory intervention when the institution is deemed to be engaging in unsafe and unsound practices or receives a less than satisfactory examination report rating. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. New risk-based capital rules became effective January 1, 2015 requiring the Bank to maintain a “capital conservation buffer” of 250 basis points in excess of the “minimum capital ratio.” The minimum capital ratio is equal to the prompt corrective action adequately capitalized threshold ratio. The capital conservation buffer will be phased in over four years beginning on January 1, 2016, with a maximum buffer of 0.625% of risk weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. Failure to maintain the required capital conservation buffer will result in limitations on capital distributions and on discretionary bonuses to executive officers. The Bank was categorized as “well capitalized” under the regulatory guidance at December 31, 2016 and 2015, based on the most recent notification from the Federal Deposit Insurance Corporation. To be categorized as well capitalized, the Bank must maintain certain minimum Tier I risk-based, total risk-based, Tier I Leverage and Common equity Tier I risk-based capital ratios as set forth in the following tables. The Tier I Leverage ratio is defined as Tier I capital to total average assets less intangible assets. There are no conditions or events since the most recent notification that management believes have changed the Bank’s category. The Bank’s capital ratios and the minimum ratios required for capital adequacy purposes to be considered well capitalized under the prompt corrective action provisions are summarized below for the years ended December 31, 2016 and 2015: 18. Contingencies: Riverview Bank and two unrelated, third-parties have been named as defendants in a lawsuit brought on behalf of a group of 58 plaintiffs filed on March 31, 2016. The complaint against Riverview Bank relates to an IOLTA account at the Bank and alleges that the Bank failed to properly monitor and detect fraudulent activity engaged in by the owner of the account. The lawsuit seeks damages from the defendants, including the Bank, alleged to be in excess of $11.3 million, treble damages and attorneys’ fees with respect to alleged violations of the Pennsylvania Unfair Trade Practices and Consumer Protection Law, punitive damages, plus interest and costs. Riverview believes that the allegations against it are without merit and it will continue to defend against plaintiffs’ claims. Even if the litigation were determined adversely to the Bank, the Bank believes the impact on the Bank would not be material. In the opinion of the Company, after review with legal counsel, there are no other proceedings pending to which the Company is a party or to which its property is subject, which, if determined adversely to the Company, would be material in relation to the Company’s consolidated financial condition. There are no proceedings pending other than ordinary, routine litigation incident to the business of the Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company by governmental authorities. Neither the Company nor any of its property is subject to any material legal proceedings. Management, after consultation with legal counsel, does not anticipate that the ultimate liability, if any, arising out of pending and threatened lawsuits will have a material effect on the operating results or financial position of the Company 19. Subsequent Events: On January 20, 2017, the Company completed the sale of approximately $17.0 million in common and preferred equity, before expenses, to accredited investors and qualified institutional buyers through the private placement of 269,885 shares of its no par value common stock at a price of $10.50 per share and 1,348,809 shares of a newly created series of convertible, perpetual stock at a price of $10.50 per share. The Company plans to use the additional capital for general corporate purposes.
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This appears to be a partial financial statement focused primarily on investment securities accounting policies rather than a complete financial statement. Here are the key points:
1. Time Period: Year ended December 31, 2016
2. Investment Securities Classification:
- All securities were classified as "available-for-sale" in 2016
- Three possible classifications exist:
* Held-to-maturity
* Available-for-sale
* Trading account securities
3. Key Accounting Practices:
- Available-for-sale securities are reported at fair value
- Unrealized gains/losses are excluded from earnings
- Fair values are based on market prices from a national pricing service
- Realized gains/losses use specific identification method
4. Notable Estimates Include:
- Allowance for loan losses
- Fair value of financial instruments
- Valuation of real estate from foreclosures
- Deferred tax assets
- Impairment assessments
Note: The text provided appears to be more of an accounting policy disclosure than a traditional financial statement, as it lacks specific numerical figures for profit/loss, expenses, and liabilities.
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Claude
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ACCOUNTING FIRM Board of Directors and Shareholders of Frequency Electronics, Inc. We have audited the accompanying consolidated balance sheets of Frequency Electronics, Inc. and Subsidiaries (the "Company") as of April 30, 2016 and 2015, and the related consolidated statements of income, comprehensive income, cash flows and changes in stockholders' equity for each of the years then ended. The financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Frequency Electronics, Inc. and Subsidiaries as of April 30, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America. /s/ EisnerAmper LLP EisnerAmper LLP New York, New York July 29, 2016 FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES Consolidated Balance Sheets April 30, 2016 and 2015 (In thousands, except par value) The accompanying notes are an integral part of these financial statements. FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES Consolidated Statements of Income and Comprehensive Income Years ended April 30, 2016 and 2015 Consolidated Statements of Income The accompanying notes are an integral part of these financial statements. FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES Consolidated Statements of Cash Flows Years ended April 30, 2016 and 2015 The accompanying notes are an integral part of these financial statements - continued. FREQUENCY ELECTRONICS, INC. and SUBSIDIARIES Consolidated Statements of Cash Flows Years ended April 30, 2016 and 2015 (Continued) The accompanying notes are an integral part of these financial statements. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity Years ended April 30, 2016 and 2015 (In thousands, except share data) The accompanying notes are an integral part of these financial statements. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS April 30, 2016 and 2015 1. Summary of Accounting Policies Principles of Consolidation: The consolidated financial statements include the accounts of Frequency Electronics, Inc. and its wholly-owned subsidiaries (the "Company" or "Registrant"). References to “FEI” are to the parent company alone and do not refer to any of its subsidiaries. The Company is principally engaged in the design, development and manufacture of precision time and frequency control products and components for microwave integrated circuit applications. See Note 13 for information regarding the Company’s FEI-NY (which includes the subsidiaries FEI Government Systems, Inc., FEI Communications, Inc., Frequency Electronics, Inc. Asia (“FEI-Asia”) and FEI-Elcom Tech, Inc. (“FEI-Elcom”)), Gillam-FEI, and FEI-Zyfer business segments. Intercompany accounts and significant intercompany transactions are eliminated in consolidation. To accommodate the different fiscal periods of Gillam-FEI, the Company recognizes its share of net income or loss on a one month lag. Any material events which may occur during the intervening month at Gillam-FEI will be accounted for in the consolidated financial statements. These financial statements have been prepared in conformity with United States generally accepted accounting principles (“U.S. GAAP”) and require management to make estimates and assumptions that affect amounts reported and disclosed in the financial statements and related notes. Actual results could differ from these estimates. Cash Equivalents: The Company considers certificates of deposit and other highly liquid investments with maturities of three months or less when purchased to be cash equivalents. The Company places its temporary cash investments with high credit quality financial institutions. Such investments may at times be in excess of the FDIC and SIPC insurance limits. No losses have been experienced on such investments. Marketable Securities: Marketable securities consist of investments in common stocks, including exchange-traded funds, corporate debt securities and debt securities of U.S. Government agencies. All marketable securities were held in the custody of financial institutions; three institutions at April 30, 2016 and 2015. Investments in debt and equity securities are categorized as available for sale and are carried at fair value, with unrealized gains and losses excluded from income and recorded directly to stockholders' equity. The Company recognizes gains or losses when securities are sold using the specific identification method. Allowance for Doubtful Accounts: Losses from uncollectible accounts receivable are provided for by utilizing the allowance for doubtful accounts method based upon management’s estimate of uncollectible accounts. Management analyzes accounts receivable and the potential for bad debts, customer concentrations, credit worthiness, current economic trends and changes in customer payment terms when evaluating the amount recorded for the allowance for doubtful accounts. Property, Plant and Equipment: Property, plant and equipment are recorded at cost and include interest on funds borrowed to finance construction. Expenditures for renewals and betterments are capitalized; maintenance and repairs are charged to income when incurred. When fixed assets are sold or retired, the cost and related accumulated depreciation and amortization are eliminated from the respective accounts and any gain or loss is credited or charged to income. If events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable, the Company estimates the future cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the long-lived asset, an impairment loss is recognized. To date, no impairment losses have been recognized. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Inventories: Inventories, which consist of finished goods, work-in-process, raw materials and components, are accounted for at the lower of cost (specific and average) or market. Depreciation and Amortization: Depreciation of fixed assets is computed on the straight-line method based upon the estimated useful lives of the assets (40 years for buildings and 3 to 10 years for other depreciable assets). Leasehold improvements and equipment acquired under capital leases are amortized on the straight-line method over the shorter of the term of the lease or the useful life of the related asset. Amortization of identifiable intangible assets is based upon the expected lives of the assets and is recorded at a rate which approximates the Company’s utilization of the assets. Intangible Assets: Intangible assets consist of the ISO 9000 certification arising from the acquisition of FEI-Elcom in the assignment of fair value to its acquired assets including intangibles. The certification is valued at fair value and was amortized over the estimated useful life of 3 years from the date of acquisition. Goodwill: The Company records goodwill as the excess of purchase price over the fair value of identifiable net assets acquired. Goodwill is tested for impairment on at least an annual basis at year end. When it is determined that the carrying value of goodwill may not be recoverable, the Company writes down the goodwill to an amount commensurate with the revised value of the acquired assets. The Company measures impairment based on revenue projections, recent transactions involving similar businesses and price/revenue multiples at which they were bought and sold, price/revenue multiples of competitors, and the present market value of publicly-traded companies in the Company’s industry. Revenue and Cost Recognition: Revenues under larger, long-term contracts, which generally require billings based on achievement of milestones rather than delivery of product, are reported in operating results using the percentage of completion method. For U.S. Government and other fixed-price contracts that require initial design and development of the product, revenue is recognized on the cost-to-cost method. Under this method, revenue is recorded based upon the ratio that incurred costs bear to total estimated contract costs with related cost of sales recorded as the costs are incurred. Costs and estimated earnings in excess of billings on uncompleted contracts, net of billings on uncompleted contracts in excess of costs and estimated earnings, are included in current assets. On production-type orders, revenue is recorded as units are delivered with the related cost of sales recognized on each shipment based upon a percentage of estimated final program costs. Changes in job performance on long-term and production-type orders may result in revisions to costs and revenue and are recognized in the period in which revisions are determined to be required. Provisions for the full amount of anticipated losses are made in the period in which they become determinable. For customer orders in the Company’s subsidiaries, and smaller contracts or orders in the other business segments, sales of products and services to customers are reported in operating results upon shipment of the product or performance of the services pursuant to terms of the customer order. Contract costs include all direct material, direct labor costs, manufacturing overhead and other direct costs related to contract performance. Selling, general and administrative costs are charged to expense as incurred. In accordance with industry practice, inventoried costs contain amounts relating to contracts and programs with long production cycles, a portion of which will not be realized within one year. Program costs for which production-level orders cannot be determined as probable are written down in the period in which that assessment is made. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes changes in unrealized gains or losses, net of tax, on securities available for sale during the year and the effects of foreign currency translation adjustments. Research and Development Expenses: The Company engages in research and development activities to identify new applications for its core technologies, to improve existing products and to improve manufacturing processes to achieve cost reductions and manufacturing efficiencies. Research and development costs include direct labor, manufacturing overhead, direct materials and contracted services. Such costs are expensed as incurred. Income Taxes: The Company recognizes deferred tax liabilities and assets based on the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established and adjusted when necessary to increase or reduce deferred tax assets to the amount expected to be realized. The Company analyzes its tax positions under accounting standards which prescribe recognition thresholds that must be met before a tax benefit is recognized in the financial statements and provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. An entity may only recognize or continue to recognize tax positions that meet a "more likely than not" threshold. When and if the Company were to recognize interest or penalties related to income taxes, it would be reported net of the federal tax benefit in the tax provision. Earnings Per Share: Basic earnings per share are computed by dividing net earnings by the weighted average number of shares of common stock outstanding. Diluted earnings per share are computed by dividing net earnings by the sum of the weighted average number of shares of common stock and the if-converted effect of unexercised stock options and stock appreciation rights. Fair Values of Financial Instruments: Cash and cash equivalents, short-term credit obligations, long term debt and cash surrender value are reflected in the accompanying consolidated balance sheets at amounts considered by management to reasonably approximate fair value based upon the nature of the instrument and current market conditions. Management is not aware of any factors that would significantly affect the value of these amounts. The Company also has an investment in a privately-held company, Morion, Inc. (“Morion”). The Company is unable to reasonably estimate a fair value for this investment. Foreign Operations and Foreign Currency Adjustments: The Company maintains manufacturing operations in Belgium and the People’s Republic of China. The Company is vulnerable to currency risks in these countries. The local currency is the functional currency of each of the Company’s non-U.S. subsidiaries. No foreign currency gains or losses are recorded on intercompany transactions since they are effected at current rates of exchange. The results of operations of foreign subsidiaries, when translated into U.S. dollars, reflect the average rates of exchange for the periods presented. The balance sheets of foreign subsidiaries, except for equity accounts which are translated at historical rates, are translated into U.S. dollars at the rates of exchange in effect on the date of the balance sheet. As a result, similar results in local currency can vary upon translation into U.S. dollars if exchange rates fluctuate significantly from one period to the next. Equity-based Compensation: The Company values its share-based payment transactions using the Black-Scholes valuation model. Such value is recognized as expense on a straight-line basis over the service period of the awards, which is generally the vesting period, net of estimated forfeitures. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The weighted average fair value of each option or stock appreciation right (“SAR”) has been estimated on the date of grant using the Black-Scholes option pricing model with the following range of weighted average assumptions used for grants: The expected life assumption was determined based on the Company’s historical experience as well as the term of recent SAR agreements. The expected volatility assumption was based on the historical volatility of the Company’s common stock. The dividend yield assumption was determined based upon the Company’s past history of dividend payments and the Company’s current decision to suspend payment of dividends. The risk-free interest rate assumption was determined using the implied yield currently available for zero-coupon U.S. Government issues with a remaining term equal to the expected life of the stock options or SARs. Concentration of Credit Risk Financial instruments, which potentially subject the Company to concentration of credit risk, consist principally of cash and cash equivalents and trade receivables. The Company maintains accounts at several commercial banks at which the balances exceed Federal Deposit Insurance Corporation limits. The Company has not experienced any losses on such amounts. Concentration of credit risk with respect to trade receivables is generally diversified due to the large number of entities comprising the Company’s customer base and their dispersion across geographic areas principally within the United States. The Company routinely addresses the financial strength of its customers and, as a consequence, believes that its receivable credit risk exposure is limited. The Company does not require customers to post collateral. New Accounting Pronouncements: In March 2016, the Financial Accounting Standards Board (“FASB”) amended the existing accounting standards for stock-based compensation, Accounting Standards Update (“ASU”) 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments impact several aspects of accounting for share-based payment transactions, including the income tax consequences, forfeitures, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This guidance requires a mix of prospective, modified retrospective, and retrospective transition to all annual and interim periods presented and is effective for the Company beginning in fiscal 2018. The Company has not determined the full impact of implementation of this standard, but does not expect it will have a material effect on the Company’s financial condition or results of operations. In February 2016, the FASB issued ASU No. 2016-02 Leases (Topic 842). The objective of the update is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The amendments of the ASU 2016-02 are effective for fiscal years beginning after December 31, 2018 and early adoption is permitted. The Company is currently evaluating the impact of this standard on our consolidated financial statements. In November 2015, the FASB issued ASU No. 2015-17 (“ASU 2015-17”), Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. The amendments in ASU 2015-17 seek to simplify the presentation of deferred income taxes and require that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods, with early application permitted for all entities as of the beginning of an interim or annual reporting period. The Company has not determined the full impact of implementation of this standard, but believes it will not be material to net income. The Company believes that the main impact of adoption of the standard will be the reclassification of current deferred tax assets to an increase in noncurrent deferred tax assets for the period ending April 30, 2018. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory (“ASU 2015-11”) which changes the measurement principle for inventory from the lower of cost or market to the lower of cost or net realizable value. ASU 2015-11 defines net realizable value as estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The new guidance must be applied on a prospective basis and is effective for periods beginning after December 15, 2016, with early adoption permitted. The Company is currently evaluating the effect that the new guidance will have on its consolidated financial statements. In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”), which is effective for annual periods after December 15, 2016 and for annual periods and interim periods thereafter. Early application is permitted. Under ASU 2014-15, entities will be required to formally assess their ability to continue as a going concern and provide disclosures under certain circumstances. While current practice regarding such disclosures is often guided by U.S. auditing standards, the new standard explicitly requires the assessment at interim and annual periods, and provides management with its own disclosure guidance. The standard can be adopted early. The company is currently assessing the impact that adopting these new assessment and disclosure requirements will have on its financial statements and footnote disclosures. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 eliminates most of the existing industry-specific revenue recognition guidance and significantly expands related disclosures. The required disclosures will include both quantitative and qualitative information about the amount, timing and uncertainty of revenue from contracts with customers and the significant judgments used. Entities can retrospectively apply ASU 2014-09 or use an alternative transition method. In July 2015, the FASB approved a one-year deferral of the effective date of this ASU. Although the amending ASU has not yet been issued, since it will be amended, this ASU is effective for public companies for annual reporting periods beginning on or after December 15, 2017 and for the Company, must be adopted for its fiscal year 2019 beginning on May 1, 2018. The Company is in the process of determining the effect that ASU 2014-09 may have on its financial statements. 2. Earnings Per Share Reconciliations of the weighted average shares outstanding for basic and diluted Earnings Per Share are as follows: Dilutive securities consist of unexercised stock options and stock appreciation rights (“SARS”). The computation of diluted shares outstanding excludes those options and SARS with an exercise price in excess of the average market price of the Company’s common shares during the periods presented. The inclusion of such options and SARS in the computation of earnings per share would have been antidilutive. For the years ended April 30, 2016 and 2015, the number of excluded options and SARS were 388,625 and 271,500, respectively. 3. Costs and Estimated Earnings in Excess of Billings At April 30, 2016 and 2015, costs and estimated earnings in excess of billings, net, consist of the following: FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Such amounts represent revenue recognized on long-term contracts that had not been billed at the balance sheet dates or represent a liability for amounts billed in excess of the revenue recognized. Amounts are billed to customers pursuant to contract terms. In general, the recorded amounts will be billed and collected or revenue recognized within twelve months of the balance sheet date. Revenue on these long-term contracts is accounted for on the percentage of completion basis. During the years ended April 30, 2016 and 2015, revenue recognized under percentage of completion contracts was approximately $32.5 million and $46.8 million, respectively. If contract losses are anticipated, costs and estimated earnings in excess of billings are reduced for the full amount of such losses when they are determinable. Total anticipated contract losses at April 30, 2016 and 2015 were approximately $450,000 and $400,000, respectively. 4. Inventories Inventories at April 30, 2016 and 2015, respectively, consisted of the following (in thousands): As of April 30, 2016 and 2015, approximately $35.3 million and $32.0 million, respectively, of total inventory is located in the United States, approximately $5.0 million and $5.4 million, respectively, is located in Belgium and approximately $1.0 million and $0.8 million, respectively, is located in China. The company buys inventory in bulk quantities which may be used over significant time periods; due to its nature the inventory does not deteriorate. 5. Property, Plant and Equipment and Leases Property, plant and equipment at April 30, 2016 and 2015, consists of the following (in thousands): Depreciation and amortization expense for the years ended April 30, 2016 and 2015 was $2,660,000 and $2,828,000, respectively. Maintenance and repairs charged to operations for the years ended April 30, 2016 and 2015 was approximately $611,000 and $1,017,000, respectively. The Company leases its Long Island, New York headquarters building at an annual rent of $800,000 following the Company’s exercise of its option to renew the lease for a second 5-year period. The lease will end in January 2019. Under the terms of the lease, the Company is required to pay its proportionate share of real estate taxes, insurance and other charges. In addition, the Company’s subsidiaries in New Jersey, China, France and California lease their office and manufacturing facilities. FEI-Elcom leases 32,000 square feet of office and manufacturing space at current monthly rental of approximately $40,000 through the end of the lease which expires in March 2018. The lease for the FEI-Asia facility is for a one-year term with monthly rent of $5,000 through February 2017. FEI-Zyfer leases office and manufacturing space encompassing 27,850 square feet. Monthly rental payments are currently $31,200 for the remaining 16 months of the lease term. Satel-FEI, a wholly-owned subsidiary of Gillam-FEI, occupies office space under a 9-year lease, cancelable after three years, at an approximate rate of $1,000 per month. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Rent expense under operating leases was approximately $1.5 million for both fiscal years ended April 30, 2016 and 2015. The Company records rent expense on its New York building and FEI-Zyfer facility on the straight-line method over the lives of the respective leases. As a result, as of April 30, 2016 and 2015, the Company’s balance sheet includes deferred rent payable of approximately $214,000 and $290,000, respectively, which will be recognized over the respective rental periods. Future noncancellable minimum lease payments required by the operating leases are as follows (in thousands): 6. Marketable Securities The cost, gross unrealized gains, gross unrealized losses and fair market value of available-for-sale securities at April 30, 2016 and 2015 are as follows (in thousands): The following table presents the fair value and unrealized losses, aggregated by investment type and length of time that individual securities have been in a continuous unrealized loss position: FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The Company regularly reviews its investment portfolio to identify and evaluate investments that have indications of possible impairment. The Company does not believe that its investments in marketable securities with unrealized losses at April 30, 2016 are other-than-temporary due to market volatility of the security’s fair value, analysts’ expectations and the Company’s ability to hold the securities for a period of time sufficient to allow for any anticipated recoveries in market value. Proceeds from the sale or redemption of available-for-sale securities and the resulting gross realized gains and losses included in the determination of net income (loss) are as follows (in thousands): Maturities of fixed income securities classified as available-for-sale at April 30, 2016 are as follows (at cost, in thousands): The fair value accounting framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy are described below: Level 1 Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access. Level 2 Inputs to the valuation methodology include: - Quoted prices for similar assets or liabilities in active markets; - Quoted prices for identical or similar assets or liabilities in inactive markets - Inputs other than quoted prices that are observable for the asset or liability; - Inputs that are derived principally from or corroborated by observable market data by correlation or other means. Level 3 Inputs to the valuation methodology are unobservable and significant to the fair value measurement. The asset’s or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs. All of the Company’s investments in marketable securities are Level 1 assets. 7. Debt Obligations On June 6, 2013, the Company obtained a credit facility (the “Facility”) from JPMorgan Chase Bank, N.A. (“JPMorgan”) pursuant to a credit agreement (the “Credit Agreement”) between the Company and JPMorgan. The maximum aggregate amount of the Facility is $25.0 million. Proceeds from the Facility will be used for working capital and to finance acquisitions. During the year ended April 30, 2015, the Company borrowed an additional $2.3 million under the Facility primarily to finance the acquisition of additional manufacturing equipment and repaid an aggregate of $6.4 million from its operating cash flow and as a result of redemptions of certain fixed income marketable securities. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The Company may make borrowings under the Facility, from either Tranche A or Tranche B or a combination of both, not to exceed $25.0 million. Pursuant to the Credit Agreement, the amount of Tranche A borrowings may not exceed the value of the Pledged Investments (as defined in the Credit Agreement). The amount of Tranche B borrowings may not exceed the lesser of (i) $15.0 million and (ii) the Borrowing Base (as defined in the Credit Agreement). Current outstanding borrowings under the Facility are all under Tranche A. The Facility is fully guaranteed by certain of the Company’s subsidiaries and is secured by, among other things, a pledge of substantially all personal property of the Company and certain of the Company’s subsidiaries. Borrowings under the Facility are evidenced by a line of credit note (the “Note”) and bear interest, payable monthly, at a rate equal to the LIBOR Rate, as determined from time to time by JPMorgan pursuant to the terms of the Note, plus a margin of 0.75% for Tranche A borrowings and 1.75% for Tranche B borrowings. At April 30, 2016 and 2015, the rate was 1.1913% and 0.9305%, respectively, based on the one-month LIBOR rate. The principal balance on the Note, along with any accrued and unpaid interest, is due and payable no later than June 5, 2018, which is the maturity date of the Facility. In addition, the Company is required to pay JPMorgan fees equal to 0.1% per annum on any unused portion of the Facility. The Credit Agreement contains a number of affirmative and negative covenants, including limitations on the incurrence of additional debt, liens on property, acquisitions, loans and guarantees, mergers, consolidations, liquidations and dissolutions, asset sales, and distributions and other payments in respect of the Company’s capital stock. The Credit Agreement also contains certain events of default customary for credit facilities of this type, including nonpayment of principal or interest when due, material incorrectness of representations and warranties when made, breach of covenants, bankruptcy and insolvency, unstayed material judgment beyond specified periods, and acceleration or payment default of other material indebtedness. The Credit Agreement requires the Company to maintain, as of the end of each fiscal quarter, a funded debt to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) ratio and, if there are any borrowings under Tranche B, an interest charge coverage ratio. The calculation of both ratios is defined in the Credit Agreement. For the year ended April 30, 2016, the Company met the required covenants for its borrowings under Tranche A. The Company’s European subsidiaries have available 250,000 Euros (approximately $275,000 based on current rates of exchange between the dollar and the Euro) in a bank credit line to meet short-term cash flow requirements. As of April 30, 2016 and 2015, no amounts were outstanding under such line of credit. Borrowings under the bank credit line, if any, must be repaid within one year of receipt of funds. Interest on this credit line is at 1.0% over the EURO Interbank Offered rate (EURIBOR). At April 30, 2016 and 2015, the rate was 0.692% and 1.12% respectively, based on the one-month EURIBOR. 8. Accrued Liabilities Accrued liabilities at April 30, 2016 and 2015 consist of the following (in thousands): FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 9. Investment in Morion, Inc. The Company has an investment in Morion, Inc., a privately-held Russian company, which manufactures high precision quartz resonators and crystal oscillators. The Company’s investment consists of 4.6% of Morion’s outstanding shares, accordingly, the Company accounts for its investment in Morion on the cost basis. This investment is included in other assets in the accompanying balance sheets. During the fiscal years ended April 30, 2016 and 2015, the Company acquired product from Morion in the aggregate amount of approximately $140,000 and $201,000, respectively, and the Company sold product to Morion in the aggregate amount of approximately $845,000 and $615,000, respectively. At April 30, 2016, accounts receivable included $33,000 due from Morion and $37,000 was payable to Morion. On October 22, 2012, the Company entered into an agreement to license its rubidium oscillator production technology to Morion. The agreement required the Company to sell certain fully-depreciated production equipment previously owned by the Company and to provide training to Morion employees to enable Morion to produce a minimum of 5,000 rubidium oscillators per year. Morion will pay the Company approximately $2.7 million for the license and the equipment plus 5% royalties on third party sales for a 5-year period following an initial production run. During the same 5-year period, the Company commits to purchase from Morion a minimum of approximately $400,000 worth of rubidium oscillators per year although Morion is not obligated to sell that amount to the Company. During the fiscal year ended April 30, 2016, sales to Morion included $375,000 for product and training services under this agreement. Per the amended agreement, the balance of $1 million for the transfer of the license will be due once the United States Department of State (“State Department”) approves the removal of certain provisions of the original agreement. The State Department has approved the technology transfer called for under the agreement. On March 29, 2016, the Company renegotiated the $1 million dollar amendment under the original agreement dated October 22, 2012 to $602,000 due to the U.S. Government easing of export regulations. Of this amount $392,500 was billed and paid during FY 2016 and the balance of $210,000 will be billed during FY 2017. 10. Goodwill and Other Intangible Assets During fiscal year 2004, the Company acquired FEI-Zyfer, Inc. (“FEI-Zyfer”). This acquisition resulted in the recording of $218,000 in goodwill. In February 2012, the Company acquired FEI-Elcom resulting in the recording of goodwill in the amount of $398,000 plus other intangible assets with a value of $275,000. Management has determined that goodwill is not impaired as of April 30, 2016 and 2015. The other intangible assets were amortized over a three-year period from the date of acquisition. Amortization expense for the year ended April 30, 2015 was approximately $73,000. As of April 30, 2015 these intangible assets were fully amortized. 11. Employee Benefit Plans Profit Sharing Plan: The Company provides its U.S.-based employees with a profit sharing plan and trust under section 401(k) of the Internal Revenue Code. This plan allows all eligible employees to defer a portion of their income through voluntary contributions to the plan. In accordance with the provisions of the plan, the Company can make discretionary matching contributions in the form of cash or common stock. For the years ended April 30, 2016 and 2015, the Company contributed 46,743 and 40,324 shares of common stock, respectively. The approximate value of these shares at the date of contribution was $498,000 in fiscal year 2016 and $485,000 in fiscal year 2015. Contributed shares are drawn from the Company’s common stock held in treasury and are removed at the Company’s original cost of acquisition of such shares on a specific identification basis. In addition to changes in the treasury stock accounts, during fiscal years 2016 and 2015, such transactions increased additional paid in capital by $283,000 and $302,000, respectively. As of April 30, 2016, all shares of the Company’s common stock held by the two plans were combined for an aggregate holding of 790,136 shares, which are allocated to the accounts of the individual participants. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 On May 6, 2015, the ESOP Plan (see below) was merged into the Company’s profit sharing plan. As of April 30, 2015, the profit sharing plan held an aggregate of 467,975 shares of the Company’s common stock allocated to the accounts of the individual participants. Income Incentive Pool: The Company maintains incentive bonus programs for certain employees which are based on operating profits of the individual subsidiaries to which the employees are assigned. The Company also adopted a plan for the President and Chief Executive Officer of the Company, which formula is based on consolidated pre-tax profits. Under these plans, the Company charged approximately $0.7 million and $1.3 million to selling and administrative expenses for the fiscal years ended April 30, 2016 and 2015, respectively. Employee Stock Plans: The Company has various stock plans, some of which have been approved by the Company’s stockholders, for key management employees, including officers and directors who are employees, certain consultants and independent members of the Board of Directors. The plans are Nonqualified Stock Options (“NQSO”) plans, Incentive Stock Option ("ISO”) plans and Stock Appreciation Rights (“SARS”). Under these plans, options or SARS are granted at the discretion of the Stock Option Committee at an exercise price not less than the fair market value of the Company's common stock on the date of grant. Typically, options and SARS vest over a four-year period from the date of grant. The options and SARS generally expire ten years after the date of grant (the most recent SAR award expires in five years) and are subject to certain restrictions on transferability of the shares obtained on exercise. Under the Company’s 2005 Stock Award Plan (“Plan”) the Company provided option holders the opportunity to exercise stock options either by paying the exercise price for the shares or to do a cashless exercise whereby the individual receives the net number of shares of stock equal in value to the exercised number of shares times the difference between the current market value of the Company’s stock and the exercise price. Under the Plan, instruments granted under other plans which expire, are canceled, or are tendered in the exercise of such instruments, increase the shares available under the Plan. As of April 30, 2013, a consultant, who is the son of the Company’s president, had been granted options to purchase 37,500 shares of Company stock under NQSO plans at a weighted average exercise price of $6.67. During the year ended April 30, 2015, the consultant elected cashless exercises of 20,000 shares at an exercise price of $6.67, resulting in a net issuance of 8,638 shares. As of April 30, 2015, the consultant has no outstanding stock options. At the beginning of fiscal year 2015, eligible employees had been granted options to purchase approximately 172,500 shares of which 95,000 options with a weighted average exercise price of $13.15 were outstanding and exercisable. During the year ended April 30, 2015, 57,000 options expired and were returned to the Plan. The remaining 38,000 shares were exercised by the employees using the cashless method resulting in the net issuance of 6,931 shares of Company stock. Total fiscal year 2015 cashless exercises of stock options under ISO and NQSO plans, including the consultant shares above, aggregated 58,000 shares. Accordingly, the Company issued 15,569 shares on exercise and returned 42,431 shares to the pool of available shares which may be used for future grants under the Plan. As of April 30, 2016, eligible employees and directors have been granted SARS based on approximately 2,021,000 shares of Company stock, of which approximately 1,653,000 shares are outstanding and approximately 1,314,000 shares with a weighted average exercise price of $8.45 are exercisable. As of April 30, 2015, eligible employees and directors had been granted SARS based on approximately 1,950,000 shares of Company stock, of which approximately 1,603,000 shares were outstanding and approximately 1,131,000 shares with a weighted average exercise price of $8.27 were exercisable. When the SARS become exercisable, the Company will settle the SARS by issuing to exercising recipients the number of shares of stock equal to the appreciated value of the Company’s stock between the grant date and exercise date. At the time of exercise, the quantity of shares under the SARS grant equal to the exercise value divided by the then market value of the shares will be returned to the pool of available shares for future grant under the Plan. During the year ended April 30, 2016, employees exercised SARS representing 19,500 shares of Company stock and received 5,736 shares of Company stock. The 13,764 share difference was returned to the pool of available shares and may be used for future grants. During the year ended April 30, 2015, employees exercised SARS representing 147,500 shares of Company stock and received 70,675 shares of Company stock. The 76,825 share difference was returned to the pool of available shares and may be used for future grants. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The excess of the consideration received over the par value of the common stock or cost of treasury stock issued under both types of option plans is recognized as an increase in additional paid-in capital. The following table summarizes information about stock option and stock appreciation rights activity for the years ended April 30: As of April 30, 2016, total unrecognized compensation cost related to nonvested options and stock appreciation rights under the plans was approximately $1,094,000. These costs are expected to be recognized over a weighted average period of 2.3 years. During the years ended April 30, 2016 and 2015, 151,500 and 244,625 shares, respectively, vested, the fair value of which was approximately $661,000 and $1,053,000, respectively. The weighted average grant date fair value of stock appreciation rights granted during the years ended April 30, 2016 and 2015, were approximately $4.06 and $4.45, respectively. Stock-based compensation costs capitalized as part of work in process inventory or included in the cost of sales of programs on which the Company recognizes revenue under the percentage of completion method were approximately $265,000 and $394,000 for the years ended April 30, 2016 and 2015, respectively. Selling and administrative expenses include stock-based compensation expense of approximately $559,000 and $683,000 for the years ended April 30, 2016 and 2015, respectively. The Company classifies cash flows resulting from the tax benefits from tax deductions recognized upon the exercise of stock options or SARS (tax benefits) as financing cash flows. For the years ended April 30, 2016 and 2015, the Company realized $141,000 and $200,000 respectively, of tax benefits from the exercise of stock options and SARS. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Independent Contractor Stock Option Plan: The Company had an Independent Contractor Stock Option Plan under which up to 350,000 shares could be granted. This plan was terminated in fiscal year 2006. An Independent Contractor Stock Option Committee determined to whom options may be granted from among eligible participants, the timing and duration of option grants, the option price, and the number of shares of common stock subject to each option. Options were granted to certain independent contractors at a price equal to the then fair market value of the Company’s common stock. The options were exercisable over specified periods per terms of the individual agreements. No compensation expense was recorded during the year ended April 30, 2015 as no other grants were made in those years and previous grants have been fully expensed. As a result of the adoption by the stockholders of the 2005 Stock Award Plan, the Independent Contractor Stock Option Plan was discontinued. No additional grants will be made under this plan and the outstanding grant of an option for 30,000 shares at an exercise price of $14.76 expired during fiscal year 2015. Restricted Stock Plan: During fiscal year 1990, the Company adopted a Restricted Stock Plan which provided that key management employees could be granted rights to purchase an aggregate of 375,000 shares of the Company's common stock. The grants, transferability restrictions and purchase price were determined at the discretion of a special committee of the board of directors. The purchase price could not be less than the par value of the common stock. Transferability of shares is restricted for a four-year period, except in the event of a change in control as defined. As a result of the adoption by the Company’s stockholders of the 2005 Stock Award Plan, the Restricted Stock Plan was discontinued. No additional grants will be made under this plan. As of April 30, 2016 and 2015, grants for 7,500 shares are available to be purchased at a price of $4.00 per share. Employee Stock Ownership Plan/Stock Bonus Plan: During 1990, the Company amended its Stock Bonus Plan to become an Employee Stock Ownership Plan (“ESOP”). By means of a bank note, subsequently repaid, the Company reacquired 561,652 shares of its common stock during fiscal year 1990. These shares plus approximately 510,000 additional shares issued by the Company from its authorized, unissued shares were sold to the ESOP in May 1990. Shares were released for allocation to participants based on a formula as specified in the ESOP document. By the end of fiscal year 2000, all shares (1,071,652) had been allocated to participant accounts of which 385,626 shares remain in the ESOP. On May 6, 2015, the ESOP plan was merged into the Company’s profit sharing plan. Deferred Compensation Agreements: The Company has a series of agreements with key employees providing for the payment of benefits upon retirement or death. Under these agreements, each key employee receives specified retirement payments for the remainder of the employee's life with a minimum payment of ten years' benefits to either the employee or his beneficiaries. The agreements also provide for lump sum payments upon termination of employment without cause and reduced benefits upon early retirement. The Company pays the benefits out of its working capital, but has also purchased whole life or term life insurance policies on the lives of certain of the participants to cover the optional lump sum obligations of the agreements upon the death of the participant. Deferred compensation expense charged to selling and administrative expenses during the years ended April 30, 2016 and 2015 was approximately $959,000 and $1,038,000, respectively. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Life Insurance Policies and Cash Held in Trust: The whole-life insurance policies on the lives of certain participants covered by deferred compensation agreements have been placed in a trust. Upon the death of any insured participant, cash received from life insurance policies in excess of the Company’s deferred compensation obligations to the estate or beneficiaries of the deceased, are also placed in the trust. These assets belong to the Company until a change of control event, as defined in the trust agreement, should occur. At that time, the Company is required to add sufficient cash to the trust so as to match the deferred compensation liability described above. Such funds will be used to continue the deferred compensation arrangements following a change of control. 12. Income Taxes The income before provision for income taxes consisted of (in thousands): The provision for income taxes consists of the following (in thousands): The following table reconciles the reported income tax expense with the amount computed using the federal statutory income tax rate (in thousands): FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The components of deferred taxes are as follows (in thousands): The components of the deferred tax asset, by balance sheet account, were as follows (in thousands): A valuation allowance is provided when it is more likely than not that some portion, or all, of the deferred tax assets will not be realized. We consider the level of historical income, scheduled reversal of temporary differences, tax planning strategies and projected future taxable income in determining whether a valuation allowance is warranted. The valuation allowance of $3.3 million as of April 30, 2016, is intended to provide for uncertainty regarding the ultimate realization of U.S. state investment tax credit carryovers and foreign net operating loss and tax credit carryovers. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $10.8 million as of April 30, 2016, which is net of the valuation allowance. The consolidated valuation allowance increased by approximately $890,000 during the year ended April 30, 2016. The change consists of an $830,000 deferred tax provision plus a foreign exchange adjustment and reclass of deferred state taxes of $60,000. For the year ended April 30, 2015, the change in valuation allowance was an increase of $270,000 which consists of the $760,000 deferred tax provision less a foreign exchange adjustment of $490,000. At April 30, 2016, the Company has available approximately $6.4 million in net operating losses available to offset future income of certain of its foreign subsidiaries. These loss carryforwards have no expiration date. As a result of the acquisition of FEI-Elcom, the Company has a federal net operating loss carryforward of $4.4 million which may be applied in annually limited amounts to offset future U.S.-sourced taxable income over the next 15 years. As of April 30, 2016, the Company has state investment tax credits and foreign research and development credits of $838,000 and $425,000, respectively. The state investment tax credit expires beginning in 2023 through 2031. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The Company has evaluated its tax positions and has concluded that the tax positions meet the more-likely-than-not recognition threshold as specified under accounting standards. As such, the amount of unrecognized tax benefits at April 30, 2016 and April 30, 2015 were $0. As of April 30, 2016 and April 30, 2015 the Company had $0, accrued for the payment of interest and penalties. It is difficult to predict or estimate the change in the Company’s unrecognized tax benefits over the next twelve months as a result of the progression of ongoing tax audits or other events. The Company believes, however, that there should be no change during the next twelve months. The Company is subject to taxation in the U.S. and various state, local and foreign jurisdictions. Net operating losses generated by domestic and foreign entities in closed years and utilized in open years are subject to adjustment by the tax authorities. 13. Segment Information The Company operates under three reportable segments based on the geographic locations of its subsidiaries: (1) FEI-NY - operates out of New York and its operations consist principally of precision time and frequency control products used in three principal markets- communication satellites (both commercial and U.S. Government-funded); terrestrial cellular telephone or other ground-based telecommunication stations and other components and systems for the U.S. military. (2) Gillam-FEI - operates out of Belgium and France and primarily sells wireline synchronization and network management systems in non-U.S. markets. All sales from Gillam-FEI to the United States are to other segments of the Company. (3) FEI-Zyfer - operates out of California and its products incorporate Global Positioning System (GPS) technologies into systems and subsystems for secure communications, both government and commercial, and other locator applications. This segment also provides sales and support for the Company’s wireline telecommunications family of products, including US5G, which are sold in the United States market. The FEI-NY segment also includes the operations of the Company’s wholly-owned subsidiaries, FEI-Elcom and FEI-Asia. FEI-Asia functions as a manufacturing facility for the FEI-NY segment with historically minimal sales to outside customers. Beginning in late fiscal year 2014, FEI-Asia began shipping higher volumes of product to third parties as a contract manufacturer. FEI-Elcom, in addition to its own product line, provides design and technical support for the FEI-NY segment’s satellite business. The Company’s Chief Executive Officer measures segment performance based on total revenues and profits generated by each geographic location rather than on the specific types of customers or end-users. Consequently, the Company determined that the segments indicated above most appropriately reflect the way the Company’s management views the business. The accounting policies of the three segments are the same as those described in the “Summary of Significant Accounting Policies.” The Company evaluates the performance of its segments and allocates resources to them based on operating profit which is defined as income before investment income, interest expense and taxes. The European-based director of Gillam-FEI and the president of FEI-Zyfer manage the assets of these segments. All acquired assets, including intangible assets, are included in the assets of these two segments. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 The table below presents information about reported segments for each of the years ended April 30 with reconciliation of segment amounts to consolidated amounts as reported in the statement of operations or the balance sheet for each of the years (in thousands): **For fiscal years ended April 30, 2016 and 2015, includes Gillam-FEI intersegment sales of $847,000 and $1.5 million, respectively, to the FEI-NY and FEI-Zyfer segments. Such sales consist principally of design and development of automatic test equipment for satellite hardware production and manufacture of assemblies and units of a wireline synchronization product for ultimate production and sale in the U.S. In the Gillam-FEI segment, these transactions reduced the operating loss in each of the fiscal years. FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 Major Customers The Company's products are sold to both commercial and governmental customers. For the years ended April 30, 2016 and 2015, approximately 60% and 47% respectively, of the Company's sales were made under contracts to the U.S. Government or subcontracts for U.S. Government end-use. In fiscal year 2016, sales to four customers of the FEI-NY segment aggregated $30.7 million or 69% of that segment’s total sales. Two of these customers also exceeded 10% of the Company’s consolidated revenues. During the year ended April 30, 2016, in the Gillam-FEI segment, sales to one customer exceeded 10% of that segment’s revenues. In the FEI-Zyfer segment, two customers accounted for more than 10% of that segment’s sales. None of the customers in the Gillam-FEI and FEI-Zyfer segments accounted for more than 10% of consolidated revenues. In fiscal year 2015, sales to three customers of the FEI-NY segment aggregated $33.1 million or 53% of that segment’s total sales. Each of these customers also exceeded 10% of the Company’s consolidated revenues. During the year ended April 30, 2015, in the Gillam-FEI segment, sales to one customer exceeded 10% of that segment’s revenues. In the FEI-Zyfer segment, two customers accounted for more than 10% of that segment’s sales. None of the customers in the Gillam-FEI and FEI-Zyfer segments accounted for more than 10% of consolidated revenues. The loss by the Company of any one of these customers would have a material adverse effect on the Company’s business. The Company believes its relationship with these customers to be mutually satisfactory. Sales to major customers above can include commercial and governmental end users. Foreign Sales Revenues in each of the Company’s segments include sales to foreign governments or to companies located in foreign countries. Revenues, based on the location of the procurement entity and excluding intersegment sales, were derived from the following countries: 14. Product Warranties The Company generally provides its customers with a one-year warranty regarding the manufactured quality and functionality of its products. For some limited products, the warranty period has been extended. The Company establishes warranty reserves based on its product history, current information on repair costs and annual sales levels. Changes in the carrying amount of accrued product warranty costs are as follows (in thousands): FREQUENCY ELECTRONICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued April 30, 2016 and 2015 15. Other Comprehensive Income (Loss) Changes in Accumulated Other Comprehensive Income (“AOCI”) by component and reclassifications out of AOCI are as follows (in thousands): **The reclassification adjustments represent net realized gains on the sale or redemption of available-for-sale marketable securities that were reclassified from AOCI to Other income (expense), net.
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Based on the provided financial statement excerpts, here's a summary:
1. Revenue Structure:
- Revenue is reported by geographic location rather than customer type
- Performance evaluation is based on operating profit (income before investment income, interest expense, and taxes)
- European operations are managed through Gillam-FEI and FEI-Zyfer
2. Financial Reporting:
- Follows U.S. GAAP standards
- Financial statements for foreign operations are reported on a one-month lag
- Foreign currency transactions are translated to USD using current exchange rates
3. Key Financial Policies:
- Cash Equivalents: Includes investments with maturities of ≤3 months
- Marketable Securities: Includes common stocks, exchange-traded funds, and government debt securities
- Foreign Operations: Maintained in Belgium and China with associated currency risks
- Equity-based Compensation: Valued using Black-Scholes model
4. Asset Management:
- Long-lived assets are monitored for impairment
- No impairment losses reported to date
- Fixed asset sales/retirements are recorded with gains/losses reflected in income
5. Notable Risk Factors:
- Foreign currency exposure in Belgium and China operations
- Potential exposure above FDIC and SIPC insurance limits for cash investments
- Market risks associated with marketable securities
The statement appears to be primarily focused on accounting policies and operational structure rather than specific financial figures.
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Claude
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Item 8 - Report of Castaing, Hussey & Lolan, LLC Independent Registered Accounting Firm To the Shareholders and Board of Directors First Guaranty Bancshares, Inc. We have audited the accompanying consolidated balance sheets of First Guaranty Bancshares, Inc. and subsidiary as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2016. First Guaranty's management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by Management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Guaranty Bancshares, Inc. and subsidiary as of December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. We also audited, in accordance with the standards of the American Institute of Certified Public Accountants, First Guaranty Bancshares, Inc. and subsidiary's internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 30, 2017 expressed an unqualified opinion thereon. /s/ Castaing, Hussey & Lolan, LLC Castaing, Hussey & Lolan, LLC New Iberia, Louisiana March 30, 2017 FIRST GUARANTY BANCSHARES, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS See . 1 All share amounts have been restated to reflect the ten percent stock dividend paid December 17, 2015 to shareholders of record as of December 10, 2015. FIRST GUARANTY BANCSHARES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME See 1 All share and per share amounts have been restated to reflect the ten percent stock dividend paid December 17, 2015 to shareholders of record as of December 10, 2015. FIRST GUARANTY BANCSHARES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) See FIRST GUARANTY BANCSHARES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY See (1) Effective January 1, 2015, companies incorporated under Louisiana law became subject to the Louisiana Business Corporation Act (which replaces the Louisiana Business Corporation Law). Provisions of the Louisiana Business Corporation Act eliminate the concept of treasury stock and provide that shares reacquired by a company are to be treated as authorized but unissued shares. As a result of this change in law, shares previously classified as treasury stock were reclassified as a reduction to issued shares of common stock in the consolidated financial statements as of June 30, 2015, reducing the stated value of common stock and retained earnings. (2) All share and per share amounts reflect the ten percent stock dividend paid December 17, 2015 to shareholders of record as of December 10, 2015. FIRST GUARANTY BANCSHARES, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS See . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Business and Summary of Significant Accounting Policies Business First Guaranty Bancshares, Inc. ("First Guaranty" or the "Company") is a Louisiana corporation headquartered in Hammond, LA. First Guaranty owns all of the outstanding shares of common stock of First Guaranty Bank. First Guaranty Bank (the "Bank") is a Louisiana state-chartered commercial bank that provides a diversified range of financial services to consumers and businesses in the communities in which it operates. These services include consumer and commercial lending, mortgage loan origination, the issuance of credit cards and retail banking services. The Bank also maintains an investment portfolio comprised of government, government agency, corporate, and municipal securities. The Bank has twenty-one banking offices, including one drive-up banking facility, and twenty-seven automated teller machines (ATMs) in Southeast, Southwest and North Louisiana. Summary of significant accounting policies The accounting and reporting policies of First Guaranty conform to generally accepted accounting principles and to predominant accounting practices within the banking industry. The more significant accounting and reporting policies are as follows: Consolidation The consolidated financial statements include the accounts of First Guaranty Bancshares, Inc., and its wholly owned subsidiary, First Guaranty Bank. All significant intercompany balances and transactions have been eliminated in consolidation. Acquisition Accounting Acquisitions are accounted for under the purchase method of accounting. Purchased assets, including identifiable intangibles, and assumed liabilities are recorded at their respective acquisition date fair values. If the fair value of net assets purchased exceeds the consideration given, a gain on acquisition is recognized. If the consideration given exceeds the fair value of the net assets received, goodwill is recognized. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan losses. See Acquired Loans section below for accounting policy regarding loans acquired in a business combination. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expense during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, and the valuation of investment securities. In connection with the determination of the allowance for loan losses and real estate owned, First Guaranty obtains independent appraisals for significant properties. Cash and cash equivalents For purposes of reporting cash flows, cash and cash equivalents are defined as cash, due from banks, interest-bearing demand deposits with banks and federal funds sold with maturities of three months or less. Securities First Guaranty reviews its financial position, liquidity and future plans in evaluating the criteria for classifying investment securities. Debt securities that Management has the ability and intent to hold to maturity are classified as held to maturity and carried at cost, adjusted for amortization of premiums and accretion of discounts using methods approximating the interest method. Securities available for sale are stated at fair value. The unrealized difference, if any, between amortized cost and fair value of these AFS securities is excluded from income and is reported, net of deferred taxes, in accumulated other comprehensive income as a part of shareholders' equity. Details of other comprehensive income are reported in the consolidated statements of comprehensive income. Realized gains and losses on securities are computed based on the specific identification method and are reported as a separate component of other income. Amortization of premiums and discounts is included in interest income. Discounts and premiums related to debt securities are amortized using the effective interest rate method. Management evaluates securities for other-than-temporary impairment ("OTTI") at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In estimating other-than-temporary losses, management considers the length of time and extent that fair value has been less than cost and the financial condition and near term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings. Loans held for sale Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Loans held for sale have primarily been fixed rate single-family residential mortgage loans under contract to be sold in the secondary market. In most cases, loans in this category are sold within thirty days. Buyers generally have recourse to return a purchased loan under limited circumstances. Recourse conditions may include early payment default, breach of representations or warranties and documentation deficiencies. Mortgage loans held for sale are generally sold with the mortgage servicing rights released. Gains or losses on sales of mortgage loans are recognized based on the differences between the selling price and the carrying value of the related mortgage loans sold. Loans Loans are stated at the principal amounts outstanding, net of unearned income and deferred loan fees. In addition to loans issued in the normal course of business, overdrafts on customer deposit accounts are considered to be loans and reclassified as such. Interest income on all classifications of loans is calculated using the simple interest method on daily balances of the principal amount outstanding. Accrual of interest is discontinued on a loan when Management believes, after considering economic and business conditions and collection efforts, the borrower's financial condition is such that reasonable doubt exists as to the full and timely collection of principal and interest. This evaluation is made for all loans that are 90 days or more contractually past due. When a loan is placed in nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is then recognized only to the extent that cash is received and where the future collection of interest and principal is probable. Loans are returned to accrual status when, in the judgment of Management, all principal and interest amounts contractually due are reasonably assured to be collected within a reasonable time frame and when the borrower has demonstrated payment performance of cash or cash equivalents; generally for a period of six months. All loans, except mortgage loans, are considered past due if they are past due 30 days. Mortgage loans are considered past due when two consecutive payments have been missed. Loans that are past due 90-120 days and deemed uncollectible are charged-off. The loan charge off is a reduction of the allowance for loan losses. Troubled Debt Restructurings (TDRs) TDRs are loans in which the borrower is experiencing financial difficulty at the time of restructuring, and the Bank has granted a concession to the borrower. TDRs are undertaken in order to improve the likelihood of recovery on the loan and may take the form of modifications made with the stated interest rate lower than the current market rate for new debt with similar risk, other modifications to the structure of the loan that fall outside of normal underwriting policies and procedures, or in limited circumstances forgiveness of principal and / or interest. TDRs can involve loans remaining on non-accrual, moving to non-accrual, or continuing on accrual status, depending on the individual facts and circumstances of the borrower. TDRs are subject to policies governing accrual and non-accrual evaluation consistent with all other loans as discussed in the "Loans" section above. All loans with the TDR designation are considered to be impaired, even if they are accruing. First Guaranty's policy is to evaluate TDRs that have subsequently been restructured and returned to market terms after 12 months of performance. The evaluation includes a review of the loan file and analysis of the credit to assess the loan terms, including interest rate to insure such terms are consistent with market terms. The loan terms are compared to a sampling of loans with similar terms and risk characteristics, including loans originated by First Guaranty and loans lost to a competitor. The sample provides a guide to determine market terms pursuant to ASC 310-40-50-2. The loan is also evaluated at that time for impairment A loan determined to be restructured to market terms and not considered impaired will no longer be disclosed as a TDR in the years following the restructuring. These loans will continue to be individually evaluated for impairment. A loan determined to either be restructured to below market terms or to be impaired will remain a TDR. Credit Quality First Guaranty's credit quality indicators are pass, special mention, substandard, and doubtful. Loans included in the pass category are performing loans with satisfactory debt coverage ratios, collateral, payment history, and documentation requirements. Special mention loans have potential weaknesses that deserve close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects. Borrowers may be experiencing adverse operating trends (declining revenues or margins) or an ill proportioned balance sheet (e.g., increasing inventory without an increase in sales, high leverage, tight liquidity). Adverse economic or market conditions, such as interest rate increases or the entry of a new competitor, may also support a special mention rating. Nonfinancial reasons include management problems, pending litigation, an ineffective loan agreement or other material structural weakness, and any other significant deviation from prudent lending practices. A substandard loan is inadequately protected by the paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness. They are characterized by the distinct possibility that First Guaranty will sustain some loss if the deficiencies are not corrected. These loans require more intensive supervision. Substandard loans are generally characterized by current or expected unprofitable operations, inadequate debt service coverage, inadequate liquidity, or marginal capitalization. Repayment may depend on collateral or other credit risk mitigates. For some substandard loans, the likelihood of full collection of interest and principal may be in doubt and interest is no longer accrued. Consumer loans that are 90 days or more past due or that are nonaccrual are considered substandard. Doubtful loans have the weaknesses of substandard loans with the additional characteristic that the weaknesses make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values. A loan is considered impaired when, based on current information and events, it is probable that First Guaranty will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by Management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price or the fair value of the collateral if the loan is collateral dependent. This process is only applied to impaired loans or relationships in excess of $250,000. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, individual consumer and residential loans are not separately identified for impairment disclosures, unless such loans are the subject of a restructuring agreement. Loans that have been restructured in a troubled debt restructuring will continue to be evaluated individually for impairment, including those no longer requiring disclosure. Acquired Loans Loans are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan losses. Acquired loans are segregated between those with deteriorated credit quality at acquisition and those deemed as performing. To make this determination, Management considers such factors as past due status, nonaccrual status, credit risk ratings, interest rates and collateral position. The fair value of acquired loans deemed performing is determined by discounting cash flows, both principal and interest, for each pool at prevailing market interest rates as well as consideration of inherent potential losses. The difference between the fair value and principal balances due at acquisition date, the fair value discount, is accreted into income over the estimated life of each loan pool. Loans acquired in a business combination are recorded at their estimated fair value on their purchase date with no carryover of the related allowance for loan losses. Performing acquired loans are subsequently evaluated for any required allowance at each reporting date. An allowance for loan losses is calculated using a similar methodology for originated loans. Loan fees and costs Nonrefundable loan origination and commitment fees and direct costs associated with originating loans are deferred and recognized over the lives of the related loans as an adjustment to the loans' yield using the level yield method. Allowance for loan losses The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when Management believes that the collectability of the principal is unlikely. The allowance, which is based on evaluation of the collectability of loans and prior loan loss experience, is an amount that, in the opinion of Management, reflects the risks inherent in the existing loan portfolio and exists at the reporting date. The evaluations take into consideration a number of subjective factors including changes in the nature and volume of the loan portfolio, historical losses, overall portfolio quality, review of specific problem loans, current economic conditions that may affect a borrower's ability to pay, adequacy of loan collateral and other relevant factors. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require additional recognition of losses based on their judgments about information available to them at the time of their examination. The following are general credit risk factors that affect First Guaranty's loan portfolio segments. These factors do not encompass all risks associated with each loan category. Construction and land development loans have risks associated with interim construction prior to permanent financing and repayment risks due to the future sale of developed property. Farmland and agricultural loans have risks such as weather, government agricultural policies, fuel and fertilizer costs, and market price volatility. 1-4 family, multi-family, and consumer credits are strongly influenced by employment levels, consumer debt loads and the general economy. Non-farm non-residential loans include both owner occupied real estate and non-owner occupied real estate. Common risks associated with these properties is the ability to maintain tenant leases and keep lease income at a level able to service required debt and operating expenses. Commercial and industrial loans generally have non-real estate secured collateral which requires closer monitoring than real estate collateral. Although Management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance for loan losses in the near term. However, the amount of the change that is reasonably possible cannot be estimated. The evaluation of the adequacy of loan collateral is often based upon estimates and appraisals. Because of changing economic conditions, the valuations determined from such estimates and appraisals may also change. Accordingly, First Guaranty may ultimately incur losses that vary from Management's current estimates. Adjustments to the allowance for loan losses will be reported in the period such adjustments become known or can be reasonably estimated. All loan losses are charged to the allowance for loan losses when the loss actually occurs or when the collectability of the principal is unlikely. Recoveries are credited to the allowance at the time of recovery. The allowance consists of specific, general, and unallocated components. The specific component relates to loans that are classified as doubtful, substandard, and impaired. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. Also, a specific reserve is allocated for syndicated loans. The general component covers non-classified loans and special mention loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect the estimate of probable losses. The allowance for loan losses is reviewed on a monthly basis. The monitoring of credit risk also extends to unfunded credit commitments, such as unused commercial credit lines and letters of credit. A reserve is established as needed for estimates of probable losses on such commitments. Goodwill and intangible assets Goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. First Guaranty's goodwill is tested for impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment. Adverse changes in the economic environment, declining operations, or other factors could result in a decline in the implied fair value of goodwill. If the implied fair value is less than the carrying amount, a loss would be recognized in other non-interest expense to reduce the carrying amount to implied fair value of goodwill. The goodwill impairment test includes two steps that are preceded by a, "step zero", qualitative test. The qualitative test allows Management to assess whether qualitative factors indicate that it is more likely than not that impairment exists. If it is not more likely than not that impairment exists, then no impairment exists and the two step quantitative test would not be necessary. These qualitative indicators include factors such as earnings, share price, market conditions, etc. If the qualitative factors indicate that it is more likely than not that impairment exists, then the two step quantitative test would be necessary. Step one is used to identify potential impairment and compares the estimated fair value of a reporting unit with its carrying amount, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired. If the carrying amount of a reporting unit exceeds its estimated fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. Step two of the goodwill impairment test compares the implied estimated fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of goodwill for that reporting unit exceeds the implied fair value of that unit's goodwill, an impairment loss is recognized in an amount equal to that excess. Identifiable intangible assets are acquired assets that lack physical substance but can be distinguished from goodwill because of contractual or legal rights or because the assets are capable of being sold or exchanged either on their own or in combination with the related contract, asset or liability. First Guaranty's intangible assets primarily relate to core deposits. These core deposit intangibles are amortized on a straight-line basis over terms ranging from seven to fifteen years. Management periodically evaluates whether events or circumstances have occurred that impair this deposit intangible. Premises and equipment Premises and equipment are stated at cost, less accumulated depreciation. Depreciation is computed for financial reporting purposes using the straight-line method over the estimated useful lives of the respective assets as follows: Buildings and improvements 10-40 years Equipment, fixtures and automobiles 3-10 years Expenditures for renewals and betterments are capitalized and depreciated over their estimated useful lives. Repairs, maintenance and minor improvements are charged to operating expense as incurred. Gains or losses on disposition, if any, are recorded as a separate line item in noninterest income on the Statements of Income. Other real estate Other real estate includes properties acquired through foreclosure or acceptance of deeds in lieu of foreclosure. These properties are recorded at the lower of the recorded investment in the property or its fair value less the estimated cost of disposition. Any valuation adjustments required prior to foreclosure are charged to the allowance for loan losses. Subsequent to foreclosure, losses on the periodic revaluation of the property are charged to current period earnings as other real estate expense. Costs of operating and maintaining the properties are charged to other real estate expense as incurred. Any subsequent gains or losses on dispositions are credited or charged to income in the period of disposition. Off-balance sheet financial instruments In the ordinary course of business, First Guaranty has entered into commitments to extend credit, including commitments under credit card arrangements, commitments to fund commercial real estate, construction and land development loans secured by real estate, and performance standby letters of credit. Such financial instruments are recorded when they are funded. Income taxes First Guaranty and its subsidiary file a consolidated federal income tax return on a calendar year basis. In lieu of Louisiana state income tax, the Bank is subject to the Louisiana bank shares tax, which is included in noninterest expense in First Guaranty's consolidated financial statements. With few exceptions, First Guaranty is no longer subject to U.S. federal, state or local income tax examinations for years before 2013. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the deferred tax assets or liabilities are expected to be settled or realized. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be utilized. Comprehensive income Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items along with net income, are components of comprehensive income. The components of other comprehensive income and related tax effects are presented in the Statements of Comprehensive Income. Fair Value Measurements The fair value of a financial instrument is the current amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Valuation techniques use certain inputs to arrive at fair value. Inputs to valuation techniques are the assumptions that market participants would use in pricing the asset or liability. They may be observable or unobservable. First Guaranty uses a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. See Note 21 for a detailed description of fair value measurements. Transfers of Financial Assets Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (i) the assets have been isolated from First Guaranty, (ii) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (iii) First Guaranty does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Earnings per common share Earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. In December of 2015, First Guaranty issued a pro rata, 10% common stock dividend. The shares issued for the stock dividend have been retrospectively factored into the calculation of earnings per share as well as cash dividends paid on common stock and represented on the face of the financial statements. No convertible shares of First Guaranty's stock are outstanding. Operating Segments All of First Guaranty's operations are considered by management to be aggregated into one reportable operating segment. While the chief decision-makers monitor the revenue streams of the various products and services, the identifiable segments are not material. Operations are managed and financial performance is evaluated on a Company-wide basis. Reclassifications Certain reclassifications have been made to prior year end financial statements in order to conform to the classification adopted for reporting in 2016. Note 2. Recent Accounting Pronouncements In February 2016, the FASB issued ASU 2016-02, "Conforming Amendments Related to Leases". This ASU amends the codification regarding leases in order to increase transparency and comparability. The ASU requires companies to recognize lease assets and liabilities on the statement of condition and disclose key information about leasing arrangements. A lessee would recognize a liability to make lease payments and a right-of-use asset representing its right to use the leased asset for the lease term. The ASU is effective for annual and interim periods beginning after December 15, 2018. The adoption of this ASU is not expected to have a material effect on First Guaranty's Consolidated Financial Statements. In June 2016, the FASB issued ASU 2016-13, "Measurement of Credit Losses on Financial Instruments". This ASU amends guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. The ASU amendments require the measurement of all expected credit losses for financial assets held at the reporting date be based on historical experience, current conditions, and reasonable and supportable forecasts. The ASU requires assets held at cost basis to reflect the Company's current estimate of all expected credit losses. For available for sale debt securities, credit losses should be presented as an allowance rather than as a write-down. In addition, this ASU amends the accounting for purchased financial assets with credit deterioration. This ASU is effective for annual and interim periods beginning after December 15, 2019. We are currently evaluating the impact of the adoption of this guidance on the Consolidated Financial Statements. In January 2017, the FASB issued ASU 2017-04, "Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment". This ASU amends the guidance on impairment testing. The ASU eliminates Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The ASU also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. This ASU is effective for annual and interim periods beginning after December 15, 2019. We are currently evaluating the impact of the adoption of this guidance on the Consolidated Financial Statements. In January 2017, the FASB issued ASU 2017-01, "Business Combinations: Clarifying the Definition of a Business". This ASU clarifies the definition of a business. The amendments affect all companies and other reporting organizations that must determine whether they have acquired or sold a business. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. This ASU is intended to help companies and other organizations evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. This ASU is effective for annual and interim periods beginning December 15, 2017. The adoption of this ASU is not expected to have a material effect on the Consolidated Financial Statements. Note 3. Cash and Due from Banks Certain reserves are required to be maintained at the Federal Reserve Bank. There was no reserve requirement as of December 31, 2016 and 2015. At December 31, 2016 First Guaranty had only one account at correspondent banks, excluding the Federal Reserve Bank, that exceeded the FDIC insurable limit of $250,000.This account was over the insurable limit by $4,000. At December 31, 2015 First Guaranty had only one account at correspondent banks, excluding the Federal Reserve Bank, that exceeded the FDIC insurable limit of $250,000. This account was over the insurable limit by $2,000. Note 4. Securities A summary comparison of securities by type at December 31, 2016 and 2015 is shown below. The scheduled maturities of securities at December 31, 2016, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities due to call or prepayments. Mortgage-backed securities are not due at a single maturity because of amortization and potential prepayment of the underlying mortgages. For this reason they are presented separately in the maturity table below. The following is a summary of the fair value of securities with gross unrealized losses and an aging of those gross unrealized losses as of the dates indicated: As of December 31, 2016, 357 of First Guaranty's debt securities had unrealized losses totaling 2.4% of the individual securities' amortized cost basis and 1.9% of First Guaranty's total amortized cost basis of the investment securities portfolio. 26 of the 357 securities had been in a continuous loss position for over 12 months at such date. The 26 securities had an aggregate amortized cost basis of $6.9 million and an unrealized loss of $0.5 million at December 31, 2016. Management has the intent and ability to hold these debt securities until maturity or until anticipated recovery. Securities are evaluated for other-than-temporary impairment ("OTTI") at least quarterly and more frequently when economic or market conditions warrant. Consideration is given to (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the recovery of contractual principal and interest and (iv) the intent and ability of First Guaranty to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Investment securities issued by the U.S. Government and Government sponsored agencies with unrealized losses and the amount of unrealized losses on those investment securities are the result of changes in market interest rates. First Guaranty has the ability and intent to hold these securities until recovery, which may not be until maturity. Corporate debt securities in a loss position consist primarily of corporate bonds issued by businesses in the financial, insurance, utility, manufacturing, industrial, consumer products and oil and gas industries. Two issuers have other-than-temporary impairment losses at December 31, 2016. First Guaranty believes that the remaining issuers will be able to fulfill the obligations of these securities based on evaluations described above. First Guaranty has the ability and intent to hold these securities until they recover, which could be at their maturity dates. During the years ended December 31, 2016 and 2015, First Guaranty recorded OTTI losses on available-for-sale securities as follows: There were $0.1 million, $0.2 million, and $0 other-than-temporary impairment losses recognized on securities in 2016, 2015 and 2014, respectively. The following table presents a roll-forward of the amount of credit losses on debt securities held by First Guaranty for which a portion of OTTI was recognized in other comprehensive income for the year ended December 31, 2016 and 2015: In 2016 there were no other-than-temporary impairment credit losses on securities for which we had previously recognized OTTI. The amount related to losses on securities with no previous losses amounted to $0.1 million at December 31, 2016. For securities that have indications of credit related impairment, management analyzes future expected cash flows to determine if any credit related impairment is evident. Estimated cash flows are determined using management's best estimate of future cash flows based on specific assumptions. The assumptions used to determine the cash flows were based on estimates of loss severity and credit default probabilities. Management reviews reports from credit rating agencies and public filings of issuers. The credit related impairment was related to one corporate debt security with a book balance of $0.1 million that experienced declines in its financial performance associated with the utilities industry. This corporate debt security had a non-credit related impairment of approximately $6,000. In 2015 there were no other-than-temporary impairment credit losses on securities for which we had previously recognized OTTI. The amount related to losses on securities with no previous losses amounted to $0.2 million at December 31, 2015. The credit related impairment was related to one corporate debt security with a book balance of $0.5 million that experienced declines in its financial performance associated with the mining industry. This corporate debt security had a non-credit related impairment of $0.3 million. This security was sold in 2016. A second corporate debt security had a non-credit related impairment of $0.1 million due to the fact that the issuer went private and liquidity in its debt securities was reduced. Management anticipates receipt of all scheduled cash flows for this security. Non-credit related other-than-temporary impairment losses recognized in other comprehensive income totaled $6,000 in 2016, $0.4 million in 2015, and zero in 2014. The impairment losses in 2016 were related to one available for sale corporate bond security, described above, which had original amortized cost of $0.1 million. The impairment losses in 2015 were related to two avaiable for sale corporate bond securities, described above, which had original amortized cost of $0.8 million. At December 31, 2016 and 2015 the carrying value of pledged securities totaled $368.2 million and $427.4 million, respectively. First Guaranty completed its liquidation of the common stock from a converted preferred security in the third quarter of 2015. The total gains realized on the security were $2.7 million. Gross realized gains on sales of securities were $3.6 million, $3.3 million (including the sale of the converted preferred security) and $0.2 million for the years ended December 31, 2016, 2015 and 2014, respectively. Gross realized losses were $53,000, $0.4 million and $0.2 million for the years ended December 31, 2016, 2015 and 2014. The tax applicable to these transactions amounted to $1.3 million, $1.2 million, and $0 million for 2016, 2015 and 2014, respectively. Proceeds from sales of securities classified as available-for-sale amounted to $191.0 million, $290.0 million and $109.8 million for the years ended December 31, 2016, 2015 and 2014, respectively. Net unrealized losses on available-for-sale securities included in accumulated other comprehensive income (loss) ("AOCI"), net of applicable income taxes, totaled $4.0 million at December 31, 2016. At December 31, 2015 net unrealized losses included in AOCI, net of applicable income taxes, totaled $0.9 million. During 2016 and 2015 net gains, net of tax, reclassified out of AOCI into earnings totaled $2.5 million and $2.1 million, respectively. At December 31, 2016, First Guaranty's exposure to investment securities issuers that exceeded 10% of shareholders' equity as follows: Note 5. Loans The following table summarizes the components of First Guaranty's loan portfolio as of the dates indicated: The following table summarizes fixed and floating rate loans by contractual maturity, excluding nonaccrual loans, as of December 31, 2016 and December 31, 2015 unadjusted for scheduled principal payments, prepayments, or repricing opportunities. The average life of the loan portfolio may be substantially less than the contractual terms when these adjustments are considered. As of December 31, 2016, $127.7 million of floating rate loans were at their interest rate floor. At December 31, 2015, $132.9 million of floating rate loans were at the floor rate. Nonaccrual loans have been excluded from these totals. The following tables present the age analysis of past due loans for the periods indicated: The tables above include $21.7 million and $20.0 million of nonaccrual loans for December 31, 2016 and 2015, respectively. See the tables below for more detail on nonaccrual loans. The following is a summary of nonaccrual loans by class for the periods indicated: The following table identifies the credit exposure of the loan portfolio by specific credit ratings for the periods indicated: Note 6. Allowance for Loan Losses A summary of changes in the allowance for loan losses, by loan type, for the years ended December 31, 2016, 2015 and 2014 are as follows: Negative provisions are caused by changes in the composition and credit quality of the loan portfolio. The result is an allocation of the loan loss reserve from one category to another. A summary of the allowance and loans individually and collectively evaluated for impairment are as follows: As of December 31, 2016, 2015 and 2014, First Guaranty had loans totaling $21.7 million, $20.0 million and $12.2 million, respectively, not accruing interest. As of December 31, 2016, 2015 and 2014, First Guaranty had loans past due 90 days or more and still accruing interest totaling $0.2 million, $0.4 million and $0.6 million, respectively. The average outstanding balance of nonaccrual loans in 2016 was $22.5 million compared to $14.9 million in 2015 and $13.8 million in 2014. Included in the above table is a loan for $5.3 million at December 31, 2015, that was not considered impaired but was still individually evaluated for impairment since it was formally a restructured credit that subsequently return to market terms. As of December 31, 2016, First Guaranty has no outstanding commitments to advance additional funds in connection with impaired loans. The following is a summary of impaired loans by class at December 31, 2016: The following is a summary of impaired loans by class at December 31, 2015: Troubled Debt Restructurings A Troubled Debt Restructuring ("TDR") is a debt restructuring in which the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider. The modifications to First Guaranty's TDRs were concessions on the interest rate charged. The effect of the modifications to First Guaranty was a reduction in interest income. These loans were evaluated in First Guaranty's reserve for loan losses. In 2016, there were no credit relationships that were restructured in a troubled debt restructuring. In 2015, there was one credit relationship in the amount of $0.4 million that was restructured in a troubled debt restructuring. The relationship was secured by raw land. The relationship was placed on interest only with a reduction in scheduled amortization payments and contractual interest rate. The following table is an age analysis of TDRs as of December 31, 2016 and December 31, 2015: The following table discloses TDR activity for the twelve months ended December 31, 2016. There were no commitments to lend additional funds to debtors whose terms have been modified in a troubled debt restructuring at December 31, 2016. Note 7. Premises and Equipment The components of premises and equipment at December 31, 2016 and 2015 are as follows: Depreciation expense amounted to $1.7 million, $1.6 million and $1.7 million for 2016, 2015 and 2014, respectively. Note 8. Goodwill and Other Intangible Assets Goodwill and intangible assets deemed to have indefinite lives are no longer amortized, but are subject to impairment testing. Other intangible assets continue to be amortized over their useful lives. Goodwill represents the purchase price over the fair value of net assets acquired from the Homestead Bancorp in 2007. No impairment charges have been recognized since acquisition. Goodwill totaled $2.0 million at December 31, 2016 and 2015. The following table summarizes intangible assets subject to amortization. The core deposits intangible reflect the value of deposit relationships, including the beneficial rates, which arose from acquisitions. The weighted-average amortization period remaining for the core deposit intangibles is 3.6 years. Amortization expense relating to purchase accounting intangibles totaled $0.3 million, $0.3 million, and $0.3 million for the years ended December 31, 2016, 2015, and 2014, respectively. Amortization expense of the core deposit intangible assets for the next five years is as follows: Note 9. Other Real Estate Other real estate owned consists of the following: Note 10. Deposits A schedule of maturities of all time deposits are as follows: The table above includes, for December 31, 2016, brokered deposits totaling $20.8 million. The aggregate amount of jumbo time deposits, each with a minimum denomination of $250,000 totaled $241.4 million and $305.1 million at December 31, 2016 and 2015, respectively. Note 11. Borrowings Short-term borrowings are summarized as follows: First Guaranty maintains borrowing relationships with other financial institutions as well as the Federal Home Loan Bank on a short and long-term basis to meet liquidity needs. Short-term borrowings totaled $6.5 million at December 31, 2016 and $1.8 million at December 31, 2015. Short-term borrowing consisted of a line of credit of $2.5 million, with no outstanding balance at December 31, 2016 and collateralized short-term borrowings from the Federal Home Loan Bank totaling $6.5 million at December 31, 2016. Available lines of credit totaled $133.7 million at December 31, 2016 and $206.2 million at December 31, 2015. The following schedule provides certain information about First Guaranty's short-term borrowings for the periods indicated: Long-term debt is summarized as follows: Senior long-term debt with a commercial bank, priced at Wall Street Journal Prime plus 75 basis points (4.50%), totaled $0.3 million at December 31, 2016 and $0.9 million at December 31, 2015. First Guaranty pays $50,000 principal plus interest monthly. This loan has a contractual maturity date of May 12, 2017. This long-term debt is secured by a pledge of 13.2% (735,745 shares) of First Guaranty's interest in First Guaranty Bank (a wholly owned subsidiary). Senior long-term debt with a commercial bank, priced at floating 3-month LIBOR plus 250 basis points (3.37%), totaled $21.8 million at December 31, 2016 and $25.0 at December 31, 2015. First Guaranty pays $625,000 principal plus interest quarterly. This loan was originated in December 2015 and has a contractual maturity date of December 22, 2020. This long-term debt is secured by a pledge of 85% (4,823,899 shares) of First Guaranty's interest in First Guaranty Bank (a wholly owned subsidiary). Junior subordinated debt, priced at Wall Street Journal Prime plus 75 basis points (4.00%), totaled $14.6 million at December 31, 2016 and $14.6 million at December 31, 2015. First Guaranty pays interest semi-annually for the Fixed Interest Rate Period and quarterly for the Floating Interest Rate Period. The Note is unsecured and ranks junior in right of payment to any senior indebtedness and obligations to general and secured creditors. The Note was originated in December 2015 and is scheduled to mature on December 21, 2025. Subject to limited exceptions, First Guaranty cannot repay the Note until after December 21, 2020. The Note qualifies for treatment as Tier 2 capital for regulatory capital purposes. First Guaranty maintains a revolving line of credit for $2.5 million with an availability of $2.5 million at December 31, 2016. This line of credit is secured by the same collateral as the senior term loan and is priced at 4.75%. At December 31, 2016, letters of credit issued by the FHLB totaling $226.1 million were outstanding and carried as off-balance sheet items, all of which expire in 2017. At December 31, 2015, letters of credit issued by the FHLB totaling $195.0 million were outstanding and carried as off-balance sheet items, all of which expired in 2016. The letters of credit are solely used for pledging towards public fund deposits. The FHLB has a blanket lien on substantially all of the loans in First Guaranty's portfolio which is used to secure borrowing availability from the FHLB. First Guaranty has obtained a subordination agreement from the FHLB on First Guaranty's farmland, agricultural, and commercial and industrial loans. These loans are available to be pledged for additional reserve liquidity. As of December 31, 2016 obligations on senior long-term debt and junior subordinated debentures totaled $36.7 million. The scheduled maturities are as follows: Note 12. Preferred Stock On September 22, 2011, First Guaranty received $39.4 million in funds from the U.S. Treasury's Small Business Lending Fund program. $21.1 million of the funds were used to redeem First Guaranty's Series A and B Preferred Stock issued to the U.S. Treasury under the Capital Purchase Program. The Preferred Series C shares received quarterly dividends and the initial dividend rate was 5.00%. The dividend rate was based on qualified loan growth two quarters in arrears. During 2014 First Guaranty achieved the growth in qualified loans required to achieve the 1.0% dividend rate. The 1.0% rate was locked in until December 31, 2015. During 2016 First Guaranty paid no preferred stock dividends compared to $0.4 million in 2015 and $0.4 million in 2014. On December 22, 2015, First Guaranty redeemed all of the 39,435 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C, which had been issued to the United States Department of Treasury pursuant to the Small Business Lending Fund (the "SBLF"). The shares were redeemed at their liquidation value of $1,000 per share plus accrued and unpaid dividends to, but excluding December 22, 2015, for a total redemption price of $39.5 million. The redemption was approved by the Federal Reserve Bank of Atlanta and the United States Department of Treasury. The redemption terminated First Guaranty's participation in the SBLF. Note 13. Capital Requirements First Guaranty and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions that, if undertaken, could have a direct material effect on First Guaranty's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, First Guaranty and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require First Guaranty and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Management believes, as of December 31, 2016 and 2015, that First Guaranty and the Bank met all capital adequacy requirements. In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions and certain discretionary bonus payments to management if the institution does not hold a "capital conservation buffer" consisting of 2.5% of common equity Tier 1 capital to risk-weighted asset above the amount necessary to meet its minimum risk-based capital requirements. The capital conservation buffer requirement is being phased in beginning January 1, 2016 at 0.625% of risk-weighted assets and increasing each year until fully implemented at 2.5% on January 1, 2019. For 2017, the capital conservation buffer will be 1.25% of risk-weighted assets. First Guaranty Bancshares, Inc. capital conservation buffer was 4.59% at December 31, 2016. First Guaranty Bank's capital conservation buffer was 4.99% at December 31, 2016. As of December 31, 2016, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since the notification that Management believes have changed the Bank's category. First Guaranty's and the Bank's actual capital amounts and ratios as of December 31, 2016 and 2015 are presented in the following table. Note 14. Dividend Restrictions The Federal Reserve Bank ("FRB") has stated that, generally, a bank holding company should not maintain a rate of distributions to shareholders unless its available net income has been sufficient to fully fund the distributions, and the prospective rate of earnings retention appears consistent with the bank holding company's capital needs, asset quality and overall financial condition. As a Louisiana corporation, First Guaranty is restricted under the Louisiana corporate law from paying dividends under certain conditions. First Guaranty Bank may not pay dividends or distribute capital assets if it is in default on any assessment due to the FDIC. First Guaranty Bank is also subject to regulations that impose minimum regulatory capital and minimum state law earnings requirements that affect the amount of cash available for distribution. In addition, under the Louisiana Banking Law, dividends may not be paid if it would reduce the unimpaired surplus below 50% of outstanding capital stock in any year. The Bank is restricted under applicable laws in the payment of dividends to an amount equal to current year earnings plus undistributed earnings for the immediately preceding year, unless prior permission is received from the Commissioner of Financial Institutions for the State of Louisiana. Dividends payable by the Bank in 2017 without permission will be limited to 2017 earnings plus the undistributed earnings of $3.8 million from 2016. Accordingly, at January 1, 2017, $137.4 million of First Guaranty's equity in the net assets of the Bank was restricted. In addition, dividends paid by the Bank to First Guaranty would be prohibited if the effect thereof would cause the Bank's capital to be reduced below applicable minimum capital requirements. Note 15. Related Party Transactions In the normal course of business, First Guaranty and its subsidiary, First Guaranty Bank, have loans, deposits and other transactions with its executive officers, directors and certain business organizations and individuals with which such persons are associated. These transactions are completed with terms no less favorable than current market rates. An analysis of the activity of loans made to such borrowers during the year ended December 31, 2016 and 2015 follows: Unfunded commitments to First Guaranty and Bank directors and executive officers totaled $24.9 million and $31.6 million at December 31, 2016 and 2015, respectively. At December 31, 2016 First Guaranty and the Bank had deposits from directors and executives totaling $28.7 million. There were no participations in loans purchased from affiliated financial institutions included in First Guaranty's loan portfolio in 2016 or 2015. During the years ended 2016, 2015 and 2014, First Guaranty paid approximately $0.3 million, $0.2 million and $0.2 million, respectively, for printing services and supplies and office furniture and equipment to Champion Industries, Inc., of which Mr. Marshall T. Reynolds, the Chairman of First Guaranty's Board of Directors, is President, Chief Executive Officer, Chairman of the Board of Directors and a major shareholder of Champion. First Guaranty paid insurance expenses of $0, $0 and $2.3 million for 2016, 2015 and 2014, respectively for participation in an employee medical benefit plan in which several entities under common ownership of First Guaranty's Chairman participate. First Guaranty terminated the plan in 2014 and enrolled in a fully insured plan from a third party national provider of health insurance. On December 21, 2015, First Guaranty issued a $15.0 million subordinated note (the "Note") to Edgar Ray Smith III, a director of First Guaranty. The Note is for a ten-year term (non-callable for first five years) and will bear interest at a fixed annual rate of 4.0% for the first five years of the term and then adjust to a floating rate based on the Prime Rate as reported by the Wall Street Journal plus 75 basis points for the period of time after the fifth year until redemption or maturity. First Guaranty paid interest of $0.6 million in 2016 for this note. During the years ended 2016, 2015 and 2014, First Guaranty paid approximately $0.3 million, $0.2 million and $25,000, respectively, for architectural services in relation to bank branches to Gasaway Gasaway Bankston Architects, of which bank subsidiary board member Andrew B. Gasaway is part owner. Note 16. Employee Benefit Plans First Guaranty has an employee savings plan to which employees, who meet certain service requirements, may defer 1% to 20% of their base salaries, 6% of which may be matched up to 100%, at its sole discretion. Contributions to the savings plan were $191,000, $86,000 and $87,000 in 2016, 2015 and 2014, respectively. First Guaranty has an Employee Stock Ownership Plan ("ESOP") which was frozen in 2010. No contributions were made to the ESOP for the years 2016, 2015 or 2014. As of December 31, 2016, the ESOP held 15,159 shares. First Guaranty does not plan to make future contributions to this plan. Note 17. Other Expenses The following is a summary of the significant components of other noninterest expense: First Guaranty does not capitalize advertising costs. They are expensed as incurred and are included in other noninterest expense on the Consolidated Statements of Income. Advertising expense was $0.6 million, $0.6 million and $0.4 million for 2016, 2015 and 2014, respectively. Note 18. Income Taxes The following is a summary of the provision for income taxes included in the Consolidated Statements of Income: The difference between income taxes computed by applying the statutory federal income tax rate and the provision for income taxes in the financial statements is reconciled as follows: Deferred taxes are recorded based upon differences between the financial statement and tax basis of assets and liabilities, and available tax credit carry forwards. Temporary differences between the financial statement and tax values of assets and liabilities give rise to deferred taxes. The significant components of deferred taxes classified in First Guaranty's Consolidated Balance Sheets at December 31, 2016 and 2015 are as follows: As of December 31, 2016 and 2015, there were no net operating loss carryforwards for income tax purposes. ASC 740-10, Income Taxes, clarifies the accounting for uncertainty in income taxes and prescribes a recognition threshold and measurement attribute for the consolidated financial statements recognition and measurement of a tax position taken or expected to be taken in a tax return. First Guaranty does not believe it has any unrecognized tax benefits included in its consolidated financial statements. First Guaranty has not had any settlements in the current period with taxing authorities, nor has it recognized tax benefits as a result of a lapse of the applicable statute of limitations. First Guaranty recognizes interest and penalties accrued related to unrecognized tax benefits, if applicable, in noninterest expense. During the years ended December 31, 2016, 2015 and 2014, First Guaranty did not recognize any interest or penalties in its consolidated financial statements, nor has it recorded an accrued liability for interest or penalty payments. Note 19. Commitments and Contingencies Off-balance sheet commitments First Guaranty is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby and commercial letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The contract or notional amounts of those instruments reflect the extent of the involvement in particular classes of financial instruments. The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby and commercial letters of credit is represented by the contractual notional amount of those instruments. Unless otherwise noted, collateral or other security is not required to support financial instruments with credit risk. Set forth below is a summary of the notional amounts of the financial instruments with off-balance sheet risk at December 31, 2016 and December 31, 2015. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each customer's creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on Management's credit evaluation of the counterpart. Collateral requirements vary but may include accounts receivable, inventory, property, plant and equipment, residential real estate and commercial properties. Standby and commercial letters of credit are conditional commitments to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The majority of these guarantees are short-term, one year or less; however, some guarantees extend for up to three years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities. Collateral requirements are the same as on-balance sheet instruments and commitments to extend credit. There were no losses incurred on off-balance sheet commitments in 2016, 2015 or 2014. Note 20. Fair Value Measurements The fair value of a financial instrument is the current amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Valuation techniques use certain inputs to arrive at fair value. Inputs to valuation techniques are the assumptions that market participants would use in pricing the asset or liability. They may be observable or unobservable. First Guaranty uses a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows: Level 1 Inputs - Unadjusted quoted market prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds or credit risks) or inputs that are derived principally from or corroborated by market data by correlation or other means. Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity's own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. A description of the valuation methodologies used for instruments measured at fair value follows, as well as the classification of such instruments within the valuation hierarchy. Securities available for sale. Securities are classified within Level 1 where quoted market prices are available in an active market. Inputs include securities that have quoted prices in active markets for identical assets. If quoted market prices are unavailable, fair value is estimated using quoted prices of securities with similar characteristics, at which point the securities would be classified within Level 2 of the hierarchy. Securities classified Level 3 as of December 31, 2016 include municipal bonds and an equity security. Impaired loans. Loans are measured for impairment using the methods permitted by ASC Topic 310. Fair value of impaired loans is measured by either the fair value of the collateral if the loan is collateral dependent (Level 2 or Level 3), or the present value of expected future cash flows, discounted at the loan's effective interest rate (Level 3). Fair value of the collateral is determined by appraisals or by independent valuation. Other real estate owned. Properties are recorded at the balance of the loan or at estimated fair value less estimated selling costs, whichever is less, at the date acquired. Fair values of other real estate owned ("OREO") at December 31, 2016 and 2015 are determined by sales agreement or appraisal, and costs to sell are based on estimation per the terms and conditions of the sales agreement or amounts commonly used in real estate transactions. Inputs include appraisal values or recent sales activity for similar assets in the property's market; thus OREO measured at fair value would be classified within either Level 2 or Level 3 of the hierarchy. Certain non-financial assets and non-financial liabilities are measured at fair value on a non-recurring basis including assets and liabilities related to reporting units measured at fair value in the testing of goodwill impairment, as well as intangible assets and other non-financial long-lived assets measured at fair value for impairment assessment. The following table summarizes financial assets measured at fair value on a recurring basis as of December 31, 2016 and 2015, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value: First Guaranty's valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While Management believes the methodologies used are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value. The change in Level 2 securities available for sale from December 31, 2015 was due principally to the purchase of corporate bond securities. The change in Level 3 securities available for sale from December 31, 2015 was due to the purchase of $8.5 million in municipal securities and $4.5 million of subordinated debt securities offset by the maturity of $1.3 million in municipal securities. The following table reconciles assets measured at fair value on a recurring basis using unobservable inputs (Level 3): There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held as of December 31, 2016. The following table measures financial assets and financial liabilities measured at fair value on a non-recurring basis as of December 31, 2016, segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value: ASC 825-10 provides First Guaranty with an option to report selected financial assets and liabilities at fair value. The fair value option established by this statement permits First Guaranty to choose to measure eligible items at fair value at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each reporting date subsequent to implementation. First Guaranty has chosen not to elect the fair value option for any items that are not already required to be measured at fair value in accordance with accounting principles generally accepted in the United States. Note 21. Financial Instruments Fair value estimates are generally subjective in nature and are dependent upon a number of significant assumptions associated with each instrument or group of similar instruments, including estimates of discount rates, risks associated with specific financial instruments, estimates of future cash flows and relevant available market information. Fair value information is intended to represent an estimate of an amount at which a financial instrument could be exchanged in a current transaction between a willing buyer and seller engaging in an exchange transaction. However, since there are no established trading markets for a significant portion of First Guaranty's financial instruments, First Guaranty may not be able to immediately settle financial instruments; as such, the fair values are not necessarily indicative of the amounts that could be realized through immediate settlement. In addition, the majority of the financial instruments, such as loans and deposits, are held to maturity and are realized or paid according to the contractual agreement with the customer. Quoted market prices are used to estimate fair values when available. However, due to the nature of the financial instruments, in many instances quoted market prices are not available. Accordingly, estimated fair values have been estimated based on other valuation techniques, such as discounting estimated future cash flows using a rate commensurate with the risks involved or other acceptable methods. Fair values are estimated without regard to any premium or discount that may result from concentrations of ownership of financial instruments, possible income tax ramifications or estimated transaction costs. The fair value estimates are subjective in nature and involve matters of significant judgment and, therefore, cannot be determined with precision. Fair values are also estimated at a specific point in time and are based on interest rates and other assumptions at that date. As events change the assumptions underlying these estimates, the fair values of financial instruments will change. Disclosure of fair values is not required for certain items such as lease financing, investments accounted for under the equity method of accounting, obligations of pension and other postretirement benefits, premises and equipment, other real estate, prepaid expenses, the value of long-term relationships with depositors (core deposit intangibles) and other customer relationships, other intangible assets and income tax assets and liabilities. Fair value estimates are presented for existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses have not been considered in the estimates. Accordingly, the aggregate fair value amounts presented do not purport to represent and should not be considered representative of the underlying market or franchise value of First Guaranty. Because the standard permits many alternative calculation techniques and because numerous assumptions have been used to estimate the fair values, reasonable comparison of the fair value information with other financial institutions' fair value information cannot necessarily be made. The methods and assumptions used to estimate the fair values of financial instruments are as follows: Cash and due from banks, interest-bearing deposits with banks, federal funds sold and federal funds purchased. These items are generally short-term and the carrying amounts reported in the consolidated balance sheets are a reasonable estimation of the fair values. Investment Securities. Fair values are principally based on quoted market prices. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments or the use of discounted cash flow analyses. Loans Held for Sale. Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices. These loans are classified within level 3 of the fair value hierarchy. Loans, net. Market values are computed present values using net present value formulas. The present value is the sum of the present value of all projected cash flows on an item at a specified discount rate. The discount rate is set as an appropriate rate index, plus or minus an appropriate spread. These loans are classified within level 3 of the fair value hierarchy. Impaired loans Fair value of impaired loans is measured by either the fair value of the collateral if the loan is collateral dependent (Level 2 or Level 3), or the present value of expected future cash flows, discounted at the loan's effective interest rate (Level 3). Fair value of the collateral is determined by appraisals or by independent valuation. Accrued interest receivable. The carrying amount of accrued interest receivable approximates its fair value. Deposits. Market values are actually computed present values using net present value formulas. The present value is the sum of the present value of all projected cash flows on an item at a specified discount rate. The discount rate is set as an appropriate rate index, plus or minus an appropriate spread. Deposits are classified within level 3 of the fair value hierarchy. Accrued interest payable. The carrying amount of accrued interest payable approximates its fair value. Borrowings. The carrying amount of federal funds purchased and other short-term borrowings approximate their fair values. The fair value of First Guaranty's long-term borrowings is computed using net present value formulas. The present value is the sum of the present value of all projected cash flows on an item at a specified discount rate. The discount rate is set as an appropriate rate index, plus or minus an appropriate spread. Borrowings are classified within level 3 of the fair value hierarchy. Other Unrecognized Financial Instruments. The fair value of commitments to extend credit is estimated using the fees charged to enter into similar legally binding agreements, taking into account the remaining terms of the agreements and customers' credit ratings. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. Noninterest-bearing deposits are held at cost. The fair values of letters of credit are based on fees charged for similar agreements or on estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At December 31, 2016 and 2015 the fair value of guarantees under commercial and standby letters of credit was not material. The estimated fair values and carrying values of the financial instruments at December 31, 2016 and 2015 are presented in the following table: There is no material difference between the contract amount and the estimated fair value of off-balance sheet items that are primarily comprised of short-term unfunded loan commitments that are generally at market prices. Note 22. Concentrations of Credit and Other Risks First Guaranty monitors loan portfolio concentrations by region, collateral type, loan type, and industry on a monthly basis and has established maximum thresholds as a percentage of its capital to ensure that the desired mix and diversification of its loan portfolio is achieved. First Guaranty is compliant with the established thresholds as of December 31, 2016. Personal, commercial and residential loans are granted to customers, most of who reside in northern and southern areas of Louisiana. Although First Guaranty has a diversified loan portfolio, significant portions of the loans are collateralized by real estate located in Tangipahoa Parish and surrounding parishes in Southeast Louisiana. Declines in the Louisiana economy could result in lower real estate values which could, under certain circumstances, result in losses to First Guaranty. The distribution of commitments to extend credit approximates the distribution of loans outstanding. Commercial and standby letters of credit were granted primarily to commercial borrowers. Generally, credit is not extended in excess of $10.0 million to any single borrower or group of related borrowers. Approximately 42.0% of First Guaranty's deposits are derived from local governmental agencies at December 31, 2016. These governmental depositing authorities are generally long-term customers. A number of the depositing authorities are under contractual obligation to maintain their operating funds exclusively with First Guaranty. In most cases, First Guaranty is required to pledge securities or letters of credit issued by the Federal Home Loan Bank to the depositing authorities to collateralize their deposits. Under certain circumstances, the withdrawal of all of, or a significant portion of, the deposits of one or more of the depositing authorities may result in a temporary reduction in liquidity, depending primarily on the maturities and/or classifications of the securities pledged against such deposits and the ability to replace such deposits with either new deposits or other borrowings. Public fund deposits totaled $556.9 million at December 31, 2016. Note 23. Litigation First Guaranty is subject to various legal proceedings in the normal course of its business. It is Management's belief that the ultimate resolution of such claims will not have a material adverse effect on First Guaranty's financial position or results of operations. Note 24. Subsequent Events On January 30, 2017, First Guaranty entered into an Agreement and Plan of Merger (the "Merger Agreement") with Premier Bancshares, Inc., a Texas corporation ("Premier"), pursuant to which Premier will merge with and into First Guaranty (the "Merger"). Following the consummation of the Merger, and following the consummation of a merger of Premier's wholly-owned subsidiary, Premier Delaware Bancshares, Inc. ("Premier Delaware"), with and into First Guaranty, Synergy Bank, S.S.B., a Texas-state chartered savings bank and wholly-owned subsidiary of Premier ("Synergy Bank"), will merge with and into First Guaranty Bank with First Guaranty Bank continuing as the surviving entity. The Merger Agreement was unanimously approved by the Board of Directors of each of First Guaranty and Premier. The aggregate purchase price of the transaction is approximately $21.0 million. Under the terms of the Merger Agreement, each outstanding share of Premier common stock will be converted into the right to receive (i) an amount in cash, equal to the Premier book value as of December 31, 2016 as reflected on the audited financial statements of Premier plus $1.5 million (the "Gross Consideration"), divided by the total number of shares of Premier common stock outstanding as of the business day immediately prior to the closing date, multiplied by 50%; and (ii) that number of shares of First Guaranty common stock equal to the Gross Consideration divided by the total number of shares of Premier common stock outstanding as of the business day immediately prior to the closing date, multiplied by 50%, divided by the Average Closing Price of First Guaranty common stock. Average Closing Price means the average of the closing prices of First Guaranty common stock as reported on the NASDAQ Global Market for the 20 consecutive trading days ending on the fifth business day immediately prior to the closing date. The Gross Consideration will be comprised of 50% First Guaranty common stock and 50% cash. At December 31, 2016, Premier Bancshares had total assets of approximately $154 million, including loans of $114 million. Total deposits were $129 million. The Merger Agreement includes customary representations and warranties made by First Guaranty and Premier, each with respect to its and its subsidiaries' businesses. Each party has also agreed to customary covenants, including, among others, covenants relating to the conduct of its business during the interim period between the execution of the Merger Agreement and the consummation of the Merger. The Merger is subject to approval by Premier's stockholders as well as regulatory approval and other customary closing conditions. The Merger Agreement provides certain termination rights for both First Guaranty and Premier and further provides that a termination fee of $500,000 will be payable by Premier to First Guaranty or by First Guaranty to Premier, as applicable, upon termination of the Merger Agreement under certain circumstances. The Merger is expected to close either late in the second quarter or early in the third quarter of 2017 following receipt of all regulatory and shareholder approvals. Note 25. Condensed Parent Company Information The following condensed financial information reflects the accounts and transactions of First Guaranty Bancshares, Inc. for the dates indicated: First Guaranty Bancshares, Inc. Condensed Balance Sheets First Guaranty Bancshares, Inc. Condensed Statements of Income First Guaranty Bancshares, Inc. Condensed Statements of Cash Flows Item 9
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This appears to be a partial financial statement or accounting policy disclosure rather than a complete financial statement. From the provided text, I can only definitively identify:
1. Total Assets: Approximately $154 (units not specified)
2. A Loss was reported (amount not specified)
The majority of the text describes accounting policies regarding:
- Treatment of business combinations
- Cash and cash equivalents
- Securities classification and valuation
- Other-than-temporary impairment (OTTI) evaluation procedures
Without more specific financial figures, a complete balance sheet, or income statement details, I cannot provide a more comprehensive summary of the financial position. To provide a better summary, I would need additional information about specific revenue, expenses, liabilities, and the actual profit/loss figures.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. AS-IP TECH, INC. FINANCIAL STATEMENTS June 30, 2016 and 2015 ACCOUNTING FIRM To the Board of Directors and Stockholders of AS-IP Tech, Inc.: We have audited the accompanying consolidated balance sheets of AS-IP Tech, Inc. (“the Company”) as of June 30, 2016 and 2015 and the related statement of operations, stockholders’ equity (deficit) and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statement referred to above present fairly, in all material respects, the financial position of AS-IP Tech, Inc., as of June 30, 2016 and 2015, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles in the United States of America. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the Company's internal control over financial reporting. Accordingly, we express no such opinion. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has a significant accumulated deficit. In addition, the Company continues to experience negative cash flows from operations. These factors raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ B F Borgers CPA PC B F Borgers CPA PC Lakewood, CO October 13, 2016 AS-IP TECH, INC. BALANCE SHEETS (AUDITED) See Accompanying Notes to Financial Statements. AS-IP TECH, INC. STATEMENTS OF OPERATIONS (AUDITED) See Accompanying Notes to Financial Statements. AS-IP TECH, INC. STATEMENTS OF STOCKHOLDERS' DEFICIT See Accompanying Notes to Financial Statements. AS-IP TECH, INC. STATEMENTS OF CASH FLOWS (AUDITED) See Accompanying Notes to Financial Statements. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION, OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: AS-IP Tech, Inc. (“AS-IP”, the "Company") formerly ASI Entertainment, Inc., was incorporated in the State of Delaware on April 29, 1998. Basis of Presentation The financial statements are prepared in accordance with Generally Accepted Accounting Principles in the United States of America. The financial statements are expressed in United States dollars. Going Concern The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the accompanying consolidated financial statements, the Company has a limited operating history and limited funds and has an accumulated deficit of $9,428,693 at June 30, 2016. These factors, among others, may indicate that the Company will be unable to continue as a going concern. The Company may raise additional capital through the sale of its equity securities, through an offering of debt securities, or through borrowings from financial institutions. The Company expects to generate revenue in the future from the BizjetMobile and fflya businesses from the sale of hardware and provision of on-going services. Management believes that actions presently being taken to obtain additional funding provide the opportunity for the Company to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of assets and/or liabilities that might be necessary should the Company be unable to continue as a going concern. The continuation as a going concern is dependent upon the ability of the Company to meet our obligations on a timely basis, and, ultimately to attain profitability. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS Cash and cash equivalents The Company considers all highly liquid investments with an original maturity of three months or less as cash equivalents. At certain times, cash in bank may exceed the amount covered by FDIC insurance. At June 30, 2016 and 2015 there were deposit balances in a United States bank of $64,292 and $222 respectively. Income tax The Company accounts for income taxes under FASB ASC 740 "Income Taxes". Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. At June 30, 2016 the Company had net operating loss carryforwards of $9,109,812 which begin to expire in 2019. The deferred tax asset created by the U.S. net operating losses has been offset by a 100% valuation allowance of $2,056,824 in 2016, compared to an allowance of $2,015,351 in 2015. The change in the valuation allowance for U.S. tax purposes in 2016 and 2015 was $41,473 and $18,000, respectively. Stock-based compensation The Company records stock based compensation in accordance with the guidance in ASC Topic 718 which requires the Company to recognize expenses related to the fair value of its employee stock option awards. This eliminates accounting for share-based compensation transactions using the intrinsic value and requires instead that such transactions be accounted for using a fair-value-based method. The Company recognizes the cost of all share-based awards on a graded vesting basis over the vesting period of the award. ASC 505, "Compensation-Stock Compensation", establishes standards for the accounting for transactions in which an entity exchanges its equity instruments to non-employees for goods or services. Under this transition method, stock compensation expense includes compensation expense for all stock-based compensation awards granted on or after January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of ASC 505. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS Per Share Data Net loss per common share is computed by dividing net loss by the weighted average common shares outstanding during the period as defined by Financial Accounting Standards, ASC Topic 260, "Earnings per Share". Basic earnings per common share ("EPS") calculations are determined by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share calculations are determined by dividing net income by the weighted average number of common shares and dilutive common share equivalents outstanding. During periods when common stock equivalents, if any, are anti-dilutive they are not considered in the computation. Revenue recognition The Company applies paragraph 605-10-S99-1 of the FASB Accounting Standards Codification for revenue recognition. The Company recognizes revenue when it is realized or realizable and earned less estimated future doubtful accounts. The Company considers revenue realized or realizable and earned when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped or the services have been rendered to the customer, (iii) the sales price is fixed or determinable, and (iv) collectability is reasonably assured. Revenue is recognized on an accrual basis as earned under contract or license agreements. License fees are taken up in the period they become due. Revenue from ongoing license fees is recognized on an accrual basis in the period it is earned and invoiced. Financial instruments The Company has adopted the provisions of ASC Topic 820, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. ASC 820 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. The fair value hierarchy distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs). The hierarchy consists of three levels: Level one - Quoted market prices in active markets for identical assets or liabilities; Level two - Inputs other than level one inputs that are either directly or indirectly observable; and Level three - Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS All of the Company’s financial instruments are level one and are carried at market value, requiring no adjustment to book value. The financial instruments were deemed to qualify as that classification because their value was determined by the price of identical instruments traded on an active exchange. Products and services, and geographic areas Company sales will be derived from hardware sales and on-going service fees as well as other revenue sources that might be developed from the Company's technology. Previously the Company received license fees under license arrangements covering North and South America, Asia and Australia. Stock Options The Company has no outstanding stock options. Recent Accounting Pronouncements The company has evaluated the recent accounting pronouncements through ASU 2013-09 and believes that none of them have a material effect on the Company’s financial statements. Long-Lived Assets In accordance with ASC 360, Property Plant and Equipment the Company tests long-lived assets or asset groups for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset; significant adverse changes in the business climate or legal factors; accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of the asset; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the asset; and current expectation that the asset will more likely than not be sold or disposed significantly before the end of its estimated useful life. Recoverability is assessed based on the carrying amount of the asset and its fair value which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. An impairment loss is recognized when the carrying amount is not recoverable and exceeds fair value. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS Goodwill, Trademarks and Other Intangible Assets In accordance with SFAS No. 142, ‘‘Goodwill and Other Intangible Assets,’’ we classify intangible assets into three categories: (1) intangible assets with definite lives subject to amortization; (2) intangible assets with indefinite lives not subject to amortization; and (3) goodwill. For intangible assets with definite lives, tests for impairment must be performed if conditions exist that indicate the carrying value may not be recoverable. For intangible assets with indefinite lives and goodwill, tests for impairment must be performed at least annually or more frequently if events or circumstances indicate that assets might be impaired. When facts and circumstances indicate that the carrying value of intangible assets determined to have definite lives may not be recoverable, management assesses the recoverability of the carrying value by preparing estimates of future cash flows. If the sum of the expected future cash flows is less than the carrying amount, we recognize an impairment loss. The impairment loss recognized is the amount by which the carrying amount exceeds the fair value. We test intangible assets determined to have indefinite useful lives, including trademarks, franchise rights and goodwill, for impairment annually, or more frequently if events or circumstances indicate that assets might be impaired. Intangible Assets In the year ended June 30, 2016, the Company took up Intangible Assets of $450,000 which represented the termination fee negotiated with the licensee of the Company’s SafeCell technology. The Company has provided for amortization of $60,000 in the year ended June 30, 2016 on the basis that the technology has a useful life of 5 years. NOTE 2 - RELATED PARTY TRANSACTIONS As of June 30, 2016 and 2015, the Company has incurred as "related parties payables", $252,761 and $268,670 respectively, which are due mainly to advances made by the CEO to pay for operating expenses. During the year ended June 30, 2016, $40,000 of debt due to the CEO was converted to 2,000,000 shares, on the basis of an issue price of $0.02 per share. From July 1, 2016, interest will accrue on amounts due to the CEO calculated quarterly at a rate of 6.5% per annum. The loan will be repaid from surplus operating cash, when funds are available. As of June 30, 2016 and 2015, the Company had "due to related parties" of $228,811 which are advances made by related parties to provide capital. The “related parties payables” and “due to related parties” balances are non-interest bearing, unsecured and due on demand. Due to the short term structure of these notes the company does not impute interest expense or recognize a discount on the face value of the notes. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS The Company in 2016 and 2015 incurred expenses of approximately $60,000 and $60,000 respectively to entities affiliated through common stockholders and directors for management expenses. Under the terms of termination of the license agreement with ASiQ Ltd, a related party, the $450,000 termination fee was satisfied by issue of 24,597,376 shares of the Company’s stock. NOTE 3 - LEASE COMMITMENTS The Company does not have any arrangements to lease premises for its operations. The Company previously had entered into an arrangement under which it used premises at A$3,200 per annum and but had not entered into a formal lease agreement. NOTE 4 - STOCKHOLDERS' EQUITY Common stock The Company as of June 30, 2014 had 100,000,000 shares of authorized common stock, $.0001 par value, with 86,348,704 shares issued and outstanding, and 50,000 shares in treasury. Treasury shares are accounted for by the par value method. During the year ended June 30, 2015, the Company issued a total of 2,500,000 bonus shares for fund raising valued at $0.025 per share. During the year ended June 30, 2015, the Company issued a total of 2,000,000 shares for reduction of related accounts payable valued at $0.021 per share. During the year ended June 30, 2015, the Company issued a total of 96,000 shares for reduction of accounts payable valued at $0.021 per share. During the year ended June 30, 2016, the Company issued a total of 1,250,000 bonus shares for fund raising valued at $0.021 per share. During the year ended June 30, 2016, the Company issued a total of 3,190,600 shares for cash valued at $0.015 per share. During the year ended June 30, 2016, the Company issued a total of 1,763,000 shares for cash valued at $0.016 per share. During the year ended June 30, 2016, the Company issued a total of 4,806,550 shares for cash valued at $0.02 per share. AS-IP TECH, INC. NOTES TO FINANCIAL STATEMENTS During the year ended June 30, 2016, the Company issued a total of 262,500 shares for services valued at $0.015 per share. During the year ended June 30, 2016, the Company issued a total of 3,124,752 shares for services valued at $0.02 per share. During the year ended June 30, 2016, the Company issued a total of 24,597,376 shares for reduction of related party accounts payable related to the intangible asset valued at $0.018 per share. During the year ended June 30, 2016, the Company issued a total of 2,000,000 shares for reduction of related party accounts payable valued at $0.02 per share. Preferred stock As of June 30, 2016, the Company had 50,000,000 shares of authorized preferred stock, $.0001 par value, with no shares issued and outstanding. Subscriptions payable As of June 30, 2016, the Company has a total of 4,965,556 shares payable to an individual with a net value of $91,380. NOTE 5 - BAD DEBTS The Company evaluates the need for an allowance for doubtful accounts on a regular basis. As of June 30, 2016 and 2015, the Company determined that an allowance was not needed.
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Here's a summary of the financial statement:
Financial Condition:
- The company is experiencing significant financial challenges
- Has accumulated losses of $9,428,693
- Continues to have negative cash flows from operations
- Has a limited operating history with limited funds
Going Concern:
- Substantial doubt exists about the company's ability to continue operating
- Management is seeking additional funding
- Continuation depends on meeting obligations and achieving profitability
- Future revenue expected from BizjetMobile and fflya businesses through hardware sales and services
Key Financial Risks:
- Potential inability to sustain operations
- Reliance on future funding
- Uncertainty about asset recoverability and liability classification
Accounting Approach:
- Financial statements prepared using generally accepted accounting principles
- Requires management estimates and assumptions
- Actual results may differ from these estimates
Cash Management:
- Considers investments with 3-month or
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Claude
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Financial Statements and Supplemental Data To the Board of Directors and Stockholders of Tautachrome, Inc. We have audited the accompanying consolidated balance sheets of Tautachrome, Inc. as of December 31, 2016, and 2015, and the related consolidated statements of operations, changes in stockholders’ deficit, and cash flows for each of the years in the two-year period ended December 31, 2016. Tautachrome, Inc.’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Tautachrome, Inc. as of December 31, 2016, and 2015, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the financial statements, the Company suffered a net loss from operations and has a net capital deficiency, which raises substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters are described in Note 3. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ M&K CPAS, PLLC Houston, Texas April 17, 2017 TAUTACRHOME, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Balance Sheets The accompanying notes are an integral part of these financial statements. TAUTACHROME, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statements of Operations The accompanying notes are an integral part of these financial statements. TAUTACHROME, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statement of Changes in Stockholders’ Equity (Deficit) From December 31, 2014 to December 31, 2016 The accompanying notes are an integral part of these financial statements. TAUTACHROME, INC. AND CONSOLIDATED SUBSIDIARIES Consolidated Statements of Cash Flows The accompanying notes are an integral part of these financial statements. TAUTACHROME, INC. AND CONSOLIDATED SUBSIDIARIES Note 1 - Organization and Nature of Business History Tautachrome, Inc. (formerly Roadships Holdings, Inc.) was formed in Delaware on June 5, 2006 as Caddystats, Inc. (Tautachrome, Inc. and hereinafter be collectively referred to as "Tautachrome", the "Company", "we' or "us"). The Company adopted the accounting acquirer's year end, December 31. Our Business The Division operates in the internet applications space, a space uniquely able to embrace fast growing and novel business. The iPhone, Google, Facebook, Amazon, Twitter, Android, Uber and numerous other examples are reminders of the ability of the internet applications space to surprise us with the arrival -seemingly from out of nowhere- of wholly new business universes. Click is developing a system branded "KlickZie" aimed at turning smartphones, including iPhones, Android phones and other smartphones, into trustable imagers and advanced communicators. Trustable imagers means that the pictures and videos can be trusted to be the original, untampered, un-Photoshopped pictures and videos made by the smartphone. Advanced communicators means that the pictures and videos can be used as living, trusted portals to communicate with others. The KlickZie system concept consists of downloadable software able to securitize the imaging process in the smartphone, together with an advanced cloud system to authenticate KlickZie pictures and videos and to make possible imagery based communication among people who happen upon KlickZie pictures and videos. Note 2 - Basis of Presentation and Summary of Significant Accounting Policies Basis of Presentation The Company’s financial statements are presented in accordance with accounting principles generally accepted (GAAP) in the United States. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the periods presented have been reflected herein. Principles of Consolidation Our consolidated financial statements include Tautachrome, Inc. and its wholly owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expense during the reporting period. Actual amounts could differ significantly from these estimates. Cash and Cash Equivalents The Company considers all highly liquid investments with an initial maturity of 3 months or less to be cash equivalents. The Company maintains its deposits with high quality financial institutions and, accordingly, believes its credit risk exposure associated with cash is remote. There were no cash equivalents as of December 31, 2016 and 2015. Property, Plant and Equipment We record our property plant and equipment at historical cost. The estimated useful lives of these assets range from three to seven years and are depreciated using the straight-line method over the asset’s useful life. Foreign Currency Risk We currently have two subsidiaries operating in Australia. At December 31, 2016 and 2015, we had $603 and $3,648 Australian Dollars, respectively ($434 and $2,657 US Dollars, respectively) deposited into Australian banks. Earnings Per Share Basic earnings per common share is computed by dividing net earnings or loss (the numerator) by the weighted average number of common shares outstanding during each period (the denominator). Diluted earnings per common share is similar to the computation for basic earnings per share, except that the denominator is increased by the dilutive effect of stock options outstanding and unvested restricted shares and share units, computed using the treasury stock method. There are currently no common stock equivalents. Fair Value of Financial Instruments We adopted the Financial Accounting Standards Board’s (FASB) Accounting Codification Standard No. 820 (“ASC 820), Fair Value Measurements and Disclosures. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. ASC 820 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. ASC 820 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, ASC 820 established a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: Level 1 - Observable inputs such as quoted prices in active markets; Level 2 - Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and Level 3 - Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. The following table presents assets and liabilities that were measured and recognized at fair value as of December 31, 2016 on a recurring basis: The following table presents assets and liabilities that were measured and recognized at fair value as of December 31, 2015 on a recurring basis: Income Taxes We recognize deferred tax assets and liabilities based on differences between the financial reporting and tax bases of assets and liabilities using the enacted tax rates that are expected to be in effect when the differences are expected to be recovered. We provide a valuation allowance for deferred tax assets for which we do not consider realization of such assets to be more likely than not. See Note 8 for our reconciliation of income tax expense and deferred income taxes as of and for the years ended December 31, 2016 and 2015. Recent Accounting Pronouncements Income Taxes In October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory ("ASU 2016-16"), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. Stock Compensation In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. Leases In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. Financial Instruments In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements. The new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company does not expect adoption of the new revenue standards to have a material impact on its consolidated financial statements. The adoption of these standards is not expected to have a material impact on our financial position or results of operations. Note 3 - Going Concern The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the accompanying financial statements, we had negative cash flows from operations of $320,156 and $366,403 for the years ended December 31, 2016 and 2015, respectively, recurring losses, and negative working capital at December 31, 2016 and 2015. These conditions raise substantial doubt as to our ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern. The Company may raise additional capital through the sale of its equity securities, through an offering of debt securities, or through borrowings from financial institutions or related parties. Management believes that actions presently being taken to obtain additional funding may provide the opportunity for the Company to continue as a going concern. There is no guarantee the Company will be successful in achieving these objectives. Note 4 - Related Party Transactions For the years ended December 31, 2016 and 2015, we had the following transactions with the Twenty Second Trust (the "Trust"), the trustee of whom is Tamara Nugent, the wife of our major shareholder and former Chief Executive Officer, Micheal Nugent: · · We received $18,331 and $5,408, respectively, in cash loans to pay operating expenses and repaid $0 and $162,918, respectively, in principal. · We accrued $4,400 and $4,329, respectively, in interest payable to the Trust and paid $0 and $1,571, respectively, in interest payments. · On April 20, 2015, the Registrant and Tamara Nugent, as trustee for Twenty Second Trust, entered into a Common Stock Repurchase Agreement whereby the Trust agreed to sell 1,796,571,210 shares of the our common stock to the Company in exchange for the sum of $17,966 in the form a promissory note. · The outstanding balance at December 31, 2016 to the 22nd Trust was $98,344 and $11,035 for principal and interest, respectively, after adjustments for foreign exchange effect. According to our agreement with Mr. Nugent, we accrue interest on all unpaid amounts at 5%. Principal and interest are callable at any time. If principal and interest are called and not repaid, the loan is considered in default after which interest is accrued at 10%. The outstanding balance to the 22nd Trust at December 31, 2015 was $80,107. During the year ended December 31, 2016, we received $18 On September 18, 2015, we entered into an agreement with Novagen Ingenium Inc, a Nevada corporation ("Novagen") under which we agreed to sell to Novagen all of the transportation assets of Roadships which had, at the time of the exchange, carrying values of zero, for 2,000,000 shares of Novagen common stock. Shares of Novagen's common stock are quoted under the symbol "NOVZ" on the OTC Pink operated by OTC Markets Group, Inc. Novagen's controlling shareholder is Micheal Nugent who was, until November 14, 2016, on our Board of Directors and remains a major shareholder. Since the shares represent a transaction with a related party, we recorded the value of these shares at zero. On August 9, 2015, we issued a $5,000 convertible promissory note to the brother of our Board Chairman and Chief Executive Officer in return for cash. The terms of this note are provided in Note 7, subheading "Convertible Notes Payable". On May 5, 2013 (and on August 8, 2013 with an enlargement amendment) the Company entered into a no interest demand-loan agreement with our current Chairman, Jon N Leonard ("Jon") under which the Company may borrow such money from Jon as Jon in his sole discretion is willing to loan. The outstanding loan amount at December 31, 2015 was $22,160. During the year ended December 31, 2016, the Company borrowed $27,000 leaving an ending balance owed to Jon of $49,160. The terms of the note provide that at the Company's option, the Company may make repayments in stock, at a fixed share price of $1.00 per share. Also, because this loan is a no interest loan an imputed interest expense of $3,199 and $1,767 was recorded as additional paid-in capital for the years ended December 31, 2016 and 2015, respectively. The Company evaluated Dr. Leonard's note for the existence of a beneficial conversion feature and determined that none existed. All other related party balances relate to certain officers and directors who paid expenses on behalf of the company and were reimbursed for a portion of those expenses. Balances owed at December 31, 2015 were $686. During the year ended December 31, 2016, these related parties paid $30,007 of expenses on behalf of the Company and were reimbursed $16,259, leaving a balance of $14,361 after adjustment for foreign exchange effect. On October 20, 2016, the Company filed a Certificate of Designations with the State of Delaware creating 13,795,104 shares of Series D Preferred Stock (the “Preferred Shares”) to effect the exchange. On October 27, 2016, the Company redeemed 1,379,510,380 common shares by issuing 13,795,104 Preferred Stock Series D Shares to three major shareholders (see Note 5). Note 5 - Capital Structure Common Stock At December 31, 2015, we had 2,987,633,430 common shares issued and outstanding from a total of four billion authorized. As described in Note 5, on January 15, 2016 we issued 13,000,000 common shares to acquire all of the members’ interests in Photosweep, LLC. We valued the common stock at the grant date fair value, and included this amount in our acquisition cost of $353,600, or $0.027 per share. As further discussed in Note 7, on January 1, 2016, we re-negotiated certain convertible promissory notes with certain creditors in order to remove the provisions in the notes which caused the derivative liability. We recorded this renegotiation by removing the derivative liability at December 31, 2015 and recording an increase to Additional Paid in Capital of $18,760. In October, 2016, we issued 51,666,667 common shares to convert $60,000 of convertible notes payable, and $604 in accrued interest, to common stock. In November, 2016, we received a Notice of Conversion from a holder of a US Dollar denominated convertible promissory note requesting a conversion of the outstanding principal and interest into the convertible amount of 2,142,857 common shares . We recorded a reduction of principal and interest of $10,000 and $586 of accrued interest, respectively, and we recorded an offsetting common stock payable in the amount of $10,586. Preferred Stock On September 29, 2016, the Company’s principal shareholders (“Principals”), Dr. Jon N. Leonard, Micheal P. Nugent, and Matthew W. Staker, offered to retire 1,379,510,380 of their common shares in exchange for a new series of non-trading preferred shares. On October 5, 2016, the Board of Directors voted to accept the share retirement offer, and on October 20, 2016, the Company filed a Certificate of Designations with the State of Delaware creating 13,795,104 shares of Series D Preferred Stock (the “Preferred Shares”) to effect the exchange. Share Exchange ratio and Preservation of Voting Rights In the share exchange, each principal received 1 Preferred Share for each 100 common shares retired Each share of Preferred Shares entitles the holder to 100 votes (and each 1/100th of a Preferred Share entitles the holder to one vote). Conversion Rights A holder may convert Preferred Shares to common under the following conditions: Automatic conversion - each Preferred Share automatically converts to 100 common shares upon the earlier of · The end of 5 years (5:00 PM EST, October 5, 2021), or · A change of control Optional conversion - After October 5, 2017, each holder may convert each share into 100 shares of common stock immediately following a period of ten consecutive trading days during which the average closing or last sale price exceeds $3.00 per share. Also, each holder may convert into 110 shares of common stock at any time that the shares are listed on a National exchange (for example, the NYSE or NASDAQ). Related-Party Stock Exchange On October 27, 2016, the Company entered into the above outlined Share Exchange Agreement with related-parties Common stock ownership structure immediately before and after execution of the Share Exchange Agreement was as follows: Fair Values The closing price of the common stock on the date of the Share Exchange Agreement was $0.019, resulting in a valuation of the common stock of $26,210,697. We determined that the fair value of the Series D Preferred Shares was $27,299,028 using the following inputs: 1. The common stock price was $0.019; 2. A change of control having a 20% likelihood in 2018 and 2019 each, triggering an automatic conversion of 100 common shares per Series D preferred shares; 3. The Company obtaining a NASDAQ/NYSE listing estimated at 10% in 2017, 50% in 2018 and 50% in 2019 triggering a conversion at 110 common shares per Series D preferred share; 4. The Company’s stock price was modeled using geometric Brownian motion with a volatility of 279% volatility (based on the Company’s historical volatility); 5. The common shares exchanged for the Series D preferred were valued based on the quoted market price on the date of exchange; We therefore recorded a loss on the exchange of $1,088,331 computed as the difference between the value of the common and preferred shares. Imputed Interest Several of our loans made in our Australian subsidiary were made without any nominal interest. As such, we imputed interest at 8% to these loans, crediting Additional Paid in Capital and charging Interest Expense. For the year ended December 31, 2016 and 2015, these amounted to $13,274 and $7,501, respectively. Beneficial Conversion Features of Convertible Promissory Notes During the year ended December 31, 2016, we borrowed $193,164 from 26 accredited investors in Australia (see Note 7) which contained features allowing the holder to convert the principal and accumulated interest into common stock. We evaluated these notes for beneficial conversion features and calculated a value of $147,965, all of which has been immediately expensed as interest expense as the notes are due on demand. At December 31, 2016, all outstanding convertible promissory notes issued in Australia can convert to an aggregate of 82,873,300 shares of common stock. Also during the year ended December 31, 2016, we borrowed $109,758 from four accredited investors in the United States (see Note 7). These notes contain features which allow the holder to convert the principal and interest into common stock at various negotiated rates. We evaluated these notes for beneficial conversion features and calculated a value of $187,851, which is accounted for as debt discounts. During the year ended December 31, 2016,we amortized $106,628 of debt discounts to interest expense. At December 31, 2016, all outstanding convertible promissory notes issued in the United States can convert to an aggregate of 28,473,915 shares of common stock. Note 6 - Asset Acquisition Acquisition of Photosweep, LLC On January 15, 2016, we acquired the Photosweep asset (“Photosweep”), which we accounted for as an asset purchase. Photosweep’s assets at the point of purchase consisted only of a business plan. Under the terms of the Acquisition, the Registrant paid $39,000 and issued 13,000,000 shares of its common stock to acquire Photosweep from Jeremy Snyder, Sara Snyder, Richard and Candice Snyder, Quazar Enterprises Limited and Carrington Capital Group Limited. We valued the common stock at the grant date fair value, and recorded an acquisition cost of $353,600, or $0.027 per share. As of December 31, 2016, we amortized $92,862 to expense and at December 31, 2016 we recorded an asset impairment of $299,738 as a result of the Company’s annual impairment review. Note 7 - Debt Our debt in certain categories went from $632,697 at December 31, 2015 to $861,050 at December 31, 2016 as follows: See Note 4 for a discussion of our related-party debts, including the first two entries in the above table. Convertible notes payable During the year ended December 31, 2016, we borrowed $193,164 from 26 accredited investors in Australia. These promissory notes can be converted into shares of our common stock at the rate of AU$0.01 per share (the aggregate of which shares convertible for all outstanding Australian convertible notes at December 31, 2016 is 82,873,300). These notes are callable by the makers at any time and accrue interest at 5%. For the year ended December 31, 2016, we accrued $29,343 of interest on these notes and made no interest payments. We evaluated these notes for beneficial conversion features and calculated a value of $147,965, all of which has been immediately expensed as interest expense as the notes are due on demand. Also during the year ended December 31, 2016, we issued four convertible promissory notes to four accredited investors in exchange for $109,758 in cash. These promissory notes can be converted into shares of our common stock at various separately-negotiated rates (the aggregate of which shares convertible for all outstanding USA convertible notes at December 31, 2016 is 28,473,915). We evaluated these notes for beneficial conversion features and calculated a value of $77,852 which we are accounting for as debt discounts. On January 1, 2016, we re-negotiated the eight U.S.-Dollar-denominated promissory notes that were outstanding at December 31, 2015, in order to remove the ratchet provisions which required that we account for those provisions as a derivative liability. The fair value of the derivative liability was the same at January 1, 2016 as it was on December 31, 2015 which was $23,812. However, in so renegotiating, we granted the creditors new, lower conversion prices, which resulted in new beneficial conversion features of $110,000. During the year ended December 31, 2016, we amortized $106,628 of debt discounts on convertible promissory notes originating in the United States to interest expense. The aggregate amount of shares that may be issued upon conversion for convertible notes issued in both Australia and the Unites States is 111,347,215. One of the eight accredited investors included in the above paragraph is the brother of our Board Chairman and Chief Executive Officer, Dr. Jon Leonard. This $5,000 related-party convertible promissory note is dated August 9, 2015, matures on February 26, 2017, pays interest at 5%, and may convert into 1,020,408 common shares. Derivative liability The eight convertible promissory notes issued in the United States during the year ended December 31, 2015 (and which were re-negotiated on January 1, 2016) were analyzed in accordance with EITF 07-05 and ASC 815. EITF 07-5, which is effective for fiscal years beginning after December 15, 2009, and interim periods within those fiscal years. The objective of EITF 07-5 is to provide guidance for determining whether an equity-linked financial instrument is indexed to an entity’s own stock. This determination is needed for a scope exception under Paragraph 11(a) of ASC 815 which would enable a derivative instrument to be accounted for under the accrual method. The classification of a non-derivative instrument that falls within the scope of EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” also hinges on whether the instrument is indexed to an entity’s own stock. A non-derivative instrument that is not indexed to an entity’s own stock cannot be classified as equity and must be accounted for as a liability. Derivative financial instruments should be recorded as liabilities in the consolidated balance sheet and measured at fair value. For purposes of this engagement and report, we utilized fair value as the basis for formulating our opinion which has been defined by the Financial Accounting Standards Board (“FASB”) as “the amount for which an asset (or liability) could be exchanged in a current transaction between knowledgeable, unrelated willing parties when neither party is acting under compulsion”. The FASB has provided guidance that its definition of fair value is consistent with the definition of fair market value in IRS Rev. Rule 59-60. In valuing the derivatives, the following inputs were assumed: · The underlying stock price was used as the fair value of the common stock $0.02 - as of 12/31/15; · The stock price projection was modeled such that it follows a geometric Brownian motion with constant drift and a constant volatility; · The stock projections are based on the Company historical annual volatilities using the term remaining for each Note and Valuation date and ranged from 311-338%. · An event of default would occur 0% of the time, increasing .50% per month to a maximum of 5.0%; · Capital raising events would occur quarterly at $150,000 per quarter through 2017 with potential dilutive resets for the Notes; · Discount rates were based on risk free rates in effect based on the remaining term and date of each valuation and instrument. · The Holder would redeem based on availability of alternative financing, 0% of the time increasing 0% monthly to a maximum of 0%; · The Holder would convert the note starting after 12 months to maturity (18 months from issuance) assuming the company was not in default subject to trading volume limits. We recorded the initial derivative as both a derivative liability and a debt discount (or initial reduction in carrying value of the debt). We then amortized the debt discounts, through December 31, 2015, using the Effective Interest Method which recognizes the cost of borrowing at a constant interest rate throughout the contractual term of the obligation. The effective interest rates on these seven instruments range from 5.0% to 10.6%. At each reporting date, we determine the fair market value for each derivative associated with each of the seven above instrument. At December 31, 2015, we determined the fair value of these derivatives were $23,812. We therefore included the difference in the Statement of Operations as “Change in Fair Value of Derivatives” for the year ended December 31, 2015. On January 1, 2016, we re-negotiated these notes with the creditors in order to remove the provisions in the notes which caused the derivative liability, namely the ratchet provisions which stipulate that the creditor may adjust the conversion price based on prices granted in subsequent capital raises. In re-negotiating this contract provision, we granted the creditors new conversion prices instead of the ratchet provisions. We therefore removed the derivative liability at December 31, 2015 on January 1, 2016 (whose one-day difference did not result in a change in fair value), and recorded an increase to Additional Paid in Capital of $18,760. Changes in derivative liabilities for the years ended December 31, 2016 and 2015 are as follows: In addition to the above, we recorded a liability in the amount of $2,382,374 due to a Court Judgment explained in Note 8. Note 8 - Litigation Loss Morgan Lawsuit Background The May 21, 2015 merger of the Company with Click Evidence, Inc. (“Click”) resulted in the transfer of Click’s assets and interests from Click to the Company and in Click becoming an asset-less shell inside the Company and then being disposed of on November 25, 2015. In the November 25, 2015 conveyance of the Click to the new owner, its name was changed to BH Trucking, Inc. (“BH”). Filing and service A first lawsuit was filed in the Superior Court of the State of Arizona, Pima County, by a former consultant to Click, Richard Morgan (“Morgan”). This lawsuit was served on December 2, 2015, against Click/BH, with the Company also named in the lawsuit, but not served by it or effectively made aware of it until 2017. Allegation The lawsuit claimed that the consultant’s agreement with Click/BH permitted him to recover a finder’s fee for the cashless stock swap that achieved the merger on May 21, 2015. The new owner of Click/BH, the only party served, declined to defend the lawsuit allowing it to go to default. Default judgment On December 16, 2016, the Court issued a default judgment for the plaintiff and against the defendants in the amount of $2,377,915. The Company believes that having not been served or made aware of the lawsuit, it is not a target of the judgment. Second Lawsuit On January 23, 2017, the Company and its CEO were served in a second lawsuit by Morgan alleging that the Company’s intellectual property assets that were transferred to it by Click under the May 21, 2015 merger of the Company with Click, were fraudulently removed from Click/BH, and seeks to have them returned to Click/BH. Charge to the Financials The Company believes that the second lawsuit is baseless, and is defending itself vigorously against it. The Company also believes that being named but not served, the default judgment in Morgan’s first lawsuit does not apply to the Company. Nevertheless, out of an abundance of caution, we have included in liabilities the default amount of $2,377,915 plus $4,459 interest at 4.5% from December 16, 2016, the date of the judgment, to December 31, 2016. Note 9 - Income Taxes Deferred income taxes reflect the tax consequences on future years of differences between the tax bases: In assessing the realizability of future tax assets, management considers whether it is more likely than not that some portion or all of the future tax assets will not be realized. The ultimate realization of future tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of future tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Management has provided for a valuation allowance on all of its losses as there is no assurance that future tax benefits will be realized. Our tax loss carry-forwards will begin to expire in 2022. Note 10 - Subsequent Events During the first quarter of 2017, we issued an additional 3,243,243 shares for conversion of principal and interest on convertible promissory notes issued in the United States. We have evaluated subsequent events through the date of this report.
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Based on the provided financial statement excerpt, here's a summary:
The company is experiencing financial challenges, including:
- Operating at a loss
- Significant capital deficiency
- Substantial doubt about its ability to continue operating
Key financial points:
- Seeking additional funding through debt securities or borrowings
- Management is actively working to secure additional funding
- No guarantee of success in obtaining necessary financial resources
The statement suggests the company is in a precarious financial position and is attempting to secure funding to remain viable. The full details of management's plans are referenced in Note 3, and additional financial details are in Note 4.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements required by Item 8 are presented in the following order: NightFood Holdings, Inc. Financial Statements For the years ended June 30, 2016 and June 30, 2015 ACCOUNTING FIRM To the Board of Directors and Stockholders of NightFood Holdings, Inc. We have audited the accompanying consolidated balance sheets of NightFood Holdings, Inc. (the “Company”) as of June 30, 2016 and 2015 and the related consolidated statements of operations and comprehensive loss, changes in stockholders’ equity and cash flows for the two year period ended June 30, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2016 and 2015 and the results of its operations and its cash flows for the two year in the period ended June 30, 2016, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company has incurred recurring losses and generated negative cash flows from its operating activities. These raise substantial doubt about the Company's ability to continue as a going concern. Management's plans, with respect to these matters are also described in Note 1 to the consolidated financial statements. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ RBSM LLP New York, New York September 28, 2016 NightFood Holdings, Inc. CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these audited consolidated financial statements NightFood Holdings, Inc. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these audited consolidated financial statements NightFood Holdings, Inc. STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT Years ended June 30, 2016 and 2015 The accompanying notes are an integral part of these audited consolidated financial statements NightFood Holdings, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these audited consolidated financial statements NightFood Holdings, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Description of Business NightFood Holdings, Inc. (the “Company”) is a Nevada Corporation organized October 16, 2013 to acquire all of the issued and outstanding shares of NightFood, Inc., a New York Corporation from its sole shareholder, Sean Folkson. All of its operations are conducted by the subsidiary, NightFood, Inc. The Company’s business model is to manufacture and distribute snack products specifically formulated for nighttime snacking to help consumers satisfy nighttime cravings in a better, healthier, more sleep friendly way. ● The Company’s fiscal year end is June 30. ● The Company currently maintains its corporate address in Tarrytown, New York. 2. Summary of Significant Accounting Policies ● Management is responsible for the fair presentation of the Company’s financial statements, prepared in accordance with U.S. generally accepted accounting principles (GAAP). Use of Estimates ● The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates are used in the determination of depreciation and amortization, the valuation for non-cash issuances of common stock, and the website, income taxes and contingencies, among others. Cash and Cash Equivalents ● The Company classifies as cash and cash equivalents amounts on deposit in the banks and cash temporarily in various instruments with original maturities of three months or less at the time of purchase. Fair Value of Financial Instruments ● Statement of financial accounting standard FASB Topic 820, Disclosures about Fair Value of Financial Instruments, requires that the Company disclose estimated fair values of financial instruments. The carrying amounts reported in the statements of financial position for assets and liabilities qualifying as financial instruments are a reasonable estimate of fair value. Inventories ● Inventories consisting of packaged food items and supplies are stated at the lower of cost (FIFO) or market, including provisions for spoilage commensurate with known or estimated exposures which are recorded as a charge to cost of sales during the period spoilage is incurred. The Company has no minimum purchase commitments with its vendors. Advertising Costs ● Advertising costs are expensed when incurred and are included in advertising and promotional expense in the accompanying statements of operations. Included in this category are expenses related to public relations, investor relations, new package design, website design, design of promotional materials, cost of trade shows, cost of products given away as promotional samples, and paid advertising. The Company incurred advertising costs of $110,751 and $86,200 for the years ended June 30, 2016 and 2015, respectively. Income Taxes ● The Company has not generated any taxable income, and, therefore, no provision for income taxes has been provided. ● Deferred income taxes are reported for timing differences between items of income or expense reported in the financial statements and those reported for income tax purposes in accordance with FASB Topic 740, "Accounting for Income Taxes", which requires the use of the asset/liability method of accounting for income taxes. Deferred income taxes and tax benefits are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax loss and credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company provides for deferred taxes for the estimated future tax effects attributable to temporary differences and carry-forwards when realization is more likely than not. ● A valuation allowance has been recorded to fully offset the deferred tax asset even though the Company believes it is more likely than not that the assets will be utilized. ● The Company’s effective tax rate differs from the statutory rates associated with taxing jurisdictions because of permanent and temporary timing differences as well as a valuation allowance. Revenue Recognition ● The Company generates its revenue from products sold from traditional retail outlets along with items distributed from the Company’s and other customer websites. ● All sources of revenue is recorded pursuant to FASB Topic 605 Revenue Recognition, when persuasive evidence of arrangement exists, delivery of services has occurred, the fee is fixed or determinable and collectability is reasonably assured. ● The Company occasionally offers sales incentives through various programs, consisting primarily of advertising related credits. The Company records advertising related credits with customers as a reduction to revenue as no identifiable benefit is received in exchange for credits claimed by the customer. Concentration of Credit Risk ● Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash deposits at financial institutions. At various times during the year, the Company may exceed the federally insured limits. To mitigate this risk, the Company places its cash deposits only with high credit quality institutions. Management believes the risk of loss is minimal. At June 30, 2016 and 2015 the Company did not have any uninsured cash deposits. Impairment of Long-lived Assets ● The Company accounts for long-lived assets in accordance with the provisions of FASB Topic 360, Accounting for the Impairment of Long-Lived Assets. This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Fair values are determined based on quoted market value, discounted cash flows or internal and external appraisals, as applicable. Recent Accounting Pronouncements ● All new accounting pronouncements issued but not yet effective or adopted have been deemed not to be relevant to us, hence are not expected to have any impact once adopted. 3. Going Concern ● The Company's financial statements are prepared using generally accepted accounting principles, which contemplate the realization of assets and liquidation of liabilities in the normal course of business. Because the business is new and has limited operating history and relatively few sales, no certainty of continuation can be stated. ● Management is taking steps to raise additional funds to address its operating and financial cash requirements to continue operations in the next twelve months. Management has devoted a significant amount of time in the raising of capital from additional debt and equity financing. However, the Company’s ability to continue as a going concern is dependent upon raising additional funds through debt and equity financing and generating revenue. There are no assurances the Company will receive the necessary funding or generate revenue necessary to fund operations. 4. Accounts receivable The Company’s accounts receivable arise primarily from the sale of the Company’s snack products. On a periodic basis, the Company evaluates each customer account and based on the days outstanding of the receivable, history of past write-offs, collections, and current credit conditions, writes off accounts it considers uncollectible. 5. Customer Concentrations ● During the year ended June 30, 2016, no individual customer made up more than 15% of our revenues. 6. Inventories ● Inventories consists of the following at June 30, Inventories are stated at the lower of cost or market. The Company periodically reviews the value of items in inventory and provides write-downs or write-offs of inventory based on its assessment of market conditions and the products relative shelf life. Write-downs and write-offs are charged to loss on inventory write down. 7. Other Current Liabilities ● Other current liabilities consist of the following at June 30, 8. Short and long term borrowings On November 24, 2010, the Company entered into a Small Business Working Capital Loan with a well-established Bank. The loan is personally Guaranteed by the Company’s Chief Executive Officer, which is further Guaranteed for 90% by the United States Small Business Administration (SBA). The term of the loan is seven years until full amortization and currently carries an 8.25% interest rate, which is based upon Wall Street Journal (“WSJ”) Prime 3.75 % Plus 4.75% and is adjusted quarterly. Monthly principal payments are required during this 84 month period. Interest expense for the years ended June 30, 2016 and 2015, totaled $1,267 and $743, respectively. 9. Stockholders’ Deficit ● On October 16, 2013, the NightFood, Inc. became a wholly-owned subsidiary of NightFood Holdings, Inc. Accordingly, the stockholders’ equity has been revised to reflect the share exchange on a retroactive basis. ● The Company is authorized to issue One Hundred Million (100,000,000) shares of $0.001 par value per share Common Stock. Holders of Common Stock are each entitled to cast one vote for each Share held of record on all matters presented to shareholders. Cumulative voting is not allowed; hence, the holders of a majority of the outstanding Common Stock can elect all directors. Holders of Common Stock are entitled to receive such dividends as may be declared by the Board of Directors out of funds legally available therefore and, in the event of liquidation, to share pro-rata in any distribution of the Company's assets after payment of liabilities. The Board of Directors is not obligated to declare a dividend and it is not anticipated that dividends will be paid unless and until the Company is profitable. Holders of Common Stock do not have pre-emptive rights to subscribe to additional shares if issued by the Company. There are no conversion, redemption, sinking fund or similar provisions regarding the Common Stock. All of the outstanding Shares of Common Stock are fully paid and non-assessable and all of the Shares of Common Stock offered thereby will be, upon issuance, fully paid and non-assessable. Holders of Shares of Common Stock will have full rights to vote on all matters brought before shareholders for their approval, subject to preferential rights of holders of any series of Preferred Stock. Holders of the Common Stock will be entitled to receive dividends, if and as declared by the Board of Directors, out of funds legally available, and share pro-rata in any distributions to holders of Common Stock upon liquidation. The holders of Common Stock will have no conversion, pre-emptive or other subscription rights. Upon any liquidation, dissolution or winding-up of the Company, assets, after the payment of debts and liabilities and any liquidation preferences of, and unpaid dividends on, any class of preferred stock then outstanding, will be distributed pro-rata to the holders of the common stock. The holders of the common stock have no right to require the Company to redeem or purchase their shares. Holders of shares of common stock do not have cumulative voting rights, which means that the holders of more than 50% of the outstanding shares, voting for the election of directors, can elect all of the directors to be elected, if they so choose, and, in that event, the holders of the remaining shares will not be able to elect any of our directors. ● The Company has 28,501,932 and 26,588,588 shares of its $0.001 par value common stock issued and outstanding as of June 30, 2016 and 2015 respectively. ● During the year ended June 30, 2016: ● the Company sold 1,064,000 shares of common stock for cash proceeds of $297,500, ● and issued 829,344 shares of common stock for services with a fair value of $293,875. ● and issued 20,000 shares of common stock as part as a loan agreement valued at $7,000. Dividends ● The Company has never issued dividends. Warrants ● The Company has never issued any warrants. 10. Related Party Transactions ● The Company received cash from Mr. Folkson, the Company’s Chief Executive Officer and related party, $1,000 and $15,000 in 2016 and 2015, respectively, to supplement the Company’s working capital. These short term advances have all been repaid. The Company reimbursed Mr. Folkson $5,000 for advances made previously during 2016. The company owes Mr. Folkson another $1,458 for expenses incurred on behalf of the company through June 30, 2016. ● On May 27, 2015, Mr. Folkson converted the outstanding note payable of $134,517 into 538,068 shares of the Company’s $0.001 par value common stock. ● The amounts previously included in short term borrowings - related party of $0 and $0 in 2016 and 2015, respectively had represented a Note Payable which was to be repayable upon Mr. Folkson providing the borrower with written notice of demand, according to certain terms. However Mr. Folkson was not permitted to demand repayment of the Note until the Company was profitable, and in a positive cash flow position. At that time, Mr. Folkson would have been allowed to demand repayment. The Company had agreed to make payments equal to 10% of the monthly positive cash flow of the Company until balance would have been paid in full. Subsequently, on May 27, 2015, Mr. Folkson converted his note into shares of the Company’s stock. ● During the third quarter 2015, Mr. Folkson began accruing a consulting fee of $6,000 per month which the aggregate of $72,000 and $36,000 is reflected in professional fees and presented in the accrued expenses - related party for 2016 and 2015 respectively. ● The consulting agreement for Mr. Folkson had a term of one year, and then converted into a month to month effective January 1, 2016. This agreement can be terminated after the initial term, with thirty (30) days notice by either party. ● Imputed interest expense accrued on the converted note payable to Mr. Folkson totaled $0 and $9,894 for the years ended June 30, 2016 and 2015, respectively. ● On February 10, 2016, shareholder Dror Tepper loaned the company $4,000. Mr. Tepper through his On April 8, 2016, Mr. Tepper loaned the company an additional $9,000, $4,000 of which was a cash loan made directly to the company, and $5,000 of which was paid directly to a vendor for services received. There was no compensation paid to Mr. Tepper for making these advances. These advances were secured by a promissory note from the company to Mr. Tepper, whereby the company has until November 4, 2016 to repay the $13,000. Should the company not be able to repay the note, Mr. Tepper is entitled to receive 150,000 shares of Company stock as repayment of the note. ● On March 4, 2016, shareholder Richard Faraci loaned the company $10,000. As compensation for making this loan, Mr. Faraci received 20,000 shares of Company common stock. This advance was secured by a promissory note from the company to Mr. Faraci, whereby the company has until September 1, 2016 to repay the $10,000. Should the company not be able to repay the note, Mr. Faraci is entitled to receive 100,000 shares of Company stock as repayment of the note. After the end of the fiscal year, this note was extended by both parties, see Note 14, Subsequenst Events. 11. Income Tax A reconciliation of the statutory income tax rates and the Company’s effective tax rate is as follows: The tax effects of the temporary differences and carry forwards that give rise to deferred tax assets consist of the following: At June 30, 2016 the Company had estimated U.S. federal net operating losses of approximately $1,012,000 for income tax purposes which will expire between 2031 and 2036. For financial reporting purposes, the entire amount of the net deferred tax assets has been offset by a valuation allowance due to uncertainty regarding the realization of the assets. The net change in the total valuation allowance for the year ended June 30, 2016 was an increase of $149,505. The Company follows FASC 740-10-25 P which requires a company to evaluate whether a tax position taken by the company will “more likely than not” be sustained upon examination by the appropriate tax authority. The Company has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The Company believes that its income tax filing positions and deductions would be sustained on audit and does not anticipate any adjustments that would result in a material change to its financial position. Therefore, no reserves for uncertain income tax positions have been recorded. The Company may not be able to utilize the net operating loss carryforwards for its US income taxes in future periods should it experience a change in ownership as defined in Section 382 of the Internal Revenue Code (“IRC”). Under section 382, should the Company experience a more than 50% change in its ownership over a 3 year period, the Company would be limited based on a formula as defined in the IRC to the amount per year it could utilize in that year of the net operating loss carryforwards. As of June 30, 2016 the Company had not performed an analysis to determine if the Company was subject to the provisions of Section 382. The Company is subject to U.S. federal income tax including state and local jurisdictions. Currently, no federal or state income tax returns are under examination by the respective taxing jurisdictions. The Company's accounting policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. The Company has not accrued interest for any periods. 12. Fair Value of Financial Instruments Cash and Equivalents, Receivables, Other Current Assets, Accounts Payable, Accrued and Other Current Liabilities The carrying amounts of these items approximated fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To increase the comparability of fair value measures, Financial Accounting Standards Board (“FASB”) ASC Topic 820-10-35 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurements). Level 1-Valuations based on quoted prices for identical assets and liabilities in active markets. Level 2-Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data. Level 3-Valuations based on unobservable inputs reflecting our own assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment. The application of the three levels of the fair value hierarchy under Topic 820-10-35 to our assets and liabilities are described below: 13. Net Loss per Share of Common Stock ● The Company has adopted FASB Topic 260, "Earnings per Share," which requires presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. In the accompanying financial statements, basic loss per share of common stock is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the year. Basic net loss per common share is based upon the weighted average number of common shares outstanding during the period. Dilution is computed by applying the treasury stock method. Under this method, options and warrants are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period. However, shares associated with convertible debt, stock options and stock warrants are not included because the inclusion would be anti-dilutive (i.e. reduce the net loss per common share). There were no anti-dilutive instruments. 14. Subsequent Events ● The Company and investor Richard Faraci mutually agreed to extend the length of an outstanding promissory note relating to a loan made by Faraci to the Company. In exchange for agreeing to extend the repayment period an additional 180 days, Faraci was granted an additional 25,000 shares. The Company was not in a position to repay the note, and Faraci was entitled to receive 100,000 shares in lieu of the repayment of the $10,000 principal, but the Company felt it preferable to extend. ● As part of a consulting agreement entered into by the Company with A.S. Austin Company, Inc., which commenced in June of 2016, the Company entered into a Warrant Agreement with the Consultant in July of 2017, whereby consultant receives warrants to purchase 75,000 shares of common stock of the Company at $.75 per share
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Based on the provided text, here's a summary of the financial statement:
Financial Statement Summary:
1. Overall Financial Status:
- The company is experiencing a loss
- Facing challenges with continuing operations
- Dependent on raising additional funds through debt and equity financing
2. Key Financial Characteristics:
- Current assets and liabilities are valued at approximate fair market value
- Cash and cash equivalents include bank deposits and short-term instruments
- Relies on estimates for various accounting calculations (depreciation, stock valuation, taxes)
3. Financial Risks:
- No guaranteed ability to secure necessary funding
- Uncertain about generating sufficient revenue to support operations
- Potential discrepancies between estimated and actual financial results
4. Accounting Approach:
- Follows Financial Accounting Standards Board (FASB) guidelines
- Uses fair value accounting principles
- Employs estimates in financial reporting
5. Liquidity Concerns
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Claude
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Violin Memory, Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Loss Consolidated Statements of Stockholders’ Equity (Deficit) Consolidated Statements of Cash Flows Notes to the Consolidated Financial Statements ACCOUNTING FIRM To the Board of Directors and Stockholders Violin Memory, Inc.: In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, comprehensive loss, stockholders’ equity (deficit) and cash flows present fairly, in all material respects, the financial position of Violin Memory, Inc. and its subsidiaries at January 31, 2016, and the results of their operations and their cash flows for the year ended January 31, 2016 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. /s/ PRICEWATERHOUSECOOPERS LLP San Jose, California April 5, 2016 ACCOUNTING FIRM The Board of Directors and Stockholders Violin Memory, Inc.: We have audited the accompanying consolidated balance sheets of Violin Memory, Inc. and subsidiaries (the Company) as of January 31, 2015, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity and cash flows for each of the years in the two-year period ended January 31, 2015. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Violin Memory, Inc. and subsidiaries as of January 31, 2015, and the results of their operations and their cash flows for each of the years in the two-year period ended January 31, 2015, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP Santa Clara, California April 8, 2015 VIOLIN MEMORY, INC. Consolidated Balance Sheets (In thousands, except par value) See accompanying notes to the consolidated financial statements. VIOLIN MEMORY, INC. Consolidated Statements of Operations (In thousands, except per share data) See accompanying notes to the consolidated financial statements. VIOLIN MEMORY, INC. Consolidated Statements of Comprehensive Loss (In thousands) There were no reclassification adjustments during each of the years ended January 31, 2016, 2015 and 2014, respectively. See accompanying notes to the consolidated financial statements. VIOLIN MEMORY, INC. Consolidated Statements of Stockholders’ Equity (Deficit) (In thousands, except per share amounts) See accompanying notes to the consolidated financial statements. VIOLIN MEMORY, INC. Consolidated Statements of Cash Flows (In thousands) See accompanying notes to the consolidated financial statements. VIOLIN MEMORY, INC. 1. Organization and Summary of Significant Accounting Policies Description of Business Violin Memory, Inc. (the “Company”) was incorporated in the State of Delaware on March 9, 2005 under the name Violin Technologies, Inc. The Company re-incorporated as Violin Memory, Inc. in the State of Delaware on April 11, 2007. The Company is a developer and supplier of persistent memory-based storage systems that are designed to bring storage performance in line with high-speed applications, servers and networks. These All Flash Arrays are specifically designed at each level of the system architecture, starting with memory and optimized through the array, to leverage the inherent capabilities of flash memory. The Company also recently introduced the Flash Storage Platform, a vertically integrated design of software, firmware and hardware that delivers performance, resiliency and availability at the same cost as legacy enterprise-class primary storage. The Flash Storage Platform runs the Company’s Concerto OS 7, a single operating system with integrated data protection, in-line block de-duplication and compression, stretch metro cluster and LUN mirroring as well as its suite of other Enterprise Data Services. The Company sells its products through its global direct sales force, systems vendors, resellers and other channel partners. The Company operates as a single operating segment. The Company has incurred significant operating losses and negative cash flows from operations since its inception and believes that it will continue to incur losses and negative cash flows from operations in fiscal year 2017. As of January 31, 2016, the Company had an accumulated deficit of approximately $560.6 million and cash, cash equivalents and short-term investments of $66.0 million. During the year ended January 31, 2016, the Company incurred a net loss of $99.1 million and negative cash flows from operations of $78.6 million. Management’s plans include reducing expenditures, expanding the Company’s customer base and increasing revenues, improving gross margins and seeking additional debt or equity financing. In March 2016, the Company announced a restructuring plan focused on aligning its expense structure with revenue expectations. In connection with the restructuring plan, the Company reduced headcount by approximately 25% from that as of October 31, 2015. The Company anticipates these actions to result in a significant reduction of its quarterly operating expenses and cash burn rate. As a result, the Company believes that its available cash, cash equivalents and short-term investments will be sufficient to fund its operations and capital expenditures for at least the next twelve months. There is no assurance that the Company will be successful in generating sufficient revenues, increasing gross margins or reducing operating costs. In addition, further capital may not be available on terms acceptable to the Company, if at all. Failure to generate sufficient revenues, increase gross margins, control or reduce operating costs or to raise sufficient funds may require the Company to modify, delay or abandon some of its plans and investments, which could have a material adverse effect on the Company’s business, operating results and financial condition and the Company’s ability to achieve its intended business objectives. Basis of Presentation and Consolidation We prepared the consolidated financial statements in accordance with U.S. generally accepted accounting principles (GAAP). The consolidated financial statements include the accounts of Violin Memory, Inc. and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated. Reclassifications Certain prior year amounts have been reclassified for consistency with the current period presentation. These reclassifications had no effect on the previously reported financial position, results of operations or cash flows. Foreign Currency Translations and Remeasurement The local currency is the functional currency for each of the Company’s subsidiaries. Assets and liabilities are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at average exchange rates for the respective period. Foreign currency translation adjustments are included in other comprehensive loss. Gains and losses from foreign currency transactions are included in other expense, net and have not been material for all periods presented. Use of Estimates The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, the Company evaluates its significant estimates, including those related to estimated selling prices for elements sold in multiple-element revenue arrangements, product warranty, determination of the fair value of stock options, carrying values of inventories, liabilities for unrecognized tax benefits and deferred income tax asset valuation allowances. The Company also uses estimates in determining the useful lives of property and equipment and in its provision for doubtful accounts. Actual results could differ from those estimates. Concentrations of Market, Credit Risk, Significant Customers and Manufacturing The Company participates in the business of developing and manufacturing scalable all flash arrays and believes that changes in any of the following areas could have a material adverse effect on the Company’s future financial position, results of operations or cash flows: advances and trends in new technologies and industry standards; competitive pressures in the form of new products or price reduction on current products; changes in the overall demand for products offered by the Company; changes in certain strategic relationships or customer relationships; litigation or claims against the Company based on intellectual property, patent, product, regulatory or other factors; and risks associated with changes in domestic and international economic and international and/or political conditions or regulations. Financial instruments that potentially subject the Company to concentrations of credit risk primarily consist of cash, cash equivalents, investments and accounts receivable. The Company places its cash and cash equivalents and investments with high credit quality financial institutions, which the Company believes are creditworthy. Deposits may exceed the insured limits provided on them. The Company generally requires no collateral from its customers. The Company mitigates its credit risk associated with its accounts receivable by performing ongoing credit evaluations of its customers and establishes an allowance for doubtful accounts for estimated losses based on management’s assessment of the collectability of customer accounts. Customers that represented more than 10% of total revenue and gross accounts receivable are as follows: * Less than 10% * Less than 10% The Company sells to a limited number of large systems vendors, resellers and end-customers and, as a result, maintains individually significant receivable balances with such customers. The Company’s systems vendor customers and certain large resellers tend to be well-capitalized, multi-national companies, while other customers may not be as well capitalized. Sales of products to large systems vendors and resellers are expected to account for a majority of the Company’s revenues in the foreseeable future, and the Company’s financial results will depend in part upon the success of these customers. The composition of the Company’s major customer base may change as the market demand for its products changes, and the Company expects this variability will continue in the future. The loss of, or a significant reduction in purchases by, any of the major customers may harm the Company’s business, financial condition and results of operations. The Company relies on a limited number of suppliers for its contract manufacturing and certain raw material components. The Company believes that other vendors would be able to provide similar products and services; however, the qualification of such vendors may require substantial start-up time. In order to mitigate any adverse impacts from disruption of supply, the Company attempts to maintain an adequate supply of critical single-sourced raw materials. Cash and Cash Equivalents Cash consists of deposits with financial institutions. The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents consist of money market funds, which are readily convertible into cash and are stated at cost, which approximates fair value. Cash and cash equivalents were $23.9 million and $93.4 million as of January 31, 2016 and 2015, respectively. Restricted Cash The Company maintains a $20.0 million line of credit with Silicon Valley Bank (“SVB”) from which it had borrowed $13.4 million as of January 31, 2016. The line is secured by the Company’s account receivable and the proceeds therefrom as well as a secured account with the same bank. The Company has recorded the cash held in this secured account as restricted cash on the consolidated balance sheet as of January 31, 2016. In connection with the sale of its PCIe product line in the second quarter of fiscal year 2015, the Company was obligated to maintain a balance of $2.3 million with an escrow agent for one year. The escrow expired on July 24, 2015 after which the Company received $2.3 million. Investments The Company classifies its investments as available-for-sale at the time of purchase since it is the Company’s intent that these investments are available for current operations and includes these investments on the consolidated balance sheet as short-term or long-term investments depending on their maturity and management’s intention with regard to the utilization of these investments, as needed, to fund current operations. As of January 31, 2016, all investments have been classified as short-term. Investments are considered impaired when a decline in fair value is judged to be other-than-temporary. The Company consults with its investment managers and considers available quantitative and qualitative evidence in evaluating potential impairment of its investments on a quarterly basis. If the cost of an individual investment exceeds its fair value, the Company evaluates, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and its intent and ability to hold the investment. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. Fair Value Measurements and Disclosures The Company records its financial assets and liabilities at fair value. The accounting guidance for fair value provides a framework for measuring fair value, clarifies the definition of fair value and expands disclosures regarding fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting guidance establishes a three-tiered hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value: Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The Company recognizes transfers among Level 1, Level 2 and Level 3 classifications as of the actual date of the events or change in circumstances that caused the transfers. The Company’s financial instruments, including cash equivalents, accounts receivable, accounts payable and accrued liabilities have carrying amounts which approximate fair value due to the short-term maturity of these instruments. Accounts Receivable Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The Company maintains an allowance for doubtful accounts for estimated losses inherent in its accounts receivable portfolio. In establishing the required allowance, management considers expected losses after taking into account current market conditions, customers’ financial condition, current receivable aging and current payment patterns. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. As of January 31, 2016 and 2015, the Company’s allowance for doubtful accounts was insignificant. Inventory Inventory consists of raw materials and finished goods and is stated at the lower of cost, determined on a first-in, first-out (“FIFO”) basis, or market. The Company periodically assesses the recoverability of all inventory, including raw materials and finished goods to determine whether adjustments are required to record inventory at the lower of cost or market. Inventory that the Company determines to be obsolete or in excess of forecasted usage is reduced to its estimated realizable value based on assumptions about future and current market conditions. In the case of inventory, which has been written down below cost through the use of a reserve, such reduced amount is considered the cost for subsequent accounting purposes. Revenue Recognition The Company derives revenue primarily from sales of its All Flash Arrays, software and related support and professional services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectability is reasonably assured. Evidence of an arrangement exists when there is a customer contract or purchase order. The Company considers delivery complete when title and risk of loss transfer to the customer, which is generally upon shipment, but no later than physical receipt by the customer. The Company sells its products and support services directly to end-customers, systems vendors and resellers. The Company currently does not provide price protection, rebates or other sales incentives to customers. The Company generally does not allow a right of return to its customers, including resellers. The Company’s multiple-element arrangements typically include two elements: hardware, which includes embedded software, and support services. Beginning in the second quarter of fiscal year 2014, following introduction of the Violin Symphony Management Software Suite, the Company’s multiple-element arrangements also may include software elements. The Company has determined that its hardware and the embedded software are considered a single unit of accounting, because the hardware and software individually do not have standalone value and are not sold separately. Standalone software, professional services and support services are each considered a separate unit of accounting as they can be sold separately and have standalone value. When more than one element, such as hardware, software and services, are contained in a single arrangement, the Company first allocates consideration to the software deliverables as a group and non-software deliverables based on the relative selling price method. The Company’s appliance products, embedded software and certain other services are considered to be non-software deliverables in such arrangements. The Company allocates revenue within the software group based upon fair value using vendor-specific objective evidence, or VSOE, with the residual revenue allocated to the delivered element. If VSOE of fair value cannot be objectivity determined for any undelivered software elements, we defer revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements. The Company allocates revenue within the non-software group to each element based upon its relative selling price in accordance with the selling price hierarchy, which includes: (1) VSOE, if available; (2) third-party evidence, or TPE, if VSOE is not available; and (3) best estimate of selling price, or BESP, if neither VSOE nor TPE is available. The Company establishes BESP considering multiple factors including, but not limited to, historical prices of products sold on a stand-alone basis, cost and gross margin objectives, competitive pricing practices and customer and market specific considerations. The Company then recognizes revenue on each deliverable in accordance with its policies for product and service revenue recognition. Revenue allocated to the Company’s products is recognized upon shipment or delivery. Revenue allocated to support services is recognized over the term, which is generally one or three years. The Company’s policy is to record revenue net of any applicable sales, use or excise tax. Property and Equipment Property and equipment consist primarily of capitalized equipment and computer hardware and software, which are stated at cost and depreciated using the straight-line method over the estimated useful lives of two years and three years, respectively. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the estimated useful life of the asset. Costs of maintenance and repairs that do not improve or extend the lives of the respective assets are expensed as incurred. Upon retirement or sale, the cost and related accumulated depreciation are removed from the balance sheet and the resulting gain or loss is reflected in operating expenses. Research and Development Research and development costs are expensed as incurred. Research and development costs consist primarily of personnel costs, prototype expenses, software tools, consulting services and allocated facilities costs. Software Development Costs The Company expenses software development costs as incurred until technological feasibility is attained, including research and development costs associated with stand-alone software products and software embedded in hardware products. Technological feasibility is attained when the Company has completed the planning, design and testing phase of development of its software and the software has been determined viable for its intended use, which typically occurs when beta testing commences. The period of time between when beta testing commences and when the software is available for general release to customers has historically been short with immaterial amounts of software development costs incurred during this period. Accordingly, the Company has not capitalized any internal software development costs to date. Advertising Expenses All advertising costs are expensed as incurred. The Company recognized advertising expenses of $2.6 million, $1.6 million and $0.6 million for the years ended January 31, 2016, 2015 and 2014, respectively. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income (or loss) in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established for deferred tax assets to the extent it is more likely than not that the deferred tax assets may not be realized. The Company evaluates uncertain tax positions taken or expected to be taken in the course of preparing an enterprise’s tax return to determine whether the tax positions are more likely than not of being sustained upon challenge by the applicable tax authority. Tax positions with respect to any potential income tax for the Company not deemed to meet the more likely than not threshold would be recorded as a tax expense in the current year. Net Loss Per Share Basic net loss per share is computed by dividing the net loss by the weighted-average number of shares of common stock outstanding for each fiscal period presented. Diluted net loss per share is computed by giving effect to all potential shares of common stock, including stock options, warrants and convertible preferred stock, to the extent dilutive. Basic and diluted net loss per share was the same for each period presented as the inclusion of all potential shares of common stock outstanding would have been anti-dilutive. Stock-Based Compensation The Company records stock-based compensation expense related to employee stock-based awards on a straight-line basis based on the estimated fair value of the awards as determined on the date of grant. The Company utilizes the Black-Scholes option pricing model to estimate the fair value of employee stock options and Employee Stock Purchase Plan (ESPP). The Black-Scholes model requires the input of highly subjective and complex assumptions, including the expected term of the stock option, the expected volatility of the Company’s common stock over the period equal to the expected term of the grant and forfeitures. The Company estimates forfeitures at the date of grant and revises the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company accounts for stock options that are issued to non-employees based on the estimated fair value of such awards using the Black-Scholes option pricing model. The measurement of stock-based compensation expense for these awards is variable and subject to periodic adjustments to the estimated fair value until the awards vest and the resulting change in the estimated fair value is recognized in the Company’s consolidated statements of operations during the period in which the related services are rendered. The Company grants restricted stock units (RSUs) to employees. Stock-based compensation expense related to these grants is based on the grant date fair value of the RSUs and is recognized on a straight-line basis over the applicable service period, which is generally four years. Impairment of Long-Lived Assets Long-lived assets, such as property and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment charge is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary. Investment in Privately-held Companies The Company analyzes equity investments in privately held companies to determine if it should be accounted for under the cost or equity method of accounting based on such factors as the percentage ownership of the voting stock outstanding and our ability to exert significant influence over these companies. For the cost method investments, the Company determines at each reporting period whether a decline in fair value has occurred and whether such decline is considered to be an other-than-temporary impairment. If a decline in fair value is determined to be other-than-temporary, the Company would recognize an impairment to reduce the investment to the lower of cost or fair value. For the years ended January 31, 2015 and 2014, the Company recorded impairments on its two investments in the amount of $3.5 million and $0.7 million, respectively. The charge is recorded in other expense, net in the consolidated statements of operations. In fiscal year 2016, the Company sold one of its investments for $0.4 million. As of January 31, 2016, the net carrying value of the Company’s remaining cost-method investment was nil. Commitments and Contingencies Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. Product Warranties The Company generally provides a three-year warranty on all of its products. The Company accrues for potential liability claims as a component of cost of revenue based upon performance of equipment in the Company’s test and support labs, historical data and trends of product reliability and costs of repairing and replacing defective products. The accrued warranty balance is reviewed periodically for adequacy and is included in accrued liabilities in the consolidated balance sheets. Recent Accounting Pronouncements In November 2015, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-17, Balance Sheet Classification of Deferred Taxes. The guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. The guidance becomes effective for the Company beginning with our annual report for the year ending January 31, 2017 with early adoption permitted. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. In August 2015, the FASB issued ASU No. 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements, which amends ASC 835-30, Interest - Imputation of Interest. This ASU clarifies the presentation and subsequent measurement of debt issuance costs associated with lines of credit. These costs may be presented as an asset and amortized ratably over the term of the line of credit arrangement, regardless of whether there are outstanding borrowings on the arrangement. The guidance becomes effective for the Company beginning with the first quarter of fiscal year 2017. Early adoption is permitted. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory, which replaces the current lower of cost or market test with the lower of cost or net realizable value test. Net realizable value is defined as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. This ASU requires prospective adoption and will be effective for the Company beginning in our first quarter of fiscal year 2018 with early adoption permitted. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. In April 2015, the FASB issued ASU No. 2015-03 - Simplifying the Presentation of Debt Issuance Costs, which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This ASU requires retrospective adoption and the Company has adopted it during the fourth quarter of fiscal 2016. The adoption of this guidance resulted in the reduction of other long-term assets and the convertible senior notes liability as of January 31, 2015 and January 31, 2016 by approximately $4.0 million and $2.5 million, respectively. In February 2015, the FASB issued ASU No. 2015-02 - Amendments to the Consolidation Analysis, which amends the consolidation requirements in Accounting Standards Codification 810, Consolidation. ASU 2015-02 makes targeted amendments to the current consolidation guidance for variable interest entities (“VIEs”), which could change consolidation conclusions. This ASU will be effective for the Company beginning in our first quarter of 2017. Early adoption is permitted. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. In August 2014, the FASB issued ASU No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, which requires management to assess a company’s ability to continue as a going concern and to provide related footnote disclosures in certain circumstances. Before this new standard, there was minimal guidance in U.S. GAAP specific to going concern. Under the new standard, disclosures are required when conditions give rise to substantial doubt about a company’s ability to continue as a going concern within one year from the financial statement issuance date. The new standard applies to all companies and is effective for the annual period ending after December 15, 2016, and all annual and interim periods thereafter. The Company has determined that this standard is not likely to have a material impact on the Company’s consolidated financial statements. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, a converged standard on revenue recognition. While the standard supersedes existing revenue recognition guidance, it closely aligns with current GAAP. Under the new standard, revenue is recognized at the time a good or service is transferred to a customer for the amount of consideration received for that specific good or service. Entities may use a full retrospective approach or report the cumulative effect as of the date of adoption. In July 2015, the FASB deferred the effective date by one year to December 15, 2017 for annual reporting periods beginning after that date. The FASB also proposed permitting early adoption of the standard, but not before the original effective date of December 15, 2016. The Company is currently evaluating the impact that the adoption of this pronouncement will have on its consolidated financial statements. 2. Balance Sheet Components Accounts Receivable The following table shows the components of accounts receivable, net (in thousands): The following table shows a rollforward of our allowance for doubtful accounts for the years ended January 31, 2016, 2015 and 2014 (in thousands): Inventory The following table shows the components of inventory (in thousands): Included in the components of inventory are reserves of $16.8 million and $23.2 million as of January 31, 2016 and 2015, respectively. In the fourth quarter of fiscal year 2015, the Company incurred a provision for excess and obsolete inventory of approximately $19.9 million in connection with its transition from its 6000 Series All Flash Array to its 7000 Series Flash Storage Platform. This provision resulted in an increase in inventory reserves of $17.6 million and an increase in accrued liabilities of $2.3 million for non-cancellable purchase orders related to the 6000 Series parts. During the year ended January 31, 2016 the Company recognized a net benefit of $3.5 million from the sale of previously written down inventory. Property and Equipment The following table shows the components of property and equipment (in thousands): Depreciation expense (including amortization of leasehold improvements) was $8.7 million, $11.0 million and $12.6 million for fiscal years 2016, 2015 and 2014, respectively. Other Assets The following table shows the components of intangibles and other assets (in thousands): During the year ended January 31, 2015, the Company capitalized $6.0 million in licensed OEM software, which is being amortized over the greater of an estimated useful life of six years on a straight line basis, or in proportion of the actual revenue to date over the expected revenue from our Flash Storage Platform product over the six year estimated life of the product. Amortization expense was $0.6 million and $0.1 million for the years ended January 31, 2016 and 2015, respectively. Accrued Liabilities The following table shows the components of accrued liabilities (in thousands): Accrued Warranty The following table is a reconciliation of the changes in the Company’s aggregate product warranty liability (in thousands): Restructuring Charges During the fourth quarter of fiscal year 2014, the Company initiated a restructuring plan. In connection with the Company’s restructuring activities and decision to focus on its core all flash array market, the Company sold its PCIe Flash Memory Card product line in July 2014 and realized proceeds of $23.0 million and a gain of $17.4 million thereon. The Company’s restructuring and transition charges consist primarily of severance, facility costs and other related charges. Severance generally includes severance payments, payments for pro-rata share of earned incentive pay and health insurance coverage. Facility costs include rent expense and related common area maintenance charges attributable to a leased facility that will not utilized over the remaining lease term. Other related charges primarily consist of write-off of purchased software, which will not be utilized and consulting charges associated with the reorganization of the Company. A summary of the restructuring activities is as follows (in thousands): 3. Fair Value Measurements The following tables present, for assets or liabilities measured at fair value, the respective fair value and the classification by level of input within the fair value hierarchy (in thousands): The Company measures its cash equivalents and marketable securities at fair value. Money market funds are valued primarily using quoted market prices utilizing market observable inputs. The Company’s investments in commercial paper, treasury bills, corporate debt securities and federal and municipal obligations are classified within Level 2 as the market inputs to value these instruments consist of market yields, reported trades and broker/dealer quotes. Fair Value of Other Financial Instruments Based on quoted market prices as of January 31, 2016 and 2015, the fair value of the Convertible Senior Notes (Note 13) was approximately $61.5 million and $111.9 million, respectively, determined using Level 2 inputs as they are not actively traded in markets. The carrying amounts of the Company’s accounts receivable, accounts payable, accrued liabilities and other liabilities approximate their fair value due to their short-term maturities. 4. Investments Short-term investments as of January 31, 2016 and 2015 consist of U.S. corporate debt securities, U.S. government and municipal debt, agency obligations and commercial paper. All marketable securities are deemed by management to be available-for-sale and are reported at fair value. Net unrealized gains or losses that are not determined to be other-than-temporary are reported within stockholders’ equity on the Company’s consolidated balance sheets as a component of accumulated comprehensive loss. Realized gains or losses are recorded based on the specific identification method. The Company’s investments are detailed in the tables below (in thousands): The amortized cost and fair value of investments held as of January 31, 2016 and 2015, by contractual years-to-maturity, are as follows (in thousands): 5. Stockholders’ Equity (Deficit) Convertible Preferred Stock Upon the closing of the Company’s IPO, all shares of our then-outstanding convertible preferred stock, as shown on the table below, automatically converted into an aggregate of 47.7 million shares of its common stock. The following table summarizes the convertible preferred stock authorized, issued and outstanding, and the rights and preferences of the respective series immediately prior to the conversion into common stock (in thousands, except per share data): Common Stock The Company is authorized to issue 1 billion shares of common stock at a par value of $0.0001 per share. As of January 31, 2016 and 2015, the Company had 98.6 million and 93.9 million shares of common stock issued and outstanding, respectively. Holders of common stock are entitled to one vote per share on all matters to be voted upon by the shareholders of the Company. Warrants In August 2014, the Company entered into a secured $40.0 million credit facility with Silicon Valley Bank (“SVB”). Pursuant to this arrangement, the Company agreed to issue SVB a warrant to purchase 79,323 shares of its common stock, $0.0001 par value per share, at a price per share of $3.782. The warrant expires in August 2019. During the second quarter of fiscal year 2014, the Company issued warrants to purchase 131,875 shares of Series D convertible preferred stock at $6.00 per share. These warrants were issued to TriplePoint in conjunction with the TriplePoint debt facility and to several investors in conjunction with the Company’s sale of convertible notes. In conjunction with the Company’s IPO, the warrants converted to warrants to purchase 84,278 shares of common stock at $11.80 per share. The warrants will expire during the second quarter of fiscal year 2018. 6. Equity Award and Employee Compensation Plans 2005 Stock Plan The 2005 Stock Plan (the “2005 Plan”) expired October 2, 2013 upon closing of the Company’s IPO and was replaced by the 2012 Stock Incentive Plan. Under the 2005 Plan, the Company was able to directly sell or award restricted shares, restricted stock units and options to employees, directors and consultants. The share awards and options were granted at prices no less than the estimated fair value at the date of grant and generally vest ratably over three to four years. The options generally expire ten years from the date of grant. 2012 Stock Plan In November 2012, the Company’s stockholders approved the adoption of the 2012 Stock Incentive Plan (the “2012 Plan”) as the successor plan to the 2005 Plan, which became effective at the completion of the Company’s initial public offering (“IPO”). Unexercised options or restricted stock units under the 2005 Plan that cancel due to a grantee’s termination may be reissued under the 2012 Plan. Under the 2012 Plan, stock options, restricted shares, restricted stock units and stock appreciation rights may be granted to employees, outside directors and consultants at not less than 100% of the fair value on the date of grant and generally vest ratably over three or four years. Options generally expire seven years from the date of grant. As of January 31, 2016, shares authorized under the 2012 Plan were 16,352,218 shares plus any remaining shares forfeited from the 2005 Plan. The reserve will automatically increase on the first day of each fiscal year in an amount equal to the lesser of (i) 5% of the outstanding shares of common stock on the last day of the immediately preceding fiscal year or (ii) a lesser amount determined by the Board of Directors. On February 1, 2016, the share reserve increased by 4,932,068 shares to an aggregate of 21,284,486 shares authorized under the 2012 Plan. The Compensation Committee of the Board of Directors (the “Compensation Committee”) administers the 2012 Stock Plan, and it may terminate or amend the plan at any time. Inducement Awards During fiscal year 2015, the Company issued inducement awards totaling 6,250,000 shares outside of the 2012 Plan (under the employee inducement award exemption under the New York Stock Exchange Listed Company Manual Rule 303A.08) to the Company’s CEO and certain key executives. In fiscal years 2016 and 2015, 1,000,000 shares and 1,250,000 shares were forfeited, respectively. Stock Options The following table summarizes the stock option activity related to shares of common stock under the Company’s 2005 and 2012 Plans and the inducement awards (in thousands, except per share data): (1) Aggregate intrinsic value is based on the common stock price at each respective date presented. The weighted average grant date fair value of options granted during the years ended January 31, 2016, 2015 and 2014 was $1.36, $1.74 and $2.15 per share, respectively. The total intrinsic value of options exercised during the year ended January 31, 2016, 2015 and 2014 was $2.5 million, $5.0 million and $5.6 million, respectively. The following table summarizes additional information regarding outstanding and exercisable options under the Stock Plans at January 31, 2016 (in thousands, except per share data): Restricted Stock Units The table below summarizes the RSU activity under the Company’s 2005 and 2012 Plans (in thousands, except per share data): (1) Aggregate intrinsic value is based on the common stock price at each respective date presented. The aggregate intrinsic value of RSUs that vested during the year ended January 31, 2016, 2015 and 2014, amounted to $10.1 million, $37.0 million and $1.5 million, respectively. Non-employee Stock Options and Awards The Company granted stock options to purchase 5,000 shares to a non-employee in fiscal year 2014. The Company granted 142,000, 230,098 and 6,000 shares of restricted stock units to non-employees in fiscal years 2016, 2015 and 2014, respectively. Employee Stock Purchase Plan In November 2012, the Company’s stockholders approved the adoption of the 2012 Employee Stock Purchase Plan (the “2012 Purchase Plan”). Upon adoption, a total of 1,000,000 shares were reserved for issuance under the 2012 Purchase Plan. The number of shares available for issuance under the 2012 Purchase Plan automatically increases on February 1 each year, beginning in 2014, by the lesser of 0.75% of the shares of common stock then outstanding or 1,000,000 shares, or a lesser amount as determined by the Compensation Committee. On February 1, 2016, pursuant to the provisions of the plan, no shares were added to the plan. The aggregate number of shares authorized under this plan is 2.3 million shares with 1.5 million shares available for future issuance. The 2012 Purchase Plan permits eligible employees to purchase common stock on favorable terms via payroll deductions of up to 15% of the employee’s salary, subject to certain share and statutory dollar limits. Two overlapping offering periods commence during each calendar year, on each June 1 and December 1 or such other periods or dates as determined by the Compensation Committee from time to time, and the offering periods last up to 24 months with a purchase date every six months. The price of each share purchased is 85% of the lower of a) the fair value per share of common stock on the last trading day before the commencement of the applicable offering period, or b) the fair value per share of common stock on the purchase date. The Compensation Committee administers the 2012 Purchase Plan and may terminate or amend the plan. During the year ended January 31, 2016, 141 employees purchased 356,494 shares under the 2012 Purchase Plan. Employee 401(k) Plan The Company sponsors the Violin Memory, Inc. 401(k) Plan (“401(k) Plan”), which qualifies under Section 401(k) of the Internal Revenue Code and is designed to provide retirement benefits for its eligible employees through tax-deferred salary deductions. Employees may elect to contribute up to 90% of their eligible compensation to the 401(k) Plan. Employee contributions are limited to a maximum annual amount as set periodically by the Internal Revenue Service (“IRS”). The Company does not currently match employee contributions. 7. Stock-Based Compensation As of January 31, 2016, total stock-based compensation cost related to unvested equity awards not yet recognized, net of estimated forfeitures, totaled $24.3 million. The Company expects to amortize $11.0 million in fiscal year 2017, $7.4 million in fiscal year 2018, $5.2 million in fiscal year 2019 and $0.7 million in fiscal year 2020. Capitalized stock-based compensation expense was not material for any period presented. The Company used the following assumptions for its employee stock option and ESPP grants: During the years ended January 31, 2016, 2015 and 2014, the Company recognized stock-based compensation associated with its ESPP plan of $0.5 million, $0.8 million and $0.4 million, respectively. Stock-based compensation associated with non-employee awards was approximately $0.4 million, $0.8 million and $0.8 million for fiscal years 2016, 2015 and 2014, respectively. Award Modifications During fiscal year 2014, the Company modified 225,000 options issued to a non-employee, accelerating the vesting of the award. The Company recognized a charge of $2.0 million within general and administrative expenses in the accompanying consolidated statement of operations for fiscal year 2014 relating to this modification. In January 2014, as part of its retention program, the Company repriced approximately 377,000 stock options originally granted to 51 non-executive employees in September and November 2013 at exercise prices ranging from $5.97 to $8.82 per share to $3.49 per share, the fair market value of the Company’s common stock as of the date of the modification. Total incremental charge relating to this modification, approximately $0.3 million, net of forfeitures, will be recognized using the straight-line attribution method over the remaining service period. 8. Income Taxes The components of loss before provision for income taxes are as follows (in thousands): The Company’s tax provision for the years ended January 31, 2016, 2015 and 2014 consists of state and foreign taxes. Income tax expense differed from the amounts computed by applying the federal statutory income tax rate of 35% to pretax loss for the years ended January 31, 2016, 2015 and 2014, respectively, as result of the following (in thousands): The tax effects of temporary differences and carryforwards that give rise to significant portions of the Company’s deferred tax assets and liabilities related to the following (in thousands): Management believes that, based on available evidence, both positive and negative, it is more likely than not that the net deferred tax assets will not be utilized, such that a full valuation allowance has been recorded. The valuation allowance for deferred tax assets was $201.4 million and $167.0 million as of January 31, 2016 and 2015, respectively. The net change in the total valuation allowance for the year ended January 31, 2016 and 2015 was an increase of $34.4 million and $35.6 million, respectively. As of January 31, 2016, the Company had approximately $319.0 million and $103.2 million of net operating loss carry forwards available to offset future taxable income for both federal and state purposes, respectively. If not utilized, these carry forward losses will expire in various amounts for federal and state tax purposes beginning in 2025 and 2015, respectively. The Company also has federal and state research and development tax credit carryforwards of approximately $9.8 million and $11.7 million, respectively. The federal tax credits will expire at various dates beginning in the year 2030 unless previously utilized. The state tax credits do not expire and will carry forward indefinitely until utilized. Utilization of the net operating loss carry forwards and credits may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. The following table reflects changes in the gross unrecognized tax benefits (in thousands): None of the unrecognized tax benefits would have a net impact to income tax expense if subsequently recognized since the recognition of such benefits would result in a corresponding increase to the Company’s valuation allowance. The Company’s policy is to classify interest and penalties associated with unrecognized tax benefits as income tax expense. The Company had no interest or penalty accruals associated with uncertain tax benefits. The Company is subject to taxation in the United States and in California and New Jersey among other states, and in certain foreign jurisdictions. As of January 31, 2016, the Company’s federal and state returns for the years ended 2010 through the current period are still open to examination. Net operating losses and research and development carryforwards that may be used in future years are still subject to inquiry given that the statute of limitation for these items would be from the year of the utilization. There are no tax years under examination by any jurisdiction at this time. 9. Commitments and Contingencies Legal Disclosure The Company assesses its potential liability by analyzing specific litigation and regulatory matters using reasonably available information. The Company develops its views on estimated losses in consultation with inside and outside counsel, which involves a subjective analysis of potential results and outcomes, assuming various combinations of appropriate litigation and settlement strategies. Beginning on November 26, 2013, four putative class action lawsuits were filed in the United States District Court for the Northern District of California naming the Company and a number of its present or former directors and officers, and the underwriters of the Company’s September 27, 2013 initial public offering (the “IPO”). The four complaints were consolidated into a single, putative class action, and on March 28, 2014, the plaintiffs filed a consolidated complaint purporting to assert claims under the federal securities laws, based upon seven categories of alleged omissions, on behalf of purchasers of the Company’s common stock issued in the IPO. The parties have reached a settlement that, if approved by the Court, will fully resolve the claims brought by plaintiffs on behalf of the class they seek to represent. The proposed settlement establishes a settlement fund of $7.5 million in return for a release of all claims in this matter. The settlement fund will be paid by the Company’s insurance carrier and will not result in any additional expense to the Company. On March 16, 2016, the Court granted plaintiffs’ Motion for Preliminary Approval of Class Action Settlement and set a Final Approval Hearing for July 26, 2016. Pursuant to the Court’s Preliminary Approval Order, notice and claim forms will be mailed to class members and class members will have an opportunity to submit claims, to opt-out of the settlement, and/or object to the settlement. At the final approval hearing, the Court will consider the notice process and results, any objections and other relevant information. The Court will then decide whether to finally approve the class settlement. If the settlement is approved, the settlement funds will be disbursed as provided in the settlement agreement and the Court’s orders. A putative stockholder derivative action is pending before the same court as the putative class action. In the derivative action, the plaintiffs allege that certain of the Company’s current and former officers and directors breached their fiduciary duties to the Company by violating the federal securities laws and exposing the Company to possible financial liability. The parties agreed to stay the derivative action pending further developments in the putative class action. The parties have reached a settlement in principle of the derivative action, which is in the process of being documented and presented for the Court’s approval. The Company believes the ultimate outcome of the current legal proceedings, individually and in the aggregate, will not have a material adverse effect on its financial position, results of operations or cash flows. However, because of the inherent uncertainties surrounding litigation, should the outcome of these actions be unfavorable, the Company’s business, financial condition, results of operations or cash flows could be materially and adversely affected. Indemnification The Company indemnifies certain of its officers and directors for certain events or occurrences, subject to certain limits, while the officer or director is or was serving at the Company’s request in such capacity. The Company’s certificate of incorporation and bylaws require that it indemnify its officers and directors against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred in connection with any proceedings arising out of their services to the Company. In addition, the Company has entered into separate indemnification agreements with each of its directors and executive officers, which provide for indemnification of these individuals under certain circumstances. The maximum amount of potential future indemnification is unlimited; however, the Company has a Directors and Officers insurance policy that enables the Company to recover a portion of any future amounts paid. Historically, the Company has not been obligated to make any payments for these obligations and no liabilities have been recorded for these obligations on the consolidated balance sheets as of January 31, 2016 and 2015. The Company may, in the ordinary course of business, agree to defend and indemnify some customers against legal claims that the Company’s products infringe on certain U.S. patents or copyrights. The terms of such obligations may vary. To date, the Company has not been required to make any payments resulting from such infringement indemnifications and no amounts have been accrued for such matters. Other Contingencies From time to time, the Company may become involved in legal proceeding or other claims and assessments arising in the ordinary course of business. The Company is not currently a party to any litigation matters, except as discussed above, which, individually or in the aggregate, are expected to have a material adverse effect on the Company’s business, financial condition or results of operations. Operating Lease Commitments The Company leases office space under various non-cancelable operating leases that expire at various dates through fiscal year 2018. Rent expense related to operating leases was $3.1 million, $2.4 million and $2.5 million for the years ended January 31, 2016, 2015 and 2014, respectively. Future minimum lease payments under the Company’s operating leases as of January 31, 2016, are as follows (in thousands): Purchase Commitments The Company depends entirely upon a contract manufacturer to manufacture its products and provide test services. Due to the lengthy lead times, the Company must order from its contract manufacturer well in advance and is obligated to pay for the materials when received and services once they are completed. As of January 31, 2016, the Company had approximately $4.9 million of outstanding purchase commitments to such contract manufacturer and other vendors. In June 2012, the Company entered into an agreement with the Forty Niners SC Stadium Company LLC, which was amended in April 2014. As part of the amended agreement, the Company will receive advertising and related benefits at the stadium in Santa Clara, California for $1.8 million per year until 2023. The Company has a remaining commitment of $14.0 million. Advertising expense was $1.8 million and $1.2 million related to this agreement for the years ended January 31, 2016 and 2015, respectively. 10. Related Party Transactions with Toshiba Toshiba Corporation and its affiliates, including Toshiba America Electronic Components, Inc., (collectively, “Toshiba”) own approximately 9.2 million shares of the Company’s common stock. In August 2014, Toshiba’s ownership decreased below 10%, and consequently, Toshiba ceased being an affiliate. In June 2011, the Company entered into a Sales Agreement with Toshiba pursuant to which the Company agreed to purchase at least 70% of its annual flash memory requirement from Toshiba. Our Sales Agreement with Toshiba expired in June 2014 and automatically renews for successive one-year periods unless terminated by either party. In July 2013, the Company signed an agreement with Toshiba for the development of PCIe cards and the sale of sample cards and received a prepayment of $16 million. The $16 million prepayment consisted of $8 million for services to be performed for the development of the PCIe cards and $8 million for the sale of sample PCIe cards and related support services. The Company retains all ownership of the intellectual property developed under the agreement. The Company applied ASC 605-25, Revenue Recognition - Multiple Element Arrangements to identify the deliverables. The Company concluded that the deliverables are development services, sample PCIe cards and support services for the sample PCIe cards. The Company recognized $6.0 million of revenue related to development services of PCIe cards and $3.1 million of revenue related to sample products during fiscal year 2014 as determined on a relative fair value basis. For the year ended January 31, 2015, the Company recognized an additional $1.0 million under the agreement related to development services performed. The remaining $5.8 million advance payment was repaid to Toshiba in May 2014 pursuant to a Mutual Termination of Contract Agreement between Toshiba and the Company. Any incremental research and development expense related to this arrangement was recognized as cost of services. During fiscal year 2015, the Company recognized no incremental cost of services. In addition to the development agreement, the Company recognized revenue of $1.6 million and $4.0 million related to the sale of All Flash Arrays and services to Toshiba during fiscal years 2015 and 2014, respectively, and purchased $9.2 million and $38.2 million of NAND flash memory from Toshiba during fiscal years 2015 and 2014, respectively. 11. Segment Information Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, the Company’s chief executive officer. The Company’s chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. The Company has one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, the Company considers itself to have a single reportable segment and operating unit structure. Revenue by geography is based on the billing address of the customer. The following table sets forth revenue and property and equipment by geographic area (in thousands): 12. Net Loss Per Share Basic net loss per share is computed by dividing the net loss by the weighted-average number of shares of common stock outstanding during the period, less the weighted-average unvested common stock subject to repurchase or forfeiture. Diluted net loss per share is computed by giving effect to all potential shares of common stock, including preferred stock, stock options and warrants, to the extent dilutive. Basic and diluted net loss per share was the same for each period presented as the inclusion of all potential common shares outstanding would have been anti-dilutive. The following table sets forth the computation of historical basic and diluted net loss per share (in thousands, except per share data): Since the Company experienced losses for all periods presented, basic net loss per share is the same as diluted net loss per share for all periods. The following potential common stock equivalents that could potentially dilute net loss per share in the future were excluded from the computation of diluted net loss per share because including them would have been anti-dilutive for the periods presented (in thousands): 13. Convertible Senior Notes, Line of Credit and Debt Facility Convertible Senior Notes On September 19, 2014, the Company issued $120 million aggregate principal amount of Convertible Senior Notes (the “Notes”), which included $15 million issued pursuant to an over-allotment option granted to the initial purchasers. The aggregate principal amount of the Notes is due on October 1, 2019, unless earlier repurchased, redeemed or converted. The Company received net proceeds of $115.4 million after deducting offering costs. Interest on the outstanding Notes accrues at a rate of 4.25% per annum and is payable semi-annually on April 1 and October 1 of each year beginning on April 1, 2015. Interest began to accrue on September 24, 2014. The Notes are unsecured senior obligations of Violin. These Notes were offered and sold only to qualified institutional investors, as defined in Rule 144 under the Securities Act of 1933 (“Securities Act”), and the Notes and the shares of the Company’s common stock issuable upon conversion of the Notes have not been registered under the Securities Act. The Company used the net proceeds to repay all amounts outstanding and owed under its credit agreement with SVB and intends to use the remaining net proceeds for general corporate purposes, including working capital. The Company may redeem the Notes, at its option, in whole or in part on or after October 1, 2017, if the last reported sale price per share of its common stock equals or exceeds 130% of the applicable conversion price for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period ending on the trading day immediately prior to the date on which the Company delivers notice of the redemption. Holders of the Notes may convert all or any portion of their notes, in multiples of $1,000 principal amount, at their option at any time prior to the close of business on the business day immediately preceding the maturity date. The Notes are convertible at an initial conversion rate of 177.8489 shares of our common stock per $1,000 principal amount of notes. This is equivalent to an initial conversion price of approximately $5.62 per share of the Company’s common stock, subject to adjustment upon the occurrence of certain dilutive events, or, if the Company obtains the required consent from its shareholders, into shares of the Company’s common stock, cash or a combination of cash and shares of its common stock, at the Company’s election. The conversion rate will be increased in the case of corporate events that constitute a “Make-Whole Fundamental Change” (as defined in the indenture governing the notes). As of January 31, 2016, the Notes are not convertible. The holders of the Notes will have the ability to require the Company to repurchase the notes in whole or in part upon the occurrence of an event that constitutes a “Fundamental Change” (as defined in the indenture governing the notes including such events as a “change in control” or “termination of trading”). In such case, the repurchase price would be 100% of the principal amount of the notes plus accrued and unpaid interest, if any. Certain events are also considered “Events of Default,” which may result in the acceleration of the maturity of the Notes, as described in the indenture governing the Notes, including, among other events, the Company’s failure to timely file with the SEC the reports required pursuant to Section 13 or 15(d) of the Securities Exchange of 1934, as amended or delisting by the NYSE. There were no “Fundamental Changes” or “Events of Default” that occurred during the year ended January 31, 2016. During the time that the Notes are outstanding, the Company may not at any time incur any indebtedness other than permitted debt, which is defined as: (a) revolving debt secured by the Company’s accounts receivable and the proceeds therefrom in a principal amount not to exceed $50 million; (b) unsecured indebtedness (including the Notes) in a principal amount not to exceed (when combined with any indebtedness incurred under clause (c) below) $150 million; (c) secured indebtedness secured by the Company’s intellectual property in a principal amount not to exceed (when combined with any indebtedness incurred under clause (b) above) $150 million; and (d) unsecured subordinated indebtedness in a principal amount not to exceed $50 million. Furthermore, the Company may incur indebtedness if (a) the Company is not in default and such additional debt would not put it into default and (ii) the consolidated leverage ratio, as defined, after taking the additional debt into account does not exceed 5:1. The Company was in compliance with its covenants under the Notes as of January 31, 2016. The conversion option of the Notes cannot be settled in cash prior to obtaining the necessary approval of the Company’s shareholders. In accordance with guidance in ASC 470-20, Debt with Conversion and Other Options and ASC 815-15, Embedded Derivatives, the Company determined that until shareholder approval that allows for settlement by issuing shares of the Company’s common stock, cash or a combination of cash and shares of its common stock, the embedded conversion components of the Notes do not require bifurcation and separate accounting. The $120 million principal amount of the Notes has been recorded as debt on the Company’s accompanying condensed consolidated balance sheet as of January 31, 2016. The deferred debt issuance costs have been recorded as a direct deduction from the Notes’ carrying amount in accordance with ASU No. 2015-03 - Simplifying the Presentation of Debt Issuance Costs, and are being amortized to interest and other financing expense using the effective interest method over the Notes’ five-year term. For the years ended January 31, 2016 and 2015, the Company amortized debt issuance costs of $1.5 million and $0.6 million, respectively, to interest and other financing expenses. As of January 31, 2016 and 2015, the Company had accrued interest of $1.7 million and $1.7 million related to the Notes. Silicon Valley Bank Credit Agreements In August 2014, the Company entered into a $40.0 million credit facility with SVB that provides for a term loan of $10.0 million and a line of credit with a maximum commitment of $30.0 million. The Company’s obligations under the agreement were secured by a first priority security interest in substantially all of its assets. Pursuant to this arrangement, the Company agreed to issue SVB a warrant to purchase 79,323 shares of its common stock, $0.0001 par value per share, at a price per share of $3.782. The warrant expires in August 2019. In connection with the Notes offering, the Company terminated the credit facility and repaid the loan. As a result, the Company recorded a loss on extinguishment amounting to $0.4 million in the year ended January 31, 2015, which relates to the write-off of debt issuance costs, including the warrant issued with the term loan. The loss on extinguishment is reflected as a part of interest and other financing expense in the accompanying consolidated statements of operations. In October 2014, the Company entered into a new $20.0 million secured revolving line of credit with SVB. The Company’s obligations under the agreement are secured by a first priority security interest in the Company’s accounts receivable and proceeds therefrom. Borrowings under this facility will bear interest at a rate per annum of either (a) the sum of (i) the Eurodollar rate plus (ii) 5.00%, or (b) the sum of (i) ABR plus (ii) 2.00%. The Company has a balance of $13.4 million and $10.0 million outstanding on this facility as of January 31, 2016 and 2015. The line of credit expires on October 24, 2016, subject to acceleration upon certain specified events of defaults. (See Note 14 - Subsequent Events.) The credit agreement contains financial covenants, including covenants requiring the Company to maintain a minimum cash balance, a minimum consolidated adjusted quick ratio and achieve a certain level of revenue relative to its operating plan. In addition, the credit agreement contains certain negative covenants, including restrictions on liens, indebtedness, fundamental changes, dispositions, restricted payments and investments. The Company was in compliance with the covenants under this agreement as of January 31, 2016. The remaining debt issuance costs associated with these two transactions are reflected in other assets and are being amortized to interest and other financing expense using the straight line method over the facility’s two-year term. TriplePoint Capital Debt Facility During May 2013, the Company entered into a $50.0 million debt arrangement with TriplePoint Capital LLC, or TriplePoint. The facility had first secured interest in substantially all of the Company’s assets and intellectual property other than $7.5 million of accounts receivable. The Company had one year to utilize the facility, which has a number of borrowing options ranging in duration from three months up to five years. Depending on the loan option, annualized interest rates range from 7.00% to 13.50%. In addition, the loans had an end-of-term payment, ranging from 0.50% to 14.00% of the principal amount depending on the duration of the loan. As of January 31, 2014, the Company had repaid all amounts outstanding on this facility. The facility was terminated in May 2014. Other Short-term Borrowings Convertible Notes: In fiscal year 2014, the Company issued and sold convertible promissory notes for an aggregate amount of $5.2 million pursuant to a note and warrant purchase agreement. The notes had an interest rate of 10%. The outstanding principal and accrued interest converted, upon completion of the IPO, into Company’s common stock at $9.00 per share. The convertible notes bore 6% interest per annum. Product Financing Arrangement: In July 2014, the Company entered into a managed inventory program to run through December 2014. Under the agreement, the Company gave title to 194,000 units of product to the counterparty for approximately $2.3 million. The Company is obligated to repurchase the product in five equal monthly installments, including predetermined transaction fees of between 4.5% and 6%. As of January 31, 2015, the Company had settled this liability in full. Line of Credit: In July 2013, the Company entered into a $7.5 million line of credit with Comerica Bank. The Company could borrow up to 80% of its current U.S.-based receivables, or $7.5 million, whichever is lower. The line was secured against the Company’s accounts receivable and collections thereof as well as its intellectual property. The line had a two-year term and bore interest of prime plus 1%. In August 2014, the Company repaid all outstanding amounts under the line of credit and terminated the Loan and Security Agreement with Comerica. 14. Subsequent Events In April 2016, the Company amended its secured revolving line of credit with SVB, to extend its term through May 1, 2017, modify the financial covenants and lower the commitment to $10 million. The Company’s obligations under the agreement remain secured by a first priority security interest in the Company’s accounts receivable and the proceeds therefrom. In March 2016, the United States District Court for the Northern District of California granted plaintiffs’ Motion for Preliminary Approval of Class Action Settlement and set a Final Approval Hearing for July 26, 2016 in the putative class action lawsuit. In addition, the parties have reached a settlement in principle of the derivative action, which is in the process of being documented and presented for the Court’s approval. (See Note 9.) In March 2016, the Company announced a restructuring plan. In connection with the plan, the Company reduced headcount by approximately 25% from that as of the end of the third quarter of fiscal year 2016.
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Based on the provided financial statement excerpt, here's a summary of the key points:
1. Financial Position:
- The company (Violin Memory, Inc.) appears to be operating at a loss
- Concerns exist about future funding and operational sustainability
2. Revenue:
- Specific revenue figures are not fully provided
- Customer concentration risk exists with some customers representing >10% of business
3. Operations:
- Company has sufficient cash/resources for at least 12 months of operations
- Faces challenges in:
* Generating sufficient revenues
* Increasing gross margins
* Reducing operating costs
4. Risk Factors:
- Credit risk from customer accounts receivable
- Market concentration risk
- Technology and competitive pressures
- Strategic relationship dependencies
- International economic/political risks
5. Financial Management:
- Uses GAAP accounting standards
- Maintains cash/investments with high-credit institutions
- Performs ongoing credit evaluations of customers
- Has foreign currency exposure managed through local currency operations
The statement suggests the company is in a challenging financial position with ongoing concerns about future sustainability and funding needs.
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Claude
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Financial Statements And Supplementary Data PMX Communities, Inc. Page Reports of Independent Registered Public Accounting Firms 12-13 Consolidated Balance Sheets as of December 31, 2016 and 2015 Consolidated Statements of Operations for the Years ended December 31, 2016 and 2015 Consolidated Statements of Changes in Stockholders' Deficit for the Years ended December 31, 2016 and 2015 Consolidated Statements of Cash Flows for the Years ended December 31, 2016 and 2015 ACCOUNTING FIRM To the Sole Director and Stockholders PMX Communities, Inc. We have audited the accompanying consolidated balance sheet of PMX Communities, Inc. and its subsidiaries (collectively, the “Company”) as of December 31, 2016, and the related consolidated statements of operations, changes in stockholders’ deficit, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the entity’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PMX Communities, Inc. and its subsidiaries as of December 31, 2016, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered recurring losses from operations and has a working capital deficit that raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ MaloneBailey, LLP www.malonebailey.com Houston, Texas May 1, 2017 STEVENSON & COMPANY CPAS LLC A PCAOB Registered Accounting Firm 12421 N Florida Ave. Suite.113 Tampa, FL 33612 {813)443-0619 ACCOUNTING FIRM The Board of Directors and Stockholders PMX Communities, Inc. We have audited the accompanying balance sheets of PMX Communities, Inc. as of December 31, 2015, and the related statements of operations, stockholders’ deficit, and cash flows for the period ended December 31, 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of PMX Communities, Inc. as of December 31, 2015 and the results of its operations and its cash flows for the period then ended in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the accompanying financial statements, the Company has significant net losses and cash flow deficiencies. Those conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans regarding those matters are described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Stevenson & Company CPAS LLC Stevenson & Company CPAS LLC Tampa, Florida April 18, 2016 PCAOB Registered AICPA Member PMX Communities, Inc. and Subsidiaries Consolidated Balance Sheets December 31, December 31, Assets Current assets Total current assets $ - $ - Fixed assets Equipment, net - 63,030 Total assets $ - $ 63,030 Liabilities and Stockholders' Deficit Current liabilities Accounts payable $ 62,549 $ 35,379 Accrued interest 115,644 92,017 Notes payable 157,367 153,367 Total current liabilities 335,560 280,763 Total Liabilities 335,560 280,763 Stockholders' deficit Preferred stock, $0.0001 par value; authorized 10,000,000 shares, no shares issued or outstanding - - Common stock, $0.0001 par value; authorized 500,000,000 shares, issued and outstanding 118,015,124 and 97,115,125 shares as of December 31, 2016 and December 31, 2015 respectively 11,801 9,711 Common stock payable - 38,150 Additional paid-in capital 3,102,321 3,024,261 Accumulated deficit (3,449,682) (3,289,855) Total stockholders' deficit (335,560) (217,733) Total liabilities and stockholders' deficit $ - $ 63,030 See accompanying notes to consolidated financial statements PMX Communities, Inc. and Subsidiaries Consolidated Statements of Operations For the year ended For the year ended December 31, December 31, Operating expenses: Depreciation $ 23,716 $ 33,408 Selling, general and administrative expenses 73,170 86,175 Impairment loss on equipment 39,314 - Total operating expenses 136,200 119,583 Loss from operations (136,200) (119,583) Other income (expense): Interest expense (23,627) (35,117) Gain on forgiveness of accounts payable - 35,495 Total other income (expense) (23,627) Loss before income taxes (159,827) (119,205) Income taxes - - Net loss $ (159,827) $ (119,205) Basic and Diluted Net loss per common share $ (0.00) $ (0.00) Weighted average common shares outstanding Basic and Diluted 107,684,250 95,950,289 See accompanying notes to consolidated financial statements. PMX Communities, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Deficit For the Years Ended December 31, 2016 and 2015 See accompanying notes to consolidated financial statements. PMX Communities, Inc. and Subsidiaries Consolidated Statements of Cash Flows For the year ended For the year ended December 31, December 31, Cash flows from operating activities Net loss $(159,827) $(119,205) Adjustments to reconcile net loss to net cash used in operating activities: Gain on settlement of accounts payable - (35,495) Common stock issued for services 42,000 16,000 Depreciation 23,716 33,408 Impairment loss on equipment 39,314 - Expenses paid by related party on behalf of the Company 24,550 - Change in assets and liabilities Security deposit - 4,500 Accounts payable 2,620 1,804 Accrued interest 23,627 41,773 Net cash used in operating activities (4,000) (57,215) Cash flows from financing activities Proceeds from related party notes payable 4,000 57,202 Net cash provided by financing activities 4,000 57,202 Net decrease in cash and cash equivalents - (13) Cash and cash equivalents, beginning of period - Cash and cash equivalents, end of period $ - $ - Supplementary information: Cash paid for: Interest $ - $ - Income taxes $ - $ - Non-cash transactions: Conversion of notes payable and accrued interest into common stock $ - $327,000 Common shares issued for related party note payable converted in prior year $ 38,150 $ - See accompanying notes consolidated financial statements. PMX Communities, Inc. and Subsidiaries For the Years Ended December 31, 2016 and December 31, 2015 NOTE 1 - DESCRIPTION OF BUSINESS PMX Communities, Inc. "PMX" was organized under the laws of the State of Nevada on December 29, 2004 under the name Merge II, Inc. and changed its name to PMX Communities, Inc. effective February 10, 2009. PMX's year end is December 31. On September 28, 2010, PMX formed PMX Gold, LLC, (“PMX Gold”) a Florida limited liability company as a wholly owned subsidiary of the Company to assist with evaluating and pursuing opportunities within the Gold Mining and Retail Gold Sales Industries. On September 28, 2011, PMX formed PMX Gold Bullion Sales Inc. (“PMX Bullion”), a Florida corporation as a wholly owned subsidiary of the Company. PMX, (through its wholly owned subsidiaries PMX Gold, LLC and PMX Gold Bullion Sales Inc.) focuses on the development of leveraged opportunities within the Retail Gold Sales and Gold Mining Industries. PMX Communities, Inc. and its wholly-owned subsidiaries are hereafter referred to as “the Company”. On July 18, 2016, the Board of Directors approved an increase in the number of shares available for issuance through the 2011 stock awards plan from 10,000,000 common shares to 17,700,000 common shares. NOTE 2 - GOING CONCERN The accompanying consolidated financial statements have been prepared on a going concern basis. The Company has a working capital deficit, has incurred reoccurring net losses and has not yet established revenue producing activities which raises substantial doubt about its ability to continue as a going concern. Based on the above considerations, there is a substantial doubt about the ability of the Company to continue as a going concern. The ability of the Company to continue as a going concern is dependent on the Company's ability to further implement its business plan and generate future profits or attain working capital through debt or equity financing. Management hopes that with precious metals making a turn around, they will obtain distribution networks for the machines. Management hopes to find avenues to license their terminal technologies and sell terminals which will bring sufficient revenues and investment into the Company to sustain its growth and operations. Furthermore, management believes organic growth through a new strategy in the Company’s subsidiaries will assist the Company in achievement of its goals. There is no assurance that this series of events will be satisfactorily completed. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation Our financial statements are stated in United States dollars and have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Cash and Cash Equivalents The Company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. Use of Estimates The preparation of the consolidated financial statements in conformity with U.S. GAAP requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of expenses during the period presented. We make our estimate of the ultimate outcome for these items based on historical trends and other information available when the financial statements are prepared. Changes in estimates are recognized in accordance with the accounting rules for the estimate, which is typically in the period when new information becomes available. We believe that our significant estimates, assumptions and judgments are reasonable, based upon information available at the time they were made. Actual results could differ from these estimates, making it possible that a change in these estimates could occur in the near term. Principles of Consolidation The consolidated financial statements include the accounts of PMX Communities, Inc. and its wholly-owned subsidiaries, PMX Gold, LLC and PMX Gold Bullion Sales, Inc. All inter-company transactions have been eliminated. Financial Instruments and Fair Value The Company’s balance sheet includes certain financial instruments, including accounts payable, accrued expenses and notes payable. The carrying amounts of current assets and current liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization. ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below: Level 1 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means. Level 3 Inputs that are both significant to the fair value measurement and unobservable. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2016. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values due to the short-term nature of these instruments. Equipment Equipment is stated at cost, less accumulated depreciation. Depreciation is provided using the straight line method over the estimated useful life of five years for equipment, five years for molds and seven years for furniture and fixtures. Impairment of Long-Lived Assets The Company evaluates the recoverability of long-lived assets and the related estimated remaining useful lives when events or circumstances lead management to believe that the carrying value of an asset may not be recoverable and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amounts. In such circumstances, those assets are written down to estimated fair value. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset's estimated fair value and its book value. Common Stock, Common Stock Options and Warrants The Company uses the fair value recognition provision of ASC 718, "Compensation-Stock Compensation," which requires the Company to expense the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of such instruments. The Company uses the Black-Scholes option pricing model to calculate the fair value of any equity instruments on the grant date. The Company also uses the provisions of ASC 505-50, "Equity Based Payments to Non-Employees," to account for stock-based compensation awards issued to non-employees for services. Such awards for services are recorded at either the fair value of the services rendered or the instruments issued in exchange for such services, whichever is more readily determinable, using the measurement date guidelines enumerated in ASC 505-50. Income Taxes Under the asset and liability method prescribed under ASC 740, Income Taxes, the Company uses the liability method of accounting for income taxes. The liability method measures deferred income taxes by applying enacted statutory rates in effect at the balance sheet date to the differences between the tax basis of assets and liabilities and their reported amounts on the financial statements. The resulting deferred tax assets or liabilities are adjusted to reflect changes in tax laws as they occur. A valuation allowance is provided when it is more likely than not that a deferred tax asset will not be realized. The Company recognizes the financial statement benefit of an uncertain tax position only after considering the probability that a tax authority would sustain the position in an examination. For tax positions meeting a "more-likely-than-not" threshold, the amount recognized in the financial statements is the benefit expected to be realized upon settlement with the tax authority. For tax positions not meeting the threshold, no financial statement benefit is recognized. As of December 31, 2016 and 2015, the Company had no uncertain tax positions. As of December 31, 2016, the Company has approximately $3,725,000 in net loss carry forwards. The Company recognizes interest and penalties, if any, related to uncertain tax positions as general and administrative expenses. The Company currently has no federal or state tax examinations nor has it had any federal or state examinations since its inception. The tax years for December 31, 2011-2016 remain subject to review by federal and state tax authorities. Income tax expense (benefit) consists of the following for the years ended December 31: The net deferred income tax assets and (liability) consist of the following as of December 31: Deferred: Net deferred tax asset and liabilities 1,303,700 1,261,600 Less reserve for allowance (1,303,700) (1,261,600) Total deferred tax assets and liabilities - - Revenue Recognition The Company recognizes revenue when it is realized and realizable. - Persuasive evidence of an arrangement exists; and - Delivery has occurred; and - Price is fixed or determinable; and - Collectability is reasonably assured Subject to these criterions, the Company recognizes revenue at the time the merchandise is purchased and the machine dispenses the relevant merchandise. The Company offers its individual customers a 14-day warranty if the item is returned and if the TEP packaging is not broken. The customer will receive their money back. The Company estimates an allowance for sales returns based on historical experience with product returns. The Company closely follows the provisions of ASC 605, Revenue Recognition, which includes the guidelines of Staff Accounting Bulletin No. 104 as described above. Income (loss) Per Common Share Basic income (loss) per share is calculated using the weighted-average number of common shares outstanding during each reporting period. Diluted loss per share includes potentially dilutive securities such as outstanding options and warrants, using various methods such as the treasury stock or modified treasury stock method in the determination of dilutive shares outstanding during each reporting period. As of December 31, 2016 and 2015, the Company had no warrants issued and outstanding. Recent Authoritative Accounting Pronouncement In August 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-15, “Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” (“ASU 2014-15”). ASU 2014-15 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, with early adoption permitted. The Company is currently assessing the impact the adoption of ASU 2014-15 will have on its financial statements. Management does not believe that any recently issued, but not yet effective accounting pronouncements, if adopted, would have a material effect on the accompanying consolidated financial statements. NOTE 4 - PROPERTY AND EQUIPMENT Components of property and equipment are as follows: Depreciation for the year’s ended December 31, 2016 and 2015 was $23,716 and $33,408, respectively. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. Through its analysis, the Company determined that the expected future cash flows is less than the carrying amount of the assets, therefore, an impairment loss of $39,314 was recorded during the year ended December 31, 2016. NOTE 5 - NOTES PAYABLE Promissory Notes carry outstanding principal balances of $157,367 and $153,367 as of December 31, 2016 and 2015, respectively. Related accrued interest was $115,644 and $92,017 as of December 31, 2016 and 2015, respectively. As of December 31, 2016, these notes are due on demand as their maturity dates have passed and are considered to be in default. These notes bear interest at a rate of 5% to 12% per annum. NOTE 6 - EQUITY FINANCING On December 11, 2014, the Company amended its Articles of Incorporation. The following are the authorized shares for each class: Class Par Authorized Preferred 0.0001 10,000,000 Common 0.0001 500,000,000 Shares Issued for Services On April 17, 2015, the Company issued 4,000,000 shares of stock to a company for services. These shares were valued at fair market value, which on the date of issuance was $16,000 and expensed as consulting expense. On July 1, 2016, the Board of Directors approved the issuance of the following shares: 4,000,000 shares to an officer of the Company for services and 6,000,000 shares to a related party shareholder for consulting services. The total value for the 10,000,000 shares was $42,000. Shares Issued to convert related party notes payable During the year ended December 31, 2015, one shareholder and his beneficial interests made aggregate loans of $57,202 to the Company. The loans bear interest at 5% and each have a six-month maturity. In December 2015, these new loans, prior year, related party loans and related accrued interest totaling approximately $327,000 were settled by the holders agreeing to receive 10,900,000 shares which were valued at $38,150 and recorded as common stock payable. The remaining balances of the loans were recorded as a capital contribution. The Company issued the 10,900,000 shares during the year December 31, 2016. Warrants No warrants were issued and outstanding during the years ended December 31, 2016 and 2015. NOTE 7 - RELATED PARTY TRANSACTIONS The Company is currently using space at 2700 North Military Trail #130, Boca Raton, FL 33431, which has been provided by a majority shareholder free of charge. During the year ended December 31, 2015, one shareholder and his beneficial interests made aggregate loans of $57,202 to the Company. The loans bear interest at 5% and each have a six-month maturity. In December 2015, these new loans, prior year, related party loans and related accrued interest totaling approximately $327,000 were settled by the holders agreeing to receive 10,900,000 shares which were valued at $38,150 and recorded as common stock payable. The remaining balances of the loans were recorded as a capital contribution. The Company issued the 10,900,000 shares during the year December 31, 2016. During the years ended December 31, 2016 and 2015, one shareholder and his beneficial interests made aggregate loans of $4,000 and $57,202, respectively, to the Company. The balance as of December 31, 2016 and 2015 is $4,000 and $0, respectively. The loans bear interest at 5% and each has a six-month maturity. During the year ended December 30, 2016, a related party shareholder paid $24,550 in expenses on the Company’s behalf. The amount is included in accounts payable. On July 1, 2016, the Board of Directors approved to issue a total of 10,000,000 shares of common stock to officers of the Company for services at $0.0042 per share or $42,000. The above related party transactions are not necessarily indicative of the terms and amounts that would have been incurred had comparable agreements been made with independent parties. NOTE 8 - COMMITMENTS AND CONTINGENCIES On June 19, 2015, the Company received a civil court summons regarding an unpaid note payable with a principal sum of $125,000. On February 26, 2016, a final judgment for $105,756 due to the note holder was recorded in Broward County, Florida. The Company has not repaid the judgement and as such the note continues to accrue interest, the total due including interest as of December 31, 2016 is $131,938.
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Here's a summary of the financial statement:
Financial Health:
- The company is experiencing operational losses
- Has a working capital deficit
- Significant uncertainty about continuing as a going concern
Assets:
- Total current assets: $0
- Fixed assets (equipment, net): $63,030
Liabilities:
- Current liabilities (accounts payable): $62,549
Key Observations:
- Minimal assets
- High current liabilities
- Potential financial distress
- Management may have plans to address financial challenges (referenced in Note 2)
The company appears to be in a precarious financial position with limited assets and substantial liabilities.
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Claude
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. ETHEMA HEALTH CORPORATION (formerly known as Greenestone Healthcare Corporation) INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS (Expressed in US$ unless otherwise indicated) ACCOUNTING FIRM To the Board of Directors and Stockholders of Ethema Health Corporation (formerly known as Greenestone Healthcare Corporation) We have audited the accompanying consolidated balance sheets of Ethema Health Corporation (“the Company”) as of December 31, 2016 and 2015 and the related consolidated statements of operations and other comprehensive loss, stockholders’ deficit and cash flows for the two years in the period ended December 31, 2016 and 2015. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ethema Health Corporation as of December 31, 2016 and 2015 and the results of its operations and its cash flows for the two years in the period ended December 31, 2016 and 2015 in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company has sustained net losses and has a working capital and stockholder’s deficit. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regards to these matters are also described in Note 3. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ RBSM LLP New York, NY 10022 April 17, 2017 ETHEMA HEALTH CORPORATION (formerly known as Greenestone Healthcare Corporation) CONSOLDATED BALANCE SHEETS ETHEMA HEALTH CORPORATION (formerly known as Greenestone Healthcare Corporation) CONSOLIDATED STATEMENTS OF OPERATIONS ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) CONSOLIDATED STATEMENT OF CASH FLOWS The accompanying notes are an integral part of the consolidated financial statements ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1.Nature of Business Ethema Health Corporation (the “Company”) was incorporated under the laws of the state of Colorado, USA, on April 1, 1993. Effective April 4, 2017, the Company changed its name to Ethema Health Corporation and prior to that, on May 2012, the Company had changed its name to Greenestone Healthcare Corporation from Nova Natural Resources Corporation. As at December 31, 2016 and 2015, the Company owns 100% of the outstanding shares of Greenestone Clinic Muskoka Inc., which was incorporated in 2010 under the laws of the Province of Ontario, Canada. Greenestone Clinic Muskoka Inc. provides medical services to various patients in a clinic located in the regional municipality of Muskoka. On May 17, 2016 Greenstone, through its newly formed, wholly owned subsidiaries; Seastone Delray Healthcare, LLC (“Seastone”) and Delray Andrews RE, LLC (“Andrews”), both Florida limited liability companies, entered into an Asset Purchase Agreement (“Seastone APA”), a Commercial Real estate contract (“RE Contract”), and a Management Services Agreement (“Management Agreement”), with Seastone of Delray, LLC, a Florida limited liability company (“Seastone Delray”). Pursuant to the terms of the Seastone APA, the Company would purchase Seastone Delray’s business, which is primarily the practice of providing addiction treatment health care services (the “Business”), and substantially all the assets used in connection with the Business and other assets in which Seastone Delray has any right, title or interest, except those certain assets specifically excluded in the Seastone APA. Pursuant to the terms of the Management Agreement, the Company would have the right to operate Seastone Delray’s Business for 90 days commencing on June 15, 2016 or earlier if the Company waives the Due Diligence Period (the “Management Period”). During the Management Period, the Company is entitled to the revenues from the Business and will pay Seastone Delray $20,000 per month to cover certain costs related to the Business, which shall increase to $28,000 per month if the Management Agreement is extended beyond 90 days. The Management Agreement may be terminated by either party if the Purchase Agreement did not close by September 15, 2016. Also on May 17, 2016, the Company entered into a commercial real estate contract (the “RE Contract”) with Seastone Condominiums of Delray, LLC and 810 Andrews, LLC, both Florida limited liability companies (“the RE Sellers”). Pursuant to the RE Contract, the Company would acquire certain real property, and, prior to the closing, intends to assign the RE Contract to Andrews. The purchase price for the Transaction was $6,150,000, which was being funded by a purchase money first mortgage in the amount of $3,000,000 at 5% per annum payable at $15,000 per month for three years; and $3,150,000 in cash. On February 14, 2017, GreeneStone completed a series of transactions (referred to collectively as the “Restructuring Transactions”), including a share purchase agreement (the “SPA”) whereby GreeneStone acquired the stock of the company holding the Muskoka Healthcare Clinic real estate, an asset purchase agreement (the “APA”) and lease (the “Lease”) whereby the Company sold all of the Muskoka clinic business assets and leased the clinic building to the buyer, and a real estate purchase agreement and asset purchase agreement whereby the Company purchased the real estate and business assets of Seastone Delray (the “Florida Purchase”). The Stock Purchase Agreement Under the SPA, the Company acquired 100% of the stock of Cranberry Cove Holdings Ltd. (“CCH”) from Leon Developments Ltd. (“Leon Developments”), a company wholly owned by Shawn E. Leon, who is the President, CEO, and CFO of GreeneStone (“Mr. Leon”). CCH owns the real estate on which the Company’s rehabilitation clinic (“the Canadian Rehab Clinic”) in Muskoka, Ontario is located. The total consideration paid by GreeneStone was CDN$3,300,000 (an appraised value of CDN$10,000,000 less the outstanding mortgage loan), which was funded by the assignment to Leon Developments of certain indebtedness owing to GreeneStone in the amount of CDN$659,918, and the issuance of 60,000,000 shares of the Company’s common stock to Leon Developments, valued at approximately US$0.033 per share (the “Shares”). ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1.Nature of Business (continued) The Asset Purchase Agreement and Lease Under the APA, the assets of the Canadian Rehab Clinic were sold by GreeneStone, through its subsidiary, GreeneStone Clinic Muskoka Inc. (“Muskoka”), to Canadian Addiction Residential Treatment LP (the “Purchaser”), for a total consideration of CDN$10,000,000, plus an additional performance payment of up to CDN$3,000,000 as a performance payment to be received in 2019 if certain clinic performance metrics are met. The Purchaser completed the sale with cash proceeds to the Company of CDN$10,000,000, of which CDN$1,500,000 will remain in escrow for up to two years to cover indemnities given by the Company. The proceeds of the Muskoka clinic asset sale were used to pay down certain tax debts and operational costs of the Company and to fund the Florida Purchase, mentioned below. Through the APA, substantially all of the assets of the Rehab Clinic Subsidiary were sold, leaving GreeneStone with only the underlying clinic real estate, which GreeneStone through its newly acquired subsidiary CCH concurrently leased to the Purchaser. The Lease is a triple net lease and provides for a five (5) year primary term with three (3) five year renewal options, annual base rent for the first year at CDN$420,000 with annual increases, an option to tenant to purchase the leased premises and certain first refusal rights,. The Florida Purchase Immediately after closing on the sale of its Muskoka clinic business, GreeneStone closed on the acquisition of the business and real estate assets of Seastone Delray pursuant to certain real estate and asset purchase agreements This business will be operated through its wholly owned subsidiary Seastone. The purchase price for the Seastone assets was US$6,150,000 financed with a purchase money mortgage of US$3,000,000, and US$3,150,000 in cash. 2.Summary of Significant Accounting Policies a)Financial Reporting The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. Revenues and expenses are reported on the accrual basis, which means that income is recognized as it is earned and expenses are recognized as they are incurred. Management further acknowledges that it is solely responsible for adopting sound accounting practices, establishing and maintaining a system of internal accounting control and preventing and detecting fraud. The Company's system of internal accounting control is designed to assure, among other items, that i) recorded transactions are valid; ii) valid transactions are recorded; and iii) transactions are recorded in the proper period in a timely manner to produce financial statements which present fairly the financial condition, results of operations and cash flows of the Company for the respective periods being presented. b)Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) c)Principals of consolidation and foreign currency translation The accompanying consolidated financial statements include the accounts of the Company, its subsidiary. All intercompany transactions and balances have been eliminated on consolidation The Company’s subsidiary’s functional currency was the Canadian dollar, while the Company’s reporting currency is the U.S. dollar. All transactions initiated in Canadian dollars are translated into US dollars in accordance with ASC 830, “Foreign Currency Translation” as follows: •Monetary assets and liabilities at the rate of exchange in effect at the balance sheet date. •Equity at historical rates. •Revenue and expense items at the average rate of exchange prevailing during the period. Adjustments arising from such translations are deferred until realization and are included as a separate component of stockholders’ deficit as a component of accumulated other comprehensive income or loss. Therefore, translation adjustments are not included in determining net income (loss) but reported as other comprehensive income (loss). For foreign currency transactions, the Company translates these amounts to the Company’s functional currency at the exchange rate effective on the invoice date. If the exchange rate changes between the time of purchase and the time actual payment is made, a foreign exchange transaction gain or loss results which is included in determining net income for the period. The relevant translation rates are as follows: For the year ended December 31, 2016 a closing rate of CAD$1.0000 equals US$0.7448 and an average exchange rate of CAD$1.0000 equals US$0.7555. d)Revenue Recognition The Company recognizes revenue from the rendering of services when they are earned; specifically, when all of the following conditions are met: •the significant risks and rewards of ownership are transferred to customers and the Company retains neither continuing involvement nor effective control; •there is clear evidence that an arrangement exists; •the amount of revenue and related costs can be measured reliably; and •it is probable that the economic benefits associated with the transaction will flow to the Company. In particular, the Company recognizes: •Fees for out-patient counselling, coaching, intervention, psychological assessments and other related services when patients receive the service; and •Fees for in-patient addiction treatments proportionately over the term of the patient’s treatment. Deferred revenue represents monies deposited by the patients for future services to be provided by the Company. Such monies will be recognized into revenue as the patient progresses through their treatment term. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) e)Non-monetary transactions The Company’s policy is to measure an asset exchanged or transferred in a non-monetary transaction at the more reliable measurement of the fair value of the asset given up and the fair value of the asset received, unless: •The transaction lacks commercial substance; •The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange; •Neither the fair value of the asset received nor the fair value of the asset given up is reliably measurable; or •The transaction is a non-monetary, non-reciprocal transfer to owners that represents a spin-off or other form of restructuring or liquidation. f)Cash and cash equivalents The Company's policy is to disclose bank balances under cash, including bank overdrafts with balances that fluctuate frequently from being positive to overdrawn and term deposits with a maturity period of three months or less from the date of acquisition. The Company has $74,480 (CAD$100,000) in restricted cash held by their bank to cover against the possibility of credit card charge backs, for services not performed. g)Accounts receivable The Company provides an allowance for doubtful accounts equal to the estimated uncollectible amounts. The Company's estimate is based on historical collection experience and a review of the current status of trade accounts receivable. It is reasonably possible that the Company’s estimate of the allowance for doubtful accounts will change. At December 31, 2016 and December 31, 2015, the Company has a $0 and $0 allowance for doubtful accounts, respectively. h)Financial instruments The Company initially measures its financial assets and liabilities at fair value, except for certain non-arm's length transactions. The Company subsequently measures all its financial assets and financial liabilities at amortized cost. Financial assets measured at amortized cost include cash and accounts receivable. Financial liabilities measured at amortized cost include bank indebtedness, accounts payable and accrued liabilities, harmonized sales tax payable, withholding taxes payable, convertible notes payable, loans payable and related party notes. Financial assets measured at cost are tested for impairment when there are indicators of impairment. The amount of the write-down is recognized in net income. The previously recognized impairment loss may be reversed to the extent of the improvement, directly or by adjusting the allowance account, provided it is no greater than the amount that would have been reported at the date of the reversal had the impairment not been recognized previously. The amount of the reversal is recognized in net income. The Company recognizes its transaction costs in net income in the period incurred. However, financial instruments that will not be subsequently measured at fair value are adjusted by the transaction costs that are directly attributable to their origination, issuance or assumption. FASB ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: •Level 1. Observable inputs such as quoted prices in active markets; •Level 2. Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and •Level 3. Unobservable inputs in which there is little or no market data, which requires the reporting entity to develop its own assumptions. The Company does not have assets or liabilities measured at fair value on a recurring basis at December 31, 2016 and 2015. The Company did not have any fair value adjustments for assets and liabilities measured at fair value on a non-recurring basis during the year ended December 31, 2016 and 2015. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2.Summary of Significant Accounting Policies (continued) i)Plant and equipment Fixed assets are recorded at cost. Depreciation is calculated on the declining balance method at the following annual rates: Leasehold improvements are depreciated using the straight-line method over the term of the lease. Half rates are used for all fixed assets in the year of acquisition. j)Leases Leases are classified as either capital or operating leases. Leases that transfer substantially all of the benefits and inherent risks of ownership of property to the Company are accounted for as capital leases. At the time a capital lease is entered into, an asset is recorded together with its related long-term obligation to reflect the acquisition and financing. Equipment recorded under capital leases is amortized on the same basis as described above. Payments under operating leases are expensed as incurred. k)Income taxes The Company accounts for income taxes under the provisions of ASC Topic 740, “Income Taxes”. Under ASC Topic 740, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred income taxes are provided using the liability method. Under this method, deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The tax basis of an asset or liability is the amount attributed to that asset or liability for tax purposes. The effect on deferred taxes of a change in tax rates is recognized in income in the period of change. A valuation allowance is provided to reduce the amount of deferred tax assets if it is considered more likely than not that some portion of, or all of, the deferred tax assets will not be realized. ASC Topic 740 contains a twostep approach to recognizing and measuring uncertain tax positions taken or expected to be taken in a tax return. The first step is to determine if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained in an audit, including resolution of any related appeals or litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. The Company recognizes interest and penalties accrued on unrecognized tax benefits within general and administrative expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction in general and administrative expenses in the period that such determination is made. The tax returns for fiscal 2001, through 2016 are subject to audit or review by the US tax authorities, whereas fiscal 2010 through 2016 are subject to audit or review by the Canadian tax authority. l)Loss per share information FASB ASC 260-10, “Earnings Per Share” provides for calculation of "basic" and "diluted" earnings per share. Basic earnings per share includes no dilution and is computed by dividing net income (loss) applicable to common shareholders by the weighted average common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity similar to fully diluted earnings per share. The effect of computing diluted loss per share is anti-dilutive and, as such, basic and diluted loss per share is the same for the years ended December 31, 2016 and 2015. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) m)Stock based compensation ASC 718-10 "Compensation Stock Compensation" prescribes accounting and reporting standards for all stockbased payments awarded to employees, including employee stock options, restricted stock, employee stock purchase plans and stock appreciation rights that may be classified as either equity or liabilities. The Company should determine if a present obligation to settle the sharebased payment transaction in cash or other assets exists. A present obligation to settle in cash or other assets exists if: (a) the option to settle by issuing equity instruments lacks commercial substance or (b) the present obligation is implied because of an entity's past practices or stated policies. If a present obligation exists, the transaction should be recognized as a liability; otherwise, the transaction should be recognized as equity. The Company accounts for stockbased compensation issued to nonemployees and consultants in accordance with the provisions of ASC 505- 50 "Equity Based Payments to NonEmployees". Measurement of sharebased payment transactions with nonemployees shall be based on the fair value of whichever is more reliably measurable: (a) the goods or services received; or (b) the equity instruments issued. The fair value of the sharebased payment transaction should be determined at the earlier of performance commitment date or performance completion date. n)Derivatives The Company evaluates embedded conversion features within convertible debt under ASC 815 “Derivatives and Hedging” to determine whether the embedded conversion feature should be bifurcated from the host instrument and accounted for as a derivative at fair value with changes in fair value recorded in earnings. The Company uses a BlackScholes Option Pricing model to estimate the fair value of convertible debt conversion features at the end of each applicable reporting period. Changes in the fair value of these derivatives during each reporting period are included in the statements of operations. Inputs into the BlackScholes Option Pricing model require estimates, including such items as estimated volatility of the Company’s stock, riskfree interest rate and the estimated life of the financial instruments being fair valued. If the conversion feature does not require derivative treatment under ASC 815, the instrument is evaluated under ASC 470-20 “Debt with Conversion and Other Options” for consideration of any beneficial conversion feature. o)Recent accounting pronouncements In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) 2016-01, which amends the guidance in U.S. GAAP on the classification and measurement of financial instruments. Changes to the current guidance primarily affect the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. In addition, the ASU clarifies guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on availableforsale debt securities. The new standard is effective for fiscal years and interim periods beginning after December 15, 2017, and upon adoption, an entity should apply the amendments by means of a cumulativeeffect adjustment to the balance sheet at the beginning of the first reporting period in which the guidance is effective. Early adoption is not permitted except for the provision to record fair value changes for financial liabilities under the fair value option resulting from instrumentspecific credit risk in other comprehensive income. The Company is currently evaluating the impact of adopting this guidance. In February 2016, the FASB issued Accounting Standards Update (ASU) 2016-02, which amends the guidance in U.S. GAAP on accounting for operating leases, a lessee will be required to recognize assets and liabilities for operating leases with lease terms of more than 12 months on the balance sheet. The new standard is effective for fiscal years and interim periods beginning after December 15, 2018, and upon adoption, an entity should apply the amendments by means of a cumulativeeffect adjustment to the balance sheet at the beginning of the first reporting period in which the guidance is effective. Early adoption is not permitted. The Company is currently evaluating the impact of adopting this guidance. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) o)Recent accounting pronouncements (continued) In March 2016, the FASB issued an Accounting Standards Update (ASU) “ASU 2016 - 09 Improvements to Employee Share-Based Payment Accounting” which is intended to improve the accounting for employee share-based payments. The ASU simplifies several aspects of the accounting for share-based payment award transactions, including; the income tax consequences, classification of awards as either equity or liabilities, and the classification on the statement of cash flows. The new standard is effective for fiscal years and interim periods beginning after December 15, 2016, and upon adoption, an entity should apply the amendments by means of a cumulative-effect adjustment to the balance sheet at the beginning of the first reporting period in which the guidance is effective. Early adoption is permitted. The Company is currently evaluating the impact of adopting this guidance. In April 2016, the FASB issued an Accounting Standards Update (ASU) “ASU 2016 - 10 Revenue from Contract with Customers: identifying Performance Obligations and Licensing”. The amendments in this Update clarify the two following aspects (a) contracts with customers to transfer goods and services in exchange for consideration and (b) determining whether an entity’s promise to grant a license provides a customer with either a right to use the entity’s intellectual property (which is satisfied at a point in time) or a right to access the entity’s intellectual property (which is satisfied over time). The amendments in this Update are intended to reduce the degree of judgement necessary to comply with Topic 606. This guidance has no effective date as yet. The Company is currently evaluating the impact of adopting this guidance. In June 2016, the FASB issued ASU 2016-13, "Measurement of Credit Losses on Financial Instruments." ASU 2016-13 will replace the current incurred loss approach with an expected loss model for instruments measured at amortized cost and require entities to record allowances for available-for-sale debt securities rather than reduce the carrying amount under the current other-than-temporary impairment model. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted for all entities for annual periods beginning after December 15, 2018, and interim periods therein. The Company is currently evaluating the impact of adopting this guidance. In August 2016, the FASB issued ASU 2016-15, "Classification of Certain Cash Receipts and Cash Payments." ASU 2016-15 is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted. The Company is currently evaluating the impact of adopting this guidance. In October 2016, the FASB issued Accounting Standards Update No. (“ASU”) 2016-16, "IntraEntity Transfers of Assets Other Than Inventory." ASU 2016-16 requires immediate recognition of income tax consequences of intercompany asset transfers, other than inventory transfers. Existing GAAP prohibits recognition of income tax consequences of intercompany asset transfers whereby the seller defers any net tax effect and the buyer is prohibited from recognizing a deferred tax asset on the difference between the newly created tax basis of the asset in its tax jurisdiction and its financial statement carrying amount as reported in the consolidated financial statements. ASU 2016-16 specifically excludes from its scope intercompany inventory transfers whereby the recognition of tax consequences will take place when the inventory is sold to third parties. ASU 2016-16 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted as of the beginning of an annual reporting period for which financial statements have not been issued or made available for issuance. The Company is currently evaluating the impact of adopting this guidance. In October 2016, the FASB issued Accounting Standards Update No. (“ASU”) 2016-17, Consolidation (Topic 810): Amendments to the Consolidation Analysis. Upon the effective date of Update 2015-02, a single decision maker of a variable interest entity (VIE) is required to consider indirect economic interests in the entity held through related parties on a proportionate basis when determining whether it is the primary beneficiary of that VIE unless the single decision maker and its related parties are under common control. If a single decision maker and its related parties are under common control, the single decision maker is required to consider indirect interests in the entity held through those related parties to be the equivalent of direct interests in their entirety. The Board is issuing this Update to amend the consolidation guidance on how a reporting entity that is the single decision maker of a VIE should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that VIE. The primary beneficiary of a VIE is the reporting entity that has a controlling financial interest in a VIE and, therefore, consolidates the VIE. A reporting entity has an indirect interest in a VIE if it has a direct interest in a related party that, in turn, has a direct interest in the VIE. As part of a separate initiative, the Board will consider whether other changes to the consolidation guidance for common control arrangements are necessary. The amendments in this Update are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect this guidance to have a material impact on its financial statements. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) o)Recent accounting pronouncements (continued) In November 2016, FASB issued Accounting Standards Update No. (“ASU”) 2016-18, Topic 230, Statement of Cash Flows. Entities classify transfers between cash and restricted cash as operating, investing, or financing activities, or as a combination of those activities, in the statement of cash flows. ] The amendments in this Update apply to all entities that have restricted cash or restricted cash equivalents and are required to present a statement of cash flows under Topic 230. The amendments in this Update require that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The amendments in this Update do not provide a definition of restricted cash or restricted cash equivalents. The amendments in this Update are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The amendments in this Update should be applied using a retrospective transition method to each period presented. The Company does not expect this guidance to have a material impact on its financial statements. In December 2016, the FASB issued Accounting Standards Update No. (“ASU”) 2016-19, Technical Corrections and Improvements. Several topics are amended: 1.The amendment to Subtopic 350-40, Intangibles-Goodwill and Other- InternalUse Software, adds a reference to guidance to use when accounting for internaluse software licensed from third parties that is within the scope of Subtopic 350-40. The transition guidance for that amendment is the same as the transition guidance in Accounting Standards Update No. 2015-05, Intangibles-Goodwill and Other- InternalUse Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, to which the amendment relates. The Company does not expect this guidance to have a material impact on its financial statements. 2.The amendment to Subtopic 360-20, Property, Plant, and Equipment- Real Estate Sales, corrects the guidance to include the final decision of the EITF that loans insured under the Federal Housing Administration and the Veterans Administration do not have to be fully insured by those governmentinsured programs to recognize profit using the full accrual method. The transition guidance for that amendment must be applied prospectively because it could potentially involve the use of hindsight that includes fair value measurements. The Company does not expect this guidance to have a material impact on its financial statements. 3.The amendment to Topic 820, Fair Value Measurement, clarifies the difference between a valuation approach and a valuation technique when applying the guidance in that Topic. That amendment also requires an entity to disclose when there has been a change in either or both a valuation approach and/or a valuation technique. The transition guidance for the amendment must be applied prospectively because it could potentially involve the use of hindsight that includes fair value measurements. The Company does not expect this guidance to have a material impact on its financial statements. 4.The amendment to Subtopic 405-40, Liabilities-Obligations Resulting from Joint and Several Liability Arrangements, which clarifies that for an amount of an obligation under an arrangement to be considered fixed at the reporting date, the amount that must be fixed is not the amount that is the entity’s portion of the obligation but, rather, is the obligation in its entirety. The transition guidance for that amendment must be applied prospectively because it could potentially involve the use of hindsight that includes fair value measurements. The Company does not expect this guidance to have a material impact on its financial statements. 5.The amendment to Subtopic 860-20, Transfers and Servicing-Sales of Financial Assets, aligns implementation guidance in paragraph 860-20- 55-41 with its corresponding guidance in paragraph 860-20-25-11. That amendment clarifies the considerations that should be included in an analysis to determine whether a transferor once again has effective control over transferred financial assets. The transition guidance for that amendment must be applied prospectively because it could potentially involve the use of hindsight that includes fair value measurements. The Company does not expect this guidance to have a material impact on its financial statements. 6.The amendment to Subtopic 860-50, Transfers and Servicing-Servicing Assets and Liabilities, adds guidance that existed in AICPA Statement of 5 Position 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others, on the accounting for the sale of servicing rights when the transferor retains loans that was omitted from the Accounting Standards Codification. The transition guidance for the amendment must be applied prospectively because it could potentially involve the use of hindsight that includes fair value measurements. The Company does not expect this guidance to have a material impact on its financial statements. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) o)Recent accounting pronouncements (continued) In November 2016, the FASB issued Accounting Standards Update No. (“ASU”) 2016-20, an amendment to Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU addressed several areas related to contracts with customers. This topic is not yet effective and will become effective with Topic 606. The Company is currently evaluating the impact of adopting this guidance. In January 2017, the FASB issued Accounting Standards Update No. (“ASU”) 2017-02, an amendment to Topic 805, Business Combinations. The amendments in this Update clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendments in this Update affect all reporting entities that must determine whether they have acquired or sold a business. The amendments in this Update provide a more robust framework to use in determining when a set of assets and activities is a business. The amendments in this Update apply to annual periods beginning after December 15, 2017. The amendments in this Update should be applied prospectively on or after the effective date. No disclosures are required at transition. The Company is currently evaluating the impact of adopting this guidance. In January 2017, the FASB issued Accounting Standards Update No. (“ASU”) 2017-04, an amendment to Topic 350, Intangibles - Goodwill and Other, an entity no longer will determine goodwill impairment by calculating the implied fair value of goodwill by assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. Because these amendments eliminate Step 3 2 from the goodwill impairment test, they should reduce the cost and complexity of evaluating goodwill for impairment. An entity should apply the amendments in this Update on a prospective basis. The amendments in this Update are effective for Goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the impact of adopting this guidance. In February 2017, the FASB issued Accounting Standards Update No. (“ASU”) 2017-05, an amendment to Subtopic 610-20, Other Income- Gains and Losses from the Derecognition of Nonfinancial Assets The amendments in this Update are required for public business entities and other entities that have goodwill reported in their financial statements, under the amendments in this Update, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The amendments in this Update modify the concept of impairment from the condition that exists when the carrying amount of goodwill exceeds its implied fair value to the condition that exists when the carrying amount of a reporting unit exceeds its fair value. An entity no longer will determine goodwill impairment by calculating the implied fair value of goodwill by assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. An entity should apply the amendments in this Update on a prospective basis. The amendments in this Update are effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the impact of adopting this guidance. Any new accounting standards, not disclosed above, that have been issued or proposed by FASB that do not require adoption until a future date are not expected to have a material impact on the financial statements upon adoption. p)Reclassification of Prior Year Presentation Certain prior year amounts have been reclassified for consistency with the current year presentation. These reclassifications had no effect on the reported results of operations. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) q)Financial instruments Risks The Company is exposed to various risks through its financial instruments. The following analysis provides a measure of the Company’s risk exposure and concentrations at the balance sheet date, December 31, 2016 and 2015. i.Credit risk Credit risk is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. Financial instruments that subject the Company to credit risk consist primarily of accounts receivable. Credit risk associated with accounts receivable of Greenestone Clinic Muskoka Inc. is mitigated due to balances from many customers, as well as through credit checks and frequent reviews of receivables to ensure timely collection. In addition, there is no concentration risk with the Greenestone Clinic Muskoka Inc. accounts receivable balance since balances are due from many customers. In the opinion of management, credit risk with respect to accounts receivable is assessed as low, not material and remains unchanged from the prior year. ii.Liquidity risk Liquidity risk is the risk the Company will not be able to meet its financial obligations as they fall due. The Company is exposed to liquidity risk through its working capital deficiency of $(3,361,536) and accumulated deficit of $(20,981,914). As disclosed in note 3, the Company will be dependent upon the raising of additional capital in order to implement its business plan. There is no assurance that the Company will be successful with future financing ventures, and the inability to secure such financing may have a material adverse effect on the Company’s financial condition. In the opinion of management, liquidity risk is assessed as high, material and remains unchanged from the prior year. iii.Market risk Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises of three types of risk: interest rate risk, currency risk, and other price risk. The Company is exposed to interest rate risk and currency risk. iv.Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The Company is exposed to interest rate risk on its bank indebtedness as there is a balance of $56,116 at December 31, 2016. This liability is based on floating rates of interest that have been stable during the current reporting period. In the opinion of management, interest rate risk is assessed as low, not material and remains unchanged from the prior year. v.Currency risk Currency risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. The Company is subject to currency risk as its subsidiaries operate in Canada and are subject to fluctuations in the Canadian dollar. Most of the Company’s financial assets and liabilities are denominated in Canadian dollars. Based on the net exposures at December 31, 2016, a 5% depreciation or appreciation of the Canadian dollar against the U.S. dollar would result in an approximate $49,835 increase or decrease in the Company’s aftertax net loss from continuing operation. The Company has not entered into any hedging agreements to mediate this risk. In the opinion of management, currency risk is assessed as low, material and remains unchanged from the prior year. vi.Other price risk Other price risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market. In the opinion of management, the Company is not exposed to this risk and remains unchanged from the prior year. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 3Going Concern The Company’s consolidated financial statements have been prepared in accordance with US GAAP applicable to a going concern, which assumes that the Company will be able to meet its obligations and continue its operations in the normal course of business. As at December 31, 2016 the Company has a working capital deficiency of $(3,361,536) and accumulated deficit of $(20,981,914). Subsequent to year end, on February 14, 2017, the Company sold its Greenestone Muskoka Treatment Center and out of the proceeds therefrom settled the outstanding payroll and GST tax liabilities and used the remaining proceeds to acquire the Seastone of Delray business, an alcohol and drug rehabilitation and treatment center located in Delray Beach, Florida. Management believes that current available resources will not be sufficient to fund the restructured Company’s planned expenditures, over the next 12 months. Accordingly, the Company will be dependent upon the raising of additional capital through placement of common shares, and, or debt financing in order to implement its business plan, and, or generating sufficient revenue in excess of costs. If the Company raises additional capital through the issuance of equity securities or securities convertible into equity, stockholders will experience dilution, and such securities may have rights, preferences or privileges senior to those of the holders of common stock or convertible senior notes. If the Company raises additional funds by issuing debt, the Company may be subject to limitations on its operations, through debt covenants or other restrictions. If the Company obtains additional funds through arrangements with collaborators or strategic partners, the Company may be required to relinquish its rights to certain geographical areas, or techniques that it might otherwise seek to retain. There is no assurance that the Company will be successful with future financing ventures, and the inability to secure such financing may have a material adverse effect on the Company’s financial condition. These consolidated financial statements do not include any adjustments to the amounts and classifications of assets and liabilities that might be necessary should the Company be unable to continue operations. These factors create substantial doubt about the Company’s ability to continue as a going concern. These consolidated financial statements do not include any adjustments relating to the recoverability or classification of recorded assets and liabilities or other adjustments that may be necessary should the Company not be able to continue as a going concern. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 4Discontinued Operations Subsequent to year end, on February 14, 2017, GreeneStone completed a series of transactions (referred to collectively as the “Restructuring Transactions”), including a share purchase agreement (the “SPA”) whereby GreeneStone acquired the stock of the company holding the Muskoka Healthcare Clinic real estate, an asset purchase agreement (the “APA”) and lease (the “Lease”) whereby the Company sold all of the Muskoka clinic business assets and leased the clinic building to the buyer, and a real estate purchase agreement and asset purchase agreement whereby the Company purchased the real estate and business assets of Seastone Delray (the “Florida Purchase”). The Muskoka clinic business represented substantially all of the operating assets of the Company and has been disclosed as a discontinued operation for the years ended December 31, 2016 and 2015. The assets and liabilities of discontinued operations as of December 31, 2016 and 2015, respectively is as follows: Income from discontinued operations is as follows: ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 5.Loans Payable The Company had an automobile loan payable during the prior year, bearing interest at 4.49% with blended monthly payments of $835 that matures in March 2018. This loan was settled during the current financial year. The loan was secured by the vehicle with a net book value as at December 31, 2015 of $14,960. 6.Loans Payable The company had a short-term loan payable to a third party of $21,675 as of December 31, 2015. This loan, together with interest thereon was settled during the current year. 7.Short-Term Convertible Notes JMJ Financial convertible note The Company entered into a Securities Purchase Agreement with JMJ Financial on April 13, 2016, in terms of the agreement the Company borrowed $200,000 in terms of an unsecured convertible promissory note with a maturity date of seven months from the closing date. The principal amount due under the promissory note was $220,000, inclusive of an Original Issue discount and a further 10% once-off interest charge of $20,000 was due in terms of this note. The note was only convertible upon a repayment default, at the lower of $0.03 per share of 60% of the lowest traded price over the preceding 25 day trading period. The Company also issued 3,703,700 warrants exercisable over common shares at $0.03 per share, which warrants contain a cashless exercise option, in terms of the financing arrangement. The note, together with interest thereon was repaid in full during November 2016. Series L convertible notes The Company entered into Series L Convertible Securities Purchase Agreements with 8 individuals on December 30, 2016. In terms of these agreements, the Company borrowed an aggregate principal amount of $468,969 in terms of a senior ranking convertible promissory note with a maturity date six months from the issue date and bearing interest at 0% per annum. The notes are convertible at the option of the holder into shares of common stock of the Company at a conversion price of $0.03 per share, subject to certain recapitalization adjustments. In terms of the Series L Convertible notes issued above, on December 30, 2016, the Company granted three year warrants to the Series L Convertible noteholders, exercisable for 15,633,709 shares of common stock at an exercise price of $0.03, subject to certain recapitalization adjustments, per share, expiring on December 30, 2019 (Refer note 10 below). ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 8.Taxation Payable The company has the following outstanding tax liabilities a)Harmonized Sales Taxes This represents sales tax liabilities in Canada, these taxes were never paid, management intends paying these taxation liabilities together with interest and penalties thereon. Subsequent to year end, upon the disposal of the assets of the Greenestone Muskoka Treatment Center, a portion of the proceeds realized were used by the Company to settle the outstanding Harmonized Sales tax and Payroll taxes liability. b)Payroll Taxes The Company is delinquent in filing its payroll tax returns resulting in taxes, interest and penalties payable at December 31, 2016 and 2015. As of December 31, 2016 and 2015 as part of Taxes Payable, the Company has payroll tax liabilities of approximately $2,220,731 and $1,780,000, respectively due to various taxing authorities. If the Company does not satisfy these liabilities, the taxing authorities may place liens on its bank accounts which would have a negative impact on its ability to operate. Further, the actual liability may be higher due to interest or penalties assessed by the taxing authorities. Subsequent to year end, upon the disposal of the assets of the Greenestone Muskoka Treatment Center, a portion of the proceeds realized were used by the Company to settle the outstanding Harmonized Sales tax and Payroll taxes liability. c)US taxation and penalties The Company had assets and operated a business in Canada and is required to disclose these operations to the US taxation authorities, the requisite disclosure has not been made and management has reserved the maximum penalty due to the IRS in terms of non-disclosure. This non-compliance with US disclosure requirements is currently being addressed. The taxes and penalties due are as follows: 9.Related Parties Shawn E. Leon As of December 31, 2016 and 2015, the Company had payables of $8,492 and $159,551, respectively to the CEO, Shawn Leon. The amounts payable are non-interest bearing and have no fixed repayment terms. The Company paid a management fee of $120,000 to Shawn Leon during the current year. Cranberry Cove Holdings Ltd. As of December 31, 2016 and 2015, the Company had a receivable of $84,867 and a payable of $87,356, respectively to Cranberry Cove Holdings, Ltd. The Company entered into an agreement to lease premises from Cranberry Cove Holdings Ltd. at market terms. The Company had rental expense amounting to CDN $485,055 and CDN $451,380 for the years ended December 31, 2016 and 2015, respectively. Cranberry Cove Holdings Ltd. is owned indirectly by Shawn Leon, our CEO. The balance due is noninterest bearing and no fixed repayment terms. Subsequent to year end, in terms of a Stock Purchase Agreement entered into, as disclosed in note 1 above, the Company acquired 100% of the equity of Cranberry Cove Holdings. GreeneStone Clinic Inc. As of December 31, 2016 and 2015, the Company had a payable of $79,592 and $5,284, respectively, to Greenestone Clinic, Inc. GreeneStone Clinic Inc., is controlled by one of the Company’s directors. The balance owing is non-interest bearing, not secured and has no specified terms of repayment. The Company incurred management fees to GreeneStone Clinic, Inc., totaling $137,283 and $97,152 for the years ended December 31, 2016 and 2015, respectively. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 9.Related Parties (continued) 1816191 Ontario As of December 31, 2016 and 2015, the Company had a payable of $70,763 and $22,305 to 1816191 Ontario. The payable is non- interest bearing, and has no specific repayment terms. Eileen Greene Eileen Greene is the spouse of our CEO, Shawn Leon. On December 30, 2016 we entered into a Securities Purchase agreement with Ms. Greene, whereby $163,011 (CDN $220,000) was advanced to the Company in the form of a promissory note, bearing interest at 0% per annum and convertible into shares of common stock at a conversion price of $0.03 per share. In connection with the promissory note above, Ms. Greene was granted a 3-year option exercisable for 5,433,709 shares of common stock of the Company at an exercise price of $0.03 per share, expiring on December 30, 2019. All related party transactions occur in the normal course of operations and in terms of agreements entered into between the parties. 10.Stockholders’ deficit a) Common shares Authorized, issued and outstanding The Company has authorized 500,000,000 shares with a par value of $0.01 per share. The company has issued and outstanding 48,738,755 and 47,738,755 shares of common stock on December 31, 2016 and 2015, respectively. On June 7, 2016, the Company issued 1,000,000 common shares to an investor relations firm, in terms of an agreement. b) Preferred shares Authorized, issued and outstanding The Company has authorized 13,000,000 preferred shares with a par value of $0.01 per share, designated as 3,000,000 series A convertible preferred shares and 10,000,000 series B convertible preferred shares. The Company has no preferred shares issued and outstanding. c)Warrants In terms of the shortterm convertible loan agreement entered into with JMJ Financial, disclosed in note 7 above, on April 13, 2016, the Company awarded fiveyear warrants exercisable for 3,703,700 shares of common stock at an exercise price of $0.03 per share. In terms of the shortterm Series L Convertible short term notes entered into with 8 parties, as disclosed in note 7 above, the Company awarded threeyear warrants exercisable over 15,633,709 shares of common stock, at an exercise price of $0.03 per share. The fair value of Warrants awarded during the year ended December 31, 2016 were valued at $311,955 using the BlackScholes pricing model and the following weighted average assumptions were used: ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 10.Stockholders’ deficit (continued) c)Warrants (continued) The volatility of the common stock is estimated using historical data of the Company’s common stock. The riskfree interest rate used in the Black Scholes pricing model is determined by reference to historical U.S. Treasury constant maturity rates with maturities approximate to the life of the warrants granted. An expected dividend yield of zero is used in the valuation model, because the Company does not expect to pay any cash dividends in the foreseeable future. As of December 31, 2016, the Company does not anticipate any awards will be forfeited in the valuation of the warrants. During the current year, warrants exercisable for 6,000,000 shares expired. A summary of all of the Company’s warrant activity during the period January 1, 2015 to December 31, 2016 is as follows: The following table summarizes warrants outstanding and exercisable as of December 31, 2016: * In terms of an agreement entered into with an investor relations company, 300,000 warrants were to be issued as part of the Investor Relations Agreement. These warrants have not been issued as yet, therefore the warrant terms are uncertain. All of the warrants outstanding as of December 31, 2016 are vested. The warrants outstanding as of December 31, 2016 have an intrinsic value of $5,001. d)Stock options Our board of directors adopted the Greenestone Healthcare Corporation 2013 Stock Option Plan (the “Plan”) to promote our longterm growth and profitability by (i) providing our key directors, officers and employees with incentives to improve stockholder value and contribute to our growth and financial success and (ii) enable us to attract, retain and reward the best available persons for positions of substantial responsibility. A total of 10,000,000 shares of our common stock have been reserved for issuance upon exercise of options granted pursuant to the Plan. The Plan allows us to grant options to our employees, officers and directors and those of our subsidiaries; provided that only our employees and those of our subsidiaries may receive incentive stock options under the Plan. We have granted a total of 480,000 options as of December 31, 2016 under the Plan. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 10.Stockholders’ deficit (continued) d)Stock options (continued) No options were issued, exercised or cancelled during the year ended December 31, 2016. A summary of all of the Company’s option activity during the period January 1, 2015 to December 31, 2016 is as follows: The following table summarizes options outstanding and exercisable as of December 31, 2016: The Company agreed to issue Stock options to a former officer vesting over a 24-month period commencing on November 1, 2014 expiring on October 31, 2019, a formal option agreement has not been issued as yet, as such the terms of these options are uncertain. As of December 31, 2016 there was no unrecognized compensation costs related to these options and the intrinsic value of the options as of December 31, 2016 is $0. 11.Net loss per common share For the years ended December 31, 2016 and 2015, the following options and warrants were excluded from the computation of diluted net loss per shares as the result of the computation was anti-dilutive: ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 12.Commitments and contingencies a.Operating leases The Company had entered into a lease agreement for the rental of premises operated by GreeneStone Clinic Muskoka Inc. which term initially expires on March 31, 2019. The Company has an option to extend the lease for an additional three terms, each term being an additional three years. The Company also has an option to purchase the property for $10,000,000, which option must be exercised in writing, accompanied by a $250,000 deposit and must be closed within 30 days of exercising the option. The Company also has a right of first refusal should the landlord receive an acceptable offer for the premises, the Company would be entitled to acquire the premises on the same terms and conditions of the acceptable offer, provided the Company has met certain covenants. The rental expense for the year ended December 31, 2016 was CDN $485,055. Subsequent to year end, on February 14, 2017, the Company sold the GreeneStone Muskoka Treatment Center to a third party, simultaneously with the disposal of the Treatment Center, the Company acquired 100% of Cranberry Cove Holdings, LTD, the entity in which the property, subject to the lease mentioned above is registered. Cranberry Cove Holdings, Ltd, entered into a new lease agreement with the purchasers and the existing lease was terminated. b.Contingency related to outstanding tax liabilities The Company was delinquent in paying harmonized sales tax, filing and paying payroll taxes and may also be subject to US taxation and penalties as fully disclosed in note 7 above. Subsequent to year end, on February 14, 2017, the Company disposed of its GreeneStone Muskoka Treatment Center. A portion of the proceeds realized on the sale of the business was used to settle the outstanding Harmonized Sales Tax and Payroll tax liabilities. The Company has also provided for US tax liabilities of $250,000 due to non-compliance with the filing of certain required returns. The actual liability may be higher due to interest and penalties assessed by these taxing authorities. c.Other From time to time, the Company and its subsidiaries enter into legal disputes in the ordinary course of business. The Company believes there are no material legal or administrative matters pending that are likely to have, individually or in the aggregate, a material adverse effect on its business or results of operations. ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 13.Income taxes The Company is not current in its tax filings as of December 31, 2016. The Company accounts for income taxes under Accounting Standards Codification 740, Income Taxes “ASC 740”. ASC 740 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statements and the tax basis of assets and liabilities, and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards. ASC 740 additionally requires the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Internal Revenue Code Section 382 “IRC 382” places a limitation on the amount of taxable income that can be offset by carry forwards after a change in control (generally greater than a 50% change in ownership). A reconciliation of income taxes to the income tax recorded is as follows: ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 13.Income taxes (continued) The components of the Company’s deferred taxes asset as at December 31, 2016 and December 31, 2015 are as follows: As of December 31, 2016, the Company is in arrears on filing its statutory income tax returns and the amounts presented above are based on estimates. The actual losses available could differ from these estimates. In addition, the Company could be subject to penalties for these unfiled tax returns. During the year ended December 31, 2016, the Company has accrued and expensed $250,000 (2015: $200,000) in penalties and interest attributable to delinquent tax returns. Management believes the Company has adequately provided for any ultimate amounts that are likely to result from audits of these returns once filed; however, final assessments, if any, could be significantly different than the amounts recorded in the financial statements. The Company operates in foreign jurisdictions and is subject to audit by taxing authorities. These audits may result in the assessment of amounts different than the amounts recorded in the consolidated financial statements. The Company liaises with the relevant authorities in these jurisdictions in regard to its income tax and other returns. Management believes the Company has adequately provided for any taxes, penalties and interest that may fall due. 14.Subsequent events Subsequent to December 31, 2016, during January 2017, the Company raised an additional $71,000 in convertible short-term notes with a maturity in July 2017. These notes bear interest at 0% and are convertible into shares of common stock at $0.03 per share. The Company also issued three-year warrants exercisable for 2,366,667 shares of common stock, at an exercise price of $0.03 per share to these noteholders. On February 2, 2017, The Company entered into a Securities Purchase Agreement with LABRYS FUND LP, in terms of the agreement the Company borrowed $100,000 in terms of an unsecured convertible promissory note with a maturity date of August 2, 2017. The principal amount due under the promissory note is $110,000, inclusive of an Original Issue discount of $10,000. The note bears interest at a rate of 8% per annum. The note is only convertible upon a repayment default, at the lower of 60% of the lowest traded price over the preceding 30 day trading period prior to the issuance of this note or 60% of the lowest traded price 30 days prior to the conversion date. The Company issued 1,200,000 common shares to the note holder as a commitment fee which returnable shares will be returned to the company is fully repaid prior to August 2, 2017. On February 14, 2017, GreeneStone completed a series of transactions (referred to collectively as the “Restructuring Transactions”), including a share purchase agreement (the “SPA”) whereby GreeneStone acquired the stock of the company holding the Muskoka Healthcare Clinic real estate, an asset purchase agreement (the “APA”) and lease (the “Lease”) whereby the Company sold all of the Muskoka clinic business assets and leased the clinic building to the buyer, and a real estate purchase agreement and asset purchase agreement whereby the Company purchased the real estate and business assets of Seastone Delray (the “Florida Purchase”). The Stock Purchase Agreement Under the SPA, the Company acquired 100% of the stock of Cranberry Cove Holdings Ltd. (“CCH”) from Leon Developments Ltd. (“Leon Developments”), a company wholly owned by Shawn E. Leon, who is the President, CEO, and CFO of GreeneStone (“Mr. Leon”). CCH owns the real estate on which the Company’s rehabilitation clinic (“the Canadian Rehab Clinic”) in Muskoka, Ontario is located. The total consideration paid by GreeneStone was CDN$3,300,000 (an appraised value of CDN$10,000,000 less the outstanding mortgage loan), which was funded by the assignment to Leon Developments of certain indebtedness owing to GreeneStone in the amount of CDN$659,918, and the issuance of 60,000,000 shares of the Company’s common stock to Leon Developments, valued at approximately US$0.033 per share (the “Shares”). ETHEMA HEALTH CORPORATION (formerly known as Greenstone Healthcare Corporation) NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 14.Subsequent events (continued) The Asset Purchase Agreement and Lease Under the APA, the assets of the Canadian Rehab Clinic were sold by GreeneStone, through its subsidiary, GreeneStone Clinic Muskoka Inc. (the “Rehab Clinic Subsidiary”), to Canadian Addiction Residential Treatment LP (the “Purchaser”), for a total consideration of CDN$10,000,000, plus an additional performance payment of up to CDN$3,000,000 performance payment to be received in 2019 if certain clinic performance metrics are met. The Purchaser completed the sale with cash proceeds to the Company of CDN$10,000,000, of which CDN$1,500,000.00 will remain in escrow for up to two years to cover indemnities given by the Company. Aside from using the proceeds of the Muskoka clinic asset sale to pay down significant tax debts and operational costs of the Company, the Company also used the proceeds to fund the Florida Purchase. Through the APA, substantially all of the assets of the Rehab Clinic Subsidiary were sold, leaving GreeneStone with only the underlying clinic real estate, which GreeneStone through its newly acquired subsidiary CCH concurrently leased to the Purchaser. The Lease is a triple net lease and provides for a five (5) year primary term with three (3) fiveyear renewal options, annual base rent for the first year at CDN$420,000 with annual increases, an option to tenant to purchase the leased premises and certain first refusal rights. The Florida Purchase Immediately after closing on the sale of its Muskoka clinic business, GreeneStone closed on the acquisition of the business and real estate assets of Seastone Delray pursuant to certain real estate and asset purchase agreements This business will be operated through its wholly owned subsidiary Seastone. The purchase price for the Seastone assets was US$6,150,000 financed with a purchase money mortgage of US$3,000,000, and US$3,150,000 in cash. During January 2017, the Company raised a further $71,000 in convertible notes, each note convertible into shares of common stock at a conversion price of $0.03 per share. In connection with the notes issued, warrants to purchase 2,366,667 shares of common stock were issued to the note holders. During February 2017, the Company raised a further loan of $110,000 from LABRYS FUND LP for net proceeds of $100,000, including an Original issue Discount of 10%. The loan bears interest at 8% per annum and matures on August 2, 2017. Subject to an Event of Defualt, this loan is convertible into common stock at a 40% discount to market price as determined by a pre-determined formula. The Company issued 1,200,000 shares of Common stock to the note holder as a commitment fee, which is returnable if the note is repaid in full before maturity date. Other than disclosed above, the Company has evaluated subsequent events through the date of the consolidated financial statements were available to be issued and has concluded that no such events or transactions took place that would require disclosure herein.
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Based on the provided excerpt, here's a summary of the financial statement:
Company: ETHEMA HEALTH CORPORATION (formerly Greenstone Healthcare Corporation)
Key Financial Highlights:
1. Financial Performance: The company reported a loss for the two-year period ending December 31st
2. Asset Management:
- Fixed assets recorded at cost
- Depreciation calculated using declining balance method
- Leasehold improvements depreciated using straight-line method
- Half rates applied for assets in the year of acquisition
3. Lease Accounting:
- Leases classified as capital or operating
- Capital leases recorded as assets with corresponding long-term obligations
- Operating lease payments expensed as incurred
4. Liabilities:
- Reported indebtedness to GreeneStone: CDN$659,918
5. Accounting Practices:
- Income taxes accounted for under ASC Topic
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Registered Certified Public Accounting Firm The Board of Directors and Shareholders of Chico’s FAS, Inc. We have audited the accompanying consolidated balance sheets of Chico’s FAS, Inc. and subsidiaries (the Company) as of January 30, 2016 and January 31, 2015, and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three fiscal years in the period ended January 30, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Chico’s FAS, Inc. and subsidiaries at January 30, 2016 and January 31, 2015, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended January 30, 2016, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Chico’s FAS, Inc. and subsidiaries’ internal control over financial reporting as of January 30, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 8, 2016 expressed an unqualified opinion thereon. /s/ ERNST & YOUNG LLP Tampa, Florida March 8, 2016 CHICO’S FAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) The accompanying notes are an integral part of these consolidated statements. CHICO’S FAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) The accompanying notes are an integral part of these consolidated statements. CHICO’S FAS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands) The accompanying notes are an integral part of these consolidated statements. CHICO’S FAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In thousands) The accompanying notes are an integral part of these consolidated statements. CHICO’S FAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) The accompanying notes are an integral part of these consolidated statements. CHICO’S FAS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except share and per share amounts and where otherwise indicated) 1. BUSINESS ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Description of Business The accompanying consolidated financial statements include the accounts of Chico’s FAS, Inc., a Florida corporation, and its wholly-owned subsidiaries (“the Company”, “we”, “us”, and “our”). We operate as an omni-channel specialty retailer of women’s private branded, sophisticated, casual-to-dressy clothing, intimates, complementary accessories, and other non-clothing items. We currently sell our products through retail stores, catalog, and via our websites at www.chicos.com, www.whbm.com, and www.soma.com. As of January 30, 2016, we had 1,518 stores located throughout the United States, the U.S. Virgin Islands, Puerto Rico and Canada, and sold merchandise through 37 franchise locations in and around Mexico. Fiscal Year Our fiscal years end on the Saturday closest to January 31 and are designated by the calendar year in which the fiscal year commences. The periods presented in these consolidated financial statements are the fiscal years ended January 30, 2016 (“fiscal 2015” or “current period”), January 31, 2015 (“fiscal 2014” or “prior period”) and February 1, 2014 (“fiscal 2013”). Fiscal 2015, 2014 and 2013 all contained 52 weeks. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Segment Information Our brands, Chico’s, Soma, and White House Black Market ("WHBM") have been identified as separate operating segments and aggregated into one reportable segment due to the similarities of the economic and operating characteristics of the brands. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications Reclassifications of certain prior year balances were made in order to conform to the current year presentation. Cash and Cash Equivalents Cash and cash equivalents include cash on hand and in banks, short-term highly liquid investments with original maturities of three months or less and payments due from banks for third-party credit card and debit transactions for approximately 3 to 5 days of sales. Marketable Securities Marketable securities are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of income taxes, reflected in accumulated other comprehensive income until realized. For the purposes of computing realized and unrealized gains and losses, cost and fair value are determined on a specific identification basis. We consider all securities available-for-sale, including those with maturity dates beyond 12 months, and therefore classify these securities within current assets on the consolidated balance sheets as they are available to support current operational liquidity needs. Fair Value of Financial Instruments Our consolidated financial instruments consist of cash, money market accounts, marketable securities, assets held in our non-qualified deferred compensation plan, accounts receivable and payable, and debt. Cash, accounts receivable and accounts payable are carried at cost, which approximates their fair value due to the short-term nature of the instruments. Inventories We use the weighted average cost method to determine the cost of merchandise inventories. We identify potentially excess and slow-moving inventories by evaluating inventory aging, turn rates and inventory levels in conjunction with our overall sales trend. Excess quantities of inventory are identified through evaluation of inventory aging, review of inventory turns and historical sales experience, as well as specific identification based on fashion trends. Further, inventory realization exposure is identified through analysis of gross margins and markdowns in combination with changes in current business trends. We record excess and slow-moving inventories at net realizable value. We estimate our expected shrinkage of inventories between physical inventory counts by using average store shrinkage experience rates, which are updated on a regular basis. Substantially all of our inventories consist of finished goods. Costs associated with sourcing are generally capitalized while merchandising, distribution, and product development costs are generally expensed as incurred, and are included in the accompanying consolidated statements of income as a component of cost of goods sold. Approximately 23% of total purchases in fiscal 2015 and 24% of total purchases in 2014 were made from one supplier. Property and Equipment Property and equipment is stated at cost, net of accumulated depreciation and amortization. Depreciation of property and equipment is provided on a straight-line basis over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of their estimated useful lives (generally 10 years or less) or the related lease term, plus one anticipated renewal when there is an economic cost associated with non-renewal. Our property and equipment is generally depreciated using the following estimated useful lives: Maintenance and repairs of property and equipment are expensed as incurred, and major improvements are capitalized. Upon retirement, sale or other disposition of property and equipment, the cost and accumulated depreciation or amortization are eliminated from the accounts, and any gain or loss is charged to income. Operating Leases We lease retail stores and a limited amount of office space under operating leases. The majority of our lease agreements provide for tenant improvement allowances, rent escalation clauses and/or contingent rent provisions. Tenant improvement allowances are recorded as a deferred lease credit within deferred liabilities and amortized as a reduction of rent expense over the term of the lease. Rent escalation clauses, “rent-free” periods, and other rental expenses are amortized on a straight-line basis over the term of the leases, including the construction period. This is generally 60 - 90 days prior to the store opening date, when we generally begin improvements in preparation for our intended use. Certain leases provide for contingent rents, in addition to a basic fixed rent, which are determined as a percentage of gross sales in excess of specified levels. We record a contingent rent liability in accrued liabilities on the consolidated balance sheets and the corresponding rent expense when specified levels have been achieved or when it is determined that achieving the specified levels during the lease year is probable. Goodwill and Other Intangible Assets Goodwill and other indefinite-lived intangible assets are tested for impairment at least annually. We perform our annual impairment test during the fourth quarter, or more frequently should events or circumstances change that would indicate that impairment may have occurred. Goodwill represents the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired and liabilities assumed in a business combination. Impairment testing for goodwill is done at a reporting unit level. Reporting units are defined as an operating segment or one level below an operating segment, called a component. Using these criteria, we identified our reporting units and concluded that the goodwill related to the territorial franchise rights for the state of Minnesota should be allocated to the Chico’s reporting unit and the goodwill associated with the WHBM acquisition should be assigned to the WHBM reporting unit. We evaluate the appropriateness of performing a qualitative assessment, on a reporting unit level, based on current circumstances. If the results of the qualitative assessment indicate that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, the two-step impairment test will not be performed. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the two-step impairment test is performed. We may elect to skip the qualitative assessment and perform the two-step impairment test. The first step of the impairment test compares the fair value of our reporting units with their carrying amounts, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. Fair value is determined based on both an income approach and market approach. The income approach is based on estimated future cash flows, discounted at a rate that approximates the cost of capital of a market participant, while the market approach is based on sales or EBITDA multiples of similar companies and transactions or other available indications of value. For 2015, we performed a qualitative assessment of the goodwill associated with the Chico's and WHBM reporting units and concluded it was more likely than not that the fair value exceeded the carrying amount as of the annual assessment date. In fiscal 2015, 2014 and 2013, we performed a goodwill impairment assessment of the Boston Proper reporting unit and recorded pre-tax, non-cash goodwill impairment charges of $48.9 million, $25.8 million and $67.3 million, respectively, as further discussed in Note 8. We test indefinite-lived intangible assets for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the intangible is less than its carrying amount. If the results of the qualitative assessment indicate that it is more likely than not that the fair value of the intangible is less than its carrying amount, we calculate the value of the indefinite-lived intangible assets using a discounted cash flow method, based on the relief from royalty concept, and compare the fair value to the carrying value to determine if the asset is impaired. We may elect to skip the qualitative assessment when appropriate based on current circumstances. For 2015, we performed a qualitative assessment of the WHBM trade name and concluded it was more likely than not that the fair value exceeded the carrying amount as of the annual assessment date. In fiscal 2015, 2014 and 2013 we performed an impairment assessment of Boston Proper indefinite-lived intangible assets and recorded pre-tax, non-cash impairment charges of $39.4 million, $4.3 million and $5.2 million on the Boston Proper trade name as further discussed in Note 8. Intangible assets subject to amortization consisted of the value of Boston Proper customer relationships. In fiscal 2015, we performed an impairment assessment of the Boston Proper customer relationships and recorded pre-tax, non-cash impairment charges of $24.2 million as further discussed in Note 8. All remaining Boston Proper intangible assets, including the Boston Proper trade name and customer relationships were included in the sale of the Boston Proper direct-to-consumer business in fiscal 2015. Accounting for the Impairment of Long-lived Assets and Assets Held for Sale Long-lived assets, including definite-lived intangibles, are reviewed periodically for impairment if events or changes in circumstances indicate that the carrying amount may not be recoverable. If future undiscounted cash flows expected to be generated by the asset are less than its carrying amount, an asset is determined to be impaired. The fair value of an asset is estimated using estimated future cash flows of the asset discounted by a rate commensurate with the risk involved with such asset while incorporating marketplace assumptions. The impairment loss recorded is the amount by which the carrying value of the asset exceeds its fair value. In fiscal 2015, 2014 and 2013, we completed an evaluation of long-lived assets at certain underperforming stores for indicators of impairment and, as a result, recorded impairment charges of approximately $1.4 million, $1.3 million and $1.3 million, which are included in selling, general and administrative expense ("SG&A") in the accompanying consolidated statements of income, respectively. Additionally, in connection with the restructuring program initiated in fiscal 2014 further discussed in Note 2, we have identified approximately 175 stores, including the Boston Proper stores, to be closed from fiscal 2015 through 2017. As a result, in fiscal 2015 and 2014, we recorded additional impairment charges of approximately $12.5 million and $5.4 million, respectively, which are included in restructuring and strategic charges in the accompanying consolidated statements of income. Assets held for sale are measured at the lower of their carrying value or fair value less costs of disposal. Upon retirement or disposition, the asset cost and related accumulated depreciation or amortization are removed from the accounts, and a gain or loss is recognized based on the difference between the fair value of proceeds received and the asset’s carrying value. Revenue Recognition Retail sales by our stores are recorded at the point of sale and are net of estimated customer returns, sales discounts under rewards programs and company issued coupons, promotional discounts and employee discounts. For sales from our websites and catalogs, revenue is recognized at the time we estimate the customer receives the product, which is typically within a few days of shipment. Our gift cards do not have expiration dates. We account for gift cards by recognizing a liability at the time the gift card is sold. The liability is relieved and revenue is recognized for gift cards upon redemption. In addition, we recognize revenue for the amount of gift cards expected to go unredeemed (commonly referred to as gift card breakage) under the redemption recognition method. This method records gift card breakage as revenue on a proportional basis over the redemption period based on our historical gift card breakage rate. We determine the gift card breakage rate based on our historical redemption patterns. We recognize revenue on the remaining unredeemed gift cards based on determining that the likelihood of the gift card being redeemed is remote and that there is no legal obligation to remit the unredeemed gift cards to relevant jurisdictions. Soma offers a points based loyalty program in which customers earn points based on purchases. Attaining specified loyalty point levels results in the issuance of reward coupons to discount future purchases. As program members accumulate points, we accrue the estimated future liability, adjusted for expected redemption rates. The liability is relieved and revenue is recognized for loyalty point reward coupons upon redemption. In addition, we recognize revenue on unredeemed points when it can be determined that the likelihood of the point being redeemed is remote and there is no legal obligation to remit the point value. We determined the loyalty point breakage rate based on historical and redemption patterns. As part of the normal sales cycle, we receive customer merchandise returns related to store, website, and catalog sales. To account for the financial impact of potential customer merchandise returns, we estimate future returns on previously sold merchandise. Reductions in sales and gross margin are recorded for estimated merchandise returns based on return history, current sales levels and projected future return levels. Our policy towards taxes assessed by a government authority directly imposed on revenue producing transactions between a seller and a customer is, and has been, to exclude all such taxes from revenue. Advertising Costs Costs associated with the production of non-catalog advertising, such as writing, copying, printing, and other costs are expensed as incurred. Costs associated with communicating advertising that has been produced, such as television and magazine, are expensed when the advertising event takes place. Catalog expenses consist of the cost to create, print, and distribute catalogs. Such costs are amortized over their expected period of future benefit, which is typically less than six weeks. For fiscal 2015, 2014 and 2013, advertising expense was approximately $159.9 million, $153.1 million, and $151.9 million, respectively, and is included within SG&A in the accompanying consolidated statements of income. Stock-Based Compensation Stock-based compensation for all awards is based on the grant date fair value of the award, net of estimated forfeitures, and is recognized over the requisite service period of the awards. The fair value of restricted stock awards and performance-based awards is determined by using the closing price of the Company’s common stock on the date of the grant. Compensation expense for performance-based awards is recorded based on the amount of the award ultimately expected to vest, depending on the level and likelihood of the performance condition to be met. Shipping and Handling Costs Shipping and handling costs to transport goods to customers, net of amounts paid to us by customers, amounted to $19.0 million, $19.1 million, and $18.4 million in fiscal 2015, 2014 and 2013, respectively, and are included within SG&A in the accompanying consolidated statements of income. Amounts paid by customers to cover shipping and handling costs are immaterial. Store Pre-opening Costs Operating costs (including store set-up, rent and training expenses) incurred prior to the opening of new stores are expensed as incurred and are included within SG&A in the accompanying consolidated statements of income. Income Taxes Income taxes are accounted for in accordance with authoritative guidance, which requires the use of the asset and liability method. Deferred tax assets and liabilities are recognized based on the difference between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, we follow a comprehensive model to recognize, measure, present, and disclose in our consolidated financial statements the estimated aggregate tax liability of uncertain tax positions that we have taken or expect to take on a tax return. This model states that a tax benefit from an uncertain tax position may be recognized if it is “more likely than not” that the position is sustainable, based upon its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that has greater than a 50% likelihood of being realized upon the ultimate settlement with a taxing authority having full knowledge of all relevant information. Foreign Currency The functional currency of our foreign operations is generally the applicable local currency. Assets and liabilities are translated into U.S. dollars using the current exchange rates in effect as of the balance sheet date, while revenues and expenses are translated at the average exchange rates for the period. The resulting translation adjustments are recorded as a component of comprehensive income in the consolidated statements of comprehensive income. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the local functional currency are included in the consolidated statements of income. Self-Insurance We are self-insured for certain losses relating to workers’ compensation, medical and general liability claims. Self-insurance claims filed and claims incurred but not reported are accrued based upon management’s estimates of the aggregate liability for uninsured claims incurred based on historical experience. While we do not expect the amount we will ultimately pay to differ significantly from our estimates, self-insurance accruals could be affected if future claims experience differs significantly from the historical trends and assumptions. Supplier Allowances From time to time, we receive allowances and/or credits from certain of our suppliers. The aggregate amount of such allowances and credits, which is included in cost of goods sold, is immaterial to our consolidated results of operations. Earnings Per Share In accordance with relevant accounting guidance, unvested share-based payment awards that include non-forfeitable rights to dividends, whether paid or unpaid, are considered participating securities. As a result, such awards are required to be included in the calculation of earnings per common share pursuant to the “two-class” method. For us, participating securities are composed entirely of unvested restricted stock awards and performance-based stock units that have met their relevant performance criteria. Under the two-class method, net income is reduced by the amount of dividends declared in the period for common stock and participating securities. The remaining undistributed earnings are then allocated to common stock and participating securities as if all of the net income for the period had been distributed. Basic EPS excludes dilution and is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period including the participating securities. Diluted EPS reflects the dilutive effect of potential common shares from non-participating securities such as stock options and performance-based stock units. Newly Issued Accounting Pronouncements In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU No. 2016-02, Leases, which replaces the existing guidance in Accounting Standard Codification 840, Leases. ASU 2016-02 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018. ASU 2016-02 requires a dual approach for lessee accounting under which a lessee would account for leases as finance leases or operating leases. Both finance leases and operating leases will result in the lessee recognizing a right-of-use asset and corresponding lease liability. For finance leases the lessee would recognize interest expense and amortization of the right-of-use asset and for operating leases the lessee would recognize straight-line total lease expense. We are currently assessing the new standard and its impact to our consolidated results of operations, financial positions and cash flows. In January 2016, the FASB issued ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, under which entities will no longer be able to recognize unrealized holding gains and losses on equity securities they classify as available for sale in other comprehensive income but instead recognize the change in fair value in net income. The standard is effective for interim and annual reporting periods beginning after December 15, 2017. We are currently assessing the new standard, but do not, at this time, anticipate a material impact to our consolidated results of operations, financial positions and cash flows. In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes, which modifies the presentation of noncurrent and current deferred taxes. ASU 2015-17 requires that all deferred tax assets and liabilities be classified as noncurrent on the balance sheet instead of separating deferred taxes into current and noncurrent amounts. The standard is effective for interim and annual reporting periods beginning after December 15, 2016. Early adoption is permitted. We early adopted this standard in the fourth quarter of 2015, with retrospective presentation, as shown in our consolidated balance sheets. Our retrospective presentation resulted in a $4.6 million reclassification from current assets to other assets, net for the period ending January 31, 2015. In July 2015, the Financial Accounting Standards Board ("FASB") issued ASU No. 2015-11, Simplifying the Measurement of Inventory (Topic 330). The amendments, which apply to inventory that is measured using any method other than the last-in, first-out (LIFO) or retail inventory method, require that entities measure inventory at the lower of cost or net realizable value. ASU 2015-11 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016 and should be applied on a prospective basis. We are currently assessing the potential impact of adopting this ASU, but do not, at this time, anticipate a material impact to our consolidated results of operations, financial position or cash flows. In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, which modifies the presentation of debt issuance costs in financial statements. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts, rather than as an asset. ASU 2015-03 is effective for interim and annual reporting periods beginning after December 15, 2016. Early adoption is permitted. We elected to early adopt this guidance in the second quarter ended August 1, 2015, and have presented the debt issuance costs related to our term loan as a direct deduction of the term loan and have presented the debt issuance costs related to our revolving credit facility as a deferred asset within Other Assets, as is permitted by ASU No. 2015-15, Imputation of Interest, which was issued in August 2015. Such adoption did not have a material impact to our consolidated financial position. The adoption of the guidance is made on a retrospective basis, however there was no material impact to prior periods that required reclassification. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. The update outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. ASU 2014-09 requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services. In August 2015, the FASB approved a one year deferral of the effective date, to make it effective for annual and interim reporting periods beginning after December 15, 2017. The standard allows for either a full retrospective or a modified retrospective transition method. We are currently assessing the new standard and its potential impact to our consolidated results of operations, financial position and cash flows. In April 2014, the FASB issued ASU No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360). Under ASU 2014-08, only disposals that represent a strategic shift that has (or will have) a major effect on the entity's operations and financial results would qualify as discontinued operations. The update also requires expanded disclosures for discontinued operations and requires entities to disclose information about disposals of individually significant components that don't qualify for discontinued operations reporting. ASU 2014-08 was effective prospectively for interim and annual reporting periods beginning after December 15, 2014. We adopted this standard beginning with the first quarter ended May 2, 2015 and have applied this standard to the Boston Proper disposal, as further discussed in Note 2. 2. RESTRUCTURING AND STRATEGIC CHARGES: During the fourth quarter of fiscal 2014, we initiated a restructuring program, including the acceleration of domestic store closures and an organizational realignment, to ensure that resources align with long-term growth initiatives, including omni-channel. In connection with this effort, in the fourth quarter of fiscal 2014, we recorded pre-tax restructuring and strategic charges of approximately $16.7 million primarily related to severance and termination benefits, store closures and other impairment charges. In connection with the program, in fiscal 2015 we continued our evaluation of our domestic store portfolio and increased the number of under-performing stores identified for closure to approximately 175, including the Boston Proper stores, with 69 stores across our brands closed in fiscal 2015. We expect to incur additional cash charges related to lease termination expenses of approximately $1.7 million over the next two fiscal years related to these future closures. During the second quarter of fiscal 2015, in connection with the restructuring program, we completed an evaluation of the Boston Proper brand and initiated a plan (the "Plan") to sell the direct-to-consumer ("DTC") business and close its stores, allowing us to focus our efforts on our core brands. In fiscal 2015, we completed the sale of the Boston Proper DTC business and closed its stores. We assessed the disposal group and determined that the sale of the Boston Proper DTC business will not have a major effect on our consolidated results of operations, financial position or cash flows. Accordingly, the disposal group is not presented in the consolidated financial statements as a discontinued operation. Pretax losses for the Boston Proper DTC business for fiscal 2015, 2014, and 2013 were $11.8 million, $7.9 million, and $4.9 million, respectively. The loss recorded in the fourth quarter of fiscal 2015 upon disposition of the Boston Proper assets held for sale was not material. A summary of the restructuring and strategic charges is presented in the table below: As of January 30, 2016, a reserve of $5.3 million related to restructuring and strategic activities was included in other current and deferred liabilities in the accompanying consolidated balance sheets. A roll-forward of the reserve is presented as follows: 3. MARKETABLE SECURITIES: Marketable securities are classified as available-for-sale and as of January 30, 2016 generally consist of corporate bonds, and U.S. government agencies with $24.9 million of securities with maturity dates within one year or less and $25.3 million with maturity dates over one year and less than two years. As of January 31, 2015, marketable securities generally consisted of corporate bonds, municipal securities, and U.S. government and agency securities. The following tables summarize our investments in marketable securities at January 30, 2016 and January 31, 2015: 4. FAIR VALUE MEASUREMENTS: Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date. Entities are required to use a three-level hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability on the measurement date. The three levels are defined as follows: Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities Level 2 - Unadjusted quoted prices in active markets for similar assets or liabilities, or; Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or; Inputs other than quoted prices that are observable for the asset or liability Level 3 - Unobservable inputs for the asset or liability. We measure certain financial assets at fair value on a recurring basis, including our marketable securities, which are classified as available-for-sale securities, certain cash equivalents, specifically our money market accounts, and assets held in our non-qualified deferred compensation plan. The money market accounts are valued based on quoted market prices in active markets. Our marketable securities are generally valued based on other observable inputs for those securities (including market corroborated pricing or other models that utilize observable inputs such as interest rates and yield curves) based on information provided by independent third party pricing entities, except for U.S. government securities which are valued based on quoted market prices in active markets. The investments in our non-qualified deferred compensation plan are valued using quoted market prices and are included in other assets on our consolidated balance sheets. From time to time, we measure certain assets at fair value on a non-recurring basis. This includes the evaluation of long-lived assets, goodwill and other intangible assets for impairment using company-specific assumptions which would fall within Level 3 of the fair value hierarchy. We estimate the fair value of assets held for sale using market values for similar assets which would fall within Level 2 of the fair value hierarchy. To assess the fair value of goodwill, we utilize both an income approach and a market approach. Inputs used to calculate the fair value based on the income approach primarily include estimated future cash flows, discounted at a rate that approximates the cost of capital of a market participant. Inputs used to calculate the fair value based on the market approach include identifying sales and EBITDA multiples based on guidelines for similar publicly traded companies and recent transactions. To assess the fair value of the trade names, we utilize a relief from royalty approach. Inputs used to calculate the fair value of the trade names primarily include future sales projections, discounted at a rate that approximates the cost of capital of a market participant and an estimated royalty rate. To assess the fair value of long-term debt, we utilize a discounted future cash flow model using current borrowing rates for similar types of debt of comparable maturities. During fiscal 2015, we recorded a $112.5 million pre-tax impairment charge related to assets measured at fair value on a non-recurring basis, comprised of $48.9 million in Boston Proper goodwill impairment, $39.4 million pre-tax related to the Boston Proper trade name, and $24.2 million pre-tax related to the Boston Proper intangible customer list. During fiscal 2014, we recorded a $30.1 million pre-tax impairment charge related to assets measured at fair value on a non-recurring basis, comprised of $25.8 million in Boston Proper goodwill impairment and $4.3 million pre-tax related to the Boston Proper trade name. Fair value calculations contain significant judgments and estimates, which may differ from actual results due to, among other things, economic conditions, changes to the business model or changes in operating performance. During fiscal 2015, we did not make any transfers between Level 1 and Level 2 financial assets. Furthermore during fiscal 2015 and 2014, we did not have any Level 3 financial assets measured on a recurring basis. We conduct reviews on a quarterly basis to verify pricing, assess liquidity, and determine if significant inputs have changed that would impact the fair value hierarchy disclosure. In accordance with the provisions of the guidance, we categorized our financial assets and liabilities which are valued on a recurring basis, based on the priority of the inputs to the valuation technique for the instruments, as follows: 5. PREPAID EXPENSES AND ACCOUNTS RECEIVABLE: Prepaid expenses and accounts receivable consisted of the following: 6. ASSETS HELD FOR SALE In connection with the restructuring program, we determined that certain vacant land met the criteria to be classified as held for sale as of January 31, 2015. In fiscal 2015, we reevaluated the fair value of the land held for sale and recorded approximately $0.3 million in impairment charges which is included in restructuring and strategic charges in the accompanying consolidated statements of income. This vacant land was the sole item in the $16.5 million balance of assets held for sale as of January 30, 2016 and is currently under contract. 7. PROPERTY AND EQUIPMENT, NET: Property and equipment, net, consisted of the following: Total depreciation expense for fiscal 2015, 2014 and 2013 was $116.6 million, $117.8 million and $113.8 million, respectively. 8. GOODWILL AND OTHER INTANGIBLE ASSETS: Goodwill and other intangible assets consisted of the following: In fiscal 2015, based on market indications of value and a decline in sales, we recorded a pre-tax goodwill impairment charge of $48.9 million related to Boston Proper goodwill, reducing the carrying value of goodwill to zero, pre-tax impairment charges related to the Boston Proper trade name of $39.4 million, reducing the carrying value of the trade name to $2.3 million, and a pre-tax impairment charge related to Boston Proper customer relationships of $24.2 million, reducing the carrying value of the customer relationships to $2.6 million. All impairment charges were recorded within Goodwill and intangible impairment charges in the accompanying consolidated statements of income. There were no changes or cumulative impairment charges for other outstanding goodwill and intangible balances during fiscal 2015. On January 15, 2016, in connection with the Plan, the Company completed the sale the Boston Proper DTC business, which included the carrying values of the Boston Proper trade name of $2.3 million and Boston Proper customer relationships of $2.6 million. The net proceeds on the sale of the Boston Proper DTC business are included in restructuring and strategic charges in the accompanying consolidated statements of income. Amortization expense for fiscal 2015 was approximately $2.2 million related to Boston Proper customer relationships. In fiscal 2014, as a result of sales and margin declines in the Boston Proper brand due to issues with merchandising and marketing effectiveness, we recorded a pre-tax goodwill impairment charge of $25.8 million, reducing the carrying value of Boston Proper goodwill to $48.9 million and an impairment charge related to the Boston Proper trade name of $4.3 million pre-tax, reducing the carrying value of the Boston Proper trade name to $41.7 million. All impairment charges were recorded within 'Goodwill and intangible impairment charges' in the accompanying consolidated statements of income. The following table provides the carrying amounts of Boston Proper goodwill and pre-tax cumulative goodwill impairment charges: Other than the impairment of the Boston Proper goodwill as discussed above, there were no changes in goodwill during fiscal 2015 and there are no cumulative impairment charges as of January 30, 2016. 9. OTHER CURRENT AND DEFERRED LIABILITIES: Other current and deferred liabilities consisted of the following: 10. DEBT: In fiscal 2015, we entered into a credit agreement (the "Agreement") among the Company, JPMorgan Chase Bank, N.A. as Administrative Agent, Bank of America, N.A., as Syndication Agent and the other lenders. Our obligations under the Agreement are guaranteed by certain of our material U.S. subsidiaries. The Agreement provides for a term loan commitment in the amount of $100.0 million, of which $100.0 million was drawn at closing, and matures on May 4, 2020, payable in quarterly installments, as defined in the Agreement, with the remainder due at maturity. The Agreement also provides for a $100.0 million revolving credit facility, of which $24.0 million was drawn at closing and was repaid in the second quarter of fiscal 2015. There were no amounts outstanding on the revolving credit facility as of January 30, 2016. The revolving credit facility matures on May 4, 2020. The Agreement contains various covenants and restrictions, including maximum leverage ratio, as defined, of no more than 3.50 to 1.00 until July 31, 2018, and 3.25 to 1.00 after July 31, 2018, and minimum fixed charge coverage ratio, as defined, of not less than 1.20 to 1.00. If the Company failed to comply with these financial covenants, a default would trigger and all principal and outstanding interest would be due and payable. At January 30, 2016, the Company was in compliance with all financial covenant requirements of the Agreement. The Agreement has borrowing options which accrue interest by reference, at our election, at either an adjusted eurodollar rate tied to LIBOR or an Alternate Base Rate ("ABR") plus an interest rate margin, as defined in the Agreement. The interest rate on borrowings and our commitment fee rate vary based on the maximum leverage ratio as follows: On May 4, 2015, in connection with our entry into the Agreement, we repaid and terminated with no prepayment penalties, the $124.0 million outstanding obligation under our 2011 revolving credit facility. We used the proceeds from the initial draw of the term loan and revolving credit facility of the Agreement to repay such obligations. As of January 30, 2016, $92.2 million in borrowings were outstanding under the Agreement, and are reflected as $10.0 million in current debt and $82.2 million in long-term debt in the accompanying consolidated balance sheets. The following table provides details on our debt outstanding as of January 30, 2016 and January 31, 2015: Aggregate future maturities of long-term debt are as follows: 11. NON-CURRENT DEFERRED LIABILITIES: Deferred liabilities consisted of the following: Deferred rent represents the difference between operating lease obligations currently due and operating lease expense, which is recorded on a straight-line basis over the appropriate respective terms of the leases. Deferred lease credits represent construction allowances received from landlords and are amortized as a reduction of rent expense over the appropriate respective terms of the related leases. 12. COMMITMENTS AND CONTINGENCIES: Leases We lease retail stores, a limited amount of office space and various office equipment under operating leases expiring in various years through the fiscal year ending 2025. Certain operating leases provide for renewal options that generally approximate five years at a pre-determined rental value. In the normal course of business, operating leases are generally renewed or replaced by other leases. Minimum future rental payments under non-cancelable operating leases (including leases with certain minimum sales cancellation clauses described below and exclusive of common area maintenance charges and/or contingent rental payments based on sales) as of January 30, 2016, are approximately as follows: Certain of the leases provide that we may cancel the lease if our retail sales at that location fall below an established level. A majority of our store operating leases contain cancellation clauses that allow the leases to be terminated at our discretion, if certain minimum sales levels are not met within the first few years of the lease term. We have not historically met or exercised a significant number of these cancellation clauses and, therefore, have included commitments for the full lease terms of such leases in the above table. For fiscal 2015, 2014 and 2013, total rent expense under operating leases was approximately $266.2 million, $253.2 million, and $230.0 million, respectively, including common area maintenance charges of approximately $46.7 million, $42.5 million, and $37.2 million, respectively, other rental charges of approximately $40.1 million, $37.6 million, and $32.8 million, respectively, and contingent rental expense, based on sales, of approximately $5.8 million, $7.0 million, and $9.1 million, respectively. Credit Facility As of January 30, 2016, $92.2 million in net borrowings were outstanding as further disclosed in Footnote 10. The following table provides details on our debt outstanding as of January 30, 2016 and January 31, 2015: Other At January 30, 2016 and January 31, 2015, we had approximately $398.6 million and $424.5 million, respectively, of open purchase orders for inventory, in the normal course of business, which are cancellable with no or limited recourse available to the vendor until the merchandise shipping date. In June 2015, the Company was named as a defendant in a putative representative Private Attorney General action filed in the Superior Court of California, County of Los Angeles, Ackerman v. Chico’s FAS, Inc. The complaint attempts to allege numerous violations of California law related to wages, meal periods, rest periods, wage statements, and failure to reimburse business expenses, among other things. The Company denies the material allegations of the complaint and filed its answer on July 27, 2015. The Company believes that the case is without merit, and intends to vigorously defend. As a result, the Company does not believe that it is probable that the case will have a material adverse effect on the Company’s consolidated financial condition or results of operations. In July 2015, the Company was named as a defendant in a putative class action filed in the United States District Court for the Northern District of Georgia, Altman v. White House Black Market, Inc. The complaint alleges that the Company, in violation of federal law, published more than the last five digits of a credit or debit card number or an expiration date on customers’ receipts. The Company denies the material allegations of the complaint and filed a motion to dismiss on September 9, 2015, which is pending. The Company believes that the case is without merit and intends to vigorously defend. As a result, the Company does not believe that it is probable that the case will have a material adverse effect on the Company’s consolidated financial condition or results of operations. Other than as noted above, we are not currently a party to any legal proceedings, other than various claims and lawsuits arising in the normal course of business, none of which we believe should have a material adverse effect on our consolidated financial condition or results of operations. 13. STOCK COMPENSATION PLANS AND CAPITAL STOCK TRANSACTIONS: General In April 2012, the Board approved the Chico’s FAS, Inc. 2012 Omnibus Stock and Incentive Plan (the “Omnibus Plan”), which replaced the Chico’s FAS, Inc. 2002 Omnibus Stock and Incentive Plan and was approved by our shareholders, effective June 21, 2012. As of the effective date, the Omnibus Plan provided for 7.0 million shares of our common stock that may be delivered to participants and their beneficiaries in addition to approximately 3.5 million shares of our common stock available for future awards under prior plans. Awards under the Omnibus Plan may be in the form of restricted stock, restricted stock units, performance-based restricted stock, performance-based stock units, stock options, and stock appreciation rights, in accordance with the terms and conditions of the Omnibus Plan. The terms of each award will be determined by the Compensation and Benefits Committee of the Board of Directors. We have historically issued restricted stock, including non-vested restricted stock and performance-based restricted stock, performance-based stock units, and stock options. Shares of non-vested restricted stock and performance-based restricted stock have the same voting rights as common stock, are entitled to receive dividends and other distributions thereon, and are considered to be currently issued and outstanding. Performance-based stock units are entitled to dividends based on certain Company-specific performance goals and are entitled to voting rights upon meeting these Company-specific performance goals. Generally, stock-based awards vest evenly over three years; stock options generally have a 10-year term. As of January 30, 2016, approximately 1.1 million nonqualified stock options are outstanding under the Omnibus Plan and approximately 6.9 million shares remain available for future grants of stock-based awards. Stock-based compensation expense for all awards is based on the grant date fair value of the award, net of estimated forfeitures, and is recognized over the requisite service period of the awards. Compensation expense for restricted stock awards and stock options with a service condition is recognized on a straight-line basis over the requisite service period. Compensation expense for performance-based awards with a service condition is recognized ratably for each vesting tranche based on our estimate of the level and likelihood of meeting certain Company-specific performance goals. We estimate the expected forfeiture rate for all stock-based awards, and only recognize expense for those shares expected to vest. In determining the portion of the stock-based payment award that is ultimately expected to be earned, we derive forfeiture rates based on historical data. In accordance with the authoritative guidance, we revise our forfeiture rates, when necessary, in subsequent periods if actual forfeitures differ from those originally estimated. Total compensation expense related to stock-based awards in fiscal 2015, 2014 and 2013 was $30.1 million, $26.5 million and $27.1 million, respectively. The total tax benefit associated with stock-based compensation for fiscal 2015, 2014 and 2013 was $11.5 million, $10.1 million and $10.4 million, respectively. Restricted Stock Awards Restricted stock activity for fiscal 2015 was as follows: Total fair value of shares of restricted stock that vested during fiscal 2015, 2014 and 2013 was $34.8 million, $21.8 million and $17.6 million, respectively. The weighted average grant date fair value of restricted stock granted during the fiscal 2015, 2014 and 2013 was $16.97, $16.44, and $16.99, respectively. As of January 30, 2016, there was $23.1 million of unrecognized stock-based compensation expense related to non-vested restricted stock awards. That cost is expected to be recognized over a weighted average remaining period of 1.9 years. Performance-based Stock Units Performance-based stock unit activity for fiscal 2015 was as follows: Total fair value of performance-based stock units that vested during fiscal 2015 and 2014 was $3.9 million and $4.2 million, respectively. There was $1.9 million of unrecognized stock-based compensation expense related to performance-based stock units expected to vest. That cost is expected to be recognized over a weighted average period of approximately 1.52 years. Stock Option Awards We used the Black-Scholes option-pricing model to value our stock options. No stock options have been issued since 2011. Using this option-pricing model, the fair value of each stock option award was estimated on the date of grant. The fair value of the stock option awards, which are subject to pro-rata vesting generally over three years, was expensed on a straight-line basis over the vesting period of the stock options. As of January 30, 2016, all outstanding stock options were fully vested, and there was no unrecognized compensation expense. Stock option activity for fiscal 2015 was as follows: The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the excess, if any, of the closing stock price on the last trading day of fiscal 2015 and the exercise price, multiplied by the number of such in-the-money options) that would have been received by the option holders had all option holders exercised their options on January 30, 2016. This amount changes based on the fair market value of our common stock. Total intrinsic value of options exercised during fiscal 2015, 2014 and 2013 (based on the difference between our stock price on the respective exercise date and the respective exercise price, multiplied by the number of respective options exercised) was $4.6 million, $1.5 million and $4.3 million, respectively. Cash received from option exercises for fiscal 2015 was $8.2 million. The actual tax benefit realized for the tax deduction from option exercises of stock option awards totaled $1.8 million for fiscal 2015. Employee Stock Purchase Plan We sponsor an employee stock purchase plan (“ESPP”) under which substantially all full-time employees are given the right to purchase shares of our common stock during each of the two specified offering periods each fiscal year at a price equal to 85 percent of the value of the stock immediately prior to the beginning of each offering period. During fiscal 2015, 2014 and 2013, approximately 174,000, 180,000, and 187,000 shares, respectively, were purchased under the ESPP. Cash received from purchases under the ESPP for fiscal 2015 was $2.4 million. Share Repurchase Program During fiscal 2015, we repurchased 18.3 million shares, at a total cost of approximately $290.0 million. The Company repurchased 14.6 million shares for $250.0 million through our $300 million share repurchase program announced in December 2013, and 3.7 million shares for $40.0 million under its $300 million share repurchase program announced in November 2015, with $260.0 million remaining under the share repurchase program. However, we have no continuing obligation to repurchase shares under this authorization, and the timing, actual number and value of any additional shares to be purchased will depend on the performance of our stock price, market conditions and other considerations. 14. RETIREMENT PLANS: We have a 401(k) defined contribution employee retirement benefit plan (the “Plan”) covering all employees upon the completion of one year of service, working 1000 hours or more, and are at least age 21. Employees’ rights to Company contributions vest fully upon completing five years of service, with incremental vesting starting in service year two. Under the Plan, employees may contribute up to 100 percent of their annual compensation, subject to certain statutory limitations. We have elected to match employee contributions at 50 percent on the first 6 percent of the employees’ contributions and can elect to make additional contributions over and above the mandatory match. For fiscal 2015, 2014 and 2013, our costs under the Plan were approximately $3.8 million, $3.7 million, and $3.5 million, respectively. In April 2002, we adopted the Chico’s FAS, Inc. Deferred Compensation Plan (the “Deferred Plan”) to provide supplemental retirement income benefits for a highly compensated employees. Eligible participants may elect to defer up to 80 percent of their base salary and 100 percent of their bonus earned under an approved bonus plan pursuant to the terms and conditions of the Deferred Plan. The Deferred Plan generally provides for payments upon retirement, death, disability or termination of employment. In addition, we may make employer contributions to participants under the Deferred Plan. To date, no Company contributions have been made under the Deferred Plan. The amount of the deferred compensation liability payable to the participants is included in deferred liabilities in the consolidated balance sheets. These obligations are funded through the purchase of corporated owned life insurance (COLI), cash and other securities held within a rabbi trust established on behalf of the employee group participating in the plan. The trust assets are reflected in other assets in the accompanying consolidated balance sheets. 15. INCOME TAXES: The income tax provision consisted of the following: The foreign component of pre-tax income (loss), arising principally from operating foreign stores and other management and cost sharing charges we are required to allocate under U.S. tax law, for fiscal 2015, 2014, and 2013 was $(0.8) million, $(2.8) million, and $(0.6) million respectively. A reconciliation between the statutory federal income tax rate and the effective income tax rate follows: Deferred tax assets and liabilities are recorded due to different carrying amounts for financial and income tax reporting purposes arising from cumulative temporary differences. These differences consist of the following as of January 30, 2016 and January 31, 2015: As of January 30, 2016, the Company had available for state income tax purposes net operating loss and tax credit carryovers which expire, if unused, in the years 2020 - 2035 and 2021 - 2025, respectively. We have not recognized any United States (“U.S.”) tax expense on undistributed foreign earnings as they are intended to be indefinitely reinvested outside of the U.S. There were no significant undistributed earnings at January 30, 2016 and January 31, 2015. Accumulated other comprehensive income is shown net of deferred tax assets and deferred tax liabilities. These deferred taxes are not reflected in the table above. The amount is not significant at January 30, 2016 or January 31, 2015. A reconciliation of the beginning and ending amounts of uncertain tax positions for each of fiscal 2015, fiscal 2014 and fiscal 2013 is as follows: At January 30, 2016, January 31, 2015, and February 1, 2014, balances included $4.0 million, $1.6 million, and $2.6 million respectively, of unrecognized tax benefits that, if recognized, would favorably impact the effective tax rate in future periods. Included in the January 30, 2016 uncertain tax positions balance of $4.8 million is $1.6 million of unrecognized tax benefits that have been offset directly against the associated tax attributes. Our continuing practice is to recognize potential accrued interest and penalties relating to unrecognized tax benefits in the income tax provision. For fiscal 2015, 2014 and 2013, we accrued $0.2 million, $0.3 million and $0.4 million, respectively for interest and penalties. We had approximately $0.4 million, $0.5 million and $2.3 million, respectively for the payment of interest and penalties accrued at January 30, 2016, January 31, 2015 and February 1, 2014, respectively. The amounts included in the reconciliation of uncertain tax positions do not include accruals for interest and penalties. In fiscal 2006, we began participating in the IRS’s real time audit program, Compliance Assurance Process (“CAP”). Under the CAP program, material tax issues and initiatives are disclosed to the IRS throughout the year with the objective of reaching agreement as to the proper reporting treatment when the federal return is filed. Our fiscal 2013 year has been examined and a full acceptance letter issued. For fiscal 2014, we have received a partial acceptance letter, and are currently in the post-file review process. Through the end of fiscal 2015, the majority of fiscal 2014 issues have been resolved with the exception of transfer pricing and the domestic production activities deduction. With few exceptions, we are no longer subject to state and local examinations for years before fiscal 2011. Various state examinations are currently underway for fiscal periods spanning from 2010 through 2014; however, we do not expect any significant change to our uncertain tax positions within the next year. 16. NET EARNINGS PER SHARE: The following table sets forth the computation of basic and diluted EPS shown on the face of the accompanying consolidated statements of income (in thousands, except per share amounts): In fiscal 2015, 2014 and 2013, 0.3 million, 0.6 million and 0.9 million potential shares of common stock, respectively, were excluded from the diluted per share calculation relating to non-participating securities, because the effect of including these potential shares was antidilutive. 17. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): 18. SUBSEQUENT EVENTS: On February 25, 2016, we announced that our Board of Directors declared a quarterly dividend of $0.08 per share on our common stock. The dividend will be payable on March 28, 2016 to shareholders of record at the close of business on March 14, 2016. Although it is our Company’s intention to continue to pay a quarterly cash dividend in the future, any decision to pay future cash dividends will be made by the Board of Directors and will depend on future earnings, financial condition and other factors.
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Here's a summary of the financial statement:
1. Profit/Loss:
- Losses are reported net of income taxes
- Reflected in accumulated other comprehensive income until realized
- Cost and fair value determined by specific identification
2. Expenses:
- Based on estimates of liabilities and contingent assets/liabilities
- Includes reporting of revenues and expenses during the period
- Some prior year balances were reclassified to match current presentation
3. Assets:
- Include cash, money market accounts, marketable securities
- Non-qualified deferred compensation plan assets
- Accounts receivable
- Current assets support operational liquidity
- Cash and receivables carried at cost (approximating fair value)
4. Liabilities:
- Include accounts payable and debt
- Carried at cost due to short-term nature
- Inventory management system:
* Uses weighted average cost method
* Tracks excess/slow-moving inventory
* Evaluates inventory aging and turn rates
* Records inventory at net realizable value
* Estimates shrinkage using store experience rates
* Capitalizes sourcing costs
* Expenses merchandising, distribution, and product development costs
The statement appears to be from a retail business with significant inventory management procedures and standard accounting practices for cash, receivables, and payables.
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Claude
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. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Shareholders’ Equity Consolidated Statements of Cash Flows Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Pace Holdings Corp.: We have audited the accompanying consolidated balance sheets of Pace Holdings Corp. as of December 31, 2016 and 2015, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the year ended December 31, 2016 and the period from June 3, 2015 (inception) to December 31, 2015, and the related notes to the consolidated financial statements. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pace Holdings Corp. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for the year ended December 31, 2016 and period from June 3, 2015 (inception) to December 31, 2015, in conformity with U.S. generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has current liabilities in excess of cash on hand and its lack of resources to pay the current liabilities raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1 to the consolidated financial statements. The consolidated financial statements and related notes to the consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/KPMG LLP Fort Worth, Texas March 3, 2017 Pace Holdings Corp. Consolidated Balance Sheets The accompanying notes are an integral part of these consolidated financial statements. Pace Holdings Corp. Consolidated Statements of Operations The accompanying notes are an integral part of these consolidated financial statements. Pace Holdings Corp. Consolidated Statement of Shareholders’ Equity The accompanying notes are an integral part of these consolidated financial statements. Pace Holdings Corp. Consolidated Statements of Cash Flows The accompanying notes are an integral part of these consolidated financial statements. Pace Holdings Corp. 1. Organization and Business Operations Organization and General Pace Holdings Corp. (the “Company”) was incorporated in the Cayman Islands on June 3, 2015 under the name Paceline Holdings Corp. The Company changed its name to Pace Holdings Corp. on August 7, 2015. The Company was formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (“Business Combination”). The Company is an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended (the “Securities Act”), as modified by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). The Company’s sponsor is TPACE Sponsor Corp., a Cayman Islands exempted company (the “Sponsor”). On December 9, 2016, the Company formed Porto Holdco B.V., a Dutch private limited liability company (besloten vennootschap met beperkte aansprakelijkheid) (“Holdco”), and New PACE Holdings Corp., a Cayman Islands exempted company (“New Pace”), in contemplation of a business combination. Holdco is a wholly owned subsidiary of the Company. New Pace is a wholly owned subsidiary of Holdco. On December 13, 2016, the Company, Playa Hotels & Resorts B.V., a Dutch private limited liability company (besloten vennootschap met beperkte aansprakelijkheid) (“Playa”), Porto Holdco B.V., a Dutch private limited liability company (besloten vennootschap met beperkte aansprakelijkheid) (“Holdco”), and New PACE Holdings Corp., a Cayman Islands exempted company (“New Pace”), entered into a Transaction Agreement (as amended on February 6, 2017 and as it may be further amended from time to time, the “Transaction Agreement”), providing for a business combination involving the Company and Playa (the “Business Combination”). The corporate form of Holdco will be converted to a Dutch public limited liability company prior to consummation of the Business Combination. Upon the terms and subject to the conditions of the Transaction Agreement, the Company and Playa have agreed to effect a transaction that would replicate the economics of a merger of the Company and Playa. The Transaction Agreement and the transactions contemplated thereby (the “Transactions”) were unanimously approved by the Board of Directors of the Company on December 12, 2016. On December 19, 2016, Holdco filed with the Securities and Exchange Commission (the “SEC”) a registration statement on Form S-4 (the “Form S-4”) in connection with the Proposed Business Combination. The Form S-4 and subsequent amendments thereof constitutes a prospectus of Holdco and includes a proxy statement of the Company. On February 10, 2017, the Form S-4 was declared effective by the SEC. On February 13, 2017, the Company filed with the United States Securities and Exchange Commission (the “SEC”) a Definitive Proxy Statement on Schedule 14A relating to the Transactions. In connection with the execution of the Transaction Agreement, the Company entered into subscription agreements with certain investors, including affiliates and certain members of the Company’s management, pursuant to which such investors agreed to subscribe for and purchase, and the Company agreed to issue and sell to such investors, newly issued Class A Shares for gross proceeds of approximately $50,000,000 at the time of the Business Combination. All activity for the period from June 3, 2015 (“Inception”) through December 31, 2016 relates to the Company’s formation and initial public offering of units consisting of the Company’s Class A ordinary shares and warrants to purchase Class A ordinary shares (the “Public Offering”) and the identification, evaluation and undertaking of a Business Combination. The Company will not generate any operating revenues until after completion of a Business Combination at the earliest. The Company has selected December 31st as its fiscal year end. Going Concern If the Company does not complete an initial Business Combination within 24 months of September 16, 2015 (the “Close Date”), the Company will (i) cease all operations except for the purposes of winding up, (ii) as promptly as reasonably possible, but not more than ten business days thereafter, redeem all of the Class A ordinary shares issued as part of the units in the Public Offering (“Public Shares”) at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account with Continental Stock Transfer and Trust Company acting as trustee (the “Trust Account”), including interest, net of taxes (less up to $50,000 of such net interest to pay dissolution expenses), divided by the number of then outstanding Public Shares, which redemption will completely extinguish the shareholder rights of owners of Class A ordinary shares (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. In the event of such distribution, it is possible that the per share value of the residual assets remaining available for distribution, including Trust Account assets, will be less than the initial public offering price per unit in the Public Offering. In addition, if the Company fails to complete its Business Combination within 24 months of the Close Date, there will be no redemption rights or liquidating distributions with respect to warrants to purchase the Company’s Class A ordinary shares, which will expire worthless. This mandatory liquidation and subsequent dissolution requirement raises substantial doubt about the Company’s ability to continue as a going concern. In addition, at December 31, 2016, the Company had cash on hand of $144,046 and current liabilities of $4,069,883 largely due to amounts owed to professionals, consultants, advisors and others who are working on completing a Business Combination. Such work is continuing after December 31, 2016 and amounts are continuing to accrue. The Company's ability to continue as a going concern is dependent upon its ability to consummate a Business Combination or obtain additional funds. On March 1, 2017, the Company’s shareholders voted to, among other things, adopt the Transaction Agreement and approve the Transactions. The Transactions are subject to certain conditions and are not expected to close before March 10, 2017 unless the parties agree otherwise. There can be no assurance that the Transactions will close. Management's options for obtaining additional working capital include potentially requesting loans from the Sponsor or affiliates of the Sponsor, or certain of the Company’s executive officers or directors. Additional funds could also be raised through a private offering of debt or equity. There can be no assurance that the Company will be able to raise such funds. The uncertainty regarding the lack of resources to pay the above noted liabilities raises substantial doubt about the Company’s ability to continue as a going concern. The accompanying consolidated financial statements have been prepared on a going concern basis and do not include any adjustments that might arise as a result of uncertainties about the Company’s ability to continue as a going concern. Financing The registration statement for the Company’s Public Offering was declared effective by the United States Securities and Exchange Commission (the “SEC”) on September 10, 2015. The Public Offering closed on September 16, 2015 (the “Close Date”). The Company’s Sponsor purchased $11,000,000 of warrants in a private placement at the Close Date. The Company intends to finance a Business Combination with proceeds from its $450,000,000 Public Offering and $11,000,000 private placement (see Note 3). At the Close Date, $450,000,000 of the proceeds from the Public Offering and private placement were deposited in the Trust Account. At December 31, 2016, all Trust Account funds were invested in a money market account invested in permitted United States “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), having a maturity of 180 days or less, or in money market funds meeting certain conditions under Rule 2a-7 under the Investment Company Act (“Money Market Investments”). At the Close Date, the Company held proceeds from the Public Offering and private placement outside the Trust Account of $11,000,000, of which $9,000,000 was used to pay underwriting discounts and $300,000 was used to repay notes payable from the Sponsor. The balance was reserved to pay accrued offering and formation costs, business, legal and accounting due diligence on prospective acquisitions and continuing general and administrative expenses. The Trust Account On January 4, 2016, funds held in the Trust Account were invested in Money Market Investments. Trust Account funds will not be removed except for the withdrawal of a portion of interest income to be utilized to pay taxes, if any, until the earliest of (i) the completion of a Business Combination, (ii) the redemption of any Public Shares properly tendered in connection with a shareholder vote to amend the amended and restated memorandum and articles of association to modify the substance and timing of the Company’s obligation to redeem 100% of the Public Shares if the Company does not complete a Business Combination within 24 months after the Close Date, or (iii) the redemption of all of the Company’s Public Shares if it is unable to complete a Business Combination within 24 months after the Close Date, subject to applicable law. Business Combination The Company has broad discretion with respect to the specific application of the net proceeds of the Public Offering, although substantially all of the net proceeds of the Public Offering are intended to be generally applied toward consummating a Business Combination with, or acquisition of, one or more target businesses that together have a fair market equal to at least 80% of the balance of the Trust Account, net of any deferred underwriting discounts and taxes payable on earned interest, at the date a definitive agreement to proceed with a Business Combination is signed. There is no assurance that the Company will be able to successfully effect a Business Combination. The Company, after signing a definitive agreement for a Business Combination, will either (i) seek shareholder approval of the Business Combination at a meeting called for such purpose in connection with which shareholders may seek to redeem their shares, regardless of whether they vote for or against the Business Combination, for cash equal to their pro rata share of the aggregate amount then on deposit in the Trust Account as of two business days prior to the consummation of the Business Combination, including interest but less taxes payable, or (ii) provide shareholders with the opportunity to sell their shares to the Company by means of a tender offer (and thereby avoid the need for a shareholder vote) for an amount in cash equal to their pro rata share of the aggregate amount then on deposit in the Trust Account as of two business days prior to consummation of the Business Combination, including interest but less taxes payable. The decision as to whether the Company will seek shareholder approval of a Business Combination or will allow shareholders to sell their shares in a tender offer will be made by the Company, solely in its discretion, and will be based on a variety of factors such as the timing of the transaction and whether the terms of the transaction would otherwise require the Company to seek shareholder approval, unless a vote is required by NASDAQ rules or otherwise required by law. If the Company seeks shareholder approval, it will complete a Business Combination only if a majority of the outstanding ordinary shares voted are voted in favor of the Business Combination. However, in no event will the Company redeem its Public Shares in an amount that would cause its net tangible assets, or total shareholder’s equity, to be less than $5,000,001. In such case, the Company would not proceed with the redemption of its Public Shares and related Business Combination, and would resume its search for an alternate Target Business with which to undertake a Business Combination. If the Company holds a shareholder vote or there is a tender offer for shares in connection with a Business Combination, a public shareholder will have the right to redeem its shares for an amount in cash equal to its pro rata share of the aggregate amount then on deposit in the Trust Account as of two business days prior to the consummation of the Business Combination, including interest but less taxes payable. As a result, such ordinary shares are recorded at their redemption amount and classified as temporary equity in accordance with Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity” (“ASC 480”). The Company has 24 months from the Close Date to complete a Business Combination. If the Company does not complete a Business Combination within this time period, it shall (i) cease all operations except for the purposes of winding up, (ii) as promptly as reasonably possible, but not more than ten business days thereafter, redeem the Public Shares, at a per share price, payable in cash, equal to the aggregate amount then on deposit in the Trust Account, including interest, net of tax (less up to $50,000 of such net interest to pay dissolution expenses), divided by the number of then outstanding Public Shares, which redemption will completely extinguish the shareholder rights of owners of Class A ordinary shares (including the right to receive further liquidation distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and the board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. The Sponsor and the Company’s four independent directors (collectively, the “Initial Shareholders”) have entered into a letter agreement with the Company, pursuant to which they have waived their rights to liquidating distributions from the Trust Account with respect to the Founder Shares if the Company fails to complete a Business Combination within 24 months after the Close Date. However, if the Initial Shareholders acquire Public Shares after the Public Offering, they will be entitled to liquidating distributions from the Trust Account with respect to such Public Shares if the Company fails to complete the Business Combination within 24 months after the Close Date. If the Company fails to complete a Business Combination within 24 months after the Close Date, the resulting redemption of the Company’s Class A ordinary shares will reduce the book value per share for the Class F ordinary shares held by the Initial Shareholders, who would be the only remaining shareholders after such a redemption. If the Company completes a Business Combination within 24 months after the Close Date, funds in the Trust Account will be used to pay for the Business Combination, redemptions of Class A ordinary shares, if any, the deferred underwriting compensation of $15,750,000 and accrued expenses related to the Business Combination. Any funds remaining will be made available to the Company to provide working capital to finance the Company’s business operations. 2. Summary of Significant Accounting Policies Basis of Presentation The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and pursuant to the accounting and disclosure rules and regulations of the SEC, and reflect all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the Company’s financial position at December 31, 2016 and 2015, and the results of operations and cash flows for the periods presented. Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and the accounts of the Company’s wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated upon consolidation. Reclassification Certain amounts in the financial statements at December 31, 2015 have been reclassified to conform to the presentation of financial information at December 31, 2016. These reclassifications have no effect on results as previously reported. Emerging Growth Company Section 102(b)(1) of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, as amended) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected not to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies adopt the new or revised standard. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash accounts in a financial institution which, at times, may exceed the Federal depository insurance coverage of $250,000. The Company has not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts. Financial Instruments The fair values of the Company’s assets and liabilities which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximate the carrying amounts represented in the balance sheets due to their short-term nature. Fair Value Measurement ASC 820 establishes a fair value hierarchy that prioritizes and ranks the level of observability of inputs used to measure investments at fair value. The observability of inputs is impacted by a number of factors, including the type of investment, characteristics specific to the investment, market conditions and other factors. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level I measurements) and the lowest priority to unobservable inputs (Level III measurements). Investments with readily available quoted prices or for which fair value can be measured from quoted prices in active markets will typically have a higher degree of input observability and a lesser degree of judgment applied in determining fair value. The three levels of the fair value hierarchy under ASC 820 are as follows: Level I - Quoted prices (unadjusted) in active markets for identical investments at the measurement date are used. Level II - Pricing inputs are other than quoted prices included within Level I that are observable for the investment, either directly or indirectly. Level II pricing inputs include quoted prices for similar investments in active markets, quoted prices for identical or similar investments in markets that are not active, inputs other than quoted prices that are observable for the investment, and inputs that are derived principally from or corroborated by observable market data by correlation or other means. Level III - Pricing inputs are unobservable and include situations where there is little, if any, market activity for the investment. The inputs used in determination of fair value require significant judgment and estimation. In some cases, the inputs used to measure fair value might fall within different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the investment is categorized in its entirety is determined based on the lowest level input that is significant to the investment. Assessing the significance of a particular input to the valuation of an investment in its entirety requires judgment and considers factors specific to the investment. The categorization of an investment within the hierarchy is based upon the pricing transparency of the investment and does not necessarily correspond to the perceived risk of that investment. Redeemable Ordinary Shares All 45,000,000 Class A ordinary shares sold as part of the units in the Public Offering contain a redemption feature as discussed in Note 1. In accordance with ASC 480, redemption provisions not solely within the control of the Company require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments, are excluded from the provisions of ASC 480. Although the Company did not specify a maximum redemption threshold, its charter provides that in no event will it redeem its Class A ordinary shares in an amount that would cause its net tangible assets, or total shareholders’ equity, to fall below $5,000,001. Accordingly, at December 31, 2016 and 2015, 42,634,936 and 42,990,227, respectively, of the Company’s 45,000,000 Class A ordinary shares were classified outside of permanent equity. Net Loss per Ordinary Share Net loss per ordinary share is computed by dividing net loss attributable to ordinary shares by the weighted average number of ordinary shares outstanding during the period, plus, to the extent dilutive, the incremental number of ordinary shares to settle warrants, as calculated using the treasury stock method. At December 31, 2016, the Company had outstanding warrants for the purchase of up to 22,333,333 Class A ordinary shares. For all periods presented, the weighted average of these shares was excluded from the calculation of diluted net loss per ordinary share because its inclusion would have been anti-dilutive. As a result, diluted net loss per ordinary share is equal to basic net loss per ordinary share. Use of Estimates The preparation of the Company’s consolidated financial statements in conformity with U.S. GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Offering Costs The Company complies with the requirements of ASC 340-10-S99-1 and SEC Staff Accounting Bulletin Topic 5A, “Expenses of Offering.” The Company incurred offering costs in connection with its Public Offering of $1,114,002, primarily consisting of accounting and legal services, securities registration expenses and exchange listing fees. These costs, along with paid and deferred underwriter discounts totaling $24,750,000, were charged to additional paid-in capital at the Close Date. Income Taxes The Company follows the asset and liability method of accounting for income taxes under ASC 740, “Income Taxes” (“ASC 740”). Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period of the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. ASC 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. No amounts were accrued for the payment of interest and penalties at December 31, 2016. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. There is currently no taxation imposed on income by the Government of the Cayman Islands. In accordance with Cayman federal income tax regulations, income taxes are not levied on the Company. Consequently, income taxes for the Company are not reflected in the Company’s consolidated financial statements. Certain costs relating to the incorporation a subsidiary of the Company are deductible for income tax purposes in the Netherlands, and resulted in the generation of a deferred tax asset of $11,922 that was offset by a valuation allowance. An effective tax rate of 25% was utilized to compute the deferred tax asset. Recent Accounting Pronouncements Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s consolidated financial statements. 3. Public Offering In its Public Offering, the Company sold 45,000,000 units at a price of $10.00 per unit (the “Units”). Each Unit consists of one of the Company’s Class A ordinary shares, $0.0001 par value, and one redeemable Class A ordinary share purchase warrant (“Warrant”). The Company has agreed to use its best efforts to file a registration statement, and cause such registration statement to become effective under the Securities Act, covering the Class A ordinary shares underlying the Warrants following the completion of a Business Combination. Each Warrant entitles the holder to purchase one third of one Class A ordinary share for one third of $11.50 per one third share. Warrants may be exercised only for a whole number of ordinary shares; no fractional shares will be issued upon exercise of the Warrants. If, upon exercise of the Warrants, a holder would be entitled to receive a fractional interest in a share, the Company will round down to the nearest whole number the number of Class A ordinary shares to be issued to the Warrant holder. Each Warrant will become exercisable on the later of 30 days after the completion of a Business Combination or 12 months from the Close Date, and will expire after the earlier of five years after the completion of a Business Combination, or upon redemption or liquidation. Alternatively, if the Company does not complete a Business Combination within 24 months after the Close Date, the Warrants will expire at the end of such period. If the Company is unable to deliver registered Class A ordinary shares to a holder upon exercise of Warrants issued in connection with the 45,000,000 Units during the exercise period, the Warrants will expire worthless, except to the extent that they may be exercised on a cashless basis in the circumstances described in the Warrant agreement. Once the Warrants become exercisable, the Company may redeem the outstanding Warrants in whole, but not in part, at a price of $0.01 per Warrant upon a minimum of 30 days’ prior written notice of redemption, and only in the event that the last sale price of the Company’s Class A ordinary shares equals or exceeds $18.00 per share for any 20 trading days within the 30-trading day period ending on the third trading day before the Company sends the notice of redemption to the Warrant holders. The Company paid an underwriting discount of 2.00% of the gross proceeds of the Public Offering, or $9,000,000, to the underwriters at the Close Date, with an additional fee (the “Deferred Discount”) of 3.50% of the gross proceeds of the Public Offering, or $15,750,000, payable upon the Company’s completion of a Business Combination. The Deferred Discount will become payable to the underwriters from the amounts held in the Trust Account solely in the event the Company completes a Business Combination. The underwriters are not entitled to receive any of the interest earned on Trust Account funds that would be used to pay the Deferred Discount. The Deferred Discount is recorded as deferred underwriter compensation at the Company’s balance sheet. 4. Related Party Transactions Founder Shares On June 30, 2015, the Sponsor purchased 10,062,500 Class F ordinary shares for $25,000, or approximately $0.002 per share. On September 4, 2015, the Sponsor transferred 35,000 Class F ordinary shares to each of the Company’s four independent directors at their original purchase price. Immediately prior to the pricing of the Public Offering, on September 10, 2015, the Company’s board of directors effected a capitalization of 1,437,500 Class F ordinary shares to the Initial Shareholders, resulting in an aggregate issuance of 11,500,000 Class F ordinary shares (the “Founder Shares”) of which 1,500,000 shares were subject to forfeiture by the Sponsor if the underwriters’ over-allotment option was not exercised in full by a specified date. On October 25, 2015, our Sponsor forfeited 250,000 Founder Shares on the expiration of the unexercised portion of the underwriters’ over-allotment option. Following the capitalization and forfeiture, the Sponsor held 11,090,000 Founder Shares and each of the Company’s four independent directors held 40,000 Founder Shares. The Founder Shares are identical to the Class A ordinary shares included in the Units sold in the Public Offering except that the Founder Shares are subject to certain rights and transfer restrictions, as described in further detail below, and are automatically converted into Class A ordinary shares at the time of a Business Combination on a one-for-one basis, subject to adjustment pursuant to the anti-dilution provisions contained in the Company’s amended and restated memorandum and articles of association. The Initial Shareholders have agreed not to transfer, assign or sell any Founder Shares until the earlier of (i) one year after the completion of a Business Combination, or earlier if, subsequent to a Business Combination, the last sale price of the Company’s ordinary shares equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after a Business Combination or (ii) the date at which the Company completes a liquidation, merger, stock exchange or other similar transaction after a Business Combination that results in all of the Company’s public shareholders having the right to exchange their ordinary shares for cash, securities or other property (the “Lock Up Period”). Private Placement Warrants Prior to the Close Date, the Sponsor purchased 22,000,000 warrants at a price of $0.50 per warrant, or $11,000,000, in a private placement (the “Private Placement Warrants”). Each Private Placement Warrant entitles the holder to purchase one third of one Class A ordinary share for one third of $11.50 per one third share. Private Placement Warrants may not be redeemed by the Company so long as they are held by the Sponsor or its permitted transferees. If any Private Placement Warrants are transferred to holders other than the Sponsor or its permitted transferees, such Private Placement Warrants will be redeemable by the Company and exercisable by the holders on the same basis as the Warrants included in the Units sold in the Public Offering. The Sponsor or its permitted transferees have the option to exercise the Private Placement Warrants on a cashless basis. If the Company does not complete a Business Combination within 24 months after the Close Date, the proceeds of the sale of the Private Placement Warrants will be used to fund the redemption of the Company’s Class A ordinary shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless. Registration Rights Holders of the Founder Shares and Private Placement Warrants hold registration rights pursuant to a registration rights agreement. The holders of these securities are entitled to make up to three demands that the Company register the Private Placement Warrants and the Class A ordinary shares underlying the Private Placement Warrants and the Class F ordinary shares. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed by the Company subsequent to its completion of a Business Combination and rights to require the Company to register for resale such securities pursuant to Rule 415 under the Securities Act. However, the registration rights agreement provides that that Company will not permit any registration statement filed under the Securities Act to become effective until termination of the applicable Lock Up Period. The Company will bear the expenses incurred in connection with the filing of any such registration statements. Related Party Notes On November 9, 2016, the Company issued an unsecured promissory note to the Sponsor that provides for the Sponsor to advance the Company up to $1,250,000 (the “Note”). The Note is non-interest bearing with all unpaid principal due and payable on the first to occur of (i) September 15, 2017, or (ii) the date on which the Company consummates a business combination. Funds in the Trust Account will not be used to repay any amounts outstanding under the Note if the Company does not complete a Business Combination. On November 18, 2016, the Company borrowed $250,000 under the Note. The outstanding balance on the Note at December 31, 2016 was $250,000. Between Inception and the Close Date, the Sponsor loaned the Company $300,000 in unsecured promissory notes. The funds were used to pay up front expenses associated with the Public Offering. These notes were non-interest bearing and were repaid in full to the Sponsor at the Close Date. Administrative Services Agreement On September 10, 2015, the Company entered into an agreement to pay monthly recurring expenses of $10,000 for office space, administrative and support services to an affiliate of the Sponsor effective at the Close Date. The agreement terminates upon the earlier of the completion of a Business Combination or the liquidation of the Company. For the year ended December 31, 2016 and the period from Inception to December 31, 2015, the Company incurred expenses of $120,000 and $35,000, respectively, under this agreement. Subscription Agreements On December 13, 2016, the Company and Holdco entered into subscription agreements (the “PHC Subscription Agreements”) with members of the Company’s management and affiliates (collectively, the “PHC Investors”), pursuant to which the PHC Investors agreed to purchase 1,015,000 Class A ordinary shares for a purchase price of $10.00 per share, or an aggregate of $10,150,000 million, at the time of the Transactions (defined below). The PHC Investors may assign their rights under the PHC Subscription Agreements to one or more parties, subject to compliance with the securities laws. The PHC Subscription Agreements are conditioned on the closing of the Transactions and other customary closing conditions. 5. Cash Held in Trust Account Gross proceeds of $450,000,000 and $11,000,000 from the Public Offering and the sale of the Private Placement Warrants, respectively, less underwriting discounts of $9,000,000; and funds of $2,000,000 designated to pay the Company’s accrued formation and offering costs, ongoing administrative and acquisition search costs, plus repay notes payable of $300,000 to the Sponsor at the Close Date were placed in the Trust Account at the Close Date. On January 4, 2016, funds held in the Trust Account were invested in Money Market Investments, which are considered Level I investments under ASC 820. For the year ended December 30, 2016, the investments held in the Trust Account generated interest income of $898,287, all of which was reinvested in Money Market Investments. At December 31, 2016, the balance of funds held in the Trust Account was $450,898,287. 6. Deferred Underwriting Compensation The Company is committed to pay the Deferred Discount of 3.50% of the gross proceeds of the Public Offering, or $15,750,000, to the underwriters upon the Company’s completion of a Business Combination. The underwriters are not entitled to receive any of the interest earned on Trust Account funds that would be used to pay the Deferred Discount, and no Deferred Discount is payable to the underwriters if a Business Combination is not completed within 24 months after the Close Date. 7. Shareholders’ Equity Class A Ordinary Shares The Company is authorized to issue 200,000,000 Class A ordinary shares. Depending on the terms of a potential Business Combination, the Company may be required to increase the number of authorized Class A ordinary shares at the same time as its shareholders vote on the Business Combination to the extent the Company seeks shareholder approval in connection with its Business Combination. Holders of Class A ordinary shares are entitled to one vote for each share with the exception that prior to the completion of a Business Combination only holders of Class F ordinary shares have the right to vote on the election of directors. At December 31, 2016 and 2015, there were 45,000,000 Class A ordinary shares issued and outstanding, of which 42,634,936 and 42,990,227 shares, respectively, were subject to possible redemption. Class F Ordinary Shares The Company is authorized to issue 20,000,000 Class F ordinary shares. Holders of the Company’s Class F ordinary shares are entitled to one vote for each ordinary share, plus prior to the completion of a Business Combination only holders of Class F ordinary shares have the right to vote on the election of directors. Class F ordinary shares are automatically converted to Class A ordinary shares on a one-for-one basis, subject to adjustment, at the time of a Business Combination. The Initial Shareholders, the sole holders of Class F ordinary shares, have agreed not to transfer, assign or sell any Class F ordinary shares during the Lock Up Period. On October 25, 2015, the Sponsor forfeited 250,000 Class F ordinary shares on the expiration of the remaining portion of the underwriters’ over-allotment option so that the Founder Shares would represent 20% of the total ordinary shares outstanding. At both of December 31, 2016 and 2015, there were 11,250,000 Class F ordinary shares issued and outstanding. Preferred Shares The Company is authorized to issue 1,000,000 preferred shares. The Company’s board of directors has the authority to determine the voting rights, if any, designations, powers, preferences, the relative, participating, optional or other special rights and any qualifications, limitations and restrictions thereof, applicable to the preferred shares of each series. The board of directors may, without shareholder approval, issue preferred shares with voting and other rights that could adversely affect the voting power and other rights of the holders of Class A ordinary shares, and which could have anti-takeover effects. At both of December 31, 2016 and 2015, there were no shares of preferred stock issued or outstanding. 8. Quarterly Financial Information (Unaudited) Following are the Company’s unaudited quarterly statements of operations for the period from Inception to June 30, 2015 and the quarters ended September 30, 2015 through December 31, 2016. The Company has prepared the quarterly data on a consistent basis with the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, the financial information reflects all necessary adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of operations for these periods. This information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of the Company’s operating results for any future period. The financial information presented below has been prepared assuming the Company will continue as a going concern. See Note 1 for additional discussion regarding the going concern uncertainty. 9. Subsequent Events On January 5, 2017, the Company, received a letter from the staff of the Listing Qualifications Department of The Nasdaq Stock Market (“NASDAQ”) notifying the Company that the Company no longer complies with NASDAQ Listing Rule 5620(a) for continued listing due to its failure to hold an annual meeting of stockholders within twelve months of the end of the Company’s fiscal year ended December 31, 2015. The Company had 45 calendar days from January 5, 2017 to submit a plan to regain compliance. On February 21, 2017, the Company submitted its plan to NASDAQ. If NASDAQ accepts the Company’s plan, NASDAQ may grant an exception of up to 180 calendar days from the fiscal year end, or until June 29, 2017, to regain compliance. Effective February 8, 2017, the Sponsor re-registered as a limited liability company under the name TPG Pace Sponsor, LLC. On February 17, 2017, the Company as sole shareholder of Holdco made a capital contribution of 50,000 Euros to Holdco prior to the conversion of Holdco into an Dutch public limited liability company (naamloze vennootschap) (“N.V.”). The Company made the capital contribution in order to comply with Dutch law which mandates regulatory minimum capital requirements for a Dutch N.V On March 1, 2017, the Company held a shareholders’ meeting at which its shareholders voted to, among other things, adopt the Transaction Agreement and approve the Transactions. The Transactions are subject to certain conditions and are not expected to close before March 10, 2017 unless the parties agree otherwise. There can be no assurance that the Transactions will close. If the Transactions are not consummated, the Company will continue to review opportunities to enter into Business Combination with another target business. In such event, there can be no assurance that the Company will complete a Business Combination with any other target business. Other than the foregoing, management has performed an evaluation of subsequent events through March 3, 2017, the date the consolidated financial statements were issued, noting no items which require adjustment or disclosure.
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Based on the provided financial statement excerpt, here's a summary:
The company is currently experiencing financial challenges:
- No operating revenues are reported until after a potential Business Combination
- The company has significant current liabilities that exceed its available cash
- There are substantial doubts about the company's ability to continue operating (going concern issue)
- Management is aware of these financial limitations and has plans to address them (referenced in Note 1)
The statement suggests the company is in a pre-revenue stage and facing financial constraints, with uncertain future prospects pending a potential business combination.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Loss Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit) Consolidated Statements of Cash Flows ACCOUNTING FIRM The Board of Directors and Stockholders Nimble Storage, Inc. We have audited the accompanying consolidated balance sheets of Nimble Storage, Inc. as of January 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive loss, redeemable convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended January 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nimble Storage, Inc. at January 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended January 31, 2016, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Nimble Storage, Inc.‘s internal control over financial reporting as of January 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 31, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California March 31, 2016 ACCOUNTING FIRM The Board of Directors and Stockholders Nimble Storage, Inc. We have audited Nimble Storage, Inc.‘s internal control over financial reporting as of January 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). Nimble Storage, Inc.‘s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Nimble Storage, Inc. maintained, in all material respects, effective internal control over financial reporting as of January 31, 2016, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Nimble Storage, Inc. as of January 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive loss, redeemable convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended January 31, 2016 of Nimble Storage, Inc. and our report dated March 31, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California March 31, 2016 Nimble Storage, Inc. Consolidated Balance Sheets (in thousands, except per share data) See . Nimble Storage, Inc. Consolidated Statements of Operations (in thousands, except per share data) See . Nimble Storage, Inc. Consolidated Statements of Comprehensive Loss (In thousands) See . Nimble Storage, Inc. Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit) (in thousands) See . Nimble Storage, Inc. Consolidated Statements of Cash Flows (In thousands) See . Nimble Storage, Inc. 1. Description of Business and Basis of Presentation Description of Business Nimble Storage, Inc., or the Company was incorporated in the state of Delaware in November 2007. The Company’s enduring mission is to engineer and deliver the industry’s most efficient flash storage platform. The Company’s Predictive Flash platform is comprised of a Unified Flash Fabric that provides a single consolidation architecture with common data services across a portfolio of All Flash and Adaptive Flash arrays and InfoSight predictive analytics with integrated support and service offerings. The Company is headquartered in San Jose, California, with employees in several international locations, including the United Kingdom, Australia, Canada, Germany, and Singapore. Basis of Presentation and Consolidation The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP, and include the consolidated accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. 2. Summary of Significant Accounting Policies Use of Estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates include, but are not limited to, the determination of the best estimated selling prices of deliverables included in multiple-deliverable revenue arrangements; the allowance for doubtful accounts; provision for excess or obsolete inventory; the useful lives of property and equipment; and the determination of the best estimated achievement of financial performance metrics related to the Company’s performance based stock awards. Actual results could differ from these estimates. Concentrations The Company’s financial instruments that are exposed to concentrations of credit risk are primarily cash and cash equivalents and trade accounts receivable. Cash and cash equivalents are maintained primarily at one financial institution, and deposits may exceed the amount of insurance provided on such deposits. Risks associated with cash and cash equivalents are mitigated by banking with a creditworthy institution. The Company has not experienced any losses on its deposits of cash and cash equivalents. The Company performs ongoing credit evaluations of its end-customers’ financial condition whenever deemed necessary and generally does not require collateral. The Company’s policy is to maintain an allowance for doubtful accounts based upon the expected collectability of its accounts receivable, which takes into consideration specific end-customer creditworthiness and current economic trends. During the third and fourth quarters of the year ended January 31, 2014, the Company consolidated the majority of its North American sales to three distributors, and as a result, accounts receivable and revenue increased in concentration. The majority of previous value added resellers, or VARs, are now purchasing from the Company’s distributors. Of all the Company’s customers, which include direct end-customers, VARs and distributors, the following distributors individually accounted for more than 10% of the Company’s accounts receivable and revenue at the end of and for each period presented: * Represents less than 10%. There are no concentrations of business transacted with a particular market that would severely impact the Company’s business in the near term. However, the Company currently relies on one key contract manufacturer and supplier to produce most of its products; any disruption or termination of these arrangements could materially adversely affect the Company’s operating results. Foreign Currency Translation and Transactions The functional currency of each of the Company’s foreign subsidiaries is its respective local currency. The Company translates all monetary assets and liabilities denominated in foreign currencies into U.S. dollars using the exchange rates in effect at the balance sheet dates and other assets and liabilities using historical exchange rates. Revenue and expenses are translated at average exchange rates in effect during the year. Translation adjustments are recorded within accumulated other comprehensive income (loss), a separate component of stockholders’ equity. Foreign currency denominated transactions are initially recorded and re-measured at the end of each period using the applicable exchange rate in effect. Foreign currency re-measurement losses are recognized in other expense, net, in the consolidated statements of operations. Foreign currency re-measurement net losses recognized were $0.7 million, $2.1 million, and $0.1 million for the years ended January 31, 2016, 2015, and 2014, respectively. For the year ended January 31, 2016 and 2015, the $0.7 million and $2.1 million net losses from foreign currency remeasurement included $0.2 million and $0.7 million gains related to foreign currency forward contracts, respectively. Fair Value The carrying value of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, approximates fair value. Cash and Cash Equivalents The Company considers all highly liquid investments with an original maturity of 90 days or less at the date of purchase to be cash equivalents. Cash and cash equivalents consist principally of cash accounts and investments in money market accounts. Restricted Cash Beginning January 2016, the Company was required to maintain a monthly balance of $0.8 million for its employee medical and dental self-funded reimbursement plan. This restricted cash balance has been excluded from the Company’s cash and cash equivalents balance and is classified as restricted cash, current on the Company’s consolidated balance sheets. As of January 31, 2016, the amount of restricted cash, current was $0.8 million. As a condition of the Company’s headquarters facility lease agreement, the Company was required to maintain a letter of credit of $3.9 million, with the landlord named as the beneficiary. In January 2016, the Company cancelled the letter of credit and instead substituted the letter of credit through a line of credit obtained from Wells Fargo. As a consequence, the restricted cash was released. Accounts Receivable Accounts receivable are recorded at the invoiced amounts and do not bear interest. The Company maintains an allowance for doubtful accounts for estimated losses inherent in its accounts receivable portfolio. An allowance for doubtful accounts is calculated based on the aging of the Company’s trade receivables, historical experience, and management judgment. The Company writes off trade receivables against the allowance when management determines a balance is uncollectible and no longer actively pursues collection of the receivable. As of January 31, 2016 and 2015, the allowance for doubtful accounts was $25,000 and $0, respectively. Inventories Inventories consist primarily of raw materials related to component parts, finished goods, which include both inventory held for sale and service inventory held at service depots in support of end-customer service agreements, and end-customer evaluation inventory. Service inventory held at service depots was $5.6 million and $4.1 million as of January 31, 2016 and 2015, respectively. The following is a summary of the Company’s inventories, net of inventory provisions recorded to adjust inventory to its estimated realizable value, by major category (in thousands): Inventory values are stated at the lower of cost (on a first-in, first-out method), or market value. A provision is recorded to adjust inventory to its estimated realizable value when inventory is determined to be in excess of anticipated demand or obsolete. In determining the provision, the Company also considers estimated recovery rates based on the nature of the inventory. Inventory write-downs are charged to the provision for inventory, which is a component of the Company’s cost of revenue. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. In addition, inventory reserves, which consist of mainly reserves for service inventory, were $4.5 million and $2.3 million as of January 31, 2016 and 2015, respectively. Property and Equipment Property and equipment are stated at cost, net of accumulated depreciation. Demonstration units are not sold and are transferred from inventory at cost. Depreciation is computed using the straight-line method over the following estimated useful lives: Property and Equipment Useful Life Computer equipment, lab equipment, software and Storage on Demand equipment 3 years Furniture and fixtures 5 years Leasehold improvements Shorter of estimated useful life or remaining lease term Demonstration equipment 2 years Repairs and maintenance are expensed as incurred. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which is generally three years. Impairment of Long-Lived Assets The Company evaluates events and changes in circumstances that could indicate carrying amounts of long-lived assets, including property and equipment, may not be recoverable. When such events or changes in circumstances occur, the Company assesses the recoverability of long-lived assets by determining whether or not the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the future undiscounted cash flows is less than the carrying amount of an asset, the Company records an impairment charge for the amount by which the carrying amount of the assets exceeds the fair value of the asset. Warranties The Company provides a standard one-year warranty for hardware components covering material defects in materials and workmanship. In addition, the Company provides a 90-day warranty on the embedded software in its products for non-conformance with documented specifications. The Company accrues for estimated warranty costs based upon historical experience, and periodically assesses the adequacy of its recorded warranty liability at the end of each period. These costs are expensed as incurred and included in cost of product revenue in the Company’s consolidated statements of operations. In addition, failed parts recovered from end-customers are submitted to the Company’s suppliers for repair or replacement. These cost recoveries are offset against the Company’s warranty costs. The Company records warranty liability in other current liabilities in its consolidated balance sheet. As of January 31, 2016, the Company’s warranty liability was not material. Revenue Recognition The Company generates revenue from sales of software-enabled storage products and related support. The Company’s software that is integrated on the storage products is more than incidental, and functions together with the storage product to deliver its essential functionality. The Company also offers an optional support plan (typically one to five years). The support plan includes automated support (Proactive Wellness), bug fixes, updates and upgrades to product firmware and the Company’s management platform, including InfoSight, telephone support and expedited delivery times for replacement hardware parts. While support is not contractually mandatory, substantially all products shipped have been purchased together with a support plan. The Company also periodically sells optional installation services with its products that are not essential to the functionality of the storage product. Substantially all of the Company’s end-customer arrangements contain multiple deliverables. As a result, the Company accounts for the revenue for these sales in accordance with Accounting Standards Codification (ASC) 605-25 Revenue Recognition-Multiple Element Arrangements. Arrangements are divided into separate units of accounting based on whether the delivered items have stand-alone value. In its typical end-customer arrangements, the Company considers the following to be separate units of accounting: the storage product (together with the integrated software), support services and installation services. The Company has determined that each unit of accounting has stand-alone value because they are sold separately by the Company or could be resold by an end-customer on a stand-alone basis. The Company allocates the total consideration to all deliverables based on its determination of the units of accounting and their relative selling prices. As the Company has not yet established vendor-specific objective evidence, or VSOE, or identified third-party evidence of fair value for its storage product (together with the integrated software) and installation services, it uses the best estimate of the selling price, or BESP, of each deliverable to allocate the total arrangement fee among the separate units of accounting. The Company’s process to determine its BESP for its products and installation services is based on qualitative and quantitative considerations of multiple factors, which primarily include historical stand-alone sales, margin objectives, and discount behavior. Additional considerations are given to factors such as end-customer demographics, competitive alternatives, anticipated sales volume, costs to manufacture products or provide services, pricing practices, and market conditions. The Company has established VSOE of fair value for support services based on stand-alone renewals offered to its end-customers, and allocates the fair value of consideration related to support services based on VSOE of fair value for its support services. Revenue is recognized when all of the following criteria are met: • Persuasive Evidence of an Arrangement Exists. The Company relies upon non-cancelable sales agreements and purchase orders to determine the existence of an arrangement. • Delivery Has Occurred. The Company uses shipping documents to verify delivery. • The Fee Is Fixed or Determinable. The Company assesses whether the fee is fixed or determinable based on the payment terms associated with the transaction. • Collectability Is Reasonably Assured. The Company assesses collectability based on credit analysis and payment history. It is the Company’s practice to identify an end-customer from its distributors prior to shipment. In the majority of instances, products are shipped directly to the end-customers. For certain end-customer orders, products are shipped to resellers, distributors and third-party systems integrators for various reasons including importing of products to non-U.S. countries and systems integration (e.g. SmartStack integrations) prior to shipment to the end-customer or the end-customer specified location. Assuming all other revenue recognition criteria have been met, the Company generally recognizes revenue upon shipment from its origin location in California, as title and risk of loss are transferred at that time. For certain distributors, title and risk of loss is transferred upon delivery to the end-customer and revenue is recognized after delivery has been completed. The Company’s arrangements with distributors do not contain rights of return, subsequent price discounts, price protection or other allowances for shipments completed. The majority of the Company’s deferred revenue consists of the unrecognized portion of revenue from sales of its support and service contracts. The Company records amounts to be recognized during the twelve months following the balance sheet date in deferred revenue, current portion in the consolidated balance sheets, and the remainder in deferred revenue, non-current portion in the consolidated balance sheets. As of January 31, 2016, the weighted average remaining contract period related to non-current deferred revenue was approximately 2.2 years. In November 2014, the Company announced its Storage on Demand, or SoD, service offering, for enterprises and service providers managing storage in cloud environments. Under this pay-as-you-go subscription model, end-customers are generally billed on a monthly basis based on the amount of data consumed during the month. The SoD service offering includes all support services such as InfoSight. Revenue is recognized as services are performed. SoD revenue is recognized in support and service revenue in the consolidated statements of operations. Shipping Costs Shipping charges billed to end-customers are included in product revenue and the related shipping and handling costs are included in cost of revenue. Research and Development Research and development expense consists of personnel costs, including stock-based compensation expense, for the Company’s research and development personnel and product development costs, including engineering services, development software and hardware tools, depreciation of capital equipment and facility costs. Research and development costs are expensed as incurred. Advertising Costs Advertising costs are expensed as incurred and are included in sales and marketing expense. Advertising costs for the years ended January 31, 2016, 2015 and 2014 were $6.6 million, $3.0 million and $1.2 million, respectively. Stock-Based Compensation The Company determines the fair value of its stock options and shares of common stock to be issued related to its 2013 Employee Stock Purchase Plan, or the ESPP, on the date of grant utilizing the Black-Scholes-Merton option-pricing model, and is impacted by the fair value of its common stock, as well as changes in assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected common stock price volatility over the term of the option awards, the expected term of the awards, risk-free interest rates and expected dividend yield. The Company generally recognizes compensation expense for stock option grants and ESPP on a straight-line basis over the requisite service period, which is generally four years for stock options, and six months to two years for ESPP. Stock-based compensation expense recognized at fair value includes the impact of estimated forfeitures. Stock-based compensation cost for restricted stock units, or RSUs, is measured based on the fair value of the underlying shares on the date of grant. The RSUs generally vest over the requisite service period. The fair value of RSUs is determined by the estimated fair value of the Company’s common stock at the time of grant. Stock-based compensation expense is recognized at fair value and includes the impact of estimated forfeitures. Income Taxes The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the years in which the temporary differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Derivative Financial Instruments During the year ended January 31, 2015, the Company entered into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations on cash and certain trade and inter-company receivables and payables. These contracts reduce the exposure to fluctuations in foreign currency exchange rate movements as the gains and losses associated with foreign currency balances are offset with the gains and losses on the forward contracts. The Company does not enter into foreign currency forward contracts for trading or speculative purposes. These instruments are marked to market through earnings every period and generally are one month in original maturity. The net gains or losses from the settlement of these foreign currency forward contracts are recorded in other expense, net in the consolidated statements of operations. Net Loss Per Share Attributable to Common Stockholders Prior to the Company’s initial public offering on December 13, 2013, the Company calculated its basic and diluted net loss per share attributable to common stockholders in conformity with the two-class method required for companies with participating securities. The Company considers all series of its redeemable convertible preferred stock to be participating securities. In the event a dividend is declared or paid on the Company’s common stock, holders of redeemable convertible preferred stock are entitled to a proportionate share of such dividend in proportion to the holders of common stock on an as-if converted basis. Under the two-class method, basic net loss per share attributable to common stockholders is calculated by dividing the net loss attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period, less shares subject to repurchase. Net loss attributable to common stockholders is determined by allocating undistributed earnings between common and redeemable convertible preferred stockholders. The diluted net loss per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. For purposes of this calculation, redeemable convertible preferred stock, options to purchase common stock, repurchasable shares from early exercised options, unvested RSUs and shares subject to ESPP withholding are considered common stock equivalents but have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible redeemable preferred stock as the convertible redeemable preferred stock do not have a contractual obligation to share in the Company’s losses. On December 13, 2013, all shares of redeemable convertible preferred stocks were converted to common stock. The following table sets forth the computation of net loss per share (in thousands, except per share amounts): The following potentially dilutive securities were excluded (as common stock equivalents) from the computation of diluted net loss per share for the periods presented as their effect would have been antidilutive (in thousands): Recent Accounting Pronouncements In February 2016, the Financial Accounting Standards Board, or FASB, released an Accounting Standard Update, or ASU, that requires the recognition of lease assets and lease liabilities by lessees for operating leases. The standard will be effective for the Company for its first quarter of fiscal 2020, and early adoption is permitted. The Company is currently evaluating adoption methods and whether this standard will have a material impact on its consolidated financial statements and related disclosures. In November 2015, the FASB released an ASU, Balance Sheet Classification of Deferred Taxes, which is intended to simplify and improve how deferred taxes are classified on the balance sheet. The guidance in this ASU eliminates the current requirement to present deferred tax assets and liabilities as current and noncurrent in a classified balance sheet and now requires entities to classify all deferred tax assets and liabilities as noncurrent. The standard is effective for the Company for its first quarter of fiscal 2018, though early adoption is permitted. The standard is a change in balance sheet presentation only. The Company early adopted this ASU in fiscal 2016. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements. In July 2015, the FASB issued amendments to simplify the measurement of inventory. Under the amendments, inventory will be measured at the “lower of cost and net realizable value” and options that currently exist for “market value” will be eliminated. The guidance defines net realizable value as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation”. No other changes were made to the current guidance on inventory measurement. The amendments are effective for the Company for its first quarter of fiscal 2018, although early adoption is permitted. The Company is currently evaluating the effect of the updated standard on its consolidated financial statements and related disclosures. In April 2015, the FASB released an ASU on fees paid in a cloud computing arrangement. The standard requires customers in a cloud computing arrangement to evaluate whether the arrangement includes a software license. If the arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. The standard will be effective for the Company for its first quarter of fiscal 2017, and will be applied on either a prospective or retrospective basis. The Company is currently evaluating adoption methods, but does not anticipate this standard will have a material impact on its consolidated financial statements and related disclosures. In May 2014, the FASB released an ASU, Revenue from Contracts with Customers, requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The guidance supersedes the revenue recognition requirements in Accounting Standards Codification Topic 605, Revenue Recognition and permits the use of either the retrospective or cumulative effect transition method. The Company is required to adopt this standard starting February 1, 2018. Early adoption to the original public company adoption timelines is permitted. The Company has not yet selected a transition method and is currently in the process of determining the impact on its consolidated financial statements and related disclosures. 3. Fair Value Measurements Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, to measure the fair value: • Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities. • Level 2-Inputs are quoted prices for similar assets and liabilities in active markets or inputs other than quoted prices that are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments. • Level 3-Inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation. Beginning November 2014, the Company entered into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations on cash and certain trade and inter-company receivables and payables. These are not designated hedge instruments. These instruments are marked to market through earnings every period and generally have an original maturity period of one month. These instruments are classified within level 2 of the fair value hierarchy. The Company’s derivative assets and derivative liabilities as of January 31, 2016 and 2015 are as follows (in thousands): 4. Balance Sheet Components Property and Equipment Property and equipment, net consisted of the following (in thousands): Depreciation expense related to property and equipment for the years ended January 31, 2016, 2015 and 2014 was $15.6 million, $8.8 million and $4.2 million, respectively. 5. Employee Loans During the years ended January 31, 2011 and 2012, the Company issued full recourse loans to two employees to facilitate the exercise of their stock options. The first of these loans was issued in December 2011 with a principal amount of $1.0 million and an interest rate of at 1.3% per annum. The loan was contractually due and payable in full in December 2020 or upon such earlier date that the Company files a registration statement related to an initial public offering. The second of these loans was issued in June 2012 with a principal amount of $0.4 million and an interest of 2.3% per annum. The loan was contractually due and payable in full in June 2020 or upon such earlier date that the Company files a registration statement related to an initial public offering. The principal loan amount and the accrued interest were $1.6 million as of January 31, 2013, and were reported as a deduction from stockholders’ equity (deficit) on the Company’s consolidated statements of redeemable convertible preferred stock and stockholders’ equity (deficit). Both of these loans and related interest were repaid in full in August 2013. 6. Commitments and Contingencies Leases The Company leases its facilities under various noncancelable operating leases with fixed rental payments. Rent expense totaled $6.2 million, $5.3 million and $3.1 million for the years ended January 31, 2016, 2015 and 2014, respectively. Future minimum commitments under these operating leases as of January 31, 2016 were as follows (in thousands): In July 2014, the Company entered into a facility lease agreement for its North Carolina office. The 84-month lease commenced on August 1, 2014. Total rent, including common area maintenance expense and fixed operating expense, payable over the lease period is $5.0 million. As part of the lease agreement, the Company received $1.4 million in tenant improvements allowance during the year ended January 31, 2016. This allowance was included in the calculation of rent expense and related deferred rent balances. In December 2014, the Company amended the lease agreement for its North Carolina office giving the Company access to an additional space on February 1, 2016 through the same term as the original facility lease. As part of the lease amendment, the Company will receive an allowance of $1.0 million for tenant improvements. In April 2013, the Company entered into a facility lease agreement for its headquarters in San Jose, California. The 96-month lease commenced on November 1, 2013. Total rent, including operating expenses, payable over the lease period is $35.5 million. As part of the lease agreement, the Company received $4.9 million in tenant improvement allowance during the year ended January 31, 2014. This allowance was included in the calculation of rent expense and related deferred rent balances. As a condition of the lease agreement, the Company is required to maintain a letter of credit of $3.9 million, with the landlord named as the beneficiary. The Company has the option to extend the term of the lease for an additional period of 60 months. Contingencies From time to time, the Company is party to litigation and subject to claims that arise in the ordinary course of business, including actions with respect to employment claims and other matters. Although the results of litigation and claims are inherently unpredictable, the Company believes that the final outcome of such matters will not have a material adverse effect on the business, consolidated financial position, results of operations or cash flows. On December 17, 2015, a purported securities class action entitled Vikramkumar v. Nimble Storage, Inc., et al. was filed in the United States District Court for the Northern District of California, against the Company and certain of its officers and directors. A second purported securities class action entitled Guardino v. Nimble Storage, Inc., et al. was filed on December 23, 2015, and a third purported class action entitled Madhani v. Nimble Storage, Inc., et al. was filed on February 5, 2016, also in the Northern District of California against the same parties. The complaints in the three actions allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, based on allegedly misleading statements regarding the Company’s business and financial results. On March 28, 2016, the Court ordered that the three actions be consolidated under the caption In re Nimble Storage, Inc. Securities Litigation. The Company has not yet responded to any complaint. Given the early stage in the litigation, we are unable to estimate a possible loss or range of possible loss. On February 23, 2016, a purported shareholder derivative action entitled Schwartz v. Vasudevan, et al. was filed in the United States District Court for the Northern District of California, against certain of the Company’s officers and directors. The complaint alleges that defendants breached their fiduciary duties by allowing the Company to make allegedly misleading statements regarding the Company’s business and financial results, and by selling stock while in possession of material non-public information. Given the early stage in the litigation, we are unable to estimate a possible loss or range of possible loss. Indemnification Some of the Company’s sales contracts require the Company to indemnify its end-customers against third-party claims asserting infringement of certain intellectual property rights, which may include patents, copyrights, trademarks, or trade secrets, and to pay judgments entered on such claims. The Company’s exposure under these indemnification provisions is generally limited to the total amount paid by the end-customer under the contract. However, certain contracts include indemnification provisions that could potentially expose the Company to losses in excess of the amount received under the contract. In addition, the Company indemnifies its officers, directors, and certain key employees while they are serving in good faith in their respective capacities. To date, there have been no claims under any indemnification provisions. Purchase Commitments The Company purchases components from a variety of suppliers and one contract manufacturer to provide manufacturing services for products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company enters into agreements with its contract manufacturer and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or that establish the parameters defining the requirements. These agreements generally do not include any legally binding minimum commitment obligations. As of January 31, 2016, the Company had $36.4 million in several operating commitments to fulfill inventory requirements arising from growing forecasts and several non-cancelable software license and service agreements for the internal use of software and services for vendor and customer relationship management, human resource, inventory forecasting application and communication and desktop applications. 7. Common Stock In December 2013, the Company completed its initial public offering of 9.2 million shares of its common stock at a public offering price of $21.00 per share. Net cash proceeds from the initial public offering were approximately $175.4 million. In connection with the closing of the initial public offering, all of the shares of preferred stock outstanding automatically converted into an aggregate of 38.9 million shares of common stock. On December 18, 2013, the Company filed its Restated Certificate of Incorporation in connection with the closing of its initial public offering. Following the amendment, the Company had authorized capital stock of 755.0 million shares, comprising: (i) 750.0 million shares of common stock, par value $0.001 per share and (ii) 5.0 million shares of preferred stock, par value $0.001 per share. As of January 31, 2016, there were 750.0 million shares of common stock authorized with a par value of $0.001 per share. The Company had reserved the following shares of authorized but unissued common stock (in thousands): 8. Equity Incentive Plans Plan Descriptions 2008 Equity Incentive Plan In May 2008, the Company adopted the 2008 Equity Incentive Plan, or the 2008 Plan, for the benefit of its eligible employees, consultants, and independent directors. The 2008 Plan provides for the grant of stock awards, including incentive stock options, nonqualified stock options, restricted stock, stock appreciation rights and RSUs. The Company grants stock options with an exercise price equal to the fair market value of its common stock on the date of the grant, as determined by the board of directors. The Company’s equity awards vest over a period of time as determined by the board of directors and expire no later than 10 years from the date of grant. Grants to new employees generally vest over a four-year period, at a rate of 25% one year from the date the optionee’s service period begins and 1/48 monthly thereafter. Subject to adjustment for certain changes in the Company’s capital structure, the maximum aggregate number of shares of common stock that may be issued under the 2008 Plan is 55.6 million. In December 2013, in connection with the closing of the Company’s initial public offering, the 2008 Plan was terminated and shares authorized for issuance under the 2008 Plan were cancelled (except for those shares reserved for issuance upon exercise of outstanding stock options). As of January 31, 2016, options to purchase and RSUs to convert to a total of 8.8 million shares of common stock were outstanding under the 2008 Plan pursuant to their original terms and no shares were available for future grant. 2013 Equity Incentive Plan In September 2013, the Company adopted the 2013 Equity Incentive Plan, or the 2013 Plan, which became effective on December 12, 2013 and serves as the successor to the Company’s 2008 Plan. Upon completion of the Company’s initial public offering, the Company ceased granting awards under the 2008 Plan and any remaining shares available for issuance under the 2008 Plan were added to the shares reserved under the 2013 Plan. The 2013 Plan will terminate in September 2023, unless sooner terminated by the board of directors. The 2013 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, stock bonus awards, stock appreciation rights, RSUs and performance awards, all of which may be granted to eligible employees, consultants or directors. Under the terms of the 2013 Plan, awards may be granted at prices not less than 100% of the fair value of the Company’s common stock, as determined by the Company’s board of directors, on the date of grant for stock options. Options vest over a period of time as determined by the board of directors, generally a four-year period, and expire ten years from date of grant. Initially, the aggregate number of shares of the Company’s common stock that may be issued pursuant to stock awards under the 2013 Plan after the 2013 Plan became effective was 10.2 million shares, plus any reserved shares not issued or subject to outstanding grants under the 2008 Plan on the date the 2013 Plan became effective, shares that are subject to stock options or RSUs granted under the 2008 Plan that cease to be subject to such stock options or other awards by forfeiture or otherwise or are issued and later forfeited or repurchased by the Company after the date the 2013 Plan became effective, and shares that are subject to stock options or other awards under the 2008 Plan that are used to pay the exercise price of an option or withheld to satisfy the tax withholding obligations related to any award. The number of shares available for grant and issuance under the 2013 Plan will automatically increase on February 1st of each of the calendar years 2014 through 2022, by the lesser of (i) 5% of the number of shares issued and outstanding on each January 31st immediately prior to the date of increase or (ii) such number of shares determined by the Company’s board of directors. The maximum number of shares that may be issued pursuant to the exercise of incentive stock options under the 2013 Plan is 300.0 million shares. As of January 31, 2016, stock options to purchase and RSUs to convert to a total of 9.7 million shares of common stock were outstanding under the 2013 Plan and 6.8 million shares were reserved for future issuance. 2013 Employee Stock Purchase Plan In September 2013, the Company adopted the ESPP which became effective on December 12, 2013. The ESPP initially authorizes the issuance of 2.0 million shares of the Company’s common stock pursuant to purchase rights granted to eligible employees. The number of shares of common stock reserved for issuance will automatically increase on February 1st of each calendar year, by an amount equal to (i) 1% of the total number of outstanding shares of common stock and common stock equivalents on the immediately preceding January 31st, or (ii) such lesser number of shares of common stock as determined by the Company’s board of directors. The maximum number of shares that may be issued pursuant to the ESPP is 30.0 million shares. The ESPP is intended to qualify as an “employee stock purchase plan” within the meaning of Section 423 of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code. The ESPP was implemented through a series of offerings of purchase rights to eligible employees. Except for the initial offering period, each offering period is for 24 months beginning March 10th and September 10th of each year, with each such offering period consisting of four six-month purchase periods. The initial offering period began December 12, 2013 and ended on March 9, 2016, with purchase dates on September 9, 2014, March 9, 2015, September 9, 2015 and March 9, 2016. Eligible employees may participate through payroll deductions of 1% to 15% of their earnings. Common stock will be issued to participating employees at a price per share equal to 85% of the lesser of (i) the fair market value on the offering date, or (ii) the fair market value on the purchase date. As of January 31, 2016, the Company had 2.6 million shares reserved for future issuance. Early Exercises of Stock Options Stock options granted under the 2008 Plan provide employee option holders, if approved by the board of directors, the right to exercise unvested options in exchange for restricted common stock, which is subject to a repurchase right held by the Company at the lower of (i) the fair market value of its common stock on the date of repurchase or (ii) the original purchase price. Early exercises of options are not deemed to be substantive exercises for accounting purposes and accordingly, amounts received for early exercises are recorded as a liability. As of January 31, 2016 and 2015, there were 0.2 million and 0.7 million shares, respectively, subject to repurchase related to stock options early exercised and unvested. These amounts are reclassified to common stock and additional paid-in capital as the underlying shares vest. As of January 31, 2016 and 2015, the Company recorded a liability related to these shares subject to repurchase in the amount of $0.7 million and $2.1 million, respectively, within other long-term liabilities in its consolidated balance sheets. Fair Value of Common Stock Prior to the Company’s initial public offering, the Company’s board of directors considered numerous objective and subjective factors to determine the fair value of common stock at each grant date. These factors included, but were not limited to, (i) contemporaneous valuations of common stock performed by unrelated third-party firms; (ii) the prices for the preferred stock sold to outside investors; (iii) the rights, preferences and privileges of the preferred stock relative to the common stock; (iv) the lack of marketability of the Company’s common stock; (v) developments in the business; and (vi) the likelihood of achieving a liquidity event, such as an initial public offering or a merger or acquisition of the Company, given prevailing market conditions. The Company has used the publicly quoted price as the fair value of its common stock since its common stock became publicly traded in December 2013. Stock Options and RSUs The following is a summary of the Company’s stock option and RSU activity during the year ended January 31, 2016 (in thousands, except per-share amounts): The following table summarizes information about the Company’s stock options outstanding as of January 31, 2016 (in thousands, except per-share amounts): The options exercisable as of January 31, 2016 included options that are exercisable prior to vesting. The intrinsic value of options vested and expected to vest and become exercisable as of January 31, 2016 was calculated based on the difference between the exercise price and the fair value of the Company’s common stock as of January 31, 2016. The intrinsic value of exercised options for the years ended January 31, 2016, 2015 and 2014 was $63.1 million, $89.1 million and $10.0 million, respectively, and was calculated based on the difference between the exercise price and the fair value of the Company’s common stock as of the exercise date. The fair value of stock options that vested in the years ended January 31, 2016, 2015 and 2014 was $8.4 million, $11.4 million and $3.9 million, respectively. Stock-Based Compensation The following table summarizes the components of stock-based compensation expense related to stock options, RSUs and ESPP (in thousands): The Company did not issue any stock options in the year ended January 31, 2016. The weighted-average fair value of options granted was $14.52 and $3.94 per share for the years ended January 31, 2015 and 2014, respectively. The Company started to issue RSUs in the year ended January 31, 2014. The weighted-average fair value of RSUs granted was $19.61, $31.30 and $18.92 per share for the years ended January 31, 2016, 2015 and 2014, respectively. The weighted average fair value of stock purchase rights granted was $7.04, $7.20 and $6.91 per share for the year ended January 31, 2016, 2015 and 2014, respectively. The Company issues RSUs to certain employees based on the Company meeting certain performance thresholds. The estimated probability of the number of these RSUs expected to vest is assessed for each reporting period until the total shares granted are determined. For the year ended January 31, 2016 and 2015, the Company recognized expense of $5.0 million and $7.2 million stock-based compensation related to these RSUs, respectively. The reduction of expense related to these RSUs in the year ended January 31, 2016 is due to a reduction in estimated achievement of performance thresholds for fiscal year 2016. As of January 31, 2016, there was $9.2 million of unrecognized stock-based compensation expense for stock options that will be recognized over the remaining weighted-average period of 1.6 years. As of January 31, 2016, there was $183.4 million of unrecognized stock-based compensation expense for RSUs that will be recognized over the remaining weighted-average period of 2.8 years. As of January 31, 2016, there was $1.8 million of unrecognized stock-based compensation expense for stock purchase rights that will be recognized over the remaining offering period, through September 2017. The Company accounted for the stock purchase rights under ESPP at the grant date (first day of the offering period) by valuing the four purchase periods separately. The option was valued using the Black-Scholes-Merton option-pricing model with the following assumptions: Expected Term. The expected term for the ESPP is based on the length of the offering period. Expected Volatility. Since the Company does not have sufficient trading history for its common stock, the expected volatility used is based on volatility of similar entities. In evaluating similarity, the Company considered factors such as industry, stage of life cycle, size, and financial leverage. Risk-Free Interest Rate. The risk-free rate that the Company used is based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term of the ESPP. Dividend Yield. The Company has never declared or paid any cash dividends and does not plan to pay cash dividends in the foreseeable future and, therefore, uses an expected dividend yield of zero in the valuation model. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and records stock-based compensation expense only for those awards that are expected to vest. 9. 401(k) Plan The Company has a qualified defined contribution plan under Section 401(k) of the Internal Revenue Code covering eligible employees. Participants may make pre-tax contributions to the plan from their eligible earnings up to the statutorily prescribed annual limit on pre-tax contributions under the Internal Revenue Code. Although the plan provides for a discretionary employer matching contribution, to date the Company has not made such a contribution on behalf of employees. 10. Income Taxes The provision for income taxes is based upon the loss before provision for income taxes as follows (in thousands): The Company’s provision for income taxes of $1.0 million for the year ended January 31, 2016 consisted of current foreign taxes, current state taxes and deferred foreign taxes. The Company’s provision for income taxes of $0.8 million for the year ended January 31, 2015 consisted of current foreign taxes, current state taxes and deferred foreign taxes. The Company’s provision for income taxes of $0.4 million for the year ended January 31, 2014 consisted of current foreign taxes, current federal taxes, current state taxes and deferred foreign taxes. The Company’s effective tax rate differs from the U.S. federal statutory tax rate due to the following (in thousands): The significant components of net deferred tax assets were as follows (in thousands): The net valuation allowance increased by $38.1 million during the year ended January 31, 2016. Management has recorded a full valuation allowance against its net domestic deferred tax assets as it is not more likely than not that the assets will be realized based on the Company’s history of losses. The passage of Protecting Americans from Tax Hike Act of 2015, on December 18, 2015, retroactively and permanently reinstated the U.S. federal R&D tax credit effective January 1, 2015. As of January 31, 2016, the Company had net operating loss, or NOL, carryforwards and research and development credits as follows (in thousands): The Company uses the ‘with-and-without’ approach to determine the recognition and measurement of excess tax benefits. Accordingly, the Company has elected to recognize excess income tax benefits from stock option exercises in additional paid in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to the Company. As of January 31, 2016, the amount of such excess tax benefits from stock options included in NOLs was $97.3 million and $22.9 million for federal and California purposes. In addition, the Company has elected to account for the indirect effects of stock-based awards on other tax attributes, such as the research and alternative minimum tax credits, through its statements of operations. Under Section 382 of the Internal Revenue Code, the Company’s ability to utilize NOL carryforwards or other tax attributes, such as research tax credits, in any taxable year may be limited if the Company experiences an “ownership change.” A Section 382 “ownership change” generally occurs if one or more stockholders or groups of stockholders who own at least 5% of the Company’s stock increase their ownership by more than 50 percentage points over their lowest ownership percentage within a rolling three-year period. Similar rules may apply under state tax laws. It is possible that an ownership change, or any future ownership change, could have a material effect on the use of the Company’s NOL carryforwards or other tax attributes. Due to the existence of the valuation allowance, future changes in unrecognized tax benefits will not impact the Company’s effective tax rate. The Company does not intend on remitting undistributed earnings of foreign subsidiaries and, accordingly, no deferred tax liability has been established relative to these earnings. As of January 31, 2016, the Company’s undistributed earnings of foreign subsidiaries were $4.6 million. The Company recognizes interest and penalties related to uncertain tax positions, if any, as a component of its income tax provision. The Company recognized de minimis interest and penalties related to uncertain tax positions for the years ended January 31, 2016, 2015 and 2014. A reconciliation of the beginning and ending balances of gross unrecognized tax benefits, before interest and penalties is as follows (in thousands): The gross unrecognized tax benefits, if recognized, would affect the effective tax rate by approximately $410,000 and $39,000 as of January 31, 2016 and 2015, respectively. While it is often difficult to predict the final outcome of any particular uncertain tax position, the Company does not believe it is reasonably possible that the total amount of unrecognized tax benefits as of January 31, 2016 will materially change in the next 12 months. The Company files federal, state, and foreign income tax returns in many jurisdictions in the United States and abroad. For U.S. federal and state income tax purposes, the statute of limitations currently remains open for all years due to the Company’s NOL carryforwards. The Company is not currently under examination in any jurisdiction. 11. Segments The Company’s chief operating decision maker is its chief executive officer. The chief executive officer reviews consolidated financial information accompanied by information about revenue by product line for purposes of allocating resources and evaluating financial performance. The Company has one business activity and there are no segment managers who are held accountable for operations, or operating results for levels or components. In addition, the majority of the Company’s operations and end-customers are located in the United States. As such, the Company has a single reporting segment and a single operating unit structure. Revenue by region, based on the bill to mailing address of the end-customer, for the periods presented was as follows (in thousands): Long-lived assets located in the following countries and regions as of each period end were as follows (in thousands): 12. Line of Credit In October 2013, the Company entered into an agreement with Wells Fargo Bank, National Association, or Wells Fargo, to provide a secured revolving credit facility, or the Credit Facility, that allows the Company to borrow up to $15.0 million for general corporate purposes. There was a $0.9 million reduction of the available line related to a letter of credit issued in July 2014 for the Company’s facility lease in North Carolina. In April 2015, the Company increased its letter of credit from $0.9 million to $1.1 million, with the landlord named as the beneficiary. In January 2016, there was a $3.9 million reduction of the available line related to a letter of credit issued for the Company’s headquarters facility lease in California, with the landlord named as the beneficiary. As a consequence, the Company released its restricted cash of $3.9 million. As of January 31, 2016, the remaining Credit Facility available for borrowings was $10.0 million. Amounts outstanding under the Credit Facility will bear interest at Wells Fargo’s prime rate with accrued interest payable on a monthly basis. In addition, the Company is obligated to pay a commitment fee of 0.20% per annum on the unused portion of the Credit Facility, with such fee payable on a quarterly basis. As of January 31, 2016, the commitment fee was capitalized and being amortized on the Company’s consolidated balance sheet. The Credit Facility was renewed in September 2014 for an incremental two-year period and now expires in October 2016. Under the Credit Facility renewal, the Company granted to Wells Fargo a first priority lien in its accounts receivable and other corporate assets, agreed to not pledge its intellectual property to other parties and became subject to certain reporting and financial covenants, as follows: (i) maintain minimum tangible net worth, defined as the aggregate of total stockholders’ equity plus subordinated debt less any intangible assets and less any loans or advances to, or investments in, any related entities or individuals, of $135 million; and (ii) maintain a monthly ratio of not less than 1.25 to 1.00, based on the aggregate of its cash and net accounts receivable divided by total current liabilities minus current deferred revenue. As of January 31, 2016, no amounts had been drawn against the Credit Facility and the Company was in compliance with all covenants associated with the Credit Facility. 13. Selected Quarterly Financial Data (unaudited) The following tables set forth selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in fiscal 2016 and 2015 (in thousands, except per share data):
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt. It seems to be a partial audit report or financial statement from Nimble Storage, Inc., but the key financial details are missing or cut off.
From the available text, I can only discern a few limited details:
- The document relates to Nimble Storage, Inc.
- It includes some information about foreign currency translation and accounting methods
- There's a mention of a foreign currency re-measurement net loss of $0.7 (presumably million)
To provide a meaningful summary, I would need the complete financial statement with full revenue, expense, asset, and liability figures. Could you provide the full document or clarify which specific parts you'd like me to analyze?
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NF ENERGY SAVING CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations And Comprehensive Income Consolidated Statements of Cash Flows Consolidated Statements of Changes in Stockholders’ Equity - ACCOUNTING FIRM The Board of Directors and Stockholders NF Energy Saving Corporation We have audited the accompanying consolidated balance sheets of NF Energy Saving Corporation and its subsidiary (“the Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations and comprehensive income, cash flows and changes in stockholders’ equity for the years ended December 31, 2016 and 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and cash flows for the years ended December 31, 2016 and 2015 in conformity with accounting principles generally accepted in the United States of America. /s/ HKCMCPA Company Limited HKCMCPA Company Limited Certified Public Accountants Hong Kong, China March 31, 2017 NF ENERGY SAVING CORPORATION CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) See accompanying notes to consolidated financial statements. NF ENERGY SAVING CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) See accompanying notes to consolidated financial statements. NF ENERGY SAVING CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”)) See accompanying notes to consolidated financial statements. NF ENERGY SAVING CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) See accompanying notes to consolidated financial statements. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) 1.ORGANIZATION AND BUSINESS BACKGROUND NF Energy Saving Corporation (the “Company” or “NFEC”) was incorporated in the State of Delaware in the name of Galli Process, Inc. on October 31, 2000. On February 7, 2002, the Company changed its name to “Global Broadcast Group, Inc.” On November 12, 2004, the Company changed its name to “Diagnostic Corporation of America.” On March 15, 2007, the Company changed its name to “NF Energy Saving Corporation of America.” On August 24, 2009, the Company further changed its current name to “NF Energy Saving Corporation.” On October 1, 2010, the Company’s common stock was traded on Nasdaq global market. On March 7, 2012, and upon approval by NASDAQ, the common stock transferred from the Nasdaq Global Market to the Nasdaq Capital Market. The Company, through its subsidiary, mainly operates in the energy technology business in the People’s of Republic of China (the “PRC”). The Company specializes in the provision of energy saving technology consulting, optimization design services, energy saving reconstruction of pipeline networks and contractual energy management services to China’s electric power, petrochemical, coal, metallurgy, construction, and municipal infrastructure development industries. The Company also engages in the manufacturing and sales of the energy-saving flow control equipment. All the customers are located in PRC. Description of subsidiary NFEC and its subsidiary are hereinafter referred to as (the “Company”). 2.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ·Basis of presentation These accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). ·Use of estimates In preparing these consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenues and expenses during the years reported. Actual results may differ from these estimates. ·Basis of consolidation The consolidated financial statements include the financial statements of NFEC and its subsidiary. All significant inter-company balances and transactions within the Company have been eliminated upon consolidation. ·Cash and cash equivalents NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) Cash and cash equivalents are carried at cost and represent cash on hand, demand deposits placed with banks or other financial institutions and all highly liquid investments with an original maturity of three months or less as of the purchase date of such investments. ·Restricted cash The Company maintains restricted cash accounts held with financial institutions in the PRC, which are pledged as collateral for short-term bank demand notes payable that will be expired or matured in the next twelve months. ·Accounts receivable and allowance for doubtful accounts Accounts receivable are recorded at the invoiced amount and do not bear interest, which are due within contractual payment terms, generally 30 to 90 days from shipment. Credit is extended based on evaluation of a customer's financial condition, the customer credit-worthiness and their payment history. Accounts receivable outstanding longer than the contractual payment terms are considered past due. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. At the end of each period, the Company specifically evaluates individual customer’s financial condition, credit history, and the current economic conditions to monitor the progress of the collection of accounts receivables. The Company will consider the allowance for doubtful accounts for any estimated losses resulting from the inability of its customers to make required payments. For the receivables that are past due or not being paid according to payment terms, the appropriate actions are taken to exhaust all means of collection, including seeking legal resolution in a court of law. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance-sheet credit exposure related to its customers. As of December 31, 2016 and 2015, the allowance for doubtful accounts was $712,288 and $762,001, respectively. ·Retention receivable Retention receivable is the amount withheld by a customer based upon 5-10% of the contract value, until a product warranty is expired. The warranty period is usually 12 months. ·Inventories Inventories are stated at the lower of cost or market value (net realizable value), cost being determined on a weighted average method. Costs include material, labor and manufacturing overhead costs. The Company reviews historical sales activity quarterly to determine excess, slow moving items and potentially obsolete items and also evaluates the impact of any anticipated changes in future demand. The Company provides inventory allowances based on excess and obsolete inventories determined principally by customer demand. As of December 31, 2016 and 2015, the Company did not record an allowance for obsolete inventories, nor have there been any write-offs. ·Property, plant and equipment Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, if any. Depreciation is calculated on the straight-line basis over the following expected useful lives from the date on which they become fully operational and after taking into account their estimated residual values: Expenditures for repairs and maintenance are expensed as incurred. When assets have been retired or sold, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in the results of operations. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) ·Land use right All lands in the PRC are owned by the PRC government. The government in the PRC, according to the relevant PRC law, may sell the right to use the land for a specified period of time. Thus, the Company’s land purchases in the PRC is considered to be leasehold land and is stated at cost less accumulated amortization and any recognized impairment loss. Amortization is provided over the term of the land use right agreement on a straight-line basis, which is 50 years and will expire in 2059. ·Construction in progress Construction in progress is stated at cost, which includes acquisition of land use rights, cost of construction, purchases of plant and equipment and other direct costs attributable to the construction of a new manufacturing facility in Yinzhou District Industrial Park, Tieling City, Liaoning Province, the PRC. Construction in progress is not depreciated until such time as the assets are completed and put into operational use. No capitalized interest is incurred during the period of construction. ·Impairment of long-lived assets In accordance with the provisions of ASC Topic 360, “Impairment or Disposal of Long-Lived Assets”, all long-lived assets such as property, plant and equipment held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of an asset to its estimated future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. There has been no impairment charge for the years presented. ·Revenue recognition The Company offers the following products and service to its customers: (a)Energy saving flow control equipment; and (b)Energy project management and sub-contracting service. In accordance with the ASC Topic 605, “Revenue Recognition”, the Company recognizes revenue when persuasive evidence of an arrangement exists, transfer of title has occurred or services have been rendered, the selling price is fixed or determinable and collectability is reasonably assured. (a)Sale of products The Company derives a majority of its revenues from the sale of energy saving flow control equipment. Generally, these products are manufactured and configured to customer requirements. The Company typically produces and builds the energy saving flow control equipment for customers in a period from 1 to 6 months. When the Company completes the production in accordance with the customer’s specification, the customer is required to inspect the finished products for quality and product conditions, to its full satisfaction, then the Company makes delivery to the customer. The Company recognizes revenue from the sale of such finished products upon delivery to the customer, whereas the title and risk of loss are fully transferred to the customers. The Company records its revenues, net of value added taxes (“VAT”). The Company is subject to VAT which is levied on the majority of the products at the rate of 17% on the invoiced value of sales. The Company experienced no product returns and recorded no reserve for sales returns for the years ended December 31, 2016 and 2015. (b)Service revenue Service revenue is primarily derived from energy-saving technical services or project management or sub-contracting services that are not an element of an arrangement for the sale of products. These services are generally billed on a time-cost plus basis, for a period of service time from 2 to 3 months. Revenue is recognized, net of business taxes when the service is rendered and accepted by the customer. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) (c)Interest income Interest income is recognized on a time apportionment basis, taking into account the principal amounts outstanding and the interest rates applicable. ·Cost of revenue Cost of revenue consists primarily of material costs, direct labor, depreciation and manufacturing overhead, which are directly attributable to the manufacture of products and the rendering of services or projects. Shipping and handling costs, associated with the distribution of finished products to customers, are borne by the customers. ·Research and development Research and development costs are expensed when incurred in the development of new products or processes including significant improvements and refinements of existing products. Such costs mainly relate to labor and material cost. The Company incurred $96,572 and $105,168 of such costs for the years ended December 31, 2016 and 2015. ·Comprehensive income ASC Topic 220, “Comprehensive Income”, establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income as defined includes all changes in equity during a period from non-owner sources. Accumulated other comprehensive income, as presented in the accompanying condensed consolidated statement of stockholders’ equity, consists of changes in unrealized gains and losses on foreign currency translation. This comprehensive income is not included in the computation of income tax expense or benefit. ·Income taxes Income taxes are determined in accordance with the provisions of ASC Topic 740, “Income Taxes” (“ASC 740”). Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Any effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. ASC 740 prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under ASC 740, tax positions must initially be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions must initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and relevant facts. For the years ended December 31, 2016 and 2015, the Company did not have any interest and penalties associated with tax positions. As of December 31, 2016, the Company did not have any significant unrecognized uncertain tax positions. The Company conducts the majority of its businesses in the PRC and is subject to tax in this jurisdiction. As a result of its business activities, the Company files tax returns that are subject to examination by a foreign tax authority. For the year ended December 31, 2016, the Company filed and cleared 2015 tax return with its local tax authority. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) ·Product warranty Under the terms of the contracts, the Company offers its customers with a free product warranty on a case-by-case basis, depending upon the type of customers, nature and size of the infrastructure projects. Under such arrangements, a portion of the project contract balance (usually 5-10% of contract value) is withheld by a customer from 12 to 24 months, until the product warranty has expired. The Company has not experienced any material returns or claims where it was under obligation to honor this standard warranty provision. As such, no reserve for product warranty has been provided in the result of operations for the years ended December 31, 2016 and 2015. ·Net loss per share The Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” Basic income per share is computed by dividing the net income by the weighted-average number of common shares outstanding during the period. Diluted income per share is computed similar to basic income per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common stock equivalents had been issued and if the additional common shares were dilutive. ·Foreign currencies translation Transactions denominated in currencies other than the functional currency are translated into the functional currency at the exchange rates prevailing at the dates of the transaction. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency using the applicable exchange rates at the balance sheet dates. The resulting exchange differences are recorded in the statement of operations. The reporting currency of the Company is the United States Dollar ("US$"). The Company's subsidiary in the PRC maintain their books and records in their local currency, the Renminbi Yuan ("RMB"), which is the functional currency as being the primary currency of the economic environment in which these entities operate. In general, for consolidation purposes, assets and liabilities of its subsidiary whose functional currency is not the US$ are translated into US$, in accordance with ASC Topic 830-30, “Translation of Financial Statement”, using the exchange rate on the balance sheet date. Revenues and expenses are translated at average rates prevailing during the period. The gains and losses resulting from translation of financial statements of foreign subsidiaries are recorded as a separate component of accumulated other comprehensive income within the statement of stockholders’ equity. Translation of amounts from RMB into US$ has been made at the following exchange rates for the respective year: ·Stock based compensation The Company accounts for employee and non-employee stock awards under ASC Topic 718, whereby equity instruments issued to employees for services are recorded based on the fair value of the instrument issued and those issued to non-employees are recorded based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliably measurable. ·Retirement plan costs Contributions to retirement plans (which are defined contribution plans) are charged to general and administrative expenses in the accompanying consolidated statements of operation as the related employee service is provided. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) ·Related parties Parties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence. ·Segment reporting ASC Topic 280, “Segment Reporting” establishes standards for reporting information about operating segments on a basis consistent with the Company’s internal organization structure as well as information about geographical areas, business segments and major customers in financial statements. For the years ended December 31, 2016 and 2015, the Company operates in one reportable operating segment in the PRC. ·Fair value of financial instruments The carrying value of the Company’s financial instruments (excluding short-term bank borrowing and convertible promissory notes): cash and cash equivalents, restricted cash, accounts and retention receivable, prepayments and other receivables, accounts payable, income tax payable, amount due to a related party, other payables and accrued liabilities approximate at their fair values because of the short-term nature of these financial instruments. Management believes, based on the current market prices or interest rates for similar debt instruments, the fair value of its obligation under finance lease and short-term bank borrowing approximate the carrying amount. The fair value of convertible promissory notes is disclosed in Note 10. The Company also follows the guidance of the ASC Topic 820-10, “Fair Value Measurements and Disclosures” ("ASC 820-10"), with respect to financial assets and liabilities that are measured at fair value. ASC 820-10 establishes a three-tier fair value hierarchy that prioritizes the inputs used in measuring fair value as follows: · Level 1 : Inputs are based upon unadjusted quoted prices for identical instruments traded in active markets; · Level 2 : Inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. Black-Scholes Option-Pricing model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs; and · Level 3 : Inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. ·Recent accounting pronouncements In May 2014, the Financial Accounting Standard Board (‘FASB”) issued ASU 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In July 2015, the FASB approved a one-year deferral of the effective date of the new revenue recognition standard. The amendments in ASU 2014-09 are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The standard permits the use of either the retrospective or cumulative effect transition method. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606), Principal versus Agent Considerations (Reporting Revenue versus Net). In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606), Identifying Performance Obligations and Licensing. In May 2016, the FASB issued ASU 2016-11, Revenue from Contracts with Customers (Topic 606) and Derivatives and Hedging (Topic 815) - Rescission of SEC Guidance Because of ASU 2014-09 and 2014-16, and ASU 2016-12, Revenue from Contracts with Customers (Topic 606) - Narrow Scope Improvements and Practical Expedients. These ASUs clarify the implementation guidance on a few narrow areas and adds some practical expedients to the guidance Topic 606. The Company is evaluating the effect the ASUs will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of these standards on its ongoing financial reporting. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) In June 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40) which provides guidance to an organization’s management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that are commonly provided by organizations today in the financial statement footnotes. This guidance in ASU 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. The Company does not expect that the adoption will have a material impact on its consolidated financial statements. In November 2014, FASB issued Accounting Standards Update No. 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity (a consensus of the FASB Emerging Issues Task Force). The amendments permit the use of the Fed Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate, or OIS) as a benchmark interest rate for hedge accounting purposes. Public business entities are required to implement the new requirements in fiscal years (and interim periods within those fiscal years) beginning after December 15, 2015. The Company does not expect the adoption of ASU 2014-16 to have a material impact on its consolidated financial statements. In February 2015, the FASB issued ASU 2015-02 Consolidation (Topic 810): Amendments to the Consolidation Analysis. ASU 2015-02 changes the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. It is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. The Company is currently in the process of evaluating the impact of the adoption of ASU 2015-02 on its consolidated financial statements. In April 2015, the FASB issued ASU 2015-03 Simplifying the Presentation of Debt Issuance Costs, which changes the presentation of debt issuance costs in the financial statements. ASU 2015-03 requires an entity to present such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs will continue to be reported as interest expense. The guidance is effective for annual reporting periods beginning after December 15, 2016, with early adoption permitted. The guidance will be applied retrospectively to each period presented. The adoption of this standard update is not expected to have any impact on the Company's financial statements. In July 2015, the FASB issued ASU 2015-11, Inventory, which requires an entity to measure inventory within the scope at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The effective date for the standard is for fiscal years beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASU 2015-11 to have a material impact on its consolidated financial statements. In September 2015, the FASB issued ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments. To simplify the accounting for adjustments made to provisional amounts recognized in a business combination, the amendments eliminate the requirement to retrospectively account for those adjustments. For public business entities, the amendments are effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. The amendments should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. The Company does not expect the adoption of ASU 2015-16 to have a material impact on its consolidated financial statements. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) In November 2015, the FASB issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. To simplify the presentation of deferred income taxes, the amendments in this update require that deferred income tax liabilities and assets be classified as noncurrent in a classified statement of financial position. The amendments in ASU 2015-17 are effective for public business entities for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The amendments may be applied prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. The Company does not expect that the adoption will have a material impact on its consolidated financial statements. In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this update require all equity investments to be measured at fair value with changes in the fair value recognized through net income (other than those accounted for under equity method of accounting or those that result in consolidation of the investee). The amendments in this update also require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. The amendments in ASU 2016-01 are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not expect that the adoption will have a material impact on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company does not expect that the adoption will have a material impact on its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-07, Simplifying the Transition to the Equity Method of Accounting, which eliminates the requirement to apply the equity method of accounting retrospectively when a reporting entity obtains significant influence over a previously held investment. The amendments in ASU 2016-07 are effective for public companies for fiscal years beginning after December 15, 2016 including interim periods therein. Early adoption is permitted. The new standard should be applied prospectively for investments that qualify for the equity method of accounting after the effective date. The Company does not expect that the adoption will have a material impact on its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, which includes amendments to accounting for income taxes at settlement, forfeitures, and net settlements to cover withholding taxes. The amendments in ASU 2016-09 are effective for public companies for fiscal years beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted but requires all elements of the amendments to be adopted at once rather than individually. The Company is evaluating the effect that ASU No. 2016-09 will have on the Company’s consolidated financial statements and related disclosures. In June 2016, the FASB issued Accounting Standards Update ("ASU") 2016-13, Financial Instruments-Credit Losses (Topic 326), which requires entities to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early application will be permitted for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating the impact that the standard will have on its consolidated financial statements and related disclosures. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) In August 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 clarifies the presentation and classification of certain cash receipts and cash payments in the statement of cash flows. This ASU is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted. The Company is currently assessing the potential impact of ASU 2016-15 on its financial statements and related disclosures. In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. This ASU improves the accounting for the income tax consequences of intra-entity transfers of assets other than inventory. This ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2017. Early adoption is permitted. The Company does not anticipate that the adoption of this ASU to have a significant impact on its consolidated financial statements. In October 2016, the FASB issued ASU No. 2016-17, Consolidation (Topic 810): Interests Held through Related Parties That Are Under Common Control. The amendments in this ASU change how a reporting entity that is the single decision maker of a variable interest entity should treat indirect interests in the entity held through related parties that are under common control with the reporting entity when determining whether it is the primary beneficiary of that variable interest entity. The ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2016. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements. In November 2016, the FASB issued Accounting Standards Update 2016-18 (ASU 2016-18), Statement of Cash Flows: Restricted Cash. This ASU provides guidance on the classification of restricted cash in the statement of cash flows. The amendments in this ASU are effective for interim and annual periods beginning after December 15, 2017. Early adoption is permitted. The amendments in the ASU should be adopted on a retrospective basis. The Company does not expect that adoption of this ASU to have a material effect on its consolidated financial statements. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s consolidated financial statements upon adoption. 3.ACCOUNTS AND RETENTION RECEIVABLE The majority of the Company’s sales are on open credit terms and in accordance with terms specified in the contracts governing the relevant transactions. The Company evaluates the need of an allowance for doubtful accounts based on specifically identified amounts that management believes to be uncollectible. If actual collections experience changes, revisions to the allowance may be required. Based upon the aforementioned criteria, the Company provided an allowance $0 and $405,708 for the years ended December 31, 2016 and 2015. Up to February 28, 2017, the Company has subsequently recovered from approximately 10% of accounts and retention receivable as of December 31, 2016. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) 4.INVENTORIES Inventories consisted of the following: For the years ended December 31, 2016 and 2015, no allowance for obsolete inventories was recorded by the Company. Finished goods are expected to be delivered to the customer in the next twelve months. 5.PREPAYMENTS AND OTHER RECEIVABLES Prepayments and other receivables consisted of the following: The Company generally makes prepayments to vendors for raw materials in the normal course of business. Prepayments to vendors are recorded when payment is made by the Company and relieved against inventory when goods are received, which include provisions that set the purchase price and delivery date of raw materials. 6.PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consisted of the following: Depreciation expense for the years ended December 31, 2016 and 2015 were $936,064 and $1,207,446, of which $556,016 and $933,216 were included in cost of revenue, respectively. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) 7.LAND USE RIGHT Land use right consisted of the following: Amortization expense for the years ended December 31, 2016 and 2015 were $62,125 and $66,377, respectively. The estimated amortization expense on the land use right in the next five years and thereafter is as follows: 8.CONSTRUCTION IN PROGRESS In 2008, the Company received approval from the local government to construct a new manufacturing facility for energy-saving products and equipment in Yingzhou District Industrial Park, Tieling City, Liaoning Province, the PRC. Total estimated construction cost of a new manufacturing facility is approximately $24 million. The first phase of construction project was completed and began its operations in December 2012. The cost of construction was transferred to property, plant and equipment and its depreciation expense was recorded in 2013. The second phase of construction project was structurally completed in 2013 and was transferred to property, plant and equipment of $8,158,192 upon the granting of ownership certificate from the local authority during 2016. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) 9.SHORT-TERM BANK BORROWINGS Short-term bank borrowings consist of the following: The effective Bank of China Benchmark Lending rate was 4.35% and 4.35% per annum for the years ended December 31, 2016 and 2015. 10.AMOUNT DUE TO A RELATED PARTY As of December 31, 2016 and 2015, the amount due to a related party represented temporary advances made by the Company’s major stockholder, Pelaris International Ltd, which is controlled by Ms. Li Hua Wang (the Company’s CFO) and Mr. Gang Li (the Company’s CEO), which was unsecured, interest-free with no fixed repayment term. Imputed interest on this amount is considered insignificant. 11.OTHER PAYABLES AND ACCRUED LIABILITIES Other payables and accrued liabilities consisted of the following: NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) 12.STOCKHOLDERS’ EQUITY In July 2016, the Company issued 100,000 shares of its common stock to an IR Firm for investor relations services to be rendered for a service period of five months, at a market value of $0.96 per share, or a total value of $96,000 which full amortized during the year . In December 2016, the Company issued 120,000 shares of its common stock to an IR Firm for investor relations services to be rendered for a service period of six months, at a market value of $0.81 per share, or a total value of $97,200. The Company issued 300,000 shares of its common stock to an IR Firm for investor relations services to be rendered for a service period of twelve months, at a market value of $0.86 per share, or a total value of $258,000. As of December 31, 2016 and 2015, the Company had a total of 7,073,289 and 6,553,289 shares of its common stock issued and outstanding. 13.INCOME TAXES For the years ended December 31, 2016 and 2015, the local (“United States of America”) and foreign components of loss before income taxes were comprised of the following: The provision for income taxes consisted of the following: The effective tax rate in the years presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rate. The Company operates in various countries: United States of America and the PRC that are subject to taxes in the jurisdictions in which they operate, as follows: United States of America NFEC is registered in the State of Delaware and is subject to the tax laws of United States of America. As of December 31, 2016, the operations in the United States of America incurred $3,361,700 of cumulative net operating losses which can be carried forward to offset future taxable income. The net operating loss carryforwards begin to expire in 2036, if unutilized. The Company has provided for a full valuation allowance against the deferred tax assets of $1,123,394 on the expected future tax benefits from the net operating loss carryforwards as the management believes it is more likely than not that these assets will not be realized in the future. NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) The PRC The Company’s subsidiary operating in the PRC are subject to the Corporate Income Tax Law of the People’s Republic of China at a unified income tax rate of 25%. The reconciliation of income tax rate to the effective income tax rate for the years ended December 31, 2016 and 2015 is as follows: The following table sets forth the significant components of the aggregate deferred tax assets of the Company as of December 31, 2016 and 2015: Management believes that it is more likely than not that the deferred tax assets will not be fully realizable in the future. Accordingly, the Company provided for a full valuation allowance against its deferred tax assets of $1,123,394 as of December 31, 2016. In 2016, the valuation allowance increased by $15,374, primarily relating to net operating loss carryforwards from the local tax regime. 14.NET LOSS PER SHARE Basic net loss per share is computed using the weighted average number of common shares outstanding during the year. The dilutive effect of potential common shares outstanding is included in diluted net loss per share. The following table sets forth the computation of basic and diluted net loss per share for the years ended December 31, 2016 and 2015: NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) 15.CHINA CONTRIBUTION PLAN Under the PRC Law, full-time employees of its subsidiaries of the Company in the PRC are entitled to state welfare benefits including medical care, welfare subsidies, unemployment insurance and pension benefits through a China government-mandated multi-employer defined contribution plan. These benefits are required to accrue for, based on certain percentages of the employees’ salaries. The total contributions made for such employee benefits were $173,699 and $235,508 for the years ended December 31, 2016 and 2015, respectively. 16.STATUTORY RESERVES Under the PRC Law the Company’s subsidiaries are required to make appropriations to the statutory reserve based on after-tax net earnings and determined in accordance with generally accepted accounting principles of the People’s Republic of China (the “PRC GAAP”). Appropriation to the statutory reserve should be at least 10% of the after-tax net income until the reserve is equal to 50% of the registered capital. The statutory reserve is established for the purpose of providing employee facilities and other collective benefits to the employees and is non-distributable other than in liquidation. 17.CONCENTRATIONS OF RISK The Company is exposed to the following concentrations of risk: (a)Major customers For the year ended December 31, 2016, one customer represented more than 10% of the Company’s revenues. This customer accounted for 98% of the Company’s revenues amounting to $6,050,695 with $6,856,520 of accounts receivable. For the year ended December 31, 2015, one customer represented more than 10% of the Company’s revenues. This customer accounted for 83% of the Company’s revenues amounting to $5,551,731 with $6,651,208 of accounts receivable. All major customers are located in the PRC. (b)Major vendors For the year ended December 31, 2016, the vendors who accounted for 10% or more of the Company’s purchases and its outstanding accounts payable balances as at year-end dates, are presented as follows: For the year ended December 31, 2015, the vendors who accounted for 10% or more of the Company’s purchases and its outstanding accounts payable balances as at year-end dates, are presented as follows: NF ENERGY SAVING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (Currency expressed in United States Dollars (“US$”), except for number of shares) All major vendors are located in the PRC. (c) Credit risk Financial instruments that are potentially subject to credit risk consist principally of trade receivables. The Company believes the concentration of credit risk in its trade receivables is substantially mitigated by its ongoing credit evaluation process and relatively short collection terms. The Company does not generally require collateral from customers. The Company evaluates the need for an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information. (d)Interest rate risk As the Company has no significant interest-bearing assets, the Company’s income and operating cash flows are substantially independent of changes in market interest rates. The Company’s interest-rate risk arises from short-term bank borrowings. The Company manages interest rate risk by varying the issuance and maturity dates variable rate debt, limiting the amount of variable rate debt, and continually monitoring the effects of market changes in interest rates. As of December 31, 2016, short-term bank borrowings were at fixed rates. (e) Exchange rate risk The reporting currency of the Company is US$, to date the majority of the revenues and costs are denominated in RMB and a significant portion of the assets and liabilities are denominated in RMB. As a result, the Company is exposed to foreign exchange risk as its revenues and results of operations may be affected by fluctuations in the exchange rate between US$ and RMB. If RMB depreciates against US$, the value of RMB revenues and assets as expressed in US$ financial statements will decline. The Company does not hold any derivative or other financial instruments that expose to substantial market risk. (f) Economic and political risks The Company's operations are conducted in the PRC. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy. The Company's operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation. 18.COMMITMENTS AND CONTINGENCIES As of December 31, 2016 and 2015, there were no commitments and contingencies involved. 19.SUBSEQUENT EVENTS In accordance with ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued, the Company has evaluated all events or transactions that occurred after December 31, 2016 up through the date was the Company issued the audited consolidated financial statements. During the period, the Company did not have any material recognizable subsequent events.
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Based on the provided text, which appears to be a partial financial statement excerpt, here's a summary:
The financial statement covers NF Energy Saving Corporation's financial position, focusing on:
1. Receivables Management:
- The company takes appropriate actions to collect past due payments
- Legal resolution may be pursued if necessary
- Account balances are charged off when recovery is considered remote
- No off-balance-sheet credit exposure exists
2. Consolidation:
- Financial statements include the company and its subsidiary
- Inter-company balances and transactions are eliminated during consolidation
3. Liabilities:
- Debt instruments and short-term bank borrowings are valued at carrying amount
- Fair value of convertible promissory notes is detailed in a separate note
The statement suggests a careful approach to financial reporting, with attention to receivables collection, consolidation practices, and liability valuation. However, the excerpt seems incomplete, so a
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Claude
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. Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Hardinge Inc. and Subsidiaries We have audited the accompanying consolidated balance sheets of Hardinge Inc. and Subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive (loss) income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hardinge Inc. and Subsidiaries at December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 11 to the consolidated financial statements, the Company retrospectively adjusted the presentation of deferred tax assets and liabilities in the consolidated balance sheet as a result of the adoption of the amendments to the FASB Accounting Standards Codification resulting from Accounting Standards Update No. 2015-17, “Balance Sheet Classification of Deferred Taxes,” effective December 31, 2016. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hardinge Inc. and Subsidiaries' internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 3, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Buffalo, New York March 3, 2017 HARDINGE INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data) See accompanying notes to the consolidated financial statements. HARDINGE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) See accompanying notes to the consolidated financial statements. HARDINGE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (in thousands) See accompanying notes to the consolidated financial statements. HARDINGE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See accompanying notes to the consolidated financial statements. HARDINGE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) See accompanying notes to the consolidated financial statements. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2016 NOTE 1. SIGNIFICANT ACCOUNTING POLICIES AND BASIS OF PRESENTATION Nature of Business Hardinge Inc. ("Hardinge" or "the Company") is a machine tool manufacturer, which designs and manufactures computer-numerically controlled cutting lathes, machining centers, grinding machines, collets, chucks, index fixtures and other industrial products. Products are sold to customers in North America, Europe and Asia. A substantial portion of sales are to small and medium-sized independent job shops, which in turn sell machined parts to their industrial customers. Industries directly and indirectly served by the Company include: aerospace, automotive, communications, computer, construction equipment, defense, energy, farm equipment, medical equipment, recreational equipment and transportation. The Company operates through two reportable segments, Metalcutting Machine Solutions (“MMS”) and Aftermarket Tooling and Accessories (“ATA”). The MMS segment includes high precision computer controlled metalcutting turning machines, vertical machining centers, horizontal machining centers, grinding machines, and repair parts related to those machines. The ATA segment includes products, primarily collets and chucks that are purchased by manufacturers throughout the lives of their Hardinge or other branded machines. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. Use of Estimates The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the Unites States of America ("US GAAP") which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Cash Equivalents Cash equivalents are highly liquid financial instruments with an original maturity of three months or less at the date of purchase. Restricted Cash Occasionally, the Company is required to maintain cash deposits with certain banks with respect to contractual obligations as collateral for customer deposits. Additionally, restricted cash includes amounts due under mandatory principal reduction provisions associated with certain term debt agreements. As of December 31, 2016 and 2015, the amount of restricted cash was approximately $2.9 million and $2.2 million, respectively. Accounts Receivable A review of the financial condition of the Company's customers is performed periodically through credit reviews. No collateral is required for sales made on open account terms. Letters of credit from major banks back the majority of sales in the Asian region. Concentrations of credit risk with respect to accounts receivable are generally limited due to the large number of customers comprising the customer base. Trade accounts receivable are considered to be past due when in excess of 30 days past terms, and charge off of uncollectible balances occurs when all collection efforts have been exhausted. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The allowance for doubtful accounts was $0.8 million and $0.9 million at December 31, 2016 and 2015, respectively. If the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would result in additional expense to the Company. Other Current Assets Other current assets consist of prepaid insurance, prepaid real estate taxes, prepaid software license agreements, prepaid income taxes and deposits on certain inventory purchases. When applicable, prepayments are expensed on a straight-line basis over the corresponding life of the underlying asset. Inventories Inventories are stated at the lower of cost (computed in accordance with the first-in, first-out method) or market. Elements of cost include raw materials, purchased components, labor and overhead. The Company assesses the valuation of inventory balances, and reduce the carrying value of those inventories that are obsolete or in excess of forecasted usage to their estimated net realizable value. The net realizable value of such inventories is estimated based on analysis and assumptions including, but not limited to, historical usage, future demand and market requirements. The carrying value of inventory is also compared to the estimated selling price less costs to sell and inventory carrying value will be adjusted accordingly. Reductions to the carrying value of inventories are recorded in cost of goods sold. If future demand for products is less favorable than forecasts, inventories may need to be reduced, which would result in additional expense. Property, Plant and Equipment Property, plant and equipment are recorded at cost. Major additions, renewals or improvements that extend the useful lives of assets are capitalized. Maintenance and repairs are expensed to operations as incurred. Depreciation expense is computed using the straight-line and accelerated methods, generally over the following estimated useful lives of the assets (in years): Goodwill and Intangible Assets In accordance with Financial Accounting Standards Board ("FASB") Accounting Standard Update ("ASU") Topic 350, Intangibles-Goodwill and Other ("ASC 350"), goodwill and intangible assets with indefinite lives are not amortized but are tested for impairment annually on the first day of the fourth quarter or when events indicate that an impairment could exist. Goodwill impairment is deemed to exist if the carrying value of a reporting unit exceeds its estimated fair value. The reporting units are determined based upon whether discrete financial information is available and reviewed regularly, whether those units constitute a business, and the extent of economic similarities between those reporting units for purposes of aggregation. The reporting units identified under ASC 350-20-35-33 are at the component level, or one level below the reporting segment level as defined under ASC 280-10-50-10 "Segment Reporting-Disclosure." The Company has three reporting units. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Goodwill is evaluated for potential impairment by assessing a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for the Company's products and services, regulatory and political developments, entity specific factors such as strategy and changes in key personnel and overall financial performance. If it is determined after completing this assessment that it is more likely than not that the fair value of a reporting unit is less than its carrying value, a step-two impairment test is performed. The measurement of impairment of goodwill consists of two steps. In the first step, the fair value of each reporting unit is compared to its carrying value. As part of the impairment analysis, the fair value of each of its reporting units with goodwill is determined using the income approach and market approach. If the carrying value of the reporting unit exceeds its fair value, the second step of the analysis is performed to determine the amount of the impairment. The Company performed its qualitative assessment as of October 1, 2016 and determined that it was not more likely than not that the fair value of each of its reporting units with goodwill was less than that its applicable carrying value. Accordingly, the Company did not perform the two-step goodwill impairment test for any of its reporting units. See Note 7: "Goodwill and Intangible Assets" for more information. Intangible assets with indefinite lives are not subject to amortization. They are reviewed for impairment at least annually or more frequently if an event occurs or circumstances change that would indicate the carrying amount may be impaired. Intangible assets that are determined to have a finite life are amortized over their estimated useful lives and are also subject to review for impairment, if indicators of impairment are identified. Future impairment indicators, such as declines in forecasted cash flows, may cause additional significant impairment charges. Impairment charges could be based on such factors as the Company's stock price, forecasted cash flows, assumptions used, control premiums or other variables. Impairment of Long-Lived Assets Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. To assess whether impairment exists, undiscounted cash flows are used to measure any impairment loss using discounted cash flows. Assets to be held for sale are reported at the lower of their carrying amount or fair value less costs to sell and are no longer depreciated. Accrued Expenses Accrued expenses include $8.0 million and $10.5 million in compensation related expenses at December 31, 2016 and 2015, respectively, as well as $7.2 million of commissions payable for both years. Income Taxes Deferred income tax assets and liabilities are recognized for the income tax consequences attributable to operating loss carryforwards, tax credit carryforwards, and differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be reversed. A valuation allowance is established when it is more likely than not that all or a portion of deferred tax assets are not expected to be realized. The Company assesses all available positive and negative evidence to determine whether a valuation allowance is needed. Positive and negative evidence to be considered includes scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. Supporting a conclusion that a valuation allowance is not necessary is difficult when there is negative evidence such as cumulative losses in recent years. A full valuation allowance is maintained on the tax benefits of the U.S. net deferred tax assets and it is expected that a full valuation allowance on future tax benefits will be recorded until an appropriate level of profitability in the U.S. is sustained. A valuation allowance is also maintained on the U.K., German, Dutch, and Canadian deferred tax assets related to tax loss carryforwards in those jurisdictions, as well as all other deferred tax assets of those entities. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The calculation of the tax liabilities requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. The provision for income taxes reflects a combination of income earned and taxed in the U.S. and the various states, as well as federal and provincial jurisdictions in Switzerland, U.K., Canada, Germany, France, the Netherlands, China, Taiwan, and India. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate. The Company accounts for uncertain tax positions using a more likely than not recognition threshold. The evaluation of uncertain tax positions is based on factors including, but not limited to, changes in tax law, the measurement of tax positions taken or expected to be taken in tax returns, the effective settlement of matters subject to audit, new audit activity and changes in facts or circumstances related to a tax position. Interest and penalties related to uncertain tax positions are included as a component of income tax expense. Revenue Recognition Revenue from product sales is generally recognized upon shipment, provided persuasive evidence of an arrangement exists, the sales price is fixed or determinable, collectability is reasonably assured, and the title and risk of loss have passed to the customer. Sales are recorded net of discounts, customer sales incentives and returns. Discounts and customer sales incentives are typically negotiated as part of the sales terms at the time of sale and are recorded as a reduction of revenue. The Company does not routinely permit customers to return machines. In the rare case that a machine return is permitted, a restocking fee is typically charged. Returns of spare parts and workholding products are limited to a period of 90 days subsequent to purchase, excluding special orders which are not eligible for return. An estimate of returns, which is not significant, is recorded as a reduction of revenue and is based on historical experience. Transfer of ownership and risk of loss are generally not contingent upon contractual customer acceptance. Prior to shipment, each machine is tested to ensure the machine's compliance with standard operating specifications as listed in the promotional literature. On an exception basis, where larger multiple machine installations are delivered which require run-offs and customer acceptance at their facility, revenue is recognized in the period of customer acceptance. Sales Tax/VAT Taxes assessed by different governmental authorities are collected and remitted that are both imposed on and concurrent with revenue producing transactions between the Company and its customers. These taxes may include sales, use and value-added taxes. The collection of these taxes is reported on a net basis (excluded from revenues). Shipping and Handling Costs Shipping and handling costs are recorded as part of cost of goods sold. Warranties The Company offers warranties for products sold. The specific terms and conditions of those warranties vary depending upon the product sold and the country in which the product was sold. A basic limited warranty is generally provided for a period of one to two years. The costs that may be incurred are estimated under the basic limited warranty, based largely upon actual warranty repair cost history and we record a liability for such costs when the related product revenue is recognized. The resulting accrual balance is reviewed during the year. Factors that affect the warranty liability include the number of installed units, historical and anticipated rates of warranty claims, and cost per claim. Extended warranties for some of the Company's products are also sold. These extended warranties usually cover a one year to two year period that begins after the basic warranty expires. Revenue from extended warranties are deferred and recognized on a straight-line basis across the term of the warranty contract. These liabilities are reported in "Accrued expenses" in the Consolidated Balance Sheets. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Research and Development Costs The costs associated with research and development programs for new products and significant product improvements are expensed as incurred and reported in the Consolidated Statement of Operations. Foreign Currency Translation and Re-measurement The functional currency of the Company's foreign subsidiaries is their local currency. Net assets are translated at month end exchange rates while income, expense and cash flow items are translated at average exchange rates for the applicable period. Translation adjustments are recorded within accumulated other comprehensive income (loss). Gains and losses resulting from foreign currency denominated transactions are included as a component of "Other expense, net" in the Consolidated Statements of Operations. Fair Value of Financial Instruments Financial instruments consist primarily of cash and cash equivalents, accounts receivable, notes receivable, accounts payable, notes payable, long-term debt and foreign currency forwards. See Note 3. "Fair Value of Financial Instruments" for additional disclosure. Derivative Financial Instruments As a multinational company, the results of operations and financial condition are exposed to market risk from changes in foreign currency exchange rates. To manage this risk, derivative instruments are entered into, namely in the form of foreign currency forwards. These derivative instruments are held to hedge economic exposures, such as fluctuations in foreign currency exchange rates on balance sheet exposures of both trade and intercompany assets and liabilities. This exposure is hedged with contracts settling in less than one year. These derivatives do not qualify for hedge accounting treatment. Gains or losses resulting from the changes in the fair value of these hedging contracts are recognized immediately in earnings. There are some forward contracts to hedge certain customer orders and vendor firm commitments. These contracts are typically for less than one year, and have maturity dates in alignment with the recognition dates of the underlying financial transactions. These derivatives qualify for hedge accounting treatment and are designated as cash flow hedges. Unrealized gains or losses resulting from the changes in the fair value of these hedging contracts are charged to other comprehensive income (loss) until the underlying transaction is recognized through earnings. Gains or losses on any ineffective portion of the contracts are recognized in earnings. Stock-Based Compensation Stock-based compensation is accounted for based on the estimated fair value of the award as of the grant date and recognized as expense over the requisite service period. Earnings Per Share Basic earnings per common share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per common share are calculated by adjusting the weighted average outstanding shares to assume conversion of all potentially dilutive shares. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 2. ACQUISITIONS Acquisition of Voumard On September 22, 2014, Hardinge Inc., along with its indirect wholly-owned subsidiaries Hardinge GmbH and L. Kellenberger & Co., AG acquired certain assets and assumed certain liabilities associated with a product line of grinding machine systems and applications marketed and sold under the Voumard brand from Peter Wolters GmbH. The purchase price was EUR 1.7 million (approximately $2.2 million), before taking into account customary purchase price adjustments. The acquisition of Voumard expands the Company's product offerings to include internal diameter ("ID") cylindrical grinding solutions, which are a complement to the existing grinding product lines offered by the Company. The acquisition was funded with cash and has been included in the MMS business segment. Voumard is a global leader in the ID grinding market with an installed base of over 9,000 machine solutions serving more than 2,500 customers around the world. The results of operations of Voumard have been included in the consolidated financial statements from the date of acquisition. Acquisition related costs of $0.1 million were incurred related to the acquisition of the Voumard business for the year ended December 31, 2014 and reported in "Selling, general and administrative expenses" in the Consolidated Statements of Operations. In accordance with the acquisition method of accounting, the acquired net assets were recorded at fair value at the date of acquisition. The identifiable intangible assets acquired, which primarily consists of drawings of $0.1 million, were valued using a cost approach. The fair values of the acquired assets and liabilities exceeded the purchase price of Voumard, resulting in a gain on the purchase of $0.5 million. The values of assets acquired and liabilities assumed were finalized during the third quarter 2015, resulting in no valuation adjustments. The following table summarizes the fair values of the assets acquired and liabilities assumed in the Voumard acquisition at the date of acquisition (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Supplemental Pro Forma Information The following table illustrates the unaudited pro forma effect on the Company’s consolidated operating results for the year ended December 31, 2014 as if the Voumard acquisition had occurred on January 1, 2014 (in thousands, except per share data): ____________________ (1) The pro forma results above include abbreviated financial results for Voumard, consisting of revenues and direct expenses for that product line. During the year ended December 31, 2014, but prior to its acquisition by the Company, the Voumard business incurred $4.9 million in restructuring charges, which included inventory write-offs, headcount reductions and other related costs. These amounts are included in the pro forma information presented above. The above unaudited pro forma financial information is presented for informational purposes only and does not purport to represent what the results of operations would have been had the acquisition been completed on the date assumed, nor is it necessarily indicative of the results that may be expected in future periods. Pro forma adjustments exclude cost savings from any synergies resulting from the acquisition. NOTE 3. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value is defined as the price that would be received upon sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Depending on the nature of the asset or liability, various techniques and assumptions can be used to estimate fair value. The following presents the fair value hierarchy definitions utilized by the Company: Level 1 - Quoted prices in active markets for identical assets and liabilities. Level 2 - Observable inputs other than quoted prices in active markets for similar assets and liabilities. Level 3 - Inputs for which significant valuation assumptions are unobservable in a market and therefore value is based on the best available data, some of which is internally developed and considers risk premiums that a market participant would require. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The following table presents the carrying amount, fair values, and classification level within the fair value hierarchy of financial instruments measured or disclosed at fair value on a recurring basis (in thousands): The fair value of cash and cash equivalents and restricted cash are based on the fair values of identical assets in active markets. Due to the short period to maturity or the nature of the underlying liability, the fair value of variable interest rate debt approximates their respective carrying amounts. The fair value of foreign currency forward contracts is measured based on observable market inputs such as spot and forward rates. Based on the Company’s continued ability to enter into forward contracts, the markets for the fair value instruments are considered to be active. As of December 31, 2016 and December 31, 2015, there were no significant transfers in and/or out of Level 1 and Level 2. The following table presents the fair value on the Consolidated Balance Sheets of the foreign currency forward contracts (in thousands): The Company applied fair value principles during goodwill impairment tests. Step one of the goodwill impairment test consisted of determining a fair value for each of the Company's reporting units. The fair value for the Company's reporting units cannot be determined using readily available quoted Level 1 or Level 2 inputs that are observable or available from active markets. Therefore, the Company used valuation models to estimate the fair values of its reporting units, which use Level 3 inputs. To estimate the fair values of reporting units, the Company uses significant estimates and judgmental factors. The key estimates and factors used in the valuation models included revenue growth rates and profit margins based on internal forecasts, terminal value, WACC, and earnings multiples. As a result of the goodwill impairment test performed during 2014, the Company recognized goodwill impairment charges (See Note 7. "Goodwill and Intangible Assets" for more information regarding the Company's goodwill impairment tests). During 2014, the Company recognized impairments to intangible assets associated with trade names. The impairment charges were calculated by determining the fair value of these assets. The fair value measurements were calculated using discounted cash flow analysis, which rely upon unobservable inputs classified as Level 3 inputs. The key estimates and factors used in the valuation models, for which the Company used significant estimates and judgmental factors, include revenue growth rates based on internal forecasts, royalty rates and discounts rates (See Note 7. "Goodwill and Intangible Assets" for more information regarding the impairment of intangible assets). HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Pension Plan Assets The fair values and classification of the defined benefit plan assets is as follows (in thousands): ____________________ (1) Growth funds represent a type of fund containing a diversified portfolio of domestic and international equities with a goal of capital appreciation. (2) Income funds represent a type of fund with an emphasis on current income as opposed to capital appreciation. Such funds may contain a variety of domestic and international government and corporate debt obligations, preferred stock, money market instruments and dividend-paying stocks. (3) Growth and income funds represent a type of fund containing a combination of growth and income securities. (4) Hedge funds represent a managed portfolio of investments that use advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. These funds are subject to quarterly redemptions and advanced notification requirements, as well as the right to delay redemption until sufficient fund liquidity exists. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 A summary of the changes in the fair value of the defined benefit plans assets classified within Level 3 of the valuation hierarchy is as follows (in thousands): Most of the defined benefit pension plan's Level 1 assets are debt and equity investments that are traded in active markets, either domestically or internationally. They are measured at fair value using closing prices from active markets. The Level 2 assets are typically investments in pooled funds, which are measured based on the value of their underlying assets that are publicly traded with observable values. The fair value of the Level 3 plan assets are measured by compiling the portfolio holdings and independently valuing the securities in those portfolios. NOTE 4. INVENTORIES Net inventories consist of the following (in thousands): NOTE 5. DERIVATIVE INSTRUMENTS Foreign currency forward contracts are utilized to mitigate the impact of currency fluctuations on assets and liabilities denominated in foreign currencies as well as on forecasted transactions denominated in foreign currencies. These contracts are considered derivative instruments and are recognized as either assets or liabilities and measured at fair value. Generally these contracts have a term of less than one year. The valuations of these derivatives are measured at fair value based on observable market inputs such as spot and forward rates. A group of highly rated domestic and international banks are used in order to mitigate counterparty risk on the forward contracts. For contracts that are designated and qualify as cash flow hedges, the gain or loss on the contracts is reported as a component of other comprehensive income (“OCI”) and reclassified from accumulated other comprehensive income (“AOCI”) into the “Sales” or “Cost of sales” line item on the Consolidated Statements of Operations when the underlying hedged transaction affects earnings, or “Other expense, net” when the hedging relationship is deemed to be ineffective. As of December 31, 2016 and December 31, 2015, the notional amounts of the derivative financial instruments designated to qualify for cash flow hedges were $45.5 million and $27.4 million, respectively. The Company expects approximately $0.1 million of net losses, net of income tax effect, to be reclassified from AOCI to earnings within the next 12 months. As of December 31, 2016 and December 31, 2015, the notional amounts of the derivative financial instruments not qualifying or otherwise designated as hedges were $35.4 million and $38.5 million, respectively. For the years ended December 31, 2016 and 2015, losses of $0.1 million and $0.8 million, respectively, were recorded related to this type of derivative financial instruments. For contracts that are not designated as hedges, the gain or loss on the contracts are recognized in current earnings in the “Other expense, net” line item in the Consolidated Statements of Operations. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 6. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following (in thousands): Depreciation expense was $6.6 million, $7.0 million, and $7.7 million for the years ended December 31, 2016, 2015 and 2014, respectively. NOTE 7. GOODWILL AND INTANGIBLE ASSETS Detail and activity of goodwill by segment is presented below (in thousands): Goodwill is reviewed for possible impairment at least annually or more frequently upon the occurrence of an event or when circumstances indicate that a reporting unit's carrying amount is greater than its fair value. The Company performed a qualitative assessment during the fourth quarter of 2016 and determined that it was not more likely than not that the fair value of each of our reporting units with goodwill was less than that its applicable carrying value. Accordingly, the Company did not perform the two-step goodwill impairment test for any reporting unit in 2016. In 2015, the Company performed a review and test of goodwill and determined that the fair value exceeded the carrying amount for all of our reporting units with goodwill. Based on lower than expected performance in the Usach reporting unit during 2014, combined with a downward revision in the anticipated future results, the Company determined that there were indicators of an impairment of that reporting unit during the third quarter of 2014. Accordingly, a calculation of the fair value was performed using the expected present value of future cash flows, recent industry transaction multiples and using estimates, judgments and assumptions that management believed were appropriate in the circumstances, which resulted in the carrying amount of the Usach reporting unit HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 exceeding its fair value. Accordingly, a goodwill impairment charge of $4.8 million was recognized in the "Impairment charges" caption in the Consolidated Statements of Operations in that reporting unit during the third quarter of 2014, resulting in the entire MMS goodwill balance to be written off. Subsequently, the Company performed the annual impairment analysis for the ATA reporting unit, which resulted in the fair value exceeding the carrying value. The Company performed further analysis of the reporting units' long-lived assets and determined that impairment of these assets was not present. The estimates and judgments used in the assessment included multiples of EBITDA, the weighted average cost of capital and the terminal growth rate. The major components of intangible assets other than goodwill are as follows (in thousands): Amortization expense related to the definite-lived intangible assets are as follows (in thousands): Estimated amortization expense for each of the five succeeding fiscal years and thereafter is as follows (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The Company performed a qualitative review of its indefinite lived intangible assets in the fourth quarter of 2016 and determined that there were no indicators of impairment. In 2015, the Company performed a review and test for impairment of indefinite lived intangible assets. The fair value of the indefinite lived intangible assets were calculated using a discounted cash flow analysis, and resulted in the fair value exceeding the carrying value. As a result of interim impairment indicators present in the third quarter of 2014, it was determined that the fair value of the Company's Usach trade name was less than the carrying value, resulting in an impairment charge of $0.9 million, which was recognized in the "Impairment charges" caption in the Consolidated Statements of Operations. Additionally, in the fourth quarter of 2014, the Company concluded that the Usach trade name no longer had an indefinite life based on management plans surrounding the future use of the Usach name. Accordingly, an analysis was performed to assess the remaining useful life of this trade name, and the remaining balance is being amortized on a straight-line basis over a period of 18.25 years. See Note 3. "Fair Value of Financial Instruments" for a discussion of the fair value measures used in determining these impairment charges. NOTE 8. FINANCING ARRANGEMENTS Financing arrangements are maintained with several financial institutions. These financing arrangements are in the form of long term loans, credit facilities, and lines of credit. The credit facilities allow the Company to borrow up to $74.7 million at December 31, 2016, of which $53.0 million can be borrowed for working capital needs. As of December 31, 2016, $67.1 million was available for borrowing under these arrangements of which $51.9 million was available for working capital needs. Total consolidated term borrowings outstanding, net of unamortized debt issuance fees were $5.9 million at December 31, 2016 and $11.6 million at December 31, 2015. Additionally, the Company had borrowings under revolving credit facilities of $0.7 million at December 31, 2016. Details of these financing arrangements are discussed below. Long-term Debt Long-term debt consists of (in thousands): In January 2016 we adopted guidance which requires that debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. As a result, the Company reclassified $0.07 million and $0.09 million of debt issuance cost as of December 31, 2015 into "Current portion of long-term debt" and "Long-term debt", respectively, to reduce the carrying amount of debt liability, from "Other current assets" and "Other non-current assets" on the Consolidated Balance Sheets. Debt issuance costs associated with line of credit arrangements remained in the "Other current assets" and "Other non-current assets" on the Consolidated Balance Sheets. Unamortized debt issuance costs of $0.07 million and $0.02 million were recorded as "Current portion of long-term debt" and "Long-term debt" respectively to reduce the carrying amount of debt liability, on the Consolidated Balance Sheets at December 31, 2016. The Company's debt issuance cost amortization was not affected by the adoption of the new guidance. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The annual maturities of long-term debt for each of the years after December 31, 2016, are as follows (in thousands): In May 2006, Hardinge Taiwan Precision Machinery Limited, an indirectly wholly-owned subsidiary in Taiwan, entered into a mortgage loan with a local bank. The principal amount of the loan was $180.0 million New Taiwanese Dollars ("TWD") ($5.6 million equivalent). The loan, which matured and was paid in full in June 2016, was secured by real property owned and required quarterly principal payment in the amount of TWD 4.5 million ($0.1 million equivalent). The loan interest rate, 1.75% at June 30, 2016 and December 31, 2015, was based on the bank's one year fixed savings rate plus 0.4%. The principal amount outstanding was TWD 9.0 million ($0.3 million equivalent) at December 31, 2015. In May 2013, the Company and Hardinge Holdings GmbH, a direct wholly-owned subsidiary, entered into a term loan agreement with a bank pursuant to which the bank provided a $23.0 million secured term loan facility for the acquisition of Forkardt. The agreement, which was amended in October 2013 and matures in April 2018, calls for scheduled annual principal repayments of $2.1 million and $1.0 million in 2017 and 2018, respectively. The interest rate on the term loan is determined from a pricing grid with the London Interbank Offered Rate ("LIBOR") and base rate options based on the Company's leverage ratio and was 2.81% and 2.50% at December 31, 2016 and 2015 respectively. LIBOR is the average interest rate estimated by leading banks in London that they would be charged when borrowing from other banks. The principal amount outstanding at December 31, 2016 and 2015 was $3.1 million and $5.1 million, respectively. In November 2013, the Company and Hardinge Holdings GmbH entered into a replacement term loan agreement with the same bank pursuant to which the bank converted $10.8 million of the then outstanding principal on the term loan to CHF 3.8 million ($3.7 million equivalent) and EUR 5.0 million ($5.3 million equivalent) borrowings. The agreement calls for scheduled annual principal repayments in CHF and EUR. The CHF principal balance outstanding at December 31, 2015 was CHF 0.6 million ($0.6 million historic equivalent) and was paid in full in November 2016. The scheduled annual principal repayments in EUR are EUR 0.9 million ($0.9 million equivalent) in 2017 and EUR 1.9 million ($2.0 million equivalent) in 2018. The interest rate on the EUR portion of the term loan is determined with a pricing grid with the Euro Interbank Offered Rate ("EURIBOR") and base rate options based on the Company's leverage ratio and was 1.88% and 2.18% at December 31, 2016 and December 31, 2015, respectively. The principal amounts outstanding were EUR $2.8 million ($2.9 million equivalent) and EUR $3.7 million ($4.0 million equivalent) at December 31, 2016 and 2015, respectively. The term loan is secured by (i) liens on all of the Company's U.S. assets (exclusive of real property); (ii) a pledge of 65% of the Company's investment in Hardinge Holdings GmbH; (iii) a negative pledge on the Company's headquarters in Elmira, New York; (iv) liens on all of the personal property assets of Hardinge Grinding Group (formerly Usach), Forkardt Inc. (formerly Cherry Acquisition Corporation) and Hardinge Technology Systems Inc., a wholly-owned subsidiary and owner of the real property comprising the Company's world headquarters in Elmira, New York ("Technology"); and (v) negative pledges on the intellectual property of the Revolving Credit Borrowers and Technology. The loan agreement contains financial covenants requiring a minimum fixed charge coverage ratio of not less than 1.15 to 1.00 (tested quarterly on a rolling four-quarter basis), a maximum consolidated total leverage ratio of 3.00 to 1.00 (tested quarterly on a rolling four-quarter basis), and maximum annual consolidated capital expenditures of $10.0 million. The loan agreement also contains such other representations, affirmative and negative covenants, prepayment provisions and events of default that are customary for these types of transactions. At December 31, 2016, the Company was in compliance with the covenants under the loan agreement. In July 2013, Hardinge Holdings GmbH, a direct wholly-owned subsidiary, and Kellenberger & Co. AG, an indirect wholly-owned subsidiary of the Company, entered into a credit facility agreement with a bank whereby the bank made available a CHF 2.6 million ($2.6 million equivalent) mortgage loan facility. Interest on the facility accrued at a fixed rate of 2.50% per annum. The remaining outstanding balance of principal and accrued interest was paid in full at the final maturity in December 2016. The principal amount outstanding was CHF 1.8 million ($1.8 million equivalent) at December 31, 2015. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Foreign Credit Facilities In December 2012, Hardinge Jiaxing entered into a secured credit facility with a local bank for working capital purposes, which was subsequently amended in December 2015. The total availability under the facility is CNY 20.0 million ($2.9 million equivalent) or its equivalent in other currencies. The facility renews annually and currently expires in December 2017. Borrowings under the credit facility are secured by real property owned by the subsidiary. The interest rate on the credit facility is based on the basic interest rate as published by the People's Bank of China, plus a 10% mark-up, amounting to 4.79% at December 31, 2016 and December 31, 2015. There was no principal amount outstanding under this facility at December 31, 2016 or December 31, 2015. In July 2013, Hardinge Machine Tools B.V., Taiwan Branch, an indirectly wholly-owned subsidiary in Taiwan, entered into an unsecured credit facility subject to annual renewal. The facility, which expires in June 2017, provides up to $12.0 million, or its equivalent in other currencies, for working capital and export business purposes. This credit facility's interest rate is subject to change by the lender based on market conditions, and carries no commitment fees on unused funds. The facility's interest rate was 1.40% at December 31, 2016 and was a variable rate at December 31, 2015. The principal amount outstanding at December 31, 2016 was NTD 22.0 million ($0.7 million equivalent). There were no principal amounts outstanding under this facility at December 31, 2015. In September 2014, Hardinge Machine (Shanghai) Co., Ltd., an indirectly wholly-owned subsidiary in China, entered into a credit facility with a bank, subject to annual renewal. The facility provides up to CNY 30.0 million ($4.3 million equivalent) for letters of guarantee, and expires in August 2017. Individual letters of guarantee issued under this facility require a cash deposit at the bank of 30% of the letter’s face value. The total issued letters of guarantee at both December 31, 2016 and December 31, 2015 had a face value of CNY 0.6 million (approximately $0.1 million). In July 2013, Hardinge Holdings GmbH, a direct wholly-owned subsidiary, and Kellenberger, an indirect wholly-owned subsidiary, entered into a credit facility agreement with a bank whereby the bank made available a CHF 18.0 million ($17.7 million equivalent) multi-currency revolving working capital facility. This facility matures in July 2018. The facility is to be used by Hardinge Holdings GmbH and its subsidiaries (collectively the "Holdings Group") for general corporate and working capital purposes, including standby letters of credit and standby letters of guarantee. Borrowings against the facility can be drawn upon in Swiss Francs, Euros, British Pounds Sterling and United States Dollars ("Optional Currencies"). Under the terms of the facility, the maximum amount of borrowings available to the Holdings Group on an aggregate basis for working capital purposes shall not exceed CHF 8.0 million ($7.8 million equivalent) or its equivalent in Optional Currencies, as applicable. The interest rate on the borrowings drawn in the form of fixed term advances (excluding Euro-based fixed term advances) is calculated based on the applicable LIBOR. With respect to fixed term advances in Euros, the interest rate on borrowings is calculated based on the applicable EURIBOR, plus an applicable margin, (initially set at 2.25% per annum) that is determined by the bank based on the financial performance of the Holdings Group. This facility also charges a commitment fee on the average unutilized amount of the facility of 30% of the applicable margin. At December 31, 2016 and 2015, there were no outstanding borrowings on this facility. The total issued letters of guarantee on this facility had a face value of $5.0 million and $5.4 million at December 31, 2016 and December 31, 2015, respectively. The letters were issued in various currencies. The terms of the credit facility contains customary representations, affirmative, negative and financial covenants and events of default. The credit facility is secured by mortgage notes in an aggregate amount of CHF 9.2 million ($9.0 million equivalent) on two buildings owned by Kellenberger. In addition to the mortgage notes provided by Kellenberger, Holdings Group serves as a guarantor with respect to this facility. The facility is also subject to a minimum equity covenant requirement whereby the equity of both the Holdings Group and Kellenberger must be at least 35% of the subsidiary's balance sheet total assets. At December 31, 2016, the Company was in compliance with the covenants under the loan agreement. Kellenberger also maintains a credit agreement with another bank. This agreement, which was originally entered into in October 2009 was most recently amended in May 2013 and is subject to annual renewal. This agreement provides a credit facility of up to CHF 7.0 million ($6.9 million equivalent) for guarantees, documentary credit and margin cover for foreign exchange trades, of which up to CHF 3.0 million ($2.9 million equivalent) is available for working capital purposes. The facility is secured by the subsidiary's certain real property up to CHF 3.0 million ($2.9 million equivalent). The interest rate, HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 currently at LIBOR plus 2.50% for a 90-day borrowing, is determined by the bank based on the prevailing money and capital market conditions and the bank's assessment of the subsidiary. This facility carries no commitment fees on unused funds. At December 31, 2016 and 2015, there were no working capital borrowings outstanding under this facility. The outstanding letters of guarantee on this facility at December 31, 2016 had a face value of CHF $0.2 million ($0.2 million equivalent). There were no issued letters of guarantee at December 31, 2015. The above credit facility is subject to a minimum equity covenant requirement where the minimum equity for the subsidiary must be at least 35% of its balance sheet total assets. At December 31, 2016, the Company was in compliance with the required covenant. In October 2015, Hardinge China Limited, an indirectly wholly-owned subsidiary in China, entered into a revised credit facility with a bank, subject to annual renewal. This facility, which provides up to $3.0 million for letters of guarantee, required Hardinge China Limited to maintain net worth of at least CNY 22.0 million ($3.2 million equivalent). The facility was amended in August 2016 to remove the net worth requirement for Hardinge China Limited, and expires in August 2017. The total issued letters of guarantee at December 31, 2016 and December 31, 2015 had a face value of CNY 4.2 million ($0.6 million equivalent) and CNY 6.0 million ($0.9 million equivalent), respectively. Domestic Credit Facilities In May 2013, the Company entered into an amended revolving credit facility for $25.0 million with a bank, which includes Hardinge Grinding Group and Forkardt as additional borrowers. The facility matures in April 2018. The interest rate is determined from a pricing grid with LIBOR and base rate options, based on the Company's leverage ratio and was 2.94% and 2.50% at December 31, 2016 and December 31, 2015 respectively. This credit facility is secured by substantially all of the Company's U.S. assets (exclusive of real property), a negative pledge on its worldwide headquarters in Elmira, NY, and a pledge of 65% of our investment in Hardinge Holdings GmbH. The credit facility is guaranteed by Hardinge Technology Inc., one of the Company's wholly-owned subsidiaries, which is the owner of the real property comprising the Company's world headquarters. The credit facility charges a 0.25% commitment fee on unused funds and does not include any financial covenants. There were no borrowings outstanding under this facility at December 31, 2016 and 2015. Letters of guarantee outstanding under this facility had a face value of $1.1 million and $0.9 million at December 31, 2016 and December 31, 2015, respectively. The Company has a $3.0 million unsecured short-term line of credit from a bank with an interest rate based on the prime rate with a floor of 5.0% and a ceiling of 16.0%. The agreement is negotiated annually, requires no commitment fee and is payable on demand. Outstanding borrowings on this line of credit were immaterial at December 31, 2016 and there were no outstanding borrowings on this line of credit at December 31, 2015. The Company maintains a standby letter of credit for potential liabilities pertaining to self-insured workers compensation exposure, which is renewed annually. The amount of the letter of credit was $0.7 million at December 31, 2016 and December 31, 2015. The letter of credit expires in March 2017. Interest paid in 2016, 2015 and 2014 totaled $0.4 million, $0.3 million and $0.8 million respectively. NOTE 9. RESTRUCTURING CHARGES On August 4, 2015, the Company's Board of Directors approved a strategic restructuring program (the "Program") with the goals of streamlining the Company's cost structure, increasing operational efficiencies and improving shareholder returns. This Program consisted of the consolidation of certain facilities and restructuring of certain business units and is expected to generate annual pre-tax savings in the range of approximately $4.5 million. The Program was completed during 2016, with the exception of severance and pension payments which have been fully reserved. Restructuring charges are included in the "Restructuring charges" line item in the Consolidated Statements of Operations. The table below presents the total costs incurred in connection with the Program, the amount of costs that have HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 been recognized during the twelve months ended December 31, 2016 and 2015 and the cumulative costs recognized by the Program (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The amounts accrued associated with the Program are included in "Accrued expenses" and "Pension and postretirement liabilities" in the Consolidated Balance Sheets. A rollforward of the accrued restructuring costs is presented below (in thousands): NOTE 10. WARRANTIES A reconciliation of the changes in the product warranty accrual, which is included in accrued expenses, is as follows (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 11. INCOME TAXES The Company's pre-tax income (loss) from continuing operations for domestic and foreign sources is as follows (in thousands): Significant components of income tax expense attributable to continuing operations are as follows (in thousands): The following is a reconciliation of income tax expense computed at the United States statutory rate to amounts shown in the Consolidated Statements of Operations: HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Significant components of the Company's deferred tax assets and liabilities are as follows (in thousands): In November 2015, the Financial Accounting Standards Board (“FASB”) issued an accounting standards update with new guidance on simplifying the presentation of deferred income taxes that requires deferred tax assets and liabilities, along with any related valuation allowance, to be classified as non-current on the balance sheet. We adopted the standards update effective December 31, 2016, electing to apply it retrospectively to all periods presented. The below table summarizes the adjustments made to conform prior period classification with the new guidance (in thousands): Non-current deferred tax assets of $3.0 million and $2.4 million for 2016 and 2015, respectively, are reported in "Other non-current assets" in the Consolidated Balance Sheets. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 In 2016, the valuation allowance increased by $1.3 million, of which $0.4 million was due to operational results and $0.9 million of valuation allowance was recorded in other comprehensive income (loss). In 2015, the valuation allowance decreased by $1.1 million, of which $1.0 million was due to operational results and $0.1 million of valuation allowance was recorded in other comprehensive income (loss). At December 31, 2016, there were U.S. federal and state net operating loss carryforwards of $23.9 million and $21.6 million, respectively, which expire from 2028 through 2031. If certain substantial changes in the Company's ownership occur, there would be an annual limitation on the amount of the carryforwards that can be utilized. The U.S. net operating loss includes approximately $2.2 million of the net operating loss carryforwards for which a benefit will be recorded in "Additional paid-in capital" in the Consolidated Balance Sheets when realized. There are Foreign Tax Credit Carryforwards of $7.7 million which expire between 2020 and 2025. There also are foreign net operating loss carryforwards of $47.8 million, of which $11.1 million will expire between 2020 through 2036, and of which $36.7 million have no expiration date. At the end of 2016, the undistributed earnings of the Company's foreign subsidiaries, which amounted to approximately $52.4 million, are considered to be indefinitely reinvested and, accordingly, no provision for taxes has been provided thereon. Given the complexities of the foreign tax credit calculations, it is not practicable to compute the tax liability that would be due upon distribution of those earnings in the form of dividends or liquidation or sale of the foreign subsidiaries. A reconciliation of the beginning and ending amount of uncertain tax positions is as follows (in thousands): If recognized, essentially all of the uncertain tax positions and related interest at December 31, 2016 would be recorded as a benefit to income tax expense on the Consolidated Statements of Operations. It is reasonably possible that certain of the uncertain tax positions pertaining to the foreign operations may change within the next 12 months due to audit settlements and statute of limitations expirations. The estimated change in uncertain tax positions for these items is estimated to be up to $1.0 million. Interest and penalties related to uncertain tax positions are recorded as income tax expense in the Consolidated Statements of Operations. Accrued interest related to the uncertain tax positions was $0.1 million at December 31, 2016 and 2015. There were no accrued penalties related to uncertain tax positions in 2016 and 2015. The accrued interest is reported in other liabilities on the Consolidated Balance Sheets. The tax years 2013, 2014, 2015 and 2016 remain open to examination by the U.S. federal taxing authorities. The tax years 2011 through 2016 remain open to examination by the U.S. state taxing authorities. For other major jurisdictions (Switzerland, U.K., Taiwan, India, Germany, Netherlands and China); the tax years between 2008 and 2016 generally remain open to routine examination by foreign taxing authorities, depending on the jurisdiction. Net taxes paid in 2016, 2015 and 2014 totaled $1.7 million, $1.5 million and $1.9 million, respectively. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 12. COMMITMENTS AND CONTINGENCIES The Company is a defendant in various lawsuits as a result of normal operations and in the ordinary course of business. Management believes the outcome of these lawsuits will not have a material effect on the financial position or results of operations. The Company’s operations are subject to extensive federal, state, local and foreign laws and regulations relating to environmental matters. Certain environmental laws can impose joint and several liability for releases or threatened releases of hazardous substances upon certain statutorily defined parties regardless of fault or the lawfulness of the original activity or disposal. Hazardous substances and adverse environmental effects have been identified with respect to real property owned by the Company, and on adjacent parcels of real property. In particular, the Elmira, NY manufacturing facility is located within the Kentucky Avenue Wellfield on the National Priorities List of hazardous waste sites designated for cleanup by the United States Environmental Protection Agency (“EPA”) because of groundwater contamination. The Kentucky Avenue Wellfield Site (the “Site”) encompasses an area which includes sections of the Town of Horseheads and the Village of Elmira Heights in Chemung County, NY. In February 2006, the Company received a Special Notice Concerning a Remedial Investigation/Feasibility Study (“RI/FS”) for the Koppers Pond (the “Pond”) portion of the Site. The EPA documented the release and threatened release of hazardous substances into the environment at the Site, including releases into and in the vicinity of the Pond. The hazardous substances, including metals and polychlorinated biphenyls, have been detected in sediments in the Pond. Until receipt of this Special Notice in February 2006, the Company had never been named as a potentially responsible party (“PRP”) at the Site nor had the Company received any requests for information from the EPA concerning the Site. Environmental sampling on the Company’s property within this Site under supervision of regulatory authorities had identified off-site sources for such groundwater contamination and sediment contamination in the Pond, and found no evidence that the Company’s operations or property have contributed or are contributing to the contamination. All appropriate insurance carriers have been notified, and the Company is actively cooperating with them, but whether coverage will be available has not yet been determined and possible insurance recovery cannot be estimated with any degree of certainty at this time. A substantial portion of the Pond is located on the Company’s property. The Company, along with Beazer East, Inc., the Village of Horseheads, the Town of Horseheads, the County of Chemung, CBS Corporation and Toshiba America, Inc., (collectively, the "PRP's"), agreed to voluntarily participate in the RI/FS by signing an Administrative Settlement Agreement and Order of Consent on September 29, 2006. On September 29, 2006, the Director of Emergency and Remedial Response Division of the EPA, Region II, approved and executed the Agreement on behalf of the EPA. The PRP's also signed a PRP Member Agreement, agreeing to share the costs associated with the RI/FS study on a per capita basis. The EPA approved the RI/FS Work Plan in May of 2008. In July of 2012 the PRP's submitted a Remedial Investigation (RI) to respond to EPA issues raised in the initial draft RI. In January 2016, the PRP's submitted a draft Feasibility Study (FS), also to respond to issues raised by the EPA about previous drafts of the FS. In July 2016, the EPA announce its proposed remediation plan based on an alternative put forth in a July 2016 Woodruff & Curran FS with an estimated total clean-up phase cost of $1.9 million. The preferred remedy consists of the placement of a continuous six-inch thick soil and sand cap, including a geotextile membrane to act as a demarcation layer, over Koppers Pond. The preferred remedy includes long-term monitoring and institutional controls. After a public comment period the EPA concluded this RI phase of its process documented in a letter in December 2016. The company has $0.3 million as of December 31, 2016 as a reserve for its estimated related liability, assuming all of the PRP's would continue to share costs equally in the clean-up phase of the project. Based on our understanding including discussions with our experts, it is possible that the PRP's may change and/or the relative split of costs may be different for this final phase of the project. However, this will not be known for quite some time, and this ongoing estimate of “7 split equally” is viewed as the best possible estimate at the moment. This reserve is reported in Accrued expenses in the Consolidated Balance Sheets. Based upon information currently available, except as described in the preceding paragraphs, the Company does not have material liabilities for environmental remediation. Though the foregoing reflects the Company’s current assessment as it HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 relates to environmental remediation obligations, it is possible that future remedial requirements or changes in the enforcement of existing laws and regulations, which are subject to extensive regulatory discretion, will result in material liabilities to the Company. The Company had purchase commitments of $23.5 million as of December 31, 2016. The Company leases space for some of the manufacturing, sales and service operations with remaining lease terms of up to 7 years and use certain office equipment and automobiles under lease agreements expiring at various dates. Rent expense under these leases totaled $3.0 million, $3.3 million and $3.2 million, during the years ended December 31, 2016, 2015, and 2014, respectively. At December 31, 2016, future minimum payments under non-cancelable operating leases are as follows (in thousands): The Company has entered into written employment contracts with its executive officers. The current effective term of the employment agreements is one year and the agreements contain an automatic, successive one year extension unless either party provides the other with two months prior notice of termination. In the case of a change in control, as defined in the employment contracts, the term of each officer's employment will be automatically extended for a period of two years following the date of the change in control. These employment contracts also provide for severance payments in the event of specified termination of employment, the amount of which is increased upon certain termination events to the extent such events occur within twelve months following a change in control. NOTE 13. SHAREHOLDERS' EQUITY The Company's common stock has a par value of $0.01 per share. The common stock outstanding activity for each of the years ended December 31, 2016, 2015, and 2014 was as follows (in shares): On August 9, 2013, the Company entered into a sales agreement (the “Agreement”) with an independent sales agent (“Agent”), under which the Company could sell shares of its common stock, par value $0.01 per share (the “Shares”), having an aggregate offering price of up to $25.0 million through the Agent. Under the Agreement, the Agent could sell the Shares by methods deemed to be an “at-the-market” offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended. The Company's Board of Directors authorized this program for a period of one year ending August 8, 2014. As of December 31, 2014, 1,014,252 shares had been sold under the Agreement for aggregated net proceeds of $14.6 million, of HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 which 663,276 of the shares sold were issued from treasury. The Registration Statement under which the shares were being offered expired in April 2016. NOTE 14. EMPLOYEE BENEFITS Pension and Postretirement Plans The Company provides a qualified defined benefit pension plan covering all eligible domestic employees hired before March 1, 2004. The plan bases benefits upon both years of service and earnings through June 15, 2009. The policy is to fund at least an amount necessary to satisfy the minimum funding requirements of ERISA. For the foreign plans, contributions are made on a monthly basis and are governed by their governmental regulations. Each foreign plan requires employer contributions. Additionally, one of the Swiss plans requires employee contributions. In 2010, the accrual of benefits under the domestic plan and one of the foreign plans were permanently frozen. Domestic employees hired on or after March 1, 2004 have retirement benefits under the 401(k) defined contribution plan. After the completion of one year of service, the Company will contribute 4% of an employee's pay and will further match 25% of the first 4% that the employee contributes. For employees participating in the domestic 401(k) plan, the Company made contributions of $1.7 million, $2.0 million, and $1.8 million in 2016, 2015, and 2014, respectively. In conjunction with the permanent freeze of benefit accruals under the domestic defined benefit pension plan, employees that were actively participating in the domestic defined benefit pension plan became eligible to receive company contributions in the 401(k) plan. Additionally, upon reaching age 50, employees who were age 40 or older as of January 1, 2011 and were participants in the domestic defined benefit pension plan are provided enhanced employer contributions in the 401(k) plan to compensate for the loss of future benefit accruals under the defined benefit pension plan. The Company recognized $1.6 million, $2.0 million, and $2.0 million of expense for the domestic defined contribution plan in 2016, 2015, and 2014, respectively. Employees may contribute additional funds to the plan for which there is no required company match. All employer and employee contributions are invested at the direction of the employees in a number of investment alternatives, one being Hardinge Inc. common stock. In 2016, as a result of a significant lump sum benefit paid out of the Switzerland Kellenberger Stiftung Plan, a $0.6 million settlement charge was recognized as of January 31, 2016 in the 2016 net periodic benefit cost. The annual 2016 net periodic benefit cost for this plan has been re-measured as a result of the settlement. In 2015, as a result of a voluntary early retirement program that provided a temporary enhancement under the qualified domestic pension plan, a $0.2 million special termination benefit was recognized in the net period benefit cost. In 2014, as a result of significant lump sum benefits paid out of the Switzerland Pensionskasse L. Kellenberger Plan, a $0.8 million settlement charge was recognized in the net periodic benefit cost. This was offset by a $0.4 million curtailment gain, which was recognized as a result of a significant portion of the active population terminating employment. As a result of the acquisition of the Forkardt operations from Illinois Tool Works in May 2013, the benefit obligations of the Forkardt defined benefit and postretirement medical plans were assumed. These obligations included a Termination Indemnity Plan in France and a Postretirement Medical Plan in the U.S. The Company provides a contributory retiree health plan covering all eligible domestic employees who retire on or after age 65 with at least 10 years of service (the years of service requirement does not apply to individuals hired before 1993). Employees who elect early retirement on or after reaching age 55 are eligible for the medical coverage if they have 15 years of service at retirement. Benefit obligations and funding policies are at the discretion of management. Increases in the cost of the retiree health plan are paid by the participants. The Company also provides a non-contributory life insurance plan to individuals who retire on or after age 65 (or on or after age 55 if they have 15 years of service at retirement). Because the amount of liability relative to this plan is insignificant, it is combined with the health plan for purposes of this disclosure. The discount rate for determining benefit obligations in the postretirement benefits plans was 4.38% and 4.69% at December 31, 2016 and 2015, respectively. The change in the discount rate increased the accumulated postretirement benefit obligation as of December 31, 2016 by $0.1 million. A summary of the pension and postretirement benefits plans' funded status and amounts recognized in the Consolidated Balance Sheets is as follows (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The projected benefit obligations for the foreign pension plans included in the amounts above were $120.2 million and $120.3 million at December 31, 2016 and 2015, respectively. The plan assets for the foreign pension plans included above were $105.1 million and $104.1 million at December 31, 2016 and 2015, respectively. The accumulated benefit obligations for the foreign and domestic pension plans were $232.5 million and $230.2 million at December 31, 2016 and 2015, respectively. The following information is presented for pension plans where the projected benefit obligations exceeded the fair value of plan assets (in thousands): The following information is presented for pension plans where the accumulated benefit obligations exceeded the fair value of plan assets (in thousands): A summary of the components of net periodic benefit cost for the Company, which includes an executive supplemental pension plan, is presented below (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 A summary of the changes in pension and postretirement benefits recognized in other comprehensive (income) loss is presented below (in thousands): The net periodic benefit cost for the foreign pension plans included in the amounts above was $2.1 million, $0.6 million, and $0.7 million, for the years ended December 31, 2016, 2015, and 2014, respectively. The Company expects to recognize $3.7 million of net loss, $0.0 million of net transition assets and $0.3 million of net prior service credit as components of net periodic benefit cost in 2017 for the defined benefit pension plans. The Company expects to recognize $0.04 million of net gain as a component of net periodic benefit cost for the postretirement benefits plans in 2017. Actuarial assumptions used to determine pension costs and other postretirement benefit costs include: Actuarial assumptions used to determine pension obligations and other postretirement benefit obligations include: HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 For the domestic and foreign plans (except for the Taiwan plan), discount rates used to determine the benefit obligations are based on the yields on high grade corporate bonds in each market with maturities matching the projected benefit payments. The discount rate for the Taiwan plan is based on the yield on long-dated government bonds plus a spread. To develop the expected long-term rate of return on assets assumption, for the domestic and foreign plans, management considers the current level of expected returns on least risk investments (primarily government bonds) in each market, the historical level of the risk premium associated with the other asset classes in which the portfolio is invested, and the expectations for future returns of each asset class. The expected return for each asset class was then weighted based on the asset allocation to develop the expected long-term rate of return on assets assumption. The market-related value of assets for the U.S. qualified defined benefit pension plan recognizes asset losses and gains over a five-year period, which the Company believes is consistent with the long-term nature of the pension obligations. Investment Policies and Strategies For the qualified domestic defined benefit pension plan, the plan targets an asset allocation of approximately 55% equity securities, 36% debt securities and 9% other. For the foreign defined benefit pension plans, the plans target blended asset allocation of 38% equity securities, 44% debt securities and 18% other. Given the relatively long horizon of the aggregate obligation, the investment strategy is to improve and maintain the funded status of the domestic and foreign plans over time without exposure to excessive asset value volatility. This risk is managed primarily by maintaining actual asset allocations between equity and fixed income securities for the plans within a specified range of its target asset allocation. In addition, the Company ensures that diversification across various investment subcategories within each plan are also maintained within specified ranges. The domestic and foreign pension assets are managed by outside investment managers and held in trust by third-party custodians. The selection and oversight of these outside service providers is the responsibility of management, investment committees, plan trustees and their advisors. The selection of specific securities is at the discretion of the investment manager and is subject to the provisions set forth by written investment management agreements, related policy guidelines and applicable governmental regulations regarding permissible investments and risk control practices. Contributions The Company's funding policy is to contribute to the defined benefit pension plans when pension laws and economics either require or encourage funding. The Company contributions expected to be paid during the year ended December 31, 2017 to the qualified domestic plan are $2.0 million. The Company contributions expected to be paid during the year ending December 31, 2017 to the foreign defined benefit pension plans are $2.3 million. Additionally, one of the Switzerland plans requires employee contributions. Estimated Future Benefit Payments The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Foreign Operations The Company has employees in certain foreign countries that are covered by defined contribution retirement plans and other employee benefit plans. Related obligations and costs charged to operations for these plans are not material. The foreign entities with defined benefit pension plans are included in the consolidated pension plans described earlier within this footnote. NOTE 15. STOCK-BASED COMPENSATION On May 3, 2011, the Company's shareholders approved the 2011 Incentive Stock Plan (the "Plan"), which was amended on May 6, 2014. The Plan's purpose is to enhance the profitability and value of the Company for the benefit of its shareholders by attracting, retaining, and motivating officers and other key employees who make important contributions to the success of the Company. The Plan initially reserved 750,000 shares of the Company's common stock (as such amount may be adjusted in accordance with the terms of the Plan, the "Authorized Plan Amount") to be issued for grants of several different types of incentives including incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock incentives, and performance share incentives. Any shares of common stock granted under options or stock appreciation rights prior to May 6, 2014 shall be counted against the Authorized Plan Amount on a one-for-one basis and any shares of common stock granted as awards other than options or stock appreciation rights shall be counted against the Authorized Plan Amount as two (2) shares of common stock for every one (1) share of common stock subject to such award. On May 6, 2014, the Company's Board of Directors approved an amendment to the plan to (a) increase the number of shares available for the plan to 1,500,000, and (b) change the ratio of shares of common stock granted as awards other than options or stock appreciation rights to be counted against the Authorized Plan Amount as 1.75 shares of common stock for every one (1) share of common stock subject to such award. Authorized and issued shares of common stock or previously issued shares of common stock purchased by the Company for purposes of the Plan may be issued under the Plan. Stock-based compensation to employees is recorded in "Selling, general and administrative expenses" in the Consolidated Statements of Operations based on the fair value at the grant date of the award. These non-cash compensation costs were included in the "Depreciation and amortization" amounts in the Consolidated Statements of Cash Flows. A summary of stock-based compensation expense is as follows (in thousands): Restricted stock/unit awards, performance share incentives and stock options are the only award types currently outstanding. Restricted stock/unit awards and performance share incentives are discussed below. Stock option activity is not significant. Restricted Stock/Unit Awards Restricted stock/units (the "RSA") are awarded to employees. RSAs vest at the end of the service period and are subject to forfeiture as well as transfer restrictions. During the vesting period, the RSAs are held by the Company and the recipients are entitled to exercise rights pertaining to such shares, including the right to vote such shares. The RSAs are valued based on the closing market price of the Company's common stock on the date of the grant. The deferred compensation is being amortized on a straight-line basis over four years for all outstanding RSAs. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 All outstanding RSAs are unvested. A summary of the RSA activity is as follows (in shares): Performance Share Incentives Performance share incentives ("PSI") are awarded to certain employees. PSIs are expressed as shares of the Company's common stock. They are earned only if the Company meets specific performance targets over the specified performance period. During this period, PSI recipients have no voting rights. When dividends are declared, such dividends are deemed to be paid to the recipients. The Company withholds and accumulates the deemed dividends until such point that the PSIs are earned. If the PSIs are not earned, the accrued dividends are forfeited. The payment of PSIs can be in cash, or in the Company's common stock, or a combination of the two, at the discretion of the Company. The PSIs were first awarded to employees in 2011. The PSIs are valued based on the closing market price of the Company's common stock on the date of the grant. The deferred compensation is being recognized into earnings based on the passage of time and achievement of performance targets. A summary of the PSI activity is as follows (in shares): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 16. CHANGES IN ACCUMULATED OTHER COMPREHENSIVE LOSS Changes in AOCI by component for 2016, 2015 and 2014 are as follows (in thousands): HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 Details about reclassification out of AOCI for the 2016, 2015, and 2014 are as follows (in thousands): ____________________ (a) These AOCI components are included in the computation of net period pension and post retirement costs. See Note 14. "Employee Benefits" for details. NOTE 17. EARNINGS (LOSS) PER SHARE Basic earnings (loss) per share is computed using the weighted average number of shares of common stock outstanding during the period. For diluted earnings (loss) per share, the weighted average number of shares includes common stock equivalents related to stock options and restricted stock. The following table presents the basis of the earnings (loss) per share computation (in thousands): For the year ended December 31, 2016 there were no shares excluded from the calculation of diluted earnings per share. For the years ended December 31, 2015 and December 31, 2014, there were15,995 and 39,752 shares of certain stock-based compensation awards excluded from the calculation of diluted earnings per share, as they were anti-dilutive. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 18. SEGMENT INFORMATION The Company operates through segments for which separate financial information is available, and for which operating results are evaluated regularly by the Company's chief operating decision maker in determining resource allocation and assessing performance. The two reportable business segments are Metalcutting Machine Solutions ("MMS") and Aftermarket Tooling and Accessories ("ATA"). Metalcutting Machine Solutions (MMS) This segment includes operations related to grinding, turning, and milling, as discussed below, and related repair parts. The products are considered to be capital goods with sales prices ranging from approximately forty thousand dollars for some high volume products to around two million dollars for some lower volume grinding machines or other specialty built turnkey systems of multiple machines. Sales are subject to economic cycles and, because they are most often purchased to add manufacturing capacity, the cycles can be severe with customers delaying purchases during down cycles and then aggressively requiring machine deliveries during up cycles. Machines are purchased to a lesser extent during down cycles as customers seek productivity improvements or they have new products that require new machining capabilities. The Company engineers and sells high precision computer controlled metalcutting turning machines, vertical machining centers, horizontal machining centers, grinding machines, and repair parts related to those machines. Turning Machines or lathes are power-driven machines used to remove material from either bar stock or a rough-formed part by moving multiple cutting tools against the surface of a part rotating at very high speeds in a spindle mechanism. The multi-directional movement of the cutting tools allows the part to be shaped to the desired dimensions. On parts produced by Hardinge machines, those dimensions are often measured in millionths of an inch. Management considers Hardinge to be a leader in the field of producing machines capable of consistently and cost-effectively producing parts to very close dimensions. Machining centers are designed to remove material from stationary, prismatic or box-like parts of various shapes with rotating tools that are capable of milling, drilling, tapping, reaming and routing. Machining centers have mechanisms that automatically change tools based on commands from an integrated computer control without operator assistance. Machining centers are generally purchased by the same customers who purchase other Hardinge equipment. The Company supplies a broad line of machining centers under the Bridgeport brand name addressing a range of sizes, speeds, and powers. Grinding machines are used in a machining process in which a part's surface is shaped to closer tolerances with a rotating abrasive wheel or tool. Grinding machines can be used to finish parts of various shapes and sizes. The Kellenberger and Usach grinding machines are used to grind the inside and outside diameters of cylindrical parts. Such grinding machines are typically used to provide a more exact finish on a part that has been partially completed on a lathe. The Hauser jig grinding machines are used to make demanding contour components, primarily for tool and mold-making applications. The Jones & Shipman brand is a line of high quality grinder (surface, creepfeed, and cylindrical) machines used by a wide range of industries. Voumard machines are high quality internal diameter cylindrical grinding systems. Aftermarket Tooling and Accessories (ATA) This segment includes products that are purchased by manufacturers throughout the lives of their machines. The prices of units are relatively low per piece with prices ranging from forty dollars on high volume collets to two hundred thousand dollars or more for specialty chucks, and they typically are considered to be a fairly consumable, but durable, product. The Company's products are used on all types and brands of machine tools, not limited to Hardinge Brand machines. Sales levels are affected by manufacturing cycles, but not as severely as capital goods lines. While customers may not purchase large dollar machines during a down cycle, their factories are operating with their existing equipment and accessories are still needed as they wear out or they are needed for a change in production requirements. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 The two primary product groups are collets and chucks. Collets are cone-shaped metal sleeves used for holding circular or rod like pieces in a lathe or other machine that provide effective part holding and accurate part location during machining operations. Chucks are a specialized clamping device used to hold an object with radial symmetry, especially a cylindrical object. A chuck is most commonly used to hold a rotating tool or a rotating work piece. Some of the specialty chucks can also hold irregularly shaped objects that lack radial symmetry. While the Company's products are known for accuracy and durability, they are consumable in nature. Segment income is measured for internal reporting purposes by excluding corporate expenses, acquisition related charges, impairment charges, interest income, interest expense, and income taxes. Corporate expenses consist primarily of executive employment costs, certain professional fees, and costs associated with the Company’s global headquarters. Financial results for each reportable segment are as follows (in thousands): ____________________ (1) Segment assets primarily consist of restricted cash, accounts receivable, inventories, prepaid and other assets, property, plant and equipment, and intangible assets. Unallocated assets primarily include, cash and cash equivalents, corporate property, plant and equipment, deferred income taxes, and other non-current assets. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 A reconciliation of segment income to consolidated income (loss) from continuing operations before income taxes for the years ended December 31, 2016, 2015, and 2014 are as follows (in thousands): A reconciliation of segment assets to consolidated total assets follows (in thousands): Unallocated assets include cash of $28.3 million, $32.8 million and $16.3 million at December 31, 2016, 2015 and 2014, respectively. No single customer accounted for more than 5% of the consolidated sales in 2016, 2015 or 2014. Products are sold throughout the world and sales are attributed to countries based on the country where the products are shipped. Information concerning the principal geographic areas is follows (in thousands): ____________________ (1) Long-lived assets consist of property, plant and equipment, goodwill, and other intangible assets. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 NOTE 19. SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial information for 2016 and 2015 is as follows (in thousands, except per share data): ____________________ (1) Due to the changes in outstanding shares from quarter to quarter, the total earnings per share of the four quarters may not necessarily equal the earnings per share for the year. NOTE 20. NEW ACCOUNTING STANDARDS In January 2017 the FASB issued Accounting Standards Update ("ASU") No. 2017-01 Business Combinations: Clarifying the Definition of a Business. This guidance revises the definition of a business and may affect acquisitions, disposals, goodwill impairment and consolidation. The new guidance specifies that when substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. The changes to the definition of a business in this guidance will likely result in more acquisitions being accounted for as asset acquisitions and would also affect the accounting for disposal transactions. The new guidance is effective in 2018. Early adoption is permitted. The Company is evaluating the impact that this guidance will have on the financial statements. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 In January 2017 the FASB issued ASU No: 2017-04, Intangibles - Goodwill and Other: Simplifying the Accounting for Goodwill Impairment. This guidance simplifies the accounting for goodwill impairment by eliminating the need to determine the fair value of individual assets and liabilities of a reporting unit to measure the goodwill impairment. The revised guidance is effective for calendar year end 2020. The Company is evaluating the impact that this guidance will have on the financial statements. In October 2016, the FASB issued ASU No. 2016-16, Accounting for Income Taxes: Intra-Entity Asset Transfers of Assets Other than Inventory, which removes the prohibition against the immediate recognition of the current and deferred income tax effects of intra-entity transfers of assets other than inventory. The new guidance is effective in fiscal years beginning after December 15, 2017, including interim periods within those years. The Company is evaluating the impact that this guidance will have on the financial statements. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows - a Consensus of the FASB’s Emerging Issues Task Force, which provides guidance intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows: Restricted Cash, which specifies that amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows. These standards are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company is evaluating the impact that this guidance will have on the financial statements. In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation. The guidance simplifies several areas of accounting for share based compensation arrangements, including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This guidance is expected to impact net income, EPS, and the statement of cash flows. In particular, the tax effects of all stock compensation awards will be included in income. The guidance is effective for public companies in annual periods beginning after December 15, 2016, and interim periods within those years. The Company is evaluating the impact that this guidance will have on the financial statements. In March 2016 the FASB ASU No. 2016-05, Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships. The new guidance clarifies that a change in counterparty to a derivative contract (i.e. a novation), in and of itself, does not require the dedesignation of a hedging relationship provided that all other hedging criteria continue to be met. This guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within fiscal years beginning after December 15, 2018. The Company does not expect that the adoption of this guidance will have a material impact on the financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases, which establishes a comprehensive new lease accounting model. ASU 2016-02 clarifies the definition of a lease, requires a dual approach to lease classification similar to current lease classifications, and requires lessees to recognize leases on the balance sheet as a lease liability with a corresponding right-of-use asset for leases with a lease-term of more than twelve months. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within the fiscal year, and requires modified retrospective application. Early adoption is permitted. The Company is evaluating the impact that this guidance will have on the financial statements. In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities, which amends the guidance on the classification and measurement of financial instruments under the fair value option, as well as the presentation and disclosure requirements for financial instruments. Among other things, the new guidance requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. In addition, the guidance requires public companies to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, to separate presentation of financial assets and financial liabilities by measurement category and form of financial asset, and to eliminate the requirement to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost. The guidance is effective in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is evaluating the method to adopt this guidance and its impact on the financial statements and related disclosures. HARDINGE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2016 In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes. The guidance requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. For public business entities, the guidance is effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Earlier application is permitted. The guidance may be applied either prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. We adopted this guidance in December 2016, electing to apply it retrospectively to all periods presented. As a result, the Company reclassified $2.1 million and $2.2 million from current deferred tax assets and liabilities, respectively, reducing Other current assets and Deferred tax liabilities on the Consolidated Balance Sheets as of December 31, 2015. Non-current deferred tax assets and liabilities increased by $1.9 million and $2.0 million, respectively, resulting in an increase to Other non-current assets and Deferred income taxes on the Consolidate Balance Sheets, as of December 31, 2015. In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory. authoritative guidance on the valuation of inventory. This guidance directs an entity to measure inventory at lower of cost or net realizable value, versus lower of cost or market. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2016, and all annual and interim periods thereafter. The Company uses estimated net realizable value as an approximation of fair value and therefore does not anticipate any changes to our financial statements as a result of this guidance. In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs. This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. In January 2016, the Company adopted the guidance. As a result, the Company reclassified $0.07 million and $0.09 million of debt issuance cost as of December 31, 2015 into Current portion of long-term debt and Long-term debt respectively to reduce the carrying amount of debt liability, from Other current assets and Other non-current assets on the Consolidated Balance Sheets. Unamortized debt issuance costs of $0.07 million and $0.02 million were recorded as Current portion of long-term debt and Long-term debt respectively to reduce the carrying amount of debt liability, on the Consolidated Balance Sheet at December 31, 2016. The Company's debt issuance cost amortization was not affected by the adoption of the new guidance. In August 2014, the FASB issued ASU No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, which requires management to assess a company’s ability to continue as a going concern and to provide related footnote disclosures in certain circumstances. Under the new standard, disclosures are required when conditions give rise to substantial doubt about a company’s ability to continue as a going concern within one year from the financial statement issuance date. The new standard is effective for annual periods ending after December 15, 2016, and all annual and interim periods thereafter. The adoption of this guidance did not have a material impact on the Company's financial statements. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. establishing a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. This update provides a five-step analysis in determining when and how revenue is recognized. The new model will require revenue recognition to depict the transfer of promised goods or services to customers in an amount that reflects the consideration a company expects to receive in exchange for those goods or services and will supersede most of the existing revenue recognition guidance, including industry-specific guidance. We have the option of using either a full retrospective or modified approach to adopt this guidance. Between August 2015 and May 2016, the FASB issued four additional updates to 1) ASU No. 2015-14, Deferral of the Effective Date, 2) ASU No. 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net), 3) ASU No. 2016-10, Identifying Performance Obligations and Licensing, and 4) ASU No. 2016-12, Narrow-Scope Improvements and Practical Expedients to provide further guidance and clarification in accounting for revenue arising from contracts with customers. The new guidance is effective for annual reporting periods beginning after December 15, 2017, and all annual and interim periods thereafter. The Company has not determined the impact this standard may have on the financial statements, nor decided upon the method of adoption. The Company expects to complete a diagnostic assessment and begin developing solutions in the first half of 2017. In the second half of 2017, the Company expects to implement and test any changes in policy, processes, systems and internal controls and compute required transition adjustments and disclosures.
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Based on the provided text, here's a summary of the financial statement excerpt:
Assets:
- Current Assets include prepaid items like insurance, taxes, software licenses, and inventory deposits
- Inventories are valued at the lower of cost (using first-in, first-out method) or market value
- Inventory valuation considers factors like historical usage, future demand, and market requirements
- Property, plant, and equipment are recorded at cost
- Depreciation is calculated using straight-line and accelerated methods
Key Accounting Practices:
- Prepayments are expensed on a straight-line basis
- Inventory carrying value is adjusted based on estimated net realizable value
- Major improvements to assets are capitalized
- Maintenance and repairs are expensed as incurred
Limitations:
- Inventory values may need reduction if future product demand is less favorable than forecasts
Note: The provided text appears to be
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Rockies Region 2007 Limited Partnership Report of Independent Registered Public Accounting Firm To the Partners of the Rockies Region 2007 Limited Partnership: We have audited the accompanying balance sheet of Rockies Region 2007 Limited Partnership (Partnership) as of December 31, 2016 and the related statements of operations, partners’ equity and cash flows for the year then ended. The Partnership’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Partnership is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal controls over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Partnership as of December 31, 2016, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 2 to the financial statements, the Partnership has suffered recurring losses from operations, which raises substantial doubt about its ability to continue as a going concern. Management's plans regarding those matters are described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. As discussed in Note 9 to the financial statements, the Partnership has had significant related party transactions with its Managing General Partner, PDC Energy, Inc., and its subsidiaries. /s/ Schneider Downs and Company, Inc. Pittsburgh, Pennsylvania March 28, 2017 Report of Independent Registered Public Accounting Firm To the Partners of the Rockies Region 2007 Limited Partnership: In our opinion, the accompanying balance sheets and the related statements of operations, partners’ equity, and cash flows present fairly, in all material respects, the financial position of Rockies Region 2007 Limited Partnership at December 31, 2015, and the results of its operations and its cash flows of the period ended December 31, 2015 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 9 to the financial statements, this Partnership has significant related party transactions with this Partnership's Managing General Partner, PDC Energy, Inc., and its subsidiaries. /s/ PricewaterhouseCoopers LLP Denver, Colorado March 25, 2016 Rockies Region 2007 Limited Partnership Balance Sheets See accompanying notes to financial statements. Rockies Region 2007 Limited Partnership Statements of Operations See accompanying notes to financial statements. Rockies Region 2007 Limited Partnership Statements of Partners' Equity For the Years Ended December 31, 2016 and 2015 See accompanying notes to financial statements. Rockies Region 2007 Limited Partnership Statements of Cash Flows See accompanying notes to financial statements. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS NOTE 1 - GENERAL Rockies Region 2007 Limited Partnership was organized in 2007 as a limited partnership, in accordance with the laws of the State of West Virginia, for the purpose of engaging in the exploration and development of crude oil and natural gas properties. Business operations commenced upon closing of an offering for the private placement of Partnership units. Upon funding, this Partnership entered into a D&O Agreement with the Managing General Partner which authorizes PDC to conduct and manage this Partnership's business. In accordance with the terms of the Agreement, the Managing General Partner is authorized to manage all activities of this Partnership and initiates and completes substantially all Partnership transactions. As of December 31, 2016, there were 1,757 Investor Partners in this Partnership. PDC is the designated Managing General Partner of this Partnership and owns a 37 percent Managing General Partner ownership in this Partnership. According to the terms of the Agreement, revenues, costs, and cash distributions of this Partnership are allocated 63 percent to the Investor Partners, which are shared pro rata based upon the number of units in this Partnership, and 37 percent to the Managing General Partner. The Managing General Partner may repurchase Investor Partner units under certain circumstances provided by the Agreement, upon request of an individual Investor Partner. Through December 31, 2016, the Managing General Partner had repurchased 150.3 units of Partnership interests from the Investor Partners at an average price of $2,299 per unit. As of December 31, 2016, the Managing General Partner owned 39.1 percent of this Partnership. The preparation of this Partnership's financial statements in accordance with U.S. GAAP requires the Managing General Partner to make estimates and assumptions that affect the amounts reported in this Partnership's financial statements and accompanying notes. Actual results could differ from those estimates. Estimates which are particularly significant to this Partnership's financial statements include estimates of crude oil, natural gas, and NGLs sales revenue, crude oil, natural gas, and NGLs reserves, future cash flows from crude oil and natural gas properties and impairment of proved properties. NOTE 2 - GOING CONCERN This Partnership has historically funded its operations with cash flows from operations. This Partnership’s most significant cash outlays have related to its operating expenses, capital program and distributions to partners. The market price for crude oil, natural gas, and NGLs decreased significantly during the fourth quarter of 2015, with continued weakness through the first half of 2016 and this Partnership's production and average selling price for 2016 were flat as compared to 2015. While this Partnership generated positive cash flows from operations during 2016, due to anticipated future capital expenditures required to remain in compliance with certain regulatory requirements and to satisfy asset retirement obligations, the Managing General Partner believes that cash flows from operations will be insufficient to meet this Partnership’s obligations. To the extent that the costs of plugging and abandonment activities exceed available cash flows generated by this Partnership's operations, the Managing General Partner expects to fund such activities. The Managing General Partner would recover amounts funded from future cash flows of this Partnership, if available. One of this Partnership's most significant obligations is to the Managing General Partner, which is currently due, for reimbursement of costs paid on behalf of this Partnership by the Managing General Partner. Such amounts are generally paid to third parties for general and administrative expenses and equipment and operating costs, as well as monthly operating fees payable to the Managing General Partner. During 2016 and 2015, this Partnership's quarterly cash distributions to the Managing General Partner or Investor Partners have been declining as compared to prior years and will be suspended beginning in the first quarter of 2017 until such time that cash flows can support the necessary costs of plugging and abandoning the wells that are becoming unproductive or require capital investments that are unsupportable at current commodity prices. The ability of this Partnership to continue as a going concern is dependent upon its ability to attain a satisfactory level of cash flows from operations. Greater cash flow would most likely occur from improved commodity pricing and, to a lesser extent, a sustained increase in production. However, historically, as a result of the normal production decline in a well's production life cycle, this Partnership has not experienced a sustained increase in production without capital expenditures. The Managing General Partner is considering various options to mitigate risks that raise substantial doubt about this Partnership’s ability to continue as a going concern, including, but not limited to, deferral of obligations, continued suspension of distributions to partners, and partial or complete sale of assets. However, there can be no assurance that this Partnership will be able to mitigate such conditions. Failure to do so could result in a partial asset sale or some form of bankruptcy, liquidation, or dissolution of this Partnership. The accompanying financial statements have been prepared on a going concern basis of accounting, which contemplates continuity of operations, realization of assets and satisfaction of liabilities and commitments in the normal course of business. The financial statements do not reflect any adjustments that might result if this Partnership is unable to continue as a going concern. NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The financial statements include only those assets, liabilities, and results of operations of the partners which relate to the business of this Partnership. Cash and Cash Equivalents. This Partnership considers all highly liquid investments with original maturities of three months or less to be cash equivalents. This Partnership maintains substantially all of its cash and cash equivalents in a bank account at one financial institution. The balance in this Partnership's account is insured by Federal Deposit Insurance Corporation, up to $250,000. This Partnership has not experienced losses in any such accounts to date and limits this Partnership's exposure to credit loss by placing its cash and cash equivalents with a high-quality financial institution. Accounts Receivable and Allowance for Doubtful Accounts. This Partnership's accounts receivable are from purchasers of crude oil, natural gas, and NGLs. This Partnership sells substantially all of its crude oil, natural gas, and NGLs to customers who purchase crude oil, natural gas, and NGLs from other partnerships managed by this Partnership's Managing General Partner. The Managing General Partner periodically reviews accounts receivable for credit risks resulting from changes in the financial condition of its customers. In making the estimate for receivables that are uncollectible, the Managing General Partner considers, among other things, subsequent collections, historical write-offs, and overall creditworthiness of this Partnership's customers. It is reasonably possible that the Managing General Partner's estimate of uncollectible receivables will change periodically. Historically, neither PDC, nor any of the other partnerships managed by this Partnership's Managing General Partner, have experienced significant losses from uncollectible accounts receivable. Commitments. As Managing General Partner, PDC maintains performance bonds for plugging, reclaiming, and abandoning of this Partnership's wells as required by governmental agencies. If a government agency were required to access these performance bonds to cover plugging, reclaiming or abandonment costs on a Partnership well, this Partnership would be obligated to fund these expenses. Inventory. Inventory consists of crude oil, stated at the lower of cost to produce or market. Crude Oil and Natural Gas Properties. This Partnership accounts for its crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties and developmental dry hole costs are capitalized and depreciated or depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depreciated or depleted on the unit-of-production method based on estimated proved reserves. This Partnership calculates quarterly DD&A expense by using estimated prior period-end reserves as the denominator, with the exception of this Partnership's fourth quarter where this Partnership uses the year-end reserve estimate adjusted to add back fourth quarter production. Upon the sale or retirement of significant portions of or complete fields of depreciable or depletable property, the net book value thereof, less proceeds or salvage value, is recognized in the statement of operations as a gain or loss. Upon the sale of individual wells, the proceeds are credited to accumulated DD&A. In accordance with the Agreement, all capital contributed to this Partnership, after deducting syndication costs and a one-time management fee, was used solely for the drilling of crude oil and natural gas wells. Proved Reserves. Partnership estimates of proved reserves are based on those quantities of crude oil, natural gas, and NGLs which, by analysis of geoscience and engineering data, are estimated with reasonable certainty to be economically producible in the future from known reservoirs under existing conditions, operating methods and government regulations. Annually, the Managing General Partner engages independent petroleum engineers to prepare a reserve and economic evaluation of this Partnership's properties on a well-by-well basis as of December 31. Additionally, this Partnership adjusts reserves for major well rework or abandonment during the year, as needed. The process of estimating and evaluating crude oil, natural gas, and NGLs reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering, and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur from time to time. Although every reasonable effort is made to ensure that reserve estimates represent this Partnership's most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect this Partnership's DD&A expense, a change in this Partnership's estimated reserves could have an effect on this Partnership's results of operations. Proved Property Impairment. Upon a triggering event, this Partnership assesses its producing crude oil and natural gas properties for possible impairment by comparing net capitalized costs, or carrying value, to estimated undiscounted future net cash flows on a field-by-field basis using estimated production based upon prices at which the Managing General Partner reasonably estimates the commodities to be sold. The estimates of future prices may differ from current market prices of crude oil and natural gas. Certain events, including but not limited to, downward revisions in estimates to this Partnership's reserve quantities, expectations of falling commodity prices or rising operating costs, could result in a triggering event and, therefore, a possible impairment of this Partnership's proved crude oil and natural gas properties. If net capitalized costs exceed undiscounted future net cash flows, a Level 3 fair value input, the measurement of impairment is based on estimated fair value utilizing a future discounted cash flows analysis and is measured by the amount by which the net capitalized costs exceed their fair value. Impairment charges are included in the statement of operations line item "Impairment of crude oil and natural gas properties", with a corresponding reduction to "Crude oil and natural gas properties" and "Accumulated depreciation, depletion, and amortization" line items on the balance sheets. Production Tax Liability. Production tax liability represents estimated taxes, primarily severance, ad valorem and property, to be paid to the states and counties in which this Partnership produces crude oil, natural gas, and NGLs. This Partnership's share of these taxes recorded in the line item "Crude oil, natural gas, and NGLs production costs" on this Partnership's statements of operations. This Partnership's production taxes payable are included in the caption accounts payable and accrued expenses on this Partnership's balance sheets. Income Taxes. Since the taxable income or loss of this Partnership is reported in the separate tax returns of the individual investor partners, no provision has been made for income taxes by this Partnership. Asset Retirement Obligations. This Partnership accounts for asset retirement obligations by recording the fair value of Partnership well plugging and abandonment obligations when incurred, which is at the time the well is spud. Upon initial recognition of an asset retirement obligation, this Partnership increases the carrying amount of the long-lived asset by the same amount as the liability. Over time, the liabilities are accreted for the change in present value. The initial capitalized costs, net of salvage value, are depleted over the useful lives of the related assets through charges to DD&A expense. If the fair value of the estimated asset retirement obligation changes, an adjustment is recorded to both the asset retirement obligation and the asset retirement cost. Revisions in estimated liabilities can result from changes in retirement costs or the estimated timing of settling asset retirement obligations. Revenue Recognition. Crude oil, natural gas, and NGLs revenues are recognized when production is sold to a purchaser at a fixed or determinable price, delivery has occurred, rights, and responsibility of ownership have transferred and collection of revenue is reasonably assured. This Partnership's crude oil, natural gas, and NGLs sales are recorded under either the “net-back” or "gross" method of accounting, depending upon the transportation method used. This Partnership uses the net-back method of accounting for transportation and processing arrangements of this Partnership's sales pursuant to which the transportation and/or processing is provided by or through the purchaser. Under these arrangements, the Managing General Partner sells this Partnership's natural gas at the wellhead and collects a price and recognizes revenues based on the wellhead sales price since transportation and processing costs downstream of the wellhead are incurred by this Partnership's purchasers and reflected in the wellhead price. The majority of this Partnership's natural gas and NGLs is sold by the Managing General Partner on a long-term basis, primarily over the life of the well. Virtually all of the Managing General Partner's contract pricing provisions are tied to a market index, with certain adjustments based on, among other factors, whether a well delivers to a gathering or transmission line and the quality of the natural gas. The net-back method results in the recognition of a sales price that is below the indices for which the production is based. This Partnership uses the gross method of accounting for crude oil delivered through the White Cliffs pipeline as the purchasers do not provide transportation, gathering or processing services. Under this method, this Partnership recognizes revenues based on the gross selling price. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued Recently Adopted Accounting Standard In August 2014, the FASB issued a new standard related to the disclosure of uncertainties about an entity's ability to continue as a going concern. The new standard requires management to assess an entity's ability to continue as a going concern at the end of every reporting period and to provide related footnote disclosures in certain circumstances. The new standard was effective for all entities in the first annual period ending after December 15, 2016, with early adoption permitted. This Partnership adopted this standard in the fourth quarter of 2016. Recently Issued Accounting Standard. In May 2014, the FASB and the International Accounting Standards Board issued their converged standard on revenue recognition that provides a single, comprehensive model that entities will apply to determine the measurement of revenue and timing of when it is recognized. The underlying principle is that an entity will recognize revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. The standard outlines a five-step approach to apply the underlying principle: (a) identify the contract with the customer (b) identify the separate performance obligations in the contract (c) determine the transaction price (d) allocate the transaction price to separate performance obligations and (e) recognize revenue when (or as) each performance obligation is satisfied. In August 2015, the FASB deferred the effective date of the revenue standard to annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The revenue standard can be adopted under the full retrospective method or simplified transition method. Entities are permitted to adopt the revenue standard early, beginning with annual reporting periods after December 15, 2016. The Managing General Partner of this Partnership is currently evaluating the impact these changes will have on this Partnership's financial statements. NOTE 4 - FAIR VALUE OF MEASUREMENTS This Partnership's fair value measurements were estimated pursuant to a fair value hierarchy that requires this Partnership to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. In these cases, the lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability, and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The carrying value of the financial instruments included in current assets and current liabilities approximate fair value due to the short-term maturities of these instruments. NOTE 5 - CONCENTRATION OF RISK Accounts Receivable. This Partnership's accounts receivable are from purchasers of crude oil, natural gas, and NGLs production. This Partnership sells substantially all of its crude oil, natural gas, and NGLs to customers who purchase crude oil, natural gas, and NGLs from this Partnership's Managing General Partner. Inherent to this Partnership's industry is the concentration of crude oil, natural gas, and NGLs sales to a limited number of customers. This industry concentration has the potential to impact this Partnership's overall exposure to credit risk in that its customers may be similarly affected by changes in economic and financial conditions, commodity prices or other conditions. As of December 31, 2016 and 2015, this Partnership did not record an allowance for doubtful accounts and did not incur any losses on accounts receivable. As of December 31, 2016 and 2015, this Partnership had three customers representing 10 percent or more of the accounts receivable balances. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued Major Customers. The following table presents the individual customers constituting 10 percent or more of total revenues: NOTE 6 - ASSET RETIREMENT OBLIGATIONS The following table presents the changes in carrying amounts of the asset retirement obligations associated with this Partnership's working interest in crude oil and natural gas properties: This Partnership's estimated asset retirement obligation liability is based on historical experience in plugging and abandoning wells, estimated economic lives, estimated plugging and abandonment cost, and federal and state regulatory requirements. The liability is discounted using the credit-adjusted risk-free rate estimated at the time the liability is incurred or revised. In 2016, the credit-adjusted risk-free rates used to discount this Partnership's plugging and abandonment liabilities ranged from 6.5 percent to 8.2 percent. In periods subsequent to initial measurement of the liability, this Partnership must recognize period-to-period changes in the liability resulting from the passage of time, revisions to either the amount of the original estimate of undiscounted cash flows or changes in inflation factors and changes to this Partnership's credit-adjusted risk-free rate as market conditions warrant. The revisions in estimated cash flows during 2016 were due to a decrease in the estimated useful life of these wells, which resulted in an increase to the asset retirement obligation liability and a corresponding increase to crude oil and natural gas properties. The revisions in estimated cash flows during 2015 were due to changes in estimates of costs for materials and services related to the plugging and abandonment of certain vertical wells, as well as a decrease in the estimated useful life of these wells. The current portion of the asset retirement obligations relates to 20 to 25 wells that are expected to be plugged and abandoned within the next 12 months. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued NOTE 7 - COMMITMENTS AND CONTINGENCIES Litigation and Legal Items. Neither this Partnership nor PDC, in its capacity as the Managing General Partner of this Partnership, are party to any pending legal proceeding that PDC believes would have a materially adverse effect on this Partnership's business, financial condition, results of operations, or liquidity. Environmental. Due to the nature of the oil and gas industry, this Partnership is exposed to environmental risks. The Managing General Partner has various policies and procedures in place to prevent environmental contamination and mitigate the risks from environmental contamination. The Managing General Partner conducts periodic reviews to identify changes in this Partnership's environmental risk profile. Liabilities are recorded when environmental remediation efforts are probable and the costs can be reasonably estimated. These liabilities are reduced as remediation efforts are completed or are adjusted as a consequence of subsequent periodic reviews. The Managing General Partner is not currently aware of any environmental claims existing as of December 31, 2016 which have not been provided for or would otherwise have a material impact on this Partnership's financial statements; however, there can be no assurance that current regulatory requirements will not change or unknown past non-compliance with environmental laws or other potential sources of liability will not be discovered on this Partnership's properties. In August 2015, the Managing General Partner received an Information Request from the EPA. The Information Request sought, among other things, information related to the design, operation, and maintenance of the Managing General Partner's Wattenberg Field production facilities in the Denver-Julesburg Basin of Colorado. The Information Request focused on historical operation and design information for 46 of the Managing General Partner's production facilities and asks that it conduct sampling and analyses at the identified 46 facilities. These 46 facilities included eight of this Partnership's wells. The Managing General Partner responded to the Information Request in January 2016. Throughout 2016, it continued to meet with the EPA, U.S. Department of Justice, and Colorado Department of Public Health and Environment, and in December 2016 it received a draft consent decree from the EPA. In addition, in December 2015, the Managing General Partner received a Compliance Advisory pursuant to C.R.S. § 25-7-115(2) from the Colorado Department of Public Health and Environment's Air Quality Control Commission's Air Pollution Control Division alleging that the Managing General Partner failed to design, operate, and maintain certain condensate collection, storage, processing, and handling operations to minimize leakage of volatile organic compounds at 65 Wattenberg Field production facilities consistent with applicable standards under Colorado law. These 65 facilities include eight of this Partnership's wells. These eight Partnership wells are the same wells identified in the EPA Information Request noted in the previous paragraph. This matter has been combined with the matter discussed above. The ultimate outcome related to these combined actions has not been determined at this time. NOTE 8 - PARTNERS' EQUITY AND CASH DISTRIBUTIONS Partners' Equity Limited Partner Units. A limited partner unit represents the individual interest of an individual investor partner in this Partnership. No public market exists or will develop for the units. While units of this Partnership are transferable, assignability of the units is limited, requiring the consent of the Managing General Partner. Further, individual investor partners may request that the Managing General Partner repurchase units pursuant to the unit repurchase program described below. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued Allocation of Partners' Interest. The following table presents the participation of the Investor Partners and the Managing General Partner in the revenues and costs of this Partnership: (a) Represents operating costs incurred after the completion of productive wells, including monthly per-well charges paid to the Managing General Partner. (b) The Managing General Partner receives monthly reimbursement from this Partnership for direct costs - general and administrative incurred by the Managing General Partner on behalf of this Partnership. Unit Repurchase Provisions. Investor Partners may request that the Managing General Partner repurchase limited partnership units at any time beginning with the third anniversary of the first cash distribution of this Partnership. The repurchase price is set at a minimum of four times the most recent 12 months of cash distributions from production. In accordance with the Partnership Agreement, the Managing General Partner has elected to suspend cash distributions, beginning in the first quarter of 2017, in order to fund the plugging and abandonment costs of certain Partnership wells. Since the formula for the repurchase price is set at a minimum of four times the most recent 12 months of cash distributions, due to the suspension of cash distributions, starting in the second quarter of 2017, the Managing General Partner will be unable to repurchase units as there is expected to be no value upon which to base the calculation. In any calendar year, the Managing General Partner is conditionally obligated to purchase Investor Partner units aggregating up to 10 percent of the initial subscriptions, if requested by an individual investor partner, subject to PDC's financial ability to do so and upon receipt of opinions of counsel that the repurchase will not cause this Partnership to be treated as a “publicly traded partnership” or result in the termination of this Partnership for federal income tax purposes. If accepted, repurchase requests are fulfilled by the Managing General Partner on a first-come, first-served basis. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued Cash Distributions The Agreement requires the Managing General Partner to distribute cash available for distribution no less frequently than quarterly. Historically, the Managing General Partner has made distributions of Partnership cash on a monthly basis, if funds have been available for distribution. Beginning in the second quarter of 2015, the frequency of cash distributions, if any, was changed to a quarterly basis. Additionally, as the wells have gotten older and the likelihood of plugging and abandonment activities in the foreseeable future has increased, the Managing General Partner has elected to suspend distributions, beginning in the first quarter of 2017, to cover the costs of necessary plugging and abandonment activities. As a result of the impact to the cash distribution policy, if cash were to become available in excess of the plugging and abandonment activities, the Managing General Partner would likely hold cash distributions until the current asset retirement obligations are significantly reduced. Based on current economic conditions, it appears likely that the costs of plugging and abandonment operations will exceed available cash and earnings from this Partnership. The Managing General Partner makes cash distributions of 63 percent to the Investor Partners and 37 percent to the Managing General Partner. Cash distributions began in May 2008. The following table presents the cash distributions made to the Investor Partners and Managing General Partner during the years indicated: NOTE 9 - TRANSACTIONS WITH MANAGING GENERAL PARTNER The Managing General Partner transacts business on behalf of this Partnership under the authority of the D&O Agreement. Revenues and other cash inflows received by the Managing General Partner on behalf of this Partnership are distributed to the partners, net of corresponding operating costs and other cash outflows incurred on behalf of this Partnership. The following table presents transactions with the Managing General Partner reflected in the balance sheets line item “Due to Managing General Partner-other, net” which remain undistributed or unsettled with this Partnership's investors as of the dates indicated: (1) All other unsettled transactions between this Partnership and the Managing General Partner, the majority of which are capital expenditures, operating costs and general and administrative costs which, as of December 31, 2016, have not been deducted from distributions. The following table presents Partnership transactions with the Managing General Partner for the years ended December 31, 2016 and 2015. “Well operations and maintenance” are included in the “Crude oil, natural gas, and NGLs production costs” line item on the statements of operations. (1) Under the D&O Agreement, the Managing General Partner, as operator of the wells, receives payments for well charges and lease operating supplies and maintenance expenses from this Partnership when the wells begin producing. ROCKIES REGION 2007 LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS - Continued Well charges. The Managing General Partner receives reimbursement at actual cost for all direct expenses incurred on behalf of this Partnership, monthly well operating charges for operating and maintaining the wells during producing operations, which reflects a competitive field rate, and a monthly administration charge for Partnership activities. Under the D&O Agreement, PDC provides all necessary labor, vehicles, supervision, management, accounting, and overhead services for normal production operations, and may deduct from Partnership revenues a fixed monthly charge for these services. The charge for these operations and field supervision fees (referred to as “well tending fees”) for each producing well is based on competitive industry field rates, which vary based on areas of operation. The well tending fees and administration fees may be adjusted annually to an amount equal to the rates initially established by the D&O Agreement multiplied by the then current average of the Oil and Gas Extraction Index and the Professional and Technical Services Index, as published by the United States Department of Labor, Bureau of Labor Statistics, provided that the charge may not exceed the rate which would be charged by comparable operators in the area of operations. This average is commonly referred to as the Accounting Procedure Wage Index Adjustment which is published annually by the Council of Petroleum Accountants Societies. These rates are reflective of similar costs incurred by comparable operators in the production field. PDC, in certain circumstances, has and may in the future, provide equipment or supplies, perform salt water disposal services, and other services for this Partnership at the lesser of cost or competitive prices in the area of operations. The Managing General Partner as operator bills non-routine operations and administration costs to this Partnership at its cost. The Managing General Partner may not benefit by inter-positioning itself between this Partnership and the actual provider of operator services. In no event is any consideration received for operator services duplicative of any consideration or reimbursement received under the Agreement. The well operating, or well tending, charges cover all normal and regularly recurring operating expenses for the production, delivery and sale of crude oil, natural gas, and NGLs, such as: • well tending, routine maintenance, and adjustment; • reading meters, recording production, pumping, maintaining appropriate books and records; and • preparing production related reports to this Partnership and government agencies. The well supervision fees do not include costs and expenses related to: • the purchase or repairs of equipment, materials, or third-party services; • the cost of compression and third-party gathering services, or gathering costs; • brine disposal; or • rebuilding of access roads. These costs are charged at the invoice cost of the materials purchased or the third-party services performed. Lease operating supplies and maintenance expense. The Managing General Partner may enter into other transactions with this Partnership for services, supplies, and equipment during the production phase of this Partnership, and is entitled to compensation at competitive prices and terms as determined by reference to charges of unaffiliated companies providing similar services, supplies, and equipment. Management believes these transactions were on terms no less favorable than could have been obtained from non-affiliated third parties. (2) The Managing General Partner is reimbursed by this Partnership for all direct costs expended on this Partnership’s behalf for administrative and professional fees, such as legal expenses, audit fees, and engineering fees for reserve reports. (3) The Agreement provides for the allocation of cash distributions 63 percent to the Investors Partners and 37 percent to the Managing General Partner. The Investor Partner cash distributions during the years ended December 31, 2016 and 2015 include $8,407 and $7,684, respectively, related to equity cash distributions for Investor Partner units that have been repurchased by PDC. NOTE 10 - IMPAIRMENT OF CRUDE OIL AND NATURAL GAS PROPERTIES In 2015, this Partnership recognized an impairment charge of approximately $4.6 million to write-down certain capitalized well costs on its proved crude oil and natural gas properties. The impairment charge represented the amount by which the carrying value of the crude oil and natural gas properties exceeded the estimated fair value, and was therefore not recoverable. The estimated fair value of approximately $1.4 million, excluding estimated salvage value of $0.5 million, was determined based on estimated future discounted net cash flows, a Level 3 input, using estimated production and future crude oil and natural gas prices which the Managing General Partner reasonably expects this Partnership's crude oil and natural gas will be sold and decreased reserve quantities. This Partnership did not record an impairment charge in 2016. ROCKIES REGION 2007 LIMITED PARTNERSHIP Supplemental Crude Oil, Natural Gas and NGLs Information - Unaudited Net Proved Reserves All of this Partnership's crude oil, natural gas and NGLs reserves are located in the U.S. This Partnership utilized the services of an independent petroleum engineer to estimate this Partnership's 2016 and 2015 crude oil, natural gas, and NGLs reserves. As of December 31, 2016 and 2015, all of this Partnership's estimates of proved reserves were based on reserve reports prepared by Ryder Scott Company, L.P. These reserve estimates have been prepared in compliance with professional standards and the reserves definitions prescribed by the SEC. Proved reserves estimates may change, either positively or negatively, as additional information becomes available and as contractual, economic, and political conditions change. This Partnership's net proved reserve estimates have been adjusted as necessary to reflect all contractual agreements, royalty obligations and interests owned by others at the time of the estimate. Proved developed reserves are the quantities of crude oil, natural gas, and NGLs expected to be recovered from currently producing zones under the continuation of present operating methods. Proved undeveloped reserves are those reserves expected to be recovered from existing wells where a relatively major expenditure is required for additional reserve development. As of December 31, 2016 and 2015, there are no proved undeveloped reserves for this Partnership. The following table presents the index prices for our reserves, as required by SEC regulations and are referred to as SEC commodity prices: The following table presents the netted back price used to estimate our reserves, by commodity. The prices used to estimate reserves have been prepared in accordance with SEC commodity prices. Future estimated cash flows were based on a 12-month average price calculated as the unweighted arithmetic average of the prices on the first day of each month, January through December, applied to this Partnership's year-end estimated proved reserves. Prices for each of the two years were adjusted for Btu content, transportation and regional price differences. ROCKIES REGION 2007 LIMITED PARTNERSHIP Supplemental Crude Oil, Natural Gas and NGLs Information - Unaudited The following table presents the changes in estimated quantities of this Partnership's reserves, all of which are located within the United States: 2016 Activity. As of December 31, 2016, this Partnership recorded an upward revision of its previous estimate of proved reserves by approximately 91 MBoe. The revision includes upward revisions to previous estimates of 32 MBbl of crude oil, 190 MMcf of natural gas, and 27 MBbl of NGLs. The upward revisions were the result of reductions in gathering system line pressures, which has enhanced the productive profile of some of this Partnership's wells. There were no proved undeveloped reserves developed in 2016 and no proved undeveloped reserves attributable to this Partnership's assets as of December 31, 2016. 2015 Activity. As of December 31, 2015, this Partnership recorded a downward revision of its previous estimate of proved reserves by approximately 1,069 MBoe. The revision includes downward revisions to previous estimates of 316 MBbl of crude oil, 2,673 MMcf of natural gas, and 307 MBbl of NGLs. The downward revisions were the result of reduced asset performance. There were no proved undeveloped reserves developed in 2015 and no proved undeveloped reserves attributable to this Partnership's assets as of December 31, 2015. Standardized Measure of Discounted Future Net Cash Flows and Changes Therein Relating to Proved Reserves The standardized measure below has been prepared in accordance with U.S. GAAP. Future estimated cash flows were based on a 12-month average price calculated as the unweighted arithmetic average of the prices on the first day of each month, January through December, applied to our year-end estimated proved reserves. Prices for each year were adjusted for Btu content and transportation. Production, development and abandonment costs were based on prices as of December 31 for each of the respective years presented. The amounts shown do not give effect to non-property related expenses, such as corporate general and administrative expenses, or to depreciation, depletion, and amortization expense. No income taxes were considered in the standardized measure as this Partnership is not subject to income tax. The following table presents information with respect to the standardized measure of discounted future net cash flows relating to proved reserves. Changes in the demand for crude oil, natural gas, and NGLs, inflation and other factors make such ROCKIES REGION 2007 LIMITED PARTNERSHIP Supplemental Crude Oil, Natural Gas and NGLs Information - Unaudited estimates inherently imprecise and subject to substantial revision. This table should not be construed to be an estimate of the current market value of our proved reserves. Capitalized Costs and Costs Incurred in Crude Oil and Natural Gas Property Development Activities Crude oil and natural gas development costs include costs incurred to gain access to and prepare development well locations for drilling, drill and equip developmental wells, complete additional production formations or recomplete existing production formations, and provide facilities to extract, treat, gather, and store crude oil and natural gas. This Partnership is engaged solely in crude oil and natural gas activities, all of which are located in the continental United States. Drilling operations began upon funding in August 2007. This Partnership currently owns an undivided working interest in 73 gross (71.9 net) productive crude oil and natural gas wells located in the Wattenberg Field within the Denver-Julesburg Basin, northeast of Denver, Colorado. Aggregate capitalized costs related to crude oil and natural gas development and production activities with applicable accumulated DD&A are presented below: (1) Includes estimated costs associated with this Partnership's asset retirement obligations. From time to time, this Partnership invests in additional equipment which supports treatment, delivery and measurement of crude oil and natural gas or environmental protection. This Partnership may also invest in equipment and services to complete refracturing or recompletion opportunities.
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Based on the provided financial statement excerpt, here's a summary:
Financial Condition:
- The company is experiencing significant financial challenges, with substantial operational losses
- There are serious doubts about the company's ability to continue operating (going concern issue)
- Management has outlined plans to address these challenges in Note 2
Market Context:
- Experienced a significant decrease in market prices for crude oil, natural gas, and NGLs (natural gas liquids) in Q4 2015
- Expenses include operating expenses, capital program, and partner distributions
Financial Instruments:
- Current assets and current liabilities are valued close to fair market value
- This is due to the short-term nature of these financial instruments
Key Concerns:
- Operational losses
- Potential financial instability
- Volatile energy market conditions
Note: A full comprehensive analysis would require reviewing the complete financial statement and referenced notes.
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Claude
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Financial Statement and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS The following financial statements are filed as part of this Annual Report Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Changes in Equity Consolidated Statements of Comprehensive Loss Consolidated Statements of Cash Flows ACCOUNTING FIRM To the Board of Directors and Stockholders of Cavium, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Cavium, Inc. and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. As described in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, management has excluded QLogic Corporation (“QLogic”) from its assessment of internal control over financial reporting as of December 31, 2016 because it was acquired by the Company in a purchase business combination in August 2016. We have also excluded QLogic from our audit of internal control over financial reporting. QLogic is a wholly-owned subsidiary that constituted approximately 18% of the Company’s total assets as of December 31, 2016 and approximately 26% of total revenues for the year ended December 31, 2016. /s/ PricewaterhouseCoopers LLP San Jose, California February 28, 2017 PART I. FINANCIAL INFORMATION Financial Statements CAVIUM, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data) The accompanying notes are an integral part of these consolidated financial statements. CAVIUM, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements. CAVIUM, INC. CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (in thousands, except share data) The accompanying notes are an integral part of these consolidated financial statements. CAVIUM, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (in thousands) The accompanying notes are an integral part of these consolidated financial statements. CAVIUM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) The accompanying notes are an integral part of these consolidated financial statements. CAVIUM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Significant Accounting Policies Organization Cavium, Inc., (the “Company”), was incorporated in the state of California on November 21, 2000 and was reincorporated in the state of Delaware effective February 6, 2007. The Company designs, develops and markets semiconductor processors for intelligent and secure networks. On August 16, 2016, the Company completed the acquisition of QLogic Corporation (“QLogic”). QLogic designs and supplies high performance server and storage networking connectivity products that provide, enhance and manage computer data communication used in enterprise, managed service provider and cloud service provider datacenters. See Note 2 of for further discussion regarding the Company’s acquisition of QLogic. Basis of Consolidation The consolidated financial statements include the accounts of Cavium, Inc. and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. Prior to the closing of the acquisition of Xpliant, Inc. (“Xpliant”) in April 2015 as discussed in Note 2 of , the Company accounted for Xpliant as a variable interest entity, or VIE. Under the accounting principles generally accepted in the United States of America, or US GAAP, a VIE is required to be consolidated by its primary beneficiary. The primary beneficiary is the party that absorbs a majority of the VIE’s anticipated losses and/or a majority of the expected returns. All intercompany transactions and balances have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in its consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis of making judgments about the carrying values of assets and liabilities. Actual results could differ from those estimates. Revenue Recognition The Company primarily derives its revenue from sales of semiconductor products to original contract manufacturers, or OEM, or through OEM’s contract manufacturers or distributors. To a lesser extent, the Company also derive revenue from licensing software and related maintenance and support and from professional service arrangements. The Company recognizes revenue when (i) persuasive evidence of a binding arrangement exists; (ii) delivery has occurred or service has been rendered; (iii) the price is deemed fixed or determinable and free of contingencies and significant uncertainties; and (iv) collectibility is reasonably assured. The Company records a reduction in revenue for provision for estimated sales returns in the same period the related revenues are recorded. These estimates are based on historical patterns of return, analysis of credit memo data and other known factors at the time. The Company also records reductions of revenue for pricing adjustments, such as competitive pricing programs and rebates, in the same period that the related revenue is recorded. The Company accrues the full potential rebates at the time of sale and does not apply a breakage factor. The reversal of the accrual of unclaimed rebate will be made if the specific rebate programs contractually end and when the Company believes that the unclaimed rebates are no longer subject to payment. Revenue is recognized upon shipment to distributors with limited rights of returns and price protection if the Company concludes that it can reasonably estimate the credit for returns and price adjustments issuable. The Company records an estimated allowance, at the time of shipment, based on the Company’s historical patterns of returns and pricing credit of sales recognized upon shipment. Credits issued to distributors or other customers have historically not been material. The inventory at these distributors at the end of the period may fluctuate from time to time mainly due to the OEM production ramps and/or new customer demands. Software arrangements typically include time-based licenses for 12 months with related support. The Company does not sell support separately, therefore, revenue from software arrangements is recognized ratably over the support period. The software arrangement may also include professional services, and these services may be purchased separately. Professional services engagements are billed on either a fixed-fee or time-and-materials basis. For fixed-fee arrangements, professional services revenue is recognized under the proportional performance method, with the associated costs included in cost of revenue. The Company estimates the proportional performance of the arrangements based on an analysis of progress toward completion. The Company periodically evaluates the actual status of each project to ensure that the estimates to complete each contract remain accurate, and a loss is recognized when the total estimated project cost exceeds project revenue. If the amount billed exceeds the amount of revenue recognized, the excess amount is recorded as deferred revenue. Revenue recognized in any period is dependent on progress toward completion of projects in progress. To the extent we are unable to estimate the proportional performance, revenue is recognized on a completed performance basis. Revenue for time-and-materials engagements is recognized as the effort is incurred. For sales that include multiple deliverables, the Company allocates revenue based on the relative selling price of the individual components. When more than one element, such as hardware and services, are contained in a single arrangement, the Company allocates revenue between the elements based on each element’s relative selling price, provided that each element meets the criteria for treatment as a separate unit of accounting. Accounting for Stock-Based Compensation The Company applies the fair value recognition provisions of stock-based compensation. The Company recognizes the fair value of the awards on a straight-line basis over its vesting periods. The Company estimates the grant date fair value of stock options using the Black-Scholes option valuation model. The Black-Scholes option-pricing model used to determine the fair value of stock options requires various subjective assumptions, including expected volatility, expected term and the risk-free interest rates. The stock price volatility assumption is estimated using the Company’s historical stock price volatility. For options granted beginning 2016, the Company used historical exercise patterns to estimate the expected life. Prior to 2016, the Company used the simplified method as permitted by the guidance on stock-based compensation to estimate the expected life since the Company had no sufficient history of weighted average period from the date of grant to exercise, cancellation, or expiration. The risk free interest rate is based on the implied yield currently available on United States. Treasury securities with an equivalent remaining term. The Company recognizes stock-based compensation expense only for the portion of stock options that are expected to vest, based on the Company’s estimated forfeiture rate. For all restricted stock unit, or RSU, grants other than RSU grants with a market condition, the fair value of the RSU grant is based on the market price of the Company’s common stock on the date of grant. For performance-based RSU grants, the Company evaluates the probability of achieving the milestones for each of the outstanding performance-based RSU grants at each reporting period and updates the related stock-based compensation expense. The fair value of market-based RSUs is determined using the Monte Carlo simulation method which takes into account multiple input variables that determine the probability of satisfying the market conditions stipulated in the award. This method requires the input of assumptions, including the expected volatility of the Company’s common stock, and a risk-free interest rate, similar to assumptions used in determining the fair value of the stock option grants discussed above. The grant date fair value of RSUs, less estimated forfeitures, is recorded based upon the vesting method over the service period. Income Taxes The Company accounts for income taxes under the asset and liability method. Under this method, deferred tax assets, including those related to tax loss carryforwards and credits, and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is recorded to reduce deferred tax assets when management cannot conclude that it is more-likely-than-not that the net deferred tax asset will be recovered. The valuation allowance is determined by assessing both positive and negative evidence to determine whether it is more-likely-than-not that deferred tax assets are recoverable; such assessment is required on a jurisdiction-by-jurisdiction basis. The Company recognizes uncertain tax positions when it meets a more-likely-than-not threshold. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits as income tax expense. Business Combinations The Company accounts for business combinations using the purchase method of accounting. The Company determines the recognition of intangible assets based on the following criteria: (i) the intangible asset arises from contractual or other rights; or (ii) the intangible is separable or divisible from the acquired entity and capable of being sold, transferred, licensed, returned or exchanged. In accordance with the guidance provided under business combinations, the Company allocates the purchase price of business combinations to the tangible assets, liabilities and intangible assets acquired, including in-process research and development, or IPR&D, based on their estimated fair values. The excess purchase price over those fair values is recorded as goodwill. The Company’s valuation assumption of acquired assets and assumed liabilities requires significant estimates, especially with respect to intangible assets. The Company estimates the fair value based upon assumptions the Company believes to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed. Acquisition-related costs, including advisory, legal, accounting, valuation and other costs, are expensed in the periods in which the costs are incurred. The results of operations of acquired businesses are included in the consolidated financial statements from the acquisition date. Goodwill and indefinite-lived intangible assets Goodwill is measured as the excess of the cost of an acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets and liabilities assumed. The Company evaluates goodwill for impairment at its single reporting unit level at least on an annual basis in the fourth quarter of the calendar year or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future cash flow. The Company performs a qualitative assessment to determine if any events have occurred or circumstances exist that would indicate that it is more-likely-than-not that a goodwill impairment exists. If any indicators exist based on the qualitative analysis that it is more-likely-than-not that a goodwill impairment exists, the quantitative test is required. Otherwise, no further testing is required. IPR&D acquired in an asset acquisition is capitalized only if it has an alternative future use. IPR&D recorded as an asset acquired through business combinations is not amortized but instead is tested annually for impairment, or more frequently when events or changes in circumstances indicate that the asset might be impaired. The Company initially assesses qualitative factors to determine whether it is more likely than not that the fair value of IPR&D is less than its carrying amount, and if so, the Company conducts a quantitative impairment test. The quantitative impairment test consists of a comparison of the fair value of IPR&D to its carrying amount. If the carrying value exceeds its fair value, an impairment loss is recognized in an amount equal to the difference. When an IPR&D project is complete, the related intangible asset becomes subject to amortization and impairment analysis as a long-lived asset. Long-lived assets The Company reviews long-lived assets, including property and equipment and intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets (or asset group) may not be fully recoverable. Whenever events or changes in circumstances suggest that the carrying amount of long-lived assets may not be recoverable, the Company estimates the future cash flows expected to be generated by the assets (or asset group) from its use or eventual disposition. If the sum of the expected future cash flows is less than the carrying amount of those assets, the Company recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets. Significant management judgment is required in the grouping of long-lived assets and forecasts of future operating results that are used in the discounted cash flow method of valuation. Inventories Inventories consist of work-in-process and finished goods. Inventories not related to an acquisition are stated at the lower of cost (determined using the first-in, first-out method), or market value (estimated net realizable value). Inventories from acquisitions are stated at fair value at the date of acquisition. The Company writes down excess and obsolete inventory based on its age and forecasted demand, generally over a 12 month period, which includes estimates taking into consideration the Company’s outlook on uncertain events such as market and economic conditions, technology changes, new product introductions and changes in strategic direction. Actual demand may differ from forecasted demand and such differences may have a material effect on recorded inventory values. Inventory write-downs are not reversed until the related inventories have been sold or scrapped. Inventories acquired through business combinations are recorded at their acquisition date fair value, which is the estimated selling price less the costs of disposal and a normal profit allowance. Property and Equipment Property and equipment are stated at cost and depreciated over their estimated useful lives using the straight-line method. Leasehold improvements are amortized over the shorter of estimated useful lives or unexpired lease term. Additions and improvements that increase the value or extend the life of an asset are capitalized. Upon retirement or sale, the cost of assets disposed of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is credited or charged to income. Ordinary repairs and maintenance costs are expensed as incurred. The Company capitalizes the cost of fabrication masks that are reasonably expected to be used during production manufacturing. Such amounts are included within property and equipment and are depreciated over a period of 12 to 24 months and recorded as a component of cost of revenue. If the Company does not reasonably expect to use the fabrication mask during production manufacturing, the related mask costs are expensed to research and development in the period in which the costs are incurred. The Company leases certain design tools under financing arrangements which are included in property and equipment. The Company also capitalizes acquired internally used software in property and equipment. Subsequent additions, modifications or upgrades to internally used software are capitalized to the extent it provides additional usage or functionality. Fair Value Measurements Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs that may be used to measure fair value. The first two levels of inputs are considered observable and the last unobservable. A description of the three levels of inputs is as follows: • Level 1 - Quoted prices in active markets for identical assets or liabilities. • Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. • Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Cash and Cash Equivalents The Company considers all highly liquid investments with an original or remaining maturity of 90 days or less at the date of purchase to be cash equivalents. Cash equivalents consist of an investment in a money market fund. Allowance for Doubtful Accounts The Company reviews its allowance for doubtful accounts by assessing individual accounts receivable over a specific age and amount. The Company’s allowance for doubtful accounts were not significant as of December 31, 2016 and 2015. Concentration of Risk The Company’s products are currently manufactured, assembled and tested by third-party contractors in Asia. There are no long-term agreements with any of these contractors. A significant disruption in the operations of one or more of these contractors would impact the production of the Company’s products for a substantial period of time, which could have a material adverse effect on the Company’s business, financial condition and results of operations. Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash, cash equivalents and accounts receivable. The Company deposits cash with credit worthy financial institutions. The Company has not experienced any losses on its deposits of cash. Management believes that the financial institutions the Company utilizes are reputable and, accordingly, minimal credit risk exists. The Company’s cash equivalents are invested in a money market fund. The Company follows an established investment policy and set of guidelines to monitor, manage and limit the Company’s exposure to interest rate and credit risk. The policy sets forth credit quality standards and limits the Company’s exposure to any one issuer, as well as the maximum exposure to various asset classes. A majority of the Company’s accounts receivable are derived from customers headquartered in the United States. The Company performs ongoing credit evaluations of its customers’ financial condition and, generally, requires no collateral from its customers. The Company provides an allowance for doubtful accounts receivable based upon the expected collectability of accounts receivable. Summarized below are individual customers whose accounts receivable balances were 10% or higher of the consolidated gross receivable: * Represents less than 10% of the gross accounts receivable for the respective period end. Summarized below are individual OEM customers whose revenue balances were 10% or higher of the consolidated net revenue: * Represents less than 10% of the net revenue for the respective year ended Deferred revenue The Company records deferred revenue for customer billings and advance payments received from customers before the performance obligations have been completed and/or services have been performed for products and/or service related agreements. The Company records deferred revenue, net of deferred costs on shipments to sell-through distributors. Warranty Accrual The Company’s products are generally subject to a one-year warranty period though certain products carry a warranty for up to three years. The Company records a liability for product warranty obligations in the period the related revenue is recorded based on historical warranty experience. Research and Development Research and development costs are expensed as incurred and primarily include personnel costs, prototype expenses, which include the cost of fabrication mask costs not reasonably expected to be used in production manufacturing, and allocated facilities costs as well as depreciation of equipment used in research and development. Deferred Research and Development Cost Occasionally, the Company receives funding from third party companies for certain collaboration research and development. The Company records the funding received as deferred research and development costs within accrued expense and other liabilities. The liability for deferred research and development cost will be reduced over time to offset the research and development expenses incurred by the Company related to such funding. Advertising The Company expenses advertising costs as incurred. Advertising expenses were $2.8 million, $2.5 million and $1.8 million for the years ended December 31, 2016, 2015 and 2014, respectively. Operating Leases The Company recognizes rent expense on a straight-line basis over the term of the lease. The difference between rent expense and rent paid is recorded as deferred rent in accrued expenses and other current and non-current liabilities on the consolidated balance sheets. Other Comprehensive Income (Loss) Comprehensive income (loss) includes all changes in equity other than transactions with stockholders. The Company’s accumulated other comprehensive loss consists of foreign currency translation adjustments. Foreign Currency Remeasurement Certain of the Company’s foreign subsidiaries utilize a functional currency other than United States dollars. Assets and liabilities of these subsidiaries are translated to United States dollars at exchange rates in effect at the balance sheet date, and income and expenses are translated at average exchange rates during the period. The resulting translation adjustments are recorded as a component of accumulated other comprehensive income (loss). Gains and losses resulting from transactions denominated in currencies other than the functional currency are included in other, net in the consolidated statements of operations were not material for the years ended December 31, 2016, 2015 and 2014. Recently Adopted Accounting Standards In January 2017, the FASB issued an update to the guidance on business combinations to clarify the definition of a business. This new guidance provides a more robust framework to use in determining when a set of assets and activities is a business. This new standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The new standard should be applied prospectively on or after the effective date. Early adoption of this new standard is allowed for transactions for which the acquisition date occurs before the issuance date or effective date of the amendments, only when the transaction has not been reported in financial statements that have been issued or made available for issuance. The Company early adopted this new guidance effective on its December 31, 2016 financial reporting. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements and related disclosures. In September 2015, the FASB issued an update to the business combinations standards simplifying the accounting for measurement period adjustments. The amendments in this update require that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments in this update require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The amendments in this update require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The update is effective for interim and annual periods beginning after December 15, 2015. The amendments in this update should be applied prospectively to adjustments to provisional amounts that occur after the effective date of this update with earlier application permitted for financial statements that have not been issued. The Company adopted this new guidance effective during its fourth quarter ended December 31, 2016. See Note 2 of for discussion of measurement period adjustments relating to the QLogic acquisition. In April 2015, the FASB issued an update simplifying the presentation of debt issuance cost. This new guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The new standard is effective for fiscal years beginning after December 15, 2015 and interim periods within those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. The Company adopted this guidance during fiscal 2016 and has presented debt issuance costs as a direct deduction from the related debt liability. Recently Issued Accounting Standards Not Yet Effective In January 2017, the FASB issued an update to the guidance to simplify the measurement of goodwill by eliminating the Step 2 impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. The new guidance requires an entity to compare the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The update is effective for goodwill impairment test in fiscal years beginning after December 15, 2019, though early adoption is permitted. The Company is currently assessing the impact of this new guidance. In November 2016, the FASB issued an update to the guidance on statement of cash flows - restricted cash presentation. This new guidance which requires entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flow. This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period, but any adjustments must be reflected as of the beginning of the fiscal year that includes that interim period. The new standard must be adopted retrospectively. Upon adoption, the Company will present its statement of cash flows in accordance with this updated guidance. In October 2016, the FASB, issued an update to guidance on income taxes. This new guidance requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. This new guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted as of the beginning of an annual reporting period for which financial statements have not been issued or made available for issuance. The Company is currently evaluating the adoption date and the impact, if any, adoption will have on its financial position and results of operations. In August 2016, the FASB, issued a new guidance on cash flow classification of certain cash receipts and cash payments. This new guidance will make eight targeted changes to how cash receipts and cash payments are presented and classified in the statement of cash flows. The eight specific cash flow issues include: (i) debt prepayment or debt extinguishment costs, (ii) settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effecting interest rate of the borrowing, (iii) contingent consideration payments made after a business combination, (iv) proceeds from settlement of insurance claims, (v) proceeds from the settlement of corporate-owned life insurance policies, (vi) distributions received from equity method investees, (vii) beneficial interests in securitization transactions, and (viii) separately identifiable cash flows and application of the predominance principle. This new guidance is effective for fiscal years beginning after December 15, 2017 including interim periods during the annual period and require adoption on a retrospective basis unless it is impracticable to apply, in which case it would be required to apply the amendments prospectively as of the earliest date practicable. Early adoption is permitted. The Company will present its statement of cash flows in accordance with this guidance subsequent to adoption. In June 2016 the FASB issued an updated guidance on measurement of credit losses on financial instruments. This updated guidance introduces a new forward-looking approach, based on expected losses, to estimate credit losses on certain types of financial instruments, including trade receivables. The estimate of expected credit losses will require entities to incorporate considerations of historical information, current information and reasonable and supportable forecasts. This updated guidance also expands the disclosure requirements to enable users of financial statements to understand the entity’s assumptions, models and methods for estimating expected credit losses. This new guidance is effective for fiscal years beginning after December 15, 2020 including interim periods during the annual period. Early adoption is permitted for fiscal years beginning after December 15, 2015 including interim periods during the annual period. The Company is currently evaluating the impact of this updated guidance on its consolidated financial statements and related disclosures. In March 2016, the FASB issued an update to the guidance on stock-based compensation. Under the new guidance, all excess tax benefits and tax deficiencies will be recognized in the income statement as they occur. This will replace the current guidance, which requires tax benefits that exceed compensation cost (windfalls) to be recognized in equity. It will also eliminate the need to maintain a “windfall pool,” and will remove the requirement to delay recognizing a windfall until it reduces current taxes payable. The new guidance will also change the cash flow presentation of excess tax benefits, classifying them as operating inflows, consistent with other cash flows related to income taxes. Today, windfalls are classified as financing activities. Also, most companies with stock-based compensation will show additional dilutive effects in earnings per share, or EPS, calculations. This is because there will no longer be excess tax benefits recognized in additional paid in capital. Today those excess tax benefits are included in assumed proceeds from applying the treasury stock method when computing diluted EPS. Under the amended guidance, companies will be able to make an accounting policy election to either (1) continue to estimate forfeitures or (2) account for forfeitures as they occur. This updated guidance is effective for annual and interim periods beginning after December 15, 2016. Early adoption is permitted. Although the Company is currently evaluating the effect of this new guidance, the Company does not expect to have a material impact on its consolidated financial statements and related disclosures upon adoption of this standard. In February 2016, the FASB issued updated guidance on leases which requires a lessee to recognize the assets and lease liabilities on the balance sheet for certain leases classified as operating leases under previous GAAP. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from previous GAAP. This updated guidance is effective for annual and interim periods beginning after December 15, 2018. Early adoption is permitted. Although the Company is currently evaluating the impact this new guidance will have on its consolidated financial statements and related disclosures, the Company expects that most of its operating lease commitments will be subject to the new standard and will be recognized as operating lease liabilities and right-of-use assets upon adoption. In January 2016, the FASB issued an updated guidance on Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this updated guidance, among other things, requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. It requires entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. Further, it requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables). It also eliminates the requirement for entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this updated guidance are effective for annual and interim periods beginning after December 15, 2017. Early adoption is not permitted. The adoption of this updated guidance is not expected to have a material effect on the Company’s consolidated financial statements and related disclosures. In July 2015, the FASB issued guidance to simplify the measurement of inventory. The updated standard more closely aligns the measurement of inventory with that of International Financial Reporting Standards and amends the measurement standard from lower of cost or market to lower of cost or net realizable value. The new guidance is effective for fiscal years beginning after December 15, 2016, including interim periods during the annual period and requires a prospective approach to adoption. Early adoption is permitted. The Company does not expect that this guidance will have a material impact on its consolidated financial statements. In May 2014, the FASB issued a new guidance on the recognition of revenue from contracts with customers, which includes a single set of rules and criteria for revenue recognition to be used across all industries. Under the new revenue guidance, revenue will be recognized when an entity satisfies a performance obligation by transferring control of a promised good or service to a customer in an amount that reflects the consideration to which the entity expects to be entitled for that good or service. The amended guidance also requires additional quantitative and qualitative disclosures. In 2016, the FASB issued several amendments to the standard, these amendments are intended to address implementation issues that were raised by stakeholders and provide additional practical expedients to reduce the cost and complexity of applying the new revenue standard. These amendments have the same effective date as the new revenue standard. This new guidance, as amended is effective for annual reporting periods beginning after December 15, 2017, including interim periods during the annual period. Early adoption is allowed for annual reporting periods beginning after December 15, 2016. This new guidance may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company intends to adopt this standard using the modified retrospective method and is currently evaluating the impact of the adoption of this guidance on its consolidated financial statements. Based on a preliminary assessment, the Company does not expect the adoption of this new guidance to have a material impact on the Company’s consolidated financial statements. As the Company continues its assessment of the impact of the new guidance on its various arrangements with customers, it may identify additional areas of impact as well as revise the results of the preliminary assessment. 2. Business Combinations QLogic Corporation On August 16, 2016, pursuant to the terms of an Agreement and Plan of Merger dated June 15, 2016, by and among the Company, Quasar Acquisition Corp. (a wholly owned subsidiary of the Company) and QLogic (the “QLogic merger agreement”), the Company acquired all outstanding shares of common stock of QLogic (the “QLogic shares”) pursuant to an exchange offer for $11.00 per share in cash and 0.098 of a share of the Company’s common stock for each share of QLogic stock (“Transaction Consideration”) followed by a merger. The acquisition was funded with a combination of cash and proceeds from debt financing. See Note 11 of for discussion of the debt financing. The following table summarizes the total acquisition consideration (in thousands, except shares and per share data): Pursuant to the QLogic merger agreement, the Company assumed the unvested equity awards originally granted by QLogic and converted them into the Company’s equivalent awards. The portion of the fair value of partially vested awards associated with prior service of QLogic employees represented a component of the total consideration, as presented above. The Company also made cash payments for vested and in the money stock options and for the fractional shares that resulted from conversion as specified in the QLogic merger agreement. The Company allocated the acquisition consideration to tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The fair value of the acquired tangible and identifiable intangible assets were determined based on inputs that are unobservable and significant to the overall fair value measurement. It is also based on estimates and assumptions made by management at the time of the acquisition. As such, this was classified as Level 3 fair value hierarchy measurements and disclosures. The purchase price allocation presented below is preliminary, primarily with respect to tax contingency matters. The Company continues to reevaluate the items with any adjustments to its preliminary estimates being recognized as goodwill provided that it is within the measurement period (which will not exceed 12 months from the acquisition date). As additional information becomes available, the Company may further revise its preliminary purchase price allocation during the remainder of the measurement period. Any such revisions or changes to the preliminary purchase price allocation may be material. The Company recorded QLogic’s tangible and intangible assets and liabilities based on their estimated fair values as of the acquisition date and allocated the remaining acquisition consideration to goodwill. The allocation is as follows: (1) As reported in the Company’s September 30, 2016 Quarterly Report on Form 10-Q. (2) The Company obtained new information regarding the valuation of inventories as of the acquisition date which led to an increase in fair value of inventories, and a corresponding decrease in goodwill. (3) The Company obtained new information regarding the valuation of property and equipment as of the acquisition date which led to a net decrease in the fair value of property and equipment, and a corresponding increase in goodwill. This measurement adjustment was mainly related to the acquired real property which was classified as held for sale asset as of September 30, 2016. (4) The Company obtained new information regarding the valuation of intangible assets as of the acquisition date which led to a net increase in the fair value of intangible assets, and a corresponding decrease in goodwill. (5) The changes to the deferred tax liability, accrued expenses and other current and non-current liabilities pertains to tax related purchase price allocation adjustments. The Company obtained additional information related to its deferred income taxes which led to a decrease in the net deferred tax liability, and a corresponding decrease in goodwill. See detailed discussion below. The Company does not believe that the measurement period adjustments to inventory, property and equipment, intangibles accrued expense and other current and non-current liabilities had a material impact on its consolidated statement of operations, balance sheet or cash flow previously reported on Form 10-Q as of and for the quarter ended September 30, 2016. During the third quarter of 2016 upon closing of the acquisition, the Company recorded a partial release of its net deferred tax assets valuation allowance primarily due to a net deferred tax liability recorded for purchased intangibles and recognized a $82.9 million tax benefit in the third quarter of 2016. During the fourth quarter of 2016, the Company was able to assess and measure an additional deferred tax asset that existed as of the acquisition date of QLogic. Due to the identification of this additional deferred tax asset, the Company made adjustments during the fourth quarter of 2016 to certain tax balances including the reversal of the partial release of the valuation allowance recorded in the third quarter, resulting in an adjustment to goodwill of $78.5 million. The valuation of identifiable intangible assets and their estimated useful lives are as follows: The IPR&D consists of two projects relating to the development of process technologies to manufacture next generation Fibre Channel and Ethernet products. The projects are estimated to be completed in fiscal years 2017 and 2019 for the related Ethernet and Fibre Channel products, respectively. The estimated remaining cost to complete the IPR&D projects were $112.2 million as of the acquisition date. The fair value of existing and core technology and IPR&D was determined by performing a discounted cash flow analysis using the multi period excess earnings approach. This method includes discounting the projected cash flows associated with each technology over its expected life. Projected cash flows attributable to the existing and core technology and IPR&D were discounted to their present value at a rate commensurate with the perceived risk. The IPR&D will be accounted for as an indefinite-lived intangible asset until the underlying projects are completed or abandoned. The IPR&D will not be amortized until the completion of the related products which is determined by when the underlying projects reached technological feasibility. Upon completion, the IPR&D will be amortized over its estimated useful life; useful lives for IPR&D are expected to range between 5 to 6 years. The valuation of customer relationships was based on the distributor method, taking into account the profit margin a market participant distributor would obtain in selling QLogic products. The useful lives of customer relationships are estimated based upon customer turnover data and management estimates. Other identifiable intangible assets consisted of tradename and trademark, valued using a relief from royalty method. The useful lives of tradename and trademark are expected to correlate to the life of the technology or customer relationships. The assumptions used in forecasting cash flows for each of the identified intangible assets included consideration of the following: • Historical performance including sales and profitability. • Business prospects and industry expectations • Estimated economic life of asset • Development of new technologies • Acquisition of new customers and attrition of existing customers • Obsolescence of technology over time Depending on the structure of a particular acquisition, goodwill and identifiable intangible assets may not be deductible for tax purposes. Goodwill recorded in the QLogic acquisition is not expected to be deductible for tax purposes. The factors that contributed to the recognized goodwill with the acquisition of QLogic include the Company’s belief that the acquisition will create a more diverse semiconductor company with expansive offerings which will enable the Company to expand its product offerings and expected synergies from the combined operations of the Company and QLogic. The Company incurred $16.6 million in acquisition related costs which were recorded in selling, general and administrative expense in the consolidated statements of operations in the year ended December 31, 2016. Unaudited Supplemental Pro Forma Information The unaudited supplemental pro forma financial information presented below is for illustrative purposes only and is not necessarily indicative of the financial operations or results of operations that would have been realized if the acquisition had been completed on the date indicated, does not reflect synergies that might have been achieved, nor is it indicative of future operating results or financial position. The pro forma adjustments are based upon currently available information and certain assumptions the Company believe are reasonable under the circumstances. The following unaudited supplemental pro forma financial information summarizes the results of operations for the periods presented, as if the acquisition was completed on January 1, 2015. The unaudited supplemental pro forma information reports actual operating results, adjusted to include the pro forma effect of certain fair value adjustments for acquired items, such as the amortization of identifiable intangible assets, depreciation of property and equipment and inventories. It also includes pro forma adjustments for stock-based compensation expense related to replacement equity awards, interest expense on debt and the related tax effects of the acquisition. In accordance with the pro forma acquisition date, the Company recorded in the year ended December 31, 2015 supplemental pro forma financial information the cost of goods sold of $23.3 million from the fair value mark-up in acquired inventory and $40.9 million for the acquisition-related transaction costs incurred by the Company and QLogic. The corresponding adjustments to the supplemental pro forma financial information in the year ended December 31, 2016 were made for the aforementioned pro forma adjustments. QLogic constituted approximately 26% of the consolidated net revenue for the year ended December 31, 2016. Post-acquisition income (loss) on a standalone basis is impracticable to determine as, on the acquisition date, the Company implemented a plan developed prior to the completion of the acquisition and began to immediately integrate QLogic into the Company’s existing operations, engineering groups, sales distribution networks and management structure. The supplemental pro forma financial information for the periods presented is as follows: Xpliant, Inc. Pursuant to the Agreement and Plan of Merger and Reorganization (the “Xpliant merger agreement”) between the Company and Xpliant, Inc., a final closing occurred on April 29, 2015 as discussed in detail below. Between May 2012 and March 2015, the Company entered into several note purchase agreements and promissory notes with Xpliant to provide cash advances. Xpliant was a Delaware incorporated and privately held company, engaged in the design and development of next generation software defined network switch chips. Prior to the closing of the merger pursuant to the Xpliant merger agreement, the Company concluded that Xpliant was a VIE as the Company was Xpliant’s primary beneficiary due to the Company’s involvement with Xpliant and the Company’s purchase option to acquire Xpliant. As such, the Company has included the accounts of Xpliant in the consolidated financial statements. The Company had made total cash advances of $85.8 million, consisting of $10.0 million under nine convertible notes which, as amended, matured on August 31, 2014 and $75.8 million under several promissory notes which matured between April 2015 and March 2016. All promissory notes were cancelled as of July 31, 2015. The convertible notes and promissory notes bore an annual interest rate of 6%. In addition to the funding received by Xpliant from the Company, between May 2012 and January 2014, certain third party investors (“non-controlling interest”) made cash advances of $13.0 million under several convertible notes which, as amended, matured on August 31, 2014 and $2.9 million under a convertible security. All of the convertible notes bore interest at a rate of 6%, payable at maturity. Two of the convertible notes held by a third party investor with a principal amount of $1.0 million matured and were paid by Xpliant in December 2013. Pursuant to the convertible notes, in the event Xpliant closed a corporate transaction, as defined in the convertible notes, the holders of the convertible notes were entitled to receive two times the outstanding principal plus any unpaid accrued interest. The convertible security had the same features as the convertible notes, with the exception of the requirement for repayment, interest and maturity. For accounting purposes, the Company determined that the convertible security had derivative features and determined that the fair value of the derivative features of the convertible security at the issuance date was approximately the same as the principal amount. All of the convertible notes and the derivative feature of convertible security were classified as Level 3 liability and were all remeasured and presented at fair value in the consolidated financial statements at each reporting period. Pursuant to the option to acquire Xpliant, in June 2014, the Company provided notice to Xpliant of its decision to exercise the purchase option. Therefore, the convertible notes and derivative features of convertible security were valued to two times its principal amount at its maturity date. As such, the Company recorded the change in estimated fair value of notes payable and other of $14.9 million in the consolidated statement of operations in 2014. Pursuant to the Xpliant merger agreement between the Company and Xpliant as discussed in detail below, in October 2014, a portion of the cash advances made by the Company to Xpliant were used to settle all outstanding convertible notes, related accrued interest and convertible security held by non-controlling interest. Pursuant to the Xpliant merger agreement and in connection with the transaction contemplated by the Xpliant merger agreement, in October 2014, a portion of the cash advances made by the Company to Xpliant were used to settle all outstanding convertible notes, related accrued interest and the convertible security held by non-controlling interest of $30.8 million. On July 30, 2014, the Company entered into the Xpliant merger agreement, which was amended on October 8, 2014 and March 31, 2015 with Xpliant. Under the terms of the Xpliant merger agreement, as amended, the Company paid approximately $3.6 million in total cash consideration in exchange for all outstanding securities held by Xpliant’s stockholders. Pursuant to the Xpliant merger agreement, as amended, a first closing occurred on March 31, 2015 and the Company paid $2.5 million to Xpliant’s stockholders with respect to approximately 70% of the Xpliant stock outstanding and a second and final closing occurred on April 29, 2015 and the Company paid $1.1 million to Xpliant’s stockholders with respect to the then remaining approximately 30% of the Xpliant stock outstanding. Based on the substance of the transaction, the Company recorded the payments of cash consideration to Xpliant stockholders as a decrease to the Company’s additional paid-in capital within stockholders’ equity. Prior to the closing of the merger pursuant to the Xpliant merger agreement and the settlement of the outstanding convertible notes and convertible security to non-controlling interest, the net loss of Xpliant was allocated to the Company and to the non-controlling interest based on the outstanding cash advances provided to Xpliant at each reporting period. 3. Net Loss Per Common Share Basic net income (loss) per share is computed using the weighted-average common shares outstanding. Diluted net income per share is computed using the weighted-average common shares outstanding and any dilutive potential common shares. Diluted net loss per common share is computed using the weighted-average common shares outstanding and excludes all dilutive potential common shares when the Company is in a net loss position their inclusion would be anti-dilutive. The Company’s dilutive securities primarily include stock options and restricted stock units. The following outstanding options and restricted stock units were excluded from the computation of diluted net loss per common share for the periods presented because including them would have had an anti-dilutive effect: 4. Fair Value Measurements At December 31, 2016 and 2015, the Company’s cash equivalents comprised of an investment in a money market fund. In accordance with the guidance for fair value measurements and disclosures, the Company determined the fair value hierarchy of its money market fund as Level 1, which approximated $61.4 million and $102.2 million as of December 31, 2016 and 2015, respectively. The carrying amount of the Company’s accounts receivable, accounts payable and accrued expenses and other current liabilities approximate fair value due to their short term maturities. There are no other financial assets and liabilities, except those disclosed in Notes 2, 7, 11 and 13 of that require Level 2 or Level 3 fair value hierarchy measurements and disclosures. 5. Balance Sheet Components Inventories Property and equipment, net Depreciation and amortization expense was $46.7 million, $32.9 million and $19.5 million for years ended December 31, 2016, 2015 and 2014, respectively. Certain fully depreciated property and equipment have been eliminated from both the gross and accumulated amount as they were disposed of as the Company no longer utilized them. The Company leases certain design tools under financing arrangements which are included in property and equipment, which total cost, net of accumulated amortization amounted to $46.3 million and $25.3 million at December 31, 2016 and 2015, respectively. Amortization expense related to assets recorded under capital lease and certain financing arrangements was $16.8 million, $14.7 million and $9.5 million for the years ended December 31, 2016, 2015 and 2014, respectively. Sale of held for sale assets In September 2016, the Company began to actively market the real property located in Aliso Viejo, California that was acquired in the QLogic acquisition. The Company classified this real property as held for sale assets on its consolidated balance sheet as of September 30, 2016. On December 16, 2016, the Company completed the sale of this real property for a total net cash consideration of $32.4 million. Concurrently, the Company leased back the property on a month-to-month basis until the expected occupancy of the new leased property located in Irvine, California. See related discussions on the new lease agreement for the Irvine, California property in Note 13 of . The first six months of the leaseback were rent free; thereafter, the rents will be lower than the market rates. For accounting purposes, these rents were deemed to have been netted against the sale proceeds and represent a prepaid rent. Accordingly, the Company recorded $1.8 million representing the off-market rental rate adjustment as prepaid rent on the consolidated balance sheets and such amount will be recognized as rent expense over the expected lease-back term. The Company adjusted fair value of the acquired property and equipment disclosed in the purchase price allocation in Note 2 of Notes to Financial Statements based upon the business combination guidance on measurement period and accordingly did not recognize a gain or loss upon the sale of the real property. Other Asset Acquisition In November 2016, the Company entered into an asset purchase agreement with a third party company. Pursuant to the asset purchase agreement, the Company acquired property and equipment of $9.2 million and IPR&D of $2.0 million. The IPR&D was recorded at its relative fair using the multi-period excess earnings valuation approach and was written off immediately as the asset had no alternative future use. Accrued expenses and other current liabilities Accrued Rebates In 2016, the Company started its rebate programs with certain customers. In addition, the Company assumed and continued the existing QLogic rebate programs following the closing of the QLogic acquisition. The Company assumed an outstanding rebate accrual of $2.1 million from the acquisition of QLogic. For the year ended December 31, 2016, the Company recorded estimated rebates amounting to $2.9 million and made rebate settlements of $1.8 million. As of December 31, 2016, total accrued rebates included within accrued expenses and other current liabilities was $3.2 million. Warranty Accrual The following table presents a rollforward of the warranty liability, which is included within accrued expenses and other current liabilities: Deferred revenue Other non-current liabilities 6. Goodwill and Intangible Assets, Net Goodwill Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. The carrying value of goodwill as of December 31, 2016 and 2015 was $241.1 million and $71.5 million, respectively. The change in the carrying value of goodwill from December 31, 2015 to December 31, 2016 was due to the goodwill additions from the acquisition of QLogic. See Note 2 of for discussions related to the acquisition of QLogic. The Company reviews goodwill for impairment annually at the beginning of its fourth calendar quarter or whenever events or changes in circumstances that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. The Company manages and operates as one reporting unit. The Company performed a qualitative assessment of the goodwill at the Company level as a whole and concluded that it was more-likely-than-not that goodwill is not impaired as of December 31, 2016 and 2015. In assessing the qualitative factors, the Company considered among others these key factors: (i) changes in the industry and competitive environment; (ii) market capitalization; (iii) stock price; and (iv) overall financial performance. Intangible assets, net Amortization expense was $52.6 million, $9.6 million and $14.6 million for the years ended December 31, 2016, 2015 and 2014, respectively. Certain fully amortized intangible assets have been eliminated from both the gross and accumulated amortization amounts. The following table presents the estimated future amortization expense of amortizable intangible assets as of December 31, 2016 (in thousands): 7. Restructuring Accrual In connection with a workforce reduction during the year ended December 31, 2014, the Company incurred and paid $1.4 million severance and other benefits. There was no restructuring activity during the year ended December 31, 2015. The following table summarizes the activity and the outstanding balances of the restructuring liability as of and for the year ended December 31, 2016: Following the acquisition of QLogic, the Company assumed outstanding liabilities from the restructuring initiatives undertaken by QLogic prior to the acquisition. This restructuring initiative was designed to enhance product focus and streamline the business operations. The assumed restructuring liability was related to the excess facility which was calculated based on the discounted future lease payments. This non-recurring fair value measurement was classified as Level 3 fair value hierarchy measurements and disclosures. The outstanding excess facility related restructuring liability is expected to be settled over the term of the related agreement through April 2018. In addition, the Company recorded employee severance expense of $12.0 million within sales, general and administrative on the consolidated statement of operations for the year ended December 31, 2016 related to actions following the acquisition of QLogic and integration of QLogic with the Company. The amount has been substantially paid as of December 31, 2016 and the remaining unpaid balance is expected to be settled in 2017. 8. Stockholders’ Equity Common and Preferred Stock As of December 31, 2016 and 2015, the Company is authorized to issue 200,000,000 shares of $0.001 par value common stock and 10,000,000 shares of $0.001 par value preferred stock. The Company is authorized to issue preferred stock in one or more series and to fix the rights, preferences, privileges and restrictions thereof, including dividend rights, dividend rates, conversion rights, voting rights, terms of redemption and liquidation preferences. 2001 Stock Incentive Plan The Company’s 2001 Stock Incentive Plan (the “2001 Plan”) expired as of December 31, 2011, thus as of December 31, 2016 there were no outstanding shares reserved for issuance. Options granted under the 2001 Plan were either incentive stock options or non-statutory stock options as determined by the Company’s board of directors. Options granted under the 2001 Plan vested at the rate specified by the plan administrator, typically with 1/8th of the shares vesting six months after the date of grant and 1/48th of the shares vesting monthly thereafter over the next three and one half years to four and one half years. The term of option expire ten years from the date of grant. 2007 Equity Incentive Plan Upon completion of its IPO in May 2007, the Company adopted the 2007 Equity Incentive Plan, the (“2007 Plan”), which initially reserved 5,000,000 shares of the Company’s common stock. The 2007 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards, and other forms of equity compensation (collectively, “stock awards”), and performance cash awards, all of which may be granted to employees (including officers), directors, and consultants or affiliates. Awards granted under the 2007 Plan vest at the rate specified by the plan administrator, for stock options, typically with 1/8th of the shares vesting six months after the date of grant and 1/48th of the shares vesting monthly thereafter over the next three and one half years and for restricted stock unit awards typically with quarterly vesting over four years. The term of awards expires seven to ten years from the date of grant. As of December 31, 2016, there were 8,863,022 shares reserved for issuance under the 2007 Plan. 2016 Equity Incentive Plan On June 15, 2016, the Company adopted the 2016 Equity Incentive Plan (the “2016 EIP”), which initially reserved for issuance 3,600,000 shares of the Company’s common stock. The 2016 EIP is intended as the successor to and continuation of the Company’s 2007 Plan and following the adoption of the 2016 EIP, no more awards will be granted from the 2007 Plan. The 2016 EIP provides for the grant of incentive stock options, non-statutory stock options, stock appreciation rights, restricted stock awards, restricted stock unit awards, performance stock awards, performance cash awards and other stock awards, which may be granted to employees, directors and consultants. Following the effective date, no additional awards may be granted under the 2007 Plan. All outstanding awards granted under the 2007 EIP will remain subject to the terms of such plan, provided however, that the following shares of common stock subject to any outstanding stock award granted under the 2007 Plan (collectively, the “2007 Plan Returning Shares”) will immediately be added to the share reserve as and when such shares become 2007 Plan Returning Shares and become available for issuance pursuant to awards granted under the 2016 EIP: (i) any shares subject to such stock award that are not issued because such stock award or any portion thereof expires or otherwise terminates without all of the shares covered by such stock award having been issued; (ii) any shares subject to such stock award that are not issued because such stock award or any portion thereof is settled in cash; and (iii) any shares issued pursuant to such stock award that are forfeited back to or repurchased by the Company because of the failure to meet a contingency or condition required for the vesting of such shares. As of December 31, 2016, there were 3,418,573 shares reserved for issuance under the 2016 EIP. QLogic 2005 Plan Following the closing of the acquisition of QLogic, the Company assumed and will continue the QLogic 2005 Performance Incentive Plan (the “QLogic 2005 Plan”). Following the closing of the acquisition of QLogic, the total shares available for future grant under the QLogic 2005 Plan was 3,612,039 shares of the Company’s common stock. The QLogic 2005 Plan provides for the issuance of restricted stock unit awards, incentive and non-qualified stock options, and other stock-based incentive awards. Restricted stock unit awards, or RSUs, granted pursuant to the QLogic 2005 Plan to employees subject to a service condition generally vest over four years from the date of grant. Stock options granted pursuant to the QLogic 2005 Plan to employees have ten year terms and generally vest over four years from the date of grant. Shares issued in respect of any full value award granted under this plan shall be counted against the shares available for future grant as 1.75 shares for every one share issued in connection with such award. Full value award means any award under the QLogic 2005 Plan that is not a stock option grant or a stock appreciation right grant. As of December 31, 2016, there were 1,998,131 shares reserved for issuance under the QLogic 2005 Plan. Stock Options Detail related to stock option activity is as follows: The aggregate intrinsic value for options exercised during the years ended December 31, 2016, 2015 and 2014, was $41.5 million, $37.4 million and $36.2 million, respectively, representing the difference between the closing price of the Company’s common stock at the date of exercise and the exercise price paid. The following table summarizes information about stock options outstanding as of December 31, 2016: The aggregate intrinsic value for options outstanding at December 31, 2016, represents the difference between the weighted average exercise price and the closing price of the Company’s common stock at December 31, 2016, as reported on The NASDAQ Global Market, for all in the money options outstanding. The estimated weighted-average grant date fair value of options granted for years ended December 31, 2016, 2015 and 2014 was $18.65 per share, $23.79 per share, and $14.63 per share, respectively. The fair value of each option grant for the years ended December 31, 2016, 2015 and 2014 were estimated on the date of grant using the Black-Scholes option-pricing model using the assumptions below. As of December 31, 2016, there was $3.9 million of unrecognized compensation cost, net of estimated forfeitures, related to stock options granted under the 2007 Plan, the Company’s 2001 Stock Incentive Plan and the QLogic 2005 Plan. The unrecognized compensation cost is expected to be recognized over a weighted average period of 2.50 years. Restricted Stock Units A summary of the activity of RSU for the related periods are presented below: For the year ended December 31, 2016, the Company issued 1,547,694 shares of common stock in connection with the vesting of RSUs. The difference between the number of RSUs vested and the shares of common stock issued for the year ended December 31, 2016 is the result of RSUs withheld in satisfaction of minimum tax withholding obligations associated with the vesting. The total intrinsic value of the RSUs outstanding as of December 31, 2016 was $256.9 million, representing the closing price of the Company’s stock on December 31, 2016, multiplied by the number of non-vested RSUs expected to vest as of December 31, 2016. In February 2015, the Company granted one-year and two-year performance-based RSUs with grant date fair values of $2.1 million and $0.7 million, respectively. In February 2016, the Company granted one-year performance-based RSUs with a grant date fair value of $2.9 million. The Company recorded the related stock-based compensation expense based on its evaluation of the probability of achieving the milestones of all of the outstanding performance-based RSUs as of December 31, 2016 and 2015. At each reporting period, the Company evaluates the probability of achieving the milestone of each of the outstanding performance-based RSUs and updates the recognition of related stock-based compensation expense. The Company also granted four-year vesting market-based RSUs in February 2015 with a grant date fair value of $1.5 million. In February 2016, the Company granted three-year vesting market-based RSUs with a grant date fair value of $3.3 million. These market-based RSUs will vest if: (i) during the performance period, the Company’s total stockholder return over a period of 30 consecutive trading days is equal to or greater than that of the price per share with respect to the February 2015 grant and industry index with respect to the February 2016 grant, set by the compensation committee of the board of directors; and (ii) the recipient remains in continuous service with the Company through such vesting period. The fair value of the market-based RSU was determined by management using the Monte Carlo simulation method which takes into account multiple input variables that determine the probability of satisfying the market conditions stipulated in the award. This method requires the input of assumptions, including the expected volatility of the Company’s common stock, and a risk-free interest rate, similar to assumptions used in determining the fair value of the stock option grants discussed above. The Company recorded the related stock-based compensation expense for the years ended December 31, 2016 and 2015 related to these grants. As of December 31, 2016, there was $164.8 million of unrecognized compensation costs, net of estimated forfeitures, related to RSUs granted under the 2007 Plan, 2016 EIP and the QLogic 2005 Plan. The unrecognized compensation cost is expected to be recognized over a weighted average period of 2.57 years. Stock-Based Compensation The following table presents the detail of stock-based compensation expense amounts included in the consolidated statements of operations for each of the periods presented: The total stock-based compensation cost capitalized as part of inventory as of December 31, 2016 and 2015 was not material. 9. Income Taxes The following table presents the provision for income taxes and the effective tax rates: The provision for income taxes for the year ended December 31, 2016 was primarily related to tax on earnings in foreign jurisdictions and the deferred tax liability related to the indefinite lived intangible assets. The provision for income taxes for the years ended December 31, 2015 and 2014 was primarily related to earnings in foreign jurisdictions. As discussed in Note 2 of , during the third quarter of 2016 upon closing of the acquisition, the Company recorded a partial release of its net deferred tax assets valuation allowance primarily due to a net deferred tax liability recorded for purchased intangibles and recognized a $82.9 million tax benefit in the third quarter of 2016. During the fourth quarter of 2016, the Company was able to assess and measure an additional deferred tax asset that existed as of the acquisition date of QLogic. Due to the identification of this additional deferred tax asset, the Company made adjustments during the fourth quarter of 2016 to certain tax balances including the reversal of the partial release of the valuation allowance recorded in the third quarter of 2016. The domestic and foreign components of income (loss) before income tax expense were as follows: The provision for income taxes consists of the following: The Company’s effective tax rate differs from the United States federal statutory rate as follows: On July 27, 2015, the United States Tax Court in Altera Corp. v. Commissioner, 145 T.C. No. 3 (2015) issued an opinion with respect to Altera’s litigation with the Internal Revenue Service, concerning the treatment of stock-based compensation expense in an inter-company cost sharing arrangement. In ruling in favor of Altera, the Tax Court invalidated the portion of the Treasury regulations requiring the inclusion of stock-based compensation expense in such inter-company cost-sharing arrangements. Accordingly, the Company adjusted its inter-company arrangement to reflect the recent ruling. There was no material impact on the Company’s consolidated financial statements as of and for the year ended December 31, 2016 considering the full valuation allowance on the Company’s federal and state net deferred tax assets. QLogic had a similar global structure prior to the acquisition and the Company is currently evaluating various alternatives to integrate the two groups of entities. The Company’s QLogic subsidiary has not amended its inter-company arrangement to exclude stock-based compensation as of December 31, 2016. The tax effects of the temporary differences that give rise to deferred tax assets and liabilities are as follows: As of December 31, 2016, the Company had total net operating loss carryforwards for federal and states of California and Massachusetts income tax purposes of $1,408.0 million and $496.1 million, respectively. If not utilized, these federal and state net operating loss carryforwards will expire beginning in 2020 and 2017, respectively. The federal and states of California and Massachusetts net operating loss carryforwards include excess windfall deductions of $260.7 million and $143.0 million, respectively. The Company is tracking the portion of its deferred tax assets attributable to stock option benefits in a separate memo account pursuant to the accounting guidance for stock-based compensation. Therefore, these amounts are no longer included in the Company’s gross or net deferred tax assets. Pursuant to the guidance for stock-based compensation, the stock option benefits of approximately $101.7 million will be recorded within stockholders’ equity when it reduces cash taxes payable. The Company uses the “with and without” approach in determining when excess tax benefits have been realized, and the Company considers the direct effects of stock option deductions to calculate excess tax benefits. As of December 31, 2016, the Company also had federal and state research and development tax credit carryforwards of approximately $59.3 million and $75.9 million, respectively. The federal and state tax credit carryforwards will expire commencing 2020 and 2017, respectively, except for the California research tax credits which carry forward indefinitely. The Company also has various foreign and alternative minimum tax credits of approximately $1.1 million. The Company’s net deferred tax assets relate predominantly to its United States tax jurisdiction. A full valuation allowance against the Company federal and state net deferred tax assets has been in place since 2012. The Company periodically evaluates the realizability of its net deferred tax assets based on all available evidence, both positive and negative. The realization of net deferred tax assets is dependent on the Company's ability to generate sufficient future taxable income during periods prior to the expiration of tax attributes to fully utilize these assets. The Company weighed both positive and negative evidence and determined that there is a continued need for a valuation allowance on its federal and state deferred tax assets as of December 31, 2015 and 2016. The Company reviews whether the utilization of its net operating losses and research credits are subject to an annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Utilization of these carryforwards is restricted and results in some amount expiring prior to benefiting the Company. The deferred tax assets shown above have been adjusted to reflect these expiring carryforwards. During 2016, the Company repatriated $50.0 million from its offshore operations. The Company recorded no tax expense related to this cash repatriation due to the utilization of net operating losses. Additionally, in connection with a review of the Company’s cash position and anticipated cash needs for investment in the Company’s core business, including principal prepayments to the Company’s outstanding Term Loan Facility, the Company determined that the current earnings from certain QLogic foreign entities will no longer be indefinitely reinvested, and the Company has provided a deferred tax liability for anticipated United States federal income taxes. For all remaining Cavium foreign entities, the Company will continue to indefinitely reinvest foreign earnings. The undistributed earnings of the Company’s foreign subsidiaries was approximately $359.7 million and $38.3 million as of December 31, 2016 and 2015, respectively. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both United States income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to various foreign countries. As of December 31, 2016 and 2015, the computation of potential United States income tax of a future distribution is impracticable. The following table summarizes the activity related to the unrecognized tax benefits: The gross increase resulting from the acquisition of QLogic was primarily related to the unrecognized tax benefits against the additional tax assets identified in the measurement period but existed as of the acquisition date. Also included in the unrecognized tax benefits at December 31, 2016 is $12.1 million that, if recognized, would reduce the Company’s annual effective tax rate after considering the valuation allowance. The Company’s practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company has accrued $2.8 million potential penalties and interest during the year ended December 31, 2016. The Company does not expect its unrecognized tax benefits to change materially over the next 12 months. Beginning in 2011, the Company is operating under tax incentives in Singapore, which are effective through February 2020. The tax incentives are conditional upon the Company meeting certain employment, revenue, and investment thresholds. The Company realized benefits from the reduced tax rate for the periods presented as follows: The Company’s major tax jurisdictions are the United States federal government, the states of California and Massachusetts, China, India, Ireland, Israel, Japan, Singapore and the United Kingdom. The Company files income tax returns in the United States federal jurisdiction, the states of California and Massachusetts, various other states, and foreign jurisdictions in which it has a subsidiary or branch operations. The United States federal corporation income tax returns beginning with the 2000 tax year remain subject to examination by the Internal Revenue Service, or IRS. The California corporation income tax returns beginning with the 2000 tax year remain subject to examination by the California Franchise Tax Board. As of December 31, 2016, QLogic’s 2014 tax year is under audit by the IRS. There are no on-going foreign tax audits other than in various India tax jurisdictions which are under income tax audits for certain tax years between 2008 and 2015. The Company does not expect any material tax adjustments from either of these audits. 10. Retirement Plan The Company has established a defined contribution savings plan under Section 401(k) of the Internal Revenue Code for substantially all United States employees. This plan covers substantially all United States employees who meet minimum age and service requirements and allows participants to defer a portion of their annual compensation on a pre-tax basis. The Company matches 50% of the employees’ annual contribution up to two thousand dollars per employee. The Company contributions to the plan may be made at the discretion of the Company’s board of directors. For the years ended December 31, 2016, 2015 and 2014, the Company’s defined contribution expense was $1.5 million, $1.1 million and $1.0 million, respectively. In connection with local foreign laws, the Company is required to have a tenured-based defined benefit plan for its employees in certain non-US locations. The Company’s tenured-based payout liability is calculated based on the salary of each employee multiplied by the years of such employee’s employment, and is reflected on the Company’s consolidated balance sheets in other non-current liabilities on an accrual basis. The total expense and total obligation for these plans were not material to the consolidated financial statements. 11. Debt On August 16, 2016, the Company entered into a Credit Agreement with JPMorgan Chase Bank, N.A. (“JPMCB”), as administrative agent and collateral agent, the other agents party thereto and the lenders referred to therein (collectively, the “Lenders”). The Lenders provided (i) a $700.0 million six year term B loan facility (the “Initial Term B Loan Facility”) and (ii) a $50.0 million interim term loan facility (the “Interim Term Loan Facility”, (i) and (ii) together, the “Term Facility”) to finance the acquisition of QLogic and pay fees and expenses of such acquisition. The outstanding debt under the Term Facility are collateralized by a lien on substantially all of the Company’s assets. The interest rates applicable to loans outstanding under the Credit Agreement with respect to the Initial Term B Loan Facility are, at the Company's option, equal to either a base rate plus a margin of 2.00% per annum or LIBOR plus a margin of 3.00% per annum. In no event shall the LIBOR for any interest period be less than 0.75% with respect to the Initial Term B Facility. The Initial Term B Loan Facility will mature on August 16, 2022 and requires quarterly principal payments commencing on December 31, 2016 equal to 0.25% of the aggregate original principal amount, with the balance payable at maturity (in each case subject to adjustment for prepayments). The interest rates applicable to loans outstanding under the Credit Agreement with respect to the Interim Term Loan Facility are, at the Company's option, equal to either a base rate plus a margin of 1.00% per annum or LIBOR plus a margin of 2.00% per annum. In October 2016, the Company paid the outstanding Interim Term Loan Facility. As of December 31, 2016, the carrying value of the Term Facility approximates the fair value. The Company classified this under Level 2 fair value measurement hierarchy as the borrowings are not actively traded and have variable interest structure based upon market rates currently available to the Company for debt with similar terms and maturities. The following table summarizes the outstanding borrowings from the Term Facility as of December 31, 2016: In January 2017, the Company made payments totaling $86.0 million towards the outstanding principal balance of the Initial Term B Loan. The deferred financing costs associated with the Term Facility were recorded as a reduction to principal outstanding in the consolidated balance sheets and is being amortized over the term of the Term Facility. For the year ended December 31, 2016, the Company recognized contractual interest expense and amortization of deferred financing costs of $10.2 million and $1.6 million, respectively. The Credit Agreement contains customary representations and warranties and affirmative and negative covenants that, among other things, restrict the ability of the Company and its subsidiaries to create or incur certain liens, incur or guarantee additional indebtedness, merge or consolidate with other companies, payment of dividends, transfer or sell assets and make restricted payments. These covenants are subject to a number of limitations and exceptions set forth in the Credit Agreement. The Company is in compliance with these covenants as of December 31, 2016. 12. Segment and Geographic Information Operating segments are based on components of the Company that engage in business activity that earn revenue and incur expenses and (a) whose operating results are regularly reviewed by the Company’s chief operating decision maker, or CODM, to make decisions about resource allocation and performance and (b) for which discrete financial information is available. The Company manages and operates as one reportable segment. The closing of the acquisition of QLogic did not change the Company’s reportable segment as management views and operates the combined companies as one reportable segment. The Company implemented a plan developed prior to the completion of the QLogic acquisition and began to immediately integrate QLogic into the Company’s existing operations, engineering groups, sales distribution networks and management structure. The Company’s net revenue consists primarily of the sale of semiconductor products and the Company also derives revenue from licensing software. The revenue from these sources is classified by the Company as product revenue. The Company also generates revenue from professional service arrangements which is categorized as service revenue. The total service revenue is less than 10% of the Company’s total net revenue for the years ended December 31, 2016, 2015 and 2014. The Company categorizes its net revenue in two different markets, (i) the enterprise, datacenter, and service provider markets; and (ii) broadband and consumer markets. The net revenue by markets for the periods indicated was as follows: Revenues by geographic area are presented based upon the ship-to location of the original equipment manufacturers, the contract manufacturers or the distributors who purchased the Company’s products. For sales to the distributors, their geographic location may be different from the geographic locations of the ultimate end customers. Net revenues by geographic area are as follows: The following table sets forth tangible long lived assets, which consist of property and equipment, net by geographic regions: 13. Commitments and Contingencies The Company is not currently a party to any legal proceedings, the outcome of which, if determined adversely to the Company, would have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company. The Company leases its facilities under non-cancelable operating leases, which contain renewal options and escalation clauses, and expire on various dates ending in October 2025. Rent expense incurred under operating leases was $11.3 million, $8.0 million and $6.4 million for the years ended December 31, 2016, 2015 and 2014, respectively. On November 18, 2016, the Company entered into a lease agreement to lease approximately 105,600 square feet in a building located in Irvine, California. The lease term is 8 years and is expected to commence in October 2017. This leased facility is for the relocation of QLogic employees from real property previously owned located in Aliso Viejo, California. As discussed in Note 5 of , the Company completed the sale of the previously owned real property located in Aliso Viejo, California, which the Company leased back on a month-to-month basis. The Company also has non-cancellable software and maintenance commitments which are generally billed on a quarterly basis. These commitments are included in the operating leases. The Company acquired certain assets under capital lease and technology license obligations. The capital lease and technology license obligations include future cash payments payable primarily for license agreements with various outside vendors. For license agreements which qualify under capital lease and where installment payments extend beyond one year, the present value of the future installment payments are capitalized and included as part of intangible assets or property and equipment which is amortized over the estimated useful lives of the related licenses. In July 2016, the Company signed design kit license agreements with a third party vendor for an aggregate consideration of $9.0 million, payable in four equal installments. The first installment was due on the effective date of the agreement and the remaining installment payments are due in the succeeding quarters following the effective date. The aggregate total consideration was recorded as intangible assets which will be amortized over the term of the license and the related liability was recorded under capital lease and technology license obligations. In July and September 2016, the Company signed design tools purchase agreements with a third party vendor for an aggregate total consideration of $15.6 million, payable in equal quarterly installments up to May 2019. The present value of the aggregate total consideration was recorded as design tools under property and equipment which will be amortized over the term of the license and the related liability was recorded under capital lease and technology license obligations. On September 27, 2016, the Company signed a new purchase agreement with a third party vendor for $31.5 million, payable in quarterly installments up to August 2019, in exchange for a three-year license to certain design tools effective October 1, 2016. This new purchase agreement replaced the purchase agreement entered into by the Company in October 2014 with the same third party company for $28.5 million in exchange for a three-year license to certain design tools. The present value of the aggregate total consideration was recorded as design tools under property and equipment which will be amortized over the term of the license and the related liability was recorded under capital lease and technology license obligations. As a result of the cancellation of the October 2014 purchase agreement in October 2016, the Company wrote-off the related design tools within property and equipment and the unpaid installment obligations under capital lease and technology license obligations. Minimum commitments under non-cancelable operating and capital lease agreements as of December 31, 2016 are as follows: On January 31, 2017, the Company entered into a lease agreement to lease approximately 116,000 sq. ft. in a building located adjacent to the Company’s corporate headquarter in San Jose, California. The lease term is through July 2027 and the Company expects to occupy the building beginning October 2017. QLogic Manufacturing Rights Buy-outs The Company exercised non-cancellable options to purchase the manufacturing rights from a QLogic application specific integrated circuit, or ASIC, vendor effective at the closing of the acquisition of QLogic for certain QLogic ASIC products and on November 1, 2016 for certain other QLogic ASIC products. In consideration for the exercise of the manufacturing rights, the Company paid an aggregate of $55.0 million in September 2016. In addition, the Company paid a one-time royalty buy-out fee of $10.0 million for certain QLogic ASIC products. On September 29, 2016, the Company entered into an ownership transfer and manufacturing rights agreement with another QLogic third party ASIC vendor to acquire manufacturing rights and relieve the Company from future royalty obligations related to certain ASIC products. In consideration for this, the Company agreed to pay a total of $10.0 million. Subject to the terms of the agreement, the Company paid $7.5 million on the effective date of the agreement and the remaining $2.5 million was placed in escrow in November 2016, to be released on the earlier of (i) receipt of the validation notice that the related ASIC product has been put into production by the Company and (ii) transfer of specified assets to a third party vendor approved by the Company. The amount placed in escrow was classified within prepaid expense and other current assets on the consolidated balance sheets as of December 31, 2016. The Company determined that the total consideration amounting to $75.0 million as discussed above, pertained to the use of technologies and the cost associated with cancelling the exclusive rights to manufacture the related products. The Company estimated the components of the total consideration attributable to the use of technologies and the cost to cancel the exclusive manufacturing rights using market-based fair value estimation. The fair value estimation was determined based on inputs that are unobservable and significant to the overall fair value measurement. It was also based on estimates and assumptions made by management. As such this was classified as Level 3 fair value hierarchy measurements and disclosures. Based on the analysis, the Company attributed $42.8 million of the total consideration to the use of the related technologies in future periods and recorded this amount as an intangible asset in the consolidated balance sheets as of December 31, 2016 and the remaining balance of $32.2 million was attributed to the cost of cancelling the exclusive rights to manufacture the related products and was recorded as cost of revenue in the consolidated statements of operations in the year ended December 31, 2016. Xpliant Manufacturing Rights Buy-out On March 30, 2015, Xpliant exercised its option to purchase the manufacturing rights to accelerate the takeover of manufacturing, and to relieve Xpliant from any further obligation to purchase product quantities from an Xpliant ASIC vendor. In consideration for this, Xpliant agreed to pay a $7.5 million manufacturing rights licensing fee and a per-unit royalty fee for certain ASIC products sold to certain customers for a limited time. The manufacturing rights licensing fee was payable in four equal quarterly payments, with the first installment payment due on April 29, 2015 and each of the subsequent three installment payments were due on the first day of the following calendar quarter. Considering the terms of the purchase of the manufacturing rights and the stage of development of the related ASIC products covered by the manufacturing rights, the Company recorded the full amount of the manufacturing rights licensing fee within research and development expense on the consolidated statement of operations in the first quarter of 2015 and the related liability was recorded within other accrued expenses and other current liabilities on the consolidated balance sheets. In 2015, the Company settled three installments due. The final installment payment was made in the first quarter of 2016. Selected Quarterly Consolidated Financial Data (Unaudited) The following table summarizes certain unaudited quarterly financial information in each of the quarters in 2016 and 2015. The quarterly data have been prepared on the same basis as the audited consolidated financial statements. This should be read together with the consolidated financial statements and related notes included elsewhere in this Annual Report. (1) Cost of revenue for the quarter ended December 31, 2016 includes charges of $12.6 million for the purchase accounting effect on inventory and amortization of acquired intangible assets of $27.1 million. (2) Cost of revenue for the quarter ended September 30, 2016 included charges of $37.1 million related to the QLogic manufacturing rights buy-out, purchase accounting effect on inventory of $7.3 million and amortization of acquired intangible assets of $12.7 million. (3) Sales, general and administrative expense for the quarter ended September 30, 2016 included stock-based compensation expense related to QLogic employees with change in control provisions of $15.6 million, acquisition and integration costs of $13.4 million and restructuring, severance and other employment charges of $12.0 million related to the QLogic acquisition. (4) Benefit from income taxes for the quarter ended September 30, 2016 included a tax benefit from the partial release of the valuation allowance on net deferred tax assets of $82.9 million. As a result of the QLogic acquisition, a net deferred tax liability was recorded due to the book-tax basis difference mainly related to purchased intangibles. This net deferred tax liability provided an additional source of income to support the realizability of the Company’s pre-existing deferred tax assets which resulted in the partial release of its valuation allowance. (5) Provision for income taxes for the quarter ended December 31, 2016 included tax expense due to the reversal of the partial release of the valuation allowance on net deferred tax assets recorded in the quarter ended September 30, 2016 as discussed above. During the fourth quarter of 2016, the Company was able to assess and measure an additional deferred tax asset that existed as of the acquisition date of QLogic. Due to the identification of this additional deferred tax asset, the Company made adjustments to certain tax balances including the reversal of the partial release of the valuation allowance recorded in the third quarter of 2016. (6) Research and development expense for the quarter ended March 31, 2015 included a charge of $7.5 million related to the Xpliant manufacturing rights buy-out. Schedule II - Valuation and Qualifying Accounts All other schedules are omitted because they are inapplicable or the requested information is shown in the consolidated financial statements of the registrant or related notes thereto.
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This appears to be a partial financial statement with limited numerical data. Here's a summary of the key components:
Revenue:
- Primary source is semiconductor product sales to OEMs, contract manufacturers, and distributors
- Secondary source is software licensing, maintenance, support, and professional services
- Revenue recognition requires:
* Binding arrangement evidence
* Delivery completion
* Fixed/determinable pricing
* Reasonable assurance of collectibility
Profit/Loss:
- Specific figures not provided
- Shows consolidated statements of cash flows
Expenses:
- Details focus on revenue reductions including:
* Sales returns
* Pricing adjustments
* Competitive pricing programs
* Rebates
Assets:
- Total assets figure not provided
- Referenced as of December 31 (year not specified)
Liabilities:
- Specific figures not provided
- Referenced as current liabilities on consolidated balance sheets
Additional Notes:
- Includes foreign currency translation adjustments
- Has international operations with foreign subsidiaries
- Software licenses typically run for 12 months
Without specific numerical values, this appears to be more of a description of accounting policies rather than a complete financial statement.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FRESHPET, INC. INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Freshpet Inc.: We have audited the accompanying consolidated balance sheets of Freshpet, Inc. and subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of operations and comprehensive loss, changes in stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Freshpet, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP Short Hills, New Jersey March 14, 2017 FRESHPET INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See accompanying notes to the consolidated financial statements. FRESHPET INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS See accompanying notes to the consolidated financial statements. FRESHPET INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) See accompanying notes to the consolidated financial statements. FRESHPET INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying notes to the consolidated financial statements. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Nature of the Business and Summary of Significant Accounting Policies: Nature of the Business - Freshpet, Inc. (hereafter referred to as “Freshpet” or the “Company”), a Delaware corporation, manufactures and markets natural fresh, refrigerated meals and treats for dogs and cats. The Company’s products are distributed throughout the United States, Canada and an international test market into major retail classes including Grocery and Mass (which includes club) as well as Pet specialty and Natural retail. Principles of Consolidation - The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”). The financial statements include the accounts of the Company as well as the Company’s wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Segments - The Company operates as a single operating segment reporting to its chief operating decision maker. Estimates and Uncertainties - The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results, as determined at a later date, could differ from those estimates. Cash and Cash Equivalents - The Company at times considers money market funds and all other highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Short-Term Investments - The Company at times holds interest-bearing certificates of deposits with financial institutions with maturities ranging from three months to one year. Certificates of deposit are classified as short-term investments and interest is recorded as other expenses, net. Historically, interest income has not been material. The Company will continue to monitor interest income and will disclose separately if significant. Accounts Receivable - The Company records trade accounts receivable at net realizable value. This value includes an appropriate allowance for estimated uncollectible accounts. On a periodic basis, the Company evaluates its accounts receivable and establishes an allowance for doubtful accounts based on its history of write-offs and collections and current credit conditions. Accounts receivable are written off when management deems them to be uncollectible. Inventories - Inventories are stated at the lower of cost or market, using the first-in, first-out method. When necessary, the Company provides allowances to adjust the carrying value of its inventories to the lower of cost or net realizable value, including any costs to sell or dispose and consideration for obsolescence, excessive inventory levels, product deterioration and other factors in evaluating net realizable value. Property, Plant and Equipment - Property, plant and equipment are recorded at cost. The Company provides for depreciation on the straight-line method by charges to income at rates based upon estimated recovery periods of 7 years for furniture and office equipment, 5 years for automotive equipment, 9 years for refrigeration equipment, 5 to 10 years for machinery and equipment, and 15 to 39 years for building and improvements. Capitalized cost includes the costs incurred to bring the property, plant and equipment to the condition and location necessary for its intended use, which includes any necessary delivery, electrical and installation cost for equipment. Maintenance and repairs that do not extend the useful life of the assets over two years are charged to expense as incurred. Leasehold improvements are amortized over the shorter of the term of the related lease or the estimated useful lives on the straight-line method. Long-Lived Assets - The Company evaluates all long-lived assets for impairment. Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future net cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Recoverability of assets held for sale is measured by a comparison of the carrying amount of an asset or asset group to their fair value less estimated costs to sell. Estimating future cash flows and calculating fair value of assets requires significant estimates and assumptions by management. If the carrying amount is not fully recoverable, an impairment loss is recognized to reduce the carry amount to fair value, and is charged to expense in the period of impairment. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Income Taxes - The Company provides for deferred income taxes for temporary differences between financial and income tax reporting, principally net operating loss carryforwards, depreciation, and share-based compensation. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is appropriate when management believes it is more likely than not, the deferred tax asset will not be realized. At December 31, 2016, and 2015, the Company determined that a valuation allowance of 100% is appropriate. Revenue Recognition and Incentives - Revenue from product sales is recognized upon shipment to the customers as terms are free on board (“FOB”) shipping point, at which point title and risk of loss is transferred and the selling price is fixed or determinable. This completes the revenue-earning process specifically that an arrangement exists, delivery has occurred, ownership has transferred, the price is fixed and collectability is reasonably assured. A provision for payment discounts and product return allowances, which is estimated based upon the Company’s historical performance, management’s experience and current economic trends, is recorded as a reduction of sales in the same period that the revenue is recognized. Trade incentives, consisting primarily of customer pricing allowances and merchandising funds, and consumer coupons are offered through various programs to customers and consumers. Sales are recorded net of estimated trade incentive spending, which is recognized as incurred at the time of sale. Accruals for expected payouts under these programs are included as accrued expense in the consolidated balance sheet. Coupon redemption costs are also recognized as reductions of net sales when the coupons are issued. Estimates of trade promotion expense and coupon redemption costs are based upon programs offered, timing of those offers, estimated redemption/usage rates from historical performance, management’s experience and current economic trends. Advertising - Advertising costs are expensed when incurred, with the exception of production costs which are expensed the first time advertising takes place. Advertising costs, consisting primarily of media ads, were $15,374,392, $16,302,237, and $14,231,930, in 2016, 2015, and 2014, respectively. Shipping and Handling Costs/Freight Out - Costs incurred for shipping and handling are included in selling, general, and administrative expenses within the statement of operations and comprehensive loss. Shipping and handling costs primarily consist of costs associated with moving finished products to customers, including costs associated with our distribution center and the cost of shipping products to customers through third-party carriers. Shipping and handling cost totaled $11,202,392, $11,407,908, and $9,447,406 for the years ended December 31, 2016, 2015, and 2014, respectively. Research & development - Research and development costs consist of expenses to develop and test new products. The cost are expensed as incurred. Share-Based Compensation - The Company recognizes share-based compensation based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Share-based compensation expense recognized in the statement of operations included compensation expense for share-based payment awards granted subsequent to December 31, 2006, based on the grant date fair value estimated. Share awards are amortized under the straight-line method over the requisite service period of the entire award. Upon the adoption of ASU 2016-09, the Company no longer estimates expected forfeitures but accounts for forfeitures as they occur. The Company determines the fair value of the stock options granted as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. Fair Value of Financial Instruments - Financial Accounting Standards Board (“FASB”) guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The three levels of the fair value hierarchy are as follows: • Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 primarily consists of financial instruments whose value is based on quoted market prices such as exchange-traded instruments and listed equities. • Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly (e.g., quoted prices of similar assets or liabilities in active markets, or quoted prices for identical or similar assets or liabilities in markets that are not active). Level 2 includes financial instruments that are valued using models or other valuation methodologies. • Level 3 - Unobservable inputs for the asset or liability. Financial instruments are considered Level 3 when their fair values are determined using pricing models, discounted cash flows or similar techniques and at least one significant model assumption or input is unobservable. The carrying amounts reported in the balance sheets for cash and cash equivalents, other receivables, accounts payable and accrued expenses approximate their fair value based on the short-term maturity of these instruments. The warrant liability is recorded at fair value with changes in fair value reflected in the statement of operations and comprehensive loss. As of December 31, 2016, the Company only maintained Level 1 assets and liabilities. Note 2 - Recently Issued Accounting Standards: Adopted In April 2015, the FASB issued ASU 2015-03, “Interest-Imputation of Interest,” which requires that debt issuance cost be presented on the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. This new guidance was adopted beginning January 1, 2016 and did not impact the Company’s consolidated financial statements other than presentation. In November 2015, the FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes,” which requires entities with a classified balance sheet to present all deferred tax assets and liabilities as noncurrent. The new guidance was adopted beginning January 1, 2016. The effects of ASU 2015-17 will change retrospectively how deferred tax assets and liabilities are classified within the balance sheet and notes thereto. Due to the Company’s full valuation allowance, deferred tax assets and liabilities have not been disclosed within the consolidated balance sheet. In March 2016, the FASB issued ASU No. 2016-09, “Improvements to Employee Share-Based Payment Accounting,” which simplifies several aspects of the accounting for share-based payment transactions including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The Company elected to early adopt this amendment in the second quarter of 2016. The Company has elected to account for forfeitures when they occur rather than estimating the number of awards that are expected to vest. The impact on the Company’s Consolidated Statements of Operations and Comprehensive Loss was not material. The amendments related to excess tax benefits are not material due to the Company’s net operating losses. Not Yet Adopted In May 2014, the Financing Accounting Standard Board (“FASB”) issued ASU No. 2014-09, “Revenue from Contracts with Customers”, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In connection with this ASU, the FASB also issued ASU No. 2016-10 regarding identification of performance obligations and licensing considerations, ASU No. 2016-12 regarding narrow scope improvements and practical expedients, and ASU No. 2016-08 which clarifies the implementation of guidance on principal versus agent considerations. In August 2015, the FASB deferred the effective date of ASU No. 2014-09 to fiscal years beginning after December 15, 2017, with early adoption permitted only for fiscal years beginning after December 15, 2016. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is currently utilizing a comprehensive approach to assess the impact of this guidance by reviewing current accounting policies to identify the potential impact of the new requirements on its revenue contracts. The Company does FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS not currently expect this guidance to have a material impact on its consolidated financial statements and related disclosures. The Company currently expects to adopt the new guidance beginning in the fiscal year ended December 31, 2018 and has not yet selected a transition method. In July 2015, the FASB issued ASU No. 2015-11, “Simplifying the Measurement of Inventory,” which requires that an entity carry its inventory at lower of cost or net realizable value (which replaces “lower of cost or market”) if the first-in first-out (“FIFO”) or average cost methods are used. This new guidance is effective for the Company’s fiscal year beginning after December 15, 2016. ASU No. 2015-11 is not expected to have impact upon adoption, but could have an impact in future periods depending upon the future valuation of the Company’s inventory. In February 2016, the FASB issued ASU No. 2016-02, "Leases,” which requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet. A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. The new guidance is effective for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The amendments should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is assessing the impact of ASU No. 2016-02 on its corporate office lease, and upon adoption of this guidance, expects to record the lease on its consolidated balance sheet in accordance with ASU No. 2016-02. In August 2016, FASB issued ASU No. 2016-15, “Statement of Cash Flows”, which clarifies how companies present and classify certain cash receipts and cash payments in the statement of cash flows, such as proceeds from insurance claims. The new guidance is effective for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Company accounts for all applicable cash flows in accordance with this guidance and does not expect the standard to have a material impact on its consolidated financial statements and financial statement disclosures. Note 3 - Inventories: Inventories are summarized as follows: Note 4 - Property, Plant and Equipment: Depreciation and amortization expense related to property, plant and equipment totaled approximately $9,708,062, $7,433,876 and $6,356,736 for the years ended December 31, 2016, 2015 and 2014, respectively; of which $4,028,022, FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS $2,566,013 and $2,453,883 was recorded in cost of goods sold for 2016, 2015 and 2014, respectively; with the remainder of depreciation and amortization expense being recorded to selling, general and administrative expense. In June 2015, the Company purchased a building and 6.5 acres of land adjacent to the Company’s manufacturing facility in Bethlehem, Pennsylvania. The assets have been recorded in Building, Land and Improvements at a cost of approximately $5.0 million, of which approximately $2.1 million was the value of the land, with the remaining portion representing the value of the building. Due to our continued growth, the Company has undertaken a capital expansion project at its Freshpet Kitchens manufacturing facility to expand the plant capacity and increase distribution. Since 2015, the Company invested approximately $35.2 million in capital expenditures related to this project, with $17.6 million recorded during each of 2016 and 2015. A portion of the new equipment was placed into service in July 2016, with the remaining portion placed into service in October 2016, which resulted in incremental depreciation expense of approximately $1.6 million in the year ended December 31, 2016. In order to fund the expansion, we borrowed $10.0 million under our Credit Facilities and repaid $3.0 million by the end of 2016. We expect to repay the remainder of this indebtedness by the end of 2017. Note 5 - Income Taxes: A summary of income taxes as follows: The provisions for income taxes do not bear a normal relationship to loss before income taxes primarily as a result of the valuation allowance on deferred tax assets. The reconciliation of the statutory federal income tax rate to the Company’s effective tax is presented below: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows: In assessing the realizability of the net deferred tax assets, the Company considers all relevant positive and negative evidence to determine whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the generation of sufficient taxable income prior to the expiration of the net operating loss carryforwards. The Company believes that it is more likely than not that the Company’s deferred income tax assets will not be realized. The Company has experienced taxable losses from inception. As such, there is a full valuation allowance against the net deferred tax assets as of December 31, 2016 and 2015. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2016, the Company had federal net operating loss (“NOL”) carryforwards of $160,728,383, which expire between 2025 and 2036. The Company may be subject to the net operating loss utilization provisions of Section 382 of the Internal Revenue Code. The effect of an ownership change would be the imposition of an annual limitation on the use of NOL carry forwards attributable to periods before the change. The amount of the annual limitation depends upon the value of the Company immediately before the change, changes to the Company’s capital during a specified period prior to the change, and the federal published interest rate. Although we have not completed an analysis under Section 382 of the Code, it is likely that the utilization of the NOLs will be limited. At December 31, 2016, the Company had $132,394,673 of State NOLs which expire between 2016 and 2036. Entities are also required to evaluate, measure, recognize and disclose any uncertain income tax provisions taken on their income tax returns. The Company has analyzed its tax positions and has concluded that as of December 31, 2016, there were, no uncertain positions. The Company’s U.S. federal and state net operating losses have occurred since its inception in 2005 and as such, tax years subject to potential tax examination could apply from that date because the utilization of net operating losses from prior years opens the relevant year to audit by the IRS and/or state taxing authorities. Interest and penalties, if any, as they relate to income taxes assessed, are included in the income tax provision. The Company did not have any unrecognized tax benefits and has not accrued any interest or penalties through 2016. Net deferred tax assets and liabilities are summarized as follows: Note 6 - Accrued Expenses: (1) Accrued Leadership Transition Costs represent unpaid costs detailed within our former Chief Executive Officer’s separation agreement. Note 7 - Debt: On November 13, 2014, the Company entered into senior secured credit facilities (the “Debt Refinancing”) comprised of a 5-year $18.0 million term facility (the “Term Facility”), a 3-year $10.0 million revolving facility (the “Revolving Facility”) and FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS a $12.0 million additional term loan commitment earmarked primarily for capital expenditures (the “Capex Commitments” and together with the Term Facility and Revolving Facility, the “Credit Facilities” and such loan agreement, the “Loan Agreement”). On December 23, 2014, the Company modified the terms of the $40.0 million Credit Facilities. The $18.0 million Term Facility was repaid and extinguished, the 3-year $10.0 million Revolving Facility remained unchanged, and the $12.0 million Capex Commitments was increased to $30.0 million. Amounts borrowed under the Capex Commitments reduce the $30.0 million available such that the borrowed funds are no longer available after repayment. Any drawn Capex Commitments will mature on the fifth anniversary of the execution of the Loan Agreement, and undrawn Capex Commitments will expire on the third anniversary of the execution of the Loan Agreement. Under the terms of the Loan Agreement, the commitments for the $10.0 million Revolving Facility may be increased up to $20.0 million subject to certain conditions. Any borrowings under the Credit Facilities bear interest at variable rates depending on our election, either at a base rate or at LIBOR, in each case, plus an applicable margin. The initial applicable margin is 3.75% for base rate loans and 4.75% for LIBOR loans. Thereafter, subject to our leverage ratio, the applicable base rate margin will vary from 2.75% and 3.75% and the applicable LIBOR rate margin will vary from 3.75% and 4.75%. The Credit Facilities are secured by substantially all of our assets. The Loan Agreement provides for the maintenance of various covenants, including financial covenants. The Loan Agreement includes events of default that are usual for facilities and transactions of this type. During the year ended December 31, 2016, the Company borrowed $10.0 million and repaid $3.0 million from the Capex Commitments, and had $30.0 million available under the Credit Facilities as of December 31, 2016. The Company was in compliance with all covenants in the Loan Agreement and had $7.0 million outstanding under the Credit Facilities as of December 31, 2016. There was no outstanding debt as of December 31, 2015. There was less than $0.1 million of accrued interest as of December 31, 2016 and no accrued interest as of December 31, 2015. Interest expense and fees totaled $0.7 million, $0.5 million, and $4.6 million for the years ended December 31, 2016, 2015, and 2014, respectively. Note 8 - Commitments and Contingencies: Commitments - The Company leases office space under non-cancelable operating leases that expire at various dates through June 30, 2024. As of December 31, 2016, future minimum rentals due under these leases for the next five years were as follows: Rent expense related to these non-cancelable operating leases was $473,853, $393,718, and $404,438 for the years ended December 31, 2016, 2015, and 2014, respectively. Certain of the Company’s executives are covered by employment contracts requiring the Company to pay severance in the event of certain terminations. Contingency - In November 2015, Freshpet entered into an incentive agreement with a vendor. Under the terms of the agreement, a cash incentive will be earned by the vendor upon achievement of certain performance goals that must be reached by the end of the contract term, which expires on November 30, 2017. The incentive payout is based on the fair value of the Company’s common stock price as of the achievement date specified within the contract. As of December 31, 2016, the Company does not believe it is probable that the vendor will reach the performance goals during the term of the contract and accordingly has not provided an accrual for this agreement. However, if the performance goal were deemed probable as of December 31, 2016, the Company would have established an accrual ranging from $305,000 to $1,015,000, depending on the goal achieved. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 9 - Redeemable Preferred Stock: Immediately following the closing of the IPO on November 13, 2014, the Company redeemed all the outstanding shares of Series B Preferred Stock (“Series B”), including cumulative dividends, for a cash payment of $34,998,957. Additionally, immediately prior to the closing of the IPO, the Company converted the outstanding shares of Series C Preferred Stock (“Series C”) to 11,067,090 shares of common stock. Based on the Series C anti-dilutive clause, the conversion from Series C to common stock was to be equivalent to the 1-to-0.7396 common stock share split that occurred during 2014 in connection with the IPO. The converted Series C included 2,477,756 Series C related to the Fees on Debt Guarantee, which were converted to 1,832,531 shares of common stock. See Note 11 for further detail. Dividends Holders of Series B were entitled to receive dividends payable in additional fully paid and non-assessable shares of Series B at a rate per annum of 15% of the original issue price. Such dividends were to be fully cumulative from the first day of issuance and accrued without interest on both the initial Series B shares obtained and shares obtained via dividend, on a quarterly basis. The dividend accrued during the year ended December 31, 2014 was $4,271,550. The total cumulative dividends that were paid on November 13, 2014, upon redemption of the Series B, was $23,840,008. Holders of Series C were entitled to dividends at a rate of 8% per annum of the Series C original issue price, subject to appropriate adjustment in the event of any stock dividend, stock split, combination or other similar recapitalization with respect to Series C. Accrued dividends were to be payable only when, and if declared by the Board of Directors. In addition, holders of Series C were entitled to share ratably in any cash dividends declared and paid on the common stock in an amount per share equal to the amount of the dividend proposed to be paid on a share of common stock multiplied by the number of shares of common stock issuable upon conversion of the Series C. Once the Series C shares were converted to common stock, the accrued dividends that had not been declared by the Board of Directors were relinquished. Upon conversion, none of the accrued dividends had been declared by the Board of Directors. Immediately prior to the conversion of Series C to Common Stock, the Series C shares were fair valued utilizing the share price at the date of conversion. The difference between fair value and book value of $82,654,683 was recorded to net loss attributable to common stockholders. The difference between fair value and book value was net of $64,341,539 of cash proceeds received, net off issuance costs, and $19,687,856 of dividend accretion through the settlement date, of which $7,014,643 was recorded in 2014. See the table below for detail over the cumulative dividends prior to the Company’s IPO. (1) - Represents the cash proceeds received, net of issuance costs, by the company from Series C investors throughout the life of the security. Series B and Series C were historically classified on the balance sheet outside of permanent equity. There were no preferred stock dividends accrued or payable as of December 31, 2016 or 2015. Note 10 - Warrant: In connection with a loan transaction with a bank prior to 2011, and in consideration thereof, the Company issued to a bank a warrant to purchase up to an aggregate of 61,117 shares of voting common stock of the Company at a purchase price of $6.28 per share. In the event the Company issues additional equity instruments at a purchase price or exercise price lower than the warrant exercise price, such exercise price shall be adjusted. The warrant was recorded as a liability with adjustments to fair value recorded in the statement of operations. The warrant is exercised upon surrender to the Company, on a net basis, such that, without the exchange of any funds, such holder purchases that number of shares otherwise issuable upon exercise of its warrant less that number of shares having a current market price at the time of exercise equal to the aggregate exercise price that would otherwise have been paid by such holder upon the exercise of the warrant. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The warrant automatically converts in October 2017 without any action by the holder. The accrued value of the warrant as of December 31, 2016 was $253,391. Note 11 - Guarantee Agreement: In connection with a $62,500,000 revolving note payable, the Company entered into a Fee and Reimbursement Agreement with certain stockholders who were also guarantors of the note. That agreement stipulated that the Company would pay each guarantor a contingent fee equal to 10% per annum of the amount that each guarantor had committed to guarantee. The payment was to be made in the form of newly issued shares of Series C Preferred Stock at the price of $5.25 per share. The fee accrued only from and after the date that the Guarantor entered into the Guarantee, and if at any time any Guarantor’s obligation was terminated in full or in part, the Fee would continue to accrue only with respect to the amount, if any of such Guarantor’s remaining commitment under the Credit Agreement. The fee was contingent in that it would become due and payable only if all principal and interest under the credit agreement had been repaid and a Change of Control had occurred. A Change of Control was defined as any sale, merger, consolidation, share exchange, business combination, equity issuance, or other transaction or series of related transactions, specifically excluding public offerings, which result in the stockholders immediately prior to the transaction(s) owning collectively less than 50% of the voting control immediately following the transaction(s); or (ii) any sale, lease, exchange, transfer, or other disposition of substantially all of the assets, taken as a whole, in a single transaction or series of transactions, excluding sales in the ordinary course of business, sale/leaseback and corporate restructuring transactions. Immediately prior to the closing of the IPO, the Company converted outstanding fees under the guarantee into 2,477,756 shares of Series C, which were then converted into 1,832,531 shares of common stock. The fees on debt guarantee was a financial instrument that was recognized as a liability by the Company and recorded at fair value at issuance. The instrument was then adjusted to its then fair value at each reporting period with changes in fair value recorded in the consolidated statement of operations and comprehensive loss. Historically, the Company measured the fair value of the outstanding fee on debt guarantee using an option pricing method with several possible distribution outcomes depending on the timing and kind of liquidity event. Expected volatility was estimated utilizing the historical volatility of similar companies. The risk-free interest rates was based on the U.S. Treasury yield for a period consistent with the expected contractual life. Upon the conversion of the fees on debt guarantee into shares of Series C, and then subsequently into common stock, the share price of the Company’s common stock was utilized to fair value the fees on debt guarantee and record the final fees on debt guarantee. Note 12 - Equity Incentive Plans: Total compensation cost for share-based payments recognized for the years ended December 31, 2016, 2015, and 2014 was approximately $4,225,149, $3,976,423, and $1,563,976, respectively. Cost of goods sold the year ended December 31, 2016, 2015, and 2014 included share-based compensation of approximately $221,559, $201,086, and $71,669, respectively. Selling, general, and administrative expense for the year ended December 31, 2016, 2015, and 2014 included share-based compensation of approximately $3,971,930, $3,722,770, and $1,492,307, respectively. Capital expenditures recorded during the years ended December 31, 2016 and 2015 for the Freshpet Kitchens expansion project included share-based compensation of approximately $31,660 and $52,566 respectively. 2006 Stock Plan-In December 2006, the Company approved the 2006 Stock Plan (the “2006 Plan”) under which options to purchase approximately 624,223 shares of the Company’s common stock were granted to employees and affiliates of the Company. These options are time-based (vest over five years). Certain option awards provide for accelerated vesting if there is a change in control (as defined in the 2006 Plan). At December 31, 2016, there were zero shares available for grant as the plan is frozen. 2010 Stock Plan-In December 2010, the Company approved the 2010 Stock Plan (the “2010 Plan”) under which options to purchase approximately 2,146,320 shares of the Company’s common stock were granted to employees and affiliates of the Company (in 2012, the 2010 Plan was amended to allow for option to purchase approximately 2,220,280 shares of the Company’s common stock). These options are either time-based (vest over four years), performance-based (vest when performance targets are met, as defined in the stock option grant agreement), or vest at the occurrence of an exit event which is defined as a Change of Control in the Company or an initial public offering registered under the Securities Act, as defined in the stock grant agreement. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In November 2014, the Company modified its performance-based awards and exit-event awards under the 2010 Plan. All performance-based awards (680,753 awards) were modified to time-vested awards that cliff vest over two years. At the time of the November 2014 modification the original performance-based awards’ vesting criteria was not considered probable. In addition, all exit-event awards (657,693 awards) were modified to performance-based awards. In December 2016, the Company modified 419,366 of its performance-based awards to time-based awards that vest over two years. These awards were originally included in the November 2014 modification from exit-event awards to performance-based awards. At the time of the December 2016 modification the performance-based awards’ vesting criteria was not considered probable. All modified awards were fair valued on the modification date. As of December 31, 2016 the vesting of any remaining performance-based awards which were not modified in December 2016 is not considered probable of vesting and accordingly the Company has not recognized the related compensation expense. The options granted have maximum contractual terms of 10 years. The Board of Directors froze the 2010 Stock Plan such that no further grants may be issued under the 2010 Stock Plan. 2014 Omnibus Incentive Plan-In November 2014, the Company approved the 2014 Omnibus Incentive Plan (the “2014 Plan”) under which 1,479,200 shares of common stock may be issued or used for reference purposes as awards granted under the 2014 Plan. In September 2016, the 2014 Plan was amended to allow for the granting of an additional 2,500,000 shares of common stock to be issued or used for reference purposes as awards granted, for a total of 3,979,200 shares. These awards may be in the form of stock options, stock appreciation rights, restricted stock, as well as other stock-based and cash-based awards. As of December 31, 2016, the awards granted were either time-based (cliff vest over three years), performance-based (vest when performance targets are met, as defined in the stock option grant agreement), or restricted stock units (employee RSUs cliff vest over three years and non-employee director RSUs cliff vest over one year). At December 31, 2016, there were 2,627,585 shares of common stock available to be issued or used for reference purposes under the 2014 Plan. NASDAQ Marketplace Rules Inducement Award-During the year ended December 31, 2016, 500,000 service period stock options and 500,000 performance-based stock options were granted to the Company’s CEO as an inducement under the NASDAQ Marketplace Rules. Under the terms of the agreement, the grant is governed as if issued under the 2014 Omnibus Plan. As of December 31, 2016, the awards granted were time-based (cliff vest over four years) and performance-based (vest when performance targets are met, as defined in the stock option grant agreement). FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Service Period Stock Options-A summary of service period stock options outstanding and changes under the plans during the year ended December 31, 2016 is presented below: Of the options exercisable at December 31, 2016, 1,274,034 were in-the-money, which account for the entire aggregate intrinsic value. The total intrinsic value of options exercised during the years ended December 31, 2016 and December 31, 2015 were $1,467,076 and $531,962, respectively. A summary of the nonvested service period stock options as of December 31, 2016, and changes during the year ended December 31, 2016, is presented below: As of December 31, 2016, there was $6,027,096 of total unrecognized compensation costs related to non-vested service period options, of which $2,535,584 will be incurred in 2017, $2,202,286 will be incurred in 2018, $841,354 will be incurred in 2019 and the remaining will be incurred in 2020. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Performance Based Options-Performance based option vesting is contingent upon the Company achieving certain annual or cumulative revenue goals. A summary of performance-based stock options outstanding and changes under the plans during the year ended December 31, 2016 is presented below: No performance-based options were exercisable at December 31, 2016, 2015, or 2014. A summary of the nonvested performance-based options as of December 31, 2016, and changes during the year ended December 31, 2016, is presented below: During the fourth quarter of the year ended December 31, 2015, the achievement of the vesting criteria related to the performance-based awards under the 2010 and 2014 plans (which were modified and granted in November 2014, respectively) was no longer probable. As a result, the Company reversed $2,573,484 of compensation expenses related to performance-based awards during the fourth quarter of the year ended December 31, 2015. Additional performance-based awards were granted in 2016 under the 2014 Omnibus Plan. During the fourth quarter of the year ended December 31, 2016, the achievement of the vesting criteria related to the tranche of these awards which would have vested on December 31, 2016 was no longer probable. As a result, the Company reversed $56,815 of compensation expenses related to performance-based awards during the fourth quarter of the year ended December 31, 2016. As of December 31, 2016, unrecognized compensation costs related to performance-based awards for which the achievement of the vesting criteria is considered probable as of December 31, 2016 have performance target dates ranging from December 31, 2017 through December 31, 2020. There was approximately $2,248,392 of total unrecognized compensation costs related to non-vested performance-based options, of which $648,843 will be incurred in 2017, $655,368 will be incurred in 2018, $471,444 will be incurred in 2019 and the remaining will be incurred in 2020. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Restricted Stock Units-The following table includes activity related to outstanding restricted stock units during the twelve months ended December 31, 2016. As of December 31, 2016, there was approximately $537,513 of total unrecognized compensation costs related to restricted stock units, of which $302,447 will be incurred in 2017, $173,332 will be incurred in 2018, and $61,735 will be incurred in 2019. Exit Event Options-Exit event option vesting is contingent upon the occurrence of an exit event, which results from a Change of Control in the Company or an Initial Public Offering of the Company’s common stock under the Securities Act, as defined in the option grant agreement. A summary of exit event stock options outstanding and changes under the plans during the year ended December 31, 2014 is presented below: No exit event options were granted during 2016 or 2015. A summary of the nonvested exit event stock options as of December 31, 2014 and changes during the year ended December 31, 2014, is presented below: Grant Date Fair Value of Options-The weighted average grant date fair value of options (service period options and performance based options) granted during the years ended December 31, 2016, 2015, and 2014 were $5.09, $7.66 and $8.35 per share, respectively. Expected Volatility-For the grants during the year ended December 31, 2013, the expected volatility was based on the historical volatility of the Company’s common stock. The Company utilized its historical stock price as an indicator of volatility for all grants prior to 2013. The grants during 2014 all occurred while the Company was publicly traded. Subsequent to the IPO, we no longer deemed it appropriate to use historical volatility as it was not representative of the Company’s stock on the public market. As such expected volatility that was utilized was based upon the volatility of a group of similar entities, referred to as “guideline” companies. As Freshpet has more historical data based on more time as a public company, the historical volatility of Freshpet becomes a more significant input. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Weighted Average Expected Term-The Company determined the expected term based on the “shortcut method” described in FASB ASC 718, Compensation-Stock Compensation (an expected term based on the midpoint between the vesting date and the end of the contractual term). Risk-Free Interest Rate-The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant. Expected Dividend Yield-The Company has not historically declared dividends, and no future dividends are expected to be available to benefit option holders. Accordingly, the Company used an expected dividend yield of zero in the valuation model. Note 13 - Net Loss Attributable to Common Stockholders: Basic net loss per common share is calculated by dividing net loss attributable to common stockholders by the weighted-average number of common share outstanding for the period. Diluted net loss per common share is computed by giving effect to all potentially dilutive securities. Diluted net loss per common share is the same as basic net loss per common share, due to the fact that potentially dilutive securities would have an antidilutive effect as the Company incurred a net loss for the years ended December 31, 2016, 2015 and 2014. The computation of net income attributable to common stockholders is as follows: The potentially dilutive securities excluded from the determination of diluted loss per share, as their effect is antidilutive, are as follows: Note 14 - Retirement Plan: The Company sponsors a safe harbor 401(k) plan covering all employees. All employees are eligible to participate. Active participants in the plan may make contributions of up to 50% of their compensation, subject to certain limitations. Company contributions totaled approximately $497,731 in 2016, $380,357 in 2015, and $307,754 in 2014. FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 15 - Related Party Transactions: Payments made to a privately held entity, who is a stockholder of the Company, for the purchase of raw materials totaled approximately $6,565,384 in 2016, $6,068,038 in 2015, and $5,545,835 in 2014. The Company believes that all payments made to the shareholder are at market value and thus at arms-length. Note 16 - Concentrations: Concentration of Credit Risk-The Company maintains its cash balances in financial institutions that are insured by the Federal Deposit Insurance Corporation up to $250,000 each. At times, such balances may be in excess of the FDIC insurance limit. Major Customers-In 2016, 2015, and 2014, net sales to one of our distributors which sells directly to three of our customers, accounted for 23%, 22%, and 22% of our net sales, respectively. In 2016, no customers accounted for 10% of our net sales, while for the same period in 2015, one customer accounted for more than 10% of our net sales. In 2014, no customer accounted for more than 10% of our net sales. Major Suppliers-The Company purchased approximately 23% of its raw materials from one vendor during 2016, approximately 34% of its raw materials from two vendors during 2015, and approximately 54% of its raw materials from three vendors during 2014. The Company also purchased approximately 89% of its treats finished goods from four vendors in 2016, approximately 90% from three vendors in 2015, and approximately 96% from three vendors in 2014. The Company purchased approximately 84% of its packaging material from three vendors during 2016, 64% of its packaging material from three vendors during 2015, and approximately 74% of its packaging material from three vendors during 2014. Net Sales by Class of Retail-The following table sets forth net sales by class of retail. (1) Other sales represent less than 1% of net sales FRESHPET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 17 - Unaudited Quarterly Results: Unaudited quarterly results for the years ended December 31, 2016, 2015, and 2014 were as follows: (1) See note 9 for further detail regarding the dividend accretion that is included within net loss attributable to common stockholders. (2) Fourth quarter 2015 results include the reversal of $2.6 million of stock-based compensation expense related to performance-based awards. See Note 12.
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Based on the provided financial statement excerpt, here's a summary of the key financial policies and practices:
Key Financial Components:
1. Cash & Cash Equivalents
- Includes money market funds and liquid debt instruments
- Original maturity of 3 months or less
2. Short-Term Investments
- Interest-bearing certificates of deposits
- Maturities: 3 months to 1 year
- Interest recorded as other expenses
- Interest income historically immaterial
3. Accounts Receivable
- Recorded at net realizable value
- Includes allowance for uncollectible accounts
- Periodic evaluation of collectibility
- Write-offs based on management assessment
4. Inventories
- Valued at lower of cost or market
- Uses first-in, first-out (FIFO) method
- Includes allowances for:
* Obsolescence
* Excessive inventory
* Product deterioration
5. Property, Plant & Equipment
- Recorded at cost
- Depreciation: straight-line method
- Recovery period: 7 years
Note: The statement indicates a loss position, but specific figures are not provided in the excerpt.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ACCOUNTING FIRM To the Board of Directors and Stockholders of Kingold Jewelry, Inc. We have audited the consolidated balance sheets of Kingold Jewelry, Inc. (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2016. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. /s/ Friedman LLP New York, New York April 17, 2017 KINGOLD JEWELRY, INC. CONSOLIDATED BALANCE SHEETS (IN U.S. DOLLARS) The accompanying notes are an integral part of these consolidated financial statements KINGOLD JEWELRY, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (IN U.S. DOLLARS) The accompanying notes are an integral part of these consolidated financial statements KINGOLD JEWELRY, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015 (IN U.S. DOLLARS) The accompanying notes are an integral part of these consolidated financial statements KINGOLD JEWELRY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN U.S. DOLLARS) The accompanying notes are an integral part of these consolidated financial statements KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION Kingold Jewelry, Inc. (“Kingold” or “the Company”) was incorporated in the State of Delaware on September 5, 1995. Dragon Lead Group Limited (“Dragon Lead”) was incorporated in the British Virgin Islands (“BVI”) on July 1, 2008 as an investment holding company and was 100% controlled by Kingold. Wuhan Vogue-Show Jewelry Co., Limited (“Wuhan Vogue-Show”), which is principally engaged in design and manufacture of gold and platinum ornaments in the People’s Republic of China (“PRC”), was incorporated in the PRC as a wholly-owned foreign enterprise on February 16, 2009, and was 100% owned by Dragon Lead. Wuhan Vogue-Show’s business permit expires on February 16, 2019, and is renewable upon expiration. Wuhan Kingold Jewelry Co., Limited (“Wuhan Kingold”) was incorporated in the PRC on August 2, 2002 as a limited liability company. On October 26, 2007, Wuhan Kingold was restructured as a joint stock company limited by shares and its business activities are the same as those of Wuhan Vogue-Show. Wuhan Kingold’s business permit expires on July 1, 2052 and is renewable upon expiration. Wuhan Kingold is effectively controlled by Wuhan Vogue-Show through a series of agreements and Amendment Agreements (collectively referred to as the Restructuring Agreements). In accordance with the Agreements and Amendments, shareholders holding 100% of the outstanding equity of Wuhan Kingold were parties to the agreements such that Wuhan Kingold has agreed to pay 100% of its after-tax profits to Wuhan Vogue-Show and shareholders owning 100% of Wuhan Kingold’s shares have pledged and delegated their voting power in Wuhan Kingold to Wuhan Vogue-Show. These contractual arrangements enable Wuhan Vogue-Show to: •exercise effective control over Wuhan Kingold; •receive substantially all of the economic benefits from Wuhan Kingold; and •have an exclusive option to purchase 100% of the equity interest in Wuhan Kingold, when and to the extent permitted by PRC law. Through such arrangements, Wuhan Kingold has become Wuhan Vogue-Show’s contractually controlled affiliate. Kingold is empowered, through its wholly owned subsidiaries Dragon Lead and Wuhan Vogue-Show, with the ability to control and substantially influence Wuhan Kingold’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholders’ approval. Kingold is also obligated to absorb a majority of expected losses of Wuhan Kingold, which enables Kingold to receive a majority of expected residual returns from Wuhan Kingold, and because Kingold has the power to direct the activities of Wuhan Kingold that most significantly impact Wuhan Kingold’s economic performance, Kingold, through its wholly-owned subsidiaries, accounts for Wuhan Kingold as its Variable Interest Entity (“VIE”) under ASC 810-10-05-8A. Accordingly, Kingold consolidates Wuhan Kingold’s operating results, assets and liabilities. In April 2015, Wuhan Kingold Jewelry Co., Inc. (“Wuhan Kingold”) established a new subsidiary Wuhan Kingold Internet Co., Ltd. (“Kingold Internet”), of which Wuhan Kingold holds a 55% ownership interest and a third-party minority shareholder holds the remaining 45% ownership interest. Kingold Internet engaged in promoting the online sales of jewelry products through cooperation with Tmall.com, a large business-to-consumer online retail platform owned by Alibaba Group. In May 2015, Kingold Internet also established a new subsidiary Yuhuang Jewelry Design Co., Ltd (“Yuhuang”). On December 14, 2016, Wuhan Kingold transferred its 55% ownership interest in Kingold Internet to Wuhan Kingold Industrial Group Co., Ltd., a related party, for a consideration of $79,196 (RMB 550,000), which was the same amount Wuhan Kingold originally invested. After the transfer, Kingold Internet and Yuhuang were no longer the subsidiaries of Wuhan Kingold. Kingold, Dragon Lead, and Wuhan Vogue-Show, are hereinafter collectively referred to as the “Company.” KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The accompanying consolidated financial statements include the financial statements of Kingold, Dragon Lead, Wuhan Vogue-Show and Wuhan Kingold. All inter-company balances and transactions have been eliminated in consolidation. Use of Estimates The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements as well as the reported amounts of revenues and expenses during the reporting period. Significant estimates required to be made by management include, but are not limited to, useful lives of property, plant and equipment, intangible assets, the recoverability of long-lived assets, inventory valuation, allowance for doubtful accounts, investment in gold and share based compensation. Actual results could differ from those estimates. Cash Cash includes cash on hand and demand deposits in accounts maintained with commercial banks within the PRC. The Company considers all highly liquid investments with original maturities of three months or less when purchased to be cash equivalents. The Company maintains most of the bank accounts in the PRC. Cash balances in bank accounts in PRC are not insured by the Federal Deposit Insurance Corporation or other programs. Restricted Cash As of December 31, 2016 and 2015, the Company had restricted cash of $60,344,430 and $26,649,687, respectively. Approximately total of $9.9 million was related to the various bank loans with banks and financial institutions - see Note 6 - Bank Loans. Approximately total of $28.8 million was used to guarantee a thirty party to obtain a bank loan - see Note 10 - Third Party Loan. Approximately total of $21.6 million was related to the gold lease deposits with Shanghai Pudong Development Bank (“SPD Bank”) and China Construction Bank (“CCB”) - see Note 21 - Gold Lease Transactions. Accounts Receivable The Company generally receives cash payment upon delivery of a product, but may extend unsecured credit to its customers in the ordinary course of business. The Company mitigates the associated risks by performing credit checks and actively pursuing past due accounts. An allowance for doubtful accounts is established and recorded based on management’s assessment of the credit history of the customers and current relationships with them. At December 31, 2016 and 2015, there was no allowance recorded as the Company considers all of the accounts receivable fully collectible. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Inventories Inventories are stated at the lower of cost or market value, and cost is calculated on the weighted average basis. As of December 31, 2016 and December 31, 2015, there was no lower of cost or market adjustment because the carrying value of the Company’s inventories was lower than the current and expected market price of gold. The cost of inventories comprises all costs of purchases, costs of fixed and variable production overhead and other costs incurred in bringing the inventories to their present condition. Property and equipment Property, equipment and leasehold improvements are stated at cost, less accumulated depreciation. Expenditures for additions, major renewals and betterments are capitalized, and expenditures for maintenance and repairs are charged to expense as incurred. For property and equipment, depreciation is provided on a straight-line basis, less estimated residual value, over an asset’s estimated useful life. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful life of the related assets. The estimated useful lives used in connection with the preparation of the financial statements are as follows: Construction-in-Progress Construction in progress represents property and buildings under construction and consists of construction expenditures, equipment procurement, and other direct costs attributable to the construction. Construction in progress is not depreciated. Upon completion and when ready for intended use, construction in progress is reclassified to the appropriate category within property, plant and equipment or will be classified as an asset held for sale. Land Use Right Under PRC law, all land in the PRC is owned by the government and cannot be sold to an individual or company. The government grants individuals and companies the right to use parcels of land for specified periods of time. These land use rights are sometimes referred to informally as “ownership.” Land use rights are stated at cost less accumulated amortization. Amortization is provided over the respective useful lives, using the straight-line method. Estimated useful life is 50 years, and is determined in connection with the term of the land use right. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Long-lived assets Certain assets such as property, plant and equipment and construction in progress, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Recoverability of assets that are held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount exceeds the fair value of the asset. There were no events or changes in circumstances that necessitated a review of impairment of long-lived assets as of December 31, 2016 and 2015. Fair value of financial instruments The Company follows the provisions of Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures.” ASC 820 clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows: Level 1-Observable inputs such as unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date. Level 2-Inputs other than quoted prices that are observable for the asset or liability in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs derived from or corroborated by observable market data. Level 3-Inputs are unobservable inputs which reflect management’s assumptions based on the best available information. The carrying value of current assets and current liabilities approximate their fair values because of the short-term nature of these instruments. The Company determined that the carrying value of the long term loans approximated their fair value by comparing the stated loan interest rate to the rate charged by similar financial institutions. The Company uses quoted prices in active markets to measure the fair value of investments in gold. Investments in Gold The Company pledged the gold leased from related party and part of its own gold inventory to meet the requirements of bank loans. The pledged gold will be available for sale upon the repayment of the bank loans. The Company classified these pledged gold as investments in gold, and carried at fair market value, with the unrealized gains and losses, included in accumulated other comprehensive income (loss) and reported in shareholders’ equity. The fair market value of the investments in gold is determined by quoted market prices at Shanghai Gold Exchange. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Revenue recognition Net sales are primarily composed of sales of branded products to wholesale and retail customers, as well as fees generated from customized production. In customized production, a customer supplies the Company with the raw materials and the Company creates products per that customer’s instructions, whereas in branded production the Company generally purchases gold directly and manufactures and markets the products on its own. The Company recognizes revenues under ASC 605 as follows: Sαles of brαnded products The Company recognizes revenue on sales of branded products when the goods are delivered and title to the goods passes to the customer provided that: there are no uncertainties regarding customer acceptance; persuasive evidence of an arrangement exists; the sales price is fixed and determinable; and collectability is deemed probable. Customized production fees The Company recognizes services-based revenue (the processing fee) from such contracts for customized production when: (i) the contracted services have been performed and (ii) collectability is deemed probable. Income taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period including the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. The provisions of ASC 740-10-25, “Accounting for Uncertainty in Income Taxes,” prescribe a more-likely-than-not threshold for consolidated financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return. This interpretation also provides guidance on the recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and related disclosures. The Company does not believe that there was any uncertain tax position at December 31, 2016 and 2015. To the extent applicable, the Company records interest and penalties as a general and administrative expense. The statute of limitations for the Company’s U.S. federal income tax returns and certain state income tax returns remains open for tax years 2010 and after. As of December 31, 2016 the tax years ended December 31, 2010 through December 31, 2016 for the Company’s PRC subsidiaries remain open for statutory examination by PRC tax authorities. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Foreign currency translation Kingold, as well as its wholly owned subsidiary, Dragon Lead, maintain accounting records in United States Dollars (“US$”), whereas Wuhan Vogue-Show and Wuhan Kingold maintain their accounting records in Renminbi (“RMB”), which is the primary currency of the economic environment in which their operations are conducted. The Company’s principal country of operations is the PRC. The financial position and results of its operations are determined using RMB, the local currency, as the functional currency. The results of operations and the statement of cash flows denominated in foreign currency are translated at the average rate of exchange during the reporting period. Assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the applicable rates of exchange in effect at that date. The equity denominated in the functional currency is translated at the historical rate of exchange at the time of capital contribution. Because cash flows are translated based on the average translation rate, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet. Translation adjustments arising from the use of different exchange rates from period to period are included as a component of stockholders’ equity as “Accumulated Other Comprehensive Income. ” The value of RMB against US$ and other currencies may fluctuate and is affected by, among other things, changes in the PRC’s political and economic conditions. Any significant revaluation of RMB may materially affect the Company’s financial condition in terms of US$ reporting. The following table outlines the currency exchange rates that were used in creating the consolidated financial statements in this report: Comprehensive income (loss) Comprehensive income consists of two components, net income and other comprehensive income (loss). The unrealized gain or loss resulting from the change of the fair market value from the gold investments and the foreign currency translation gain or loss resulting from translation of the financial statements expressed in RMB to US$ are reported in other comprehensive income in the consolidated statements of income and comprehensive income. Earnings per share (“EPS”) Basic EPS is measured as net income divided by the weighted average common shares outstanding for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (i.e., options and warrants) as if they had been converted at the beginning of the periods presented, or issuance date, if later. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS. Share or Stock-Based compensation The Company follows the provisions of ASC 718, “Compensation - Stock Compensation,” which establishes the accounting for employee stock-based awards. For employee stock-based awards, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense with graded vesting on a straight-line basis over the requisite service period for the entire award. For the non-employee stock-based awards, the fair value of the awards to non-employees are measured every reporting period based on the value of the Company’s common stock. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Debts issuance cost During the quarter ended June 30, 2015, the Company adopted Accounting Standards Update (“ASU”) 2015-03, “Simplifying the Presentation of Debt Issuance Costs,” which requires that debt issuance cost related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the debt liability, consistent with debt discounts, without changing existing recognition and measurement guidance for debt issuance costs. Amortization of debt issuance costs is calculated using the effective interest method and is included as a component of financing costs. The new guidance is required to be applied on a retrospective basis and to be accounted for as a change in an accounting principle. Deposit payables - Jewelry Park Deposit payables consist of amounts received from customers relating to the pre-sale of the residential or commercial units in the Jewelry Park. The Company receives these funds and recognizes them as a liability until the revenue can be recognized. During the year ended December 31, 2016, deposit payables balance was settled when the Jewelry Park was transferred from the Company to Wuhan Lianfuda (See Note 5). Risks and Uncertainties The jewelry industry generally is affected by fluctuations in the price and supply of diamonds, gold, and, to a lesser extent, other precious and semi-precious metals and stones. The Company potentially has exposure to the fluctuation in gold commodity prices as part of its normal operations. In the past, the Company has not hedged its requirement for gold or other raw materials through the use of options, forward contracts or outright commodity purchasing. A significant increase in the price of gold could increase the Company’s production costs beyond the amount that it is able to pass on to its customers, which would adversely affect the Company’s sales and profitability. A significant disruption in the Company’s supply of gold, or other commodities, could decrease its production and shipping levels, materially increase its operating costs, and materially and adversely affect its profit margins. Shortages of gold, or other commodities, or interruptions in transportation systems, labor strikes, work stoppages, war, acts of terrorism, or other interruptions to or difficulties in the employment of labor or transportation in the markets in which the Company purchases its raw materials, may adversely affect its ability to maintain production of its products and sustain profitability. Although the Company generally attempts to pass on increased commodity prices to its customers, there may be circumstances in which it is not able to do so. In addition, if the Company were to experience a significant or prolonged shortage of gold, it would be unable to meet its production schedules and to ship products to its customers in a timely manner, which would adversely affect its sales, margins and customer relations. Furthermore, the value of the Company’s inventory may be affected by commodity prices. The Company records the value of its inventory using the lower of cost or market value, cost calculated on the weighted average method. As a result, decreases in the market value of precious metals such as gold would result in a lower stated value of the Company’s inventory, which may require it to take a charge for the decrease in the value of its inventory. The Company also allocated significant portion of its inventories as investment in gold and pledged as collateral to secure loans from banks and financial institutions, there is a risk that the Company is unable to utilize its inventories, and there could be a disruption in the Company’s supply of gold which could decrease its production and shipping levels. In addition, the investment in gold may be deficient if the fair market value of the pledged gold in connection with the loans declines, then the Company may need to increase the pledged gold inventory for the loan collateral or increase restricted cash. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Risks and Uncertainties (continued) The Company’s operations are located in the PRC. Accordingly, the Company’s business, financial condition, and results of operations may be influenced by the political, economic, and legal environments in the PRC, as well as by the general state of the PRC economy. The Company’s operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment, and foreign currency exchange. The Company’s results may be adversely affected by changes in the political, regulatory and social conditions in the PRC, and by changes in governmental policies or interpretations with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation, among other things. In addition, the Company only controls Wuhan Kingold through a series of agreements. Although the Company believes the contractual relationships through which it controls Wuhan Kingold comply with current licensing, registration and regulatory requirements of the PRC, it cannot assure you that the PRC government would agree, or that new and burdensome regulations will not be adopted in the future. If the PRC government determines that the Company’s structure or operating arrangements do not comply with applicable law, it could revoke the Company’s business and operating licenses, require it to discontinue or restrict its operations, restrict its right to collect revenues, require it to restructure its operations, impose additional conditions or requirements with which the Company may not be able to comply, impose restrictions on its business operations or on its customers, or take other regulatory or enforcement actions against the Company that could be harmful to its business. If such agreements were cancelled, modified or otherwise not complied with, the Company would not be able to retain control of this consolidated entity and the impact could be material to the Company’s operations. Although the Company has not experienced losses from these situations and believes that it is in compliance with existing laws and regulations, including the organization and structure disclosed in Note 1, this may not be indicative of future results. Recent Accounting Pronouncements In April 2016, the Financial Accounting Standard Board (“FASB”) released ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The ASU includes multiple provisions intended to simplify various aspects of the accounting for share-based payments. While aimed at reducing the cost and complexity of the accounting for share-based payments, the amendments are expected to significantly impact net income, EPS, and the statement of cash flows. Implementation and administration may present challenges for companies with significant share-based payment activities. The ASU is effective for public companies in annual periods beginning after December 15, 2016, and interim periods within those years. The Company does not expect that the adoption of this guidance will have a material impact on its consolidated financial statements. In May 2016, the FASB issued ASU No. 2016-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815); Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting, which is rescinding certain SEC Staff Observer comments that are codified in Topic 605, Revenue Recognition, and Topic 932, Extractive Activities-Oil and Gas, effective upon adoption of Topic 606. The Company does not expect that the adoption of this guidance will have a material impact on its consolidated financial statements. In May 2016, FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606); Narrow-Scope Improvements and Practical Expedients, which is intended to not change the core principle of the guidance in Topic 606, but rather affect only the narrow aspects of Topic 606 by reducing the potential for diversity in practice at initial application and by reducing the cost and complexity of applying Topic 606 both at transition and on an ongoing basis. The Company does not expect that the adoption of this guidance will have a material impact on its consolidated financial statements. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Recent Accounting Pronouncements (continued) In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, to provide guidance on the presentation and classification of certain cash receipts and cash payments on the statement of cash flows. The guidance specifically addresses cash flow issues with the objective of reducing the diversity in practice. The guidance will be effective for the Company in fiscal year 2018, but early adoption is permitted. The Company does not expect that the adoption of this guidance will have a material impact on its consolidated financial statements. In October 2016, the FASB issued ASU No. 2016-17, Consolidation (Topic 810): Interest Held through Related Parties That Are under Common Control, to provide guidance on the evaluation of whether a reporting entity is the primary beneficiary of a VIE by amending how a reporting entity, that is a single decision maker of a VIE, treats indirect interests in that entity held through related parties that are under common control. The amendments are effective for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company does not expect that the adoption of this guidance will have a material impact on its consolidated financial statements. In October 2016, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2016-17, Consolidation (Topic 810): Interest Held through Related Parties That Are under Common Control, to provide guidance on the evaluation of whether a reporting entity is the primary beneficiary of a VIE by amending how a reporting entity, that is a single decision maker of a VIE, treats indirect interests in that entity held through related parties that are under common control. The amendments are effective for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The adoption of this ASU will not have any impact to the Company’s consolidated financial statements as the Company did not have any interest held through related parties with common control. In November 2016, the FASB issued Accounting Standards Update No. 2016-18, “Statement of Cash Flows (Subtopic 230)” (“ASU 2016-18”). The new guidance requires that the statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. The standard will be effective for the first interim period within annual reporting periods beginning after December 15, 2017 and early adoption is permitted. The amendments should be applied using retrospective transition method to each period presented. The adoption of this guidance will increase cash and cash equivalents by the amount of restricted cash on the Company’s consolidated statement of cash flows. In December 2016, the FASB issued ASU No. 2016-20, "Technical Corrections and Improvements to Topic 606," which includes thirteen technical corrections or improvements that affect only narrow aspects of the guidance in ASU No. 2014-09. ASU No. 2014-09 and all of the related ASUs have the same effective date. On July 9, 2015, the FASB deferred the effective date of ASU No. 2014-09 for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early adoption is permitted as of the original effective dates, which are annual reporting periods beginning after December 15, 2016 and interim periods within those annual periods. The new standard is to be applied retrospectively and permits the use of either the retrospective or cumulative effect transition method. The Company is currently evaluating the effect that the adoption of this update will have on the consolidated financial statements. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Recent Accounting Pronouncements (continued) In January 2017, the FASB issued ASU No. 2017-01, "Business Combinations (Topic 805): Clarifying the Definition of a Business". The amendments in this ASU clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. Basically these amendments provide a screen to determine when a set is not a business. If the screen is not met, the amendments in this ASU first, require that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output and second, remove the evaluation of whether a market participant could replace missing elements. These amendments take effect for public businesses for fiscal years beginning after December 15, 2017 and interim periods within those periods, and all other entities should apply these amendments for fiscal years beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. The Company does not expect that the adoption of this guidance will have a material impact on its consolidated financial statements. Reclassification: Certain prior year amounts have been reclassified for consistency with the current year presentation. This reclassification has no effect on the previously reported consolidated financial statements for the year ended December 31, 2015 KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 - INVENTORIES Inventories as of December 31, 2016 and December 31, 2015 consisted of the following: (A)Included 185,000 grams of Au9999 gold as of December 31, 2016 and 5,624,476 grams of Au9999 gold as of December 31, 2015. (B)Included 2,358,178 grams of Au9999 gold as of December 31, 2016 and 3,549,984 grams of Au9999 gold as of December 31, 2015. (C)Included 993,699 grams of Au9999 gold as of December 31, 2016 and 886,849 grams of Au9999 gold as of December 31, 2015. As of December 31, 2016, no inventory was pledged on the debts payable because it has been fully repaid upon maturity and accordingly previously pledged inventory has been released (see Note 13). As of December 31, 2015, 3,977,490 grams of Au9999 gold with carrying value of approximately $115.1 million were pledged for certain bank loans and another 2,456,000 grams of Au9999 gold with carrying value of approximately $72.29 million were pledged for the Company’s debts payable. No lower of cost or market adjustment was recorded at December 31, 2016 and 2015, respectively. NOTE 4 - PROPERTY AND EQUIPMENT, NET The following is a summary of property and equipment as of December 31, 2016 and December 31, 2015: Depreciation expense for the years ended December 31, 2016 and 2015 was $1,403,688 and $1,388,389, respectively. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5 - JEWELRY PARK On October 23, 2013, the Company, through its wholly-owned subsidiary, Wuhan Kingold, entered into an acquisition agreement (the “Acquisition Agreement”) with third-parties Wuhan Wansheng House Purchasing Limited (“Wuhan Wansheng”) and Wuhan Huayuan Science and Technology Development Limited Company (“Wuhan Huayuan”). The Acquisition Agreement provides for the build out of the planned “Shanghai Creative Industry Park,” which is proposed to be renamed to “Kingold Jewelry Cultural Industry Park” (the “Jewelry Park”). Pursuant to the Acquisition Agreement, Wuhan Kingold acquired the land use rights for a parcel of land (the “Land”) in Wuhan for a total of 66,667 square meters (approximately 717,598 square feet, or 16.5 acres) (the “Land Use Right”), which had been approved for real estate development use. Wuhan Kingold committed to provide a total sum of RMB 1.0 billion (approximately $144 million as of December 31, 2016) for the acquisition of this Land Use Right and to finance the entire development and construction of a total of 192,149 square meters (approximately 2,068,000 square feet) of commercial properties, which were proposed to include a commercial wholesale center for various jewelry manufacturers, two commercial office buildings, a commercial residence of condominiums as well as a hotel. On June 27, 2016, Wuhan Kingold entered into a transfer contract with Wuhan Lianfuda Investment Management Co., Ltd. (“Wuhan Lianfuda”), an unrelated party, to sell all of its interest in the Jewelry Park to Wuhan Lianfuda (“Transfer Transaction”). Pursuant to the transfer contract, Wuhan Lianfuda is obligated to pay Wuhan Kingold RMB 1.14 billion (approximately US $164.2 million) (“Selling Price”). This amount includes (1) RMB 640 million (approximately US $92.2 million) for the share acquisition fees and the construction fees that Wuhan Kingold has paid to Wuhan Wansheng; and (2) transfer fees of RMB 500 million (approximately US $72 million). In addition, Wuhan Kingold transfers and Wuhan Lianfuda receives all the rights and obligations in the Transfer Transaction Agreement, including 60% stock rights of Wuhan Huayuan. Wuhan Lianfuda will undertake Wuhan Kingold’s remaining payment obligation of RMB 360 million (approximately US $54.2 million) stipulated in the Acquisition Agreement. Before the Transfer Transaction, the carrying value of Jewelry Park was approximately $162.6 million (RMB 1.08 billion), included the following components (1) Land use right of approximately $9.1 million (RMB 60.4 million), which represents the total cost of the Land Use Right and (2) the construction progress of approximately $153.4 million (RMB 1.02 billion), consisting of the Company’s cash payment of approximately $87.3 million (RMB 580 million) towards the construction of Jewelry Park project, capitalized interest of approximately $12 million (RMB 80 million), and the construction payable of approximately $54.2 million (RMB 360 million) has been accrued based on the billing request by the construction company Wuhan Wansheng. As of December 31, 2016, the project has passed all inspections and completed acceptance procedures. The Company transferred its 60% ownership in Wuhan Huayuan to Wuhan Lianfuda to complete the transaction. In connection with the Jewelry Park Transfer Transaction, Wuhan Lianfuda undertook Wuhan Kingold’s remaining payment obligation of $54.2 million (RMB 360 million).The following table presents the components of the property held for sale- Jewelry Park at of the transaction date and December 31, 2015: As of the transaction date, the carrying value of Jewelry Park was approximately $162.6 million (RMB 1,080 million), with total construction payables and deposit payable of approximately $225.8 million (RMB 1,500 million). For the year ended December 31, 2016, the Company recognized gain of $63,212,496 due to this Transfer Transaction. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - LOANS Short term loans consist of the following: (a) Loans payable to CITIC Bank Wuhan Branch Loans payable to CITIC Bank Wuhan Branch with an aggregate amount of approximately $6.2 million (RMB 40 million) consisted of two working capital loan contracts originated on May 29, 2015 and June 1, 2015, with maturity dates of March 29, 2016 and March 1, 2016, respectively. The annual interest rate for both loans was 6.7%. The prior year loan balance was repaid upon maturity. All the loans from CITIC Bank Wuhan Branch were secured by restricted cash of approximately $1.3 million (RMB 9 million). The loan is also secured by 800,000 grams of Au9999 gold with carrying value of approximately $26.8 million (RMB 186 million). In addition, the Company's subsidiary Wuhan Kingold and Mr. Zhihong Jia, Chairman and Chief Executive Officer of the Company, separately signed a maximum guarantee agreement with the bank, to provide a maximum amount of approximately $22.3 million (RMB 155 million) guarantee for a line of credit of approximately $22.3 million (RMB 155 million) from CITIC Bank during May 25, 2015 through May 25, 2016. The $6.2 million loan has been fully repaid upon maturity. (b) Loan payable to Bank of Hubei, Wuhan Jiang’an Branch Loan payable to Bank of Hubei, Wuhan Jiang’an Branch with an aggregate amount of approximately $3.1 million (RMB 20 million) originated on November 12, 2015, with a maturity date of November 12, 2016. The annual interest rate was 6.7%. The $3.1 million loan has been fully repaid upon maturity. (c) Loan payable to Minsheng Trust Loan payable to Minsheng Trust with an aggregate amount of approximately $46.2 million (RMB 300 million) originated on September 17, 2015, with a maturity date of September 25, 2016. The annual interest rate was 12.5%. The loan is to be used for the Company’s working capital. The loan was fully repaid by December 31, 2016. The previous pledged restricted cash of approximately $0.4 million (RMB 3 million) was returned by December 31, 2016. On October 14, 2016, the Company entered into a Trust Loan Agreement with the Minsheng Trust to borrow a maximum of 70% of amount of pledged gold as a working capital loan. The Company is subject to 7.6% fixed annual interest rate. The term of the loan is one year from receiving of the principal amount. The Company is required to pledge 1877.49 kilograms of Au9995 gold with carrying value of approximately $62.9 million (RMB 436.5 million) as collateral. The total amount received by the Company was approximately $51.7 million (RMB 359 million) according to the calculation stated in the agreement. The Company was also required to pledge approximately $0.5 million (RMB 3.6 million) restricted cash with Minsheng Trust as collateral. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - LOANS (continued) (d) The current portion of loans payable to Yantai Huanshan Road Branch of Evergrowing Bank (see note (h) below). (e) Loans payable to National Trust On April 26, 2016, the Company entered into a trust loan agreement and an amendment to the trust loan agreement with the National Trust Ltd. (“National Trust”) to borrow a maximum of approximately $72 million (RMB 500 million) as working capital loan. The loan is comprised of two installments, with the first installment of approximately $14.4 million (RMB 100 million) and the second installment of approximately $57.6 million (RMB 400 million). Each installment has a one-year term starting from the installment release date. For each installment, the Company is required to make the first interest payment equal to 4.1% of the principal received as loan origination fee, then the rest of interest payments are calculated based on a fixed interest rate of 8% and due on semi-annual basis. The Company is required to pledge 2,600 kilograms of Au9995 gold with carrying value of approximately $87 million (RMB 604.5 million) as collateral to secure this loan. The loan is jointly guaranteed by the CEO and Chairman of the Company, and Wuhan Vogue-Show. The Company received full proceeds in May 2016. The Company also made a restricted deposit of approximately $0.7 million (RMB 5 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. The Company paid approximately $5 million (RMB 34.7 million) as loan origination fee for obtaining the loan. The loan origination fee was recorded as deferred financing cost against the loan balance. For the year ended December 31, 2016, approximately $3.2 million (RMB 22.1 million) deferred financing cost was amortized. As of December 31, 2016, the deferred financing cost related to obtaining this loan was approximately $1.8 million (RMB 12.6 million). On July 11, 2016, the Company entered into a Trust Loan Agreement with the National Trust Ltd. (“National Trust”) to borrow a maximum of approximately $72 million (RMB 500 million) as a working capital loan. The Company is required to make a loan origination fee equivalent to 4.1% of the loan principal amount which was approximately $5 million (RMB 34.7 million). The Company is subject to 8% interest which will be paid on a semiannual basis. The term of the loan could be extended for one additional year. The Company is required to pledge 2,660 kilograms of Au9995 gold with carrying value of approximately $89.1 million (RMB 618.5 million) as collateral. The loan is guaranteed by the CEO and Chairman of the Company, and Wuhan Vogue-Show. The Company also made a restricted deposit of approximately $0.7 million (RMB 5 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. The Company paid approximately $5 million (RMB 34.7 million) as loan origination fee for obtaining the loan. The loan origination fee was recorded as deferred financing cost against the loan balance. For the year ended December 31, 2016, approximately $2.3 million (RMB 16.1 million) deferred financing cost was amortized. As of December 31, 2016, the deferred financing cost related to obtaining this loan was approximately $2.7 million (RMB 18.6 million). (f) Loan payable to Aijian Trust On April 28, 2016, Wuhan Kingold and Shanghai Aijian Trust Co., Ltd. (“Aijian Trust”) entered into a gold income right transfer and repurchase agreement. According to the agreement, Aijian Trust acquired the income rights from Wuhan Kingold for Wuhan Kingold’s Au9999 gold worth at least RMB 412.5 million based on the closing price of gold on the most recent trading day at the Shanghai Gold Exchange (the “Gold Income Right”). Aijian Trust’s acquisition price for the Gold Income Right was approximately $43.2 million (RMB 300 million) (the “Acquisition Price”). Wuhan Kingold is required to repurchase the Gold Income Right back from Aijian Trust with installments and the last installment shall be within the 24 months after establishment of the trust plan. The repurchase price is equal to the Acquisition Price with annual return of 10% for the period from the agreement date and the last repayment date. The repurchase obligation may be accelerated under certain conditions, including upon breach of representations or warranties, certain cross-defaults, upon the occurrence of certain material events affecting the financial viability of Wuhan Kingold, and other customary conditions. Wuhan Kingold pledged the 1,542 kilograms of related Au9999 gold under the Gold Income Right to Aijian Trust with carrying value of approximately $51.6 million (RMB 358.5 million) as collateral. The agreement is also personally guaranteed by Mr. Zhihong Jia, our CEO and Chairman. The Company also made a restricted deposit of $0.4 million (RMB 3 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. Since Wuhan Kingold has a right to repurchase the Gold Income Right in 12 months, the loan is treated as a short term loan. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - LOANS (continued) Interest expense for all of the loans mentioned above for the years ended December 31, 2016 and 2015 was $14.8 million and $2.2 million, respectively. The weighted average interest rate for the year ended December 31, 2016 and 2015 was 9.4% and 11.5%, respectively. Long term loans consist of the following: (g) Loans payable to Evergrowing Bank - Qixia Branch On December 18, 2015, Wuhan Kingold signed a loan agreement with the Qixia Branch of Evergrowing Bank in the amount of approximately $30 million (RMB 200 million). This loan was used to partially fund the construction of the Jewelry Park and as working capital. The loan period was from December 18, 2015 to December 15, 2017 with the annual interest of 7.5%. The loan is secured by 1,300,000 grams of Au9999 gold with carrying value of approximately $49.4 million (RMB 343.1 million). In addition, the Company’s CEO and Chairman signed a guarantee agreement with the bank, to provide a guarantee for the loan. The loan was fully repaid by December 31, 2016. In January 2016, Wuhan Kingold further signed two Loan Agreements of Circulating Funds with the Qixia Branch of Evergrowing Bank for loans of approximately $115.2 million (RMB 800 million) in aggregate. The purpose of the loans is for purchasing gold. The terms of loans are two years and bear fixed interest of 7.5% per year. The loans are secured by 6,300,000 grams of Au9999 gold in aggregate with carrying value of approximately $210.9 million (RMB 1.5 billion) and are guaranteed by the CEO and Chairman of the Company. Both loans are due in January 2018. The repayment of the loans may be accelerated under certain conditions, including upon a default of principal or interest payment when due, breach of representations or warranties, certain cross-defaults, upon the occurrence of certain material events affecting the financial viability of Wuhan Kingold, and other customary conditions. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - LOANS (continued) (h) Loans payable to Evergrowing Bank - Yantai Huanshan Road Branch From February 24, 2016 to March 24, 2016, Wuhan Kingold signed ten Loan Agreements with the Yantai Huangshan Road Branch of Evergrowing Bank for loans of approximately $144 million (RMB 1 billion) in aggregate. The purpose of the loans is for purchasing gold. The terms of loans are two years and bear fixed interest of 7% per year. The loans are secured by 5,550,000 grams of Au9999 gold in aggregate with carrying value of approximately $185.8 million (RMB 1.3 billion) and are guaranteed by the CEO and Chairman of the Company. Based on the loan repayment plan as specified in the loan agreements, approximately $143,993 (RMB 1 million) was repaid in August 2016. Approximately $143,993 (RMB 1 million) should be repaid on February 23, 2017 and another $143,993 (RMB 1 million) should be repaid in August 23, 2017. Accordingly, these amounts have been reclassified as the current portion of the long-term loans. The remaining loans are due in February to March 2018. The repayment of the loans may be accelerated under certain conditions, including upon a default of principal or interest payment when due, breach of representations or warranties, certain cross-defaults, upon the occurrence of certain material events affecting the financial viability of Wuhan Kingold, and other customary conditions. Subsequently in February 2017, $143,993 (RMB 1 million) was repaid upon maturity. The repayment requirement is listed below: (i) Loans payable to Anxin Trust Co., Ltd In January 2016, Wuhan Kingold signed a Collective Trust Loan Agreement with Anxin Trust Co., Ltd. (“Anxin Trust”). The agreement allows the Company to access of approximately $431.9 million (RMB 3 billion) within 60 months. Each individual loan will bear a fixed annual interest of 14.8% with a term of 36 months or more. The purpose of this trust loan is to provide working capital for the Company to purchase gold. The loan is secured by 15,450,000 grams of Au9999 gold in aggregate with carrying value of approximately $517.3 million (RMB 3.6 billion). The loan is also guaranteed by the CEO and Chairman of the Company. As of December 31, 2016, the Company received full amount from the loan. The Company also made a restricted deposit of approximately $3.6 million (RMB 25 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. (j) Loans payable to Minsheng Trust On June 24, 2016, Wuhan Kingold entered into a loan agreement with Minsheng Trust, with an aggregate amount of approximately $28.8 million (RMB 200 million), with a maturity date of June 22, 2018. The annual interest rate was 10.85%. The loan is to be used for the working capital. Wuhan Kingold pledged 1,090,000 grams of gold with carrying value of approximately $36.5 million (RMB 253.4 million) as of December 31, 2016 to secure this loan. The Company was also required to pledge approximately $0.3 million (RMB 2 million) restricted cash with Minsheng Trust as collateral. The Company paid approximately $0.8 million (RMB 5.3 million) as loan origination fee for obtaining the loan. The loan origination fee was recorded as deferred financing cost against the loan balance. For the year ended December 31, 2016, approximately $0.2 million (RMB 1.4 million) deferred financing cost was amortized. As of December 31, 2016, the deferred financing cost related to obtaining this loan was approximately $0.6 million (RMB 3.9 million). KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - LOANS (continued) (k) Loans payable to Chang’An Trust On March 9, 2016, Wuhan Kingold entered into a Trust Loan Contract with Chang’An International Trust Co., Ltd. (“Chang’An Trust”). The agreement allows the Company to access a total of approximately $43.2 million (RMB 300 million) for the purpose of working capital needs. The loan has a 24-month term starting from the date of releasing the loan, and bears interest at a fixed rate of 13% per annum. The loan is secured by 1,121 kilograms of Au9995 gold, approximately $37.5 million (RMB 260.6 million) is pledged by Wuhan Kingold. The loan is guaranteed by the CEO and Chairman of the Company and shall be repaid upon maturity. As of December 31, 2016, the Company received an aggregate of approximately $28.7 million (RMB 199 million) from the loan. The Company also made a restricted deposit of $0.3 million (RMB 2 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. (l) Loans payable to Sichuan Trust On September 7, 2016, the Company entered into two trust loan agreements with the Sichuan Trust Ltd. (“Sichuan Trust”) to borrow a maximum of approximately $288 million (RMB 2 billion) as working capital loan. The loan period is 24 months from receiving. For the loan obtained the Company is required to make interest payments are calculated based on a fixed annual interest rate of 7.25%. The Company is required to make the first interest payment equal to 1.21% of the principle received as loan origination fee, then the rest of interest payments are calculated based on a fixed interest rate of 7.25%. The Company is required to pledge 7,258 kilograms of Au9999 gold with carrying value of approximately $243 million (RMB 1.7 billion) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. The Company also made a restricted deposit of approximately $2.2 million (RMB 15 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. As of December 31, 2016, the Company received an aggregate of approximately $216 million (RMB 1.5 billion) from the loan. The Company paid approximately $2.6 million (RMB 18.2 million) as loan origination fee for obtaining the loan. The loan origination fee was recorded as deferred financing cost against the loan balance. For the year ended December 31, 2016, approximately $0.3 million (RMB 1.8 million) deferred financing cost was amortized. As of December 31, 2016, the deferred financing cost related to obtaining this loan was approximately $2.4 million (RMB 16.4 million). (m) Loans payable to China Aviation Capital On September 7, 2016, the Company entered into a trust loan agreement with China Aviation Capital Investment Management (Shenzhen) ("China Aviation Capital") to borrow a maximum of approximately $86.4 million (RMB 600 million) as working capital loan. The first instalment of the loan is approximately $41.8 million (approximately RMB 290 million) with a period of 24 months from September 7, 2016 to September 7, 2018. For the loan obtained the Company is required to make interest payments are calculated based on a fixed annual interest rate of 7.5% and an one time consulting fee of 3% based on the principle amount received as loan origination fee. The Company is required to pledge 1,473 kilograms of Au9999 gold with carrying value of approximately $49.3 million (RMB 342.5 million) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. As of December 31, 2016, the Company received an aggregate of approximately $41.8 million (approximately RMB 290 million) from the loan. The Company paid approximately $1.3 million (RMB 8.7 million) as loan origination fee for obtaining the loan. The loan origination fee was recorded as deferred financing cost against the loan balance. For the year ended December 31, 2016, approximately $0.2 million (RMB 1.4 million) deferred financing cost was amortized. As of December 31, 2016, the deferred financing cost related to obtaining this loan was approximately $1.1 million (RMB 7.3 million). KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 - LOANS (continued) (n) Loans payable to China Construction Investment Trust On August 29, 2016, the Company entered into a trust loan agreement with China Construction Investment Trust to borrow a maximum of approximately $43.2 million (RMB 300 million) as working capital loan for the purposed of purchasing of gold solely with a period of 24 months from August 29, 2016 to August 29, 2018. For the loan obtained the Company is required to make interest payments are calculated based on a fixed annual interest rate. The interest payment is divided into two parts: (1) 1% of the principle amount received need to be paid before December 25, 2016 as loan origination fee; (2) the rest of interest payments are calculated based on a fixed interest rate of 7.5% and due on quarterly basis. The Company is required to pledge 1,447 kilograms of Au9999 gold with carrying value of approximately $48.4 million (RMB 336.4 million) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. As of December 31, 2016, full amount of the loan was received by the Company. The Company paid approximately $0.4 million (RMB 3 million) as loan origination fee for obtaining the loan. The loan origination fee was recorded as deferred financing cost against the loan balance. For the year ended December 31, 2016, approximately $0.1 million (RMB 0.4 million) deferred financing cost was amortized. As of December 31, 2016, the deferred financing cost related to obtaining this loan was approximately $0.4 million (RMB 2.6 million). (o) Loans payable to Zheshang Jinhui Trust On November 7, 2016, the Company entered into a trust loan agreement with Zheshang Jinhui Trust to borrow a maximum of approximately $79.2 million (RMB 550 million) for purchasing gold with a period of 24 months from principle receiving date November 15, 2016 to November 15, 2018. For the loan obtained the Company is required to make interest payments are calculated based on a fixed annual interest rate of 7.8% based on the principal amount received. The Company is required to pledge 2,708 kilograms of Au9999 gold with carrying value of approximately $90.7 million (RMB 629.6 million) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. The Company also made a restricted deposit of approximately $0.8 million (RMB 5.5 million) to secure these loans. The deposit will be refunded when the loan is repaid upon maturity. (p) Loans payable to Hubei Assets Management On September 30, 2016, the Company entered into an Entrust Loan Agreement with the Hubei Asset Management Co., Ltd. to borrow from Industrial and Commercial Bank of China Wuhan Jiang'an Branch of a maximum of approximately $43.2 million (RMB 300 million) as a working capital loan in the later period. The Company is subject to 9.5% fixed annual interest rate. The term of the loan is two years from the date of receiving the principal amount. The Company is required to pledge 1,497 kilograms of Au9999 gold with carrying value of approximately $50.1 million (RMB 348.1 million) as collateral. The loan is guaranteed by the CEO and Chairman of the Company. The full amount of this entrust loan was received by the Company on October 28, 2016. (q) Loans payable to Zhongjiang International Trust On December 23, 2016, the Company entered into a trust loan agreement with Zhongjiang International Trust to borrow a maximum of approximately $57.6 million (RMB 400 million) for purchasing gold with a period of 24 months from December 23, 2016 to December 22, 2018. For the loan obtained the Company is required to make interest payments are calculated based on a fixed annual interest rate of 8.75% on the principle amount received. The Company is required to pledge 2,104 kilograms of Au9999 gold with carrying value of approximately $70.4 million (RMB 489 million) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. Total Interest for the above loans in the amount of $52.3 million and $3.8 million for the years ended December 31, 2016 and 2015, respectively. The weighted average interest rate for the years ended December 31, 2016 and 2015 was 11.2% and 11.5%, respectively. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 - INVESTMENTS IN GOLD During the year ended December 31, 2016, the Company leased a total of 16,000,000 grams of Au9999 gold in aggregate with carrying value of approximately $538.6 million (RMB 3,740 million) from Wuhan Shuntianyi Investment Management Ltd. (“Shuntianyi”), a related party (See Note 8). The leased gold was fully returned by the Company to Shuntianyi as of December 31, 2016. As of December 31, 2016, the Company allocated total of 54,677,490 grams of Au9999 gold in its inventories with carrying value of approximately $1,830.6 million as investments in gold for obtaining various loans from banks and financial institutions. (See Note 6) As of December 31, 2016, total investments in gold pledged had a fair market value of $1,775.8 million, which resulted in unrealized loss of $54.8 million. The Company recorded this unrealized loss as other comprehensive loss. As of December 31, 2016, a total of 45,998,000 grams of Au9999 gold with fair market value of approximately $1,494 million was pledged for long term bank loans, and therefore classified as non-current investment in gold. The remaining investments in gold of total 8,679,490 grams of Au9999 gold with fair market value of approximately $281.8 million was classified as current assets on the Company’s consolidated balance sheet as of December 31, 2016. NOTE 8 - GOLD LEASE PAYABLE - RELATED PARTY During the year ended December 31, 2016, the Company entered into multiple gold lease agreements with Wuhan Shuntianyi Investment Management Ltd. (“Shuntianyi”), a related party which is controlled by the CEO and the Chairman of the Company, to lease a total of 16,000,000 grams of Au9999 gold in aggregate with carrying value of approximately $538.6 million (RMB 3,740 million). The Company recorded these transactions as gold lease payable - related party. The leased gold was fully returned by the Company to Shuntianyi as of December 31, 2016. NOTE 9 - GOLD LEASE PAYABLE - BANK During the year ended December 31, 2016, the Company allocated significant amount of gold in its inventories as investments in gold and pledged as collateral to secure loans from banks and financial institutions. In order to meet the Company’s production needs, the Company also utilized the leased gold of 185,000 grams of Au9999 gold in aggregate with carrying value of approximately $7.2 million (RMB 49.8 million) from Shanghai Pudong Development Bank (“SPD Bank”), and recorded this transaction as gold lease payable - bank. The leased gold shall be returned to the SPD Bank upon lease maturity in June 2017. (See Note 21) Note 10 - THIRD PARTIES LOANS On April 12, 2016, the Company entered into a loan agreement with Yantai Runtie Trade Ltd. for a total loan of approximately $28.8 million (RMB 200 million). The loan is interest free and has one year term from April 12, 2016 to April 12, 2017. In order for Yantai Runtie Trade Ltd, to obtain the loan from the bank, Wuhan Kingold signed a guarantee agreement with the ultimate lender, Evergrowing Bank - Yantai Huanshan Road Branch, on April 12, 2016 to pledge restricted a deposit of totaling $28.8 million (RMB 200 million) to guarantee the loan. The deposit will be refunded when the loan is repaid upon maturity by Yantai Runtie Trade Ltd. On April 13, 2016, the Company entered into a loan agreement with Yantai Runtie Trade Ltd. for a total loan of approximately $2.9 million (RMB 20 million). In order for Yantai Runtie Trade Ltd, to obtain the loan from the bank, Wuhan Kingold signed a guarantee agreement with the ultimate lender, Evergrowing Bank - Yantai Huanshan Road Branch, on April 13, 2016 to pledge a restricted deposit of totaling $2.9 million (RMB 20 million) to guarantee the loan. The loan was repaid by the Company on October 13, 2016 and the deposit was released from the bank. On April 13, 2016, the Company entered into a loan agreement with Yantai Yongyu Trade Ltd. for a total loan of approximately $4.3 million (RMB 30 million). In order for Yantai Yongyu Trade Ltd, to obtain the loan from the bank, Wuhan Kingold signed a guarantee agreement with the ultimate lender, Evergrowing Bank - Yantai Huanshan Road Branch, on April 13, 2016 to pledge a restricted deposit of totaling $4.3 million (RMB 30 million) to guarantee the loan. The loan was repaid by the Company on December 14, 2016 and the deposit was released from the bank. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11 - RELATED PARTIES LOANS Between April 12, 2016 and May 22, 2016, the Company entered into multiple loan agreements with Wuhan Kangbo Biotech Limited (“Kangbo”), a related party which is controlled by the CEO and Chairman of the Company, for a total loan of approximately $144 million (RMB 1,000 million). The loans have one year terms and are interest free. In order for Kangbo to obtain the loans from the bank, Wuhan Kingold signed a guarantee agreement with Evergrowing Bank- Yantai Huangshan Road Branch to pledge a restricted deposit of totaling $144 million (RMB 1,000 million) to guarantee the loans. The loans were fully repaid by the Company on December 12, 2016 and the deposit was released from the bank. Between November 23, 2016 and November 29, 2016, the Company entered into multiple loan agreements with Wuhan Kingold Industrial Group, a related party which is controlled by the CEO and Chairman of the Company, as working capital loans in order to subsequently purchase raw material of gold. The aggregated borrowing amount as of December 31, 2016 is approximately $460.8 million (RMB 3,200 million) with a term of 5 years and free of interest. The Company classified these loans as non-current liabilities. NOTE 12 - OTHER RELATED PARTY TRANSACTIONS For the year ended December 31, 2016 and 2015, the Company received working capital proceeds from the CEO and Chairman of the Company, to pay certain expense to various service providers on behalf of the Company. Such amount is unsecured and repayable on demand with no interest. On December 14, 2016, Wuhan Kingold transferred its 55% ownership interest in Kingold Internet to Wuhan Kingold Industrial Group Co., Ltd., a related party which is controlled by the CEO and Chairman of the Company, for a consideration of $79,196 (RMB 550,000). After the transfer, Kingold Internet and Yuhuang were no longer the subsidiaries of Wuhan Kingold. NOTE 13 - DEBTS PAYABLE Amounts owed by the Company to Shanghai Pudong Development Bank (“SPD Bank”) under a Credit Agent Agreement were full repaid upon maturity on March 24, 2016 and approximately $5.3 million (RMB 35 million) security deposit was returned to the Company. The remaining deferred financing cost of $141,850 was fully amortized in the year ended December 31, 2016. Interest expense incurred on the debt financing instruments amounted to approximately $3.3 million for the year ended December 31, 2015 and was capitalized into construction in progress of Jewelry Park project. For the year ended December 31, 2016, approximately $1 million interest expenses were capitalized into construction in progress of Jewelry Park project, Pursuant to the Private Placement Agreement dated on August 12, 2014, the RMB 750 million debt financing instruments can be issued within two years. The Company originally planned to request the second phase of issuance of approximately $54 million (RMB 350 million) before the first phase debt expiration date in March 2016 and the proceeds will be used to pay back the first phase debt. However, the Company subsequently obtained alternative financing through several bank borrowings, management does not expect the second phase of debt issuance will be materialized in the near future. NOTE 14 - DEPOSIT PAYABLES - JEWELRY PARK As of December 31, 2015, the Company received the advance payment from potential customers approximately $22 million (RMB 144 million) to acquire certain real estate property in the Jewelry Park. During the year ended December 31, 2016, the Company transferred $22 million of customer deposits to Wuhan Lianfuda because Wuhan Kingold transferred all its interest in Jewelry Park to Wuhan Lianfuda in accordance with the Transfer Transaction. In connection with the Transfer Transaction, the Company also received the advance payments from Wuhan Lianfuda approximately $171.6 million (RMB 1,140 million) during the year ended December 31, 2016, which was subsequently settled during Transfer Transaction (see Note 5). KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15 - INCOME TAXES The Company is subject to income taxes on an entity basis on income arising in or derived from the tax jurisdiction in which each entity is domiciled. Kingold is incorporated in the United States and has incurred net operating loss for income tax purposes for 2016 and 2015. The Company has loss carry forwards of approximately $16,760,000 for U.S. income tax purposes available for offsetting against future taxable U.S. income, expiring in 2036. Management believes that the realization of the benefits from these losses is uncertain due to its history of continuing losses in the United States. Accordingly, a full deferred tax asset valuation allowance has been provided and no deferred tax asset benefit has been recorded. The valuation allowance as of December 31, 2016 and 2015 was approximately $5,699,000 and $5,335,000, respectively. The net increase in the valuation allowance for the years ended December 31, 2016 and 2015 was approximately $364,000 and $623,000, respectively. Dragon Lead is incorporated in the BVI, and under current laws of the BVI, income earned is not subject to income tax. Wuhan Vogue-Show and Wuhan Kingold are incorporated in the PRC and are subject to PRC income tax, which is computed according to the relevant laws and regulations in the PRC. The applicable tax rate is 25% for the years ended December 31, 2016 and 2015. The Company recorded $Nil deferred income tax assets as of December 31, 2016 and 2015. The Company intends to reinvest its foreign profits indefinitely in order to avoid a tax liability upon repatriation to the United States. Since the U.S. holding company does not have any earnings and profits, distributions made in 2014 were deemed as a return of capital for U.S. income tax purpose. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15 - INCOME TAXES (continued) Income (loss) from continuing operations before income taxes was allocated between the U.S. and foreign components for the year ended December 31, 2016 and 2015: Significant components of the income tax provision were as follows for the years ended December 31, 2016 and 2015: The components of deferred tax assets and deferred tax liability as of December 31, 2016 and 2015 consist of the following: The following table reconciles the U.S. statutory rates to the Company’s effective rate for the years ended December 31, 2016 and 2015: KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 16 - EARNINGS PER SHARE For the year ended December 31, 2016, the effect of potential shares of common stock was dilutive since the exercise prices for the warrant and options were lower than the average market price for the year ended December 31, 2016. As a result, total of 345,642 unexercised warrants and options are dilutive, and were included in the computation of diluted EPS. For the year ended December 31, 2015, basic average shares outstanding and diluted average shares outstanding were the same because the effect of potential shares of common stock was anti-dilutive since the exercise prices for the warrant and options were greater than the average market price for the year ended December 31, 2015. As a result, warrants to purchase 294,000 shares of common stock at weighted average exercise price of $3.61 per shares and options to purchase 3,220,000 shares of common stock at weighted average exercise price of $1.90 per share were not included in the computation of diluted EPS. The following table presents a reconciliation of basic and diluted net income per share: KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 17 - OPTIONS On March 24, 2011, the Board of Directors voted to adopt the 2011 Stock Incentive Plan (the “Plan”), which was later ratified by the Company’s stockholders on October 31, 2011, at the 2011 annual meeting. The Plan permits the granting of stock options (including incentive stock options as well as nonstatutory stock options), stock appreciation rights, restricted and unrestricted stock awards, restricted stock units, performance awards, other stock-based awards or any combination of the foregoing. Under the terms of the Plan, up to 5,000,000 shares of the Company’s common stock may be granted. Prior to January 1, 2012, the Company granted 1,620,000 options under the plan. These options have fully vested by December 31, 2015. In accordance with the vesting periods, $Nil and $110,439 were recorded as part of operating expense-stock compensation for the years ended December 31, 2016 and 2015, respectively. On January 9, 2012, the Company granted 1,300,000 options with an exercise price of $1.22 to certain members of management and directors. These options can be exercised within ten years from the grant date once they become exercisable. The options become exercisable in accordance with the schedule below: (a) 25% of the options become exercisable on the first anniversary of the grant date (such date is the initial vesting date), and (b) 6.25% of the options become exercisable on the date three months after the initial vesting date and on such date every third month thereafter, through the fourth anniversary of the grant date. The fair value of the options was calculated using the Black-Scholes options pricing model using the following assumptions: volatility of 124.81%, risk free interest rate of 1.98 %, and expected term of 10 years. The fair value of the options was $1,516,435. These options have fully vested by December 31, 2015. In accordance with the vesting periods, $Nil and $379,109 were recorded as part of operating expense-stock compensation for the 1,300,000 options above for the years ended December 31, 2016 and 2015, respectively. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 17 - OPTIONS (continued) On July 16, 2013, the Company granted 90,000 options with an exercise price of $1.18 to its non-employee directors, which options expire ten years from the grant date under the Plan. These options became exercisable in accordance with the following schedule: (a) 25% of the options became exercisable on the first anniversary of the grant date (the “Initial Vesting Date”), and (b) 6.25% of the options became exercisable on the date three months after the Initial Vesting Date and on such date every third month thereafter, through the fourth anniversary of the grant date. The fair value of the options was calculated using the Black-Scholes options pricing model using the following assumptions: volatility of 118.01%, risk free interest rate of 2.55%, and expected term of 10 years. The fair value of the options was $92,458. In accordance with the vesting periods, $23,114 and $23,114 were recorded as part of operating expense-stock compensation for the 90,000 options above for the years ended December 31, 2016 and 2015, respectively. On February 25, 2015, the Company granted 90,000 options with an exercise price of $1.11 to its non-employee directors, which options expire ten years from the grant date under the Plan. These options became exercisable in accordance with the following schedule: (a) 25% of the options became exercisable on the first anniversary of the grant date, and (b) 6.25% of the options became exercisable on the date three months after the initial vesting date and on such date every third month thereafter, through the fourth anniversary of the grant date. The fair value of the options was calculated using the Black-Scholes options pricing model under the following assumptions: volatility of 115.20%, risk free interest rate of 1.96%, and expected term of 10 years. The aggregate fair value of the options was $85,822. In accordance with the vesting periods, $21,458 and $17,880 were recorded as part of operating expense-stock compensation for the 90,000 options above for the years ended December 31, 2016 and 2015, respectively. The Company recorded $44,572 and $530,542 stock-based compensation expense for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2016 the Company had 3,152,500 outstanding vested stock options with a weighted average remaining term over 4.70 years and 67,500 unvested stock options with a weighted average remaining term over 7.63 years. Unrecorded stock-based compensation expense was $58,039 as of December 31, 2016. The following table summarized the Company’s stock option activity: KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 18 - WARRANTS Following is a summary of the status of warrant activities as of December 31, 2016 and 2015: On August 12, 2015, the Company signed a consulting agreement to engage Bespoke Independent Partners (“BIP”), a wholly owned subsidiary of FPIA Partners LLC to operate as a strategic advisor to Kingold in matters relating to investor relations, capital markets and shareholder value creation strategy. As the part of the agreement with BIP, an aggregate of 900,000 shares of warrants with exercise price ranging from $1.20 to $1.80 will be directly issued at no cost to BIP if certain stock performance targets are met within a three-year period. As of December 31, 2016, no warrants were issued to BIP because the performance target has not been met. On March 29, 2016, pursuant to the consulting agreement, the Company’s obligation to issue BIP warrants to purchase 150,000 shares of the Company’s common stock for $1.20 per share (the “First Tranche Warrants”) was triggered as a result of certain milestone accomplishments. The warrants will expire on June 29, 2017. Accordingly, the Company recorded $64,204 consulting expense and included in the general administrative expense. The fair value of the warrants was calculated using the Black-Scholes options pricing model using the following assumptions: volatility of 81%, risk free interest rate of 0.84%, and expected term of 1.25 years. The fair value of the warrants was $64,204. On April 18, 2016, pursuant to the consulting agreement, the Company’s obligation to issue BIP warrants to purchase 150,000 shares of the Company’s common stock for $1.50 per share (the “Second Tranche Warrants”) was triggered as a result of certain milestone accomplishments. The warrants will expire on July 17, 2017. Accordingly, the Company recorded $65,091 consulting expense and included in the general administrative expense. The fair value of the warrants was calculated using the Black-Scholes options pricing model using the following assumptions: volatility of 79.7%, risk free interest rate of 0.63%, and expected term of 1.25 years. The fair value of the warrants was $65,091. On May 10, 2016, the Company terminated the consulting agreement. On June 27, 2016, the Company and BIP signed a settlement agreement (the “Settlement Agreement”). In connection with the Settlement Agreement, the Company and BIP agreed that (1) the First Tranche Warrants and the Second Tranche Warrants would remain vested and outstanding, (2) the third, fourth and fifth tranches of success fee warrants would be cancelled; and (3) crediting of $66,439 in outstanding but unpaid fees against the exercise price of the First Tranche Warrants would be the only payment made or required under the Service Agreement. As a result, BIP will receive (a) 55,365 shares, (b) warrants to purchase 94,635 shares for $1.2 per share, expiring June 28, 2017, and (c) warrants to purchase 150,000 shares for $1.50 per share, which may be exercised from July 18, 2016 until July 17, 2017. As a result of the Settlement Agreement, the Company does not have any liability for future warrants issuance to BIP. As of December 31, 2016, the remaining 244,635 outstanding warrants may be exercised in the future by BIP upon delivery of cash and an exercise notice to the Company. A total of 294,000 warrants consisting of 150,000 warrants issued to Wallington Investment Holdings Ltd with exercise price of $3.25 per share on January 13, 2011 and 144,000 warrants issued to Rodman & Renshaw, LLC with exercise price of $3.99 per share on January 13, 2011 were expired on January 13, 2016. For the year ended December 31, 2016, the Company included $129,295 warrants cost in the general administrative expenses. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 19 - NONCONTROLLING INTEREST For the year ended December 31, 2015, Non-controlling interest represents the minority stockholders’ 45% proportionate share of the results of the newly established subsidiary Kingold Internet and Yuhuang. On December 14, 2016, Wuhan Kingold transferred its 55% ownership interest in Kingold Internet to Wuhan Kingold Industrial Group Co., Ltd., a related party, for a consideration of $79,196 (RMB 550,000). After the transfer, Kingold Internet and Yuhuang were no longer the subsidiaries of Wuhan Kingold. A reconciliation of non-controlling interest as of December 31, 2016 and 2015 are as follows: NOTE 20 - CONCENTRATIONS AND RISKS The Company maintains certain bank accounts in the PRC and BVI, which are not insured by Federal Deposit Insurance Corporation (“FDIC”) insurance or other insurance. The cash and restricted cash balance held in the PRC bank accounts was $81,354,642 and $29,544,475 as of December 31, 2016 and 2015, respectively. The cash balance held in the BVI bank accounts was $7,083 and $13,277 as of December 31, 2016 and December 31, 2015, respectively. As of December 31, 2016, the Company held $281,018 cash balances within the United States which is $31,018 in excess of FDIC insurance limits of $250,000. As of December 31, 2015, the Company held $144,465 of cash balances within the United States. For the years ended December 31, 2016 and 2015, almost 100% of the Company's assets were located in the PRC and 100% of the Company's revenues were derived from its subsidiaries located in the PRC. The Company’s principal raw material used during the year was gold, which accounted for almost 100% of its total purchases for the years ended December 31, 2016 and 2015. The Company purchased gold directly, and solely, from the Shanghai Gold Exchange, the largest gold trading platform in the PRC. During the year ended December 31, 2016 and 2015, approximately 21.5% and 18.8% of the Company’s net sales were generated from the Company’s five largest customers, respectively. No customer accounted for more than 10% of annual sales for the years ended December 31, 2016 or 2015. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 21 - GOLD LEASE TRANSACTIONS The Company leased gold as a way to finance its growth and will return the same amount of gold to China Construction Bank (“CCB”), Shanghai Pudong Development Bank (“SPD Bank”) and CITIC Bank at the end of the respective lease agreements. Under these gold lease arrangements, each of CCB, SPD Bank and CITIC Bank retains beneficial ownership of the gold leased to the Company and treats it as if the gold is placed on consignment to the Company. All three banks have their own representatives on the Company’s premises to monitor on a daily basis the use and security of the gold leased to the Company. Accordingly, the Company records these gold lease transactions as operating leases because the Company does not have ownership nor has it assumed the risk of loss for the leased gold. a)Gold lease transactions with CCB During 2015, the Company renewed gold lease agreements with CCB and leased an aggregate of 1,515 kilograms of gold, which amounted to approximately $56.2 million (RMB 365 million). The leases have initial terms of one year and provide an interest rate of 6% per annum. The leased gold was returned to the Bank upon lease maturity in 2016. During the year ended December 31, 2016, the Company entered into gold lease agreements with China Construction Bank and leased an aggregated of 975 kilograms of gold, which amounted to approximately $33.8 million (RMB 235 million). The leases have initial terms of one year and provide an interest rate of 5.7% per annum. The leased gold shall be returned to the Bank upon lease maturity. During the year ended December 31, 2016, the Company returned 2,490 kilograms of gold, which amounted to approximately $86.4 million (RMB 600.3 million) back to China Construction Bank upon lease maturity. As of December 31, 2016 and 2015, Nil and 1,515 kilograms of leased gold were outstanding and not yet returned to the Bank, respectively. As of December 31, 2016, the Company pledged restricted cash of approximately $14.4 million (RMB 100 million) as collateral to safeguard the gold lease from China Construction Bank, which was returned to the Company in early 2017 as the leased gold was returned at the end of December 2016. b)Gold lease transactions with SPD Bank On April 10, 2015, Wuhan Kingold entered into a gold lease agreement with SPD Bank to lease additional 197 kilograms of gold (valued at approximately RMB 46.98 million or approximately $7.2 million). The lease has initial term of one year and provides an interest rate of 3.2% per annum. In the third quarter of 2015, Wuhan Kingold entered into several gold lease agreements with SPD Bank to lease an aggregate of 720 kilograms of gold, valued approximately $25.9 million (RMB 168.2 million). The leases have initial terms of one year and provide an interest rate of 2.8% to 6% per annum. During the year ended December 31, 2016, the Company entered into gold lease agreements with Shanghai Pudong Development Bank and leased an aggregated of 345 kilograms of gold, which amounted to approximately $13.4 million (RMB 93.3 million). The leases have initial terms of six months to one year and provide an interest rate from 3.0% to 3.3% per annum. During the year ended December 31, 2016, the Company returned 1,077 kilograms of gold, which amounted to approximately $37.2 million (RMB 258.6 million) back to Shanghai Pudong Development Bank upon lease maturity. The remaining leased gold shall be returned to the Bank upon lease maturity in June 2017. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 21 - GOLD LEASE TRANSACTIONS (continued) As of December 31, 2016 and 2015, about 185 kilograms and 917 kilograms of leased gold were outstanding and not yet returned to Shanghai Pudong Development Bank, respectively, which amounted to approximately $7.2 million (RMB 49.8 million), and $33.1 million (RMB 215.2 million), respectively. As of December 31, 2016, the Company pledged restricted cash of approximately $7.2 million (RMB 50 million) as collateral to safeguard the gold lease from Shanghai Pudong Development Bank. c)Gold lease transaction with CITIC Bank During 2015, Wuhan Kingold entered into a gold lease agreement with CITIC Bank to lease an additional 850 kilograms of gold (valued at approximately $31 million or RMB 201 million). The lease has an initial term of one to six months and provides an interest rate of 6% per annum. The Company is required to deposit cash into an account at CITIC Bank equal to approximately $1.2 million (RMB 8.0 million). During 2015, the Company returned 1,150 kilograms of leased gold upon maturity, which amounted to approximately $44.3 million (RMB 287.4 million). The remaining amount was returned to the Bank upon lease maturity in 2016. The Company is required to deposit cash into an account at the Bank equal to approximately $3 million (RMB 19.5 million). As of December 31, 2016 and 2015, Nil and 350 kilograms of leased gold were outstanding and not yet returned to CITIC Bank, which amounted to approximately $Nil and $12.4 million, respectively. d)Gold lease transaction with Industrial and Commercial Bank of China (“ICBC’) During the year ended December 31, 2016, the Company entered into additional gold lease agreements with Industrial & Commercial Bank of China and leased an aggregated amount of 527 kilograms of gold, which amounted to approximately $20.1 million (RMB 139.7 million). The leases have initial terms of half year and provide an interest rate of 2.75% per annum. As of December 31, 2016, 527 kilograms of leased gold were all returned to Industrial & Commercial Bank of China. As of December 31, 2016, no restricted cash was pledged by the Company as collateral to safeguard the gold lease from Industrial & Commercial Bank of China. e)Gold lease transactions with related party During the year ended December 31, 2016, the Company entered into multiple gold lease agreements with Wuhan Shuntianyi Investment Management Ltd. (“Shuntianyi”), a related party which is controlled by the CEO and the Chairman of the Company, to lease a total of 16,000,000 grams of Au9999 gold in aggregate with carrying value of approximately $538.6 million. The leased gold was fully returned by the Company to Shuntianyi as of December 31, 2016. As of December 31, 2016 and 2015, 185 kilograms and 2,782 kilograms of leased gold were outstanding, at the approximated amounts of $7.2 million and $101.8 million, respectively. Interest expense for the leased gold for the year ended December 31, 2016 and 2015 were approximately $3.9 million and $7.0 million, respectively, which was included in the cost of sales. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 22 - COMMITMENTS AND CONTINGENCIES Commitments Guarantee for Third Party On April 12, 2016, the Company signed the collateral agreements with Evergrowing Bank - Yantai Huangshan Road Branch to pledge restricted deposits of totaling $28.8 million (RMB 200 million). The pledged deposits is to guarantee a bank acceptance note agreement signed between Yantai Runtie Trade Ltd. and Evergrowing Bank - Yantai Huangshan Road Branch, which allows Yantai Runtie Trade Ltd. to access a loan of approximately $28.8 million (RMB 200 million) with a term of one year from April 12, 2016 to April 12, 2017, and bearing a fixed annual interest rate of 2.01%. The deposits will be refunded to the Company when the loan is repaid upon maturity. Operating Lease On June 27, 2016, Wuhan Kingold signed certain 5 years lease agreements to rent office and store space at the Jewelry Park commencing in July 2016 and October 2016, respectively, with aggregated annual rent of approximately $0.4 million (RMB 2.3 million). For the year ended December 31, 2016, the Company recorded $132,600 rent expense. As of December 31, 2016, the Company was obligated under non-cancellable operating leases for minimum rentals as follows: KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 23 - CONVERTIBLE NOTE PURCHASE AGREEMENT On April 2, 2015, the Company entered into a Convertible Note Purchase Agreement (the “Purchase Agreement”) with Fidelidade - Companhia de Seguros, S.A., a company duly incorporated and existing under the laws of Portugal and a majority-owned subsidiary of Fosun International Limited (the “Holder”). Pursuant to the Purchase Agreement, the Company agreed to issue and sell to the Holder $15 million aggregate principal amount 6.0% Senior Secured Convertible Note due 2018 (the “Note”), subject to customary closing conditions. The Company will sell the Note in reliance on the exemption from registration provided by Section 4(a) (2) of the Securities Act of 1933, as amended (the “Securities Act”). The Note and the underlying shares of the Company’s common stock issuable upon conversion of the Note have not been registered under the Securities Act and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. The Note will bear interest at a rate of 6.0% per year payable annually. The Note will mature on the third anniversary of the issuance date of the Note, unless earlier converted. The Note constitutes a general, senior, secured obligation of the Company. The Company granted the Holder a security interest in certain collateral as identified in the Purchase Agreement, to secure the payment, discharge and performance of all the Company’s obligations under the Note. Mr. Zhihong Jia, Chairman and Chief Executive Officer of the Company, will execute a guarantee in favor of the Holder, pursuant to which Mr. Jia will be jointly liable for the Company’s obligations under the Note. Subject to and upon compliance with the provisions of the Purchase Agreement, the Holder has the right, at its option, to convert the principal amount of the Note or any portion of such principal amount which is $1,000 or an integral multiple of $1,000 in excess thereof, into shares of common stock at the applicable conversion rate. The conversion rate is initially 869.57 shares of common stock per $1,000 principal amount of Note (equivalent to an initial conversion price of approximately $1.15 per share), subject to adjustment in certain events described in the Purchase Agreement. Upon conversion, the Company will deliver shares of common stock as set forth in the Purchase Agreement. No fractional shares will be issued upon any conversion. In connection with the entry into the Purchase Agreement, the Company will enter into a registration rights agreement (the “Registration Rights Agreement”) with the Holder as a condition to closing the sale of the Note, which sets forth the rights of the Holder to have the shares of common stock issuable upon conversion of the Note registered with the SEC for public resale under the Securities Act. Pursuant to the Registration Rights Agreement, the Company is required to file a registration statement with the SEC (the “Initial Registration Statement”) within 60 days following the date of the issuance of the Note, registering the shares of common stock issuable upon conversion of the Note. The Company is required to use its reasonable best efforts to have the Initial Registration Statement declared effective as promptly as possible following the filing thereof and, in any event, by no later than 90 days after the date of the issuance of the Note. In addition, the agreement gives the Holder the ability to exercise certain piggyback registration rights in connection with registered offerings by the Company. The Purchase Agreement was set to terminate automatically on May 31, 2015 in the absence of a closing or extension at the discretion of the Holder. Closing did not occur prior to such time because the Company had not secured a $15 million letter of credit required under the agreement. The Holder has not provided written notice to the Company of its intention either to terminate or to extend the Purchase Agreement, and the Company continues to pursue the $15 million letter of credit. While there can be no guarantee that the Company will locate a letter of credit on terms acceptable to the Holder, the Company remains willing to proceed under the Purchase Agreement. KINGOLD JEWELRY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 24 - SUBSEQUENT EVENTS In January 2017, Wuhan Kingold entered into a trust loan agreement with China Aviation Trust Ltd. to borrow a maximum of approximately $44.6 million (RMB 310 million) for working capital with a period of 24 months from the date of releasing the loan. For the loan obtained, the Company is required to make interest payments that are calculated based on a fixed annual interest rate of 8% based on the principal amount received. The Company is required to pledge 1,000 kilograms of Au9999 gold with carrying value of approximately $33.5 million (RMB 232.5 million) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. In January 2017, Wuhan Kingold entered into a loan agreement with Wuhan Kangbo Biotech Limited (“Kangbo”), a related party, for a loan of approximately $144 million (RMB 1,000 million). The loan has one year term from January 12, 2017 to January 10, 2018, and is interest free. In order for Kangbo to obtain the loan from the bank, Wuhan Kingold signed the guarantee agreement with Evergrowing Bank- Yantai Huangshan Road Branch on January 11, 2017. As a guarantor of the bank loan, Wuhan Kingold pledged 5,470 kilograms of gold in aggregate as collateral. On January 3, 2017, Wuhan Kingold entered into a gold lease agreement with Wuhan Shuntianyi Investment Management Ltd. (“Shuntianyi”), a related party which is controlled by the CEO and the Chairman of the Company, to lease a total of 4,000 kilograms of Au9999 gold for a period from January 3, 2017 to February 28, 2017. The leased gold was fully returned by the Company to Shuntianyi on February 28, 2017. In February 2017, Wuhan Kingold entered into a loan agreement with Kangbo for a loan of approximately $144 million (RMB 1,000 million). The loan has one year term from February 20, 2017 to February 20, 2018, and is interest free. In order for Kangbo to obtain the loan from the bank, Wuhan Kingold signed the guarantee agreement with Evergrowing Bank - Yantai Huangshan Road Branch on February 16, 2017. As a guarantor of the bank loan, Wuhan Kingold pledged 4,755 kilograms of gold in aggregate as collateral. In February 2017, Wuhan Kingold entered into a trust loan agreement with National Trust Ltd. (“National Trust”) to borrow a maximum of approximately $50.4 million (RMB 350 million) for working capital with a period of 24 months from the date of releasing the loan. For the loan obtained, the Company is required to make interest payments that are calculated based on a fixed annual interest rate of 8.617% based on the principal amount received. The Company is required to pledge 1,745 kilograms of Au9999 gold with carrying value of approximately $68.6 million (RMB 476.4 million) as collateral to secure this loan. The loan is guaranteed by the CEO and Chairman of the Company. In February 2017, Wuhan Kingold entered into a loan agreement with the Qixia Branch of Evergrowing Bank in the amount of approximately $28.8 million (RMB 200 million). The loan has one year term from February 24, 2017 to February 19, 2018, and bears fixed annual interest of 4.75%. The Company is required to pledge 1,300 kilograms of Au9999 gold with carrying value of approximately $43.5 million (RMB 302.3 million) as collateral to secure this loan. The loan is also guaranteed by Mr. Zhihong Jia, the CEO and Chairman of the Company. KINGOLD JEWELRY, INC. SCHEDULE 1 - PARENT COMPANY BALANCE SHEETS (IN U.S. DOLLARS) (Unaudited) The accompanying notes are an integral part of Schedule 1. KINGOLD JEWELRY, INC. SCHEDULE 1 - PARENT COMPANY STATEMENTS OF INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS) (IN U.S. DOLLARS) (Unaudited) The accompanying notes are an integral part of Schedule 1. KINGOLD JEWELRY, INC. SCHEDULE 1 - PARENT COMPANY STATEMENTS OF CASH FLOWS (IN U.S. DOLLARS) (Unaudited) The accompanying notes are an integral part of Schedule 1. KINGOLD JEWELRY, INC. NOTES TO SCHEDULE 1 1.Basis of presentation Certain information and footnote disclosures normally included in financial statements prepared in conformity with generally accepted accounting principles have been condensed or omitted. The Company’s investment in subsidiaries is stated at cost plus equity in undistributed earnings of subsidiaries. 2.Restricted net assets Schedule I of Article 5-04 of Regulation S-X requires the condensed financial information of registrant shall be filed when the restricted net assets of consolidated subsidiaries exceed 25 percent of consolidated net assets as of the end of the most recently completed fiscal year. For purposes of the above test, restricted net assets of consolidated subsidiaries shall mean that amount of the registrant’s proportionate share of net assets of consolidated subsidiaries (after intercompany eliminations) which as of the end of the most recent fiscal year may not be transferred to the parent company by subsidiaries in the form of loans, advances or cash dividends without the consent of a third party (i.e., lender, regulatory agency, foreign government, etc.). The parent company financial statements have been prepared in accordance with Rule 12-04, Schedule I of Regulation S- X as the restricted net assets of the subsidiaries of Kingold Jewelry, Inc. exceed 25% of the consolidated net assets of Kingold Jewelry, Inc. The ability of our Chinese operating affiliates to pay dividends may be restricted due to the foreign exchange control policies and availability of cash balances of the Chinese operating subsidiaries. Because a significant portion of our operations and revenues are conducted and generated in China, a significant portion of our revenues being earned and currency received are denominated in Renminbi (RMB). RMB is subject to the exchange control regulation in China, and, as a result, we may be unable to distribute any dividends outside of China due to PRC exchange control regulations that restrict our ability to convert RMB into US Dollars. 3.Commitments The Company did not have any significant commitments or long-term obligations as at December 31, 2016 and 2015.
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Here's a summary of the financial statement:
Company: Kingold Jewelry, Inc.
Key Financial Highlights:
1. Accounting Structure:
- Kingold accounts for Wuhan Kingold as a Variable Interest Entity (VIE)
- Kingold has majority control and power to direct Wuhan Kingold's activities
2. Assets:
- Gold investments are a significant asset
- Gold is pledged as collateral for bank loans
- Fair market value of gold determined by Shanghai Gold Exchange quotes
- Investments in gold are carried at fair market value
3. Liabilities:
- Current liabilities approximate fair value due to short-term nature
- Long-term loan values are compared to rates from similar financial institutions
- Bank loans are secured by pledged gold inventory
4. Valuation Methods:
- Uses quoted prices in active markets
- Unrealized gains/losses from gold investments
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Comprehensive Income Consolidated Statements of Changes in Stockholders' Equity Consolidated Statements of Cash Flows FINANCIAL STATEMENT SCHEDULES Schedule I-Summary of Investments-Other Than Investments in Related Parties Schedule II-Condensed Financial Information of Registrant Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Essent Group Ltd. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Essent Group Ltd. and its subsidiaries at December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP Philadelphia, Pennsylvania February 15, 2017 Essent Group Ltd. and Subsidiaries Consolidated Balance Sheets See accompanying notes to consolidated financial statements. Essent Group Ltd. and Subsidiaries Consolidated Statements of Comprehensive Income See accompanying notes to consolidated financial statements. Essent Group Ltd. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity See accompanying notes to consolidated financial statements. Essent Group Ltd. and Subsidiaries Consolidated Statements of Cash Flows See accompanying notes to consolidated financial statements. Essent Group Ltd. and Subsidiaries In these notes to consolidated financial statements, “Essent”, “Company”, “we”, “us”, and “our” refer to Essent Group Ltd. and its subsidiaries, unless the context otherwise requires. Note 1. Nature of Operations and Basis of Presentation Essent Group Ltd. (“Essent Group”) is a Bermuda-based holding company, which, through its wholly-owned subsidiaries, offers private mortgage insurance and reinsurance for mortgages secured by residential properties located in the United States. Mortgage insurance facilitates the sale of low down payment (generally less than 20%) mortgage loans into the secondary mortgage market, primarily to two government-sponsored enterprises ("GSEs"), Fannie Mae and Freddie Mac. The primary mortgage insurance operations are conducted through Essent Guaranty, Inc. ("Essent Guaranty"), which is domiciled in the state of Pennsylvania. Essent Guaranty is headquartered in Radnor, Pennsylvania and maintains operations centers in Winston-Salem, North Carolina and Irvine, California. Essent Guaranty is approved as a qualified mortgage insurer by the GSEs and is licensed to write mortgage insurance in all 50 states and the District of Columbia. Effective July 2014, Essent Guaranty began to reinsure 25% of GSE-eligible new insurance written to Essent Reinsurance Ltd. (“Essent Re”), an affiliated Bermuda domiciled Class 3A Insurer licensed pursuant to Section 4 of the Bermuda Insurance Act 1978 that provides insurance and reinsurance coverage of mortgage credit risk. Essent Re also provides insurance and reinsurance to Freddie Mac and Fannie Mae. In 2016, Essent Re formed Essent Agency (Bermuda) Ltd., a wholly-owned subsidiary, which provides underwriting services to third-party reinsurers. In accordance with certain state law requirements, Essent Guaranty also reinsures that portion of the risk that is in excess of 25% of the mortgage balance with respect to any loan insured, after consideration of other reinsurance, to Essent Guaranty of PA, Inc. (“Essent PA”), an affiliate domiciled in the state of Pennsylvania. In addition to offering mortgage insurance, we provide contract underwriting services on a limited basis through CUW Solutions, LLC ("CUW Solutions"), a Delaware limited liability company, that provides, among other things, mortgage contract underwriting services to lenders and mortgage insurance underwriting services to affiliates. CUW Solutions is headquartered in Radnor, Pennsylvania and it maintains operations centers in Winston-Salem, North Carolina and Irvine, California that are subleased from Essent Guaranty. The Company operates as a single segment for reporting purposes as substantially all business operations, assets and liabilities relate to the private mortgage insurance business and management reviews operating results for the Company as a whole to make operating decisions and assess performance. The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and include the accounts of Essent Group and its consolidated subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Certain amounts in prior years have been reclassified to conform to the current year presentation. Note 2. Summary of Significant Accounting Policies Use of Estimates The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Investments Available for Sale Investments available for sale include securities that we sell from time to time to provide liquidity and in response to changes in the market. Debt and equity securities classified as available for sale are reported at fair value with unrealized gains and losses on these securities reported in other comprehensive income, net of deferred income taxes. See Note 16 for a description of the valuation methods for investments available for sale. Essent Group Ltd. and Subsidiaries (Continued) We monitor our fixed maturities for unrealized losses that appear to be other-than-temporary. A fixed maturity security is considered to be other-than-temporarily impaired when the security's fair value is less than its amortized cost basis and 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of the security's amortized cost basis, or 3) we believe we will be unable to recover the entire amortized cost basis of the security (i.e., a credit loss has occurred). When we determine that a credit loss has been incurred, but we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of the security's amortized cost basis, the portion of the other-than-temporary impairment that is credit related is recorded as a realized loss in the consolidated statements of comprehensive income, and the portion of the other-than-temporary impairment that is not credit related is included in other comprehensive income. For those fixed maturities for which an other-than-temporary impairment has occurred, we adjust the amortized cost basis of the security and record a realized loss in the consolidated statements of comprehensive income. We recognize purchase premiums and discounts in interest income using the interest method over the term of the securities. Gains and losses on the sales of securities are recorded on the trade date and are determined using the specific identification method. Short-term investments are defined as short-term, highly liquid investments, both readily convertible to cash and having maturities at acquisition of twelve months or less. Long-Lived Assets Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. Repairs and maintenance are charged to expense as incurred. Estimated useful lives are 5 years for furniture and fixtures and 2 to 3 years for equipment, computer hardware and purchased software. Certain costs associated with the acquisition or development of internal-use software are capitalized. Once the software is ready for its intended use, these costs are amortized on a straight-line basis over the software's expected useful life, which is generally 3 years. We amortize leasehold improvements over the shorter of the lives of the leases or estimated service lives of the leasehold improvements. The balances by type were as follows at December 31: Deferred Policy Acquisition Costs We defer certain personnel costs and premium tax expense directly related to the successful acquisition of new insurance policies and amortize these costs over the period the related estimated gross profits are recognized in order to match costs and revenues. We do not defer any underwriting costs associated with our contract underwriting services. Costs related to the acquisition of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs. Consistent with industry accounting practice, amortization of these costs for each underwriting year book of business is recognized in proportion to estimated gross profits. Estimated gross profits are composed of earned premium, interest income, losses and loss adjustment expenses. The deferred costs are adjusted as appropriate for policy cancellations to be consistent with our revenue recognition policy. We estimate the rate of amortization to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income. Policy acquisition costs deferred were $7.7 million, $6.6 million and $6.6 Essent Group Ltd. and Subsidiaries (Continued) million for the years ended December 31, 2016, 2015 and 2014, respectively. Amortization of deferred policy acquisition costs totaled $5.8 million, $4.7 million and $3.2 million for the years ended December 31, 2016, 2015 and 2014, respectively, and was included in other underwriting and operating expenses on the consolidated statements of comprehensive income. Insurance Premium Revenue Recognition Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premium on a monthly, annual or single basis. Upon renewal, we are not able to re-underwrite or re-price our policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Monthly policies accounted for 81% of earned premium in 2016. Premiums written on an annual basis are amortized on a pro rata basis over the year of coverage. Primary mortgage insurance written on policies covering more than one year are referred to as single premium policies. A portion of the revenue from single premium policies is recognized in earned premium in the current period, and the remaining portion is deferred as unearned premium and earned over the expected life of the policy. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized as earned premium upon notification of the cancellation. The Company recorded $36.9 million and $21.8 million of earned premium related to policy cancellations for the years ended December 31, 2016 and 2015, respectively. Unearned premium represents the portion of premium written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premium policies are estimates based on an analysis of the expiration of risk. A significant portion of our premium revenue relates to master policies with certain lending institutions. For the year ended December 31, 2016 one lender represented 12% of our total revenue. The loss of this customer could have a significant impact on our revenues and results of operations. Reserve for Losses and Loss Adjustment Expenses We establish reserves for losses based on our best estimate of ultimate claim costs for defaulted loans using the general principles contained in ASC No. 944, in accordance with industry practice. However, consistent with industry standards for mortgage insurers, we do not establish loss reserves for future claims on insured loans which are not currently in default. Loans are classified as in default when the borrower has missed two consecutive payments. Once we are notified that a borrower has defaulted, we will consider internal and third-party information and models, including the status of the loan as reported by its servicer and the type of loan product to determine the likelihood that a default will reach claim status. In addition, we will project the amount that we will pay if a default becomes a claim (referred to as "claim severity"). Based on this information, at each reporting date we determine our best estimate of loss reserves at a given point in time. Included in loss reserves are reserves for incurred but not reported ("IBNR") claims. IBNR reserves represent our estimated unpaid losses on loans that are in default, but have not yet been reported to us as delinquent by our customers. We will also establish reserves for associated loss adjustment expenses, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. Establishing reserves is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Our estimates of claim rates and claim sizes will be strongly influenced by prevailing economic conditions, such as the overall state of the economy, current rates or trends in unemployment, changes in housing values and/or interest rates, and our best judgments as to the future values or trends of these macroeconomic factors. Losses incurred are also generally affected by the characteristics of our insured loans, such as the loan amount, loan-to-value ratio, the percentage of coverage on the insured loan and the credit quality of the borrower. Premium Deficiency Reserve We are required to establish a premium deficiency reserve if the net present value of the expected future losses and expenses for a particular group of policies exceeds the net present value of expected future premium, anticipated investment income and existing reserves for that specified group of policies. We reassess our expectations for premium, losses and expenses of our mortgage insurance business periodically and update our premium deficiency analysis accordingly. As of December 31, 2016 and 2015, we concluded that no premium deficiency reserve was required to be recorded in the accompanying consolidated financial statements. Essent Group Ltd. and Subsidiaries (Continued) Derivative Instruments Through June 30, 2016, insurance and certain reinsurance policies issued by Essent Re in connection with Freddie Mac's Agency Credit Insurance Structure ("ACIS") program were accounted for as derivatives under GAAP with the fair value of these policies reported as an asset or liability and changes in the fair value of these policies reported in earnings as a component of other income. During the quarter ended September 30, 2016, these contracts were amended and are now accounted for as insurance contracts rather than as derivatives. As of December 31, 2016, the Company had no derivative instruments. Stock-Based Compensation We measure the cost of employee services received in exchange for awards of equity instruments at the grant date of the award using a fair value based method. Prior to our initial public offering, we estimated the fair value of each nonvested share grant on the date of grant based on management's best estimate using methods further described in Note 10 of our consolidated financial statements. Subsequent to our initial public offering, fair value is determined on the date of grant based on quoted market prices. We recognize compensation expense on nonvested shares over the vesting period of the award. Income Taxes Deferred income tax assets and liabilities are determined using the asset and liability (or balance sheet) method. Under this method, we determine the net deferred tax asset or liability based on the tax effects of the temporary differences between the book and tax bases of the various assets and liabilities and give current recognition to changes in tax rates and laws. Changes in tax laws, rates, regulations and policies, or the final determination of tax audits or examinations, could materially affect our tax estimates. We evaluate the realizability of the deferred tax asset and recognize a valuation allowance if, based on the weight of all available positive and negative evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. When evaluating the realizability of the deferred tax asset, we consider estimates of expected future taxable income, existing and projected book/tax differences, carryback and carryforward periods, tax planning strategies available, and the general and industry specific economic outlook. This realizability analysis is inherently subjective, as it requires management to forecast changes in the mortgage market, as well as the related impact on mortgage insurance, and the competitive and general economic environment in future periods. Changes in the estimate of deferred tax asset realizability, if applicable, are included in income tax expense on the consolidated statements of comprehensive income. ASC No. 740 provides a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In accordance with ASC No. 740, before a tax benefit can be recognized, a tax position is evaluated using a threshold that it is more likely than not that the tax position will be sustained upon examination. When evaluating the more-likely-than-not recognition threshold, ASC No. 740 provides that a company should presume the tax position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. If the tax position meets the more-likely-than-not recognition threshold, it is initially and subsequently measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. As described in Note 12, we purchase non-interest-bearing United States Mortgage Guaranty Tax and Loss Bonds ("T&L Bonds") issued by the Treasury Department. These assets are carried at cost and are reported as prepaid federal income tax on the consolidated balance sheets. It is our policy to classify interest and penalties related to unrecognized tax benefits as income tax expense. Earnings per Share Basic earnings per common share amounts are calculated based on income available to common stockholders and the weighted average number of common shares outstanding during the reporting period. Diluted earnings per common share amounts are calculated based on income available to common stockholders and the weighted average number of common and potential common shares outstanding during the reporting period. Potential common shares, composed of the incremental common shares issuable upon vesting of unvested common shares, are included in the earnings per share calculation to the extent that they are dilutive. Essent Group Ltd. and Subsidiaries (Continued) Recently Issued Accounting Standards In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This update is intended to provide a consistent approach in recognizing revenue. In accordance with the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In July 2015, the FASB delayed the effective date for this update to interim and annual periods beginning after December 15, 2017. In December 2016, the FASB clarified that all contracts that are within the scope of Topic 944, Financial Services-Insurance, are excluded from the scope of ASU 2014-09. Accordingly, this update will not impact the recognition of revenue related to insurance premiums or investments, which represent a significant portion of our total revenues. The adoption of this ASU is not expected to have a material effect on the Company's consolidated operating results or financial position. In May 2015, the FASB issued ASU 2015-09, Disclosures about Short-Duration Contracts (Topic 944). The amendments in this update require insurance entities to disclose certain information about the liability for unpaid claims and claim adjustment expenses. The additional information required is focused on improvements in disclosures regarding insurance liabilities, including the nature, amount, timing, and uncertainty of cash flows related to those liabilities and the effect of those cash flows on the statement of comprehensive income. The disclosures required by this update are included in Note 6. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This update will require organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The new guidance will also require additional disclosures about the amount, timing and uncertainty of cash flows arising from leases. The provisions of this update are effective for annual and interim periods beginning after December 15, 2018. The Company expects a gross-up of its consolidated balance sheets as a result of recognizing lease liabilities and right of use assets. The Company is still evaluating the impact the adoption of this ASU will have on the consolidated financial statements. In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting (Topic 718). This update is intended to simplify several aspects of the accounting for share-based payment award transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The new guidance requires all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement and treated as discrete items in the reporting period. In addition, excess tax benefits are required to be classified along with other income tax cash flows as an operating activity. Further, the new guidance allows for a policy election to account for forfeitures as they occur rather than on an estimated basis. The Company adopted this ASU on January 1, 2017 and recorded a charge of $0.1 million to retained earnings as of that date representing a cumulative-effect adjustment associated with our election to recognize forfeitures as they occur. The classification of excess tax benefits and tax deficiencies as income tax benefit or expense may result in net income volatility in reporting periods subsequent to 2016. Through December 31, 2016, excess tax benefits have been recognized in additional paid-in-capital. The amount of excess tax benefits or tax deficiencies in future periods will vary based on the market value of the Company’s common stock at the vesting dates of nonvested common share and nonvested common share units. In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 326). This update is intended to provide financial statement users with more information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. The amendments in this ASU replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The new guidance requires financial assets measured at amortized cost to be presented at the net amount expected to be collected through the use of an allowance for credit losses. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance rather than as a write-down of the amortized cost of the securities. The provisions of this update are effective for annual and interim periods beginning after December 15, 2019. While the Company is still evaluating this ASU, we do not expect it to impact our accounting for insurance losses and loss adjustment expenses ("LAE") as these items are not within the scope of this ASU. Essent Group Ltd. and Subsidiaries (Continued) Note 3. Investments Available for Sale Investments available for sale consist of the following: _______________________________________________________________________________ Essent Group Ltd. and Subsidiaries (Continued) The amortized cost and fair value of investments available for sale at December 31, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Because most U.S. agency mortgage-backed securities, residential and commercial mortgage securities and asset-backed securities provide for periodic payments throughout their lives, they are listed below in separate categories. Essent Group Ltd. and Subsidiaries (Continued) Gross gains and losses realized on the sale of investments available for sale were as follows: The fair value of investments in an unrealized loss position and the related unrealized losses were as follows: The gross unrealized losses on these investment securities are principally associated with the changes in market interest rates and credit spreads subsequent to their purchase. Each issuer is current on its scheduled interest and principal payments. We assess our intent to sell these securities and whether we will be required to sell these securities before the recovery of their amortized cost basis when determining whether an impairment is other-than-temporary. We recorded other-than-temporary impairments of $0.1 million and $0.3 million in the years ended December 31, 2016 and 2015, respectively, on securities in an unrealized loss position. The impairments resulted from our intent to sell these securities subsequent to the reporting date. There were no other-than-temporary impairments of investments in the year ended December 31, 2014. The fair value of investments deposited with insurance regulatory authorities to meet statutory requirements was $8.5 million at December 31, 2016 and $8.5 million at December 31, 2015. In connection with its insurance and reinsurance activities, Essent Re is required to maintain assets in trusts for the benefit of its contractual counterparties. The fair value of the investments on deposit in these trusts was $349.6 million at December 31, 2016 and $194.5 million at December 31, 2015. Essent Group Ltd. and Subsidiaries (Continued) Net investment income consists of: Note 4. Accounts Receivable Accounts receivable consists of the following at December 31: Premiums receivable consists of premiums due on our mortgage insurance policies. If mortgage insurance premiums are unpaid for more than 90 days, the receivable is written off against earned premium and the related insurance policy is cancelled. For all periods presented, no provision or allowance for doubtful accounts was required. Note 5. Triad Transaction On December 1, 2009, under the terms of an asset purchase agreement (the "Asset Purchase Agreement") dated October 7, 2009 between Essent Guaranty and Triad Guaranty, Inc. and Triad Guaranty Insurance Corporation (collectively referred to as "Triad"), we acquired all of Triad's proprietary mortgage insurance information technology and operating platform, certain software and substantially all of the supporting hardware, as well as furniture and fixtures, in exchange for fixed payments of $15 million, contingent payments of $15 million, and the assumption of certain contractual obligations. The final contingent payment of $5 million was made in the year ended December 31, 2014 and no further amounts are due to Triad under the Asset Purchase Agreement. Effective with the completion of the transaction, Essent Guaranty began providing information systems maintenance and development services, customer service and policy administration support to Triad under the terms of a services agreement dated December 1, 2009. Triad retains the obligation for all risks insured under its existing insurance contracts and will continue to directly manage loss mitigation and claim activity on its insured business. Under the terms of the services agreement, we provide the following services to Triad in exchange for fees: (i) maintain and support the licensed technology and equipment and provide to Triad certain information and technology services; (ii) access to the Triad technology platform in order to support Triad's business pursuant to the license grant outlined in the services agreement; (iii) customer support-related services; and (iv) technology development services. Effective December 1, 2010, the fee is based principally on the number of Triad's insurance policies in force on a monthly basis. Accordingly, this fee is reduced as Triad's policies in force decline. We earned fees under the services agreement of $1.4 million, $1.8 million and $2.3 million for the years ended December 31, 2016, 2015 and 2014, respectively, which are included in other income in the accompanying consolidated statements of comprehensive income. Essent Group Ltd. and Subsidiaries (Continued) Note 6. Reserve for Losses and Loss Adjustment Expenses The following table provides a reconciliation of the beginning and ending reserve balances for losses and loss adjustment expenses ("LAE") for the years ended December 31: For the year ended December 31, 2016, $4.2 million was paid for incurred claims and claim adjustment expenses attributable to insured events of prior years. There has been a $6.4 million favorable prior year development during the year ended December 31, 2016. Reserves remaining as of December 31, 2016 for prior years are $7.2 million as a result of re-estimation of unpaid losses and loss adjustment expenses. For the year ended December 31, 2015, $2.0 million was paid for incurred claims and claim adjustment expenses attributable to insured events of prior years. There was a $3.1 million favorable prior-year development during the year ended December 31, 2015. Reserves remaining as of December 31, 2015 for prior years were $3.3 million as a result of re-estimation of unpaid losses and loss adjustment expenses. In both periods, the favorable prior years' loss development was the result of a re-estimation of amounts ultimately to be paid on prior year defaults in the default inventory, including the impact of previously identified defaults that cured. Original estimates are increased or decreased as additional information becomes known regarding individual claims. The following table summarizes incurred loss and allocated loss adjustment expense development, IBNR plus expected development on reported defaults and the cumulative number of reported defaults. The information about incurred loss development for the years ended December 31, 2010 to 2015 is presented as supplementary information. Essent Group Ltd. and Subsidiaries (Continued) The following table summarizes cumulative paid losses and allocated loss adjustment expenses, net of reinsurance. The information about paid loss development for the years ended December 31, 2010 through 2015 is presented as supplementary information. For our mortgage insurance portfolio, our average annual payout of losses as of December 31, 2016 is as follows: Note 7. Debt Obligations Revolving Credit Facility On April 19, 2016, Essent Group and its subsidiaries, Essent Irish Intermediate Holdings Limited and Essent US Holdings, Inc. (collectively, the "Borrowers"), entered into a three-year, secured revolving credit facility with a committed capacity of $200 million (the “Facility”). Borrowings under the Facility may be used for working capital and general corporate purposes, including, without limitation, capital contributions to Essent’s insurance and reinsurance subsidiaries. Borrowings will accrue interest at a floating rate tied to a standard short-term borrowing index, selected at the Company’s option, plus an applicable margin. A commitment fee is due quarterly on the average daily amount of the undrawn revolving commitment. The applicable margin and the commitment fee are based on the senior unsecured debt rating or long-term issuer rating of Essent Group to the extent available, or the insurer financial strength rating of Essent Guaranty. The current annual commitment fee rate is 0.35%. The obligations under the Facility are secured by certain assets of the Borrowers, excluding the stock and assets of its insurance and reinsurance subsidiaries. The Facility contains several covenants, including financial covenants relating to minimum net worth, capital and liquidity levels, maximum debt to capitalization level and Essent Guaranty's compliance with the PMIERs (see Note 17). This description is not intended to be complete in all respects and is qualified in its entirety by the terms of the Facility, including its covenants. As of December 31, 2016, the Company was in compliance with the covenants and $100 million had been borrowed under the Facility with a weighted average interest rate of 2.73%. Essent Group Ltd. and Subsidiaries (Continued) Note 8. Commitments and Contingencies Obligations under Guarantees Under the terms of CUW Solutions' contract underwriting agreements with lenders and subject to contractual limitations on liability, we agree to indemnify certain lenders against losses incurred in the event that we make an error in determining whether loans processed meet specified underwriting criteria, to the extent that such error materially restricts or impairs the salability of such loan, results in a material reduction in the value of such loan or results in the lender repurchasing the loan. The indemnification may be in the form of monetary or other remedies. For the years ended December 31, 2016 and 2015, we paid $129,669 and $25,829, respectively, related to remedies. As of December 31, 2016, management believes any potential claims for indemnification related to contract underwriting services through December 31, 2016 are not material to our consolidated financial position or results of operations. In addition to the indemnifications discussed above, in the normal course of business, we enter into agreements or other relationships with third parties pursuant to which we may be obligated under specified circumstances to indemnify the counterparties with respect to certain matters. Our contractual indemnification obligations typically arise in the context of agreements entered into by us to, among other things, purchase or sell services, finance our business and business transactions, lease real property and license intellectual property. The agreements we enter into in the normal course of business generally require us to pay certain amounts to the other party associated with claims or losses if they result from our breach of the agreement, including the inaccuracy of representations or warranties. The agreements we enter into may also contain other indemnification provisions that obligate us to pay amounts upon the occurrence of certain events, such as the negligence or willful misconduct of our employees, infringement of third-party intellectual property rights or claims that performance of the agreement constitutes a violation of law. Generally, payment by us under an indemnification provision is conditioned upon the other party making a claim, and typically we can challenge the other party's claims. Further, our indemnification obligations may be limited in time and/or amount, and in some instances, we may have recourse against third parties for certain payments made by us under an indemnification agreement or obligation. As of December 31, 2016, contingencies triggering material indemnification obligations or payments have not occurred historically and are not expected to occur. The nature of the indemnification provisions in the various types of agreements and relationships described above are believed to be low risk and pervasive, and we consider them to have a remote risk of loss or payment. We have not recorded any provisions on the consolidated balance sheets related to these indemnifications. Commitments We lease office space for use in our operations under leases accounted for as operating leases. Total rent expense was $1.9 million, $1.9 million and $1.6 million for the years ended December 31, 2016, 2015 and 2014, respectively. The future minimum lease payments of non-cancelable operating leases are as follows at December 31, 2016: Minimum lease payments shown above have not been reduced by minimum sublease rental income of $0.1 million due in 2017 under the non-cancelable sublease. Essent Group Ltd. and Subsidiaries (Continued) Note 9. Capital Stock Our authorized share capital consists of 233.3 million shares of a single class of common shares (the "Common Shares"). The Common Shares have no pre-emptive rights or other rights to subscribe for additional shares, and no rights of redemption, conversion or exchange. Under certain circumstances and subject to the provisions of Bermuda law and our bye-laws, we may be required to make an offer to repurchase shares held by members. The Common Shares rank pari passu with one another in all respects as to rights of payment and distribution. In general, holders of Common Shares will have one vote for each Common Share held by them and will be entitled to vote, on a non-cumulative basis, at all meetings of shareholders. In the event that a shareholder is considered a 9.5% Shareholder under our bye-laws, such shareholder's votes will be reduced by whatever amount is necessary so that after any such reduction the votes of such shareholder will not result in any other person being treated as a 9.5% Shareholder with respect to the vote on such matter. Under these provisions certain shareholders may have their voting rights limited to less than one vote per share, while other shareholders may have voting rights in excess of one vote per share. In November 2014, Essent Group completed the sale of 6.0 million Common Shares in a public offering at a price of $22.25 per share and certain selling shareholders sold 7.8 million Common Shares. We did not receive any proceeds from the sale of shares by the selling shareholders. The total net proceeds from this offering were approximately $126.7 million after deducting underwriting discounts, commissions and other offering expenses. Note 10. Stock-Based Compensation On February 6, 2009, Essent Group adopted the 2009 Restricted Share Plan. In connection with the IPO in 2013, Essent Group's Board of Directors amended and restated the 2009 Restricted Share Plan, effective immediately prior to the initial public offering. In addition, Essent Group's Board of Directors adopted, and Essent Group's shareholders approved, the Essent Group Ltd. 2013 Long-Term Incentive Plan (the "2013 Plan"), which was effective upon completion of the initial public offering. The types of awards available under the 2013 Plan include nonvested shares, nonvested share units, non-qualified share options, incentive stock options, share appreciation rights, and other share-based or cash-based awards. The 2013 Plan authorized a total of 14.7 million Common Shares, which will be increased on the first day of each of the Company's fiscal years beginning with fiscal year 2014, in an amount equal to the lesser of (i) 1.5 million Common Shares, (ii) 2% of the Company's outstanding Common Shares on the last day of the immediately preceding fiscal year, or (iii) such number of Common Shares as determined by the Company's Board of Directors. The maximum number of common shares that may be issued in respect of incentive share options is 14.7 million. As of December 31, 2016, there were 14.1 million Common Shares available for future grant under the 2013 Plan. In September 2013 and February 2014, certain members of senior management were granted nonvested Common Shares under the 2013 Plan that were subject to time-based and performance-based vesting. The time-based share awards granted in September 2013 vest in four equal installments on January 1, 2015, 2016, 2017 and 2018. The time-based share awards granted in February 2014 vest in three equal installments on March 1, 2015, 2016 and 2017. The performance-based share awards vest based upon our compounded annual book value per share growth percentage during a three-year performance period that commenced on January 1, 2014. The September 2013 performance-based share awards vest on the one-year anniversary of the completion of the performance period, and the February 2014 performance-based share awards vest on March 1, 2017. In February 2015, certain members of senior management were granted nonvested Common Shares under the 2013 Plan that were subject to time-based and performance-based vesting. The time-based share awards granted in February 2015 vest in three equal installments on March 1, 2016, 2017 and 2018. The performance-based share awards granted in February 2015 vest based upon our compounded annual book value per share growth percentage during a three-year performance period that commenced on January 1, 2015 and vest on March 1, 2018. In May 2015, nonvested Common Shares were granted to an employee in connection with an employment agreement that are subject to time-based and performance-based vesting. The time-based share award vests in four equal installments on July 1, 2016, 2017, 2018 and 2019. The performance-based share award vests based upon our compounded annual book value per share growth percentage during a three-year performance period that commenced on January 1, 2015 and vests on July 1, 2019. In February 2016, certain members of senior management were granted nonvested common shares under the 2013 Plan that are subject to time-based and performance-based vesting. The time-based share awards granted in February 2016 vest in three equal installments on March 1, 2017, 2018 and 2019. The performance-based share awards granted in February 2016 vest Essent Group Ltd. and Subsidiaries (Continued) based upon our compounded annual book value per share growth percentage during a three-year performance period that commenced on January 1, 2016 and vest on March 1, 2019. The portion of the nonvested performance-based share awards that will be earned based upon the achievement of compounded annual book value per share growth is as follows: In the event that the compounded annual book value per share growth falls between the performance levels shown above, the nonvested Common Shares earned will be determined on a straight-line basis between the respective levels shown. In connection with our incentive program covering bonus awards for performance year 2013, in February 2014, time-based share awards and share units were issued to certain employees that vest in three equal installments on January 1, 2015, 2016 and 2017. In connection with our incentive program covering bonus awards for performance year 2014, in February 2015, time-based share awards and share units were issued to certain employees that vest in three equal installments on March 1, 2016, 2017 and 2018. In connection with our incentive program covering bonus awards for performance year 2015, in February 2016, time-based share awards and share units were issued to certain employees that vest in three equal installments on March 1, 2017, 2018 and 2019. In May 2014, time-based share units were issued to non-employee directors that vest one year from the date of grant. The portion of the grant that related to director compensation for the period from our initial public offering through April 2014 vested on November 1, 2014 and the portion of the grant that related to director compensation from May 2014 through April 2015 vested on May 6, 2015. In May 2015, time-based share units were granted to non-employee directors that vested one year from the date of grant. In May 2016, time-based share units were granted to non-employee directors that vest one year from the date of grant. The following tables summarize nonvested Common Share and nonvested Common Share unit activity for the year ended December 31: Essent Group Ltd. and Subsidiaries (Continued) Quoted market prices are used for the valuation of Common Shares granted subsequent to our initial public offering. For nonvested Common Share units granted in October 2013, the initial public offering price of Common Shares was used. For nonvested Common Shares granted in September 2013, prior to our IPO, the valuation estimate was based on analysis provided by the underwriters regarding the estimated fair value of Essent and the estimated IPO price range. Factors considered in determining the IPO price range and Common Share valuation included prevailing market conditions, estimates of the Company's business potential and earnings prospects, the Company's historical operating results, market valuations of companies deemed comparable to the Company and an assessment of risks and opportunities. The total fair value of nonvested shares or share units that vested was $15.6 million, $22.4 million and $32.7 million for the years ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, there was $16.0 million of total unrecognized compensation expense related to nonvested shares or share units outstanding at December 31, 2016 and we expect to recognize the expense over a weighted average period of 1.6 years. In January 2017, 290,965 nonvested Common Share units were issued to all vice president and staff level employees and are subject to time-based vesting. In connection with our incentive program covering bonus awards for performance year 2016, in February 2017, 90,508 nonvested Common Shares and 70,862 nonvested Common Share units were issued to certain employees and are subject to time-based vesting. In February 2017, 140,108 nonvested Common Shares were granted to certain members of senior management and are subject to time-based and performance-based vesting. Employees have the option to tender shares to Essent Group to pay the minimum employee statutory withholding taxes associated with shares upon vesting. Common Shares tendered by employees to pay employee withholding taxes totaled 184,583, 201,553 and 105,317 in 2016, 2015 and 2014, respectively. The tendered shares were recorded at cost and included in treasury stock. All treasury stock has been cancelled as of December 31, 2016 and 2015. Essent Group Ltd. and Subsidiaries (Continued) Compensation expense, net of forfeitures, and related tax effects recognized in connection with nonvested shares were as follows for the years ended December 31: Note 11. Dividends Restrictions Our U.S. insurance subsidiaries are subject to certain capital and dividend rules and regulations as prescribed by jurisdictions in which they are authorized to operate. Under the insurance laws of the Commonwealth of Pennsylvania, Essent Guaranty and Essent PA may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders' surplus or (ii) the preceding year's statutory net income. The Pennsylvania statute also specifies that dividends and other distributions can be paid out of positive unassigned surplus without prior approval. At December 31, 2016, Essent Guaranty had unassigned surplus of approximately $13.6 million. Essent Guaranty paid no dividends to Essent Group or any intermediate holding companies in the years ended December 31, 2016, 2015 or 2014. Essent PA had unassigned surplus of approximately $8.4 million as of December 31, 2016. In the years ended December 31, 2016 and 2014, Essent PA paid to its parent company, Essent US Holdings, Inc. ("Essent Holdings") a dividend of $3.75 million and $200,000, respectively. Essent PA did not pay a dividend in 2015. Essent PA paid a $5.0 million dividend to Essent Holdings in February 2017. Essent Re is subject to certain dividend restrictions as prescribed by the Bermuda Monetary Authority and under certain agreements with counterparties. In connection with the quota share reinsurance agreement with Essent Guaranty, Essent Re has agreed to maintain a minimum total equity of $100 million. As of December 31, 2016, Essent Re had total equity of $401.3 million. At December 31, 2016, our insurance subsidiaries were in compliance with these rules, regulations and agreements. Note 12. Income Taxes As of December 31, 2016, the statutory income tax rates of the countries where the Company does business are 35% in the United States and 0.0% in Bermuda. The statutory income tax rate of each country is applied against the taxable income from each country to calculate the income tax expense. Income tax expense consists of the following components for the years ended December 31: For the year ended December 31, 2016 pre-tax income attributable to Bermuda and U.S. operations was $51.6 million and $260.3 million, respectively, as compared to $21.4 million and $207.0 million, respectively, for the year ended December 31, 2015. For the year ended December 31, 2014 pre-tax income attributable to Bermuda operations was not significant in comparison to total pre-tax income. Essent Group Ltd. and Subsidiaries (Continued) Income tax expense is different from that which would be obtained by applying the applicable statutory income tax rates to income before taxes by jurisdiction (i.e. U.S. 35%; Bermuda 0.0%). The reconciliation of the difference between income tax expense and the expected tax provision at the weighted average tax rate was as follows for the years ended December 31: We provide deferred taxes to reflect the estimated future tax effects of the differences between the financial statement and tax bases of assets and liabilities using currently enacted tax laws. The net deferred tax liability was comprised of the following at December 31: The components of the net deferred tax liability were as follows at December 31: As a mortgage guaranty insurer, we are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the IRC for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that we purchase non-interest-bearing United States Mortgage Guaranty Tax and Loss Bonds ("T&L Bonds") issued by the Treasury Department in an amount equal to the tax benefit derived from deducting any portion of our statutory contingency reserves. During the years ended December 31, 2016 and 2015, we had net purchases of T&L Bonds in the amount of $61.9 million and $59.7 million, respectively, and held $181.3 million and $119.4 million of T&L Bonds as of December 31, 2016 and 2015, respectively. In evaluating our ability to realize the benefit of our deferred tax assets, we consider the relevant impact of all available positive and negative evidence including our past operating results and our forecasts of future taxable income. At December 31, Essent Group Ltd. and Subsidiaries (Continued) 2016 and 2015, after weighing all the evidence, management concluded that it was more likely than not that our deferred tax assets would be realized. Under current Bermuda law, the parent company, Essent Group, and its Bermuda subsidiary, Essent Re, are not required to pay any taxes on income and capital gains. In the event that there is a change such that these taxes are imposed, these companies would be exempted from any such tax until March of 2035 pursuant to the Bermuda Exempt Undertakings Tax Protection Act of 1966, and the Exempt Undertakings Tax Protection Amendment Act of 2011. Essent Holdings and its subsidiaries are subject to income taxes imposed by U.S. law and file a U.S. Consolidated Income Tax Return. Each subsidiary has executed a tax sharing agreement with its parent company, which provides that taxes are settled in cash between parent and subsidiary on a quarterly basis based on separate company pro-forma calculations. Should Essent Holdings pay a dividend to its parent company, Essent Irish Intermediate Holdings Limited, withholding taxes at a rate of 5% under the U.S./Ireland tax treaty would likely apply assuming the Company avails itself of Treaty benefits under the U.S./Ireland tax treaty. Absent treaty benefits, the withholding rate on outbound dividends would be 30%. Currently, however, no withholding taxes are accrued with respect to such unremitted earnings as management has no intention of remitting these earnings. Similarly, no foreign income taxes have been provided on the un-remitted earnings of the Company's U.S. subsidiaries as management has neither the intention of remitting these earnings, nor would any Ireland tax be due, as any Irish tax would be expected to be fully offset by credit for taxes paid to the U.S. An estimate of the cumulative amount of U.S. earnings that would be subject to withholding tax, if distributed outside of the U.S., is approximately $550 million. The associated withholding tax liability under the U.S./Ireland tax treaty would be approximately $28 million. Essent is not subject to income taxation other than as stated above. There can be no assurance that there will not be changes in applicable laws, regulations, or treaties which might require Essent to change the way it operates or becomes subject to taxation. At December 31, 2016 and 2015, the Company had no unrecognized tax benefits. As of December 31, 2016, the U.S. federal income tax returns for the tax years 2009 through 2015 remain subject to examination. The Company has not recorded any uncertain tax positions as of December 31, 2016 or December 31, 2015. Note 13. Related Party Transactions The Company is a party to an investment advisory agreement with Goldman Sachs Asset Management, L.P., a subsidiary of The Goldman Sachs Group, Inc. ("Goldman Sachs"), one of Essent Group's investors. Through the date of our IPO, Goldman Sachs beneficially owned 11.35% of our outstanding shares. Subsequent to the IPO, Goldman Sachs directly held less than 10% of our outstanding shares. Investment expense incurred under the investment advisory agreement totaled $0.8 million, $0.7 million, and $0.5 million for the years ended December 31, 2016, 2015 and 2014, respectively. Goldman Sachs is also one of several lenders under our revolving credit facility discussed in Note 7 and was paid an upfront fee of $0.1 million in 2016. Commitment fees and interest expense incurred under the revolving credit facility allocable to Goldman Sachs totaled $0.1 million in 2016. The Company was also a party to underwriting agreements with Goldman Sachs in connection with the IPO and secondary offering of Common Shares. Amounts paid to Goldman Sachs in connection with the underwriting agreements totaled $3.5 million in 2014. Essent Group Ltd. and Subsidiaries (Continued) Note 14. Earnings per Share (EPS) The following table reconciles the net income and the weighted average common shares outstanding used in the computations of basic and diluted earnings per common share for the years ended December 31: There were 96,251, 78,198 and 141,503 antidilutive shares for the years ended December 31, 2016, 2015 and 2014, respectively. The nonvested performance-based share awards are considered contingently issuable for purposes of the EPS calculation. Based on the compounded annual book value per share growth as of December 31, 2016, 2015 and 2014, 100% of the performance-based share awards would be issuable under the terms of the arrangements at each date if December 31 was the end of the contingency period. Note 15. Accumulated Other Comprehensive Income (Loss) The following table shows the rollforward of accumulated other comprehensive income (loss) for the year ended December 31: Essent Group Ltd. and Subsidiaries (Continued) _______________________________________________________________________________ (1) Included in net realized investments gains on our consolidated statements of comprehensive income. Note 16. Fair Value of Financial Instruments We carry certain of our financial instruments at fair value. We define fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation. Fair Value Hierarchy ASC No. 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. The level within the fair value hierarchy to measure the financial instrument shall be determined based on the lowest level input that is significant to the fair value measurement. The three levels of the fair value hierarchy are as follows: • Level 1-Quoted prices for identical instruments in active markets accessible at the measurement date. • Level 2-Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and valuations in which all significant inputs are observable in active markets. Inputs are observable for substantially the full term of the financial instrument. • Level 3-Valuations derived from one or more significant inputs that are unobservable. Determination of Fair Value When available, we generally use quoted market prices to determine fair value and classify the financial instrument in Level 1. In cases where quoted market prices for similar financial instruments are available, we utilize these inputs for valuation techniques and classify the financial instrument in Level 2. In cases where quoted market prices are not available, fair values are based on estimates using discounted cash flows, present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rates and estimates of future cash flows and we classify the financial instrument in Level 3. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. We used the following methods and assumptions in estimating fair values of financial instruments: • Investments available for sale-Investments available for sale are valued using quoted market prices in active markets, when available, and those investments are classified as Level 1 of the fair value hierarchy. Level 1 investments available for sale include investments such as U.S. Treasury securities and money market funds. Investments available for sale are classified as Level 2 of the fair value hierarchy if quoted market prices are not available and fair values are estimated using quoted prices of similar securities or recently executed transactions for the securities. U.S. agency securities, U.S. agency mortgage-backed securities, municipal debt securities, corporate debt securities, residential and commercial mortgage securities and asset-backed securities are classified as Level 2 investments. Essent Group Ltd. and Subsidiaries (Continued) We use independent pricing sources to determine the fair value of securities available for sale in Level 1 and Level 2 of the fair value hierarchy. We use one primary pricing service to provide individual security pricing based on observable market data and receive one quote per security. To ensure securities are appropriately classified in the fair value hierarchy, we review the pricing techniques and methodologies of the independent pricing service and believe that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. U.S. agency securities, U.S. agency mortgage-backed securities, municipal and corporate debt securities are valued by our primary vendor using recently executed transactions and proprietary models based on observable inputs, such as interest rate spreads, yield curves and credit risk. Residential and commercial mortgage securities and asset-backed securities are valued by our primary vendor using proprietary models based on observable inputs, such as interest rate spreads, prepayment speeds and credit risk. As part of our evaluation of investment prices provided by our primary pricing service, we obtained and reviewed their pricing methodologies which include a description of how each security type is evaluated and priced. We review the reasonableness of prices received from our primary pricing service by comparison to prices obtained from additional pricing sources. We have not made any adjustments to the prices obtained from our primary pricing service. • Derivative liabilities-Through June 30, 2016, certain of our Freddie Mac ACIS contracts were accounted for as derivatives. In determining an exit market, we considered the fact that there is not a principal market for these contracts. In the absence of a principal market, we valued these ACIS contracts in a hypothetical market where market participants, and potential counterparties, included other mortgage guaranty insurers or reinsurers with similar credit quality to us. We believed that in the absence of a principal market, this hypothetical market provided the most relevant information with respect to fair value estimates. These ACIS contracts were classified as Level 3 of the fair value hierarchy. During the quarter ended September 30, 2016, these contracts were amended and are now accounted for as insurance contracts rather than as derivatives. As of December 31, 2016, the Company had no derivative instruments. Through June 30, 2016, we determined the fair value of our derivative instruments primarily using internally-generated models. We utilized market observable inputs, such as the performance of the underlying pool of mortgages, mortgage prepayment speeds and pricing spreads on the reference STACR notes issued by Freddie Mac, whenever they were available. There was a high degree of uncertainty about our fair value estimates since our contracts were not traded or exchanged, which made external validation and corroboration of our estimates difficult. Considerable judgment was required to interpret market data to develop the estimates of fair value. Accordingly, the estimates may not have been indicative of amounts we could have realized in a market exchange or negotiated termination. The use of different market assumptions or estimation methodologies may have had a material effect on the estimated fair value amounts. Essent Group Ltd. and Subsidiaries (Continued) Assets and Liabilities Measured at Fair Value All assets measured at fair value are categorized in the table below based upon the lowest level of significant input to the valuations. All fair value measurements at the reporting date were on a recurring basis. Changes in Level 3 Recurring Fair Value Measurements The following table presents changes during the years ended December 31, 2016 and 2015 in Level 3 liabilities measured at fair value on a recurring basis, and the net realized and unrealized losses (gains) related to the Level 3 liabilities in the consolidated balance sheets at December 31, 2016 and 2015. During the years ended December 31, 2016 and 2015, we had no Level 3 assets. Essent Group Ltd. and Subsidiaries (Continued) The following table summarizes the significant unobservable inputs used in our recurring Level 3 fair value measurements as of December 31, 2015: The significant unobservable inputs used for derivative liabilities are constant prepayment rates ("CPR") and default rates on the reference pool of mortgages and the credit spreads on the reference STACR notes. An increase in the CPR, default rate or reference STACR credit spread will increase the fair value of the liability. Note 17. Statutory Accounting Our U.S. insurance subsidiaries prepare statutory-basis financial statements in accordance with the accounting practices prescribed or permitted by their respective state’s department of insurance, which is a comprehensive basis of accounting other than GAAP. We did not use any prescribed or permitted statutory accounting practices (individually or in the aggregate) that resulted in reported statutory surplus or capital that was significantly different from the statutory surplus or capital that would have been reported had National Association of Insurance Commissioners’ statutory accounting practices been followed. The following table presents Essent Guaranty’s and Essent PA’s statutory net income, statutory surplus and contingency reserve liability as of and for the years ended December 31: Essent Group Ltd. and Subsidiaries (Continued) Net income determined in accordance with statutory accounting practices differs from GAAP. In 2016 and 2015, the more significant differences between net income determined under statutory accounting practices and GAAP for Essent Guaranty and Essent PA relate to policy acquisition costs and income taxes. Under statutory accounting practices, policy acquisition costs are expensed as incurred while such costs are capitalized and amortized to expense over the life of the policy under GAAP. As discussed in Note 12, we are eligible for a tax deduction, subject to certain limitations for amounts required by state law or regulation to be set aside in statutory contingency reserves when we purchase T&L Bonds. Under statutory accounting practices, this deduction reduces the tax provision recorded by Essent Guaranty and Essent PA and, as a result, increases statutory net income and surplus as compared to net income and equity determined in accordance with GAAP. At December 31, 2016 and 2015, the statutory capital of our U.S. insurance subsidiaries, which is defined as the total of statutory surplus and contingency reserves, was in excess of the statutory capital necessary to satisfy their regulatory requirements. Effective December 31, 2015, Fannie Mae and Freddie Mac, at the direction of the Federal Housing Finance Agency, implemented new coordinated Private Mortgage Insurer Eligibility Requirements, which we refer to as the "PMIERs." The PMIERs represent the standards by which private mortgage insurers are eligible to provide mortgage insurance on loans owned or guaranteed by Fannie Mae and Freddie Mac. The PMIERs include financial strength requirements incorporating a risk-based framework that require approved insurers to have a sufficient level of liquid assets from which to pay claims. The PMIERs also include enhanced operational performance expectations and define remedial actions that apply should an approved insurer fail to comply with these requirements. As of December 31, 2016, Essent Guaranty, our GSE-approved mortgage insurance company, was in compliance with the PMIERs. Statement of Statutory Accounting Principles No. 58, Mortgage Guaranty Insurance, requires mortgage insurers to establish a special contingency reserve for statutory accounting purposes included in total liabilities equal to 50% of earned premium for that year. During 2016, Essent Guaranty increased its contingency reserve by $165.8 million and Essent PA increased its contingency reserve by $8.9 million. This reserve is required to be maintained for a period of 120 months to protect against the effects of adverse economic cycles. After 120 months, the reserve is released to unassigned funds. In the event an insurer’s loss ratio in any calendar year exceeds 35%, however, the insurer may, after regulatory approval, release from its contingency reserves an amount equal to the excess portion of such losses. Essent Guaranty and Essent PA did not release any amounts from their contingency reserves in 2016, 2015 or 2014. Under The Insurance Act 1978, as amended, and related regulations of Bermuda (the "Insurance Act"), Essent Re is required to annually prepare statutory financial statements and a statutory financial return in accordance with the financial reporting provisions of the Insurance Act, which is a basis other than GAAP. The Insurance Act also requires that Essent Re maintain minimum share capital of $1 million and must ensure that the value of its general business assets exceeds the amount of its general business liabilities by an amount greater than the prescribed minimum solvency margins and enhanced capital requirement pertaining to its general business. At December 31, 2016 and 2015, all such requirements were met. Essent Re's statutory capital and surplus was $390.9 million and $213.0 million as of December 31, 2016 and 2015, respectively, and statutory net income was $53.8 million and $26.7 million, respectively. Statutory capital and surplus and net income determined in accordance with statutory accounting practices differs from GAAP. The more significant differences from GAAP for Essent Re relate to policy acquisition costs and accounting for insurance and certain reinsurance policies issued in connection with the ACIS program. Under statutory accounting practices, policy acquisition costs are charged to expense when the related premiums are written while such costs are capitalized and amortized to expense over the life of the policy under GAAP. Under statutory accounting practices, the insurance and reinsurance policies issued in connection with the ACIS program are accounted for as insurance with premium received recorded as premiums earned. Through June 30, 2016, the insurance and certain reinsurance policies for the ACIS program were accounted for as derivatives under GAAP with the fair value of these policies reported as an asset or liability and changes in the fair value of these policies reported in earnings as a component of other income. During the quarter ended September 30, 2016, these contracts were amended and are now accounted for as insurance contracts rather than derivatives. See Note 16. Essent Group Ltd. and Subsidiaries (Continued) Note 18. Capital Maintenance Agreement Essent Guaranty has a capital maintenance agreement with Essent PA under which Essent Guaranty agreed to contribute funds, under specified conditions, to maintain Essent PA's risk-to-capital ratio at or below 25.0 to 1 in return for a surplus note. As of December 31, 2016, Essent PA's risk-to-capital ratio was 6.8:1 and there were no amounts outstanding related to this agreement. Note 19. Quarterly Financial Data (Unaudited) The following table summarizes the unaudited results of operations for each quarter of 2016 and 2015. We have prepared the consolidated quarterly information on a basis consistent with the audited consolidated financial statements. In the opinion of management, the financial information reflects all adjustments (which include normal recurring adjustments) required for a fair presentation of the financial information for the quarters presented. This information should be read in conjunction with our audited financial statements and the related notes. The results of interim periods are not necessarily indicative of the results for the full year. Essent Group Ltd. and Subsidiaries Schedule I-Summary of Investments-Other Than Investments in Related Parties December 31, 2016 Essent Group Ltd. and Subsidiaries Schedule II-Condensed Financial Information of Registrant Balance Sheets Parent Company Only See accompanying supplementary notes to Parent Company condensed financial information and the consolidated financial statements and notes thereto. Essent Group Ltd. and Subsidiaries Schedule II-Condensed Financial Information of Registrant Condensed Statements of Comprehensive Income Parent Company Only See accompanying supplementary notes to Parent Company condensed financial information and the consolidated financial statements and notes thereto. Essent Group Ltd. and Subsidiaries Schedule II-Condensed Financial Information of Registrant Condensed Statements of Cash Flows Parent Company Only See accompanying supplementary notes to Parent Company condensed financial information and the consolidated financial statements and notes thereto. Essent Group Ltd. and Subsidiaries Schedule II-Condensed Financial Information of Registrant Parent Company Only Supplementary Notes Note A The accompanying Parent Company financial statements should be read in conjunction with the consolidated financial statements and notes to consolidated financial statements. These financial statements have been prepared on the same basis and using the same accounting policies as described in the consolidated financial statements included herein, except that the Parent Company uses the equity-method of accounting for its majority-owned subsidiaries. Note B Under the insurance laws of the Commonwealth of Pennsylvania, the insurance subsidiaries may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders' surplus or (ii) the preceding year's statutory net income. The Pennsylvania statute also requires that dividends and other distributions be paid out of positive unassigned surplus without prior approval. As of December 31, 2016, Essent Guaranty had unassigned surplus of approximately $13.6 million. Essent PA had unassigned surplus of approximately $8.4 million as of December 31, 2016. Essent PA paid a $5.0 million dividend to Essent Holdings in February 2017. During the three years ending December 31, 2016, the Parent Company did not receive any dividends from its subsidiaries.
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Based on the provided text, here's a summary of the financial statement:
The financial statement appears to be from Essent Group, a company involved in private mortgage insurance. Key points include:
1. Revenue: There is a potential significant impact on revenues due to the loss of a major customer.
2. Losses: The company establishes reserves for losses based on estimated ultimate claim costs for defaulted loans, following accounting principles (ASC No. 944).
3. Expenses: The company reviews operating results holistically and has prepared consolidated financial statements in accordance with U.S. GAAP.
4. Liabilities: Debt and equity securities are classified as available for sale and reported at fair value, with unrealized gains and losses recorded in other comprehensive income, net of deferred income taxes.
The statement suggests a focus on risk management in the mortgage insurance sector, with careful accounting practices and comprehensive financial reporting.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CURAEGIS TECHNOLOGIES, INC. Contents Financial Statements ACCOUNTING FIRM Board of Directors and Shareholders CurAegis Technologies, Inc. We have audited the accompanying consolidated balance sheets of CurAegis Technologies, Inc. (formerly Torvec, Inc.) and its subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, cash flows, and changes in stockholders’ equity for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of the Company’s internal control over financial reporting. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of CurAegis Technologies, Inc. and its subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company's losses from operations raise substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Freed Maxick CPAs, P.C. Buffalo, New York March 20, 2017 CURAEGIS TECHNOLOGIES, INC. CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. CURAEGIS TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements. CURAEGIS TECHNOLOGIES, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY See notes to consolidated financial statements. CURAEGIS TECHNOLOGIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. CURAEGIS TECHNOLOGIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2016 NOTE 1 - THE COMPANY AND BASIS OF PRESENTATION CurAegis Technologies, Inc. (“CurAegis”, “the Company”) was incorporated as a New York business corporation in September 1996 under the name Torvec, Inc. The Company’s name was changed to CurAegis Technologies, Inc. in June 2016 in connection with the establishment of its two business divisions. The CURA division is engaged in the fatigue management business and the Aegis division is engaged in the power and hydraulic business. The Company develops and markets advanced technologies in the areas of safety, wellness and power. The Company is focused on the commercialization of a wellness and safety system (the CURA System and the myCadian watch) and a uniquely designed hydraulic pump that will be smaller, lighter and more efficient than current technology. The Company has not had any significant revenue-producing operations. The Company has created the CURA System to market products that reduce fatigue risk in the workplace and help individuals manage their sleep and improve alertness. The CURA System consists of the following capabilities: ● the myCadian watch and app, ● real-time alertness monitoring, ● the Group Wellness Index and ● the Z-Coach wellness program. Our goal with the Aegis hydraulic pump technology is to bring to the marketplace a unique concept in hydraulic pumps and motors that will be: ● smaller and lighter than conventional pumps and motors, ● more efficient, ● as reliable, ● price competitive, and ● unique in its ability to scale larger, allowing more powerful pumps and motors. It is important to note, regarding both the CURA and Aegis products, that the cycle time from the initiation of the sales process to revenue realization can be highly variable especially as a start-up entity. In addition to the activities to be undertaken to implement our plan of operations, we may expand and/or refocus our activities depending upon future circumstances and developments. Current Cash Outlook and Management Plans As of December 31, 2016, we have cash on hand of $2,009,000, working capital of $1,786,000, stockholders’ equity of $1,583,000 and an accumulated deficit of $75,418,000. During the year ended December 31, 2016 we raised $1,510,000 in gross proceeds through the sale of our Series C-3 preferred stock and $3,000,000 through the issuance of 6% convertible notes and warrants. The proceeds from these private placements are being used to support the ongoing development and marketing of our core technologies and product initiatives. Management estimates that the 2017 cash needs, based on its current development and product plans, will range from $4.0 to $4.6 million. As of December 31, 2016, the Company’s cash and cash equivalents on hand may not be sufficient to cover the Company’s future working capital requirements. This raises substantial doubt as to the Company’s ability to continue as a going concern. Management continues to use its best efforts to develop financing opportunities to fund the development and commercialization of the CURA and Aegis products. As described in Note 14 to the consolidated financial statements, subsequent to December 31, 2016, the board of directors authorized the issuance of Senior Convertible Promissory Notes and Warrants to be sold in a private placement exempt from registration under Section 4(a)(2) of the Securities Act of 1934, as amended and Rule 506(c) of Regulation D as promulgated by the Securities and Exchange Commission. The offering will be made only to “accredited investors” as defined in Rule 501(a) of Regulation D under the Securities Act of 1933. The Company will offer up to $3 million in 6% senior convertible promissory notes with a five-year maturity. The conversion price of the notes will be fixed on the date of issuance at the lower of $0.50 per share or 60% of the market price as determined based on the 90-day volume weighted average price on the date of the agreement. The investors will receive warrants to purchase an aggregate number of shares of the Company’s common stock to equal 10% of the number of shares issuable upon the conversion of the notes. The exercise price of the warrants will be fixed on the date of issuance at the lower of $0.50 per share or 60% of the market price as determined based on the 90-day volume weighted average price on the date of the agreement. No notes had been issued as of the date of this filing. Since inception, we have financed our operations by the sale of our securities and debt financings. We need to raise additional funds to meet our working capital needs, to fund expansion of our business, to complete development, testing and marketing of our products, or to make strategic acquisitions or investments. No assurance can be given that necessary funds will be available for us to finance our development on acceptable terms, if at all. Furthermore, such additional financings may involve dilution to our shareholders or may require that we relinquish rights to certain of our technologies or products. In addition, we may experience operational difficulties and delays due to working capital restrictions. If adequate funds are not available from additional sources of financing, we will have to delay or scale back our growth plans. The Company’s ability to fund its current and future commitments out of its available cash depends on a number of factors. These factors include the Company’s ability to (i) launch and generate sales from the CURA division and; (ii) decrease engineering and development and administrative expenses. If these and other factors are not met, the Company would need to raise funds in order to meet its working capital needs and pursue its growth strategy. Although there can be no such assurances, management believes that sources for these additional funds will be available through either current or future investors. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation: The financial statements include the accounts of the Company, our wholly-owned subsidiary Iso-Torque Corporation, and our majority-owned subsidiary, Ice Surface Development, Inc. (56% owned at December 31, 2016). As of December 31, 2016, each of the subsidiaries is non-operational. The Company intends to let Ice Surface Development, Inc. dissolve by proclamation. All material intercompany transactions and account balances have been eliminated in consolidation. Use of Estimates: The preparation of financial statements in conformity with U.S. generally accepted accounting principles (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. These estimates are subject to a high degree of judgment and potential change. Actual results could differ from those estimates. Reclassifications: Certain reclassifications may have been made to prior year balances to conform to the current year’s presentation. Cash and Equivalents: Cash and equivalents may include time deposits, certificates of deposit, and highly liquid debt instruments with original maturities of three months or less. We maintain cash and cash equivalents at financial institutions which periodically may exceed federally insured amounts. We have a corporate credit card program through our primary financial institution, JPMorgan Chase Bank, N.A. In connection with this, the Company granted a security interest to the bank in our money market account to act as collateral for the activity within the corporate card program, up to $25,000. Inventory: Inventory is stated at the lower of cost or market with cost determined under the average cost method. We record provisions for excess, obsolete or slow-moving inventory based on changes in customer demand, technology developments or other economic factors. The allowance for excess, obsolete or slow-moving inventory was zero at December 31, 2016 and December 31, 2015. Accounts Receivable: We carry our accounts receivable at invoice amount less an allowance for doubtful accounts. On a periodic basis, we evaluate our accounts receivable and establish an allowance for doubtful accounts, based on a history of past write-offs and collections and current credit conditions. We do not accrue interest on past due invoices. The allowance for doubtful accounts was zero at December 31, 2016 and December 31, 2015. Software, Property and Equipment: Capitalized software, property and equipment are stated at cost. Estimated useful lives are as follows: Depreciation and amortization are computed using the straight-line method. Betterments, renewals and significant repairs that extend the life of the assets are capitalized. Other repairs and maintenance costs are expensed when incurred. When disposed, the cost and accumulated depreciation applicable to assets retired are removed from the accounts and the gain or loss on disposition is recognized in other income (expense). Depreciation and software amortization expense for the years ended December 31, 2016 and 2015 amounted to $173,000 and $127,000, respectively. Whenever events or circumstances indicate, our long-lived assets including any intangible assets with finite useful lives are tested for impairment by using the estimated future cash flows directly associated with, and that are expected to arise as a direct result of, the use of the assets. If the carrying amount exceeds the estimated undiscounted cash flows, impairment may be indicated. The carrying amount is compared to the estimated discounted cash flows and if there is an excess such amount is recorded as impairment. During the years ended December 31, 2016 and 2015, we recorded no impairment charges. Fair Value of Financial Instruments: As defined by U.S. GAAP, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A hierarchy for ranking the quality and reliability of the information is used to determine fair values. Assets and liabilities carried at fair value will be classified and disclosed in one of the following three categories: Level 1: Quoted market prices in active markets for identical assets or liabilities Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data Level 3: Unobservable inputs that are not corroborated by market data The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The Financial Accounting Standards Board’s (“FASB”) guidance for the disclosure about fair value of financial instruments requires disclosure of an estimate of the fair value of certain financial instruments. The fair value of financial instruments pursuant to FASB’s guidance for the disclosure about fair value of financial instruments approximated their carrying values at December 31, 2016. The carrying amount of cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, deferred revenue and accrued expenses approximates their fair value due to their short maturity. The carrying amount of capital lease obligations approximates fair value because stated or implied interest rates approximate current interest rates that are available for debt with similar terms. The 6% senior convertible notes can be converted into common stock which have an underlying value of $8,160,000 as of December 31, 2016 based on the trading price on December 31, 2016. Revenue Recognition and Deferred Revenue: The Company began offering the Z-Coach Aviation program in the first quarter of 2016. The Z-Coach program provides fatigue safety training over a subscription period of twelve months. The Z-Coach program allows the user unlimited access during the annual subscription period. Customers are billed at the acceptance of the subscription and revenue is recognized ratably over the subscription period as our performance obligations are satisfied and when collection is reasonably assured. One customer accounted for 50% of total sales made during the year ended December 31, 2016. Our collection terms provide customers standard terms of net 30 days. Future performance obligations are reflected in deferred revenue. Engineering and Development and Patents: Engineering and development costs and patent expenses are charged to operations as incurred. Engineering and development includes personnel-related costs, materials and supplies, depreciation and consulting services. Patent costs for the years ended December 31, 2016 and 2015 amounted to $96,000 and $83,000, respectively, and are included in general and administrative expenses. Stock-based Compensation: FASB Accounting Standards Codification (“ASC”) 718-10 requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values on the grant date. The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized. In addition, the realization of tax benefits in excess of amounts recognized for financial reporting purposes will be recognized as a financing activity in accordance with ASC 718-10. No tax benefits were attributed to the stock-based compensation expense because a valuation allowance was maintained for substantially all net deferred tax assets. FASB ASC 505-50, “Equity-Based Payments to Non-Employees,” requires all share-based payments to non-employees, including grants of stock options, to be recognized in the consolidated financial statements as compensation expense generally over the service period of the consulting arrangement or until performance conditions are expected to be met. Using a Black-Scholes valuation model, we periodically reassess the fair value of non-employee options until service conditions are met, which generally aligns with the vesting period of the options, and we adjust the expense recognized in the consolidated financial statements accordingly. FASB ASC 718-20 requires that modifications of the terms or conditions of equity awards be treated as an exchange of the original award for a new award. Incremental compensation cost is measured as the excess, if any, of the fair value of the modified award over the fair value of the original award immediately before its terms are modified. Income Taxes: We account for income taxes using the asset and liability method, the objective of which is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting and the tax basis of our assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. A valuation allowance related to deferred tax assets is recorded when it is more likely than not that some portion or all of the deferred tax assets will not be realized. We account for uncertain tax positions using a more-likely-than-not recognition threshold based on the technical merits of the tax position taken. Tax benefits that meet the more-likely-than-not recognition threshold should be measured as the largest amount of tax benefits, determined on a cumulative probability basis, which is more likely than not to be realized upon ultimate settlement in the financial statements. It is our policy to recognize interest and penalties related to income tax matters as general and administrative expenses. As of December 31, 2016, and December 31, 2015, there were no accrued interest or penalties related to uncertain tax positions. Loss per Common Share: FASB’s ASC 260-10 (“Earnings Per Share”) requires the presentation of basic earnings per share, which is based on weighted average common stock outstanding, and dilutive earnings per share, which gives effect to options, warrants and convertible securities in periods when they are dilutive. At December 31, 2016 and 2015, we excluded 72,385,000 and 54,215,000 potential common shares, respectively, relating to convertible preferred stock, convertible notes, options and warrants outstanding from the diluted net loss per common share calculation because their inclusion would be anti-dilutive. In addition, we excluded 625,000 warrants from the diluted net loss per common share calculation at December 31, 2016 and 2015 as the conditions for their vesting are not time-based. Recent Accounting Pronouncements: FASB Accounting Pronouncements Related to Revenue from Contracts with Customers (Topic 606) In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers” which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 recognizes revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. In May 2015, the FASB issued ASU 2015-14, “Revenue from Contracts with Customers” extending the date of implementation of this guidance for public companies to reporting periods beginning after December 15, 2017. In March 2016, the FASB issued ASU 2016-08 “Revenue from Contracts with Customers” to provide guidance on the topic of principal versus agent considerations. In 2016, the FASB issued 2016-12 and ASU No. 2016-10 and ASU No. 2016-20 to further clarify and identify performance obligations and licensing instances, narrow-scope improvements and identify practical expedients relative to Topic 606. These standards are effective for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect recognized at the date of adoption (which includes additional footnote disclosures). The Company continues to evaluate the impact of the adoption of FASB accounting pronouncements related to revenue from Contracts with Customers (Topic 606). Since the Company has had minimal revenue since inception the impact of adoption is anticipated to be nominal. Other FASB Accounting Pronouncements In November 2016, the FASB issued ASU No. 2016-18 Statement of Cash Flows (Topic 230). This update requires that a statement of cash flows explain the change in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This change is effective for public entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not believe that the adoption of this standard will have a material effect on our consolidated financial statements and related disclosures. In August 2016, the FASB issued ASU No. 2016-15 Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments (Topic 230). There is diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other Topics. This pronouncement addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The amendments are effective for public entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company does not believe that the adoption of this standard will have a material effect on our consolidated financial statements and related disclosures. In June 2016, the FASB issued ASU No. 2016-13 Financial Instruments - Credit Losses (Topic 326) “Measurement of Credit Losses on Financial Instruments.” The pronouncement affects entities holding financial assets and net investments in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets that have the contractual right to receive cash. This pronouncement will affect an entity to varying degrees depending on the credit quality of the assets held, their duration, and how the entity applies current GAAP. The standard is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is evaluating the impact of the adoption of this standard on our consolidated financial statements and related disclosures. On March 30, 2016, the FASB issued ASU No. 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting,” which amends the current stock compensation guidance. The amendments simplify the accounting for the taxes related to stock based compensation, including adjustments as to how excess tax benefits and a company's payments for tax withholdings should be classified. The standard is effective for fiscal periods beginning after December 15, 2016, with early adoption permitted. The Company is evaluating the impact of the adoption of this standard on our consolidated financial statements and related disclosures. On February 25, 2016, the FASB issued ASU No. 2016-02, “Leases,” a comprehensive new lease standard which will supersede previous lease guidance. The standard requires a lessee to recognize in its balance sheet assets and liabilities related to long-term leases that were classified as operating leases under previous guidance. An asset will be recognized related to the right to use the underlying asset and a liability will be recognized related to the obligation to make lease payments over the term of the lease. The standard also requires expanded disclosures surrounding leases. The standard is effective for fiscal periods beginning after December 15, 2018, and requires modified retrospective adoption, with early adoption permitted. The Company does not believe that the adoption of this standard will have a material effect on our consolidated financial statements and related disclosures. NOTE 3 - 6% SENIOR CONVERTIBLE NOTES AND WARRANTS During the third quarter of 2016, the board of directors authorized the issuance of up to $3 million in 6% Senior Convertible Promissory Notes and Warrants (the “Convertible Notes”) in connection with the August 25, 2016 Securities Purchase Agreement (the “2016 SPA”). The Convertible Notes have five year maturity dates ranging from August 2021 through December 2021 and a fixed annual interest rate of 6%. The initial year of interest expense will be paid to the note holders on the first anniversary of each note's issuance and quarterly thereafter. Principal is due in full on each note's maturity date. The conversion rate of the notes has been fixed at $0.25 per share as determined at the close of business on August 25, 2016. The investors have been granted warrants to purchase an aggregate number of shares of common stock equal to 10% of the number of shares issuable upon the conversion of the notes. The warrants have a fixed exercise price of $0.25 and a ten-year term from the date of issuance. The notes were offered in a private placement exempt from registration under Section 4(a)(2) of the Securities Act of 1934, as amended and Rule 506(c) of Regulation D as promulgated by the Securities and Exchange Commission. The offering was available only to “accredited investors” as defined in Rule 501(a) of Regulation D under the Securities Act of 1933. During the year ended December 31, 2016, the Company issued Convertible Notes aggregating $3,000,000 pursuant to the 2016 SPA. In connection with the notes, the Company granted 1,200,000 warrants with an exercise price of $0.25 per share and 10 year terms. The Company incurred $28,000 in debt issuance costs in connection with the issuance of the Convertible Notes. In accordance with FASB ASU 2015-03 Interest-Imputation of Interest (Subtopic 835-30), these debt issuance costs have been presented as a direct deduction from the carrying amount of the Convertible Note liability and reflected as a component of debt discount which is amortized and included in interest expense over the five-year term of the Convertible Notes. The Company allocated $2,551,000 of the proceeds to debt discount based on the computed fair value of the warrants issued, the beneficial conversion feature and the debt issuance costs. During the year ended December 31, 2016 the Company recorded $129,000 in interest expense including amortization of debt discount of $94,000. As of December 31, 2016, the Convertible Notes have a face value of $3,000,000 and are presented net of unamortized debt discount of $2,457,000 related to warrants, beneficial conversion feature and debt issuance costs resulting in a carrying value of $543,000. NOTE 4 - CAPITAL LEASE OBLIGATION In 2015, we entered into a capital lease for a copy machine over a 5 year term, with a fair market value buyout option. The capitalized value of the lease was approximately $9,000 and the monthly payment is approximately $170 with an implicit interest rate of 5.3%. Future payments remaining under this lease agreement are less than $2,000 per year through the lease expiration date in 2020. NOTE 5 - SOFTWARE The Company invested in software for the CURA System during the years ended December 31, 2016 and 2015. These assets are amortized over an estimated useful life of 3 years. Amortization expense recognized for the years ended December 31, 2016 and 2015 was $114,000 and $33,000, respectively. The net value of capitalized software at December 31, 2016 and 2015 was $227,000 and $303,000, respectively. Future amortization expense is expected to be $121,000 in 2017, $92,000 in 2018, $10,000 in 2019, and $4,000 thereafter. NOTE 6 - PROPERTY AND EQUIPMENT At December 31, 2016 and 2015 property and equipment consist of the following: Depreciation expense for the years ended December 31, 2016 and 2015 was $59,000 and $94,000 respectively. NOTE 7- BUSINESS SEGMENTS The Company has two operating business segments. The CURA business operates in the fatigue management industry and the Aegis business is focused in the power and hydraulic industry. Segment information for the years ended December 31, 2016 for the company’s business segments follows: Segment information for the years ended December 31, 2015 for the company’s business segments follows: NOTE 8 - INCOME TAXES We account for income taxes using the asset and liability method, the objective of which is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting and the tax bases of our assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. A valuation allowance related to deferred tax assets is recorded when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The provision (benefit) for income taxes for the years ended December 31, 2016 and 2015 is summarized below: The difference between income taxes at the statutory federal income tax rate and income taxes reported in the statements of operations is attributable to the following: The deferred tax asset at December 31, 2016 and 2015 consists of the following: At December 31, 2016, we have approximately $8,794,000 and $8,093,000 of adjusted federal and New York State net operating loss carryforwards, respectively, to offset future taxable income. These net operating losses begin expiring in 2025 through 2036. In addition, we have $58,000 of federal research and development tax credit carryforwards to offset future tax. These credits expire in 2036. Additionally, from the date of inception through 2016, we have accumulated approximately $36,954,000 of adjusted deferred startup costs, subject to certain alternative minimum tax limitations. Start-up costs will be amortized over a 15 year period beginning in the year we begin an active trade or business. We have provided a full valuation allowance on the net deferred tax assets due to uncertainty of realization through future earnings. The excess tax benefits associated with stock warrant exercises are recorded directly to stockholders’ equity only when realized. As a result, the excess tax benefits available in deferred start-up costs, but not reflected in deferred tax assets was approximately $4,475,000. The uncertain tax benefits included in the tabular reconciliation relate to these excess tax benefits. Based upon the change in ownership rules under Section 382 of the Internal Revenue Code of 1986, if a company issues common stock or other equity instruments convertible into common shares which result in an ownership change exceeding a 50% limitation threshold over a rolling three-year timeframe as imposed by that Section, all of that company’s net operating loss carryforwards may be significantly limited as to the amount of use in any particular year. During 2016, we evaluated the Section 382 regulations, and concluded that we have not had a cumulative ownership change that would limit the use of our net operating loss and tax credit carryforwards. Reconciliations of the beginning and ending amounts of unrecognized tax benefits for the years ended December 31, 2016 and 2015 are as follows: Tax years that remain subject to examination for our major tax jurisdictions include the years ended December 31, 2013 through December 31, 2016. The federal income tax audit for the year 2012 recently concluded and resulted in a reduction to out net operating loss carry-forward of $222,000. State laws enacted in 2015 changed the treatment of net operating loss carry-overs related to tax years beginning prior to January 1, 2015. The deferred tax asset has been reduced to reflect the newly enacted change in treatment of net operating loss carry-overs. NOTE 9 - PREFERRED and COMMON STOCK Common Stock We have authorized 400,000,000 shares of common stock, with a par value of $0.01 per share. During the year ended December 31, 2016, the Company issued 1,270,000 shares of common stock in connection with conversion notices received from various preferred shareholders. During the year ended December 31, 2015, the Company issued 80,467 shares of common stock in connection with conversion notices received from two Series A convertible preferred shareholders. The company issued 43,880 shares of common stock in connection with these notices and an additional 36,587 in common shares attributed to dividends earned on these converted shares. Preferred Stock Our certificate of incorporation permits the Company to issue up to 100,000,000 shares of $.01 par value preferred stock. The board of directors has the authority to allocate these shares into as many separate classes of preferred as it deems appropriate and with respect to each class, designate the number of preferred shares issuable and the relative rights, preferences, seniority with respect to other classes and to our common stock and any limitations and/or restrictions that may be applicable without obtaining shareholder approval. Class A Preferred Stock We have authorized the issuance of up to 3,300,000 Class A Non-Voting Cumulative Convertible Preferred Shares. Each Class A Preferred Share is convertible after a one year holding period, at the holder’s election, into one share of our common stock. The conversion rate is subject to adjustment in the event of the issuance of our common stock as a dividend or distribution and in the case of the subdivision or combination of our common stock. The Class A Preferred has no voting rights, except with respect to matters directly impacting upon the rights and privileges accorded to such Class. The holders of the Class A Preferred are entitled to receive cumulative preferential dividends in the amount of $.40 per share of Class A Preferred for each annual dividend period. Dividends payable on the Class A Preferred will be paid in cash out of any funds legally available for the payment of dividends or, in the discretion of the board, will be paid in Class A Preferred at a rate of 1 share of Class A Preferred for each $4.00 of dividends. If dividends are paid in shares of Class A Preferred, such dividend shares are not entitled to accumulate additional dividends and themselves may be converted into the common stock of the Company on a one for one basis. Holders of Class A Preferred are permitted to request that dividends payable in Class A Preferred be immediately converted into shares of our common stock. At times, our board may elect to settle the dividends through the issuance of common stock in lieu of cash. Accumulated and unpaid dividends on the Class A Preferred will not bear interest. Class A Preferred shares are also entitled to participate pro rata in dividends declared and/or distributions made with respect to all classes of our outstanding equity. We may, in the absolute discretion of our board, redeem at any time and from time to time from any source of funds legally available any and all of the outstanding Class A Preferred at the redemption price of $4.00 per Class A Preferred, plus all unpaid accumulated dividends payable with respect to each Class A Preferred Share. During the year ended December 31, 2015, the Company issued 80,467 shares of common stock in connection with conversion notices received from two Series A convertible preferred shareholders. The company issued 43,880 shares of common stock in connection with these notices and an additional 36,587 in common shares attributed to dividends earned on these converted shares. At December 31, 2016, there were 543,221 outstanding shares of Class A Preferred stock, of which 8,709 shares resulted from the settlement of dividends due to conversion, and those shares no longer accrue dividends. The value of dividends payable upon the conversion of the remaining 534,512 outstanding shares of Class A Preferred stock amounted to approximately $2,538,000 and $2,325,000 at December 31, 2016 and 2015, respectively. In the event of a liquidation, dissolution and winding up of the Company, and subject to the liquidation rights and privileges of our Class C Preferred shareholders, Class A Preferred shareholders have a liquidation preference with respect to all accumulated and unsettled dividends. The value of the Class A Preferred shareholders’ liquidation preference was approximately $2,538,000 and $2,325,000 at December 31, 2016 and 2015, respectively. In the event of liquidation, dissolution or winding up of the Company, unpaid accumulated dividends on the Class A Preferred are payable in Class A Preferred at a rate of 1 share of Class A Preferred for each $4.00 of dividends. Class B Preferred Stock The Company authorized the issuance of up to 300,000 Class B Non-Voting, Cumulative Convertible Preferred Shares to fund the business operations of Iso-Torque Corporation, an entity incorporated to separately commercialize the Company’s Iso-Torque differential technology. Each Class B Preferred Share is convertible after a one year holding period, at the holder’s election, into one share of our common stock or one share of the common stock of Iso-Torque Corporation. The conversion rate is subject to adjustment in the event of the issuance of the company’s or Iso-Torque Corporation’s common stock as a dividend or distribution and in the case of the subdivision or combination of such common stock. The Class B Preferred has no voting rights, except with respect to matters directly impacting upon the rights and privileges accorded to such Class. Subject to the dividend rights and privileges of our Class A Preferred, the holders of the Class B Preferred are entitled to receive cumulative dividends in the amount of $.50 per share of Class B Preferred for each annual dividend period. Dividends payable on the Class B Preferred will be paid in cash out of any funds legally available for the payment of dividends or, in the discretion of the board, will be paid in Class B Preferred at a rate of 1 share of Class B Preferred for each $5.00 of dividends. If dividends are paid in shares of Class B Preferred, such dividend shares are not entitled to accumulate additional dividends and themselves may be converted into the common stock of the Company on a one for one basis. Holders of Class B Preferred are permitted to request that dividends payable in Class B Preferred be immediately converted into shares of our common stock. Accumulated and unpaid dividends on the Class B Preferred will not bear interest. Class B Preferred shares are also entitled to participate pro rata in dividends declared and/or distributions made with respect to all classes of our outstanding equity. We may, in the absolute discretion of our board, redeem at any time and from time to time from any source of funds legally available any and all of the outstanding Class B Preferred at the redemption price of $5.00 per Class B Preferred, plus all unpaid accumulated dividends payable with respect to each Class B Preferred Share. Depending upon our cash position, from time to time we may request that a converting preferred shareholder receiving dividends in cash consent to receive shares of restricted common stock in lieu thereof. For the years ended December 31, 2016 and 2015, we settled no Class B Preferred dividends. At December 31, 2016, dividends payable upon the conversion of 67,500 outstanding shares of Class B Preferred amounted to approximately $386,000. In the event of liquidation, dissolution and winding up of the Company, and subject to the liquidation rights and privileges of our Class C Preferred shareholders and our Class A Preferred shareholders, Class B Preferred shareholders have a liquidation preference with respect to all accumulated and unsettled dividends. The value of the Class B Preferred shareholders’ liquidation preference was $386,000 and $353,000 at December 31, 2016 and 2015, respectively. In the event of a liquidation, dissolution or winding up of the Company, unpaid accumulated dividends on the Class B Preferred are payable in Class B Preferred shares at a rate of 1 share of Class B Preferred for each $5.00 of dividends. Series C Preferred Stock We have authorized and issued 16,250,000 shares of Series C Voting Convertible Preferred Stock. Each Series C Preferred share is convertible, at the holder’s election, into one share of our common stock. The conversion rate is subject to adjustment in the event of the issuance of common stock as a dividend or distribution, and the subdivision or combination of the outstanding common stock. The Series C Preferred shares have a liquidation preference at their stated value per share of $0.40 that is senior to our common stock, and the Company’s Class A Non-Voting Cumulative Convertible Preferred Shares and Class B Non-Voting Cumulative Convertible Preferred Shares. The liquidation preference is payable upon a liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, or upon a deemed liquidation of the Company. The Series C Preferred shares have no right to receive dividends and have no redemption right. The Series C Preferred shares vote with the common stock on an as-converted basis. During the year ended December 31, 2016, Series C Preferred shareholders converted 250,000 shares of Series C Preferred into common stock. At December 31, 2016 and 2015, there were 16,000,000 and 16,250,000 shares of Series C Preferred stock outstanding. The value of the Series C Preferred shareholders’ liquidation preference was $6,400,000 and $6,500,000 at December 31, 2016 and 2015, respectively. Series C-2 Preferred Stock In March 2014, the board of directors authorized, and Class A Preferred, Class B Preferred and Series C Preferred shareholders approved, a series of preferred stock, namely 25,000,000 shares of Series C-2 Voting Convertible Preferred Stock. Each Series C-2 Preferred Share is convertible, at the holder’s election, into one share of our common stock, par value $0.01 per share. The conversion rate is subject to adjustment in the event of the issuance of common stock as a dividend or distribution, and the subdivision or combination of the outstanding common stock or a reorganization, recapitalization, reclassification, consolidation or merger of the Company. The Series C-2 Preferred Shares have a liquidation preference at their stated value per share of $0.20 that ranks pari passu to our existing Series C Voting Convertible Preferred Shares and is senior to our common stock, and our Class A Non-Voting Cumulative Convertible Preferred Shares and Class B Non-Voting Cumulative Convertible Preferred Shares. The liquidation preference is payable upon a liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, or upon a deemed liquidation of the Company. A deemed liquidation includes, unless decided by the holders of at least two-thirds of the Series C-2 Preferred Shares, any consolidation, merger, or reorganization of the Company in which the shareholders of the Company own less than fifty percent of the voting power of the resultant entity, or an acquisition to which the Company is a party in which at least fifty percent of the Company’s voting power is transferred, or the sale, lease, exclusive license or transfer of all or substantially all of the assets or intellectual property of the Company other than to a wholly owned subsidiary. The Series C-2 Preferred Shares are not entitled to receive preferred dividends and have no redemption right, but are entitled to participate, on an as converted basis; with holders of outstanding shares of common stock in dividends and distributions on liquidation after all preferred shares have received payment in full of any preferred dividends or liquidation preferences. The Series C-2 Preferred Shares vote with the common stock on an as-converted basis. We may not, without approval of the holders of at least two-thirds of the Series C-2 Preferred Shares, (i) create any class or series of stock that is pari passu or senior to the Series C-2 Preferred Shares; (ii) create any class or series of stock that would share in the liquidation preference of the Series C-2 Preferred Shares or that is entitled to dividends payable other than in common stock or Series C-2 Preferred Shares of its own series, (iii) acquire any equity security or pay any dividend, except dividends on a class or series of stock that is junior to the Series C Preferred Shares, payable in such junior stock, (iv) reissue any Series C-2 Preferred Shares, (v) declare or pay any dividend that would impair the payment of the liquidation preference of the Series C-2 Preferred Shares, (vi) authorize or issue any additional Preferred Shares, (vii) change the Certificate of Incorporation to adversely affect the rights of the holders of the Series C-2 Preferred Shares, or (viii) authorize, commit to or consummate any liquidation, dissolution or winding up in which the liquidation preference of the Series C-2 Preferred Shares would not be paid in full. The Series C-2 Preferred Shares have not been registered under the Securities Act of 1933, as amended, or the Securities Act, and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. Cumulatively through December 31, 2016, Series C-2 Preferred shareholders have converted no shares of Series C-2 Preferred into common stock. At December 31, 2016 and 2015, there were 25,000,000 shares of Preferred C-2 stock outstanding. The value of the Series C-2 Preferred shareholders’ liquidation preference was $5,000,000 at December 31, 2016 and 2015. In connection with the issuance of the Series C-2 Preferred Shares, the Company entered into an Investors’ Rights Agreement on September 23, 2011 (the “Investors’ Rights Agreement”). Pursuant to the Investors’ Rights Agreement, the Company granted registration rights to the investors covering Common Stock issued on the conversion of the Preferred Shares or exercise of the Warrants or other shares issued in connection with the Transaction (the “Underlying Shares”). The registration rights are triggered when the Company is eligible to utilize Form S-3, and until such time as (i) the Company is sold, (ii) dissolved, or (iii) the Underlying Shares are eligible for resale without restriction in a three month period under Rule 144. Investors holding shares for sale to receive at least $500,000 in gross proceeds have the right to make the demand up to one time in any such twelve month period. The Investors’ Rights Agreement also contains a right of first offer for the future issuance of any equity securities of the Company. Pursuant to the terms of the Investors’ Rights Agreement, the Company may not (i) grant any equity based compensation; (ii) reduce the per-share exercise price or conversion price of any equity based compensation; (iii) create or incur indebtedness in excess of $1,000,000 in the aggregate at any time, or (iv) guarantee the indebtedness of any third party except for trade account payables arising in the ordinary course of business, without the consent of the lead investor. In the event the Company grants any equity based compensation or reduces the per-share exercise price or conversion price of any equity based compensation in violation of the terms of the Investors’ Rights Agreement, and with the effect that additional equity interests are issuable as a result, then the Company shall be obligated to immediately issue to each Investor such aggregate number of additional shares of Common Stock so that immediately following such violation such Investor’s ownership percentage is unaffected by the violation. The Investors also agreed to “Market Stand-off” provisions that may be requested by an underwriter in an underwritten public offering by the Company. In addition, pursuant to the terms of the Investors’ Rights Agreement, as long as the lead investor may acquire at least 3,000,000 shares of Common Stock by conversion or exercise of his Series C Securities, (i) the lead investor is entitled to inspect the properties, assets, business and operation of the Company and discuss its business and affairs with its officers, consultants, directors and key employees, (ii) the Company shall invite the lead investor or his representative to attend all meetings of the Board of Directors and provide all information provided to directors for such purpose, and (iii) at his request, the Company shall cause him to be appointed to serve as a director until the following annual meeting of shareholders and until a successor is elected. Series C-3 Preferred Stock In 2015, the board of directors authorized and the Class A Preferred, Class B Preferred, Series C Preferred and C-2 Preferred shareholders approved, a series of preferred stock, namely 10,000,000 shares of Series C-3 Voting Convertible Preferred Stock. On December 8, 2015, the Company commenced the offering of up to $2,500,000 of the Series C-3 Preferred Shares at the price of $0.25 per share in a private placement pursuant to Rule 506(c) of Regulation D under the Securities Act of 1933. The offering was made only to “accredited investors” as defined in Rule 501(a) of Regulation D under the Securities Act of 1933. The Series C-3 Preferred Shares are convertible into shares of the Company’s common stock at the rate of one-to-one, subject to adjustment in some circumstances. The Series C-3 Preferred Shares have an aggregate liquidation preference, ranking pari passu with the Series C Preferred Shares and Series C-2 Preferred Shares and senior to the company’s common stock, the Class A Preferred Shares and Class B Preferred Shares. The Series C-3 Preferred Shares are not entitled to receive preferred dividends and have no redemption rights, but are entitled to participate, on an as converted basis, with holders of the company’s common stock in dividends and distributions. The Series C-3 Preferred Shares vote with the Company’s common stock on an as-converted basis and have certain protective provisions. The Series C-3 Preferred Shares have not been registered under the Securities Act of 1933. Accordingly, those shares and the shares of common stock issuable upon their conversion are “restricted securities” within the meaning of Rule 144 under the Securities Act of 1933 and may not be offered for resale or resold or otherwise transferred except pursuant to a registration statement under the Securities Act of 1933 or an applicable exemption from registration requirements. During 2016, the Company issued a total of 6,042,000 shares of Series C-3 Voting Convertible Preferred Stock in a private placement transaction, generating gross proceeds of $1,510,500. Direct expenses of $12,000 pertaining to the transaction, consisting of external legal costs, were incurred, resulting in net proceeds of $1,495,000. In conjunction with the issuance of the Series C-3 Preferred stock, we computed the value of the non-cash beneficial conversion feature associated with the right to convert the shares into common stock on a one-for-one basis. We compared the fair value of our common stock on the date of issuance with the effective conversion price, and determined that the value of the non-cash beneficial conversion feature was $885,000 and has been reflected in our consolidated statements of operations as an adjustment to arrive at the net loss attributable to common stockholders. During the year ended December 31, 2016 the Company issued 1,020,000 shares of common stock in connection with conversion notices received from various Series C-3 convertible preferred shareholders. NOTE 10 - STOCK OPTIONS 2016 Stock Option Plan At the 2016 Annual Meeting the shareholders approved the 2016 Stock Option Plan (the “2016 Plan”) which provides for the grant of up to 3,000,000 common stock options to provide equity incentives to directors, officers, employees and consultants. Two types of options may be granted under the 2016 Plan: non-qualified stock options and incentive stock options. As of December 31, 2016, no options have been granted under this plan. 2011 Stock Option Plan In 2011, shareholders approved the 2011 Stock Option Plan (the “2011 Plan”) which provides for the grant of up to 3,000,000 common stock options to provide equity incentives to directors, officers, employees and consultants. Two types of options may be granted under the 2011 Plan: non-qualified stock options and incentive stock options. Under the 2016 and 2011 Stock Option Plans, non-qualified stock options may be granted to our officers, directors, employees and outside consultants. Incentive stock options may be granted only to our employees, including officers and directors who are also employees. In the case of non-qualified stock options, the exercise price may be less than the fair market value of our stock on the date of grant. Stock option grants to non-employees are revalued at each reporting date to reflect the compensation expense over the vesting period. In the case of incentive stock options, the exercise price may not be less than such fair market value and in the case of an employee who owns more than 10% of our common stock, the exercise price may not be less than 110% of such market price. Options generally are exercisable for ten years from the date of grant, except that the exercise period for an incentive stock option granted to an employee who owns more than 10% of our stock may not be greater than five years. During the year ended December 31, 2016, we granted a total of 502,000 stock options to employees and non-employee board members. These included 175,000 stock options granted at exercise prices ranging from $0.38 to $0.62 per share, exercisable for 10 years that vest at a rate of 25% on each anniversary of the date of grant. The Company also granted 327,000 stock options at exercise prices ranging from $0.34 to $0.53 per share, exercisable for 10 years, with vesting tied to the market price of the Company’s common stock. These options fully vest when the trading price of the Company’s common stock reaches $5.00 per share. The expense recognized for options that are granted to consultants (i.e., non-employees) reflect fair value, based on updated valuation assumptions using the Black-Scholes valuation model at each measurement period. Such expense is apportioned over the requisite service period of the consultant, which is concurrent with the vesting dates of the various tranches. Non-Plan Options On occasion, we have granted non-qualified stock options to certain officers, directors and employees that have been outside of established Company Stock Option Plans. All such option grants have been authorized by shareholder approval. Summary For the years ended December 31, 2016 and 2015, compensation cost related to stock option awards amounted to $145,000 and $404,000, respectively. As of December 31, 2016, there was approximately $307,000 of total unrecognized compensation costs related to outstanding stock options, which are expected to be recognized over a weighted average 1.7 years. The weighted average grant date fair value of stock options granted during the years ended December 31, 2016 and 2015 was $0.46 and $0.44, respectively. The total grant date fair value of stock options vested during the years ended December 31, 2016 and 2015 was approximately $230,000 and $908,000, respectively. The fair value of each option granted was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: The average risk-free interest rate is based on the U.S. treasury security rate in effect as of the grant date. We determined expected volatility using the historical closing stock price. The expected life was generally determined using the simplified method as we do not believe we have sufficient historical stock option exercise experience on which to base the expected term. The following summarizes the activity of all of our outstanding stock options for the years ended December 31, 2016 and 2015: During year ended December 31, 2016, the Company cancelled 3,000 options and 65,000 options expired unexercised. As of December 31, 2015, there were 2,048,000 stock options outstanding under the 2011 Plan, 1,137,000 of which were vested at that date; leaving 952,000 options available for future grant under the Plan. No options, were exercised and 100,000 options expired unexercised during the year ended December 31, 2015. As of December 31, 2016, the exercise prices of all outstanding stock options ranged from $.20 per share to $1.58 per share. As of December 31, 2016, the exercise prices of all vested stock options ranged from $.20 per share to $1.58 per share. NOTE 11 - WARRANTS The following summarizes the activity of our outstanding warrants for the years ended December 31, 2016 and 2015: (A) The weighted average exercise price for warrants outstanding as of December 31, 2016 and 2015 and January 1, 2015 excludes 1,750,000 warrants in each period with no determined exercise price. (B) The weighted average remaining contractual term for warrants outstanding as of December 31, 2016 excludes 743,500 warrants with no expiration date. (C) The weighted average remaining contractual term for warrants exercisable as of December 31, 2016, and 2015 excludes 118,500 warrants with no expiration date. NOTE 12 - RELATED PARTY TRANSACTIONS During the year ended December 31, 2016, the Company issued a total of 1,990,000 shares of our Series C-3 voting convertible preferred stock generating gross proceeds of $497,500 to seven members of our board of directors and one executive officer. No Series C-3 preferred shares were issued to related parties in the year ended December 31, 2015. During the year ended December 31, 2016, the Company issued $802,500 of senior convertible notes to four members of our board of directors representing a potential of 3,210,000 convertible common shares and 321,000 in warrants. The Company also issued $1,170,000 of senior convertible notes to an investor that is deemed an affiliate through the ownership of the majority of our Series C and C-2 Preferred Stock. This investor has the right to 4,680,000 convertible common shares and 468,000 warrants as a result of this debt issuance. (See Notes 3 and 9.) These notes remain outstanding as of December 31, 2016 as well as $24,000 in related accrued interest. We occupy a leased facility for our corporate headquarters building, located in Rochester, New York, which consists of both executive offices and manufacturing space. The facility is owned by a partnership, with which one of our directors, is associated. In October 2014, we extended our lease for a three-year renewal term through May 31, 2018. The current rental rate is $6,256 per month ($75,070 per annum) for the remainder of the current lease term. In addition, we are required to pay a proportionate share of yearly real estate taxes and yearly common area operating costs. The lease agreement has a three-year renewal option that includes a 9% rate increase at the renewal period that includes the period from June 2018 through May 2021. In December 2013, we entered into a consulting agreement with SCIRE Corporation, of which one of our directors is president, to provide us with expertise and advice on hydraulic pump technology and related markets. This consulting agreement expired at December 31, 2015. During the year ended December 31, 2015, we recorded an expense of $18,000 for consulting services and travel costs related to this agreement. Effective April 13, 2015, we entered into a consulting agreement with a placement firm, of which one of our directors. is a minority investor. During the year ended December 31, 2015, we recorded approximately $65,000 in connection with this service agreement. This service agreement was completed in August 2015. In December 2010, we executed a three-year consultant agreement with one of our directors to provide consulting services to us at a rate of $200 per hour. We also agreed to pay the consultant an incentive fee for each $1,000,000 of revenue or proportionate part thereof received by us for a period of five years, provided the definitive agreement results from the material efforts by the consultant. The agreement expired on December 13, 2016. The Company incurred no expense in connection with this agreement during the years ended December 31, 2016 or 2015. NOTE 13 - COMMITMENTS AND OTHER MATTERS Leases We occupy a leased facility for our corporate headquarters building, located in Rochester, New York, which consists of both executive offices and manufacturing space. The facility is owned by a partnership in which a Company director is associated. The current rental rate is $6,256 per month ($75,070 per annum) for the remainder of the current lease term. In addition, we are required to pay a proportionate share of yearly real estate taxes and yearly common area operating costs. The lease agreement has a three-year renewal option that includes a 9% rate increase at the renewal period that includes the period from June 2018 through May 2021. Rent expense for the years ended December 31, 2016 and 2015 was approximately $80,000 and $72,000, respectively. Rent payments required under the extended lease term for the years ending December 31, 2017 and 2018 amount to approximately $75,000 and $31,000, respectively. Employment Agreements Our chief executive officer executed a five year employment agreement effective December 31, 2015 pursuant to which his base compensation would be $50,000 per annum, with a compensation increase to $200,000 per annum on the first day of the calendar year immediately following the calendar year in which we have adjusted EBITDA of at least $300,000 (earnings before interest, taxes, depreciation and amortization, but excluding all non-cash expenses associated with stock options). Under the employment agreement, the CEO is entitled to a performance bonus based upon financial targets established each year in good faith by the Governance and Compensation Committee and the achievement of individual management objectives established annually by such committee. The CEO is entitled to participate in all employee benefit plans as are provided from time to time for senior executives. If we terminate the CEO without cause, remove him as CEO, or a change in control of the Company occurs, the CEO is entitled to three years’ severance pay, consisting of base pay and any incentive compensation. In the third quarter of 2015, the Company hired a Vice President of business development for the CURA division. The hiring agreement includes a severance agreement including six months salary if a termination by the Company is initiated other than for cause or executive good reason. Such severance will be based on the salary at the time of the action in return for a general release of the Company and its officers, directors and agents satisfactory to the Company. 401(k) Retirement Benefit Plan: The Company has a defined contribution 401(k) plan covering substantially all employees. Employees can contribute a portion of their salary or wages as prescribed under Section 401(k) of the Internal Revenue Code and, subject to certain limitations, we may, at management’s discretion, authorize an employer contribution based on a portion of the employees' contributions. At the present time, we do not provide for an employer match. During 2016 and 2015, we incurred administrative expenses of approximately $2,000 in each year related to the 401(k) plan. NOTE 14- SUBSEQUENT EVENTS Subsequent to December 31, 2016, the board of directors authorized the issuance of Senior Convertible Promissory Notes and Warrants to be sold in a private placement exempt from registration under Section 4(a)(2) of the Securities Act of 1934, as amended and Rule 506(c) of Regulation D as promulgated by the Securities and Exchange Commission. The offering will be made only to "accredited investors" as defined in Rule 501(a) of Regulation D under the Securities Act of 1933. The Company will offer up to $3 million in 6% senior convertible promissory notes with a five-year maturity. The conversion price of the notes will be fixed on the date of the issuance at the lower of $0.50 per share of 60% of the market price as determined based on the 90-day volume weighted average price on the date of the agreement. The investors will receive warrants to purchase an aggregate number of shares of the Company's common stock to equal 10% of the number of shares issuable upon the conversion of the notes. The exercise price of the warrants will be fixed on the date of issuance at the lower of $0.50 per share of 60% of the market price based on the 90-day volume weighted average price on the date of the agreement, and will have a five-year term. No notes had been issued as of the date of this filing. Stock Option Grants Subsequent to December 31, 2016, the Company granted 235,000 incentive stock options at prices ranging from $0.65 to $1.00 per share, with a 10 year life and 4 year vesting. Conversion of Preferred Stock Subsequent to December 31, 2016, the Company converted 200,000 Series C-3 preferred shares to 200,000 common shares upon receipt of notices of conversion from two Series C-3 shareholders. The Company also converted 62,500 Series C preferred shares to 62,500 common shares upon receipt of a conversion notice subsequent to December 31, 2016. Exercise of Warrants Subsequent to December 31, 2016, the Company converted 40,000 warrants at an exercise price of $0.25 per share upon receipt of a duly completed subscription form by the warrant holder.
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Here's a summary of the financial statement:
Financial Health Overview:
- The company is experiencing significant operational losses that raise doubts about its ability to continue as a going concern
- There is substantial financial uncertainty and potential risk of business sustainability
Cash and Assets:
- Maintains cash and equivalents at financial institutions
- Has a corporate credit card program with JPMorgan Chase Bank
- Granted a $25,000 security interest in a money market account as collateral
Financial Challenges:
- Needs to raise additional funds for:
* Working capital
* Business expansion
* Product development and marketing
* Potential strategic acquisitions
Funding Risks:
- No guarantee of securing necessary financing
- Potential future financing might:
* Dilute shareholder value
* Require relinquishing technology or product rights
- Operational difficulties may arise from working capital restrictions
Management Outlook
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following consolidated financial statements of the Company are included herewith: ACCOUNTING FIRM The Board of Directors and Stockholders Skyworks Solutions, Inc.: We have audited the accompanying consolidated balance sheets of Skyworks Solutions, Inc. and subsidiaries as of September 30, 2016 and October 2, 2015, and the related consolidated statements of operations, comprehensive income, cash flows, and stockholders’ equity for each of the years in the three-year period ended September 30, 2016. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule listed in Item 15 of this Form 10-K. We also have audited Skyworks Solutions, Inc.’s internal control over financial reporting as of September 30, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Skyworks Solutions, Inc.’s management is responsible for these consolidated financial statements and financial statement schedule, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule, and an opinion on the Company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Skyworks Solutions, Inc. and subsidiaries as of September 30, 2016 and October 2, 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended September 30, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Also in our opinion, Skyworks Solutions, Inc. maintained, in all material respects, effective internal control over financial reporting as of September 30, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) . /s/ KPMG LLP Boston, Massachusetts November 22, 2016 SKYWORKS SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except per share amounts) See accompanying . SKYWORKS SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) See accompanying . SKYWORKS SOLUTIONS, INC. CONSOLIDATED BALANCE SHEETS (In millions, except per share amounts) See accompanying . SKYWORKS SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) See accompanying . SKYWORKS SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions) See accompanying . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION Skyworks Solutions, Inc., together with its consolidated subsidiaries (“Skyworks” or the “Company”), is empowering the wireless networking revolution. The Company’s highly innovative analog semiconductors are connecting people, places, and things, spanning a number of new and previously unimagined applications within the automotive, broadband, cellular infrastructure, connected home, industrial, medical, military, smartphone, tablet and wearable markets. The Company has evaluated subsequent events through the date of issuance of the audited consolidated financial statements. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION All Skyworks subsidiaries are included in the Company’s consolidated financial statements and all intercompany balances are eliminated in consolidation. FISCAL YEAR The Company’s fiscal year ends on the Friday closest to September 30. Fiscal years 2016 and 2015 each consisted of 52 weeks and ended on September 30, 2016 and October 2, 2015, respectively. Fiscal year 2014 consisted of 53 weeks and ended on October 3, 2014. USE OF ESTIMATES The preparation of consolidated financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States requires management to make estimates and assumptions that affect the amounts of assets, liabilities, revenue, expenses, comprehensive income and accumulated other comprehensive loss during the reporting period. The Company evaluates its estimates on an ongoing basis using historical experience and other factors, including the current economic environment. Significant judgment is required in determining the reserves for and fair value of items such as allowance for doubtful accounts, overall fair value assessments of assets and liabilities, particularly those classified as Level 2 or Level 3 in the fair value hierarchy, inventory, intangible assets associated with business combinations, share-based compensation, loss contingencies, and income taxes. In addition, significant judgment is required in determining whether a potential indicator of impairment of long-lived assets exists and in estimating future cash flows for any necessary impairment testing. Actual results could differ significantly from these estimates. CASH AND CASH EQUIVALENTS The Company invests excess cash in time deposits, certificate of deposits and money market funds which primarily consist of United States treasury obligations, United States agency obligations, and repurchase agreements collateralized by United States government and agency obligations. The Company considers highly liquid investments with original maturities of 90 days or less when purchased as cash equivalents. ALLOWANCE FOR DOUBTFUL ACCOUNTS The Company maintains general allowances for doubtful accounts related to potential losses that could arise due to customers’ inability to make required payments. These reserves require management to apply judgment in deriving these estimates. In addition, the Company performs ongoing credit evaluations of its customers’ financial condition and if it becomes aware of any specific receivables which may be uncollectable, they perform additional analysis including, but not limited to, factors such as a customer’s credit worthiness, intent and ability to pay and overall financial position, and reserves are recorded if deemed necessary. If the data the Company uses to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and results of operations could be materially affected. INVESTMENTS The Company classifies its investment in marketable securities as “available for sale”. Available for sale securities are carried at fair value with unrealized holding gains or losses recorded in other comprehensive income. Gains or losses are included in earnings in the period in which they are realized. DERIVATIVES The Company may utilize derivative financial instruments to manage market risks associated with fluctuations in foreign currency exchange rates on specific transactions that occur in the normal course of business. The criteria the Company uses for designating an instrument as a hedge is the instrument’s effectiveness in risk reduction. To receive hedge accounting treatment, hedges must be highly effective at offsetting the impact of the hedge transaction. All derivatives, whether designated as hedging relationships or not, are recorded at fair value and are included as either an asset or liability on the balance sheet. FAIR VALUE Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principle or most advantageous market in an orderly transaction between market participants at the measurement date. Applicable accounting guidance provides a hierarchy for inputs used in measuring fair value that prioritize the use of observable inputs over the use of unobservable inputs, when such observable inputs are available. The three levels of inputs that may be used to measure fair value are as follows: • Level 1 - Quoted prices in active markets for identical assets or liabilities. • Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-driven valuations in which all significant inputs are observable or can be derived principally from, or corroborated with, observable market data. • Level 3 - Fair value is derived from valuation techniques in which one or more significant inputs are unobservable, including assumptions and judgments made by the Company. It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, the Company uses quoted market prices to measure fair value. If market prices are not available, the Company is required to make judgments about assumptions market participants would use to estimate the fair value of a financial instrument. The Company measures certain assets and liabilities at fair value on a recurring basis in three levels, based on the market in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. It recognizes transfers within the fair value hierarchy at the end of the fiscal quarter in which the change in circumstances that caused the transfer occurred. The carrying value of cash and cash equivalents, accounts receivable, other current assets, accounts payable and accrued liabilities approximates fair value due to short-term maturities of these assets and liabilities. INVENTORY Inventory is stated at the lower of cost or market on a first-in, first-out basis. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are carried at cost less accumulated depreciation, with significant renewals and betterments being capitalized and retired equipment written off in the respective periods. Maintenance and repairs are expensed as incurred. Depreciation is calculated using the straight-line method over the estimated useful lives, which range from five to thirty years for buildings and improvements and three to ten years for machinery and equipment. Leasehold improvements are depreciated over the lesser of the economic life or the life of the associated lease. VALUATION OF LONG-LIVED ASSETS Definite lived intangible assets are carried at cost less accumulated amortization. Amortization is calculated based on the pattern of benefit to be recognized from the underlying asset over its estimated useful life. Carrying values for long-lived assets and definite lived intangible assets are reviewed for possible impairment as circumstances warrant. Factors considered important that could result in an impairment review include significant underperformance relative to expected, historical or projected future operating results, significant changes in the manner of use of assets or the Company’s business strategy, or significant negative industry or economic trends. In addition, impairment reviews are conducted at the judgment of management whenever asset/asset group values are deemed to be unrecoverable relative to future undiscounted cash flows expected to be generated by that particular asset/asset group. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of an asset/asset group and its eventual disposition. Such estimates require management to exercise judgment and make assumptions regarding factors such as future revenue streams, operating expenditures, cost allocation and asset utilization levels, all of which collectively impact future operating performance. The Company’s estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, technological changes, economic conditions, changes to its business model or changes in its operating performance. If the sum of the undiscounted cash flows (excluding interest) is less than the carrying value of an asset/asset group, the Company would recognize an impairment loss, measured as the amount by which the carrying value exceeds the fair value of the asset or asset group. GOODWILL AND INDEFINITE INTANGIBLE ASSETS Goodwill and indefinite-lived intangible assets are not amortized but are tested at least annually as of the first day of the fourth fiscal quarter for impairment or more frequently if indicators of impairment exist during the fiscal year. Indefinite-lived intangible assets comprise an insignificant portion of the total book value of the Company’s intangible assets. The Company assesses its conclusion regarding segments and reporting units in conjunction with its annual goodwill impairment test, and has determined that it has one reporting unit for the purposes of allocating and testing goodwill. The goodwill impairment test is a two-step process. The first step of the Company’s impairment analysis compares its fair value to its net book value to determine if there is an indicator of impairment. In the Company’s calculation of fair value, it considers the closing price of its common stock on the selected testing date, the number of shares of its common stock outstanding and other marketplace activity such as a related control premium. If the calculated fair value is determined to be less than the book value of the Company, then the Company performs step two of the impairment analysis. Step two of the analysis compares the implied fair value of the Company’s goodwill to its book value. If the book value of the Company’s goodwill exceeds its implied fair value, an impairment loss is recognized equal to that excess. BUSINESS COMBINATIONS The Company uses the acquisition method of accounting for business combinations and recognizes assets acquired and liabilities assumed at their fair values on the date acquired. Goodwill represents the excess of the purchase price over the fair value of the net assets. The fair values of the assets and liabilities acquired are determined based upon the Company’s valuation using a combination of market, income or cost approaches. The valuation involves making significant estimates and assumptions, which are based on detailed financial models including the projection of future cash flows, the weighted average cost of capital and any cost savings that are expected to be derived in the future. EMPLOYEE RETIREMENT BENEFIT PLANS The funded status of benefit pension plans, or the balance of plan assets and benefit obligations is recognized on the consolidated balance sheet and pension liability adjustments, net of tax, are recorded in Accumulated Other Comprehensive Income. The Company determines discount rates considering the rates of return on high-quality fixed income investments, and the expected long-term rate of return on pension plan assets by considering the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. Decreases in discount rates lead to increases in benefit obligations that, in turn, could lead to an increase in amortization cost through amortization of actuarial gain or loss. A decline in the market values of plan assets will generally result in a lower expected rate of return, which would result in an increase of future retirement benefit costs. REVENUE RECOGNITION Revenue from product sales is recognized when there is persuasive evidence of an arrangement, the price to the buyer is fixed and determinable, delivery and transfer of title have occurred in accordance with the shipping terms specified in the arrangement with the customer and collectability is reasonably assured. Revenue from license fees and intellectual property is recognized when due and payable, and all other criteria previously noted have been met. The Company ships product on consignment to certain customers and only recognizes revenue when the customer notifies the Company that the inventory has been consumed. Revenue recognition is deferred in all instances where the earnings process is incomplete. Certain product sales are made to electronic component distributors under agreements allowing for price protection and stock rotation on unsold products. Reserves for sales returns and allowances are recorded based on historical experience or pursuant to contractual arrangements necessitating revenue reserves. SHARE-BASED COMPENSATION The Company recognizes compensation expense for all share-based payment awards made to employees and directors including non-qualified employee stock options, share awards and units, employee stock purchase plan and other special share-based awards based on estimated fair values. The fair value of share-based payment awards is amortized over the requisite service period, which is defined as the period during which an employee is required to provide service in exchange for an award. The Company uses a straight-line attribution method for all grants that include only a service condition. Awards with both performance and service conditions are expensed over the service period for each separately vesting tranche. Share-based compensation expense recognized during the period includes actual expense on vested awards and expense associated with unvested awards that has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company reviews actual forfeitures at least annually. The Company determines the fair value of share-based option awards based on the Company’s closing stock price on the date of grant using a Black-Scholes options pricing model. Under the Black-Scholes model, a number of highly complex and subjective variables are used including, but not limited to: the expected stock price volatility over the term of the award, the risk-free rate, the expected life of the award and dividend yield. The determination of fair value of restricted and certain performance share awards and units is based on the value of the Company’s stock on the date of grant with performance awards and units adjusted for the actual outcome of the underlying performance condition. For more complex performance awards including units with market-based performance conditions the Company employs a Monte Carlo simulation valuation method to calculate the fair value of the awards based on the most likely outcome. Under the Monte Carlo simulation, a number of highly complex and subjective variables are used including, but not limited to: the expected stock price volatility over the term of the award, a correlation coefficient, the risk-free rate, the expected life of the award, and dividend yield. RESEARCH AND DEVELOPMENT COSTS Research and development costs are expensed as incurred. LOSS CONTINGENCIES The Company records its best estimates of a loss contingency when it is considered probable and the amount can be reasonably estimated. When a range of loss can be reasonably estimated with no best estimate in the range, the minimum estimated liability related to the claim is recorded. As additional information becomes available, the Company assesses the potential liability related to the potential pending loss contingency and revises its estimates. Loss contingencies are disclosed if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and legal costs are expensed as incurred. RESTRUCTURING A liability for post-employment benefits is recorded when payment is probable, the amount is reasonably estimable, and the obligation relates to rights that have vested or accumulated. FOREIGN CURRENCIES The Company’s primary functional currency is the United States dollar. Gains and losses related to foreign currency transactions, conversion of foreign denominated cash balances and translation of foreign currency financial statements are included in current results. For certain foreign entities that utilize local currencies as their functional currency, the resulting unrealized translation gains and losses are reported as currency translation adjustment through other comprehensive income (loss) for each period. INCOME TAXES The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. This method also requires the recognition of future tax benefits such as net operating loss carry forwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The carrying value of the Company’s net deferred tax assets assumes the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to record additional valuation allowances against its deferred tax assets resulting in additional income tax expense in its Consolidated Statement of Operations. Management evaluates the realizability of the deferred tax assets and assesses the adequacy of the valuation allowance quarterly. Likewise, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of their net recorded amount, an adjustment to the deferred tax assets would increase income or decrease the carrying value of goodwill in the period such determination was made. The determination of recording or releasing tax valuation allowances is made, in part, pursuant to an assessment performed by management regarding the likelihood that the Company will generate future taxable income against which benefits of its deferred tax assets may or may not be realized. This assessment requires management to exercise significant judgment and make estimates with respect to its ability to generate revenues, gross profits, operating income and taxable income in future periods. Amongst other factors, management must make assumptions regarding overall business and semiconductor industry conditions, operating efficiencies, the Company’s ability to develop products to its customers’ specifications, technological change, the competitive environment and changes in regulatory requirements which may impact its ability to generate taxable income and, in turn, realize the value of its deferred tax assets. The calculation of the Company’s tax liabilities includes addressing uncertainties in the application of complex tax regulations and is based on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company recognizes liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on its recognition threshold and measurement attribute of whether it is more likely than not that the positions the Company has taken in tax filings will be sustained upon tax audit, and the extent to which, additional taxes would be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period in which it is determined the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. The Company recognizes any interest or penalties, if incurred, on any unrecognized tax benefits as a component of income tax expense. EARNINGS PER SHARE Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share incorporate the potentially dilutive incremental shares issuable upon the assumed exercise of stock options, the assumed vesting of outstanding restricted stock units and performance stock units, and the assumed issuance of common stock under the stock purchase plan using the treasury share method. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In August 2015, the FASB deferred the effective date of Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and will supersede most current revenue recognition guidance. The guidance will be effective for the first quarter of the Company’s fiscal year 2019. Early adoption is permitted, but not before the first quarter of fiscal year 2018. The new guidance is required to be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying it recognized at the date of initial application. The Company has not yet selected a transition method and is still evaluating the impact of this ASU on its consolidated financial statements and related disclosure. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires lessees to reflect most leases on their balance sheet as assets and obligations. The effective date for the standard is for fiscal years beginning after December 15, 2018, with early adoption permitted. The standard is to be applied under the modified retrospective method, with elective reliefs, which requires application of the new guidance for all periods presented. The Company is evaluating the effects that this ASU will have on its consolidated financial statements and related disclosures. In March 2016, the FASB Issued ASU 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The updated guidance changes how companies account for certain aspects of share-based payment awards to employees, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. The effective date for the standard is for fiscal years beginning after December 15, 2016, with early adoption permitted. The Company does not anticipate it will adopt this ASU early and is evaluating the effects that this ASU will have on its consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. The standard addresses the classification and presentation of eight specific cash flow issues that currently result in diverse practices. This pronouncement is effective for annual reporting periods beginning after December 15, 2017. The amendments in this ASU should be applied using a retrospective approach. The Company is evaluating the effects that this ASU will have on its consolidated financial statements. There have been no other recent accounting pronouncements or changes in accounting pronouncements that are of significance, or potential significance, to the Company. 3. BUSINESS COMBINATIONS On October 29, 2015, the Company entered into an Amended and Restated Agreement and Plan of Merger (the “Merger Agreement”) with PMC-Sierra, Inc. (“PMC”), providing for, subject to the terms and conditions of the Merger Agreement, the cash acquisition of PMC by the Company. On November 23, 2015, PMC notified the Company that it had terminated the Merger Agreement. As a result, on November 24, 2015, PMC paid the Company a termination fee of $88.5 million pursuant to the Merger Agreement. During the fiscal year ended September 30, 2016, the Company acquired two businesses for total aggregate cash consideration of $55.6 million together with future contingent payments. The total future contingent consideration payments range from zero to $10.0 million and are based upon the achievement of specified objectives that are payable up to two years from the anniversary of the acquisitions, which at closing had a total estimated fair value of $7.4 million. In allocating the total purchase consideration for these acquisitions based on preliminary estimated fair values, the Company recorded $16.6 million of goodwill and $35.5 million of identifiable intangibles assets. Intangible assets acquired primarily included customer relationships and developed technology with weighted average useful lives of 4.0 years. These acquisitions are treated as asset purchases for tax purposes and accordingly, the goodwill resulting from these acquisitions is expected to be deductible. The fair value estimates for the assets acquired and liabilities assumed for acquisitions completed during the fiscal year ended September 30, 2016, were based upon preliminary calculations and valuations, and the Company’s estimates and assumptions for each of these acquisitions are subject to change as it obtains additional information during the respective measurement periods (up to one year from the respective acquisition dates). Net revenue and net income from these acquisitions has been included in the Consolidated Statements of Operations from the acquisition date through the end of the fiscal year on September 30, 2016. The impact of these acquisitions to the ongoing operations on the Company’s net revenue and net income was not significant for the fiscal year ended September 30, 2016. The Company incurred immaterial transaction-related costs during the period fiscal year September 30, 2016, which were included within the sales, administrative and general account. Due to the materiality of these acquisitions, the disclosures required by the applicable accounting guidance have been excluded. On August 1, 2016, the Company exercised its purchase option on the joint venture with Panasonic with respect to the design, manufacture and sale of Panasonic filter products, and paid Panasonic $76.5 million in cash. As a result of exercising the purchase option, the Company owns 100% of the filter joint venture. On October 7, 2016, the Company acquired a business for $14.4 million in cash and contingent consideration ranging from zero to $20.0 million payable over a three-year period. Due to the timing of the acquisition and the date of this filing, the Company has yet to assess the fair value of the assets acquired and liabilities assumed and accordingly, the disclosures required have been omitted. 4. FAIR VALUE Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis The Company measures certain assets and liabilities at fair value on a recurring basis such as its financial instruments and derivatives. There have been no transfers between Level 1, 2 or 3 assets or liabilities during the fiscal year ended September 30, 2016. Level 3 assets include an auction rate security that is classified as available for sale and recorded in other current assets and that is scheduled to mature in 2017. Due to the illiquid market for this security the Company has classified the carrying value as a Level 3 asset with the difference between the par and carrying value being categorized as a temporary loss and recorded in accumulated other comprehensive loss. On August 1, 2016, the Company exercised its option and paid cash for the remaining interest in the joint venture with Panasonic as detailed in Note 3 of these . This purchase option was recorded as a Level 3 liability as of October 2, 2015. The Company held foreign currency call and put options (“foreign currency options”) that were intended to hedge the potential cash exposure related to the Panasonic purchase option. These foreign currency options expired unexercised during the fiscal year ended September 30, 2016, as the call and put options were out of the money, The Company classifies its contingent consideration related to its business combinations as detailed in Note 3 of these , made during the fiscal year ended September 30, 3016, as Level 3 liabilities. This assessment is based on management judgment involved in computing the expected achievements of specified objectives that are payable up to two years from the anniversary of the acquisitions. The Company reassesses the fair value of the contingent consideration on a quarterly basis and records any applicable adjustments to earnings in the period they are determined. Assets and liabilities recorded at fair value on a recurring basis consisted of the following (in millions): The following table summarizes changes to the fair value of the Level 3 assets (in millions): The following table summarizes changes to the fair value of the Level 3 liabilities (in millions): Assets Measured and Recorded at Fair Value on a Nonrecurring Basis The Company’s non-financial assets and liabilities, such as goodwill, intangible assets, and other long-lived assets resulting from business combinations are measured at fair value using income approach valuation methodologies at the date of acquisition and are subsequently re-measured if there are indicators of impairment. 5. INVENTORY Inventory consists of the following (in millions): 6. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment net consists of the following (in millions): 7. GOODWILL AND INTANGIBLE ASSETS The changes to the carrying amount of goodwill are as follows (in millions): The changes in goodwill during the fiscal year ended September 30, 2016, relate to the amounts recognized through the business combinations completed during the period as detailed in Note 3, Business Combinations, in these Notes to the Consolidated Financial Statements. The Company performed an impairment test of its goodwill as of the first day of the fourth fiscal quarter in accordance with its regularly scheduled testing. The results of this test indicated that the Company’s goodwill was not impaired. There were no other indicators of impairment noted during the fiscal year ended September 30, 2016. Intangible assets consist of the following (in millions): The net carrying amount of intangible assets increased for the fiscal year ended September 30, 2016, primarily due to the identifiable intangible assets acquired during the fiscal year as discussed in Note 3, Business Combinations, in these Notes to the Consolidated Financial Statements. Annual amortization expense for the next five years related to intangible assets is expected to be as follows (in millions): 8. INCOME TAXES Income before income taxes consists of the following components (in millions): The provision for income taxes consists of the following (in millions): The actual income tax expense is different than that which would have been computed by applying the federal statutory tax rate to income before income taxes. A reconciliation of income tax expense as computed at the United States federal statutory income tax rate to the provision for income tax expense is as follows (in millions): The Company operates in foreign jurisdictions with income tax rates lower than the United States tax rate of 35%. The Company’s tax benefits related to foreign earnings taxed at a rate less than the United States federal rate were $164.1 million and $120.9 million for the fiscal years ended September 30, 2016, and October 2, 2015, respectively. During the fiscal year ended September 30, 2016, the Company concluded an IRS examination of its federal income tax returns for fiscal years 2012 and 2013. The Company agreed to various adjustments to its fiscal year 2012 and 2013 tax returns that resulted in the recognition of current year tax expense of $2.6 million during the fiscal year ended September 30, 2016. With the conclusion of the audit, the Company decreased the reserve for uncertain tax positions, which resulted in the recognition of an income tax benefit of $24.0 million in fiscal 2016. In December 2015, the United States Congress enacted the Protecting Americans from Tax Hikes Act of 2015, extending numerous tax provisions that had expired. This legislation included a permanent extension of the federal research and experimentation tax credit. As a result of the enactment of this legislation, $11.6 million of federal research and experimentation tax credits that were earned in the fiscal year ended October 2, 2015 reduced the Company’s tax expense and tax rate during the fiscal year ended September 30, 2016. The federal tax credit available under the Internal Revenue Code for research and development expenses expired on December 31, 2014. As of October 2, 2015, the United States Congress had not taken action to extend the Research and Experimentation Tax Credit. Accordingly, the income tax provision for the year ended October 2, 2015, did not reflect the impact of any research and development tax credits that would have been earned after December 31, 2014, had the federal tax credit not expired. On December 19, 2014, the Tax Increase Prevention Act of 2014 was signed into law, extending the Research and Experimentation Tax Credit to reinstate and retroactively extend credits earned in calendar year 2014. As a result of the enactment of this law, $11.0 million of federal research and development tax credits that were earned in fiscal 2014 reduced the tax rate during fiscal 2015. These credits were not reflected in the fiscal 2014 tax rate. During the fourth quarter of fiscal 2014, the Company concluded an IRS examination of its federal income tax return for fiscal year 2011. As a result of the conclusion of the IRS examination, the Company agreed to various adjustments to its fiscal 2011 tax return that resulted in the recognition of tax expense of $0.7 million and $1.9 million for fiscal years 2014 and 2013, respectively. In addition, the conclusion of the IRS examination also resulted in a decrease in the uncertain tax positions of $20.9 million in fiscal 2014, of which $20.4 million was recognized as a benefit to tax expense. In December 2013, Mexico enacted a comprehensive tax reform package, which became effective on January 1, 2014. As a result of this change, the Company adjusted its deferred taxes in that jurisdiction, resulting in the recognition of a tax benefit that reduced the Company’s foreign income tax expense by $4.6 million for year ended October 3, 2014. On October 2, 2010, the Company expanded its presence in Asia by launching operations in Singapore. The Company operates under a tax holiday in Singapore, which is effective through September 30, 2020 and is conditional upon the Company’s compliance with certain employment and investment thresholds in Singapore. The impact of the tax holiday decreased Singapore’s taxes by $30.8 million and $26.6 million for the fiscal years ended September 30, 2016, and October 2, 2015, respectively, which resulted in tax benefits of $0.16 and $0.14 of diluted earnings per share, respectively. Deferred income tax assets and liabilities consist of the tax effects of temporary differences related to the following (in millions): In accordance with GAAP, management has determined that it is more likely than not that a portion of its historic and current year income tax benefits will not be realized. As of September 30, 2016, the Company has maintained a valuation allowance of $79.1 million. This valuation allowance is comprised of $64.0 million related to United States state tax credits, and $15.1 million related to foreign deferred tax assets. The Company does not anticipate sufficient taxable income or tax liability to utilize these state and foreign credits. If these benefits are recognized in a future period the valuation allowance on deferred tax assets will be reversed and up to a $79.1 million income tax benefit may be recognized. The Company will need to generate $137.5 million of future United States federal taxable income to utilize our United States deferred tax assets as of September 30, 2016. The Company believes that future reversals of taxable temporary differences, and its forecast of continued earnings in its domestic and foreign jurisdictions, support its decision to not record a valuation allowance on other deferred tax assets. Deferred tax assets are recognized for foreign operations when management believes it is more likely than not that the deferred tax assets will be recovered during the carry forward period. The Company will continue to assess its valuation allowance in future periods. As of September 30, 2016, the Company has United States federal net operating loss carry forwards of approximately $9.3 million. The utilization of these net operating losses is subject to certain annual limitations as required under Internal Revenue Code section 382 and similar state income tax provisions. The United States federal net operating loss carry forwards expire at various dates through 2035. The Company also has state income tax credit carry forwards of $64.0 million, net of federal benefits, for which the Company has provided a valuation allowance. The state tax credits relate primarily to California research tax credits that can be carried forward indefinitely. The Company has continued to expand its operations and increase its investments in numerous international jurisdictions. These activities will increase the Company’s earnings attributable to foreign jurisdictions. As of September 30, 2016, no provision has been made for United States federal, state, or additional foreign income taxes related to approximately $1,676.8 million of undistributed earnings of foreign subsidiaries which have been or are intended to be permanently reinvested due to its foreign operations. It is not practicable to determine the United States federal income tax liability, if any, which would be payable if such earnings were not permanently reinvested. A reconciliation of the beginning and ending amount of gross unrecognized tax benefits is as follows (in millions): Of the total unrecognized tax benefits at September 30, 2016, $60.8 million would impact the effective tax rate, if recognized. The remaining unrecognized tax benefits would not impact the effective tax rate, if recognized, due to the Company’s valuation allowance and certain positions that were required to be capitalized. During the fiscal year ended September 30, 2016, the Company concluded an IRS examination of its federal income tax returns for fiscal 2012 and 2013. The conclusion of the IRS examination resulted in a decrease in the uncertain tax positions of $24.0 million in fiscal 2016, all of which was recognized as a benefit to its tax expense in fiscal 2016. The Company anticipates reversals within the next 12 months related to items such as the lapse of the statute of limitations, audit closures, and other items that occur in the normal course of business. During the fiscal year ended September 30, 2016, the Company recognized $0.6 million of previously unrecognized tax benefits related to the expiration of the statute of limitations and $1.9 million of accrued interest or penalties related to unrecognized tax benefits. The Company’s major tax jurisdictions as of September 30, 2016, are the United States, California, Canada, Luxembourg, Mexico and Singapore. For the United States, the Company has open tax years dating back to fiscal 1999 due to the carry forward of tax attributes. For California, the Company has open tax years dating back to fiscal 1999 due to the carry forward of tax attributes. For Canada, the Company has open tax years dating back to fiscal 2008. For Luxembourg, the Company has open tax years back to fiscal 2011. For Mexico, the Company has open tax years back to fiscal 2009. For Singapore, the Company has open tax years dating back to fiscal 2011. The Company is subject to audit examinations by the respective taxing authorities on a periodic basis, of which the results could impact our financial position, results of operations or cash flows. 9. STOCKHOLDERS’ EQUITY COMMON STOCK At September 30, 2016, the Company is authorized to issue 525.0 million shares of common stock, par value $0.25 per share, of which 222.5 million shares are issued and 184.9 million shares are outstanding. Holders of the Company’s common stock are entitled to dividends in the event declared by the Company’s Board of Directors out of funds legally available for such purpose. Dividends may not be paid on common stock unless all accrued dividends on preferred stock, if any, have been paid or declared and set aside. In the event of the Company’s liquidation, dissolution or winding up, the holders of common stock will be entitled to share pro rata in the assets remaining after payment to creditors and after payment of the liquidation preference plus any unpaid dividends to holders of any outstanding preferred stock. Each holder of the Company’s common stock is entitled to one vote for each such share outstanding in the holder’s name. No holder of common stock is entitled to cumulate votes in voting for directors. The Company’s restated certificate of incorporation as amended to date, (the “Certificate of Incorporation”) provides that, unless otherwise determined by the Company’s Board of Directors, no holder of stock has any preemptive right to purchase or subscribe for any stock of any class which the Company may issue or sell. PREFERRED STOCK The Company’s Certificate of Incorporation has authorized and permits the Company to issue up to 25.0 million shares of preferred stock without par value in one or more series and with rights and preferences that may be fixed or designated by the Company’s Board of Directors without any further action by the Company’s stockholders. The designation, powers, preferences, rights and qualifications, limitations and restrictions of the preferred stock of each series will be fixed by the certificate of designation relating to such series, which will specify the terms of the preferred stock. At September 30, 2016, the Company had no shares of preferred stock issued or outstanding. SHARE REPURCHASE On July 19, 2016, the Board of Directors approved a new share repurchase program, pursuant to which the Company is authorized to repurchase up to $400.0 million of its common stock from time to time on the open market or in privately negotiated transactions as permitted by securities laws and other legal requirements. The repurchase program is set to expire on July 19, 2018; however, it may be suspended, discontinued or extended by the Board of Directors at any time prior to its expiration on July 19, 2018. This authorized stock repurchase program replaced in its entirety the November 10, 2015, stock repurchase program. These repurchases have been and will be funded with the Company’s working capital. During the fiscal year ended September 30, 2016, the company paid approximately $525.6 million (including commissions) in connection with the repurchase of 8.0 million shares of its common stock (paying an average price of $65.70 per share) under the July 19, 2016, share repurchase plan and the replaced November 10, 2015, share repurchase plan. As of September 30, 2016, $201.4 million remained available under the July 19, 2016, share repurchase plan. During the fiscal year ended October 2, 2015, the Company paid approximately $237.3 million (including commissions) in connection with the repurchase of 2.9 million shares of its common stock (paying an average price of $83.29 per share). DIVIDENDS On November 3, 2016, the Company announced that the Board of Directors declared a cash dividend on the Company’s common stock of $0.28 per share. This dividend is payable on December 8, 2016, to the Company’s stockholders of record as of the close of business on November 17, 2016. Future dividends are subject to declaration by the Board of Directors. The dividends charged to retained earnings in fiscal 2016 and 2015 were as follows (in millions except per share amounts): EMPLOYEE STOCK BENEFIT PLANS As of September 30, 2016, the Company has the following equity compensation plans under which its equity securities were authorized for issuance to its employees and/or directors: • the 1999 Employee Long-Term Incentive Plan • the Directors’ 2001 Stock Option Plan • the Non-Qualified Employee Stock Purchase Plan • the 2002 Employee Stock Purchase Plan • the 2005 Long-Term Incentive Plan • the AATI 2005 Equity Incentive Plan • the 2008 Director Long-Term Incentive Plan • the 2015 Long-Term Incentive Plan Except for the 1999 Employee Long-Term Incentive Plan and the Non-Qualified Employee Stock Purchase Plan, each of the foregoing equity compensation plans was approved by the Company’s stockholders. As of September 30, 2016, a total of 100.7 million shares are authorized for grant under the Company’s share-based compensation plans, with 4.8 million options outstanding. The number of common shares reserved for future awards to employees and directors under these plans was 19.1 million at September 30, 2016. The Company grants new equity awards under the 2015 Long-Term Incentive Plan to employees, which replaced the 2005 Long-Term Incentive Plan on May 19, 2015, and the 2008 Director Long-Term Incentive Plan for non-employee directors. 2015 Long-Term Incentive Plan. Under this plan, officers, employees, non-employee directors and certain consultants may be granted stock options, restricted stock awards and units, performance stock awards and units and other share-based awards. The plan has been approved by the stockholders. Under the plan, up to 27.1 million shares have been authorized for grant. A total of 18.4 million shares are available for new grants as of September 30, 2016. The maximum contractual term of options under the plan is seven years from the date of grant. Options granted under the plan are exercisable at the determination of the compensation committee and generally vest ratably over four years. Restricted stock awards and units granted under the plan at the determination of the compensation committee generally vest over four or more years. With respect to restricted stock awards, dividends are accumulated and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are also forfeited. No dividends or dividend equivalents are paid or accrued with respect to restricted stock unit awards or other awards until the shares underlying such awards become vested and are issued to the award holder. Performance stock awards and units are contingently granted depending on the achievement of certain predetermined performance goals and generally vest over three or more years. 2008 Director Long-Term Incentive Plan. Under this plan, non-employee directors may be granted stock options, restricted stock awards and other share-based awards. The plan has been approved by the stockholders. Under the plan a total of 1.5 million shares have been authorized for grant. A total of 0.7 million shares are available for new grants as of September 30, 2016. The maximum contractual term of options granted under the plan is ten years from the date of grant. Options granted under the plan are generally exercisable over four years. Restricted stock awards and units granted under the plan generally vest over one or more years. With respect to restricted stock awards, dividends are accumulated and paid when the underlying shares vest. If the underlying shares are forfeited for any reason, the rights to the dividends with respect to such shares are also forfeited. Employee Stock Purchase Plans. The Company maintains a domestic and an international employee stock purchase plan. Under these plans, eligible employees may purchase common stock through payroll deductions of up to 10% of their compensation. The price per share is the lower of 85% of the fair market value of the common stock at the beginning or end of each offering period (generally six months). The plans provide for purchases by employees of up to an aggregate of 9.7 million shares. Shares of common stock purchased under these plans in the fiscal years ended September 30, 2016, October 2, 2015, and October 3, 2014, were 0.3 million, 0.3 million, and 0.5 million, respectively. At September 30, 2016, there are 1.0 million shares available for purchase. The Company recognized compensation expense of $4.6 million, $4.7 million and $4.1 million for the fiscal years ended September 30, 2016, October 2, 2015, and October 3, 2014, respectively, related to the employee stock purchase plan. The unrecognized compensation expense on the employee stock purchase plan at September 30, 2016, was $1.5 million. The weighted average period over which the cost is expected to be recognized is approximately four months. Stock Options The following table represents a summary of the Company’s stock options: The weighted-average grant date fair value per share of employee stock options granted during the fiscal years ended September 30, 2016, October 2, 2015, and October 3, 2014, was $26.30, $23.26, and $11.91, respectively. The total grant date fair value of the options vested during the fiscal years ending September 30, 2016, October 2, 2015, and October 3, 2014, was $21.9 million, $16.6 million and $21.8 million, respectively. Restricted and Performance Awards and Units The following table represents a summary of the Company’s restricted and performance awards and units: The weighted average grant date fair value per share for awards granted during the fiscal years ended September 30, 2016, October 2, 2015, and October 3, 2014, was $84.89, $63.56, and $26.69, respectively. The total grant date fair value of the awards vested during the fiscal years ending September 30, 2016, October 2, 2015, and October 3, 2014, was $197.6 million, $149.0 million and $63.1 million, respectively. The following table summarizes the total intrinsic value for stock options exercised and awards vested (in millions): Valuation and Expense Information The following table summarizes pre-tax share-based compensation expense by financial statement line and related tax benefit (in millions): The following table summarizes total compensation costs related to unvested share based awards not yet recognized and the weighted average period over which it is expected to be recognized at September 30, 2016: The fair value of the restricted stock awards and units is equal to the closing market price of the Company’s common stock on the date of grant. The Company issued performance share units during fiscal 2016, fiscal 2015 and fiscal 2014 that contained market-based conditions. The fair value of these performance share units was estimated on the date of the grant using a Monte Carlo simulation with the following weighted average assumptions: The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions: The Company used a historical volatility calculated by the mean reversion of the weekly-adjusted closing stock price over the expected life of the options. The risk-free interest rate assumption is based upon observed treasury bill interest rates appropriate for the expected life of the Company’s employee stock options. The dividend yield was included in the Black-Scholes option pricing model for options granted after the Company declared its first dividend. The expected life of employee stock options represents a calculation based upon the historical exercise, cancellation and forfeiture experience for the Company across its demographic population. The Company believes that this historical data is the best estimate of the expected life of a new option and that generally all groups of the Company’s employees exhibit similar behavior. 10. EMPLOYEE BENEFIT PLAN, PENSIONS AND OTHER RETIREE BENEFITS The Company maintains a 401(k) plan covering substantially all of its employees based in the United States under which all employees at least twenty-one years old are eligible to receive discretionary Company contributions. Discretionary Company contributions in the form of cash are determined by the Board of Directors. The Company has generally contributed a match of up to 4% of an employee’s contributed annual eligible compensation. The Company no longer provides shares of its common stock as contributions to the 401(k) plan and recognized expense of $2.8 million for the fiscal year ended September 30, 2016. For the fiscal years ended October 2, 2015, and October 3, 2014, the Company contributed shares of 0.1 million, and 0.2 million, respectively, and recognized expense of $7.2 million and $6.2 million, respectively. Defined Benefit Pension: The Company has a defined benefit pension plan for certain employees in Japan. This plan has been frozen and new employees are not eligible. However, the Company is obligated to make future contributions to fund benefits to the participants with the benefits under the plan being based primarily on a combination of years of service and compensation. The net amount of the unfunded obligation recognized in other long-term liabilities on the Balance Sheet consists of (in millions): The pension obligation has an immaterial impact to the Company’s results of operations and financial position and accordingly, the disclosures required have been excluded from this Annual Report on Form 10-K. 11. COMMITMENTS The Company has various operating leases primarily for buildings, computers and equipment. Rent expense amounted to $19.5 million, $16.5 million, and $11.1 million in the fiscal years ended September 30, 2016, October 2, 2015, and October 3, 2014, respectively. Future minimum payments under these non-cancelable leases are as follows (in millions): In addition, the Company has entered into licensing agreements for intellectual property rights and maintenance and support services. Pursuant to the terms of these agreements, the Company is committed to making aggregate payments of $6.2 million, $0.5 million and $0.1 million in the fiscal years 2017, 2018, and 2019, respectively. 12. CONTINGENCIES Legal Matters From time to time, various lawsuits, claims and proceedings have been, and may in the future be, instituted or asserted against the Company, including those pertaining to patent infringement, intellectual property, environmental hazards, product liability and warranty, safety and health, employment and contractual matters. The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company’s business and have demanded and may in the future demand that the Company license their technology. The outcome of any such litigation cannot be predicted with certainty and some such lawsuits, claims or proceedings may be disposed of unfavorably to the Company. Generally speaking, intellectual property disputes often have a risk of injunctive relief, which, if imposed against the Company, could materially and adversely affect the Company’s financial condition, or results of operations. From time to time the Company may also be involved in legal proceedings in the ordinary course of business. The Company monitors the status of legal proceedings and other contingencies on an ongoing basis to ensure amounts are recognized and/or disclosed in its financial statements and footnotes as required. At the time of this filing, the Company recorded an estimated $13.0 million accrual for loss contingencies, which is recorded in other current liabilities as of September 30, 2016. The Company does not believe that the possible range of loss is significantly different than the amount currently accrued. The Company also does not believe there are any additional pending legal proceedings that are reasonably possible to result in a material loss. The Company is engaged in various legal actions in the normal course of business and, while there can be no assurances, the Company believes the outcome of all pending litigation involving the Company will not have, individually or in the aggregate, a material adverse effect on its business. 13. GUARANTEES AND INDEMNITIES The Company has made no significant contractual guarantees for the benefit of third parties. However, the Company generally indemnifies its customers from third-party intellectual property infringement litigation claims related to its products and, on occasion, also provides other indemnities related to product sales. In connection with certain facility leases, the Company has indemnified its lessors for certain claims arising from the facility or the lease. The Company indemnifies its directors and officers to the maximum extent permitted under the laws of the state of Delaware. The duration of the indemnities varies, and in many cases is indefinite. The indemnities to customers in connection with product sales generally are subject to limits based upon the amount of the related product sales and in many cases are subject to geographic and other restrictions. In certain instances, the Company’s indemnities do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities in the accompanying consolidated balance sheets and does not expect that such obligations will have a material adverse impact on its financial condition or results of operations. 14. RESTRUCTURING AND OTHER CHARGES As of September 30, 2016, the Company recorded restructuring and other charges of approximately $4.8 million primarily related to restructuring plans to reduce redundancies associated with acquisitions during the year. The Company began formulating the plan prior to the date of acquisition. The Company does not anticipate any further significant charges associated with these restructuring activities and substantially all of the remaining cash payments related to these restructuring plans are expected to occur during the next fiscal year. As of October 2, 2015, the Company recorded restructuring and other charges of approximately $3.4 million related to costs associated with organizational restructuring plans initiated in the fiscal year. The Company does not anticipate any material charges in future periods related to these plans. As of October 3, 2014, the Company recorded restructuring and other charges of approximately $0.3 million related to costs associated with organizational restructuring plans initiated in the prior fiscal year. The Company does not anticipate any material charges in future periods related to these plans. Activity and liability balances related to the Company’s restructuring actions are as follows (in millions): 15. EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share (in millions, except per share amounts): Basic earnings per share are calculated by dividing net income by the weighted average number of shares of the Company’s common stock outstanding during the period. The calculation of diluted earnings per share includes the dilutive effect of equity based awards that were outstanding during the fiscal years ending September 30, 2016, October 2, 2015, and October 3, 2014, using the treasury stock method. Certain of the Company’s outstanding share-based awards, noted in the table above, were excluded because they were anti-dilutive, but they could become dilutive in the future. 16. SEGMENT INFORMATION AND CONCENTRATIONS The Company considers itself to be a single reportable operating segment which designs, develops, manufactures and markets similar proprietary semiconductor products, including intellectual property. In reaching this conclusion, management considers the definition of the chief operating decision maker (“CODM”), how the business is defined by the CODM, the nature of the information provided to the CODM and how that information is used to make operating decisions, allocate resources and assess performance. The Company’s CODM is the president and chief executive officer. The results of operations provided to and analyzed by the CODM are at the consolidated level and accordingly, key resource decisions and assessment of performance is performed at the consolidated level. The Company assesses its determination of operating segments at least annually. GEOGRAPHIC INFORMATION Net revenue by geographic area presented based upon the country of destination are as follows (in millions): The Company’s revenues by geography do not necessarily correlate to end market demand by region. For example, the Company’s revenues reflected in the China line item above include sales of products to a company that is not headquartered in China but that manufactures its products in China for sale to consumers throughout the world, including in the United States, Europe, China, and other markets in Asia. The Company’s revenue to external customers is generated principally from the sale of semiconductor products that facilitate various wireless communication applications. Accordingly, the Company considers its product offerings to be similar in nature and therefore not segregated for reporting purposes. Net property, plant and equipment balances, based on the physical locations within the indicated geographic areas are as follows (in millions): CONCENTRATIONS Financial instruments that potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable. Trade accounts receivable are primarily derived from sales to manufacturers of communications and consumer products and electronic component distributors. Ongoing credit evaluations of customers’ financial condition are performed and collateral, such as letters of credit and bank guarantees, are required whenever deemed necessary. In fiscal 2016 and fiscal 2014, Foxconn Technology Group (together with its affiliates and other suppliers to a large OEM for use in multiple applications including smartphones, tablets, routers, desktop and notebook computers, “Foxconn”) and Samsung-each constituted more than ten percent of the Company’s net revenue. In fiscal 2015, Foxconn constituted more than ten percent of the Company’s net revenue. The Company’s greater than ten percent customers comprised the following percentages of net revenue: At September 30, 2016, the Company’s three largest accounts receivable balances comprised 54% of aggregate gross accounts receivable. This concentration was 62% and 58% at October 2, 2015, and October 3, 2014, respectively. 17. QUARTERLY FINANCIAL DATA (UNAUDITED) Net income and earnings per share for the first fiscal quarter of 2016 include other income related to the receipt of the PMC merger termination fee as detailed in Note 3, Business Combinations, in these Notes to the Consolidated Financial Statements. The following table summarizes the quarterly and annual results (in millions, except per share data): ____________ (1) Earnings per share calculations for each of the quarters are based on the weighted average number of shares outstanding and included common stock equivalents in each period. Therefore, the sums of the quarters do not necessarily equal the full year earnings per share.
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Based on the provided financial statement information, here's a summarized overview:
Key Financial Components:
1. Revenue Recognition:
- Recognized when there is evidence of arrangement, fixed pricing, and completed delivery
- Includes product sales and license fees
- Some products shipped on consignment, revenue recognized upon customer consumption
- Reserves maintained for sales returns and allowances
2. Assets:
- Inventory valued at lower of cost or market (FIFO basis)
- Property, plant, and equipment carried at cost less depreciation
- Long-lived assets subject to impairment reviews
- Goodwill and intangible assets tested annually for impairment
3. Expenses:
- Research and development costs expensed as incurred
- Share-based compensation expenses recognized
- Maintenance and repairs expensed as incurred
4. Accounting Practices:
- Uses asset and liability method for income taxes
- Foreign currency transactions included in current results
- Employee retirement benefits recognized on balance sheet
- Loss contingencies recorded when probable and estimable
Notable Policies:
- Regular evaluation of estimates using historical experience
- Significant judgment required for fair value assessments
- Detailed impairment testing procedures
- Comprehensive approach to business combinations and valuations
The statement appears to focus more on accounting policies and procedures rather than providing specific financial figures for the reporting period.
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Claude
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ACCOUNTING FIRM To the Board of Directors and Stockholders of Renewable Energy Group, Inc. We have audited the accompanying consolidated balance sheets of Renewable Energy Group, Inc. and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income (loss), redeemable preferred stock and equity, and cash flows for each of the three years in the period ended December 31, 2016. We also have audited the Company's internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company's internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Renewable Energy Group, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. /s/ Deloitte & Touche LLP Des Moines, Iowa March 10, 2017 RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2016 AND 2015 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) See notes to consolidated financial statements. RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) See notes to consolidated financial statements. RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014 (IN THOUSANDS) See notes to consolidated financial statements. RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK AND EQUITY FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014 (IN THOUSANDS EXCEPT SHARE AND PER SHARE AMOUNTS) See notes to consolidated financial statements. RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014 (IN THOUSANDS) (continued) RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014 (IN THOUSANDS) See notes to consolidated financial statements. (concluded) RENEWABLE ENERGY GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS For The Three Years Ended December 31, 2016, 2015 and 2014 (In Thousands, Except Share and Per Share Amounts) NOTE 1-ORGANIZATION, PRESENTATION, AND NATURE OF THE BUSINESS Renewable Energy Group, Inc. (the "Company" or "REG") is a company focused on providing cleaner, lower carbon intensity products and services. Today, we principally generate revenue as a leading North American biofuels producer with a nationwide distribution and logistics system. The Company participates in each aspect of biomass-based diesel production, from acquiring feedstock, managing construction and operating biomass-based diesel production facilities, to marketing, selling and distributing biomass-based diesel and its co-products. To do this, REG utilizes this nationwide production, distribution and logistics system as part of an integrated value chain model to focus on converting natural fats, oils and greases into advanced biofuels and converting diverse feedstocks into renewable chemicals. Upon completion of acquiring the remaining interest in Petrotec AG as further discussed in Note 4 - Acquisitions, the Company owns and operates fourteen biorefineries, with twelve locations in North America and two locations in Europe, which includes thirteen operating biomass-based diesel production facilities with aggregate nameplate production capacity of 502 million gallons per year, or mmgy, and one fermentation facility. REG has one feedstock processing facility. The Company's network includes the addition of a 20-million gallon nameplate capacity biomass-based diesel refinery located in DeForest, Wisconsin, acquired in March 2016. Nine of these plants are “multi-feedstock capable” which allows them to use a broad range of lower cost feedstocks, such as inedible corn oil, used cooking oil and inedible animal fats in addition to vegetable oils, such as soybean oil and canola oil. The Company also has three partially constructed production facilities and one non-operational production facility. The Company will need to raise additional capital to complete construction of these plants and fund working capital requirements. It is uncertain when financing will be available. During fourth quarter 2016, the Company wrote down the carrying value at its Emporia facility to its estimated salvage value due to competition from foreign, imported product and the probability of that project being completed in the near term is unlikely. The biomass-based diesel industry and the Company’s business have benefited from the continuation of certain federal and state incentives. The federal biodiesel mixture excise tax credit (the "BTC") was reinstated for 2015, in effect throughout 2016 and lapsed on January 1, 2017. It is uncertain whether the BTC will be reinstated thereafter. The expiration along with other amendments of any one or more of those laws, could adversely affect the financial results of the Company. NOTE 2-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, and entities which it controls. All intercompany balances and transactions have been eliminated for consolidated reporting purposes. Cash and Cash Equivalents Cash and cash equivalents consists of money market funds and demand deposits with financial institutions. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Accounts Receivable Accounts receivable are carried at invoiced amount less allowance for doubtful accounts. Management estimates the allowance for doubtful accounts based on existing economic conditions, the financial conditions of customers, and the amount and age of past due accounts. Receivables are considered past due if full payment is not received by the contractual due date. Past due accounts are generally written off against the allowance for doubtful accounts only after reasonable collection attempts have been exhausted. Activity regarding the allowance for doubtful accounts was as follows: Inventories Inventories are valued at the lower of cost or net realizable value. Cost is determined based on the first-in, first-out method. There were no lower of cost or market adjustments made to the inventory values reported as of December 31, 2016 and 2015. Renewable Identification Numbers (RINs) When the Company produces and sells a gallon of biomass-based diesel, 1.5 to 1.7 RINs per gallon are generated. RINs are used to track compliance with Renewable Fuel Standards (RFS2). RFS2 allows the Company to attach between zero and 2.5 RINs to any gallon of biomass-based diesel. As a result, a portion of the selling price for a gallon of biomass-based diesel is generally attributable to RFS2 compliance. However, RINs that the Company generates are a form of government incentive and not a result of the physical attributes of the biomass-based diesel production. Therefore, no cost is allocated to the RIN when it is generated, regardless of whether the RIN is transferred with the biomass-based diesel produced or held by the Company pending attachment to other biomass-based diesel production sales. In addition, the Company also obtains RINs from third parties who have separated the RINs from gallons of biomass-based diesel. From time to time, the Company holds varying amounts of these separated RINs for resale. RINs obtained from third parties are initially recorded at their cost and are subsequently revalued at the lower of cost or market as of the last day of each accounting period and the resulting adjustments are reflected in costs of goods sold for the period. The value of these RINs is reflected in “Prepaid expenses and other assets” on the consolidated balance sheet. The cost of goods sold related to the sale of these RINs is determined using the average cost method, while market prices are determined by RIN values, as reported by the Oil Price Information Service (OPIS). California’s Low Carbon Fuel Standard The Company generates Low Carbon fuel Standard (LCFS) credits for its low carbon fuels or blendstocks when its qualified low carbon fuels are imported by REG to California though approved physical pathways. LCFS credits are used to track compliance with California’s LCFS, which enables the Company to generate LCFS credits based upon the carbon intensity of qualified fuels that are imported by REG into California. Other companies can take title outside of California and generate LCFS credits instead of REG upon import into the state. One LCFS credit equates to one metric ton reduction of carbon dioxide compared to the petroleum fuel baseline so the amount gallons of low carbon fuel consumption to generate one credit will vary. As a result, a portion of the selling price for a gallon of biomass-based diesel sold into California is also attributable to LCFS compliance. However, LCFS credits that the Company generates are a form of government incentive and not a result of the physical attributes of the biomass-based diesel production. Therefore, no cost is allocated to the LCFS credit when it is generated, regardless of whether the LCFS credit is transferred with the biomass-based diesel produced or held by the Company on other biomass-based diesel sales that do not transfer credits. In addition, the Company also obtains LCFS credits from third party trading activities. From time to time, the Company holds varying amounts of these 3rd party LCFS credits for resale. LCFS credits obtained from third parties is initially recorded at their cost and are subsequently revalued at the lower of cost or net realizable value as of the last day of each accounting period and the resulting adjustments are reflected in costs of goods sold for the period. The value of LCFS obtained from third parties is reflected in “Prepaid expenses and other assets” on the consolidated balance sheet. The cost of goods sold related to the sale of these LCFS credits is determined using the average cost method, while market prices are determined by LCFS values, as reported by the Oil Price Information Service (OPIS). At year end, the Company held no LCFS credits purchased from third parties. The Company records assets acquired and liabilities assumed through the exchange of non-monetary assets based on the fair value of the assets and liabilities acquired or the fair value of the consideration exchanged, whichever is more readily determinable. Derivative Instruments Derivatives are recorded on the balance sheet at fair value with changes in fair value recognized in current period earnings. The Company did not elect to use hedge accounting for all periods presented. Property, Plant and Equipment Property, plant and equipment is recorded at cost less accumulated depreciation. Maintenance and repairs are expensed as incurred. Depreciation expense is computed on a straight-line method based upon estimated useful lives of the assets. Estimated useful lives are as follows: In April 2015, the Company experienced a fire at its Geismar facility, resulting in the shutdown of the facility. The Company estimated fixed assets of approximately $11,027 were impaired as a result of the fire. At December 31, 2016, the Company had received property proceeds of $19,037 from insurance for the property damage. The excess of the property insurance proceeds over the net book value of the impaired assets, $8,010, was recorded as gain on involuntary conversion on the Consolidated Statements of Operations. These proceeds for property damage were final and have been approved and paid by the insurance carriers. In September 2015, another fire occurred at the Geismar facility. The Company estimated fixed assets of approximately $1,414 were impaired by the September fire. At December 31, 2016, the Company recorded proceeds of $2,939 from insurance for the property damage. The excess of the property insurance proceeds over the net book value of the impaired assets of $1,525, was recorded as gain on involuntary conversion on the Consolidated Statements of Operations. In addition, as of December 31, 2016, the Company recognized the undisputed portion of $15,060 from its business interruption insurance claim related to the September 2015 fire, which was recorded as an increase in biomass-based diesel sales in the Company's consolidated Statements of Operations. The Company continues to work with the insurance carriers on the in-dispute portion of the business interruption claim. None of this in-dispute business interruption insurance amount has been recognized in earnings at December 31, 2016. As of December 31, 2016, 2015 and 2014, the Company capitalized interest incurred on debt during the construction of assets of $537, $897 and $1,345, respectively. Goodwill Goodwill is tested for impairment annually on July 31 or when impairment indicators exist. Goodwill is allocated and tested for impairment by reporting units. At December 31, 2016 and December 31, 2015, the Company had goodwill in the Services reporting unit. The analysis is based on a comparison of the carrying value of the reporting unit to its fair value, determined utilizing both a discounted cash flow methodology and a market comparable methodology. The determination of whether or not the asset has become impaired involves a significant level of judgment in the assumptions underlying the approach used to determine the fair value of the Company’s reporting units. The inputs used to estimate the fair value of the Company’s Services reporting unit are considered Level 3 inputs of the fair value hierarchy and included the following: (1) The Company’s financial projections for its reporting unit were based on its analysis of various factors which include, among other things, demands, margins, whether the BTC is reinstated, capital expenditures and economic conditions. Such estimates are consistent with those used in the Company’s budgeting and capital investment reviews, incorporating current market information, historical factors and the regulatory environment; (2) The long-term growth rates assumed for the Company’s reporting unit was based on a comparison to similar publicly traded companies, supported by market information obtained from external sources; and (3) The discount rate used to measure the present value of the projected future cash flows was determined by separately estimating borrowing cost of capital, equity cost of capital, and entity structure. Changes in estimates of future cash flows caused by items such as unforeseen events or sustained unfavorable changes in market conditions could negatively affect the fair value of the reporting unit’s goodwill asset and result in an impairment charge. The 2016 annual impairment test determined that the fair value of the Services reporting unit exceeded its carrying value by approximately 16%. During 2015, the Company had a full write-off of goodwill in the Biomass-based Diesel and Renewable Chemicals reporting units. Impairment of Long-lived Assets The Company tests its long-lived assets for recoverability when events or circumstances indicate that its carrying amount may not be recoverable. Significant assumptions used in the undiscounted cash flow analysis, when it is required, include the projected demand for biomass-based diesel based on annual renewable fuel volume obligations under the Renewable Fuel Standards (RFS2), the Company's capacity to meet that demand, the market price of biomass-based diesel and the cost of feedstock used in the manufacturing process. For facilities under construction, estimates also include the capital expenditures necessary to complete construction of the plant and the projected costs of financing. Late during the year ended December 31, 2016, the Company recorded impairment charges of $15,593 related to its Emporia facility's property, plant and equipment assets resulting from competition from foreign, imported product and the probability of that project being completed in the near term is unlikely. In addition, the Company recorded impairment charges of $2,300 against certain property, plant and equipment as the carrying amounts of these assets were deemed not recoverable given the assets' deteriorating physical conditions identified during the fourth quarter of 2016. In 2015, other than those related to the 2015 Geismar fires of $12,441, which were fully offset by insurance receipts and/or accounts receivable for insurance coverage, there was no other impairments recorded for the years ended December 31, 2015 and 2014. Convertible Debt In June 2016, the Company issued $152,000 aggregate principal amount of 4% convertible senior notes due 2036 (the "2036 Convertible Notes"). The Company may not elect to issue shares of common stock upon conversion of the 2036 Convertible Notes to the extent such election would result in the issuance of more than 19.99% of the common stock outstanding immediately before the issuance of the 2036 Convertible Notes until the Company receives stockholder approval for such issuance. As a result, the embedded conversion option is accounted for as an embedded derivative liability. This liability is recorded at fair value, and $13,045 fair value adjustments were recorded for the year ended December 31, 2016. The Company expects to continue marking the embedded conversion option to market unless and until shareholders authorize additional common shares during its Annual Shareholder Meeting. See "Note 10 - Debt" for a further description of the transaction. Capped Call Transaction In connection with the issuance of the 2014 convertible senior notes, the Company entered into capped call transactions. The purchased capped call transactions were recorded as a reduction to common stock-additional paid-in-capital. Because this was considered to be an equity transaction and qualifies for the derivative scope exception, no future changes in the fair value of the capped call will be recorded by the Company. During 2016, in connection with the issuance of the 2036 Convertible Notes, certain call options covered by the original capped call transaction were rebalanced and reset to cover 100% of the total number of shares of the Company's Common Stock underlying the remaining principal of the 2019 Convertible Notes. The impact of these transactions, net of tax, was reflected as an addition/reduction to common stock-additional paid-in capital as presented in the Consolidated Statements of Redeemable Preferred Stock and Equity. Share Repurchase Programs In February 2015, the Company's board of directors approved a share repurchase program of up to $30,000 of the Company's shares of common stock. Shares may be repurchased from time to time in open market transactions, privately negotiated transactions or by other means. The Company accounts for share repurchases using the cost method. Under this method, the cost of the share repurchase is recorded entirely in treasury stock, a contra equity account. The Company used the remaining available funds of approximately $6,687 authorized under this program to repurchase 738,448 shares of Common Stock during the first 6 months of 2016. In March 2016, the Company's board of directors approved a repurchase program of up to $50,000 of the Company's shares of common stock and/or convertible notes, in effect through March 5, 2018. Under the program, which is in addition to the $30,000 common stock repurchase program announced in February 2015, the Company may repurchase shares or convertible notes from time to time in open market transactions, privately negotiated transactions or by other means. The timing and amount of repurchase transactions were determined by the Company's management based on its evaluation of market conditions, share price, bond price, legal requirements and other factors. During 2016, the Company repurchased 5,070,375 shares of Common Stock for $44,019 under this program. In addition, the Company used approximately $5,584 under this program to repurchase $6,000 principal amount of the Company's 2019 Convertible Notes, finishing up the program in 2016. Foreign Currency Transactions and Translation The Company’s reporting and functional currency is U.S. dollars. Monetary assets and liabilities denominated in currencies other than U.S. dollars are remeasured into their respective functional currencies at exchange rates in effect at the balance sheet date. The resulting exchange gain or loss is included in the Company’s Consolidated Statements of Operations as foreign exchange gain (loss) unless the remeasurement gain or loss relates to an intercompany transaction that is of a long-term investment nature and for which settlement is not planned or anticipated in the foreseeable future. Gains or losses arising from translation of such transactions are reported as a component of accumulated other comprehensive income (loss) in the Company’s Consolidated Balance Sheets. The Company translates the assets and liabilities of its foreign subsidiaries from their respective functional currencies to U.S. dollars at the appropriate spot rates as of the balance sheet date. Generally, our foreign subsidiaries use the local currency as their functional currency. Changes in the carrying value of these assets and liabilities attributable to fluctuations in spot rates are recognized in foreign currency translation adjustment, a component of accumulated other comprehensive income (loss) in the Company’s Consolidated Balance Sheets. The other comprehensive loss amounts presented in the Company's Consolidated Statements of Comprehensive Income (Loss) and Consolidated Statements of Redeemable Preferred Stock and Equity mainly include the foreign currency translation adjustment resulting from translating the financial statements of Petrotec AG from Euros to US Dollars, the Company's functional currency. Revenue Recognition The Company recognizes revenues from the following sources: • the sale of biomass-based diesel and its co-products, as well as Renewable Identification Numbers (RINs), California Low Carbon Fuel Standard credits (LCFS credits) and raw material feedstocks, purchased or produced by the Company at owned manufacturing facilities and manufacturing facilities with which the Company has tolling arrangements; • the resale of biomass-based diesel, RINs, LCFS credits and raw material feedstocks acquired from third parties; • the sale of petroleum-based heating oil and diesel fuel acquired from third parties, along with the sale of these items further blended with biodiesel produced at wholly owned facilities; • incentives received from federal and state programs for renewable fuels; and • fees received for the marketing and sales of biomass-based diesel produced by third parties and from managing operations of third party facilities. Biomass-based diesel, including RINs and LCFS credits, and raw material feedstock revenues are recognized where there is persuasive evidence of an arrangement, delivery has occurred, the price has been fixed or is determinable and collectability can be reasonably assured. Fees received under toll manufacturing agreements with third parties are generally established as an agreed upon amount per gallon of biomass-based diesel produced. The fees are recognized where there is persuasive evidence of an arrangement, delivery has occurred, the price has been fixed or is determinable and collectability can be reasonably assured. Revenues associated with the governmental incentive programs are recognized when the amount to be received is determinable, collectability is reasonably assured and the sale of product giving rise to the incentive has been recognized. The Company received funds from the United States Department of Agriculture (USDA) in the amount of $434, $624 and $600 for the years ended December 31, 2016, 2015 and 2014, respectively. The Company records amounts when it has received notification of a payment from the USDA or is in receipt of the funds and records the awards under the Program in "Biodiesel government incentives" as they are closely associated with the Company's biomass-based diesel production activities. Freight Amounts billed to customers for freight are included in biomass-based diesel sales. Costs incurred for freight are included in costs of goods sold. Advertising Costs Advertising costs are charged to expense as they are incurred. Advertising and promotional expenses were $1,746, $1,288 and $755 for the years ended December 31, 2016, 2015 and 2014, respectively. Research and Development Research and development (R&D) costs are charged to expense as incurred. In process research and development (IPR&D) assets acquired in connection with acquisitions are recorded on the Consolidated Balance Sheets as intangible assets. During October 2016, the Company entered into the first commercial sale agreement to sell certain products made from the IPR&D platform. This triggered the review of the impairment and useful life of the IPR&D assets. The Company performed a final discounted cash flow analysis at October 31, 2016 prior to assigning a useful life to the IPR&D assets. No impairment was identified related to the Company's IPR&D balance at October 1, 2016, December 31, 2016 and 2015. The Company then determined the useful life of the IPR&D assets to be 15 years and utilizes a straight line method to amortize these assets over the useful life. Employee Benefits Plan The Company sponsors an employee savings plan under Section 401(k) of the Internal Revenue Code. The Company makes matching contributions equal to 50% of the participant’s pre-tax contribution up to a maximum of 6% of the participant’s eligible earnings. Total expense related to the Company’s defined contribution plan was $1,168, $1,071 and $855 for the years ended December 31, 2016, 2015 and 2014, respectively. Stock-Based Compensation Stock-based compensation expense is measured at the grant-date fair value of the award and recognized as compensation expense over the vesting period. Income Taxes The Company uses the asset and liability method to account for income taxes. Accordingly, deferred income taxes are recognized for differences between the financial statement and tax bases of assets and liabilities at enacted statutory tax rates in effect for the years in which differences are expected to reverse. Changes in tax rates are recognized directly to the income statement as they arise. Consideration is given to positive and negative evidence related to the realization of the deferred tax assets and valuation allowances are established to reduce deferred tax assets to the amounts expected to be realized. Significant judgment is required in making this assessment. For uncertain tax positions, the Company recognizes tax benefits that are more likely than not to be sustained upon examination by tax authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely to be realized. With regard to non-US subsidiaries, the Company will indefinitely reinvest any future earnings outside of the U.S. and currently does not have any undistributed earnings. Concentrations One customer represented slightly less than 10% of the total consolidated revenues of the Company for the years ended December 31, 2016 and 2015. This customer accounted for more than 10% of the total consolidated revenues of the Company for the year ended December 31, 2014. All customer amounts disclosed in the table are related to biomass-based diesel sales: The Company maintains cash balances at financial institutions, which may at times exceed the $250 coverage by the U.S. Federal Deposit Insurance Company. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the dates of the financial statements and reported amounts of revenues and expenses during the reporting periods. These estimates are based on information that is currently available to management and on various assumptions that the Company believes to be reasonable under the circumstances. Actual results could differ from those estimates. New Accounting Pronouncements On February 25, 2016, the FASB issued ASU 2016-02, which introduces a lessee model that brings most leases on the balance sheet. The new standard also aligns many of the underlying principles of the new lessor model with those in ASC 606, the FASB’s new revenue recognition standard (e.g., those related to evaluating when profit can be recognized). Furthermore, the ASU addresses other concerns related to the current leases model. The ASU is effective for annual periods beginning after December 15, 2018 and interim periods therein. The Company anticipates this standard will have a material impact on our consolidated financial statements. While the Company is continuing to assess all potential impacts of the standard, the Company currently believes the most significant impact relates to its accounting for office, railcar and terminal operating leases. The Company plans to apply a modified retrospective transition approach to each applicable lease that exists at January 1, 2017 as well as leases entered after this date. In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting”. The amendments in this updated guidance include changes to simplify the codification for several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. For public entities, this guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is permitted. The Company elected early adoption for the quarter ended December 31, 2016. As part of the adoption the Company has elected to continue to account for forfeitures of share-based payments by estimating the number of award expected to be forfeited and adjusting the estimate when it is no longer probable that the employee will fulfill the service condition. This change had no cumulative effect on retained earnings or other components of equity and did not change the net assets as of the beginning of the period of adoption (January 1, 2016). In addition, the Company assessed that the other adjustments provided in the new guidance did not have any material impact on its consolidated financial statements. In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606), (ASU 2014-09) which will require entities to recognize revenue in an amount that reflects the transfer of promised goods or services to a customer in an amount based on the consideration the entity expects to be entitled to in exchange for those goods or services. ASU 2014-09 also requires disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. The amendments may be applied retrospectively to each prior period presented, or retrospectively with the cumulative effect recognized as of the date of initial application. ASU 2014-09 is effective for interim and annual reporting periods beginning after December 15, 2017. The Company is still evaluating its contracts with customers in relation to the requirements of ASU 2014-09, and has not concluded on the financial statement impact of implementing ASU 2014-09. The Company expects to complete its assessment by the quarter ending September 30, 2017. In March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Consideration (Reporting Revenue Gross versus Net)" that clarifies how an entity should identify the unit of accounting for the principal versus agent evaluation and how it should apply the control principle to certain types of arrangements, such as service transactions. The guidance also re-frames the indicators to focus on evidence that an entity is acting as a principal rather than an agent. The guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. In May 2016, the FASB issued ASU 2016-12, which amends certain aspects of the new revenue standard, ASU 2014-09. The amendments address issues such as collectability; presentation of sales tax and other similar taxes collected from customers; noncash consideration; contract modifications and completed contracts at transition; and transition technical correction. The guidance is effective for public business entities for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. In December 2016, the FASB issued ASU 2016-20 providing technical corrections and improvements to Topic 606, Revenue from Contracts with Customers. While the Company is continuing to assess all potential impacts of the new revenue standard, the Company anticipates that the standard will not have a material impact on its consolidated financial statements. NOTE 3-STOCKHOLDERS’ EQUITY OF THE COMPANY Common Stock The Company has authorized capital stock consisting of 450,000,000 shares, all with a par value of $.0001 per share, which includes 300,000,000 shares of Common Stock, 140,000,000 shares of Common Stock A and 10,000,000 shares of Preferred Stock including 3,000,000 shares of Series B Preferred Stock. Each holder of Common Stock is entitled to one vote for each share of Common Stock held on all matters submitted to a vote of stockholders. Subject to preferences that may apply to shares of previously outstanding Series A Preferred Stock and currently outstanding Series B Preferred Stock as outlined below, the holders of outstanding shares of Common Stock are entitled to receive dividends. After the payment of all preferential amounts required to the holders of Series B Preferred Stock, all of the remaining assets of the Company available for distribution shall be distributed ratably among the holders of Common Stock. NOTE 4-ACQUISITIONS 2016 Acquisition Sanimax Energy, LLC On March 15, 2016, the Company acquired fixed assets and inventory from Sanimax Energy, including the 20 mmgy nameplate capacity biomass-based diesel refinery in DeForest, Wisconsin. The Company completed its initial accounting of this business combination as the valuation of the real and personal property was finalized as of September 30, 2016. The following table summarizes the consideration paid for the acquisition from Sanimax Energy: The fair value of the 500,000 shares of Common Stock issued was determined using the closing market price of the Company's common shares at the date of acquisition. The Company may pay contingent consideration of up to $5,000 (Earnout Payments) over a 7-year period after the acquisition, subject to achievement of certain milestones related to the biomass-based diesel gallons produced and sold by REG Madison. The Earnout Payments are payable in cash and cannot exceed $1,700 in any one year period beginning March 15, 2016 through 2023 and up to $5,000 in aggregate. As of December 31, 2016, the Company has recorded a contingent liability of $3,835, approximately $1,790 of which has been classified as current on the Consolidated Balance Sheets. The following table summarizes the fair values of the assets acquired at the acquisition date. The following unaudited pro forma condensed combined results of operations assume that the Sanimax Energy acquisition was completed as of January 1, 2014 and as if the stock had been issued on the same date. 2015 acquisitions Imperium Renewables, Inc. On August 19, 2015, the Company acquired substantially all the assets of Imperium Renewables, Inc. (Imperium), including the 100-mmgy nameplate biomass-based diesel refinery and deepwater port terminal at the Port of Grays Harbor, Washington. The results of Imperium's operations have been included in the consolidated financial statements since that date. The Company has finalized its accounting of this business combination during the fourth quarter of 2015. The following table summarizes the consideration paid for Imperium: The fair value of the 1,675,000 shares of Common Stock issued to Imperium was determined using the closing market price of the Company's common shares at the date of acquisition. Subject to achievement of certain milestones related to the biomass-based diesel gallons produced and sold by REG Grays Harbor and whether the BTC is reinstated, Imperium may receive certain contingent consideration (Earnout Payments) over a two-year period after the acquisition. The Earnout Payments will be payable in cash. As of December 31, 2016, the Company has recorded a contingent liability of $2,093, all of which has been classified as current on the Consolidated Balance Sheets. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition date. Imperium was acquired at a price less than fair value of the net identifiable assets, and the Company recorded a net of tax bargain purchase gain of $5,358. All future adjustments will be reported in the Consolidated Statements of Operations. The bargain purchase gain is reported in the "Other Income, Net" on the Consolidated Statements of Operations. Prior to recognizing a bargain purchase gain, the Company reassessed whether all assets acquired and liabilities assumed had been correctly identified as well as the key valuation assumptions and business combination accounting procedures for this acquisition. After careful consideration and review, the Company concluded that the recognition of a bargain purchase gain was appropriate for this acquisition. Factors that contributed to the bargain purchase price were: •The assets were not fully utilized by the seller and that the transaction was completed with a motivated seller that appeared to have recapitalized its investments and desired to exit the facilities that no longer fit its strategy given the uncertainties in the industry. • The Company was able to complete the acquisition in an expedient manner, with a cash payment, stock issuance and without a financial contingency, which was a key attribute for the seller. The relatively small size of the transaction for the Company, the lack of required third-party financing and the Company's expertise in completing similar transactions in the past gave the seller confidence that the Company could complete the transaction quickly and without difficultly. • Due to the unique nature of the products and limited number of potential buyers for this business, the seller found it advantageous to accept the Company's purchase price based upon our demonstrated ability to operate similar businesses, and financial strength that may enable the Company to make improvement and run the business at increased production rates in the long run. 2014 acquisitions Petrotec AG On December 24, 2014, the Company acquired 69.08% of the outstanding common shares and voting interest of Petrotec. The results of Petrotec’s operations have been included in the consolidated financial statements since that date. During the last quarter of 2015, the Company completed its purchase accounting for this business combination. The finalization of the purchase price allocation did not result in material adjustments. The following table summarizes the consideration paid for Petrotec: The fair value of the 2,070,538 common shares issued to Petrotec was determined on the basis of the closing market price of the Company's common shares at the date of acquisition. The following table summarizes the fair values of the assets acquired and liabilities assumed at the acquisition date as the purchase price allocation was finalized: The fair value of the 30.92% noncontrolling interest in Petrotec is estimated to be $8,962 at the date of the acquisition. The fair value of the noncontrolling interest was estimated using a combination of the income approach and a market approach. The Company recognized $1,289 of acquisition related costs that were expensed in the period the acquisition occurred. In April 2015, Petrotec's application to de-list its shares of common stock from the Frankfurt Stock Exchange was approved. From the end of the October 8, 2015 trading day, Petrotec's shares of common stock are no longer traded on a regulated market of any stock exchange. During 2016 and 2015, the Company acquired additional common shares of Petrotec as part of the cash tender offers and open market purchases for $149 and $4,828, respectively. At December 31, 2016 and 2015, the Company owned 90.58% and 87.49% of the outstanding common shares and voting interest of Petrotec. In January 2017, the Company completed its acquisition of the remaining minority interest in Petrotec and now owns 100% of Petrotec's outstanding shares. Syntroleum Corporation/Dynamic Fuels, LLC On June 3, 2014, REG Synthetic Fuels, a wholly-owned subsidiary of the Company included in the Biomass-based diesel segment, acquired substantially all the assets of Syntroleum, which consisted of a 50% limited liability company membership interest in Dynamic Fuels, as well as intellectual property and other assets. Dynamic Fuels owns a 75 mmgy nameplate capacity renewable hydrocarbon diesel biorefinery located in Geismar, Louisiana. The following table summarizes the consideration paid for Syntroleum. The fair value of the 3,493,613 shares of Common Stock issued to Syntroleum was determined on the basis of the closing market price of the Company's common shares at the date of acquisition. The fair value of the Syntroleum renewable hydrocarbon diesel technology was determined using the relief from royalty method, or RFR, which reflects the savings realized by owning the intangible assets. The value under RFR method is dependent upon the following factors for an asset: royalty rate, discount rate, expected life and projected revenue. On June 6, 2014, REG Synthetic Fuels acquired the remaining 50% ownership interest in Dynamic Fuels, from Tyson Foods. The Company renamed Dynamic Fuels to REG Geismar, LLC, which is included in the Biomass-based diesel segment. The finalization of the purchase price allocation resulted in an increase in goodwill of $3,202 relating to higher than initially estimated net operating losses prior to the acquisition of Syntroleum and Dynamic Fuels. The following table summarizes the consideration paid to Tyson Foods for Dynamic Fuels: The following table summarizes the amount of assets acquired and liabilities assumed at the acquisition date for the combined acquisition of Syntroleum and Dynamic Fuels: Subsequent to the closing of the Tyson Foods transaction, REG Geismar paid off the debt owed to Tyson Foods in the amount of $13,553. Subject to achievements related to the sale of renewable hydrocarbon diesel at the REG Geismar production facility, Tyson Foods may receive contingent consideration of up to $35,000. The Company will pay contingent consideration, if and when, the Company achieves certain sales volumes. The agreement calls for periodic payments based on pre-determined payments per gallon of product sold. The probability weighted contingent payments were discounted using a risk adjusted discount rate of 5.8%. The contingent payments will be payable in cash. As of December 31, 2016, the Company has recorded a contingent liability of $27,065, of which $9,589 has been classified in accrued expenses and other liabilities on the Consolidated Balance Sheets. LS9, Inc. On January 22, 2014, REG Life Sciences, a wholly-owned subsidiary of the Company, acquired substantially all of the assets and certain liabilities of LS9. This acquisition's finalized purchase price allocation did not result in material adjustments. The following table summarizes the consideration paid and the amounts of assets acquired and liabilities assumed at the acquisition date: The fair value of the 2,230,559 shares of Common Stock issued as part of the consideration paid for LS9 was determined on the basis of the closing market price of the Company's common shares at the date of acquisition. Subject to achievement of certain milestones related to the development and commercialization of products from LS9’s technology, LS9 may receive contingent consideration of up to $21,500 (Earnout Payments) over a five-year period after the acquisition. The Earnout Payments will be payable in cash, the Company's stock or a combination of cash and stock at the Company's election. As of December 31, 2016 and 2015, the Company has recorded a contingent liability of $13,575 and $7,590, respectively, $4,165 and $3,958, respective of which has been classified as current on the Consolidated Balance Sheets. 416 S. Bell, LLC Prior to July 25, 2014, the Company had a 50% ownership in 416 S Bell, LLC (Bell, LLC), a variable interest entity (VIE) joint venture that owned and leased to the Company its corporate office building in Ames, Iowa. Commencing January 1, 2011, the Company had the right to execute a call option with the joint venture member, Dayton Park, LLC (Dayton Park), to purchase Bell, LLC and commencing on January 1, 2013, Dayton Park had the right to execute a put option with the Company to sell Bell, LLC. The Company determined it was the primary beneficiary of Bell, LLC and had consolidated Bell, LLC into the Company’s financial statements since January 1, 2011. On July 25, 2014, the Company completed the acquisition of the remaining 50% interest in Bell, LLC in exchange for $1,423 cash. The Company determined that this transaction did not result in a change of control and as such has accounted for it as an equity transaction. Neither goodwill nor a gain/loss was recognized in conjunction with the acquisition. NOTE 5-INVENTORIES Inventories consist of the following at December 31: NOTE 6-PROPERTY, PLANT AND EQUIPMENT Company's owned property, plant and equipment consists of the following at December 31: During 2016, the Company recorded impairment charges of $15,593 related to its Emporia facility's property, plant and equipment assets. Refer to Note 2 for further details. NOTE 7-INTANGIBLE ASSETS Amortizing intangible assets consist of the following at December 31: The raw material supply agreement acquired is amortized over its 15 year term based on actual usage under the agreement and expires in 2025. The Company determined the estimated amount of raw materials to be purchased over the life of the agreement to calculate a per pound rate of consumption. The rate is then multiplied by the actual usage each period for expense reporting purposes. Amortization expense of $1,471, $1,112 and $1,298 for intangible assets was recorded for the years ended December 31, 2016, 2015 and 2014, respectively. Estimated amortization expense for fiscal years ended December 31 is as follows: NOTE 8-OTHER ASSETS Prepaid expenses and other current assets consist of the following at December 31: RIN inventory is valued at the lower of cost or net realizable value and consists of (i) RINs the Company generates in connection with its production of biomass-based diesel and (ii) RINs acquired from third parties. RINs generated by the Company are recorded at no cost, as these RINs are government incentives and not a tangible output from its biomass-based diesel production. The cost of RINs acquired from third parties is determined using the average cost method. RIN market value is based upon pricing as reported by the Oil Price Information Service (OPIS). Since RINs generated by the Company have zero cost associated to them, the lower of cost or market adjustment in RIN inventory reflects only the value of RINs obtained from third parties. RIN inventory values were adjusted in the amount of $612 and $3,027 at December 31, 2016 and 2015, respectively, to reflect the lower of cost or market. Other noncurrent assets consist of the following at December 31: NOTE 9-ACCRUED EXPENSES AND OTHER LIABILITIES Accrued expenses and other liabilities consist of the following at December 31: Other noncurrent liabilities consist of the following at December 31: NOTE 10-DEBT The Company’s term debt at December 31 is as follows: REG Danville On October 31, 2015, REG Danville, LLC entered into a Second Amended and Restated Loan Agreement with Fifth Third Bank regarding the construction/term loan (the "Fifth Third Construction/Term Loan"). The renewed Fifth Third Construction/Term Loan increased the principal amount of the Construction/Term Loan to $12,000 and had a three-year term with the maturity of the loan being extended to December 19, 2017. The loan requires monthly principal payments of $212 and interest to be charged using LIBOR plus 4% per annum. The loan agreement contains various loan covenants. Convertible Senior Notes On June 2, 2016, the Company issued $152,000 aggregate principal amount of the 2036 Convertible Notes in a private offering to qualified institutional buyers. The 2036 Convertible Notes bear interest at a rate of 4.00% per year payable semi-annually in arrears on June 15 and December 15 of each year, beginning December 15, 2016. The notes will mature on June 15, 2036, unless repurchased, redeemed or converted in accordance with their terms prior to such date. Prior to December 15, 2035, the 2036 Convertible Notes will be convertible only upon satisfaction of certain conditions and during certain periods as stipulated in the indenture. On or after December 15, 2035 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders of the 2036 Convertible Notes may convert their notes at any time. Unless and until the Company obtains stockholder approval under applicable NASDAQ Stock Market rules, the 2036 Convertible Notes will be convertible, subject to certain conditions, into cash. If the Company obtains such stockholder approval, the 2036 Convertible Notes may be settled in cash, the Company’s common shares or a combination of cash and the Company’s common shares, at the Company’s election. The Company may not redeem the 2036 Convertible Notes prior to June 15, 2021. Holders of the 2036 Convertible Notes will have the right to require the Company to repurchase for cash all or some of their notes at 100% of their principal, plus any accrued and unpaid interest on each of June 15, 2021, June 15, 2026 and June 15, 2031. Holders of the 2036 Convertible Notes will have the right to require the Company to repurchase for cash all or some of their notes at 100% of their principal, plus any accrued and unpaid interest upon the occurrence of certain fundamental changes. The initial conversion rate is 92.8074 common shares per $1,000 (one thousand) principal amount of 2036 Convertible Notes (equivalent to an initial conversion price of approximately $10.78 per common share). The net proceeds from the offering of the 2036 Convertible Notes were approximately $147,118, after deducting fees and offering expenses of $4,882, which was capitalized as debt issuance costs and is being amortized through June 2036. The Company evaluated the terms of the conversion features under the applicable accounting literature, including Derivatives and Hedging, ASC 815, and determined that a certain feature required separate accounting as a derivative. This derivative was recorded as a long-term liability, "Convertible Debt Conversion Liability" on the Consolidated Balance Sheets and will be adjusted to reflect fair value each reporting date. The fair value of the convertible debt conversion liability at issuance was $40,145. The fair value of the convertible debt conversion liability at December 31, 2016 was $27,100. The Company recognized gains of $13,045 for the year ended December 31, 2016, which are reflected in the "Change in Fair Value of Convertible Debt Conversion Liability" on the Consolidated Statements of Operations. The debt liability component of 2036 Convertible Notes was determined to be $111,855 at issuance, reflecting a debt discount of $40,145. The debt discount is to be amortized through June 2036. The effective interest rate on the debt liability component was 2.45%. In June 2016, approximately $35,101 of the net proceeds from the offering of the 2036 Convertible Notes were used to repurchase 4,060,323 shares of the Company's Common Stock in privately negotiated transactions. In addition, approximately $61,954 of the net proceeds from the offering were used to repurchase $63,912 principal amount of the Company's 2019 Convertible Notes in privately negotiated transactions. In September 2016, the Company used approximately $5,584 under the March 2016 share repurchase program to repurchase an additional $6,000 principal amount of the 2019 Convertible Notes. The repurchases resulted in a gain on debt extinguishment of $2,331, which is reflected on the Consolidated Statements of Operations. REG Grays Harbor, LLC In July 2015, REG Grays Harbor entered into a credit agreement with Umpqua Bank, or Umpqua Credit Agreement, whereby it can borrow up to $10.0 million for capital expenditure projects. Amounts borrowed under the Umpqua Credit Agreement bear interest at a per annum rate at of minimum of 3.50% or Prime Rate plus 0.25%. In addition, in July 2015 REG Grays Harbor entered into a line of credit note or Umpqua Line of Credit Note in conjunction with the Umpqua Credit Agreement for a maximum borrowing amount of $5,000. In September 2016, REG Grays Harbor entered into the first loan modification agreement with Umpqua Bank, or the First Modification, to extend the maturity date of the Umpqua Line of Credit to July 31, 2018. The terms of the Umpqua Credit Agreement provide that any principal outstanding under the Umpqua Line of Credit Note on July 31, 2016 shall be converted into term debt. At December 31, 2016, the total outstanding borrowing under the Umpqua Credit Agreement was all term debt and amounted to $9,273, bearing an interest rate of 4.30% per annum. REG Geismar REG Geismar was the obligor with respect to $100,000 aggregate principal amount of Gulf Opportunity Zone tax-exempt bonds, or GOZone Bonds, originally due in October 2033, through a loan agreement with the Louisiana Public Facilities Authority. REG Geismar’s payment obligations on the GOZone Bonds were supported by a letter of credit issued by a financial institution. REG Geismar was party to an agreement to reimburse the financial institution for any draws on the letter of credit and that obligation was secured by a $101,315 certificate of deposit by the Company and pledged in favor of the financial institution. On September 6, 2016, REG Geismar caused the Louisiana Public Facilities Authority to call for redemption all of the outstanding GOZone Bonds as of September 6, 2016. The redemption was funded by application of the funds generated by release of the certificate of deposit. Lines of Credit The Company’s revolving debt at December 31 are as follows: On March 16, 2016, REG Energy Services, LLC ("REG Energy Services") entered into an operating and revolving line of credit agreement (the "Agreement") with Bankers Trust Company (“Bankers Trust”). Pursuant to the Agreement, Bankers Trust agreed to provide an operating and revolving line of credit (the "Line of Credit") to REG Energy Services in the amount of$30,000. Amounts outstanding under the Agreement bear variable interest as stipulated in the Agreement. The Agreement contains various loan covenants that restrict REG Energy Services’ ability to take certain actions, including prohibiting it in certain circumstances from making payments to the Company. In addition, the Line of Credit is secured by substantially all of REG Energy Services’ accounts receivable and inventory. On September 30, 2016, REG Services Group, LLC and REG Marketing & Logistics Group, LLC, the Company's wholly owned subsidiaries entered into a Joinder and Amendment No. 11 to Credit Agreement (the “Amendment”) to that certain Credit Agreement originally dated as of December 23, 2011, by and among Borrowers, the lenders party thereto (“Lenders”) and Wells Fargo Capital Finance, LLC, as the agent, and Fifth Third Bank, as a new lender (as amended, the “Well Fargo Revolver”). Pursuant to the Amendment, the maximum commitment of the Lenders under the M&L and Services Revolver to make revolving loans was increased from $60,000 to $150,000, and an accordion feature was added to the M&L and Services Revolver, which allows the Company's subsidiaries that are borrowers to request commitments for additional revolving loans in aggregate amount not to exceed to $50,000, subject to customary conditions, including the consent of Lenders providing such additional commitments. The Amendment extended the maturity date of the M&L and Services Revolver to September 30, 2021. Loans advanced under the M&L and Services Revolver bear interest based on a one-month LIBOR rate (which shall not be less than zero), plus a margin based on Quarterly Average Excess Availability (as defined in the Revolving Credit Agreement), which may range from 1.75% per annum to 2.25% per annum. The M&L and Services Revolver contains various loan covenants that restrict each subsidiary borrower’s ability to take certain actions, including restrictions on incurrence of indebtedness, creation of liens, mergers or consolidations, dispositions of assets, repurchase or redemption of capital stock, making certain investments, making distributions to us unless certain conditions are satisfied, entering into certain transactions with affiliates or changing the nature of the subsidiary’s business. In addition, the subsidiary borrowers are required to maintain a fixed charge coverage ratio of at least 1.0 to 1.5 if excess availability under the M&L and Services Revolver is less than 10% of the total $150,000 of current revolving loan commitments, or $15,000 currently. The M&L and Services Revolver is secured by the subsidiary borrowers’ membership interests and substantially all of their assets. In addition, the M&L and Services Revolver is secured by the accounts receivable and inventory of REG Albert Lea, LLC, REG Houston, LLC, REG New Boston, LLC, and REG Geismar, LLC (collectively, the "Plant Loan Parties") subject to a $40,000 limitation with respect to each of the Plant Loan Parties. Maturities of the term debt, including the convertible debt, are as follows for the years ending December 31: NOTE 11-INCOME TAXES Income tax benefit (expense) for the years ended December 31 is as follows: A reconciliation of the reported amount of income tax expense to the amount computed by applying the statutory federal income tax rate to earnings from continuing operations before income taxes is as follows: The Company receives government incentive payments and excludes this revenue from federal and state taxable income. This tax position of excluding government incentives from taxable income has been accepted by the Internal Revenue Service under audit for 2010 and 2011 and has been approved by the Joint Committee on Taxation. As a result of excluding these government incentive payments, the Company currently has cumulative losses in recent years and initially established a valuation allowance in 2013 to reduce its total deferred tax assets to the amount more-likely-than-not to be realized. In 2015, the Company had a non-cash impairment charge for goodwill of $175,028, of which $91,961 was not deductible for tax purposes. A $32,186 tax impact related to the non-deductible portion of the goodwill impairment charge is reflected in the tax reconciliation above for 2015 in the amount of $35,062, offset with $2,876 in 2016. The tax effects of temporary differences that give rise to the Company’s deferred tax assets and liabilities at December 31 are as follows: At December 31, 2016, the Company has recorded a deferred tax asset of $346,768 reflecting the benefit of federal, state and foreign net operating loss carry-forwards. Federal net operating loss carry-forward totals $887,228 and will begin to expire in 2028, while the amount and expiration dates of state net operating losses vary by jurisdiction. Changes in ownership of the Company, as defined by Section 382 of the Internal Revenue Code of 1986, as amended, may limit the utilization of federal and state net operating losses and credit carry-forwards in any one year. The Company has performed an ownership change analysis in 2016 to determine the impact of changes in ownership on utilization of carry-forward attributes, the results of which have been incorporated into our financial statements. In evaluating available evidence around the recoverability of net deferred tax assets, the Company considers, among other factors, historical financial performance, expectation of future earnings, length of statutory carry-forward periods and ability to carry back losses to prior periods, experience with operating loss and tax credit carry-forwards expiring unused, tax planning strategies and timing for the of reversals of temporary differences. In evaluating losses, management considers the nature, frequency and severity of losses in light of the conditions giving rise to those losses. As a result of the above described tax position of excluding government incentive payments from taxable income, the Company currently has cumulative losses in recent years and has established a valuation allowance to reduce its total deferred tax assets to the amount more-likely-than-not to be realized. Activity regarding the valuation allowance for deferred tax assets was as follows: The Company analyzes filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, and all open tax years in these jurisdictions to determine if it has any uncertain tax positions on any of its income tax returns. An uncertain tax position represents the Company’s expected treatment of a tax position taken in a filed tax return, or planned to be taken in a tax return not yet filed, that has not been reflected in measuring income tax expense for financial reporting purposes. The Company does not recognize income tax benefits associated with uncertain tax positions where it is determined that it is not more-likely-than-not, based on the technical merits, that the position will be sustained upon examination. A reconciliation of the total amounts of unrecognized tax benefits at December 31 is as follows: The amount of unrecognized tax benefits that would affect the effective tax rate if the tax benefits were recognized was $0 at December 31, 2016, 2015 and 2014. The remaining liability for unrecognized tax benefits is related to tax positions for which there is a related deferred tax asset. The Company does not believe it is reasonably possible that the amounts of unrecognized tax benefits existing as of December 31, 2016 will significantly increase or decrease over the next twelve months. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense. The Company has not recorded any such amounts in the periods presented. The Company is subject to tax in the U.S. and various state and foreign jurisdictions. The U.S. Internal Revenue Service has examined the Company's federal income tax returns through 2008, as well as 2010 and 2011. All other years are subject to examination, while various state and foreign income tax returns also remain subject to examination by state taxing authorities. The Company considers its foreign earnings of non U.S. subsidiaries to be permanently reinvested. Any amount would become taxable upon a repatriation of assets from the subsidiary or a sale or liquidation of the subsidiary. The Company has not made a provision for U.S. or additional foreign withholding taxes. The Company has $0 deferred tax liability related to investments in its foreign subsidiaries. If the Company had a deferred tax liability related to its foreign subsidiaries it would be unrecorded as the Company considers its foreign earnings indefinitely reinvested. NOTE 12-STOCK-BASED COMPENSATION On October 26, 2011, the stockholders approved the 2009 Stock Incentive Plan (the 2009 Plan) which authorizes up to 4,160,000 shares of Company Common Stock to be issued for the award of restricted stock, restricted stock units (RSUs), performance restricted stock units (PRSUs) and stock appreciation rights (SARs) at the discretion of the Company Board as compensation to employees, consultants of the Company and to non-employee directors. Under the 2009 Plan, an additional 1,800,000 shares, or 5,960,000 shares in total, are reserved for issuance as approved by shareholders on May 15, 2014. The expense is measured at the grant-date fair value of the award and recognized as compensation expense on a straight-line basis over the service period, which is the vesting period. There was no cash flow impact resulting from the grants of these awards. The 2009 Plan is generally protected from anti-dilution via adjustments for any stock dividends, stock split, combination or other recapitalization. The Company recorded stock-based compensation expense of $5,896, $5,161 and $5,883 for the years ended December 31, 2016, 2015 and 2014, respectively. The stock-based compensation costs were included as a component of selling, general and administrative expenses. At December 31, 2016, there was $8,103 of unrecognized compensation expense related to unvested awards, which is expected to be recognized over a period of approximately 2.9 years. Restricted Stock Units The following table summarizes information about the Company’s Common Stock RSU’s granted, vested, exercised and forfeited: The RSUs convert into one share of common stock upon vesting. RSU’s cliff vest at the earlier of expressly provided service or performance conditions. The service period for these RSU awards, excluding those issued to the Company’s Board of Directors (one year) and certain executive management (four year), is a three year period from the grant date. The performance conditions provide for accelerated vesting upon various conditions including a change in control or other common stock liquidity events. Performance Restricted Stock Units The following table summarizes information about the Company’s Common Stock RSU’s granted, vested, exercised and forfeited: The PRSUs convert into one share of common stock upon vesting. PRSUs vest in different tranches upon meeting certain performance conditions, which are generally based on the Company's stock price performance and expressly provided service. These PRSUs are fair valued at grant date based on Monte Carlo simulations. The derived service period for these PRSU awards as a result of the Monte Carlo simulation, is a approximately two year period from the grant date. The performance conditions provide for accelerated vesting upon various conditions including a change in control or other common stock liquidity events. Stock Appreciation Rights The following table summarizes information about SARs granted, forfeited, vested and exercisable: The SARs vest 25% annually on each of the four anniversary dates following the grant date and expire after ten years. The fair value of each SAR grant is estimated using the Black-Scholes option-pricing model as set forth in the table below: Stock Options The following table summarizes information about Common Stock options granted, exercised, forfeited, vested and exercisable: There were no outstanding stock options at December31, 2016. There was no intrinsic value of options granted, exercised or outstanding during the periods presented. NOTE 13-RELATED PARTY TRANSACTIONS The Company reassesses its related parties at reporting dates and has determined that West Central Cooperative, now known as Landus Cooperative ("Landus"), is no longer a related party because it does not hold ten percent or more of the Company’s outstanding Common Stock, and no longer has the right to a seat on the Company's board throughout 2016 and for the last nine months of 2015. Transactions with Landus, prior to the Company's determination that Landus was no longer a related party, amounted to $4,542 and $42,622 for 2015 and 2014, respectively, primarily related to raw material purchases at market prices. This amount was included in the "Costs of goods sold - Biomass-based diesel" on the Consolidated Statements of Operations. NOTE 14-OPERATING LEASES The Company leases certain land and equipment under operating leases. Total rent expense under operating leases was $22,487, $19,814 and $17,498 for the years ended December 31, 2016, 2015 and 2014, respectively. For each of the next five calendar years and thereafter, future minimum lease payments under operating leases that have initial or remaining noncancelable lease terms in excess of one year are as follows: The Company's leases consist primarily of access to distribution terminals, biomass-based diesel storage facilities, railcars and vehicles. At the end of the lease term the Company, generally, has the option to (a) return the leased equipment to the lessor, (b) purchase the property at its then fair value or (c) renew its lease at the then fair rental value on a year-to-year basis or for an agreed upon term. Certain leases allow for adjustment to minimum rentals in future periods as determined by the Consumer Price Index. NOTE 15 - DERIVATIVE INSTRUMENTS The Company has entered into heating oil and soybean oil futures, swaps and options (commodity derivative contracts) to reduce the risk of price volatility related to anticipated purchases of feedstock raw materials and to protect gross profit margins from potentially adverse effects of price volatility on biomass-based diesel sales where prices are set at a future date. All of the Company’s derivatives are recorded at fair value on the Consolidated Balance Sheets. Unrealized gains and losses on commodity futures, swaps and options contracts used to risk-manage feedstock purchases or biomass-based diesel inventory are recognized as a component of biomass-based diesel costs of goods sold reflected in current results of operations. At December 31, 2016, the net notional volumes of heating oil and soybean oil covered under the open commodity derivative contracts were 45.4 million gallons and 41.0 million pounds, respectively. The Company offsets the fair value amounts recognized for its commodity derivative contracts with cash collateral with the same counterparty under a master netting agreement. The net position is presented within Prepaid expenses and other assets in the Consolidated Balance Sheets, see "Note 10 - Other Assets". As of December 31, 2016, the Company posted $9,366 of collateral associated with its commodity-based derivatives with a net liability position of $2,239. The following tables provide details regarding the Company’s derivative financial instruments: The following table sets forth the pre-tax gains (losses) included in the Consolidated Statements of Operations: NOTE 16-FAIR VALUE MEASUREMENT The fair value hierarchy prioritizes the inputs used in measuring fair value as follows: • Level 1-Quoted prices for identical instruments in active markets. • Level 2-Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-derived valuations, in which all significant inputs are observable in active markets. • Level 3-Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. A summary of assets (liabilities) measured at fair value is as follows: The following is a reconciliation of the beginning and ending balances for liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the years ended as follows: The Company used the following methods and assumptions to estimate fair value of its financial instruments: Commodity contract derivatives: The instruments held by the Company consist primarily of futures contracts, swap agreements, purchased put options and written call options. The fair value of contracts based on quoted prices of identical assets in an active exchange-traded market is reflected in Level 1. Contract fair value is determined based on quoted prices of similar contracts in over-the-counter markets and are reflected in Level 2. Contingent consideration for acquisitions: The fair value of the contingent consideration regarding REG Life Sciences, LLC ("REG Life Sciences") is determined using an expected present value technique. Expected cash flows are determined using the probability weighted-average of possible outcomes that would occur should achievement of certain milestones related to the development and commercialization of products from REG Life Sciences' technology occur. There is no observable market data available to use in valuing the contingent consideration; therefore, the Company developed its own assumptions related to the expected future delivery of product enhancements to estimate the fair value of these liabilities. An 8.0% discount rate is used to estimate the fair value of the expected payments. The fair value of all other contingent consideration is determined using an expected present value technique. Expected cash flows are determined using the probability weighted-average of possible outcomes that would occur should the achievement of certain milestones related to the production and/or sale of biomass-based diesel at the specific production facility. A discount rate ranging from 5.8% to 10.0% is used to estimate the fair value of the expected payments. Convertible debt conversion liability: The fair value of the convertible debt conversion liability is estimated using the Black-Scholes model incorporating the terms and conditions of the 2036 Convertible Notes and considering changes in the prices of the Company's common stock, Company stock price volatility, risk-free rates and changes in market rates. The valuations are, among other things, subject to changes in the Company's credit worthiness as well as change in general market conditions. As the majority of the assumptions used in the calculations are based on market sources, the fair value of the convertible conversion liability is reflected in Level 2. Debt and lines of credit: The fair value of long-term debt and lines of credit was established using discounted cash flow calculations and current market rates reflecting Level 2 inputs. The estimated fair values of the Company’s financial instruments, which are not recorded at fair value are as follows as of December 31: NOTE 17-NET INCOME (LOSS) PER SHARE Basic net income per common share is presented in conformity with the two-class method required for participating securities. Participating securities include, or have included, Series A Preferred Stock, Series B Preferred Stock and RSU's. Under the two-class method, net income is reduced for distributed and undistributed dividends earned in the current period. The remaining earnings are then allocated to Common Stock and the participating securities. The Company calculates the effects of participating securities on diluted earnings per share (EPS) using both the “if-converted or treasury stock” and "two-class" methods and discloses the method which results in a more dilutive effect. The effects of Common Stock options, warrants, stock appreciation rights and convertible notes on diluted EPS are calculated using the treasury stock method unless the effects are anti-dilutive to EPS. The following potentially dilutive average number of securities were excluded from the calculation of diluted net income per share attributable to common stockholders during the periods presented as the effect was anti-dilutive: The following table presents the calculation of diluted net income per share for the years ended December 31, 2016, 2015 and 2014 (in thousands, except share and per share data): NOTE 18-REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION The Company reports its reportable segments based on products and services provided to customers. The Company re-assesses its reportable segment on an annual basis. During the fourth quarter of 2015, the Company determined that as activities surrounding its renewable chemicals business increase, it changed the composition of its operating segments from two reportable segments to three reportable segments by presenting Renewable Chemicals separate from Biomass-based diesel. The new reportable segments generally align the Company's external financial reporting segments with its new internal operating segments, which are based on its internal organizational structure, operating decisions, and performance assessment. There are no changes to the Company's assessments in 2016. As such, our reportable segments at December 31, 2016 include Biomass-based diesel, Services, Renewable Chemicals and Corporate and other activities. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. All prior period disclosures below have been recast to present results on a comparable basis. The Biomass-based diesel segment processes waste vegetable oils, animal fats, virgin vegetable oils and other feedstocks and methanol into biomass-based diesel. The Biomass-based diesel segment also includes the Company’s purchases and resale of biomass-based diesel produced by third parties. Revenue is derived from the purchases and sales of biomass-based diesel, RINs and raw material feedstocks acquired from third parties, sales of biomass-based diesel produced under toll manufacturing arrangements with third party facilities, sales of processed biomass-based diesel from Company facilities, related by-products and renewable energy government incentive payments, in the U.S. and internationally. The Services segment offers services for managing the construction of biomass-based diesel production facilities and managing ongoing operations of third party plants and collects fees related to the services provided. The Company does not allocate items that are of a non-operating nature or corporate expenses to the business segments. Revenues are recorded by the Services segment at cost. The Renewable Chemicals segment consists of research and development activities involving the production of renewable chemicals, additional advanced biofuels and other products from the Company's proprietary microbial fermentation process and the operations of a demonstration scale facility located in Okeechobee, Florida. The Renewable Chemicals segment started to have research and development collaborative and initial product revenues in 2016. The Corporate and Other segment includes trading activities related to petroleum-based heating oil and diesel fuel as well as corporate activities, which consist of corporate office expenses such as compensation, benefits, occupancy and other administrative costs, including management service expenses. Corporate and other also includes income/(expense) not associated with the reportable segments, such as corporate general and administrative expenses, shared service expenses, interest expense and interest income, all reflected on an accrual basis of accounting. In addition, corporate and other includes cash and other assets not associated with the reportable segments, including investments. Intersegment revenues are reported by the Services and Corporate and Other segments. The following table represents the significant items by reportable segment for the results of operations for the years ended December 31, 2016, 2015 and 2014: Geographic Information: The following geographic data include net sales attributed to the countries based on the location of the subsidiary making the sale and long-lived assets based on physical location. Long-lived assets represent the net book value of property, plant and equipment. Sales and long-lived assets of the Company's investment in Petrotec comprise substantially all of the amounts categorized as Foreign in the table below. NOTE 19-COMMITMENTS AND CONTINGENCIES The Company is involved in legal proceedings in the normal course of business. The Company currently believes that any ultimate liability arising out of such proceedings will not have a material adverse effect on the Company’s financial position, results of operations or cash flows. The Company has entered into contracts for supplies of hydrogen, nitrogen and utilities for the REG Geismar production facility and natural gas for REG Albert Lea. The following table outlines the minimum take or pay requirement related to the purchase of hydrogen, nitrogen, utilities and natural gas. As of December 31, 2016, REG Geismar relies on one supplier to provide hydrogen necessary to execute the production process. Any disruptions to the hydrogen supply during production from this supplier will result in the shutdown of the REG Geismar plant operations. The Company is currently seeking additional hydrogen suppliers for the REG Geismar facility. NOTE 20-SUPPLEMENTAL QUARTERLY INFORMATION (UNAUDITED) During the third quarter 2016 close process, the Company identified errors in its previously reported interim financial statements for the quarter ended March 31, 2016 pertaining to certain biomass-based diesel sales completed in that quarter that contained BTC sharing terms resulting in an overstatement of biomass-based diesel sales and a corresponding understatement of accounts payable, deferred income taxes and income tax expense for the three months ended March 31, 2016 and the six months ended June 30, 2016. The correction of the errors is reflected in the quarterly information below. Based on an evaluation of all relevant facts, the Company assessed the materiality of these errors on the first and second quarter interim financial statements and concluded under ASC 250 that the correction was immaterial to the Company’s results for the three months ended March 31, 2016 and six months ended June 30, 2016 and an amendment of previously filed reports was not required. In accordance with ASC 250, the Company elected to correct these errors by revising the consolidated financial statements and other financial information contained within this Annual Report on Form 10-K for the periods impacted to correct the effect of these errors. The following table represents the significant items for the results of operations on a quarterly basis for the years ended December 31, 2016 and 2015: The results of operations for the three months ended December 31, 2015 reflect a goodwill impairment of $175,028 (before tax) and net benefit from the reinstatement of the BTC of $95,008.
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Based on the provided text, which appears to be a partial financial statement excerpt, here's a summary of the key points:
Assets and Accounting Practices:
- Fixed assets valued at approximately $11,027
- Property, plant, and equipment recorded at cost less accumulated depreciation
- Depreciation calculated using straight-line method
- Inventories valued using first-in, first-out method
- Accounts receivable carried at invoiced amount with allowance for doubtful accounts
Financial Instruments:
- Derivatives recorded at fair value with changes recognized in current earnings
- Debt instruments with original maturity of three months or less considered cash equivalents
Inventory and Receivables:
- No lower of cost or market adjustments made to inventory
- Allowance for doubtful accounts estimated based on economic conditions, customer financial status, and account aging
Note: The provided text seems to be an incomplete financial statement, so
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders W. R. Berkley Corporation: We have audited the accompanying consolidated balance sheets of W. R. Berkley Corporation and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of W. R. Berkley Corporation and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), W. R. Berkley Corporation's internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 27, 2017 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. /S/ KPMG LLP New York, New York February 27, 2017 W. R. BERKLEY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See accompanying notes to consolidated financial statements. W. R. BERKLEY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME See accompanying notes to consolidated financial statements. W. R. BERKLEY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. W. R. BERKLEY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY See accompanying notes to consolidated financial statements. W. R. BERKLEY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. W. R. BERKLEY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the years ended December 31, 2016, 2015 and 2014 (1) Summary of Significant Accounting Policies (A) Principles of consolidation and basis of presentation The consolidated financial statements, which include the accounts of W. R. Berkley Corporation and its subsidiaries (the "Company"), have been prepared on the basis of U.S. generally accepted accounting principles ("GAAP"). All significant intercompany transactions and balances have been eliminated. Reclassifications have been made in the 2015 and 2014 financial statements to conform to the presentation of the 2016 financial statements. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the revenues and expenses reflected during the reporting period. The most significant items on our balance sheet that involve a greater degree of accounting estimates that are subject to change in the future are the valuation of investments, other-than-temporary impairments, loss and loss expense reserves and premium estimates. Actual results could differ from those estimates. (B) Revenue recognition Insurance premiums are recognized as written at the inception of the policy. Reinsurance premiums are estimated based upon information received from ceding companies, and subsequent differences from such estimates are recorded in the period they are determined. Insurance and reinsurance premiums are primarily earned on a pro rata basis over the policy term. Fees for services are earned over the period that the services are provided. Audit premiums are recognized when they are reliably determinable. The change in accruals for earned but unbilled audit premiums increased net premiums written and premiums earned by $8 million, $3 million and $9 million in 2016, 2015 and 2014, respectively. Revenues from non-insurance businesses are derived from a business engaged in the distribution of promotional merchandise and aircraft services provided to the general, commercial and military aviation markets. These aircraft services include (i) the distribution, manufacturing, repair and overhaul of aircraft parts and components, (ii) the sale of new and used aircraft, and (iii) avionics, fuel, maintenance, storage and charter services. Revenue is recognized upon the shipment of products and parts, the delivery of aircraft, the delivery of fuel, and upon completion of services. Insurance service fee revenue represents servicing fees for program administration and claims management services provided by the Company, including workers' compensation assigned risk plans, as well as insurance brokerage and risk management services. Fees for program administration, claims management and risk management services are primarily recognized ratably over the related contract period for which the underlying services are rendered. Commissions for insurance brokerage are generally recognized when the underlying insurance policy is effective. (C) Cash and cash equivalents Cash equivalents consist of funds invested in money market accounts and investments with an effective maturity of three months or less when purchased. (D) Investments Fixed maturity securities classified as available for sale are carried at estimated fair value, with unrealized gains and losses, net of applicable income taxes, excluded from earnings and reported as a component of comprehensive income and a separate component of stockholders' equity. Fixed maturity securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investment income from fixed maturity securities is recognized based on the constant effective yield method. Premiums and discounts on mortgage-backed securities are adjusted for the effects of actual and anticipated prepayments on a retrospective basis. Equity securities classified as available for sale are carried at estimated fair value, with unrealized gains and losses, net of applicable income taxes, excluded from earnings and reported as a component of comprehensive income and a separate component of stockholders' equity. Equity and fixed maturity securities that the Company purchased with the intent to sell in the near-term are classified as trading account securities and are reported at estimated fair value. Realized and unrealized gains and losses from trading activity are reported as net investment income and are recorded at the trade date. Short sales and short call options are presented as trading securities sold but not yet purchased. Unsettled trades and the net margin balances held by the clearing broker are presented as a trading account receivable from brokers and clearing organizations. Investment funds are carried under the equity method of accounting. For certain investment funds, the Company's share of the earnings or losses is reported on a one-quarter lag in order to facilitate the timely completion of the Company's consolidated financial statements. Loans receivable primarily represent commercial real estate mortgage loans and bank loans and are carried at amortized cost. The Company monitors the performance of its loans receivable and establishes an allowance for loan losses for loans where the Company determines it is probable that the contractual terms will not be met, with a corresponding charge to earnings. For loans that are evaluated individually and deemed to be impaired, the Company establishes a specific allowance based on a discounted cash flow analysis and comparable cost and sales methodologies, if appropriate. Individual loans that are not considered impaired and smaller-balance homogeneous loans are evaluated collectively and a general allowance is established if it is considered probable that a loss has been incurred. The accrual of interest on loans receivable is discontinued if the loan is 90 days past due based on the contractual terms of the loan unless the loan is adequately secured and in process of collection. In general, loans are placed on non-accrual status or charged off at an earlier date if collection of principal or interest is considered doubtful. Interest on these loans is accounted for on a cash basis until qualifying for return to accrual status. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value of investments is determined based on a fair value hierarchy that prioritizes the use of observable inputs over the use of unobservable inputs and requires the use of observable inputs when available. (See Note 13 of the .) Realized gains or losses represent the difference between the cost of securities sold and the proceeds realized upon sale and are recorded at the trade date. The Company uses primarily the first-in, first-out method to determine the cost of securities sold. The cost of securities is adjusted where appropriate to include a provision for a decline in value which is considered to be other than temporary. An other-than-temporary decline is considered to occur in investments where there has been a sustained reduction in fair value and where the Company does not expect to recover the cost basis of the investment prior to the time of sale or maturity. Since equity securities do not have a contractual cash flow or a maturity, the Company considers whether the price of an equity security is expected to recover within a reasonable period of time. For fixed maturity securities that the Company intends to sell or, more likely than not, would be required to sell, a decline in value below amortized cost is considered to be an other-than-temporary impairment (“OTTI”). The amount of OTTI is equal to the difference between amortized cost and fair value at the balance sheet date. For fixed maturity securities that the Company does not intend to sell or believes that it is more likely than not it would not be required to sell, a decline in value below amortized cost is considered to be an OTTI if the Company does not expect to recover the entire amortized cost basis of a security (i.e., the present value of cash flows expected to be collected is less than the amortized cost basis of the security). The portion of the decline in value considered to be a credit loss (i.e., the difference between the present value of cash flows expected to be collected and the amortized cost basis of the security) is recognized in earnings. The portion of the decline in value not considered to be a credit loss (i.e., the difference in the present value of cash flows expected to be collected and the fair value of the security) is recognized in other comprehensive income. Impairment assessments for structured securities, including mortgage-backed securities and asset-backed securities, collateralized debt obligations and corporate debt, are generally evaluated based on the performance of the underlying collateral under various economic and default scenarios that may involve subjective judgments and estimates by management. Modeling these securities involves various factors, such as projected default rates, the nature and realizable value of the collateral, if any, the ability of the issuer to make scheduled payments, historical performance and other relevant economic and performance factors. If an OTTI determination is made, a discounted cash flow analysis is used to ascertain the amount of the credit impairment. Real estate held for investment purposes is initially recorded at the purchase price, which is generally fair value, and is subsequently reported at cost less accumulated depreciation. Real estate taxes, interest and other costs incurred during development and construction are capitalized. Buildings are depreciated on a straight-line basis over the estimated useful lives of the building. Minimum rental income is recognized on a straight-line basis over the lease term. Income and expenses from real estate are reported as net investment income. The carrying value of real estate is reviewed for impairment and an impairment loss is recognized if the estimated undiscounted cash flows from the use and disposition of the property are less than the carrying value of the property. (E) Per share data The Company presents both basic and diluted net income per share (“EPS”) amounts. Basic EPS is calculated by dividing net income by weighted average number of common shares outstanding during the year. Diluted EPS is based upon the weighted average number of common and common equivalent shares outstanding during the year and is calculated using the treasury stock method for stock incentive plans. Common equivalent shares are excluded from the computation in periods in which they have an anti-dilutive effect. (F) Deferred policy acquisition costs Acquisition costs associated with the successful acquisition of new and renewed insurance and reinsurance contracts are deferred and amortized ratably over the terms of the related contracts. Ceding commissions received on reinsurance contracts are netted against acquisition costs and are recognized ratably over the life of the contract. Deferred policy acquisition costs are presented net of unearned ceding commissions. Deferred policy acquisition costs are comprised primarily of commissions, as well as employment-related underwriting costs and premium taxes. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income and, if not, are charged to expense. The recoverability of deferred policy acquisition costs is evaluated separately by each of our operating companies for each of their major lines of business. Future investment income is taken into account in measuring the recoverability of deferred policy acquisition costs. (G) Reserves for losses and loss expenses Reserves for losses and loss expenses are an accumulation of amounts determined on the basis of (1) evaluation of claims for business written directly by the Company; (2) estimates received from other companies for reinsurance assumed by the Company; and (3) estimates for losses incurred but not reported (based on Company and industry experience). These estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in the statements of income in the period in which they are determined. The Company discounts its reserves for excess and assumed workers' compensation claims using a risk-free or statutory rate. (See Note 14 of .) (H) Reinsurance ceded The unearned portion of premiums ceded to reinsurers is reported as prepaid reinsurance premiums and earned ratably over the policy term. The estimated amounts of reinsurance recoverable on unpaid losses are reported as due from reinsurers. To the extent any reinsurer does not meet its obligations under reinsurance agreements, the Company must discharge its liability. Amounts due from reinsurers are reflected net of funds held where the right of offset is present. The Company has provided reserves for estimated uncollectible reinsurance. (I) Deposit accounting Contracts that do not meet the risk transfer requirements of GAAP are accounted for using the deposit accounting method. Under this method, an asset or liability is recognized at the inception of the contract based on consideration paid or received. The amount of the deposit asset or liability is adjusted at subsequent reporting dates using the interest method with a corresponding credit or charge to interest income or expense. Deposit liabilities for assumed reinsurance contracts were $51 million and $54 million at December 31, 2016 and 2015, respectively. (J) Federal and foreign income taxes The Company files a consolidated income tax return in the U.S. and foreign tax returns in countries where it has overseas operations. The Company's method of accounting for income taxes is the asset and liability method. Under this method, deferred tax assets and liabilities are measured using tax rates currently in effect or expected to apply in the years in which those temporary differences are expected to reverse. Interest and penalties, if any, are reported as income tax expense. The Company believes there are no tax positions that would require disclosure under GAAP. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or a portion of the deferred tax assets will not be realized. (K) Foreign currency Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's functional currency) are reported on the statements of income as other operating costs and expenses. Unrealized gains or losses resulting from translating the results of non-U.S. dollar denominated operations are reported in accumulated other comprehensive income. Revenues and expenses denominated in currencies other than U.S. dollars are translated at the weighted average exchange rate during the year. Assets and liabilities are translated at the rate of exchange in effect at the balance sheet date. (L) Property, furniture and equipment Property, furniture and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the estimated useful lives of the respective assets. Depreciation expense was $47 million, $45 million and $44 million for 2016, 2015 and 2014, respectively. (M) Comprehensive income Comprehensive income encompasses all changes in stockholders' equity (except those arising from transactions with stockholders) and includes net income, net unrealized holding gains or losses on available for sale securities, unrealized foreign currency translation adjustments and changes in unrecognized pension obligations. (N) Goodwill and other intangible assets Goodwill and other intangible assets are tested for impairment on an annual basis and at interim periods where circumstances require. The Company's impairment test as of December 31, 2016 indicated that there were no material impairment losses related to goodwill and other intangible assets. Intangible assets of $82 million and $94 million are included in other assets as of December 31, 2016 and 2015, respectively. (O) Stock options The costs resulting from all share-based payment transactions with employees are recognized in the consolidated financial statements using a fair-value-based measurement method. Compensation cost is recognized for financial reporting purposes over the period in which the employee is required to provide service in exchange for the award (generally the vesting period). (P) Statements of cash flows Interest payments were $137 million, $130 million and $120 million in 2016, 2015 and 2014, respectively. Income taxes paid were $232 million, $165 million and $314 million in 2016, 2015 and 2014, respectively. Other non-cash items include unrealized investment gains and losses and pension expense. (See Note 11 and Note 25 of .) (Q) Recent accounting pronouncements Recently adopted accounting pronouncements: In February 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2015-02, Consolidation. ASU 2015-02 makes targeted amendments to the current consolidation accounting guidance, in response to accounting complexity concerns. The guidance simplifies consolidation accounting by reducing the number of approaches to consolidation. The Company adopted this updated guidance on January 1, 2016. The adoption of this guidance did not have a material effect on the Company’s financial condition or results of operations, but did result in additional disclosures. In May 2015, the FASB issued ASU 2015-09, Disclosures about Short-Duration Contracts. ASU 2015-09 requires companies that issue short duration insurance contracts to disclose additional information, including: (i) incurred and paid claims development tables; (ii) frequency and severity of claims; and (iii) information about material changes in judgments made in calculating the liability for unpaid claim adjustment expenses, including reasons for the change and the effects on the financial statements. The Company adopted this updated guidance on January 1, 2016 with regard to the annual requirements and on January 1, 2017 with regard to the interim requirements. The amendments in ASU 2015-09 are applied retrospectively by providing comparative disclosures for each period presented, except for those requirements that apply only to the current period. As the requirements are disclosure only, the adoption of this guidance did not impact our financial condition or results of operations, but did result in additional disclosures. All other accounting and reporting standards that became effective in 2016 were either not applicable to the Company or their adoption did not have a material impact on the Company. Accounting and reporting standards that are not yet effective: In May 2014, the FASB issued ASU 2014-09, Revenue from Customers. ASU 2014-09 clarifies the principles for recognizing revenue. While insurance contracts are not within the scope of this updated guidance, the Company’s insurance service fee revenue will be subject to this updated guidance. The updated guidance requires an entity to recognize revenue as performance obligations are met, in order to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration the entity is entitled to receive for those goods or services. The updated guidance, as amended by ASU 2015-14, is effective for public business entities for annual and interim reporting periods beginning after December 15, 2017. The adoption of this guidance is not expected to have a material effect on the Company’s financial condition or results of operations. In January 2016, the FASB issued ASU 2016-01, Financial Instruments. ASU 2016-01 amends the accounting guidance for financial instruments to require all equity investments to be measured at fair value with changes in the fair value recognized through net income (other than those accounted for under equity method of accounting or those that result in consolidation of the investee). The updated guidance is effective for public business entities for annual reporting periods beginning after December 15, 2017 and interim periods within those years. The adoption of this guidance is not expected to have a material effect on the Company’s financial condition upon adoption, but will impact results of operations after adoption of this guidance as unrealized gains and losses on equity securities will no longer be reported directly in accumulated other comprehensive income (AOCI), but will instead be reported in net income. In February 2016, the FASB issued ASU 2016-02, Leases, which amends the accounting and disclosure guidance for leases. This guidance retains the two classifications of a lease, as either an operating or finance lease, both of which will require lessees to recognize a right-of-use asset and a lease liability for leases with terms of more than 12 months. The right-of-use asset and the lease liability will be determined based upon the present value of cash flows. Finance leases will reflect the financial arrangement by recognizing interest expense on the lease liability separately from the amortization expense of the right-of-use asset. Operating leases will recognize lease expense (with no separate recognition of interest expense) on a straight-line basis over the term of the lease. The accounting by lessors is not significantly changed by the updated guidance. The updated guidance is effective for reporting periods beginning after December 15, 2018, and will require that the earliest comparative period presented include the measurement and recognition of existing leases with an adjustment to equity as if the updated guidance had always been applied. The Company is currently evaluating the impact that the adoption of this guidance will have on its results of operations, financial position and liquidity. In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses, which amends the accounting guidance for credit losses on financial instruments. The updated guidance amends the current other-than-temporary impairment model for available-for-sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. This guidance also applies a new current expected credit loss model for determining credit-related impairments for financial instruments measured at amortized cost. The updated guidance is effective for reporting periods beginning after December 15, 2019. The Company will not be able to determine the impact the adoption of this guidance will have on its results of operations, financial position or liquidity until the year the guidance becomes effective. All other recently issued but not yet effective accounting and reporting standards are either not applicable to the Company or are not expected to have a material impact on the Company. (2) Acquisitions / Dispositions In February 2016, the Company acquired an 85% ownership interest for $42.3 million in a company engaged in the distribution of promotional merchandise. The fair value of the assets acquired and liabilities assumed have been estimated based on a third party valuation. In July 2016, the Company acquired a specialty property and casualty insurance company for $15.5 million. The following table summarizes the estimated fair value of net assets acquired and liabilities assumed for the business combinations completed in 2016: _____________________ (1) Other assets includes $31.8 million of intangible assets. In July 2016, the Company sold Aero Precision Industries, an aviation-related business, for $253.1 million. The business had a net carrying value of $118.2 million. (3) Consolidated Statement of Comprehensive Income (Loss) The following tables present the components of the changes in accumulated other comprehensive income (loss) (AOCI) as of and for the years ended December 31, 2016 and 2015: _______________ (1) Net investment gains in the consolidated statements of income. (2) Income tax expense in the consolidated statements of income. (4) Investments in Fixed Maturity Securities At December 31, 2016 and 2015, investments in fixed maturity securities were as follows: ____________________ (1) Gross unrealized losses for mortgage-backed securities include $818,691 and $1,269,491, as of December 31, 2016 and 2015, respectively, related to the non-credit portion of OTTI recognized in other comprehensive income. The amortized cost and fair value of fixed maturity securities at December 31, 2016, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain issuers may have the right to call or prepay obligations. At December 31, 2016 and 2015, there were no investments, other than investments in United States government and government agency securities, which exceeded 10% of common stockholders’ equity. At December 31, 2016, investments with a carrying value of $1,261 million were on deposit in custodial or trust accounts, of which $1,022 million was on deposit with state insurance departments, $178 million was on deposit in support of the Company’s underwriting activities at Lloyd’s, $43 million was on deposit as security for reinsurance clients and $18 million was on deposit as security for letters of credit issued in support of the Company’s reinsurance operations. (5) Investments in Equity Securities Available for Sale At December 31, 2016 and 2015, investments in equity securities available for sale were as follows: At December 31, 2016, common stocks included HealthEquity, Inc. shares, which had previously been reported in investment funds. (6) Arbitrage Trading Account At December 31, 2016 and 2015, the fair value and carrying value of the arbitrage trading account were $300 million and $377 million, respectively. The primary focus of the trading account is merger arbitrage. Merger arbitrage is the business of investing in the securities of publicly held companies which are the targets in announced tender offers and mergers. Arbitrage investing differs from other types of investing in its focus on transactions and events believed likely to bring about a change in value over a relatively short time period (usually four months or less). The Company uses put options, call options and swap contracts in order to mitigate the impact of potential changes in market conditions on the merger arbitrage trading account. These options and contracts are reported at fair value. As of December 31, 2016, the fair value of long option contracts outstanding was $1 million (notional amount of $27 million) and the fair value of short option contracts outstanding was $2 million (notional amount of $36 million). Other than with respect to the use of these trading account securities, the Company does not make use of derivatives. (7) Net Investment Income Net investment income consists of the following: (8) Investment Funds The Company evaluates whether it is an investor in a variable interest entity (VIE). Such entities do not have sufficient equity at risk to finance their activities without additional subordinated financial support, or the equity investors, as a group, do not have the characteristics of a controlling financial interest (primary beneficiary). The Company determines whether it is the primary beneficiary of an entity subject to consolidation based on a qualitative assessment of the VIE's capital structure, contractual terms, nature of the VIE's operations and purpose, and the Company's relative exposure to the related risks of the VIE on the date it becomes initially involved in the VIE and on an ongoing basis. The Company is not the primary beneficiary in any of its investment funds, and accordingly, carries its interests in investments funds under the equity method of accounting. The Company’s maximum exposure to loss with respect to these investments is limited to the carrying amount reported on the Company’s consolidated balance sheet and its unfunded commitments of $372.1 million as of December 31, 2016. Investment funds consist of the following: The Company's share of the earnings or losses of investment funds is primarily reported on a one-quarter lag in order to facilitate the timely completion of the Company's consolidated financial statements. Other funds include private equity investments carried on the equity method of accounting, which included the Company's publicly traded common stock investment in HealthEquity, Inc. (HQY) in 2015. The Company's ownership interest in HQY was approximately 21%, as of December 31, 2015, with a fair value of $300.1 million and a carrying value of $45.4 million. In October 2016, the Company sold approximately 2.2 million shares in HQY, reducing the Company's ownership to 16.5% and causing the Company to report its investment in HQY at fair value as an available for sale security rather than under investment funds. (9) Real Estate Investment in real estate represents directly owned property held for investment, as follows: In 2016, properties in operation included a long-term ground lease in Washington, D.C., a hotel in Memphis, Tennessee, an office complex in New York City and office buildings in West Palm Beach and Palm Beach, Florida. Properties in operation are net of accumulated depreciation and amortization of $14,996,000 and $9,073,000 as of December 31, 2016 and 2015, respectively. Related depreciation expense was $14,802,000 and $7,425,000 for the years ended December 31, 2016 and 2015, respectively. Future minimum rental income expected on operating leases relating to properties in operation is $16,466,519 in 2017, $27,165,624 in 2018, $27,451,819 in 2019, $26,281,505 in 2020, $26,560,894 in 2021 and $464,803,187 thereafter. Properties under development include an office building in London and a mixed-use project in Washington, D.C. (10) Loans Receivable Loans receivable are as follows: Loans receivable in non-accrual status were $5.4 million and $3.1 million as of December 31, 2016 and 2015, respectively. The Company monitors the performance of its loans receivable and assesses the ability of the borrower to pay principal and interest based upon loan structure, underlying property values, cash flow and related financial and operating performance of the property and market conditions. Loans receivable with a potential for default are further assessed using discounted cash flow analysis and comparable cost and sales methodologies, if appropriate. The real estate loans are secured by commercial real estate primarily located in North Carolina and New York. These loans generally earn interest at floating LIBOR-based interest rates and have maturities (inclusive of extension options) through August 2025. The commercial loans are with small business owners who have secured the related financing with the assets of the business. Commercial loans generally earn interest on a fixed basis and have varying maturities not exceeding 10 years. In evaluating the real estate loans, the Company considers their credit quality indicators, including loan to value ratios, which compare the outstanding loan amount to the estimated value of the property, the borrower’s financial condition and performance with respect to loan terms, the position in the capital structure, the overall leverage in the capital structure and other market conditions. Based on these considerations, none of the real estate loans were considered to be impaired at December 31, 2016, and accordingly, the Company determined that a specific valuation allowance was not required. (11) Realized and Unrealized Investment Gains (Losses) Realized and unrealized investment gains (losses) are as follows: ____________________ (1) Other includes a gain of $134.9 million from the sale of Aero Precision Industries, and certain related aviation services business, for the year ended December 31, 2016. (2) For the year ended December 31, 2016, OTTI related to equity securities were $18.1 million. For the year ended December 31, 2015, OTTI related to equity securities were $24.3 million and related to fixed maturity securities were $9.0 million. There was no OTTI for the year ended December 31, 2014. (12) Securities in an Unrealized Loss Position The following tables summarize all securities in an unrealized loss position at December 31, 2016 and 2015 by the length of time those securities have been continuously in an unrealized loss position. Fixed Maturity Securities - A summary of the Company’s non-investment grade fixed maturity securities that were in an unrealized loss position at December 31, 2016 is presented in the table below: For OTTI of fixed maturity securities that management does not intend to sell or, more likely than not, would not be required to sell, the portion of the decline in value considered to be due to credit factors is recognized in earnings and the portion of the decline in value considered to be due to non-credit factors is recognized in other comprehensive income. For the year ended December 31, 2016, there were no OTTI recognized in earnings for fixed maturity securities. For the year ended December 31, 2015, OTTI for fixed maturity securities were $9.0 million, all of which was considered due to credit factors. The Company has evaluated its fixed maturity securities in an unrealized loss position and believes the unrealized losses are due primarily to temporary market and sector-related factors rather than to issuer-specific factors. None of these securities are delinquent or in default on financial covenants. Based on its assessment of these issuers, the Company expects them to continue to meet their contractual payment obligations as they become due and does not consider any of these securities to be OTTI. Preferred Stocks - At December 31, 2016, there was one preferred stock in an unrealized loss position, with an aggregate fair value of $22.0 million and a gross unrealized loss of $3.6 million. The preferred stock is rated investment grade. Management believes the unrealized loss is due primarily to market and sector related factors and does not consider it to be OTTI. For the year ended December 31, 2016, there were no OTTI for preferred stocks. OTTI for preferred stocks for the year ended December 31, 2015 were $13.4 million. Common Stocks - At December 31, 2016, there were two common stocks in an unrealized loss position, with an aggregate fair value of $9.1 million and a gross unrealized loss of $1.1 million. Based on management's view on these securities, the Company does not consider the common stocks to be OTTI. For the year ended December 31, 2016, OTTI for common stocks were $18.1 million. OTTI for common stocks for the year ended December 31, 2015 were $10.9 million. (13) Fair Value Measurements The Company’s fixed maturity and equity securities classified as available for sale and its trading account securities are carried at fair value. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. The Company utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels, as follows: Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date. Level 2 - Quoted prices for similar assets or valuations based on inputs that are observable. Level 3 - Estimates of fair value based on internal pricing methodologies using unobservable inputs. Unobservable inputs are only used to measure fair value to the extent that observable inputs are not available. Substantially all of the Company’s fixed maturity securities were priced by independent pricing services. The prices provided by the independent pricing services are estimated based on observable market data in active markets utilizing pricing models and processes, which may include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, sector groupings, matrix pricing and reference data. The pricing services may prioritize inputs differently on any given day for any security based on market conditions, and not all inputs are available for each security evaluation on any given day. The pricing services used by the Company have indicated that they will only produce an estimate of fair value if objectively verifiable information is available. The determination of whether markets are active or inactive is based upon the volume and level of activity for a particular asset class. The Company reviews the prices provided by pricing services for reasonableness and periodically performs independent price tests of a sample of securities to ensure proper valuation. If prices from independent pricing services are not available for fixed maturity securities, the Company estimates the fair value. For Level 2 securities, the Company utilizes pricing models and processes which may include benchmark yields, sector groupings, matrix pricing, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, bids, offers and reference data. Where broker quotes are used, the Company generally requests two or more quotes and sets a price within the range of quotes received based on its assessment of the credibility of the quote and its own evaluation of the security. The Company generally does not adjust quotes received from brokers. For securities traded only in private negotiations, the Company determines fair value based primarily on the cost of such securities, which is adjusted to reflect prices of recent placements of securities of the same issuer, financial projections, credit quality and business developments of the issuer and other relevant information. For Level 3 securities, the Company generally uses a discounted cash flow model to estimate the fair value of fixed maturity securities. The cash flow models are based upon assumptions as to prevailing credit spreads, interest rate and interest rate volatility, time to maturity and subordination levels. Projected cash flows are discounted at rates that are adjusted to reflect illiquidity, where appropriate. The following tables present the assets and liabilities measured at fair value on a recurring basis as of December 31, 2016 and 2015 by level: There were no significant transfers between Levels 1 and 2 for the years ended December 31, 2016 and 2015. The following tables summarize changes in Level 3 assets and liabilities for the years ended December 31, 2016 and 2015: During the year ended December 31, 2016, there were no securities transferred out of Level 3. During the year ended December 31, 2015, five securities were transferred out of Level 3 as an observable price was available. (14) Reserves for Losses and Loss Expenses Loss reserves included in the Company’s financial statements represent management’s best estimates based upon an actuarially derived point estimate and other considerations. The Company uses a variety of actuarial techniques and methods to derive an actuarial point estimate for each operating unit. These methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency and severity methods. In circumstances where one actuarial method is considered more credible than the others, that method is used to set the point estimate. The actuarial point estimate may also be based on a judgmental weighting of estimates produced from each of the methods considered. Industry loss experience is used to supplement the Company’s own data in selecting “tail factors” in areas where the Company’s own data is limited. The actuarial data is analyzed by line of business, coverage and accident or policy year, as appropriate, for each operating unit. The establishment of the actuarially derived loss reserve point estimate also includes consideration of qualitative factors that may affect the ultimate losses. These qualitative considerations include, among others, the impact of re-underwriting initiatives, changes in the mix of business, changes in distribution sources and changes in policy terms and conditions. The key assumptions used to arrive at the best estimate of loss reserves are the expected loss ratios, rate of loss cost inflation, and reported and paid loss emergence patterns. Expected loss ratios represent management’s expectation of losses at the time the business is priced and written, before any actual claims experience has emerged. This expectation is a significant determinant of the estimate of loss reserves for recently written business where there is little paid or incurred loss data to consider. Expected loss ratios are generally derived from historical loss ratios adjusted for the impact of rate changes, loss cost trends and known changes in the type of risks underwritten. Expected loss ratios are estimated for each key line of business within each operating unit. Expected loss cost inflation is particularly important for the long-tail lines, such as excess casualty, and claims with a high medical component, such as workers’ compensation. Reported and paid loss emergence patterns are used to project current reported or paid loss amounts to their ultimate settlement value. Loss development factors are based on the historical emergence patterns of paid and incurred losses, and are derived from the Company’s own experience and industry data. The paid loss emergence pattern is also significant to excess and assumed workers’ compensation reserves because those reserves are discounted to their estimated present value based upon such estimated payout patterns. Loss frequency and severity are measures of loss activity that are considered in determining the key assumptions described in our discussion of loss and loss expense reserves, including expected loss ratios, rate of loss cost inflation and reported and paid loss emergence patterns. Loss frequency is a measure of the number of claims per unit of insured exposure, and loss severity is a measure of the average size of claims. Factors affecting loss frequency include the effectiveness of loss controls and safety programs and changes in economic activity or weather patterns. Factors affecting loss severity include changes in policy limits, retentions, rate of inflation and judicial interpretations. Another factor affecting estimates of loss frequency and severity is the loss reporting lag, which is the period of time between the occurrence of a loss and the date the loss is reported to the Company. The length of the loss reporting lag affects our ability to accurately predict loss frequency (loss frequencies are more predictable for lines with short reporting lags) as well as the amount of reserves needed for incurred but not reported losses (less IBNR is required for lines with short reporting lags). As a result, loss reserves for lines with short reporting lags are likely to have less variation from initial loss estimates. For lines with short reporting lags, which include commercial automobile, primary workers’ compensation, other liability (claims-made) and property business, the key assumption is the loss emergence pattern used to project ultimate loss estimates from known losses paid or reported to date. For lines of business with long reporting lags, which include other liability (occurrence), products liability, excess workers’ compensation and liability reinsurance, the key assumption is the expected loss ratio since there is often little paid or incurred loss data to consider. Historically, the Company has experienced less variation from its initial loss estimates for lines of businesses with short reporting lags than for lines of business with long reporting lags. The key assumptions used in calculating the most recent estimate of the loss reserves are reviewed each quarter and adjusted, to the extent necessary, to reflect the latest reported loss data, current trends and other factors observed. A claim may be defined as an event, as a claimant (number of parties claiming damages from an event) or by exposure type (e.g., an event may give rise to two parties, each claiming loss for bodily injury and property damage). The most commonly used claim count method is by event. Most of the Company's operating units use the number of events to define and quantify the number of claims. However, in certain lines of business, where it is common for multiple parties to claim damages arising from a single event, an operating unit may quantify claims on the basis of the number of separate parties involved in an event. This may be the case with businesses writing substantial automobile or transportation exposure. Claim counts for assumed reinsurance will vary based on whether the business is written on a facultative or treaty basis. Further variability as respects treaty claim counts may be reflective of the nature of the treaty, line of business coverage, and type of participation such as quota share or excess of loss contracts. Accordingly, the claim counts have been excluded from the below Reinsurance segment tables due to this variability. The claim count information set forth in the tables presented below may not provide an accurate reflection of ultimate loss payouts by product line. The following tables present undiscounted incurred and paid claims development as of December 31, 2016, net of reinsurance, as well as cumulative claim frequency and the total of incurred but not reported liabilities (IBNR). The information about incurred and paid claims development for the years ended December 31, 2007 to 2015 is presented as supplementary information. To enhance the comparability of the loss development data, the Company has removed the impact of foreign exchange rate movements by using the December 31, 2016 exchange rate for all periods. In addition, the Company’s UK and European insurance business has been included in the Insurance segment tables below (excluding primary and excess workers' compensation) for accident years 2012 through 2016, since underwriting year information was only available prior to 2012. Insurance Other Liability (In thousands) Primary Workers' Compensation (In thousands) Excess Workers' Compensation (In thousands) Professional Liability (In thousands) Commercial Automobile (In thousands) Short-tail lines (In thousands) Reinsurance Casualty (In thousands) Property (In thousands) The reconciliation of the net incurred and paid claims development tables to the reserves for loss and loss adjustment expenses in the consolidated balance sheet is as follows: The following is supplementary information regarding average historical claims duration as of December 31, 2016: The table below provides a reconciliation of the beginning and ending reserve balances: _______________________________________ (1) Claims occurring during the current year are net of loss reserve discounts of $18,929,000, $20,357,000 and $21,306,000 in 2016, 2015, and 2014 , respectively. (2) The decrease in estimates for claims occurring in prior years is net of loss reserve discount. On an undiscounted basis, the estimates for claims occurring in prior years decreased by $59,175,000, $64,971,000 and $116,866,000 in 2016, 2015 and 2014, respectively. (3) In 2014, the Company entered into a commutation agreement that resulted in a reduction in prior year workers' compensation reserves of $30 million on an undiscounted basis and $12 million on a discounted basis. Favorable prior year development (net of additional and return premiums) was $59 million in 2016. Insurance - Reserves for the Insurance segment developed favorably by $53 million in 2016. The favorable development was primarily related to workers' compensation business, and was partially offset by unfavorable development for medical professional liability business. For workers' compensation, the favorable development was related to both primary and excess business and to many accident years, including those prior to 2007. During 2016, reported workers' compensation losses continued to be below our expectations at most of our operating units. Loss frequency and severity trends continued to be better than the assumptions underlying our previous reserve estimates. Loss severity trends also benefited from our continued investment in medical case management services and from our preferred provider networks. The long term trend of declining workers' compensation frequency can be attributed to improved workplace safety. For medical professional liability business, unfavorable development was primarily related to a class of business that has been discontinued. The adverse development for that business stemmed mainly from accident years 2010 through 2015. Reinsurance - Reserves for the Reinsurance segment developed favorably by $6 million in 2016. The favorable development was primarily related to direct facultative reinsurance business and to accident years 2008 through 2014. Favorable prior year development (net of additional and return premiums) was $63 million in 2015. Insurance - Reserves for the Insurance segment developed favorably by $52 million in 2015. The favorable development was primarily related to workers' compensation, other liability business and commercial property, and was partially offset by unfavorable development for commercial automobile liability business and professional indemnity business. For workers' compensation, the favorable development was related to both primary and excess business and to many accident years, including those prior to 2006. In 2015, reported workers' compensation losses were below our expectations for many of our operating units. In addition, overall loss frequency and severity trends emerged better than the assumptions underlying our previous reserve estimates. The long term trend of declining workers' compensation claim frequency continued in 2015. The improvement is attributable to better workplace safety and to benign medical severity trends as we continue to invest in medical case management services and higher usage of preferred provider networks. For other liability business, favorable development was concentrated in accident years 2007 through 2013. The favorable development was primarily related to our excess and surplus lines casualty business that has benefited from a persistent improvement in claim frequency trends over the past several years. For commercial property business, favorable development was attributable to accident years 2012 through 2014 and was driven by favorable frequency and severity trends on property business written in Lloyd's. For commercial automobile business, adverse development was primarily related to large losses for long-haul trucking business and to accident years 2011 through 2014. The higher loss cost trends for the commercial automobile industry are attributable, in part, to the increase in miles driven as the economy improved and fuel prices declined over the past several years. For Professional indemnity business in the U.K., adverse development was primarily for accident years 2006 through 2013. Reinsurance - Reserves for the Reinsurance segment developed favorably by $11 million in 2015. The favorable development was primarily related to direct facultative reinsurance business and to accident years 2005 through 2013. Loss reserves developed favorably for umbrella business and for other liability coverage for contractors. Favorable prior year development (net of additional and return premiums) was $85 million in 2014. Insurance - For the Insurance segment, favorable development in 2014 of $69 million was driven principally by other liability business for accident years 2006 through 2010, primarily related to our excess and surplus lines casualty business. Reported losses during these years continued to be below our initial expectations at the time the business was written, largely as a result of persistent improvement in claim frequency trends (i.e., number of reported claims per unit of exposure). As these accident years have matured, the weighting of actuarial methods has shifted from methods based on initial expected losses to methods based on actual reported losses. We believe the favorable claim frequency trends we have seen during this time period are due to changes in the mix of business written and to the general slowdown in the economy. Commercial automobile reported unfavorable development primarily as a result of large losses for long-haul trucking business in 2012 and 2013. The favorable development was also offset by adverse reserve development driven primarily by unexpected large losses from accident years 2009-2012 in the professional indemnity line of business in the United Kingdom. Reinsurance - For the Reinsurance segment, favorable reserve development in 2014 of $16 million was driven primarily by assumed professional liability excess of loss and umbrella treaty business, as well as direct facultative business. This was partially offset by adverse development on brokerage facultative business caused by completed operations losses associated with construction projects in accident years prior to 2009. Environmental and Asbestos - To date, known environmental and asbestos claims have not had a material impact on the Company’s operations, because its subsidiaries generally did not insure large industrial companies that are subject to significant environmental or asbestos exposures prior to 1986 when an absolute exclusion was incorporated into standard policy language. The Company’s net reserves for losses and loss expenses relating to asbestos and environmental claims on policies written before adoption of the absolute exclusion was $31 million at December 31, 2016 and $33 million at December 31, 2015. The estimation of these liabilities is subject to significantly greater than normal variation and uncertainty because it is difficult to make an actuarial estimate of these liabilities due to the absence of a generally accepted actuarial methodology for these exposures and the potential effect of significant unresolved legal matters, including coverage issues, as well as the cost of litigating the legal issues. Additionally, the determination of ultimate damages and the final allocation of such damages to financially responsible parties are highly uncertain. Discounting - The Company discounts its liabilities for certain workers’ compensation reserves. The amount of workers’ compensation reserves that were discounted was $1.907 million million and $2.308 million at December 31, 2016 and December 31, 2015, respectively. The aggregate net discount for those reserves, after reflecting the effects of ceded reinsurance, was $640 million and $699 million at December 31, 2016 and 2015, respectively. At December 31, 2016, discount rates by year ranged from 2.0% to 6.5%, with a weighted average discount rate of 3.9%. Substantially all of discounted workers’ compensation reserves (97% of total discounted reserves at December 31, 2016) are excess workers’ compensation reserves. In order to properly match loss expenses with income earned on investment securities supporting the liabilities, reserves for excess workers’ compensation business are discounted using risk-free discount rates determined by reference to the U.S. Treasury yield curve. These rates are determined annually based on the weighted average rate for the period. Once established, no adjustments are made to the discount rate for that period, and any increases or decreases in loss reserves in subsequent years are discounted at the same rate, without regard to when any such adjustments are recognized. The expected loss and loss expense payout patterns subject to discounting are derived from the Company’s loss payout experience. The Company also discounts reserves for certain other long-duration workers’ compensation reserves (representing approximately 3% of total discounted reserves at December 31, 2016), including reserves for quota share reinsurance and reserves related to losses regarding occupational lung disease. These reserves are discounted at statutory rates permitted by the Department of Insurance of the State of Delaware. (15) Reinsurance The Company reinsures a portion of its insurance exposures in order to reduce its net liability on individual risks and catastrophe losses. Reinsurance coverage and retentions vary depending on the line of business, location of the risk and nature of loss. The Company’s reinsurance purchases include the following: property reinsurance treaties that reduce exposure to large individual property losses and catastrophe events; casualty reinsurance treaties that reduce its exposure to large individual casualty losses, workers’ compensation catastrophe losses and casualty losses involving multiple claimants or insureds; and facultative reinsurance that reduces exposure on individual policies or risks for losses that exceed treaty reinsurance capacity. Depending on the operating unit, the Company purchases specific additional reinsurance to supplement the above programs. The following is a summary of reinsurance financial information: The Company reinsures a portion of its exposures principally to reduce its net liability on individual risks and to protect against catastrophic losses. Estimated amounts due from reinsurers are reported net of reserves for uncollectible reinsurance of $1,049,000, $1,020,000 and $1,144,000 as of December 31, 2016, 2015 and 2014, respectively. The following table presents the amounts due from reinsurers as of December 31, 2016: (16) Indebtedness Indebtedness consisted of the following as of December 31, 2016 (the difference between the face value and the carrying value is unamortized discount and debt issuance costs): ________________ (1) Subsidiary debt is due as follows: $4 million in 2017 and $2 million in 2019. (17) Income Taxes Income tax expense (benefits) consists of: Income before income taxes from domestic operations was $837 million, $689 million and $910 million for the years ended December 31, 2016, 2015 and 2014, respectively. Income before income taxes from foreign operations was $59 million, $43 million and $42 million for the years ended December 31, 2016, 2015 and 2014, respectively. A reconciliation of the income tax expense and the amounts computed by applying the Federal and foreign income tax rate of 35% to pre-tax income are as follows: At December 31, 2016 and 2015, the tax effects of differences that give rise to significant portions of the deferred tax asset and deferred tax liability are as follows: The Company had current tax receivables of $14,768,000 and $55,763,000 at December 31, 2016 and 2015, respectively. At December 31, 2016, the Company had foreign net operating loss carryforwards of $5.3 million that expire beginning in 2031, and an additional $29.9 million that have no expiration date. At December 31, 2016, the Company had a valuation allowance of $5.5 million, as compared to $4.0 million at December 31, 2015. The Company has provided a valuation allowance against future tax benefits of certain foreign operations. The statute of limitations has closed for the Company’s U.S. Federal tax returns through December 31, 2012. The realization of the deferred tax asset is dependent upon the Company’s ability to generate sufficient taxable income in future periods. Based on historical results and the prospects for future current operations, management anticipates that it is more likely than not that future taxable income will be sufficient for the realization of this asset. The Company has not provided U.S. deferred income taxes on the undistributed earnings of approximately $55 million of its non-U.S. subsidiaries since these earnings are intended to be permanently reinvested in the non-U.S. subsidiaries. However, in the future, if such earnings were distributed to the Company, taxes of approximately $6.1 million, assuming all tax credits are realized, would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested in the foreign subsidiary. (18) Dividends from Subsidiaries and Statutory Financial Information The Company’s insurance subsidiaries are restricted by law as to the amount of dividends they may pay without the approval of regulatory authorities. The Company’s lead insurer, Berkley Insurance Company (BIC), directly or indirectly owns all of the Company’s other insurance companies. During 2017, the maximum amount of dividends that can be paid by BIC without such approval is approximately $580 million. BIC’s combined net income and statutory capital and surplus, as determined in accordance with statutory accounting practices (SAP), are as follows: The significant variances between SAP and GAAP are that for statutory purposes bonds are carried at amortized cost, acquisition costs are charged to income as incurred, deferred Federal income taxes are subject to limitations, excess and assumed workers’ compensation reserves are discounted at different discount rates and certain assets designated as “non-admitted assets” are charged against surplus. The Commissioner of Insurance of the State of Delaware has allowed BIC to discount non-tabular workers' compensation loss reserves, which is a permitted practice that differs from SAP. The effect of using this permitted practice was an increase to BIC’s statutory capital and surplus by $231 million at December 31, 2016. The National Association of Insurance Commissioners (“NAIC”) has risk-based capital (“RBC”) requirements that require insurance companies to calculate and report information under a risk-based formula which measures statutory capital and surplus needs based on a regulatory definition of risk in a company’s mix of products and its balance sheet. This guidance is used to calculate two capital measurements: Total Adjusted Capital and RBC Authorized Control Level. Total Adjusted Capital is equal to the Company’s statutory capital and surplus excluding capital and surplus derived from the use of permitted practices that differ from statutory accounting practices. RBC Authorized Control Level is the capital level used by regulatory authorities to determine whether remedial action is required. Generally, no remedial action is required if Total Adjusted Capital is 200% or more of the RBC Authorized Control Level. At December 31, 2016, BIC’s Total Adjusted Capital of $5.262 billion was 422% of its RBC Authorized Control Level. See Note 4, Investments in Fixed Maturity Securities, for a description of assets held on deposit as security. (19) Common Stockholders’ Equity The weighted average number of shares used in the computation of net income per share was as follows: Treasury shares have been excluded from average outstanding shares from the date of acquisition. The difference in calculating basic and diluted net income per share is attributable entirely to the dilutive effect of stock-based compensation plans. Changes in shares of common stock outstanding, net of treasury shares, are presented below. Shares of common stock issued and outstanding do not include shares related to unissued restricted stock units and unexercised stock options. The amount of dividends paid is dependent upon factors such as the receipt of dividends from our subsidiaries, our results of operations, cash flow, financial condition and business needs, the capital and surplus requirements of our subsidiaries, and applicable insurance regulations that limit the amount of dividends that may be paid by our regulated insurance subsidiaries. (20) Fair Value of Financial Instruments The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as of December 31, 2016 and 2015: The estimated fair values of the Company’s fixed maturity securities, equity securities available for sale and arbitrage trading account securities are based on various valuation techniques that rely on fair value measurements as described in Note 13 above. The fair value of loans receivable are estimated by using current institutional purchaser yield requirements for loans with similar credit characteristics, which is considered a Level 2 input. The fair value of the senior notes and other debt and the subordinated debentures is based on spreads for similar securities, which is considered a Level 2 input. (21) Lease Obligations The Company and its subsidiaries use office space and equipment under leases expiring at various dates. These leases are considered operating leases for financial reporting purposes. Some of these leases have options to extend the length of the leases and contain clauses for cost of living, operating expense and real estate tax adjustments. Future minimum lease payments, without provision for sublease income, are: $45,305,000 in 2017; $40,634,000 in 2018; $35,805,000 in 2019; $33,575,000 in 2020; $29,374,000 in 2021 and $100,704,000 thereafter. Rental expense was $47,453,000, $46,271,000 and $45,198,000 for 2016, 2015 and 2014, respectively. (22) Commitments, Litigation and Contingent Liabilities In the ordinary course of business, the Company is subject to disputes, litigation and arbitration arising from its insurance and reinsurance businesses. These matters are generally related to insurance and reinsurance claims and are considered in the establishment of loss and loss expense reserves. In addition, the Company may also become involved in legal actions which seek extra-contractual damages, punitive damages or penalties, including claims alleging bad faith in handling of insurance claims. The Company expects its ultimate liability with respect to such matters will not be material to its financial condition. However, adverse outcomes on such matters are possible, from time to time, and could be material to the Company’s results of operations in any particular financial reporting period. At December 31, 2016, the Company had commitments to invest up to $373.2 million and $495.7 million in certain investment funds and real estate construction projects, respectively. (23) Stock Incentive Plan Pursuant to the Company's stock incentive plan, the Company may issue restricted stock units (RSUs) to employees of the Company and its subsidiaries. The RSUs generally vest three to five years from the award date and are subject to other vesting and forfeiture provisions contained in the award agreement. The following table summarizes RSU information for the three years ended December 31, 2016: Upon vesting, shares of the Company’s common stock equal to the number of vested RSUs are issued or deferred to a later date, depending on the terms of the specific award agreement. As of December 31, 2016, 4,097,497 RSUs had been deferred. RSUs that have not yet vested and vested RSUs that have been deferred are not considered to be issued and outstanding shares. The fair value of RSUs at the date of grant are recorded as unearned compensation, a component of stockholders’ equity, and expensed over the vesting period. Following is a summary of changes in unearned compensation for the three years ended December 31, 2016: (24) Compensation Plans The Company and its subsidiaries have profit sharing plans in which substantially all employees participate. The plans provide for minimum annual contributions of 5% of eligible compensation; contributions above the minimum are discretionary and vary with each participating subsidiary’s profitability. Employees become eligible to participate in the plan on the first day of the calendar quarter following the first full calendar quarter after the employee's date of hire provided the employee has completed 250 hours of service during the calendar quarter. The plans provide that 40% of the contributions vest immediately and that the remaining 60% vest at varying percentages based upon years of service. Profit sharing expense was $39 million, $42 million and $38 million in 2016, 2015 and 2014, respectively. The Company has a long-term incentive compensation plan ("LTIP") that provides for incentive compensation to key executives based on the growth in the Company's book value per share over a five year period. The following table summarizes the outstanding LTIP awards as of December 31, 2016: The following table summarizes the LTIP expense for each of the three years ended December 31, 2016: (25) Retirement Benefits The Company and its executive chairman of the board entered into an unfunded supplemental benefit agreement (SBA) in 2004. On March 28, 2013, the Company agreed to terminate and distribute the retirement benefit of the SBA. As a result, the Company distributed retirement benefits of $4.6 million in 2014. The final retirement benefit of $59.4 million, which was fully accrued at December 31, 2014, was distributed in 2015. Net retirement benefit expense was $9,994,000 in 2014, and none in 2015 and 2016. (26) Supplemental Financial Statement Data Other operating costs and expenses consist of the following: (27) Industry Segments The Company’s reportable segments include the following two business segments, plus a corporate segment: •Insurance - commercial insurance business, including excess and surplus lines and admitted lines, throughout the United States, as well as insurance business in the United Kingdom, Continental Europe, South America, Canada, Mexico, Scandinavia, Asia and Australia; and •Reinsurance - reinsurance business on a facultative and treaty basis, primarily in the United States, United Kingdom, Continental Europe, Australia, the Asia-Pacific region and South Africa. Commencing with the first quarter of 2016, the Company changed the aggregation of its reported segments. Operating units in the Insurance-Domestic segment and Insurance-International segment, previously reported separately, were combined into the Insurance segment. The segment disclosures for prior periods have been revised to be consistent with the new reportable business segment presentation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Income tax expense and benefits are calculated based upon the Company’s overall effective tax rate. Summary financial information about the Company’s reporting segments is presented in the following table. Income before income taxes by segment includes allocated investment income. Identifiable assets by segment are those assets used in or allocated to the operation of each segment. _______________________________________ (1) Revenues for Insurance includes $830.8 million, $828.3 million and $890.1 million in 2016, 2015 and 2014, respectively, from foreign countries. Revenues for Reinsurance includes $166.6 million, $186.6 million and $249.3 million in 2016, 2015 and 2014, respectively, from foreign countries. (2) Corporate, other and eliminations represent corporate revenues and expenses and other items that are not allocated to business segments Net premiums earned by major line of business are as follows: (28) Quarterly Financial Information (Unaudited) The following is a summary of quarterly financial data: _______________________________________ (1) Net income per share (“EPS”) in each quarter is computed using the weighted-average number of shares outstanding during that quarter, while EPS for the full year is computed using the weighted-average number of shares outstanding during the year. Thus, the sum of the four quarters EPS does not necessarily equal the full-year EPS.
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Here's a summary of the financial statement:
Key Points:
1. Revenue Recognition:
- Insurance premiums are recorded when policy begins
- Reinsurance premiums are estimated based on information from ceding companies
- Premiums are earned pro rata over policy term
- Service fees are earned as services are provided
- Audit premiums increased by $8
2. Expenses:
- Main accounting estimates include:
* Investment valuations
* Impairment assessments
* Loss and expense reserves
* Premium estimates
3. Liabilities:
- Debt obligations evaluated based on:
* Underlying collateral performance
* Default scenarios
* Projected default rates
* Collateral value
* Issuer payment ability
* Historical performance
4. Additional Important Policies:
- Real estate investments recorded at purchase price/fair value
- Per share data calculated for both basic and diluted EPS
- Deferred policy acquisition costs amortized over contract terms
- Loss and expense reserves are accumulated based on specific criteria
Notable: The statement indicates a conservative accounting approach with emphasis on proper timing of revenue recognition and careful evaluation of liabilities and investments.
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Claude
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Index to Page No. Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Income Consolidated Statements of Cash Flows Consolidated Statements of Equity Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of BorgWarner Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of BorgWarner Inc. and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Detroit, Michigan February 9, 2017 BORGWARNER INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See Accompanying . BORGWARNER INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS See Accompanying . BORGWARNER INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME ____________________________________ * Net of income taxes. See Accompanying . BORGWARNER INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See Accompanying . BORGWARNER INC. AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF EQUITY See Accompanying . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INTRODUCTION BorgWarner Inc. and Consolidated Subsidiaries (the “Company”) is a global product leader in clean and efficient technology solutions for combustion, hybrid and electric vehicles. Our products help improve vehicle performance, propulsion efficiency, stability and air quality. These products are manufactured and sold worldwide, primarily to original equipment manufacturers (“OEMs”) of light vehicles (passenger cars, sport-utility vehicles ("SUVs"), vans and light trucks). The Company's products are also sold to other OEMs of commercial vehicles (medium-duty trucks, heavy-duty trucks and buses) and off-highway vehicles (agricultural and construction machinery and marine applications). We also manufacture and sell our products to certain Tier One vehicle systems suppliers and into the aftermarket for light, commercial and off-highway vehicles. The Company operates manufacturing facilities serving customers in Europe, the Americas and Asia and is an original equipment supplier to every major automotive OEM in the world. The Company's products fall into two reporting segments: Engine and Drivetrain. NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The following paragraphs briefly describe the Company's significant accounting policies. Basis of presentation In the first quarter of 2016, the Company retrospectively adopted Accounting Standard Update ("ASU") No. 2015-03, "Simplifying the Presentation of Debt Issuance Costs," which resulted in the reduction of assets and liabilities by approximately $16 million in the Company's Condensed Consolidated Balance Sheet as of December 31, 2015. Certain prior period amounts have been reclassified to conform to current period presentation. Use of estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the accompanying notes, as well as, the amounts of revenues and expenses reported during the periods covered by these financial statements and accompanying notes. Actual results could differ from those estimates. Principles of consolidation The Consolidated Financial Statements include all majority-owned subsidiaries with a controlling financial interest. All inter-company accounts and transactions have been eliminated in consolidation. Investments in 20% to 50% owned affiliates are accounted for under the equity method when the Company does not have a controlling financial interest. Revenue recognition The Company recognizes revenue when title and risk of loss pass to the customer, which is usually upon shipment of product. Although the Company may enter into long-term supply agreements with its major customers, each shipment of goods is treated as a separate sale and the prices are not fixed over the life of the agreements. Cost of sales The Company includes materials, direct labor and manufacturing overhead within cost of sales. Manufacturing overhead is comprised of indirect materials, indirect labor, factory operating costs and other such costs associated with manufacturing products for sale. Cash Cash is valued at fair market value. It is the Company's policy to classify all highly liquid investments with original maturities of three months or less as cash. Cash is maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with financial institutions of reputable credit and therefore bear minimal risk. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Restricted cash Restricted cash as of December 31, 2015 related to amounts deposited with the paying agent to settle shares of Remy International Inc. ("Remy") stock in connection with the acquisition of Remy on November 10, 2015, that was not paid to the shareholders until the first half of 2016. Receivables, net The Company factors certain receivables through third party financial institutions without recourse. These are treated as a sale. The transactions are accounted for as a reduction in accounts receivable as the agreements transfer effective control over and risk related to the receivables to the buyers. The Company does not service any domestic accounts after the factoring has occurred. The Company does not have any servicing assets or liabilities. See the Balance Sheet Information footnote to the Consolidated Financial Statements for more information on receivables, net. Inventories, net Inventories are valued at the lower of cost or market. Cost of certain U.S. inventories is determined using the last-in, first-out (“LIFO”) method, while other U.S. and foreign operations use the first-in, first-out (“FIFO”) or average-cost methods. Inventory held by U.S. operations using the LIFO method was $131.4 million and $122.2 million at December 31, 2016 and 2015, respectively. Such inventories, if valued at current cost instead of LIFO, would have been greater by $15.2 million and $14.2 million at December 31, 2016 and 2015, respectively. See the Balance Sheet Information footnote to the Consolidated Financial Statements for more information on inventories, net. Pre-production costs related to long-term supply arrangements Engineering, research and development and other design and development costs for products sold on long-term supply arrangements are expensed as incurred unless the Company has a contractual guarantee for reimbursement from the customer. Costs for molds, dies and other tools used to make products sold on long-term supply arrangements for which the Company either has title to the assets or has the non-cancelable right to use the assets during the term of the supply arrangement are capitalized in property, plant and equipment and amortized to cost of sales over the shorter of the term of the arrangement or over the estimated useful lives of the assets, typically three to five years. Costs for molds, dies and other tools used to make products sold on long-term supply arrangements for which the Company has a contractual guarantee for lump sum reimbursement from the customer are capitalized in prepayments and other current assets. Property, plant and equipment, net Property, plant and equipment is valued at cost less accumulated depreciation. Expenditures for maintenance, repairs and renewals of relatively minor items are generally charged to expense as incurred. Renewals of significant items are capitalized. Depreciation is generally computed on a straight-line basis over the estimated useful lives of the assets. Useful lives for buildings range from 15 to 40 years and useful lives for machinery and equipment range from three to 12 years. For income tax purposes, accelerated methods of depreciation are generally used. See the Balance Sheet Information footnote to the Consolidated Financial Statements for more information on property, plant and equipment, net. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Impairment of long-lived assets, including definite-lived intangible assets The Company reviews the carrying value of its long-lived assets, whether held for use or disposal, including other amortizing intangible assets, when events and circumstances warrant such a review under Accounting Standards Codification ("ASC") Topic 360. In assessing long-lived assets for an impairment loss, assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. In assessing long-lived assets for impairment, management generally considers individual facilities the lowest level for which identifiable cash flows are largely independent. A recoverability review is performed using the undiscounted cash flows if there is a triggering event. If the undiscounted cash flow test for recoverability identifies a possible impairment, management will perform a fair value analysis. Management determines fair value under ASC Topic 820 using the appropriate valuation technique of market, income or cost approach. If the carrying value of a long-lived asset is considered impaired, an impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value. Management believes that the estimates of future cash flows and fair value assumptions are reasonable; however, changes in assumptions underlying these estimates could affect the valuations. Long-lived assets held for sale are recorded at the lower of their carrying amount or fair value less cost to sell. Significant judgments and estimates used by management when evaluating long-lived assets for impairment include: (i) an assessment as to whether an adverse event or circumstance has triggered the need for an impairment review; (ii) undiscounted future cash flows generated by the asset; and (iii) fair valuation of the asset. Goodwill and other indefinite-lived intangible assets During the fourth quarter of each year, the Company qualitatively assesses its goodwill and indefinite-lived intangible assets assigned to each of its reporting units. This qualitative assessment evaluates various events and circumstances, such as macro economic conditions, industry and market conditions, cost factors, relevant events and financial trends, that may impact a reporting unit's fair value. Using this qualitative assessment, the Company determines whether it is more-likely-than-not the reporting unit's fair value exceeds its carrying value. If it is determined that it is not more-likely-than-not the reporting unit's fair value exceeds the carrying value, or upon consideration of other factors, including recent acquisition or divestiture activity, the Company performs a quantitative, "step one," goodwill impairment analysis. In addition, the Company may test goodwill in between annual test dates if an event occurs or circumstances change that could more-likely-than-not reduce the fair value of a reporting unit below its carrying value. See the Goodwill and Other Intangibles footnote to the Consolidated Financial Statements for more information on goodwill and other indefinite-lived intangible assets. Product warranties The Company provides warranties on some, but not all, of its products. The warranty terms are typically from one to three years. Provisions for estimated expenses related to product warranty are made at the time products are sold. These estimates are established using historical information about the nature, frequency and average cost of warranty claim settlements as well as product manufacturing and industry developments and recoveries from third parties. Management actively studies trends of warranty claims and takes action to improve product quality and minimize warranty claims. Management believes that the warranty accrual is appropriate; however, actual claims incurred could differ from the original estimates, requiring adjustments to the accrual. The product warranty accrual is allocated to current and non-current liabilities in the Consolidated Balance Sheets. See the Product Warranty footnote to the Consolidated Financial Statements for more information on product warranties. Other loss accruals and valuation allowances The Company has numerous other loss exposures, such as customer claims, workers' compensation claims, litigation and recoverability of assets. Establishing loss accruals or valuation allowances for these matters requires the use of estimates and judgment in regard to the risk exposure and ultimate realization. The Company estimates losses under the programs using NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) consistent and appropriate methods, however, changes to its assumptions could materially affect the recorded accrued liabilities for loss or asset valuation allowances. Asbestos The Company and certain of its subsidiaries along with numerous other companies are named as defendants in personal injury lawsuits based on alleged exposure to asbestos-containing materials. With the assistance of third party consultants, the Company estimates the liability and corresponding insurance recovery for pending and future claims not yet asserted through December 31, 2059 with a runoff through 2067 and defense costs. This estimate is based on the Company's historical claim experience and estimates of the number and resolution cost of potential future claims that may be filed based on anticipated levels of unique plaintiff asbestos-related claims in the U.S. tort system against all defendants. This estimate is not discounted to present value. The Company currently believes that December 31, 2067 is a reasonable assumption as to the last date on which it is likely to have resolved all asbestos-related claims, based on the nature and useful life of the Company’s products and the likelihood of incidence of asbestos-related disease in the U.S. population generally. The Company assesses the sufficiency of its estimated liability for pending and future claims and defense costs on an ongoing basis by evaluating actual experience regarding claims filed, settled and dismissed, and amounts paid in settlements. In addition to claims and settlement experience, the Company considers additional quantitative and qualitative factors such as changes in legislation, the legal environment, and the Company's defense strategy. The Company continues to have additional excess insurance coverage available for potential future asbestos-related claims. In connection with the Company’s ongoing review of its asbestos-related claims, the Company also reviewed the amount of its potential insurance coverage for such claims, taking into account the remaining limits of such coverage, the number and amount of claims on our insurance from co-insured parties, ongoing litigation against the Company’s insurers, potential remaining recoveries from insolvent insurers, the impact of previous insurance settlements, and coverage available from solvent insurers not party to the coverage litigation. See the Contingencies footnote to the Consolidated Financial Statements for more information regarding management's judgments applied in the recognition and measurement of asbestos-related assets and liabilities. Environmental contingencies The Company accounts for environmental costs in accordance with ASC Topic 450. Costs related to environmental assessments and remediation efforts at operating facilities are accrued when it is probable that a liability has been incurred and the amount of that liability can be reasonably estimated. Estimated costs are recorded at undiscounted amounts, based on experience and assessments and are regularly evaluated. The liabilities are recorded in accounts payable and accrued expenses and other non-current liabilities in the Company's Consolidated Balance Sheets. See the Contingencies footnote to the Consolidated Financial Statements for more information regarding environmental contingencies. Derivative financial instruments The Company recognizes that certain normal business transactions generate risk. Examples of risks include exposure to exchange rate risk related to transactions denominated in currencies other than the functional currency, changes in commodity costs and interest rates. It is the objective and responsibility of the Company to assess the impact of these transaction risks and offer protection from selected risks through various methods, including financial derivatives. Virtually all derivative instruments held by the Company are designated as hedges, have high correlation with the underlying exposure and are highly effective in offsetting underlying price movements. Accordingly, gains and losses from changes in qualifying hedge fair values are matched with the underlying transactions. All hedge instruments are carried at their fair value based on quoted market prices for contracts with similar maturities. The Company does not engage in any derivative transactions for purposes other than hedging specific risks. See the Financial Instruments footnote to the Consolidated Financial Statements for more information on derivative financial instruments. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Foreign currency The financial statements of foreign subsidiaries are translated to U.S. dollars using the period-end exchange rate for assets and liabilities and an average exchange rate for each period for revenues, expenses and capital expenditures. The local currency is the functional currency for substantially all of the Company's foreign subsidiaries. Translation adjustments for foreign subsidiaries are recorded as a component of accumulated other comprehensive income (loss) in equity. The Company recognizes transaction gains and losses arising from fluctuations in currency exchange rates on transactions denominated in currencies other than the functional currency in earnings as incurred. See the Accumulated Other Comprehensive Loss footnote to the Consolidated Financial Statements for more information on accumulated other comprehensive loss. Pensions and other postretirement employee defined benefits The Company's defined benefit pension and other postretirement employee benefit plans are accounted for in accordance with ASC Topic 715. Disability, early retirement and other postretirement employee benefits are accounted for in accordance with ASC Topic 712. Pensions and other postretirement employee benefit costs and related liabilities and assets are dependent upon assumptions used in calculating such amounts. These assumptions include discount rates, expected returns on plan assets, health care cost trends, compensation and other factors. In accordance with GAAP, actual results that differ from the assumptions used are accumulated and amortized over future periods, and accordingly, generally affect recognized expense in future periods. See the Retirement Benefit Plans footnote to the Consolidated Financial Statements for more information regarding the Company's pension and other postretirement employee defined benefit plans. Income taxes In accordance with ASC Topic 740, the Company's income tax expense is calculated based on expected income and statutory tax rates in the various jurisdictions in which the Company operates and requires the use of management's estimates and judgments. See the Income Taxes footnote to the Consolidated Financial Statements for more information regarding income taxes. New Accounting Pronouncements In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2017-04, "Simplifying the Test for Goodwill Impairment." It eliminates Step 2 from the goodwill impairment test and an entity should recognize an impairment charge for the amount by which the carrying amount of goodwill exceeds the reporting unit's fair value, not to exceed the carrying amount of goodwill. This guidance is effective for annual and any interim impairment tests in fiscal years beginning after December 15, 2019. The Company does not expect this guidance to have any impact on its Consolidated Financial Statements. In January 2017, the FASB issued Accounting Standards Update ("ASU") No. 2017-01, "Clarifying the Definition of a Business." It revises the definition of a business and provides a framework to evaluate when an input and a substantive process are present in an acquisition to be considered a business. This guidance is effective for annual periods beginning after December 15, 2017. The Company does not expect this guidance to have any impact on its Consolidated Financial Statements. In November 2016, the FASB issued ASU No. 2016-18, "Restricted Cash." It requires that amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This guidance is effective for interim and annual reporting periods beginning after NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 15, 2017. The Company does not expect this guidance to have a material impact on its Consolidated Financial Statements. In August 2016, the FASB issued ASU No. 2016-15, "Classification of Certain Cash Receipts and Cash Payments." It provides guidance on eight specific cash flow issues with the objective of reducing the existing diversity in practice in how they are classified in the statement of cash flows. This guidance is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted, provided that all of the amendments are adopted in the same period. The Company does not expect this guidance to have a material impact on its Consolidated Financial Statements. In March 2016, the FASB issued ASU No. 2016-09, "Improvements to Employee Share-Based Payment Accounting." Under this guidance, the areas of simplification involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, impact on earnings per share and classification on the statement of cash flows. This guidance is effective for interim and annual reporting periods beginning after December 15, 2016 and the Company will adopt this guidance in the first quarter of 2017. Upon the adoption of the guidance, all of the tax effects of share-based payments will be recorded in the income statement. The impact to the Consolidated Financial Statements will be dependent upon the underlying vesting or exercise activity and related future stock prices. The Company is currently evaluating the other impacts this guidance will have on its Consolidated Financial Statements. In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)." Under this guidance, lessees will be required to recognize a right-of-use asset and a lease liability for all operating leases defined under previous GAAP. This guidance is effective for interim and annual reporting periods beginning after December 15, 2018. The Company is currently evaluating the impact this guidance will have on its Consolidated Financial Statements. In September 2015, the FASB issued ASU No. 2015-16, "Simplifying the Accounting for Measurement-Period Adjustments." Under this guidance, an acquirer is required to recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. This guidance is effective for interim and annual reporting periods beginning after December 15, 2015. The Company adopted this guidance in the first quarter of 2016 and recorded fair value adjustments related to the Remy acquisition based on new information obtained during the measurement period primarily related to warranty, inventory, and deferred taxes. These adjustments have resulted in a decrease in goodwill of $12.1 million from the Company's initial estimate recorded in 2016. In August 2015, the FASB issued ASU No. 2015-15, "Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements." Under this guidance, debt issuance costs associated with line-of-credit arrangements would be deferred as an asset and amortized ratably over the term, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. This guidance is effective for interim and annual reporting periods beginning after December 15, 2015 and the Company adopted this guidance in the first quarter of 2016 with no impact on the Company's Consolidated Financial Statements. In July 2015, the FASB issued ASU No. 2015-11, "Simplifying the Measurement of Inventory." Under this guidance, inventory should be measured at the lower of cost and net realizable value. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. This guidance is effective for interim and annual reporting periods beginning after December 15, 2016. The Company does not expect this guidance to have a material impact on its Consolidated Financial Statements. In May 2015, the FASB issued ASU No. 2015-07, "Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent)." Under this guidance, investments measured at net asset value, as a practical expedient for fair value, are excluded from the fair value hierarchy. This guidance is effective for interim and annual reporting periods beginning after December 15, 2015 and the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Company adopted this guidance in the first quarter of 2016. The pension asset disclosure has been updated retrospectively to reflect this guidance and there is no impact on the Company's Consolidated Financial Statements. In May 2014, the FASB amended the Accounting Standards Codification to add Topic 606, "Revenue from Contracts with Customers," outlining a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and superseding most current revenue recognition guidance. This guidance is effective for interim and annual reporting periods beginning after December 15, 2017. The Company anticipates changes to the revenue recognition of pre-production activities such as customer owned tooling and engineering design & development recoveries, including the potential recording of these items as revenue. Further, the Company is currently analyzing the impact of the new guidance on its contracts and customer arrangements that include various pricing structures and cancellation clauses, which could impact the timing of revenue recognition. The Company expects to adopt this guidance effective January 1, 2018 utilizing the Modified Retrospective approach and is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements. NOTE 2 RESEARCH AND DEVELOPMENT COSTS The Company's net Research & Development ("R&D") expenditures are included in selling, general and administrative expenses of the Consolidated Statements of Operations. Customer reimbursements are netted against gross R&D expenditures as they are considered a recovery of cost. Customer reimbursements for prototypes are recorded net of prototype costs based on customer contracts, typically either when the prototype is shipped or when it is accepted by the customer. Customer reimbursements for engineering services are recorded when performance obligations are satisfied in accordance with the contract and accepted by the customer. Financial risks and rewards transfer upon shipment, acceptance of a prototype component by the customer or upon completion of the performance obligation as stated in the respective customer agreement. The following table presents the Company’s gross and net expenditures on R&D activities: Net R&D expenditures as a percentage of net sales were 3.8%, 3.8% and 4.0% for the years ended December 31, 2016, 2015 and 2014, respectively. The Company has contracts with several customers at the Company's various R&D locations. No such contract exceeded 5% of net R&D expenditures in any of the years presented. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 3 OTHER EXPENSE, NET Items included in other expense, net consist of: In the fourth quarter of 2016, the Company determined that its best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, is $879.3 million as of December 31, 2016. The Company recorded a charge of $703.6 million before tax ($440.6 million after tax) in Other Expense, representing the difference in the total liability from what was previously accrued, consulting fees, less available insurance coverage. See the Contingencies footnote to the Consolidated Financial Statements for further discussion. During the fourth quarter of 2015, the Company acquired 100% of the equity interests in Remy. During the year ended December 31, 2016 and 2015, the Company incurred $23.7 million and $21.8 million of transition and realignment expenses and other professional fees associated with this transaction. Additionally, in October 2016, the Company entered into a definitive agreement to sell the light vehicle aftermarket business associated with Remy. This transaction closed in the fourth quarter of 2016 and the Company recorded loss on divestiture of $127.1 million in the year ended December 31, 2016. See the Recent Transactions footnote to the Consolidated Financial Statements for further discussion of this transaction. During the years ended December 31, 2016, 2015 and 2014, the Company recorded restructuring expense of $26.9 million, $65.7 million and $90.8 million, respectively, primarily related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. The restructuring expense also includes amounts related to a global realignment plan intended to enhance treasury management flexibility. See the Restructuring footnote to the Consolidated Financial Statements for further discussion of these expenses. During the fourth quarter of 2016 and 2014, respectively, the Company recorded an intangible asset impairment loss of $12.6 million related to Engine segment Etatech’s ECCOS intellectual technology and $10.3 million related to Engine segment unamortized trade names. The ECCOS intellectual technology impairment is due to the discontinuance of interest from potential customers during the fourth quarter of 2016 that significantly lowered the commercial feasibility of the product line. During the fourth quarter of 2015, the Company settled approximately $48 million of its projected benefit obligation by transferring approximately $48 million in plan assets through a lump-sum pension de-risking disbursement made to an insurance company. This agreement unconditionally and irrevocably guarantees all future payments to certain participants that were receiving payments from the U.S. pension plan. The insurance company assumes all investment risk associated with the assets that were delivered as part of this transaction. As a result, the Company recorded a non-cash settlement loss of $25.7 million related to the accelerated recognition of unamortized losses. Additionally, during the third quarter of 2014, the Company discharged certain U.S. pension plan obligations by making lump-sum payments to former employees of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) the Company. As a result of this action, the Company recorded a settlement loss of $3.1 million in the U.S. pension plan. During the first quarter of 2015, the Company completed the purchase of the remaining 51% of BERU Diesel Start Systems Pvt. Ltd. ("BERU Diesel") by acquiring the shares of its former joint venture partner. As a result of this transaction, the Company recorded a $10.8 million gain on the previously held equity interest in this joint venture. See the Recent Transactions footnote to the Consolidated Financial Statements for further discussion of this acquisition. NOTE 4 INCOME TAXES Earnings before income taxes and the provision for income taxes are presented in the following table. The provision for income taxes resulted in an effective tax rate of 15.9%, 30.3% and 29.9% for the years ended December 31, 2016, 2015 and 2014, respectively. An analysis of the differences between the effective tax rate and the U.S. statutory rate for the years ended December 31, 2016, 2015 and 2014 is presented below. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company's provision for income taxes for the year ended December 31, 2016, includes tax benefits of $263.0 million, $22.7 million, $8.6 million, $6.0 million and $4.4 million associated with an asbestos-related charge, loss on divestiture, other one-time adjustments, restructuring expense and intangible asset impairment loss, respectively, discussed in the Other Expense, Net footnote. Additionally, this rate includes a tax expense of $2.2 million related to a gain associated with the release of certain Remy light vehicle aftermarket liabilities due to the expiration of a customer contract. The Company's provision for income taxes for the year ended December 31, 2015, includes tax benefits of $9.0 million, $3.8 million and $3.7 million related to the pension settlement loss, merger and acquisition expense and restructuring expense, respectively, discussed in the Other Expense, Net footnote. Additionally, this rate includes a tax benefit of $9.9 million primarily related to foreign tax incentives and tax settlements. The Company's provision for income taxes for the year ended December 31, 2014, includes tax benefits of $15.3 million, $0.4 million and $1.1 million related to restructuring expense, intangible asset impairment losses and the pension settlement loss, respectively, discussed in the Other Expense, Net footnote. A roll forward of the Company's total gross unrecognized tax benefits for the years ended December 31, 2016 and 2015, respectively, is presented below. Of the total $88.6 million of unrecognized tax benefits as of December 31, 2016, approximately $69.9 million of the total represents the amount that, if recognized, would affect the Company's effective income tax rate in future periods. This amount differs from the gross unrecognized tax benefits presented in the table due to the decrease in the U.S. federal income taxes which would occur upon recognition of the state tax benefits and U.S. foreign tax credits included therein. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Remy applied for a bilateral Advance Pricing Agreement ("APA") between the U.S. Internal Revenue Service and South Korea National Tax Service covering the tax years 2007 through 2014. At December 31, 2015, the Company recorded an uncertain tax benefit and related U.S. foreign tax credits of approximately $44.0 million. In the second quarter of 2016, the Company received the signed APA from the tax authorities and reclassified the related uncertain tax benefit to a current tax payable, which the Company paid in the third quarter of 2016. The Company recognizes interest and penalties related to unrecognized tax benefits in income tax expense. The amount recognized in income tax expense for 2016 and 2015 is $3.2 million and $2.3 million, respectively. The Company has an accrual of approximately $16.0 million and $12.8 million for the payment of interest and penalties at December 31, 2016 and 2015, respectively. The Company estimates that payments of approximately $15.5 million will be made in the next 12 months for assessed tax liabilities from certain taxing jurisdictions and has reclassified this amount to current in the balance sheet as shown in the Balance Sheet Information footnote. Other possible changes within the next 12 months cannot be reasonably estimated at this time. The Company and/or one of its subsidiaries files income tax returns in the U.S. federal, various state jurisdictions and various foreign jurisdictions. In certain tax jurisdictions, the Company may have more than one taxpayer. The Company is no longer subject to income tax examinations by tax authorities in its major tax jurisdictions as follows: In the U.S., certain tax attributes created in years prior to 2012 were subsequently utilized. Even though the U.S. federal statute of limitations has expired for years prior to 2012, the years in which these tax attributes were created could still be subject to examination, limited to only the examination of the creation of the tax attribute. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The gross components of deferred tax assets and liabilities as of December 31, 2016 and 2015 consist of the following: At December 31, 2016, certain non-U.S. subsidiaries have net operating loss carryforwards totaling $134.7 million available to offset future taxable income. Of the total $134.7 million, $96.6 million expire at various dates from 2017 through 2036 and the remaining $38.1 million have no expiration date. The Company has a valuation allowance recorded against $72.9 million of the $134.7 million of non-U.S. net operating loss carryforwards. Certain U.S. subsidiaries have state net operating loss carryforwards totaling $817.8 million which are partially offset by a valuation allowance of $632.3 million. The state net operating loss carryforwards expire at various dates from 2017 to 2037. Certain U.S. subsidiaries also have state tax credit carryforwards of $14.8 million which are fully offset by a valuation allowance of $14.8 million. Certain non-U.S. subsidiaries located in China, Korea and Poland had tax exemptions or tax holidays, which reduced tax expense approximately $25.5 million and $21.2 million in 2016 and 2015, respectively. The U.S. has foreign tax credit carryforwards of $139.5 million, which expire at various dates from 2018 through 2025. The Company is not required to provide U.S. federal or state income taxes on cumulative undistributed earnings of foreign subsidiaries when such earnings are considered permanently reinvested. The Company's policy is to evaluate this assertion on a quarterly basis. At December 31, 2016, the Company's deferred tax liability associated with unremitted foreign earnings was $38.5 million. In connection with the acquisition of Remy in 2015, management executed a legal restructuring plan to align the Remy and BorgWarner non-US businesses. This transaction resulted in a taxable gain in the U.S., which was partially offset by Remy tax attributes including a net operating loss carryforward of $68.4 million, foreign tax credits of $93.6 million, and research and development credits of $6.9 million. The net impact of this transaction with the filing of Remy’s final 2015 U.S. consolidated federal tax return resulted in a foreign tax credit carryforward of $47.0 million. The net U.S. cash tax liability resulting from the transaction was $8.4 million. The Company has not recorded deferred income taxes on the difference between the book and tax basis of investments in foreign subsidiaries or foreign equity affiliates totaling approximately $3.9 billion in NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 2016, as these amounts are essentially permanent in nature. The difference will become taxable upon repatriation of assets, sale or liquidation of the investment. Due to fluctuation in tax laws around the world and fluctuations in foreign exchange rates, it is not practicable to determine the unrecognized deferred tax liability on this difference because the actual tax liability, if any, is dependent on circumstances existing when the repatriation occurs. NOTE 5 BALANCE SHEET INFORMATION Detailed balance sheet data is as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) As of December 31, 2016 and December 31, 2015, accounts payable of $85.3 million and $76.9 million, respectively, were related to property, plant and equipment purchases. Interest costs capitalized for the years ended December 31, 2016, 2015 and 2014 were $14.1 million, $16.5 million and $13.5 million, respectively. NSK-Warner KK ("NSK-Warner") The Company has a 50% interest in NSK-Warner, a joint venture based in Japan that manufactures automatic transmission components. The Company's share of the earnings reported by NSK-Warner is accounted for using the equity method of accounting. NSK-Warner is the joint venture partner with a 40% interest in the Drivetrain Segment's South Korean subsidiary, BorgWarner Transmission Systems Korea Ltd. Dividends from NSK-Warner were $34.3 million, $18.0 million and $45.1 million in calendar years ended December 31, 2016, 2015 and 2014, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NSK-Warner has a fiscal year-end of March 31. The Company's equity in the earnings of NSK-Warner consists of the 12 months ended November 30. Following is summarized financial data for NSK-Warner, translated using the ending or periodic rates, as of and for the years ended November 30, 2016, 2015 and 2014 (unaudited): NSK-Warner had no debt outstanding as of November 30, 2016 and 2015. Purchases by the Company from NSK-Warner were $23.9 million, $23.0 million and $21.3 million for the years ended December 31, 2016, 2015 and 2014, respectively. NOTE 6 GOODWILL AND OTHER INTANGIBLES During the fourth quarter of each year, the Company qualitatively assesses its goodwill and indefinite-lived intangible assets assigned to each of its reporting units. This qualitative assessment evaluates various events and circumstances, such as macro economic conditions, industry and market conditions, cost factors, relevant events and financial trends, that may impact a reporting unit's fair value. Using this qualitative assessment, the Company determines whether it is more-likely-than-not the reporting unit's fair value exceeds its carrying value. If it is determined that it is not more-likely-than-not the reporting unit's fair value exceeds the carrying value, or upon consideration of other factors, including recent acquisition or divestiture activity, the Company performs a quantitative, "step one," goodwill impairment analysis. In addition, the Company may test goodwill in between annual test dates if an event occurs or circumstances change that could more-likely-than-not reduce the fair value of a reporting unit below its carrying value. During the fourth quarter of 2016, the Company performed a qualitative analysis on each reporting unit, except for the reporting unit with recent acquisition and divestiture activities, and determined it was more-likely-than-not the fair value exceeded the carrying value of these reporting units. For the reporting unit with acquisition and divestiture activities, the Company performed a quantitative, "step one," goodwill impairment analysis, which requires the Company to make significant assumptions and estimates about the extent and timing of future cash flows, discount rates and growth rates. The basis of this goodwill impairment analysis is the Company's annual budget and long-range plan (“LRP”). The annual budget and LRP includes a five year projection of future cash flows based on actual new products and customer commitments and assumes the last year of the LRP data is a fair indication of the future performance. Because the LRP is estimated over a significant future period of time, those estimates and assumptions are subject to a high degree of uncertainty. Further, the market valuation models and other financial ratios used by the Company require NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) certain assumptions and estimates regarding the applicability of those models to the Company's facts and circumstances. The Company believes the assumptions and estimates used to determine the estimated fair value are reasonable. Different assumptions could materially affect the estimated fair value. The primary assumptions affecting the Company's December 31, 2016 goodwill quantitative, "step one," impairment review are as follows: • Discount rate: The Company used a 10% weighted average cost of capital (“WACC”) as the discount rate for future cash flows. The WACC is intended to represent a rate of return that would be expected by a market participant. • Operating income margin: The Company used historical and expected operating income margins, which may vary based on the projections of the reporting unit being evaluated. In addition to the above primary assumptions, the Company notes the following risks to volume and operating income assumptions that could have an impact on the discounted cash flow models: • The automotive industry is cyclical and the Company's results of operations would be adversely affected by industry downturns. • The Company is dependent on market segments that use our key products and would be affected by decreasing demand in those segments. • The Company is subject to risks related to international operations. Based on the assumptions outlined above, the impairment testing conducted in the fourth quarter of 2016 indicated the Company's goodwill assigned to the reporting unit that was quantitatively assessed was not impaired and contained a fair value substantially higher than the reporting unit's carrying value. Additionally, sensitivity analyses were completed indicating a one percent increase in the discount rate or a one percent decrease in the operating margin assumptions would not result in the carrying value exceeding the fair value of the reporting unit quantitatively assessed. The changes in the carrying amount of goodwill for the years ended December 31, 2016 and 2015 are as follows: ________________ * Acquisitions relate to the Company's 2015 purchases of Remy and BERU Diesel and fair value adjustments in 2016 based on new information obtained during the measurement period for Remy acquisition. ** Divestitures relate to the Company's 2016 disposition of Remy light vehicle aftermarket business and Divgi-Warner Private Limited. . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company’s other intangible assets, primarily from acquisitions, consist of the following: Amortization of other intangible assets was $40.4 million, $19.2 million and $27.2 million for the years ended December 31, 2016, 2015 and 2014, respectively. The estimated useful lives of the Company's amortized intangible assets range from three to 15 years. The Company utilizes the straight line method of amortization recognized over the estimated useful lives of the assets. The estimated future annual amortization expense, primarily for acquired intangible assets, is as follows: $36.9 million in 2017, $35.7 million in 2018, $35.2 million in 2019, $34.8 million in 2020 and $34.8 million in 2021. A roll forward of the gross carrying amounts of the Company's other intangible assets is presented below: ________________ * Acquisitions relate to the Company's 2015 purchases of Remy and BERU Diesel. ** Relates to the impairment of the Company's Etatech ECCOS intellectual technology in 2016. *** Divestiture relates to the Company's sale of Remy light vehicle aftermarket business in 2016. A roll forward of the accumulated amortization associated with the Company's other intangible assets is presented below: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 7 PRODUCT WARRANTY The changes in the carrying amount of the Company’s total product warranty liability for the years ended December 31, 2016 and 2015 were as follows: Acquisition activity in 2016 of $6.9 million relates to the Company's accrual for product issues that pre-dated the Company's 2015 acquisition of Remy. Disposition activity in 2016 of $9.1 million relates to the sale of the Remy light vehicle aftermarket business. Acquisitions activity in 2015 of $12.3 million, relates to $29.4 million in warranty liability associated with the Company's purchase of Remy, partially offset by $17.1 million related to a significant settled warranty claim associated with a product issue that pre-dated the Company's 2014 acquisition of Gustav Wahler GmbH u. Co. KG and its general partner ("Wahler"). Including the impact of the reversal of a corresponding receivable, the Wahler settlement had an immaterial impact on the Consolidated Balance Sheet at December 31, 2015 and Consolidated Statement of Operations for the year ended December 31, 2015. The Company’s warranty provision as a percentage of net sales has increased from 0.4% as of December 31, 2015 to 0.7% as of December 31, 2016. This change is primarily related to the Company’s fourth quarter 2015 acquisition of Remy. Furthermore, the Company's 2016 provision includes a $5.2 million warranty reversal related to the expiration of a Remy light vehicle aftermarket customer contract. The product warranty liability is classified in the Consolidated Balance Sheets as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 8 NOTES PAYABLE AND LONG-TERM DEBT As of December 31, 2016 and 2015, the Company had short-term and long-term debt outstanding as follows: In July 2016, the Company terminated interest rate swaps which had the effect of converting $384 million of fixed rate notes to variable rates. The gain on the termination is being amortized into interest expense over the remaining terms of the notes. The value related to these swap terminations as of December 31, 2016 was $3.9 million and $1.3 million on the 4.625% and 8.00% notes, respectively, as an increase to the notes. The value of these interest rate swaps as of December 31, 2015 was $1.9 million and $0.8 million on the 4.625% and 8.00% notes, respectively, as a decrease to the notes. The Company terminated fixed to floating interest rate swaps in 2009. The gain on the termination is being amortized into interest expense over the remaining term of the note. The value related to this swap termination at December 31, 2016 was $4.1 million on the 8.00% note as an increase to the note. The value related to these swap terminations at December 31, 2015 was $2.4 million and $5.5 million on the 5.75% and 8.00% notes, respectively, as an increase to the notes. The weighted average interest rate on short-term borrowings outstanding as of December 31, 2016 and 2015 was 2.3% and 1.3%, respectively. The weighted average interest rate on all borrowings outstanding, including the effects of outstanding swaps, as of December 31, 2016 and 2015 was 3.8% and 3.6%, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Annual principal payments required as of December 31, 2016 are as follows : The Company's long-term debt includes various covenants, none of which are expected to restrict future operations. The Company has a $1 billion multi-currency revolving credit facility which includes a feature that allows the Company's borrowings to be increased to $1.25 billion. The facility provides for borrowings through June 30, 2019. The Company has one key financial covenant as part of the credit agreement which is a debt to EBITDA ("Earnings Before Interest, Taxes, Depreciation and Amortization") ratio. The Company was in compliance with the financial covenant at December 31, 2016 and expects to remain compliant in future periods. At December 31, 2016 and December 31, 2015, the Company had no outstanding borrowings under this facility. The Company's commercial paper program allows the Company to issue short-term, unsecured commercial paper notes up to a maximum aggregate principal amount outstanding of $1 billion. Under this program, the Company may issue notes from time to time and will use the proceeds for general corporate purposes. At December 31, 2016 and 2015, the Company had outstanding borrowings of $50.8 million and $215.0 million, respectively, under this program, which is classified in the Consolidated Balance Sheets in Notes payable and other short-term debt. The total current combined borrowing capacity under the multi-currency revolving credit facility and commercial paper program cannot exceed $1 billion. As of December 31, 2016 and 2015, the estimated fair values of the Company's senior unsecured notes totaled $2,081.4 million and $2,197.6 million, respectively. The estimated fair values were $62.0 million and $17.7 million higher than their carrying value at December 31, 2016 and 2015, respectively. Fair market values of the senior unsecured notes are developed using observable values for similar debt instruments, which are considered Level 2 inputs as defined by ASC Topic 820. The carrying values of the Company's multi-currency revolving credit facility and commercial paper program approximates fair value. The fair value estimates do not necessarily reflect the values the Company could realize in the current markets. The Company had outstanding letters of credit of $32.3 million and $29.3 million at December 31, 2016 and 2015, respectively. The letters of credit typically act as guarantees of payment to certain third parties in accordance with specified terms and conditions. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 9 FAIR VALUE MEASUREMENTS ASC Topic 820 emphasizes that fair value is a market-based measurement, not an entity specific measurement. Therefore, a fair value measurement should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering market participant assumptions in fair value measurements, ASC Topic 820 establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair values as follows: Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets; Level 2: Inputs, other than quoted prices in active markets, that are observable either directly or indirectly; and Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. Assets and liabilities measured at fair value are based on one or more of the following three valuation techniques noted in ASC Topic 820: A. Market approach: Prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets or liabilities, such as a business. B. Cost approach: Amount that would be required to replace the service capacity of an asset (replacement cost). C. Income approach: Techniques to convert future amounts to a single present amount based upon market expectations (including present value techniques, option-pricing and excess earnings models). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following tables classify assets and liabilities measured at fair value on a recurring basis as of December 31, 2016 and 2015: The following tables classify the Company's defined benefit plan assets measured at fair value on a recurring basis as of December 31, 2016 and 2015: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) ________________ (a) Certain assets that are measured at fair value using the NAV per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy. These amounts represent investments in commingled and managed funds which have underlying assets in fixed income securities, equity securities, and other assets. Refer to the Retirement Benefit Plans footnote to the Consolidated Financial Statements for more detail surrounding the defined plan’s asset investment policies and strategies, target allocation percentages and expected return on plan asset assumptions. NOTE 10 FINANCIAL INSTRUMENTS The Company’s financial instruments include cash and marketable securities. Due to the short-term nature of these instruments, their book value approximates their fair value. The Company’s financial instruments may include long-term debt, interest rate and cross-currency swaps, commodity derivative contracts and foreign currency derivatives. All derivative contracts are placed with counterparties that have an S&P, or equivalent, investment grade credit rating at the time of the contracts’ placement. At December 31, 2016 and 2015, the Company had no derivative contracts that contained credit risk related contingent features. The Company uses certain commodity derivative contracts to protect against commodity price changes related to forecasted raw material and supplies purchases. The Company primarily utilizes forward and option contracts, which are designated as cash flow hedges. At December 31, 2016 and 2015, the following commodity derivative contracts were outstanding: The Company manages its interest rate risk by balancing its exposure to fixed and variable rates while attempting to optimize its interest costs. The Company selectively uses interest rate swaps to reduce market value risk associated with changes in interest rates (fair value hedges). In July 2016, the Company terminated the following interest swaps which were outstanding at December 31, 2015. The Company uses foreign currency forward and option contracts to protect against exchange rate movements for forecasted cash flows, including capital expenditures, purchases, operating expenses or sales transactions designated in currencies other than the functional currency of the operating unit. In addition, the Company uses foreign currency forward contracts to hedge exposure associated with our net investment in certain foreign operations (net investment hedges). The Company has also designated its Euro denominated debt as a net investment hedge of the Company's investment in a European subsidiary. Foreign currency derivative contracts require the Company, at a future date, to either buy or sell foreign currency in exchange for the operating units’ local currency. At December 31, 2016 and December 31, 2015, the following foreign currency derivative contracts were outstanding: At December 31, 2016 and 2015, the following amounts were recorded in the Consolidated Balance Sheets as being payable to or receivable from counterparties under ASC Topic 815: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Effectiveness for cash flow and net investment hedges is assessed at the inception of the hedging relationship and quarterly, thereafter. To the extent that derivative instruments are deemed to be effective, gains and losses arising from these contracts are deferred into accumulated other comprehensive income (loss) ("AOCI") and reclassified into income as the underlying operating transactions are recognized. These realized gains or losses offset the hedged transaction and are recorded on the same line in the statement of operations. To the extent that derivative instruments are deemed to be ineffective, gains or losses are recognized into income. The table below shows deferred gains (losses) reported in AOCI as well as the amount expected to be reclassified to income in one year or less. The amount expected to be reclassified to income in one year or less assumes no change in the current relationship of the hedged item at December 31, 2016 market rates. Derivative instruments designated as hedging instruments as defined by ASC Topic 815 held during the period resulted in the following gains and losses recorded in income: At December 31, 2016, derivative instruments that were not designated as hedging instruments as defined by ASC Topic 815 were immaterial. NOTE 11 RETIREMENT BENEFIT PLANS The Company sponsors various defined contribution savings plans, primarily in the U.S., that allow employees to contribute a portion of their pre-tax and/or after-tax income in accordance with plan specified guidelines. Under specified conditions, the Company will make contributions to the plans and/or match a percentage of the employee contributions up to certain limits. Total expense related to the defined contribution plans was $28.3 million, $28.0 million and $27.6 million in the years ended December 31, 2016, 2015 and 2014, respectively. The Company has a number of defined benefit pension plans and other postretirement employee benefit plans covering eligible salaried and hourly employees and their dependents. The defined pension benefits provided are primarily based on (i) years of service and (ii) average compensation or a monthly retirement NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) benefit amount. The Company provides defined benefit pension plans in France, Germany, Ireland, Italy, Japan, Mexico, Monaco, South Korea, Sweden, U.K. and the U.S. The other postretirement employee benefit plans, which provide medical benefits, are unfunded plans. All pension and other postretirement employee benefit plans in the U.S. have been closed to new employees. The measurement date for all plans is December 31. During the fourth quarter of 2015, the Company settled approximately $48 million of its projected benefit obligation by transferring approximately $48 million in plan assets through a lump-sum pension de-risking disbursement made to an insurance company. This agreement unconditionally and irrevocably guarantees all future payments to certain participants that were receiving payments from the U.S. pension plan. The insurance company assumes all investment risk associated with the assets that were delivered as part of this transaction. As a result, the Company recorded a non-cash settlement loss of $25.7 million related to the accelerated recognition of unamortized losses. During the third quarter of 2014, the Company discharged certain U.S. pension plan obligations by making lump-sum payments to former employees of the Company. As a result of this action, the Company recorded a settlement loss of $3.1 million in the U.S. pension plan. The following table summarizes the expenses for the Company's defined contribution and defined benefit pension plans and the other postretirement defined employee benefit plans. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following provides a roll forward of the plans’ benefit obligations, plan assets, funded status and recognition in the Consolidated Balance Sheets. ________________ * AOCI shown above does not include our equity investee, NSK-Warner. NSK-Warner had an AOCI loss of $10.8 million and $7.1 million at December 31, 2016 and 2015, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The funded status of pension plans with accumulated benefit obligations in excess of plan assets at December 31 is as follows: The weighted average asset allocations of the Company’s funded pension plans and target allocations by asset category are as follows: The Company's investment strategy is to maintain actual asset weightings within a preset range of target allocations. The Company believes these ranges represent an appropriate risk profile for the planned benefit payments of the plans based on the timing of the estimated benefit payments. In each asset category, separate portfolios are maintained for additional diversification. Investment managers are retained in each asset category to manage each portfolio against its benchmark. Each investment manager has appropriate investment guidelines. In addition, the entire portfolio is evaluated against a relevant peer group. The defined benefit pension plans did not hold any Company securities as investments as of December 31, 2016 and 2015. A portion of pension assets is invested in common and commingled trusts. In December 2014, the Company made a discretionary contribution of $30.2 million to its German pension plans. The Company expects to contribute a total of $15 million to $25 million into its defined benefit pension plans during 2017. Of the $15 million to $25 million in projected 2017 contributions, $3.2 million are contractually obligated, while any remaining payments would be discretionary. Refer to the Fair Value Measurements footnote to the Consolidated Financial Statements for more detail surrounding the fair value of each major category of plan assets as well as the inputs and valuation techniques used to develop the fair value measurements of the plans' assets at December 31, 2016 and 2015. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) See the table below for a breakout of net periodic benefit cost between U.S. and non-U.S. pension plans: The estimated net loss for the defined benefit pension plans that will be amortized from accumulated other comprehensive loss into net periodic benefit cost over the next fiscal year is $11.6 million. The estimated net loss and prior service credit for the other postretirement employee benefit plans that will be amortized from accumulated other comprehensive loss into net periodic benefit cost over the next fiscal year are $1.3 million and $4.1 million, respectively. The Company's weighted-average assumptions used to determine the benefit obligations for its defined benefit pension and other postretirement employee benefit plans as of December 31, 2016 and 2015 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company’s weighted-average assumptions used to determine the net periodic benefit cost for its defined benefit pension and other postretirement employee benefit plans for the years ended December 31, 2016, 2015 and 2014 were as follows: The Company's approach to establishing the discount rate is based upon the market yields of high-quality corporate bonds, with appropriate consideration of each plan's defined benefit payment terms and duration of the liabilities. The Company determines its expected return on plan asset assumptions by evaluating estimates of future market returns and the plans' asset allocation. The Company also considers the impact of active management of the plans' invested assets. The estimated future benefit payments for the pension and other postretirement employee benefits are as follows: The weighted-average rate of increase in the per capita cost of covered health care benefits is projected to be 6.79% in 2017 for pre-65 and post-65 participants, decreasing to 5.0% by the year 2022. A one-percentage point change in the assumed health care cost trend would have the following effects: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 12 STOCK-BASED COMPENSATION Under the Company's 2004 Stock Incentive Plan ("2004 Plan"), the Company granted options to purchase shares of the Company's common stock at the fair market value on the date of grant. The options vested over periods up to three years and have a term of 10 years from date of grant. At its November 2007 meeting, the Company's Compensation Committee decided that restricted common stock awards and stock units ("restricted stock") would be awarded in place of stock options for long-term incentive award grants to employees. Restricted stock granted to employees generally vests 50% after two years and the remainder after three years from the date of grant. Restricted stock granted to non-employee directors generally vests on the first anniversary date of the grant. In February 2014, the Company's Board of Directors replaced the expired 2004 Plan by adopting the BorgWarner Inc. 2014 Stock Incentive Plan ("2014 Plan"). On April 30, 2014, the Company's stockholders approved the 2014 Plan. Under the 2014 Plan, approximately 8 million shares are authorized for grant, of which approximately 5.7 million shares are available for future issuance as of December 31, 2016. Stock Options A summary of the plans’ shares under option at December 31, 2016, 2015 and 2014 is as follows: Proceeds from stock option exercises for the years ended December 31, 2016, 2015 and 2014 were as follows: Restricted Stock The value of restricted stock is determined by the market value of the Company’s common stock at the date of grant. In 2016, restricted stock in the amount of 698,788 shares and 25,048 shares was granted to employees and non-employee directors, respectively. The value of the awards is recognized as compensation expense ratably over the restriction periods. As of December 31, 2016, there was $25.6 million of unrecognized compensation expense that will be recognized over a weighted average period of approximately 2 years. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Restricted stock compensation expense recorded in the Consolidated Statements of Operations is as follows: A summary of the status of the Company’s nonvested restricted stock for employees and non-employee directors at December 31, 2016, 2015 and 2014 is as follows: Total Shareholder Return Performance Share Plans The 2004 and 2014 Plans provide for awarding of performance shares to members of senior management at the end of successive three-year periods based on the Company's performance in terms of total shareholder relative to a peer group of automotive companies. The Company recognizes compensation expense relating to its performance share plans ratably over the performance period. Compensation expense associated with the performance share plans is calculated using a lattice model (Monte Carlo simulation). The amounts expensed under the plan and the common stock issuances for the three-year measurement periods ended December 31, 2016, 2015 and 2014 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Relative Revenue Growth Performance Share Plans In the second quarter of 2016, the Company started a new performance share program to reward members of senior management based on the Company's performance in terms of revenue growth relative to the vehicle market over three-year performance periods. The value of this performance share is determined by the market value of the Company’s common stock at the date of grant. The Company recognizes compensation expense relating to its performance share plans over the performance period based on the number of shares expected to vest at the end of each reporting period. Total compensation expense was $7.1 million for the year ended December 31, 2016 with approximately 115,000 shares to be paid out in February 2017. NOTE 13 ACCUMULATED OTHER COMPREHENSIVE LOSS The following table summarizes the activity within accumulated other comprehensive loss during the years ended December 31, 2016, 2015 and 2014: NOTE 14 CONTINGENCIES In the normal course of business, the Company is party to various commercial and legal claims, actions and complaints, including matters involving warranty claims, intellectual property claims, general liability and various other risks. It is not possible to predict with certainty whether or not the Company will ultimately be successful in any of these commercial and legal matters or, if not, what the impact might be. The Company's environmental and asbestos liability contingencies are discussed separately below. The Company's management does not expect that an adverse outcome in any of these commercial and legal claims, actions and complaints will have a material adverse effect on the Company's results of operations, financial position or cash flows, although it could be material to the results of operations in a particular quarter. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Litigation In January 2006, BorgWarner Diversified Transmission Products Inc. ("DTP"), a subsidiary of the Company, filed a declaratory judgment action in United States District Court, Southern District of Indiana (Indianapolis Division) against the United Automobile, Aerospace, and Agricultural Implements Workers of America (“UAW”) Local No. 287 and Gerald Poor, individually and as the representative of a defendant class. DTP sought the Court's affirmation that DTP did not violate the Labor-Management Relations Act or the Employee Retirement Income Security Act (ERISA) by unilaterally amending certain medical plans effective April 1, 2006 and October 1, 2006, prior to the expiration of the then-current collective bargaining agreements. On September 10, 2008, the Court found that DTP's reservation of the right to make such amendments reducing the level of benefits provided to retirees was limited by its collectively bargained health insurance agreement with the UAW, which did not expire until April 24, 2009. Thus, the amendments were untimely. In 2008, the Company recorded a charge of $4.0 million as a result of the Court's decision. DTP filed a declaratory judgment action in the United States District Court, Southern District of Indiana (Indianapolis Division) against the UAW Local No. 287 and Jim Barrett and others, individually and as representatives of a defendant class, on February 26, 2009 again seeking the Court's affirmation that DTP did not violate the Labor - Management Relations Act or ERISA by modifying the level of benefits provided retirees to make them comparable to other Company retiree benefit plans after April 24, 2009. Certain retirees, on behalf of themselves and others, filed a mirror-image action in the United States District Court, Eastern District of Michigan (Southern Division) on March 11, 2009, for which a class has been certified. During the last quarter of 2009, the action pending in Indiana was dismissed, while the action in Michigan continued. On December 5, 2016, the Court granted the Company’s Motion for Summary Judgment and ordered dismissal of the retirees’ Complaint with prejudice. No appeal was filed on behalf of the retirees and the time to file an appeal has expired. Environmental The Company and certain of its current and former direct and indirect corporate predecessors, subsidiaries and divisions have been identified by the United States Environmental Protection Agency and certain state environmental agencies and private parties as potentially responsible parties (“PRPs”) at various hazardous waste disposal sites under the Comprehensive Environmental Response, Compensation and Liability Act (“Superfund”) and equivalent state laws and, as such, may presently be liable for the cost of clean-up and other remedial activities at 27 such sites. Responsibility for clean-up and other remedial activities at a Superfund site is typically shared among PRPs based on an allocation formula. The Company believes that none of these matters, individually or in the aggregate, will have a material adverse effect on its results of operations, financial position or cash flows. Generally, this is because either the estimates of the maximum potential liability at a site are not material or the liability will be shared with other PRPs, although no assurance can be given with respect to the ultimate outcome of any such matter. Based on information available to the Company (which in most cases includes: an estimate of allocation of liability among PRPs; the probability that other PRPs, many of whom are large, solvent public companies, will fully pay the cost apportioned to them; currently available information from PRPs and/or federal or state environmental agencies concerning the scope of contamination and estimated remediation and consulting costs; and remediation alternatives), the Company has an accrual for indicated environmental liabilities of $6.3 million and $5.4 million at December 31, 2016 and at December 31, 2015, respectively. The Company expects to pay out substantially all of the amounts accrued for environmental liability over the next five years. In connection with the sale of Kuhlman Electric Corporation (“Kuhlman Electric”), the Company agreed to indemnify the buyer and Kuhlman Electric for certain environmental liabilities, then unknown to the Company, relating to certain operations of Kuhlman Electric that pre-date the Company's 1999 acquisition of Kuhlman Electric. The Company previously settled or obtained dismissals of various lawsuits that were NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) filed against Kuhlman Electric and others, including the Company, on behalf of plaintiffs alleging personal injury relating to alleged environmental contamination at its Crystal Springs, Mississippi plant. The Company filed a lawsuit against Kuhlman Electric and a related entity challenging the validity of the indemnity and the defendants filed counterclaims (the “Indemnity Action”) and a related lawsuit. On September 28, 2015, the parties entered into a confidential settlement agreement that, among other things, released and terminated all of BorgWarner’s indemnity obligations. Pursuant to the settlement agreement, the parties voluntarily dismissed the Indemnity Action on September 29, 2015 and the related lawsuit was dismissed on October 13, 2015. The Company continues to pursue insurance coverage actions for reimbursement of amounts it spent under the indemnity. The Company may in the future become subject to further legal proceedings. Asbestos-related Liability Like many other industrial companies that have historically operated in the United States, the Company, or parties that the Company is obligated to indemnify, continues to be named as one of many defendants in asbestos-related personal injury actions. We believe that the Company’s involvement is limited because these claims generally relate to a few types of automotive products that were manufactured over 30 years ago and contained encapsulated asbestos. The nature of the fibers, the encapsulation of the asbestos, and the manner of the products’ use all lead the Company to believe that these products were and are highly unlikely to cause harm. Furthermore, the useful life of nearly all of these products expired many years ago. As of December 31, 2016 and 2015, the Company had approximately 9,400 and 10,100 pending asbestos-related claims, respectively. The decrease in the number of pending claims is primarily a result of the Company’s continued efforts to obtain dismissal of dormant claims. It is probable that additional asbestos-related claims will be asserted against the Company in the future. The Company vigorously defends against these claims, and has been successful in obtaining the dismissal of the majority of the claims asserted against it without any payment. The Company likewise expects that the vast majority of the pending asbestos-related claims in which it has been named (or has an obligation to indemnify a party which has been named), and asbestos-related claims that may be asserted in the future, will result in no payment being made by the Company or its insurers. In 2016, of the approximately 2,800 claims resolved, 352 (13%) resulted in payment being made to a claimant by or on behalf of the Company. In 2015, of the approximately 5,300 claims resolved, 349 (7%) resulted in payment being made to a claimant by or on behalf of the Company. The comparatively large number of claims resolved in 2015 reflected the Company’s efforts to dismiss large numbers of inactive or otherwise unmeritorious claims in order to be better positioned to evaluate remaining and future claims, while the smaller number of total claims resolved in 2016 reflects in part the outcome of those efforts. Through December 31, 2016 and 2015, the Company had accrued and paid $477.7 million and $432.7 million in indemnity (including settlement payments) and defense costs in connection with asbestos-related claims, respectively. During 2016 and 2015, the Company had paid indemnity and related defense costs totaling $45.3 million and $54.7 million, respectively. These gross payments are before tax benefits and any insurance receipts. Indemnity and defense costs are incorporated into the Company's operating cash flows and will continue to be in the future. The Company reviews, on an ongoing basis, its own experience in handling asbestos-related claims and trends affecting asbestos-related claims in the U.S. tort system generally, for the purposes of assessing the value of pending asbestos-related claims and the number and value of those that may be asserted in the future, as well as potential recoveries from the Company’s insurers with respect to such claims and defense costs. As of December 31, 2015, the Company also recorded an estimated liability of $108.5 million for asbestos-related claims asserted but not yet resolved and their associated defense costs. The Company further stated that, as of that date, its ultimate liability could not be reasonably estimated in excess of the amounts it had then accrued for claims that had been resolved and the estimated liability for claims asserted but not yet resolved and their associated defense costs. The inability to arrive at a reasonable estimate of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) the liability for potential asbestos-related claims that may be asserted in the future was based on, among other factors, the volatility in the number and type of asbestos claims that may be asserted, changes in asbestos-related litigation in the United States, the significant number of co-defendants that have filed for bankruptcy, the magnitude and timing of co-defendant bankruptcy trust payments, the inherent uncertainty of future disease incidence and claiming patterns against the Company, and the impact of tort reform legislation that may be enacted at the state or federal levels. The Company has continued efforts to evaluate these factors and, if possible, arrive at a reasonable estimate of the number and value of potential future asbestos-related claims. In recent years, there have been more observable trends in the Company’s claims data that would indicate that claiming patterns against the Company have stabilized. Concurrently, in recent years, the Company has made enhancements to the management and analysis of asbestos-related claims, including specifically: the engagement of new National Coordinating Counsel with significant asbestos litigation experience and a global presence, the engagement of several new local counsel panels; outsourcing administration and claims handling to a third party; implementing various improvements in the processing of asbestos-related claims so as to allow the Company’s management to have greater real-time insight into the handling of individual asbestos-related claims; and increasing audits and compliance reviews of counsel handling asbestos-related claims. This process has as of the end of 2016 resulted in improvements in both the quantity and the quality of the information available to the Company’s management respecting individual asbestos-related claims and their handling and disposition. This process has also resulted, in the Company’s view, in an increased ability to reasonably forecast the aggregate number of potential future asbestos-related claims that may be asserted against the Company. The Company has further engaged in a sustained effort to obtain the dismissal of thousands of dormant asbestos-related product liability claims, which has resulted in a reduction in the number of its pending claims by 48 percent over the past few years. Legislative and judicial developments affecting the U.S. tort system generally, including medical criteria legislation, procedural reforms, and docket control measures relating to so-called unimpaired claims, have also stabilized certain aspects of the Company’s defense efforts respecting asbestos-related claims and allowed the Company greater insight into the number and value of potential future claims in recent years. As part of its review and assessment of asbestos-related claims, the Company hired a third party consultant in the third quarter of 2016 to further assist in the analysis of potential future asbestos-related claims. The consultant’s work utilized the updated data and analysis resulting from the Company’s claim review process and included the development of an estimate of the potential value of asbestos-related claims asserted but not yet resolved as well as the number and potential value of asbestos-related claims not yet asserted. The Company determined based on the factors described above, including the analysis and input of the consultant, that its best estimate of the aggregate liability both for asbestos-related claims asserted but not yet resolved and potential asbestos-related claims not yet asserted, including an estimate for defense costs, is $879.3 million as of December 31, 2016. This liability reflects the actuarial central estimate, which is intended to represent an expected value of the most probable outcome. This estimate is not discounted to present value and includes an estimate of liability for potential future claims not yet asserted through December 31, 2059 with a runoff through 2067. The Company currently believes that December 31, 2067 is a reasonable assumption as to the last date on which it is likely to have resolved all asbestos-related claims, based on the nature and useful life of the Company’s products and the likelihood of incidence of asbestos-related disease in the U.S. population generally. In developing the estimate of liability for potential future claims, the third-party consultant projected a potential number of future claims based on the Company’s historical claim filings and patterns and compared that to anticipated levels of unique plaintiff asbestos-related claims asserted in the U.S. tort system against all defendants. The consultant also utilized assumptions based on the Company’s historical proportion of claims resolved without payment, historical settlement costs for those claims that result in a payment, and historical defense costs. The liabilities were then estimated by multiplying the pending and projected future NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) claim filings by projected payments rates and average settlement amounts and then adding an estimate for defense costs. The Company’s estimate of the indemnity and defense costs for asbestos-related claims asserted but not yet resolved and potential claims not yet asserted is its best estimate of such costs. That estimate is subject to numerous uncertainties. These include future legislative or judicial changes affecting the U.S. tort system, bankruptcy proceedings involving one or more co-defendants, the impact and timing of payments from bankruptcy trusts that presently exist and those that may exist in the future, disease emergence and associated claim filings, the impact of future settlements or significant judgments, changes in the medical condition of claimants, changes in the treatment of asbestos-related disease, and any changes in settlement or defense strategies. The amount recorded at December 31, 2016 for asbestos-related claims is based on currently available information and assumptions that the Company believes are reasonable. Any amounts that are reasonably possible of occurring in excess of amounts recorded are believed to not be significant. The various assumptions utilized in arriving at the Company’s estimate the number of future claims that may be asserted, the percentage of claims that may result in a payment, the average cost to resolve such claims, and potential defense costs - may also change over time, and the Company’s actual liability for asbestos-related claims asserted but not yet resolved and those not yet asserted may be higher or lower than the estimate provided herein as a result of such changes. The Company has certain insurance coverage applicable to asbestos-related claims. Prior to June 2004, the settlement and defense costs associated with all asbestos-related claims were paid by the Company's primary layer insurance carriers under a series of interim funding arrangements. In June 2004, primary layer insurance carriers notified the Company of the alleged exhaustion of their policy limits. A declaratory judgment action was filed in January 2004 in the Circuit Court of Cook County, Illinois by Continental Casualty Company and related companies against the Company and certain of its historical general liability insurers. The Cook County court has issued a number of interim rulings and discovery is continuing in this proceeding. The Company is vigorously pursuing the litigation against all carriers that are parties to it, as well as pursuing settlement discussions with its carriers where appropriate. The Company has entered into settlement agreements with certain of its insurance carriers, resolving such insurance carriers’ coverage disputes through the carriers’ agreement to pay specified amounts to the Company, either immediately or over a specified period. Through December 31, 2016 and 2015, the Company had received $270.0 million and $263.9 million in cash and notes from insurers, respectively, on account of indemnity and defense costs respecting asbestos-related claims. The Company additionally recorded assets as of December 31, 2015 in the amount of (i) $168.8 million, representing the difference between the $432.7 million in defense and indemnity costs paid by the Company as of December 31, 2015 for asbestos-related claims and the $263.9 million received from insurers prior to that date, and (ii) $108.5 million, representing the then-estimated amount of asbestos-related claims asserted but not yet resolved for which the Company believes it has insurance coverage. In each case, such amounts were expected to be fully recovered. The Company continues to have additional excess insurance coverage available for potential future asbestos-related claims. In connection with the Company’s ongoing review of its asbestos-related claims, the Company also reviewed the amount of its potential insurance coverage for such claims, taking into account the remaining limits of such coverage, the number and amount of claims on our insurance from co-insured parties, ongoing litigation against the Company’s insurers described above, potential remaining recoveries from insolvent insurers, the impact of previous insurance settlements, and coverage available from solvent insurers not party to the coverage litigation. Based on that review, the Company estimates as of December 31, 2016 that it has $386.4 million in aggregate insurance coverage available with respect to asbestos-related claims already satisfied by the Company but not yet reimbursed by the insurers, asbestos-related claims asserted but not yet resolved, and asbestos-related claims not yet asserted, in each case together with their associated defense costs. In each case, such amounts are expected to be fully recovered. However, the resolution of the insurance coverage litigation, and the number and amount of claims on our NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) insurance from co-insured parties, may increase or decrease the amount of insurance coverage available to us for asbestos-related claims from the estimates discussed above. As a result of all of the foregoing estimates of asbestos-related liabilities and related insurance assets, the Company in the fourth quarter of 2016 recorded a charge of $703.6 million before tax, or $440.6 million after tax, resulting from the difference in the total liability from what was previously accrued, consulting fees, less available insurance coverage. The amounts recorded in the Consolidated Balance Sheets respecting asbestos-related claims are as follows: NOTE 15 RESTRUCTURING In the fourth quarter of 2013, the Company initiated actions primarily in the Drivetrain segment designed to improve future profitability and competitiveness. As a continuation of these actions, the Company finalized severance agreements with three labor unions at separate facilities in Western Europe for approximately 450 employees. The Company recorded restructuring expense related to these facilities of $8.2 million, $28.0 million and $61.8 million in the years ended December 31, 2016, 2015 and 2014, respectively. Included in this restructuring expense are employee termination benefits of $3.0 million, $20.1 million and $50.6 million, respectively, and other expense of $5.2 million, $7.9 million and $11.2 million, respectively. In the second quarter of 2014, the Company initiated actions to improve the future profitability and competitiveness of Gustav Wahler GmbH u. Co. KG and its general partner ("Wahler"). The Company recorded restructuring expense related to Wahler of $9.6 million, $11.6 million and $6.5 million in the years ended December 31, 2016, 2015 and 2014, respectively. These restructuring expenses are primarily related to employee termination benefits. These termination benefits relate to approximately 70 employees in Germany and Brazil in 2015 and 95 employees in Germany, Brazil, China and the U.S. in 2014. The Company recorded restructuring expense of $12.5 million and $12.0 million in the years ended December 31, 2015 and 2014, respectively, related to a global realignment plan intended to enhance treasury management flexibility by creating a legal entity structure that better aligns with the Company's business strategy. In the fourth quarter of 2015, the Company acquired 100% of the equity interests in Remy and initiated actions to improve future profitability and competitiveness. The Company recorded restructuring expense of $6.1 million and $10.1 million in the years ended December 31, 2016 and 2015, respectively. Included in this restructuring expense is $3.1 million in the year ended December 31, 2016 related to winding down certain operations in North America. Additionally, the Company recorded employee termination benefits of $2.0 million and $10.1 million in the years ended December 31, 2016 and 2015, respectively, primarily related to contractually required severance associated with Remy executive officers and other employee termination benefits in Mexico. Cash payments for these restructuring activities are expected to be complete by the end of 2017. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Estimates of restructuring expense are based on information available at the time such charges are recorded. Due to the inherent uncertainty involved in estimating restructuring expenses, actual amounts paid for such activities may differ from amounts initially recorded. Accordingly, the Company may record revisions of previous estimates by adjusting previously established accruals. The following table displays a rollforward of the severance accruals recorded within the Company's Consolidated Balance Sheet and the related cash flow activity for the years ended December 31, 2016 and 2015: ____________________________________ * Acquisition relates to the Company's 2015 purchase of Remy. NOTE 16 LEASES AND COMMITMENTS Certain assets are leased under long-term operating leases, including rent for facilities and one airplane. Most leases contain renewal options for various periods. Leases generally require the Company to pay for insurance, taxes and maintenance of the leased property. The Company leases other equipment such as vehicles and certain office equipment under short-term leases. Total rent expense was $38.2 million, $31.9 million and $33.9 million in the years ended December 31, 2016, 2015 and 2014, respectively. The Company does not have any material capital leases. Future minimum operating lease payments at December 31, 2016 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 17 EARNINGS PER SHARE The Company presents both basic and diluted earnings per share of common stock (“EPS”) amounts. Basic EPS is calculated by dividing net earnings attributable to BorgWarner Inc. by the weighted average shares of common stock outstanding during the reporting period. Diluted EPS is calculated by dividing net earnings attributable to BorgWarner Inc. by the weighted average shares of common stock and common equivalent stock outstanding during the reporting period. The dilutive impact of stock-based compensation is calculated using the treasury stock method. The treasury stock method assumes that the Company uses the assumed proceeds from the exercise of awards to repurchase common stock at the average market price during the period. The assumed proceeds under the treasury stock method include the purchase price that the grantee will pay in the future, compensation cost for future service that the Company has not yet recognized and any windfall/(shortfall) tax benefits that would be credited/(debited) to capital in excess of par value when the award generates a tax deduction. Options are only dilutive when the average market price of the underlying common stock exceeds the exercise price of the options. The following table reconciles the numerators and denominators used to calculate basic and diluted earnings per share of common stock: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 18 RECENT TRANSACTIONS Divgi-Warner Private Limited. In August 2016, the Company sold its 60% ownership interest in Divgi-Warner Private Limited ("Divgi-Warner") to the joint venture partner. This former joint venture was formed in 1995 to develop and manufacture transfer cases and synchronizer rings in India. As a result of the sale, the Company received cash proceeds of approximately $5.4 million, net of capital gains tax and cash divested, which is classified as an investing activity within the Condensed Consolidated Statement of Cash Flows. Furthermore, the Company wrote off noncontrolling interest of $4.8 million as result of the sale and recognized a negligible gain in the year ended December 31, 2016. Remy International, Inc. On November 10, 2015, the Company acquired 100% of the equity interests in Remy for $29.50 per share in cash. The Company also settled approximately $361 million of outstanding debt. Remy was a global market leading producer of rotating electrical components that had key technologies and operations in 10 countries. The cash paid, net of cash acquired, was $1,187.0 million. The Remy acquisition is expected to strengthen the Company's position in the rapidly developing powertrain electrification trend, with a complementary combination of technologies and global operations. The operating results and assets are reported within the Company's Drivetrain reporting segment as of the date of the acquisition. Remy's results from the date of acquisition through December 31, 2015 were insignificant to the Company's Consolidated Statement of Operations. The Company paid $1,187.0 million, which is recorded as an investing activity in the Company's Consolidated Statement of Cash Flows. Additionally, the Company assumed retirement-related liabilities of $31.1 million and assumed debt of $10.9 million, which are reflected in the supplemental cash flow information on the Company's Consolidated Statement of Cash Flows. The following table summarizes the aggregated estimated fair value of the assets acquired and liabilities assumed on November 10, 2015, the date of acquisition: In connection with the acquisition, the Company capitalized $303.3 million for customer relationships, $46.4 million for developed technology, $59.0 million for the Delco Remy, Remy and Maval trade names, $3.8 million for in-process R&D and $0.1 million for leasehold interests. These intangible assets, excluding the indefinite-lived trade names, will be amortized over a period of 5 to 15 years. Various valuation techniques were used to determine the fair value of the intangible assets, with the primary techniques being forms of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) the income approach, specifically, the relief-from-royalty and excess earnings valuation methods, which use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy. Under these valuation approaches, the Company is required to make estimates and assumptions about sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. Due to the nature of the transaction, goodwill is not deductible for tax purposes. In the fourth quarter of 2016, the Company finalized all purchase accounting adjustments related to the Remy acquisition. The Company has recorded fair value adjustments based on new information obtained during the measurement period primarily related to warranty, inventory, and deferred taxes. These adjustments have resulted in a decrease in goodwill of $12.1 million from the Company's initial estimate. In October 2016, the Company entered into a definitive agreement to sell the light vehicle aftermarket business associated with the Company’s acquisition of Remy for approximately $80 million in cash, subject to customary adjustment. The Remy light vehicle aftermarket business sells remanufactured and new starters, alternators and multi-line products to aftermarket customers, mainly retailers in North America, and warehouse distributors in North America, South America and Europe. The sale of this business allows the Company to focus on the rapidly developing original equipment manufacturer powertrain electrification trend. During the third quarter of 2016, the Company determined that assets and liabilities subject to the Remy light vehicle aftermarket business sale met the held for sale criteria and recorded an asset impairment expense of $106.5 million to adjust the net book value of this business to its fair value. During the fourth quarter of 2016, upon the closing of the transaction, the Company recorded an additional loss of $20.6 million related to the finalization of the sale proceeds, changes in working capital from the amounts originally estimated and costs associated with the winding down of an aftermarket related product line, resulting in a total loss on divestiture of $127.1 million in the year ended December 31, 2016. As a result of this transaction, total assets of $284.1 million including $94.7 million of inventory and $72.6 million of accounts receivable and total liabilities of $93.2 million were removed from the Company’s consolidated balance sheet. The loss on divestiture is subject to final working capital adjustments, which is expected to be completed in the first quarter of 2017. Supplemental Pro Forma Data (Unaudited) The following supplemental pro forma information for the years ended December 31, 2015 and 2014 is based on the assumption that the acquisition of Remy occurred on January 1, 2014. The 2014 pro forma results include after-tax adjustments of $23.2 million of investment banker and other fees and accelerated stock compensation incurred by the Company and Remy related to the acquisition; $12.2 million net decrease in expense related to fair value adjustments; and $3.0 million net decrease in interest expense. These pro forma results of operations have been prepared for comparative purposes only, and do not purport to be indicative of the results of operations that actually would have resulted had the acquisition occurred on the date indicated or that may result in the future. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) BERU Diesel Start Systems Pvt. Ltd. In January 2015, the Company completed the purchase of the remaining 51% of BERU Diesel by acquiring the shares of its former joint venture partner. The former joint venture was formed in 1996 to develop and manufacture glow plugs in India. After this transaction, the Company owns 100% of the entity. The cash paid, net of cash acquired, was $12.6 million (783.1 million Indian rupees). The operating results are reported within the Company's Engine reporting segment. The Company paid $12.6 million, which is recorded as an investing activity in the Company's Consolidated Statement of Cash Flows. As a result of this transaction, the Company recorded a $10.8 million gain on the previously held equity interest in this joint venture. Additionally, the Company acquired assets of $16.0 million, including $11.2 million in definite-lived intangible assets, and assumed liabilities of $4.6 million. The Company also recorded $13.9 million of goodwill, which is expected to be non-deductible for tax purposes. Gustav Wahler GmbH u. Co KG On February 28, 2014, the Company acquired 100% of the equity interests in Wahler. Wahler was a producer of exhaust gas recirculation ("EGR") valves, EGR tubes and thermostats, and had operations in Germany, Brazil, the U.S., China and Slovakia. The cash paid, net of cash acquired was $110.5 million (80.1 million Euro). The Wahler acquisition strengthens the Company's strategic position as a producer of complete EGR systems and creates additional market opportunities in both passenger and commercial vehicle applications. The operating results and assets are reported within the Company's Engine reporting segment as of the date of the acquisition. The Company paid $110.5 million, which is recorded as an investing activity in the Company's Consolidated Statement of Cash Flows. Additionally, the Company assumed retirement-related liabilities of $3.2 million and assumed debt of $40.3 million, which are reflected in the supplemental cash flow information on the Company's Consolidated Statement of Cash Flows. The following table summarizes the aggregated estimated fair value of the assets acquired and liabilities assumed on February 28, 2014, the date of acquisition: In connection with the acquisition, the Company capitalized $24.9 million for customer relationships, $10.2 million for know-how, $4.1 million for patented technology and $3.5 million for the Wahler trade name. These intangible assets will be amortized over a period of 5 to 15 years. The income approach was used to determine the fair value of all intangible assets. Additionally, $56.9 million in goodwill is non-deductible for tax purposes. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTE 19 REPORTING SEGMENTS AND RELATED INFORMATION The Company's business is comprised of two reporting segments: Engine and Drivetrain. These segments are strategic business groups, which are managed separately as each represents a specific grouping of related automotive components and systems. The Company allocates resources to each segment based upon the projected after-tax return on invested capital ("ROIC") of its business initiatives. ROIC is comprised of Adjusted EBIT after deducting notional taxes compared to the projected average capital investment required. Adjusted EBIT is comprised of earnings before interest, income taxes and noncontrolling interest (“EBIT") adjusted for restructuring, goodwill impairment charges, affiliates' earnings and other items not reflective of on-going operating income or loss. Adjusted EBIT is the measure of segment income or loss used by the Company. The Company believes Adjusted EBIT is most reflective of the operational profitability or loss of our reporting segments. The following tables show segment information and Adjusted EBIT for the Company's reporting segments. _______________ (a) Corporate assets include investments and other long-term receivables and deferred income taxes. (b) Long-lived asset expenditures include capital expenditures and tooling outlays. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Adjusted earnings before interest, income taxes and noncontrolling interest ("Adjusted EBIT") Geographic Information Outside the U.S., only Germany, China, South Korea, Mexico and Hungary exceeded 5% of consolidated net sales during the year ended December 31, 2016, attributing sales to the location of production rather than the location of the customer. Also, the Company's 50% equity investment in NSK-Warner (see the Balance Sheet Information footnote to the Consolidated Financial Statements) of $172.9 million, $158.7 million and $143.8 million at December 31, 2016, 2015 and 2014, respectively, is excluded from the definition of long-lived assets, as are goodwill and certain other non-current assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Sales to Major Customers Consolidated net sales to Ford (including its subsidiaries) were approximately 15%, 15%, and 13% for the years ended December 31, 2016, 2015 and 2014, respectively; and to Volkswagen (including its subsidiaries) were approximately 13%, 15% and 17% for the years ended December 31, 2016, 2015 and 2014, respectively. Both of the Company's reporting segments had significant sales to Volkswagen and Ford in 2016, 2015 and 2014. Such sales consisted of a variety of products to a variety of customer locations and regions. No other single customer accounted for more than 10% of consolidated net sales in any of the years presented. Sales by Product Line Sales of turbochargers for light vehicles represented approximately 28%, 31% and 28% of total net sales for the years ended December 31, 2016, 2015 and 2014, respectively. The Company currently supplies light vehicle turbochargers to many OEMs including BMW, Daimler, Fiat Chrysler Automobiles, Ford, General Motors, Great Wall, Hyundai, Renault, Volkswagen and Volvo. No other single product line accounted for more than 10% of consolidated net sales in any of the years presented. Interim Financial Information (Unaudited) _______________ (a) The Company's results were impacted by the following: • Quarter ended December 31, 2016: The Company recorded an asbestos-related charge of $703.6 million representing the difference in the total liability from what was previously accrued, consulting fees, less available insurance coverage, and an intangible asset impairment loss of $12.6 million related to the Engine segment Etatech’s ECCOS intellectual technology. Additionally, the Company recorded an incremental loss on divestiture of $20.6 million related to the sale of Remy light vehicle aftermarket business. The Company also recorded merger and acquisition expense of $4.8 million primarily related to the Remy transaction. The Company recorded tax benefits of $263.0 million related to asbestos-related charge, $4.4 million related to intangible asset loss, and $4.9 million related to other one-time tax adjustments. The Company also recorded a tax expense of $4.9 million related to the sale of the Remy light vehicle aftermarket business and the reversal of the associated deferred tax balances. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) • Quarter ended September 30, 2016: The Company recorded an asset impairment expense of $106.5 million to adjust the net book value of the Remy light vehicle aftermarket business to fair value, based on the anticipated sale price. Additionally, the Company recorded restructuring expense of $1.3 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. The Company also recorded merger and acquisition expense of $5.9 million primarily related to the Remy transaction. The Company recorded tax benefits of $27.6 million related to asset impairment expense, $2.4 million related to other one-time tax adjustments, $0.5 million related to restructuring expense, and $0.4 million related to a gain associated with the release of certain Remy light vehicle aftermarket liabilities due to the expiration of a customer contract. • Quarter ended June 30, 2016: The Company recorded restructuring expense of $19.2 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. The Company also recorded merger and acquisition expense of $7.2 million primarily related to the Remy transaction. The Company recorded tax benefits of $4.4 million related to restructuring expense and $0.3 million related to other one-time tax adjustments, as well as a tax expense of $2.6 million related to a gain associated with the release of certain Remy light vehicle aftermarket liabilities due to the expiration of a customer contract. • Quarter ended March 31, 2016: The Company recorded restructuring expense of $6.4 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. The Company also recorded merger and acquisition expense of $5.8 million primarily related to the Remy transaction. The Company recorded tax benefits of $1.0 million related to restructuring expense and $1.0 million related to other one-time tax adjustments. • Quarter ended December 31, 2015: The Company recorded restructuring expense of $24.4 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. The Company also incurred a non-cash settlement loss of $25.7 million related to a lump-sum pension de-risking disbursement made to an insurance company to unconditionally and irrevocably guarantee all future payments to certain participants that were receiving payments from the U.S. pension plan. Furthermore, the Company recorded merger and acquisition expense of $17.9 million primarily related to the Remy transaction. The Company recorded tax benefits of $9.0 million related to the pension settlement loss, $7.7 million primarily related to foreign tax incentives and tax settlements, $3.8 million related to merger and acquisition expense, partially offset by a tax expense of $0.4 million related to restructuring expense. • Quarter ended September 30, 2015: The Company recorded restructuring expense of $6.3 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. Additionally, the Company recorded $3.0 million of restructuring expense related to a global realignment plan intended to enhance treasury management flexibility by creating a legal entity structure that better aligns with the Company's business strategy. The Company also recorded merger and acquisition expense of $3.9 million primarily related to the Remy transaction. The Company recorded tax benefits of $4.5 million related to a global realignment plan, $0.7 million related to restructuring expense and $0.4 million primarily related to foreign tax incentives. • Quarter ended June 30, 2015: The Company recorded restructuring expense of $10.5 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. Additionally, the Company recorded $9.4 million of restructuring expense related to a global realignment plan intended to enhance treasury management flexibility by creating a legal entity structure that better aligns with the Company's business strategy. The Company recorded tax expense of $10.3 million related to a global realignment plan, partially offset by tax benefits of $3.9 million related to tax settlements, $2.2 million related to restructuring expense and $1.3 million primarily related to foreign tax incentives. • Quarter ended March 31, 2015: The Company recorded restructuring expense of $9.4 million related to Drivetrain and Engine segment actions designed to improve future profitability and competitiveness. Additionally, the Company recorded $2.7 million of restructuring expense related to a global realignment plan intended to enhance treasury management flexibility by creating a legal entity structure that better aligns with the Company's business strategy. The Company also recorded a $10.8 million gain on the previously held equity interest in BERU Diesel as a result of purchasing the remaining 51% of this joint venture. The Company recorded tax benefits of $2.4 million primarily related to foreign tax incentives and $1.2 million related to restructuring expense.
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Based on the provided financial statement excerpt, here's a summary:
Financial Statement Summary:
1. Revenue Recognition:
- Profit/loss is passed to the customer upon product shipment
- Long-term supply agreements exist, but each shipment is treated as a separate sale
- Prices are not fixed over the agreement's life
2. Cost of Sales:
- Includes materials, direct labor, and manufacturing overhead
- Manufacturing overhead covers indirect materials, labor, and factory operating costs
3. Cash Management:
- Cash valued at fair market value
- Highly liquid investments with 3-month or less maturity are classified as cash
- Maintained across multiple financial institutions
- Deposits may exceed insurance coverage, but maintained with reputable institutions
4. Assets:
- Property, plant, and equipment valued at cost less accumulated depreciation
- Minor maintenance charged to expense
- Significant renewals capitalized
- Depreciation calculate
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Claude
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Avra Inc. January 31, 2016 and 2015 Index Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statement of Stockholders’ Deficit Consolidated Statements of Cash Flows Notes to the Consolidated Financial Statements ACCOUNTING FIRM To the Board of Directors and Stockholders of Avra Inc. Greenville, SC We have audited the accompanying consolidated balance sheets of Avra Inc as of January 31, 2016 and 2015, and the related consolidated statements of operations, stockholders’ deficit and cash flows for each of the years then ended. Avra Inc’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Avra Inc. as of January 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years then ended in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that Avra Inc. will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, Avra Inc. has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ GBH CPAs, PC GBH CPAs, PC www.gbhcpas.com Houston, Texas September 15, 2017 The accompanying notes are an integral part of these consolidated financial statements. Avra Inc. Balance Sheets January 31, 2016 and 2015 January 31, January 31, ASSETS Current Assets Cash and cash equivalents $ $ 19,579 Prepaid expenses Total Current Assets 20,179 Property and equipment, net of depreciation of $0 and $6 - 2,128 Total Assets $ $ 22,307 LIABILITIES AND STOCKHOLDERS’ DEFICIT Current Liabilities Accounts payable and accrued liabilities $ 149,548 $ 30,489 Accounts payable - related party 52,137 6,929 Short-term debts 169,946 63,105 Stock payable 115,496 22,167 Total Current Liabilities 487,127 122,690 Contingencies and Commitments Stockholders’ Deficit Preferred stock, 100,000,000 shares authorized, $0.00001 par value; no shares issued and outstanding - - Common stock, 300,000,000 shares authorized, $0.00001 par value; 63,397,067 shares issued and outstanding Additional paid-in capital 194,062 194,062 Accumulated deficit (681,216) (295,079) Total Stockholders’ Deficit (486,520) (100,383) Total Liabilities and Stockholders’ Deficit $ $ 22,307 The accompanying notes are an integral part of these consolidated financial statements. Avra Inc. Statements of Operations January 31, 2016 and 2015 For the For the Year Ended Year Ended January 31, January 31, Operating Expenses Depreciation $ - $ General and administrative 51,808 64,060 Professional fees 321,731 131,287 Impairment loss on fixed assets 1,061 - Total Operating Expenses (374,600) (195,353) Other Income (Expense) Foreign exchange gain Interest expense (11,721) (4,316) Total Other Expense (11,537) (4,023) Net Loss $ (386,137) $ (199,376) Net Loss Per Common Share - Basic and Diluted $ (0.01) $ (0.00) Weighted Average Common Shares Outstanding - Basic and Diluted 63,397,067 62,892,166 The accompanying notes are an integral part of these consolidated financial statements. Avra Inc. Statement of Changes in Stockholders’ Deficit January 31, 2016 and 2015 Additional Common Paid-in Stock Amount Capital Deficit Total Balance - January 31, 2014 62,797,067 $ $ 44,068 $ (95,703) $ (51,007) Issuance of common stock 600,000 149,994 - 150,000 Net loss - - - (199,376) (199,376) Balance - January 31, 2015 63,397,067 $ $ 194,062 $ (295,079) $ (100,383) Net loss - - - (386,137) (386,137) Balance - January 31, 2016 63,397,067 $ $ 194,062 $ (681,216) $ (486,520) The accompanying notes are an integral part of these consolidated financial statements. Avra Inc. Statements of Cash Flows January 31, 2016 and 2015 For the For the Year Ended Year Ended January 31, 2016 January 31, 2015 Cash Flows from Operating Activities Net loss $ (386,137) $ (199,376) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation - Stock based compensation 93,329 22,167 Impairment loss on fixed assets 1,061 - Changes in operating assets and liabilities: Prepaid expense - (600) Accounts payable and accrued liabilities 119,059 15,851 Accounts payable - related party 46,275 - Net Cash Used in Operating Activities (126,413) (161,952) Cash Flows from Investing Activities Purchase of property and equipment - (2,134) Net Cash Used in Investing Activities - (2,134) Cash Flows from Financing Activities Proceeds from short-term debts 106,841 25,665 Proceeds from the sale of common stock - 150,000 Proceeds from related party advances - 6,929 Net Cash Provided by Financing Activities 106,841 182,594 Change in Cash (19,572) 18,508 Cash - Beginning of Year 19,579 1,071 Cash - End of Year $ $ 19,579 Supplementary Information: Interest paid $ - $ - Income taxes paid $ - $ - The accompanying notes are an integral part of these consolidated financial statements. Avra, Inc. Notes to the Consolidated Financial Statements 1. Nature of Business and Continuance of Operations Avra Inc. (the “Company”) was incorporated in the State of Nevada on December 1, 2010. The Company, with offices in the United States, is focused on solutions in the cryptocurrency and digital currency markets, particularly in offering payment solutions to businesses worldwide. The Company also has a business in marketing and distributing of Smart TV boxes to home consumers throughout the United States. Smart TV boxes are hardware devices that allow consumers to combine all of the benefits of the Internet with the large size and high definition capabilities of TV screens; however currently this is not the Company’s focus. On January 4, 2015, the Company established a subsidiary AvraPay SRL under the laws of Dominican Republic, where Avra Inc. owns 99.9%, and Steve Shepherd owns 0.1% of the shares of AvraPay SRL. The Company’s business model can be broken down into four distinct categories, as follows: AvraPay: To develop a complete, turn-key and painless way for merchants to accept Bitcoin as payment; AvraATM: To promote usage and acceptance of digital currencies through the Company's proposed network of ATMs; AvraTourism: To provide cryptocurrency payment processing solutions for merchants such as hotels and casinos; AvraNews: To provide a news portal focusing on digital currency news. These consolidated financial statements have been prepared on a going concern basis, which assumes the Company will continue to realize its assets and discharge its liabilities in the normal course of business. The continuation of the Company as a going concern is dependent upon the continued financial support from its shareholders, the ability of the Company to obtain necessary equity financing to continue operations, and the attainment of profitable operations. As of January 31, 2016, the Company has working capital deficit of $486,520 and has incurred losses totaling $681,216 since inception, and has not yet generated any revenue from operations. These factors raise substantial doubt regarding the Company’s ability to continue as a going concern. These financial statements do not include any adjustments to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company’s management plans to raise funds in the next 12 months through a combination of debt financing and equity financing by way of private placements. 2. Summary of Significant Accounting Policies a) Basis of Presentation These consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States and are expressed in US dollars. The Company’s fiscal year end is January 31. b) Use of Estimates The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company regularly evaluates estimates and assumptions related to stock-based compensation and deferred income tax asset valuation allowances. The Company bases its estimates and assumptions on current facts, historical experience and various other factors that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. The actual results experienced by the Company may differ materially and adversely from the Company’s estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected. c) Reclassification Certain prior period amounts have been reclassified to conform to current period presentation. 2. Summary of Significant Accounting Policies (continued) a) Cash and Cash Equivalents The Company considers all highly liquid instruments with maturity of three months or less at the time of issuance to be cash equivalents. b) Property and Equipment Property and equipment consists of computer equipment and is recorded at cost. Depreciation is recorded on a straight-line basis over their estimated useful lives of five years. c) Financial Instruments The Company’s financial instruments consist principally of cash and cash equivalents, accounts payable and accrued liabilities, short-term debts and due to related parties. Pursuant to ASC 820, Fair Value Measurements and Disclosures and ASC 825, Financial Instruments the fair value of the Company’s cash equivalents is determined based on “Level 1” inputs, which consist of quoted prices in active markets for identical assets. d) Earnings (Loss) Per Common Share Basic EPS is computed by dividing net income (loss) available to common shareholders (numerator) by the weighted average number of shares outstanding (denominator) during the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period using the treasury stock method and convertible preferred stock using the if-converted method. In computing Diluted EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Diluted EPS excludes all dilutive potential shares if their effect is anti-dilutive. At January 31, 2016, the Company has no potentially dilutive securities outstanding. e) Foreign Currency Translation The Company’s planned operations will be in the United States, which results in exposure to market risks from changes in foreign currency exchange rates. The financial risk is the risk to the Company’s operations that arise from fluctuations in foreign exchange rates and the degree of volatility of these rates. Currently, the Company does not use derivative instruments to reduce its exposure to foreign currency risk. The Company's functional currency for all operations worldwide is the U.S. dollar. Nonmonetary assets and liabilities are translated at historical rates and monetary assets and liabilities are translated at exchange rates in effect at the end of the year. Revenues and expenses are translated at average rates for the year. Gains and losses from translation of foreign currency financial statements into U.S. dollars are included in current results of operations. f) Revenue Recognition Sales are recorded when products are shipped to customers. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. No provision for discounts or rebates to customers, estimated returns and allowances or other adjustments were recognized during the year ended January 31, 2016. In instances where products are configured to customer requirements, revenue is recorded upon the successful completion of the Company’s final test procedures and the customer’s acceptance. The Company has not made any sales as of January 31, 2016. g) Income Taxes The Company accounts for income taxes using the asset and liability method in accordance with ASC 740, Income Taxes. The asset and liability method provides that deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. h) Stock-Based Compensation We estimate the fair value of each stock option award at the grant date by using the Black-Scholes option pricing model and common shares based on the market price of the Company’s common stock on the date of the share grant. The fair value determined represents the cost for the award and is recognized over the vesting period during which an employee is required to provide service in exchange for the award. As share-based compensation expense is recognized based on awards ultimately expected to vest, we reduce the expense for estimated forfeitures based on historical forfeiture rates. Previously recognized compensation costs may be adjusted to reflect the actual forfeiture rate for the entire award at the end of the vesting period. Excess tax benefits, if any, are recognized as an addition to paid-in capital. 2. Summary of Significant Accounting Policies (continued) a) Subsequent Events The Company’s management reviewed all material events from January 31, 2016, through the issuance date of these financial statements for disclosure consideration. b) Recent Accounting Pronouncements The Company has implemented all new accounting pronouncements that are in effect and may impact its financial statements and does not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on its financial position or results of operations. 3. Property and Equipment Useful Lives Amount Computer equipment 5 yrs 2,134 Less: Accumulated depreciation (6) Less: Costs recovered upon disposal (1,067) Less: Impairment (1,061) $ - During the year ended January 31, 2016, the Company recovered $1,067 of equipment costs, deemed the remaining cost of equipment unrecoverable and recorded an impairment of $1,061 of the remaining asset costs. 4. Short-term Debts On August 1, 2013, the Company entered into a loan agreement in which the note holder agreed to provide a loan to the Company in the principal amount of up to $50,000. The loan is unsecured, bears interest at 8% per annum and payable on August 1, 2014. The loan agreement has been amended when the loan amount was increased to $75,000 with an extension of the maturity date to August 1, 2015. As of January 31, 2016, the maturity date has not been extended and the loan is due on demand. As of January 31, 2016, the note holder has provided $69,946 to the Company. On February 3, 2015, the Company entered into a loan agreement in which the note holder agreed to provide a loan to the Company in the principal amount of $25,000. Subsequently, the loan was amended to increase the principal balance to $100,000. The loan bears interest at 7.5% per annum and is due on demand. As of January 31, 2016, the note holder has provided $100,000 to the Company. 5. Related Party Transactions As of January 31, 2016, the Company is indebted to Stephen Shepherd, CEO of the Company for $52,137 (2015 - $6,929). This amount represents non-interest bearing advances payable of $8,516 and unpaid consulting fees of $43,621. During the year ended January 31, 2016, the Company expensed $60,000 of consulting fees to the CEO of the Company. 6. Stockholders’ Deficit The Company’s authorized capital consisted of 300,000,000 shares of common stock with a par value of $0.00001 per share and 100,000,000 shares of preferred stock with a par value of $0.00001 per share. On December 5, 2014, the Company entered into a subscription agreement whereby the Company issued 600,000 common shares at a purchase price of $0.25 per share for proceeds of $150,000. Pursuant to the agreement, the Company also issued a warrant to purchase 600,000 common shares of the Company with an exercise price of $0.50 per share for a period of one year. On November 4, 2014, the Company entered into a consulting agreeemnt with Pacific Seaboard Investments. Pursuant of the agreement, the Company agreed to pay a monthly payment of $7,000 of which $3,500 was cash and $3,500 to be converted into common stock at a conversion price of 50% discount of the average lowest 3 days trading prices. During the year ended January 31, 2016, the Company recorded $93,329 as stock compensation. These shares have not been issued. There were no share transactions during the year ended January 31, 2016. 7. Warrants The following table summarizes the continuity of share purchase warrants: Number of Warrants Weighted Average Exercise Price Balance, January 31, 2014 - $ - Issued 600,000 0.50 Balance, January 31, 2015 600,000 $ 0.50 Expired (600,000) 0.50 Balance, January 31, 2016 - $ - 8. Commitments And Contingencies a) On November 1, 2014, the Company entered into a consulting agreement with a consultant who will provide consulting services in consideration for $7,000 per month for a 1 year term, ending on December 1, 2015. The consulting agreement is currently month-to-month. The consulting fee is payable as follows: i. $3,500 per month settled in shares which will be converted at a 50% discount of the lowest 3 trading prices for the Company’s common stock during the last 10 trading days of each month. ii. $3,500 per month payable in cash at the end of each month in which the consultant also has the option to convert into shares at a market price less a 50% discount of the lowest 3 trading prices for the Company’s common stock during the last 10 trading days from the date of conversion. As of January 31, 2016, the Company paid $10,500 and issued 0 shares to the consultant, $42,000 and $115,496 has been accrued in accounts payable and stock payable, respectively. a) On December 1, 2014, the Company entered into a consulting agreement with a consultant who will provide consulting services in consideration for cash payments of $2,500 per month for a 6 month term ending May 31, 2015. The consulting agreement is currently month-to-month. During the year ended January 31, 2016, the Company paid $27,500 (2015 - $5,000) to the consultant. b) On December 8, 2014, the Company entered into a consulting agreement with a consultant who will provide consulting services in consideration for cash payments of $5,000 per month for a 6 month term ending May 1, 2015. The consulting agreement is currently month-to-month. During the year ended January 31, 2016, the Company paid $20,000 (2015 - $10,000) to the consultant. c) On August 31, 2015, the Company entered into a definitive Joint Venture Agreement (the "Agreement") with Mango Pay SRL ("Mango Pay") to provide their customers with the ability to purchase digital currency, specifically bitcoin. Pursuant to the terms of the Agreement, Mango Pay will handle the day-to-day caretaking and operational requirements of the machines and will exclusively use the services of the Company for provision of bitcoin through their network of kiosks for a period of one (1) year. At the conclusion of each month, both the Company and Mango Pay will be entitled to 50% of the transaction revenue from the previous month. 2. Income Taxes The Company is subject to United States federal and state income taxes at an approximate rate of 35%. The reconciliation of the provision for income taxes at the United States federal and state statutory rate compared to the Company’s income tax expense as reported is as follows: Year Ended January 31, Year Ended January 31, Income tax benefit computed at the statutory rate $ 94,724 $ 62,023 Change in valuation allowance (94,724) (62,023) Provision for income taxes $ - $ - Significant components of the Company’s deferred tax assets and liabilities after applying enacted corporate income tax rates, are as follows: January 31, January 31, Deferred income tax assets Net operating losses $ 190,244 $ 95,519 Valuation allowance (190,244) (95,519) Net deferred income tax assets $ - $ - The Company has net operating loss carryforwards of $543,553 which expire commencing in 2032. 3. Subsequent Events On August 14, 2017 the Company entered into a convertible note agreement with Corona Software for $20,000 the notes bears interest of 8% and is due March 14, 2018. Payments shall be made in US currency or paid with common stock at a 50% discount to the lowest average 20 day trading price.
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Based on the financial statement excerpt, here's a summary:
Financial Condition:
- The company is experiencing financial difficulties
- Has significant losses from operations
- Shows a net capital deficiency
- Raises substantial doubt about the company's ability to continue operating
Financial Highlights:
- Current Assets: $19,579 (primarily cash and cash equivalents)
- Current Liabilities: $149,548 (accounts payable and accrued liabilities)
- Negative financial position with liabilities significantly exceeding assets
The company appears to be in a precarious financial situation, with more liabilities than assets and ongoing operational losses. Management may have plans to address these challenges, as noted in the statement.
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Claude
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FINANCIAL STATEMENTS Index To Consolidated Financial Statements Report of Independent Registered Public Accounting Firm. Consolidated Balance Sheets at December 31, 2016 and 2015. Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2016, 2015 and 2014. Consolidated Statements of Changes to Shareholders’ Equity for the years ended December 31, 2016, 2015 and 2014. Consolidated Statements of Cash Flow for the years ended December 31, 2016, 2015 and 2014. . Report of Independent Registered Public Accounting Firm Audit Committee, Board of Directors and Stockholders Farmers & Merchants Bancorp, Inc. Archbold, Ohio We have audited the accompanying consolidated balance sheets of Farmers & Merchants Bancorp, Inc. (Company) as of December 31, 2016 and 2015, and the related consolidated statements of income and comprehensive income, changes to stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2016. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Farmers & Merchants Bancorp, Inc. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Farmers & Merchants Bancorp, Inc.’s internal control over financial reporting as of December 31, 2016, based on criteria established in 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 22, 2017, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/ BKD, LLP BKD, LLP Fort Wayne, Indiana February 22, 2017 Report of Independent Registered Public Accounting Firm Audit Committee, Board of Directors and Stockholders Farmers & Merchants Bancorp, Inc. Archbold, Ohio We have audited Farmers & Merchants Bancorp, Inc.’s (Company) internal control over financial reporting as of December 31, 2016, based on criteria established in 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Farmers & Merchants, Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Farmers & Merchants Bancorp, Inc. and our report dated February 22, 2017, expressed an unqualified opinion thereon. /s/ BKD, LLP BKD, LLP Fort Wayne, Indiana February 22, 2017 Farmers & Merchants Bancorp, Inc. and Subsidiaries Consolidated Balance Sheets December 31, 2016 and 2015 (000’s Omitted, Except Per Share Data) See Farmers & Merchants Bancorp, Inc. and Subsidiaries Consolidated Statements of Income & Comprehensive Income Years Ended December 31, 2016, 2015 and 2014 (000’s Omitted, Except Per Share Data) See Farmers & Merchants Bancorp, Inc. and Subsidiaries Consolidated Statements of Changes to Stockholders’ Equity For the Years Ended December 31, 2016, 2015 and 2014 (000’s Omitted, Except Per Share Data) See notes to Consolidated Financial Statements Farmers & Merchants Bancorp, Inc. and Subsidiaries Consolidated Statements of Cash Flows Years Ended December 31, 2016, 2015 and 2014 (000’s Omitted) See Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies Nature of Operations The Farmers & Merchants Bancorp, Inc. (the Company) through its bank subsidiary, The Farmers & Merchants State Bank (the Bank) provides a variety of financial services to individuals and small businesses through its offices in Northwest Ohio and Northeast Indiana. Consolidation Policy The consolidated financial statements include the accounts of Farmers & Merchants Bancorp, Inc. and its wholly-owned subsidiaries, The Farmers & Merchants State Bank (the Bank), a commercial banking institution and Farmers & Merchants Risk Management, Inc. (the Captive), a Captive insurance company. All significant inter-company balances and transactions have been eliminated. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of mortgage servicing rights, goodwill, available for sale investment securities, other real estate owned and impaired loans. Actual results could differ from those estimates. The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral. The Bank’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions in the agricultural industry. While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated. Cash and Cash Equivalents For purposes of the consolidated statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. This includes cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are purchased for one day periods. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies (Continued) Restrictions on Cash and Amounts Due from Banks The Bank is required to maintain average balances on hand with the Federal Reserve Bank. The aggregate reserve was $5.0 million for December 31, 2016 and it was $6.5 million for December 31, 2015. The Company and its subsidiaries maintain cash balances with high quality credit institutions. At times such balances may be in excess of the federally insured limits. Securities Debt securities are classified as available-for-sale. Securities available-for-sale are carried at fair value with unrealized gains and losses reported in other comprehensive income (loss). Net realized gains and losses on securities available for sale are included in noninterest income (expense) and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income (loss). Gains and losses on sales of securities are determined on the specific-identification method. Declines in the fair value of securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The related write-downs are included in earnings as realized losses. Other Securities Other Securities consists of Federal Home Loan Bank of Cincinnati stock and Farmer Mac stock. These stocks are carried at cost and are held to enable the Bank to conduct business with the entities. The Federal Home Loan Bank sells and purchases their stock at par. The Federal Home Loan Bank of Cincinnati stock is held as collateral security for all indebtedness of the Bank to the Federal Home Loan Bank. The Federal Home Loan Bank of Cincinnati is evaluated for impairment as conditions warrant. Loans Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at the amount of unpaid principal, reduced by unearned discounts and deferred loan fees and costs, as well as, by the allowance for loan losses. Interest income is accrued on a daily basis based on the principal outstanding. Generally, a loan is classified as nonaccrual and the accrual of interest income is generally discontinued when a loan becomes ninety days past due as to principal or interest and these loans are placed on a “cash basis” for purposes of income recognition. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to cover the principal and accrued interest, and the loan is in the process of collection. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest receivable is charged against income. Loan origination and commitment fees and certain direct loan origination costs are deferred and amortized as a net adjustment to the related loan’s yield. The Bank is generally amortizing these costs over the contractual life of such loans. Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses charged to income. Loans deemed to be uncollectable and changes in the allowance relating to loans are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies (Continued) The allowance for loan losses is evaluated on a regular basis by management and is based on management’s periodic review of the collectability of the loans in light of historical experiences, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are subject to revision as more information becomes available. The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. The unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and agricultural loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. At 90 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. For the majority of the Bank’s impaired loans, the Bank will apply the fair value of collateral or use a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine fair value of collateral, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained. Until such time that updated appraisals are received, the Bank may discount the collateral value used. Large groups of homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer loans for impairment, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower. For more information regarding the actual composition and classification of loans involved in the establishment of the allowance for loan loss, please see Note 4 provided here with the notes to consolidated financial statements. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies (Continued) Loans Held for Sale Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income. Servicing Assets Servicing assets are recognized as separate assets when rights are acquired through purchase or sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest expense in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in operating income as loan payments are received. Costs of servicing loans are charged to expense as incurred. Goodwill and Other Intangible Assets Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually. If possible impairment is likely, the Bank will utilize the assistance of an independent third party for impairment and any such impairment is recognized in the period identified. The Bank considered the following qualitative factors to determine if impairment was likely: 1) the Bank continued to perform above peer and remains profitable with capital remaining strong, 2) the Bank had improved asset quality and does not see any change in the trend, 3) the Bank had strong liquidity and capital positions, 4) in quantitative testing done in 2016, the excess fair value of capital was $11.3 million or 10.4% over the carrying value and was over two and a half times the value of the goodwill being carried and 5) the Bank was unaware of any likely circumstances that would indicate the fair value of the entity would be greatly decreased in the near future. Therefore, the Bank concluded it is unlikely impairment of Goodwill has occurred from the goodwill established from the Bank’s acquisition which occurred on December 31, 2007. Other intangible assets consist of core deposit intangible assets arising from business acquisitions. They are initially measured at fair value and then are amortized on a straight line method over their estimated useful lives and evaluated for impairment. Off Balance Sheet Instruments In the ordinary course of business, the Bank has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded. Foreclosed Real Estate Foreclosed real estate held for sale is carried at the lower of fair value minus estimated costs to sell, or cost. Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and an allowance is established by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell. Foreclosed real estate is classified as other real estate owned. The net income from operations of foreclosed real estate held for sale is reported in non-interest income. At December 31, the Bank’s holding of other real estate owned totaled $774 thousand and approximately $1.2 million for 2016 and 2015 respectively. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies (Continued) Bank Premises and Equipment Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is based on the estimated useful lives of the various properties and is computed using straight line and accelerated methods. Costs for maintenance and repairs are charged to operations as incurred. Gains and losses on dispositions are included in current operations. Federal Income Tax The Company’s income tax expense consists of the following components: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in tax expense. Based on management’s analysis, the Company did not have any uncertain tax positions as of December 31, 2016 and 2015. With a few exceptions, the Company is no longer subject to U.S. Federal, state or local examinations by tax authorities for years before 2013. Earnings Per Share Basic earnings per share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. See Note 12 for additional information. Stock-Based Compensation The fair value of restricted common stock is their fair market value on the date of grant. The fair value of restricted stock is amortized as compensation expense on a straight-line basis over the vesting period of the grants. Compensation expense recognized is included in personnel expense in the consolidated statement of income. Treasury Stock Common stock shares repurchased are recorded at market value on date of purchase. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies (Continued) Other Comprehensive Income (Loss) Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet. Such items, along with net income, are components of other comprehensive income (loss). The components of other comprehensive income (loss) and related tax effects are as follows: Reclassification Certain amounts in the 2015 and 2014 consolidated financial statements have been reclassified to conform with the 2016 presentation. These reclassifications had no effect on net income. Subsequent Events On January 20, 2017, the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 200,000 shares of its outstanding common stock commencing January 20, 2017 and ending December 31, 2017. Recent Accounting Pronouncements In January 2016, the FASB issued ASU No. 2016-01 “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 is intended to improve the recognition and measurement of financial instruments by requiring equity investments to be measured at fair value with changes in fair value recognized in net income; requiring public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; eliminating the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured and amortized at cost on the balance sheet; and requiring a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. ASU 2016-01 is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2017. The amendments should be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values (including disclosure requirements) should be applied prospectively to equity investments that exist as of the date of adoption. The Company is assessing the impact of ASU 2016-01 on its accounting and disclosures. While it would be preferred to run fair value adjustment through other comprehensive income, the Company would choose to limit any further fair value presentation on the financial statements. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 1 - Summary of Significant Accounting Policies (Continued) In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” ASU 2016-02 establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. A lease will be treated as sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing. If the lessor doesn’t convey risks and rewards or control, an operating lease results. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for public business entities. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, with certain practical expedients available. Early adoption is permitted. The Company is assessing the impact of ASU 2016-02 on its accounting and disclosures and currently has very limited exposure to the rule. In March 2016, the FASB issued ASU No. 2016-09 “Compensation - Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment Accounting.” ASU 2016-09 requires all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. It also allows an employer to repurchase more of an employee’s shares than it can today for tax withholding purposes without triggering liability accounting and to make a policy election for forfeitures as they occur. The guidance is effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those years. Early adoption is permitted. The Company is assessing the impact of ASU 2016-09 on its accounting and disclosures and working to create procedures to effectively capture and present the information. The Company does utilize restricted stock awards with three year cliff vesting to its employees presently. In June 2016, FASB issued 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The ASU is effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (i.e., January 1, 2020, for calendar year entities). Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently gathering information, reviewing possible vendors and has formed a committee to formulate the methodology to be used. Most importantly, the Company is gathering as much data as possible to enable review scenarios and determine which calculations will produce the most reliable results. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 2 - Business Combination & Asset Purchase The Company recognized core deposit intangible assets of $2.26 million with the purchase of offices. $1.17 million was recognized with the purchase of the Custar office on December 13, 2013 and $1.09 million with the Hicksville office on July 9, 2010. These are being amortized over an estimated remaining economic useful life of the deposits of 7 years on a straight line basis. In connection with a December 31, 2007 Knisely acquisition, the Company recognized a core deposit intangible asset of $1.1 million, which was fully amortized during 2014. The core deposit intangible is included in other assets on the consolidated balance sheets. The amortization expense for the years ended December 31, 2016, 2015 and 2014 was $323, $323, and $480 thousand, respectively. Amortization expense of the core deposit intangible assets remaining is as follows: Note 3 - Securities The amortized cost and fair value of securities, with gross unrealized gains and losses, follows: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 3 - Securities (Continued) Investment securities will at times depreciate to an unrealized loss position. The Bank utilizes the following criteria to assess whether impairment is other than temporary. No one item by itself will necessarily signal that a security should be recognized as an other than temporary impairment. 1. The fair value of the security has significantly declined from book value. 2. A downgrade has occurred that lowered the credit rating to below investment grade (below Baa3 by Moody and BBB - by Standard and Poors.) 3. Dividends have been reduced or eliminated or scheduled interest payments have not been made. 4. The underwater security has longer than 10 years to maturity and the loss position had existed for more than 3 years. 5. Management does not possess both the intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The new cost basis shall not be changed for subsequent recoveries in fair value. The amount of the write down shall be included in current earnings as a realized loss. The recovery in fair value, if any, shall be recognized in earnings when the security is sold. The table below is presented by category of security and length of time in a continuous loss position. The Bank currently does not hold any securities with other than temporary impairment. Information pertaining to securities with gross unrealized losses at December 31, 2016 and 2015, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows: Unrealized losses on securities have not been recognized into income because the issuers’ bonds are of high credit quality, values have only been impacted by rate changes, and the Company has the intent and ability to hold the securities for the foreseeable future. The fair value is expected to recover as the bonds approach the maturity date. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 3 - Securities (Continued) Sales of $85.7, $47.0, and $57.9 million for 2016, 2015, and 2014 respectively, generated gross realized gains and losses for the years ended December 31, as presented below: The net realized gain on sales and related tax expense is a reclassification out of accumulated other comprehensive income. The net realized gain is included in net gain on sale of securities available-for-sale and the related tax expense is included in income tax expense in the consolidated statements of income and comprehensive income. The amortized cost and fair value of debt securities at December 31, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Investments with a carrying value and fair value of $129.4 million at December 31, 2016 and $189.3 million at December 31, 2015 were pledged to secure public deposits and securities sold under repurchase agreements. Other securities include Federal Home Loan Bank of Cincinnati and Farmer Mac stock as of December 31, 2016 and 2015. Note 4 - Loans The Company had $2.1 million in loans held for sale at December 31, 2016 as compared to $1.2 million in loans held for sale at December 31, 2015. Due to materiality, these loans are included in the Consumer Real Estate and Agricultural Real Estate loan categories at the lower of cost or market. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) Loans at December 31 are summarized below: Following are the characteristics and underwriting criteria for each major type of loan the Bank offers: Commercial Real Estate: Construction, purchase, and refinance of business purpose real estate. Risks include potential construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower’s ability to repay in orderly fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval. Agricultural Real Estate: Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation. Consumer Real Estate: Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others. Commercial and Industrial: Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of profit projections, financial leverage, economic trends, management ability, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval. Agricultural: Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmer’s ability to hedge their position by the use of future contracts. The risk related to weather is often mitigated by requiring federal crop insurance. Consumer: Funding for individual and family purposes. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others. Industrial Development Bonds (IDB): Funds for public improvements in the Bank’s service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) The following is a maturity schedule by major category of loans at December 31, 2016: The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of December 31, 2016: As of December 31, 2016 and 2015 one to four family residential mortgage loans amounting to $17.9 million and $20.0 million, respectively, have been pledged as security for loans the Bank has received from the Federal Home Loan Bank. Industrial Development Bonds are included in the commercial and industrial category for the remainder of the tables in this Note 4, unless specifically noted separately. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) The following table represents the contractual aging of the recorded investment in past due loans by portfolio classification of loans as of December 31, 2016 and 2015, net of deferred loan fees and costs: The following table presents the recorded investment in nonaccrual loans by portfolio class of loans as of December 31, 2016 and December 31, 2015: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) The Bank uses a nine tier risk rating system to grade its loans. The grade of a loan may change during the life of the loan. The risk ratings are described as follows. 1. Zero (0) Unclassified. Any loan which has not been assigned a classification. 2. One (1) Excellent. Credit to premier customers having the highest credit rating based on an extremely strong financial condition, which compares favorably with industry standards (upper quartile of The Risk Management Association ratios). Financial statements indicate a sound earnings and financial ratio trend for several years with satisfactory profit margins and excellent liquidity exhibited. Prime credits may also be borrowers with loans fully secured by highly liquid collateral such as traded stocks, bonds, certificates of deposit, savings account, etc. No credit or collateral exceptions exist and the loan adheres to the Bank’s loan policy in every respect. Financing alternatives would be readily available and would qualify for unsecured credit. This grade is summarized by high liquidity, minimum risk, strong ratios, and low handling costs. 3. Two (2) Good. Desirable loans of somewhat less stature than Grade 1, but with strong financial statements. Loan supported by financial statements containing strong balance sheets, generally with a leverage position less than 1.50, and a history of profitability. Probability of serious financial deterioration is unlikely. Possessing a sound repayment source (and a secondary source), which would allow repayment in a reasonable period of time. Individual loans backed by liquid personal assets, established history and unquestionable character. 4. Three (3) Satisfactory. Satisfactory loans of average or slightly above average risk - having some deficiency or vulnerability to changing economic conditions, but still fully collectible. Projects should normally demonstrate acceptable debt service coverage. Generally, customers should have a leverage position less than 2.00. May be some weakness but with offsetting features of other support readily available. Loans are meeting the terms of repayment. Loans may be graded 3 when there is no recent information on which to base a current risk evaluation and the following conditions apply: At inception, the loan was properly underwritten and did not possess an unwarranted level of credit risk; a. At inception, the loan was secured with collateral possessing a loan value adequate to protect the Bank from loss; b. The loan exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance; c. During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants, or the business is in an industry which is known to be experiencing problems. If any of the credit weaknesses is observed, a lower risk grade is warranted. 5. Four (4) Satisfactory / Monitored. A “4” (Satisfactory/Monitored) risk grade may be established for a loan considered satisfactory but which is of average credit risk due to financial weakness or uncertainty. The loans warrant a higher than average level of monitoring to ensure that weaknesses do not advance. The level of risk in Satisfactory/Monitored classification is considered acceptable and within normal underwriting guidelines, so long as the loan is given management supervision. 6. Five (5) Special Mention. Loans that possess some credit deficiency or potential weakness which deserves close attention, but which do not yet warrant substandard classification. Such loans pose unwarranted financial risk that, if not corrected, could weaken the loan and increase risk in the future. The key distinctions of a 5 (Special Mention) classification are that (1) it is indicative of an unwarranted level of risk, and (2) weaknesses are considered “potential”, versus “defined”, impairments to the primary source of loan repayment and collateral. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) 7. Six (6) Substandard. One or more of the following characteristics may be exhibited in loans classified substandard: a. Loans, which possess a defined credit weakness and the likelihood that a loan will be paid from the primary source, are uncertain. Financial deterioration is underway and very close attention is warranted to ensure that the loan is collected without loss. b. Loans are inadequately protected by the current net worth and paying capacity of the borrower. c. The primary source of repayment is weakened, and the Bank is forced to rely on a secondary source of repayment such as collateral liquidation or guarantees. d. Loans are characterized by the distinct possibility that the Bank will sustain some loss if deficiencies are not corrected. e. Unusual courses of action are needed to maintain a high probability of repayment. f. The borrower is not generating enough cash flow to repay loan principal; however, continues to make interest payments. g. The lender is forced into a subordinate position or unsecured collateral position due to flaws in documentation. h. Loans have been restructured so that payment schedules, terms and collateral represent concessions to the borrower when compared to the normal loan terms. i. The lender is seriously contemplating foreclosure or legal action due to the apparent deterioration in the loan j. There is significant deterioration in the market conditions and the borrower is highly vulnerable to these conditions. 8. Seven (7) Doubtful. One or more of the following characteristics may be exhibited in loans classified Doubtful: a. Loans have all of the weaknesses of those classified as Substandard. Additionally, however, these weaknesses make collection or liquidation in full based on existing conditions improbable. b. The primary source of repayment is gone, and there is considerable doubt as to the quality of the secondary source of repayment. c. The possibility of loss is high, but, because of certain important pending factors which may strengthen the loan, loss classification is deferred until its exact status is known. A Doubtful classification is established deferring the realization of the loss. 9. Eight (8) Loss. Loans are considered uncollectable and of such little value that continuing to carry them as assets on the institution’s financial statements is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) The following table represents the risk category of loans by portfolio class, net of deferred fees, based on the most recent analysis performed as of the time periods shown of December 31, 2016 and December 31, 2015. For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan, which was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned risk grading as of December 31, 2016 and December 31, 2015. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) Information about impaired loans as of and for the years ended December 31, 2016 and 2015 are as follows: No additional funds are committed to be advanced in connection with impaired loans. The Bank had approximately $0.7 million of its impaired loans classified as trouble debt restructured as of December 31, 2016 as compared to $1.1 million of its impaired loans classified as trouble debt restructured as of December 31, 2015. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) The following table represents the years ended December 31, 2016 and 2015. For the years ended December 31, 2016 and 2015, there was one TDR from 2015 that subsequently defaulted after modification during 2016 at a loss of $79.6 thousand. For the majority of the Bank’s impaired loans, the Bank will apply the observable market price methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used. The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) The following tables present loans individually evaluated for impairment by portfolio class of loans as of December 31, 2016 and 2015: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) On January 1, 2015, the Company adopted Accounting Standards Update (ASU) 2014-04, Receivables, - “Troubled Debt Restructuring by Creditors. As of December 31, 2016 the Company had $169 thousand of foreclosed residential real estate property obtained by physical possession and $112 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions. This compares to the Company having $477 thousand of foreclosed residential real estate property obtained by physical possession and $425 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions as of December 31, 2015. The ALLL has a direct impact on the provision expense. An increase in the ALLL is funded through recoveries and provision expense. The following tables summarize the activities in the allowance for credit losses. The following is an analysis of the allowance for credit losses for the years ended December 31: The Company segregates its Allowance for Loan and Lease Losses (ALLL) into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL). The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses. The following table breaks down the activity within ALLL for each loan portfolio segment and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) Additional analysis related to the allowance for credit losses as of December 31, 2016 and 2015 is as follows: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 4 - Loans (Continued) Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 5 - Premises and Equipment The major categories of banking premises and equipment and accumulated depreciation at December 31 are summarized below: Depreciation expense for the years ended December 31, 2016, 2015 and 2014 amounted to $1.5, $1.4, and $1.3 million, respectively. Note 6 - Servicing Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of loans serviced for others were $280.4 and $275.6 million at December 31, 2016 and 2015, respectively. The balance of capitalized servicing rights included in other assets at December 31, 2016 and 2015, was $2.2 and $2.1 million, respectively. The capitalized addition of servicing rights is included in net gain on sale of loans on the consolidated statement of income. The fair market value of the capitalized servicing rights as of December 31, 2016 and 2015 was $2.5 million and $2.7 million, respectively. The valuations were completed by stratifying the loans into like groups based on loan type and term. Impairment was measured by estimating the fair value of each stratum, taking into consideration an estimated level of prepayment based upon current market conditions. An average constant prepayment rate of 14.3% and 11.0% were utilized for 2016 and 2015, respectively. All stratums showed positive values compared to carrying value using a discount yield of 5.38% for 2016 and 6.52% for 2015. The following summarizes mortgage servicing rights capitalized and amortized during each year: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 7 - Deposits Time deposits as of December 31 consist of the following: At December 31, 2016 the scheduled maturities for time deposits are as follows: Note 8 - Federal Funds Purchased and Securities Sold Under Agreement to Repurchase The Bank’s policy requires qualifying securities to be used as collateral for the underlying repurchase agreements. As of December 31, 2016 and 2015 securities with a book value of $56.0 million and $65.8 million, respectively, were pledged to secure the repurchase agreements. The table below presents the daily securities sold under agreement to repurchase and the term repurchase agreements. It does not include the Bank’s Federal Funds purchased. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 8 - Federal Funds Purchased and Securities Sold Under Agreement to Repurchase (continued) The Company had $17.0 and $22.0 million of Federal Funds Purchased as of December 31, 2016 and December 31, 2015 respectively. The $53.3 million in Securities Sold Under Agreements to Repurchase were comprised of U.S. Treasuries and government agency securities. The table below shows the remaining contractual maturity in the repurchase agreements December 31, 2016. Note 9 - Federal Home Loan Bank Advances Long term debit consists of various loans from the Federal Home Loan Bank. Repayment structures vary, ranging from monthly installments, annual payments or upon maturity. Interest payments are due monthly. As of December 31, 2016, the Bank had two loans which were structured as single maturities with interest rates of 1.61% and 1.34%. Total borrowings were $10.0 million and $10.0 million for December 31, 2016 and 2015, respectively. The advances were secured by $17.9 and $20.0 million of mortgage loans as of December 31, 2016 and 2015, respectively under a blanket collateral agreement. The advances are subject to pre-payment penalties and the provisions and conditions of the credit policy of the Federal Home Loan Bank. Future obligations of the advances are as follows at December 31, 2016: The Bank had access to $58 million of unsecured borrowings through correspondent banks as of both December 31, 2016 and December 31, 2015. $71.8 million and $29.4 million at the end of the same time periods, respectively, were unpledged securities which could be sold or used as collateral. An additional $4.7 million at December 31, 2016, and $4.1 million at December 31, 2015, were available from the Federal Home Loan Bank based on current pledging, with up to $115.7 million and $118.5 million, respectively, available provided adequate collateral is pledged. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 10 - Federal Income Taxes The components of income tax expense (benefit) for the years ended December 31 are as follows: The following is a reconciliation of the statutory federal income tax rate to the effective tax rate Deferred tax assets and liabilities at December 31 are comprised of the following: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 11 - Employee Benefit Plans The Bank has established a 401(k) profit sharing plan, which allows eligible employees to save at a minimum one percent of eligible compensation on a pre-tax basis, subject to certain Internal Revenue Service limitations. The Bank will match 50% of employee 401(k) contributions up to four percent of total eligible compensation. In addition, the Bank may make a discretionary contribution from time to time. A participant is 100% vested in the participant’s deferral contributions and employer matching contributions. A six-year vesting schedule applies to employer discretionary contributions. Contributions expensed for the 401(k) profit sharing plan for both the employer matching contribution and the discretionary contribution were $877, $835 and $779 thousand for 2016, 2015 and 2014, respectively. Restricted Stock Awards The Company has a Long-Term Stock Incentive Plan under which 16,150 shares of restricted stock were issued to 74 employees during 2016, 16,000 shares of restricted stock were issued to 67 employees during 2015 and 13,250 shares of restricted stock were issued to 61 employees during 2014. Under the plan, the shares vest 100% in three years. During the 3 year vesting period, the employees receive dividends or dividend equivalent compensation on the shares. Due to employee termination, there were 773, 100, and 780 forfeited during 2016, 2015 and 2014, respectively. During 2016, 4 employees retired and received 1,197 shares from the shares awarded in 2013, 2014 and 2015. During 2015, due to retirement, one employee received 250 shares from awards granted in 2012, 2013 and 2014 and 325 shares were paid to the estate of a deceased employee awarded during the same time periods. Due to retirement in 2014, two employees received 965 shares. During 2016, 10,025 shares awarded in 2013, were vested 100% and 45 employees received the stock During 2015, 9,720 shares awarded in 2012, were vested 100% and 45 employees received the stock. During 2014, 10,005 shares awarded in 2011, were vested 100%, and 48 employees received the stock. Compensation expense applicable to the restricted stock totaled $379, $286 and $252 thousand for the years ending December 31, 2016, 2015 and 2014, respectively. The following table summarizes the activity of restricted stock awards as of December 31: As of December 31, 2016, there was $730 thousand of unrecognized compensation cost related to the nonvested portion of restricted stock awards under the plan. Expense for restricted stock awards of $402 thousand, $314 thousand, and $232 thousand was recorded for the years ended December 31, 2016, 2015, and 2014, respectively. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 12 - Earnings Per Share Basic earnings per share is calculated using the two-class method. The two-class method is an earnings allocation formula under which earnings per share is calculated from common stock and participating securities according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings distributed and undistributed, are allocated to participating securities and common shares based on their respective rights to receive dividends. Unvested share-based payment awards that contain non-forfeitable rights to dividends are considered participating securities (i.e. unvested restricted stock), not subject to performance based measures. Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Application of the two-class method for participating securities results a more dilutive basic earnings per share as the participating securities are allocated the same amount of income as if they are outstanding for purposes of basic earnings per share. There is no additional potential dilution in calculating diluted earnings per share, therefore basic and diluted earnings per share are the same amounts. Other than the restricted stock plan, the Company has no other stock based compensation plans. The table below presents basic and diluted earnings per share for the years ended December 31, 2016, 2015, and 2014. Note 13 - Related Party Transactions In the ordinary course of business, the Bank has granted loans to senior officers and directors and their affiliated companies amounting to $1.5 million and $739 thousand at December 31, 2016 and 2015, respectively. One new loan was approved during 2016 of which no additional borrowings were utilized. During 2016, subsequent advances totaled $9.9 million and payments of $10.1 million were received. The difference in related borrowings amounted to $757 thousand, net increase. Deposits of directors, executive officers and companies in which they have a direct or indirect ownership as of December 31, 2016 and 2015, amounted to $21.7 million and $26.3 million, respectively. Note 14 - Off Balance Sheet Activities Credit Related Financial Instruments The Bank is a party to credit related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing need of its customers. These financial instruments include commitments to extend credit, Standby Letters of Credit, and Commercial Letters of Credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 14 - Off Balance Sheet Activities (Continued) The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance-sheet instruments. The allowance for credit losses as it relates to unfunded loan commitments (AULC) is included under other liabilities. The AULC as of December 31, 2016 and 2015 was $217 thousand and $208 thousand, respectively. At December 31, 2016 and 2015, the following financial instruments were outstanding whose contract amounts represent credit risk: Commitments to extend credit, credit card arrangements and Standby Letters of Credit all include exposure to some credit loss in the event of nonperformance of the customer. The Bank’s credit policies and procedures for credit commitments and financial guarantees are the same as those for extensions of credit that are recorded in the financial statements. Due to the fact that these instruments have fixed maturity dates, and because many of them expire without being drawn upon, they generally do not present any significant liquidity risk to the Bank. Collateral Requirements To reduce credit risk related to the use of credit-related financial instruments, the Bank might deem it necessary to obtain collateral. The amount and nature of the collateral obtained is based on the Bank’s credit evaluation of the customer. Collateral held varies but may include cash, securities, accounts receivable, inventory, property, plant, and real estate. Legal Contingencies Various legal claims also arise from time to time in the normal course of business, which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements. Note 15 - Minimum Regulatory Capital Requirements The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 15 - Minimum Regulatory Capital Requirements (Continued) The Basel III Capital Rules, a new comprehensive capital framework for U.S. banking organizations, became effective for on January 1, 2015 (subject to a phase-in period for certain provisions). Quantitative measures established by the Basel III Capital Rules to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of Common Equity Tier 1 capital, Tier 1 capital and Total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined). In connection with the adoption of the Basel III Capital Rules, we elected to opt-out of the requirement to include most components of accumulated other comprehensive income in Common Equity Tier 1. Common Equity Tier 1 is reduced by, goodwill and other intangible assets, net of associated deferred tax liabilities, and subject to transition provisions. The Common Equity Tier 1 (beginning in 2015), Tier 1 and Total capital ratios are calculated by dividing the respective capital amounts by risk-weighted assets. Risk-weighted assets are calculated based on regulatory requirements and include total assets, with certain exclusions, allocated by risk weight category, and certain off-balance-sheet items, among other things. The leverage ratio is calculated by dividing Tier 1 capital by adjusted quarterly average total assets, which exclude goodwill and other intangible assets, among other things. When fully phased in on January 1, 2019, the Basel III Capital Rules will require the Company and Bank to maintain (i) a minimum ratio of Common Equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% Common Equity Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum ratio of Common Equity Tier 1 capital to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average quarterly assets. The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to the Company or Bank. The capital conservation buffer is designed to absorb losses during periods of economic stress and, as detailed above, effectively increases the minimum required risk-weighted capital ratios. Banking institutions with a ratio of Common Equity Tier 1 capital to risk-weighted assets below the effective minimum (4.5% plus the capital conservation buffer and, if applicable, the countercyclical capital buffer) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. Management believes, as of December 31, 2016, that the Bank meets all the capital adequacy requirements to which it is subject. As of December 31, 2016 the most recent notification from the FDIC indicated the Bank was categorized as well capitalized under the regulatory framework for prompt corrective action. To remain categorized as well capitalized, the Bank will have to maintain minimum total risk-based, Tier I risk-based, Common Tier 1 and Tier I leverage ratios as disclosed in the table to follow. There are no conditions or events since the most recent notification that management believes have changed the Bank’s prompt corrective action category. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 15 - Minimum Regulatory Capital Requirements (Continued) The following tables present actual and required capital ratios as of December 31, 2016 and December 31, 2015 under the Basel III Capital Rules. The minimum required capital amounts presented include the minimum required capital levels as of December 31, 2016 and December 31, 2015. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules. The Company and the Bank’s actual and required capital amounts and ratios as of December 31, 2016 are as follows: Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 15 - Minimum Regulatory Capital Requirements (Continued) The following table presents the Company and the Bank’s actual and required capital amounts and ratios as of December 31, 2015. Note 16 - Restrictions of Dividends & Inter-company Borrowings The Bank is restricted as to the amount of dividends that can be paid. Dividends declared by the Bank that exceed the net income for the current year plus retained income for the preceding two years must be approved by federal and state regulatory agencies. Under this formula dividends of $12.1 million may be paid without prior regulatory approval. Regardless of formal regulatory restrictions, the Bank may not pay dividends that would result in its capital levels being reduced below the minimum requirements shown above. Under current Federal Reserve regulations, the Bank is limited as to the amount and type of loans it may make to the Company. These loans are subject to qualifying collateral requirements on which the amount of the loan may be based. Note 17 - Fair Value of Financial Instruments Fair values of financial instruments are management’s estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) The following assumptions and methods were used in estimating the fair value for financial instruments: Cash and Cash Equivalents The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest- bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits. Interest Bearing Time Deposits Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. Securities - Available-for-sale Fair values for securities, excluding Federal Home Loan Bank and Farmer Mac stock, are based on quoted market price, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Other Securities The carrying value of Federal Home Loan Bank and Farmer Mac stock, listed as “other securities,” approximates fair value based on the redemption provisions of the Federal Home Loan Bank. Loans, net For net variable-rate loans that re-price frequently, and with no significant change in credit risk, fair values are based on carrying values. The fair values of the fixed rate and all other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality. Deposits The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. Federal Funds Purchased and Securities Sold Under Agreement to Repurchase The carrying value of Federal Funds purchased and securities sold under agreement to repurchase approximates fair values. FHLB Advances Fair values or FHLB advances are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types or borrowing arrangements. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) Accrued Interest Receivable and Payable The carrying amounts of accrued interest approximate fair values. Off Balance Sheet Financial Instruments Fair values for off-balance-sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of December 31, 2016 and 2015, are reflected below. The aggregate fair values in the table below do not represent the total market value of the Bank’s assets and liabilities. The table excludes the following: Bank Premises and Equipment, Goodwill, Mortgage Servicing Rights, Other Real Estate Owned, Other Assets, Other Liabilities and Accrued Expenses. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) Fair Value Measurements The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis at December 31, 2016 and 2015, and the valuation techniques used by the Company to determine those fair values. In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities in active markets that the Company has the ability to access. Available-for-sale securities - When quoted prices are available in an active market, securities are valued using the quoted price and are classified as Level 1. The quoted prices are not adjusted. Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals. Available-for-sale securities classified as Level 2 are valued using the prices obtained from an independent pricing service. The prices are not adjusted. Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating. Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace. Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. The Bank holds some local municipals that the Bank evaluates based on the credit strength of the underlying project. The fair value is determined by valuing similar credit payment streams at similar rates. In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset. The following table summarizes financial assets measured at fair value on a recurring basis as of December 31, 2016 and December 31, 2015 segregated by level or the valuation inputs within the fair value hierarchy utilized to measure fair value. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) Most of the Company’s available for sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2. There have been no transfers between Levels 1, 2, and 3 during 2016 and 2015. The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At December 31, 2016 and 2015, such assets consist primarily of collateral dependent impaired loans. Collateral dependent impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals). At December 31, 2016 and 2015, collateral dependent impaired loans categorized as Level 3 were $1.7 and $1.8 million, respectively. The specific allocation for collateral dependent impaired loans was $134.5 thousand as of December 31, 2016 and $329.3 thousand as of December 31, 2015, respectively, which are accounted for in the allowance for loan losses (see Note 4). Other real estate is reported at the lower of either the fair value of the real estate, minus the estimated costs to sell the asset, or the cost of the asset. The determination of the fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset’s fair value or estimated selling costs. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) The following table presents collateral dependent impaired loans and other real estate owned as recorded at fair value: Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2016 Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 17 - Fair Value of Financial Instruments (Continued) The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements: The Company also has other assets, which under certain conditions, are subject to measurement at fair value. These assets include loans held for sale, bank owned life insurance, and mortgage servicing rights. The Company estimated the fair values of these assets utilizing Level 3 inputs, including, the discounted present value of expected future cash flows. At December 31, 2016, the Company estimates that there is no impairment of these assets and therefore, no impairment charge to other expense was required to adjust these assets to their estimated fair values. Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 18 - Condensed Financial Statements of Parent Company Balance Sheets Statements of Income and Comprehensive Income Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 18 - Condensed Financial Statements of Parent Company (Continued) Statements of Cash Flows Farmers & Merchants Bancorp, Inc. and Subsidiaries December 31, 2016, 2015, 2014 Note 18 - Condensed Financial Statements of Parent Company (Continued) During the fourth quarter of 2014, the Company established a new subsidiary, Farmers & Merchants Risk Management, Inc. which is a Captive insurance company. Note 19 - Quarterly Financial Data Quarterly Financial Data - UNAUDITED
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This appears to be a partial financial statement for Farmers & Merchants Bancorp, Inc. and Subsidiaries. Here are the key points:
1. Risk Factors:
- The bank's loan portfolio is heavily dependent on local agricultural economic conditions
- Estimates for loan losses could change significantly based on economic changes
- Regulatory agencies may require additional loss recognition during examinations
2. Cash & Equivalents Definition:
- Includes highly liquid debt instruments with original maturity of ≤3 months
- Comprises cash on hand, amounts due from banks, and federal funds sold
- Federal funds typically purchased for one-day periods
3. Key Risk Areas:
- Allowance for loan losses
- Mortgage servicing rights valuation
- Goodwill
- Available for sale investment securities
- Other real estate owned
- Impaired loans
4. Collateral Security:
- Loans are generally secured by:
* Real property
* Consumer assets
* Business assets
Note: The provided text appears to be incomplete and fragmented, making it difficult to provide specific financial figures or a more detailed analysis of the company's actual financial position.
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Claude
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Item 8 - Listed below are the consolidated financial statements included herein for Old Republic International Corporation and Subsidiaries: ________ (1) At December 31, 2016 and 2015, there were 75,000,000 shares of $0.01 par value preferred stock authorized, of which no shares were outstanding. As of the same dates, there were 500,000,000 shares of common stock, $1.00 par value, authorized, of which 262,719,660 and 261,968,328 were issued as of December 31, 2016 and 2015, respectively. At December 31, 2016 and 2015, there were 100,000,000 shares of Class B Common Stock, $1.00 par value, authorized, of which no shares were issued. See accompanying . See accompanying . See accompanying . See accompanying . See accompanying . Old Republic International Corporation and Subsidiaries ($ in Millions, Except as Otherwise Indicated) Old Republic International Corporation is a Chicago-based insurance holding company with subsidiaries engaged mainly in the general (property and liability), title, and mortgage guaranty ("MI") and consumer credit indemnity ("CCI") run-off businesses. These insurance subsidiaries are organized as the Old Republic General Insurance, Title Insurance and RFIG Run-off Business Groups, and references herein to such groups apply to the Company's subsidiaries engaged in the respective segments of business. As more fully disclosed in Note 1(s), RFIG's flagship mortgage guaranty insurance carrier, Republic Mortgage Insurance Company ("RMIC") and its affiliate Republic Mortgage Insurance Company of North Carolina ("RMICNC") have been operating in run-off pursuant to Summary Orders received from the North Carolina Department of Insurance ("NCDOI") which placed these companies under its supervision in 2012. A small life and accident insurance business is included in the corporate and other caption of this report. In this report, "Old Republic", or "the Company" refers to Old Republic International Corporation and its subsidiaries as the context requires. Note 1 - Summary of Significant Accounting Policies - The significant accounting policies employed by Old Republic International Corporation and its subsidiaries are set forth in the following summary. (a) Accounting Principles - The Company's insurance subsidiaries are managed pursuant to the laws and regulations of the various states in which they operate. As a result, the subsidiaries operate their business in the context of such laws and regulation, and maintain their accounts in conformity with accounting practices prescribed or permitted by various states' insurance regulatory authorities. Federal income taxes and dividends to shareholders are based on financial statements and reports complying with such practices. The statutory accounting requirements vary from the Financial Accounting Standards Board's ("FASB") Accounting Standards Codification ("ASC") of accounting principles generally accepted in the United States of America ("GAAP") in the following major respects: (1) the costs of selling insurance policies are charged to operations immediately, while the related premiums are recognized as income over the terms of the policies; (2) investments in fixed maturity securities designated as available for sale are generally carried at amortized cost rather than their estimated fair value; (3) certain assets classified as "non-admitted assets" are excluded from the balance sheet through a direct charge to earned surplus; (4) changes in deferred income tax assets or liabilities are recorded directly in earned surplus and not through the income statement; (5) mortgage guaranty contingency reserves intended to provide for future catastrophic losses are established as a liability through a charge to earned surplus whereas, GAAP does not allow provisions for future catastrophic losses; (6) title insurance premium reserves, which are intended to cover losses that will be reported at a future date are based on statutory formulas, and changes therein are charged in the income statement against each year's premiums written; (7) certain required formula-derived reserves for general insurance in particular are established for claim reserves in excess of amounts considered adequate by the Company as well as for credits taken relative to reinsurance placed with other insurance companies not licensed in the respective states, all of which are charged directly against earned surplus; and (8) surplus notes are classified as surplus rather than a liability. In consolidating the statutory financial statements of its insurance subsidiaries, the Company has therefore made necessary adjustments to conform their accounts with GAAP. The following table reflects a summary of all such adjustments: (a) The insurance laws of the respective states in which the Company’s insurance subsidiaries are incorporated prescribe minimum capital and surplus requirements for the lines of business they are licensed to write. For domestic property and casualty and life and accident insurance companies the National Association of Insurance Commissioners also prescribes risk-based capital ("RBC") requirements. The RBC is a measure of statutory capital in relationship to a formula-driven definition of risk relative to a company’s balance sheet and mix of business. The combined RBC ratio of our primary General insurance subsidiaries was 665% and 636% of the company action level RBC at December 31, 2016 and 2015, respectively. The minimum capital requirements for the Company’s Title Insurance subsidiaries are established by statute in the respective states of domicile. The minimum regulatory capital requirements are not significant in relationship to the recorded statutory capital of the Company’s Title and Life & Accident insurance subsidiaries. At December 31, 2016 and 2015 each of the Company’s General, Title, and Life and Accident insurance subsidiaries exceeded the minimum statutory capital and surplus requirements. Refer to Note 1(s) - Regulatory Matters for a discussion regarding the RFIG Run-off group. The preparation of financial statements in conformity with either statutory practices or GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Accordingly, actual results could differ from those estimates. (b) Consolidation Practices - The consolidated financial statements include the accounts of the Company and those of all of its majority owned insurance underwriting and service subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. (c) Statement Presentation - Amounts shown in the consolidated financial statements and applicable notes are stated (except as otherwise indicated and as to share data) in millions, which amounts may not add to totals shown due to truncation. Necessary reclassifications are made in prior periods' financial statements whenever appropriate to conform to the most current presentation. (d) Investments - The Company may classify its invested assets in terms of those assets relative to which it either (1) has the positive intent and ability to hold until maturity, (2) has available for sale or (3) has the intention of trading. As of December 31, 2016 and 2015, the majority of the Company's invested assets were classified as "available for sale." Fixed maturity securities and other preferred and common stocks (equity securities) classified as "available for sale" are included at fair value with changes in such values, net of deferred income taxes, reflected directly in shareholders' equity while fixed maturity securities classified as "held to maturity" are carried at amortized cost. Fair values for fixed maturity securities and equity securities are based on quoted market prices or estimates using values obtained from independent pricing services as applicable. The Company reviews the status and fair value changes of each of its investments on at least a quarterly basis during the year, and estimates of other-than-temporary impairments ("OTTI") in the portfolio's value are evaluated and established at each quarterly balance sheet date. In reviewing investments for OTTI, the Company, in addition to a security's market price history, considers the totality of such factors as the issuer's operating results, financial condition and liquidity, its ability to access capital markets, credit rating trends, most current audit opinion, industry and securities markets conditions, and analyst expectations to reach its conclusions. Sudden fair value declines caused by such adverse developments as newly emerged or imminent bankruptcy filings, issuer default on significant obligations, or reports of financial accounting developments that bring into question the validity of the issuer's previously reported earnings or financial condition, are recognized as realized losses as soon as credible publicly available information emerges to confirm such developments. Absent issuer-specific circumstances that would result in a contrary conclusion, any equity security with an unrealized investment loss amounting to a 20% or greater decline consecutively during a six month period is considered OTTI. In the event the Company's estimate of OTTI is insufficient at any point in time, future periods' net income (loss) would be adversely affected by the recognition of additional realized or impairment losses, but its financial position would not necessarily be affected adversely inasmuch as such losses, or a portion of them, could have been recognized previously as unrealized losses in shareholders' equity. The Company recognized $4.9 of OTTI adjustments for the year ended December 31, 2016 and no adjustments for the same periods of 2015 and 2014. The amortized cost and estimated fair values by type and contractual maturity of fixed maturity securities are shown in the following tables. Expected maturities will differ from contractual maturities since borrowers may have the right to call or repay obligations with or without call or prepayment penalties. Bonds and other investments with a statutory carrying value of $750.7 as of December 31, 2016 were on deposit with governmental authorities by the Company's insurance subsidiaries to comply with insurance laws. A summary of the Company's equity securities follows: The following table reflects the Company's gross unrealized losses and fair value, aggregated by category and the length of time that individual available for sale and held to maturity securities have been in an unrealized loss position. Fair value and issuer's cost comparisons follow: At December 31, 2016, the Company held 718 fixed maturity and 8 equity securities in an unrealized loss position, representing 37.0% (as to fixed maturities) and 7.7% (as to equity securities) of the total number of such issues it held. At December 31, 2015, the Company held 709 fixed maturity and 22 equity securities in an unrealized loss position, representing 39.2% (as to fixed maturities) and 23.9% (as to equity securities) of the total number of such issues it held. Of the securities in an unrealized loss position, 46 and 79 fixed maturity securities and 2 and 1 equity securities, had been in a continuous unrealized loss position for more than 12 months as of December 31, 2016 and 2015, respectively. The unrealized losses on these securities are primarily deemed to reflect changes in the interest rate environment and changes in fair values of fixed income and equity securities issued by participants in the extractive industries in particular. As part of its assessment of other-than-temporary impairments, the Company considers its intent to continue to hold, and the likelihood that it will not be required to sell investment securities in an unrealized loss position until cost recovery, principally on the basis of its asset and liability maturity matching procedures. Fair Value Measurements - Fair value is defined as the estimated price that is likely to be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at the measurement date. A fair value hierarchy is established that prioritizes the sources ("inputs") used to measure fair value into three broad levels: inputs based on quoted market prices in active markets (Level 1); observable inputs based on corroboration with available market data (Level 2); and unobservable inputs based on uncorroborated market data or a reporting entity's own assumptions (Level 3). Following is a description of the valuation methodologies and general classification used for financial instruments measured at fair value. The Company uses quoted values and other data provided by a nationally recognized independent pricing source as inputs into its quarterly process for determining fair values of its fixed maturity and equity securities. To validate the techniques or models used by pricing sources, the Company's review process includes, but is not limited to: (i) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value; and (ii) comparing other sources including the fair value estimates to its knowledge of the current market and to independent fair value estimates provided by the investment custodian. The independent pricing source obtains market quotations and actual transaction prices for securities that have quoted prices in active markets and uses its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of "matrix pricing" in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. Level 1 securities include U.S. and Canadian Treasury notes, publicly traded common stocks, the quoted net asset value ("NAV") mutual funds, and most short-term investments in highly liquid money market instruments. Level 2 securities generally include corporate bonds, municipal bonds, and certain U.S. and Canadian government agency securities. Securities classified within Level 3 include non-publicly traded bonds and equity securities. There were no significant changes in the fair value of assets measured with the use of significant unobservable inputs as of December 31, 2016 and December 31, 2015. The following tables show a summary of the fair value of financial assets segregated among the various input levels described above: There were no transfers between Levels 1, 2 or 3 during 2016 or 2015. Investment income is reported net of allocated expenses and includes appropriate adjustments for amortization of premium and accretion of discount on fixed maturity securities acquired at other than par value. Dividends on equity securities are credited to income on the ex-dividend date. Realized investment gains and losses, which result from sales or write-downs of securities, are reflected as revenues in the income statement and are determined on the basis of amortized value at date of sale for fixed maturity securities, and cost in regard to equity securities; such bases apply to the specific securities sold. Unrealized investment gains and losses, net of any deferred income taxes, are recorded directly as a component of accumulated other comprehensive income in shareholders' equity. At December 31, 2016, the Company and its subsidiaries had no non-income producing fixed maturity securities. The following table reflects the composition of net investment income, net realized gains or losses, and the net change in unrealized investment gains or losses for each of the years shown. __________ (a) Investment expenses consist of personnel costs and investment management and custody service fees, as well as interest incurred on funds held of $.4, $.3 and $.4 for the years ended December 31, 2016, 2015 and 2014, respectively. (b) Reflects primarily the combination of fully taxable realized investment gains or losses and judgments about the recoverability of deferred tax assets. In January 2016, the FASB issued guidance on the recognition and measurement of financial instruments. Among other changes, the standard will require equity investments to be measured at fair value with changes in fair value recognized in the consolidated statement of income. The new accounting standard will be effective in 2018. In June 2016, the FASB issued guidance on accounting for credit losses on financial instruments which will be effective in 2020. The guidance will require immediate recognition of expected credit losses for certain financial instruments such as reinsurance recoverables and held to maturity securities and also modifies the impairment model for available for sale debt securities. (e) Revenue Recognition - Pursuant to GAAP applicable to the insurance industry, revenues are recognized as follows: Substantially all general insurance premiums pertain to annual policies and are reflected in income on a pro-rata basis in general association with the related benefits, claims, and expenses. Earned but unbilled premiums are generally taken into income on the billing date, while adjustments for retrospective premiums, commissions and similar charges or credits are accrued on the basis of periodic evaluations of current underwriting experience and contractual obligations. Title premium and fee revenues stemming from the Company's direct operations (which include branch offices of its title insurers and wholly owned agency subsidiaries) represent 28% of 2016, 27% of 2015 and 27% of 2014 consolidated title business revenues. Such premiums are generally recognized as income at the escrow closing date which approximates the policy effective date. Fee income related to escrow and other closing services is recognized when the related services have been performed and completed. The remaining title premium and fee revenues are produced by independent title agents and underwritten title companies. Rather than making estimates that could be subject to significant variance from actual premium and fee production, the Company recognizes revenues from those sources upon receipt. Such receipts can reflect a three to four month lag relative to the effective date of the underlying title policy, and are offset concurrently by production expenses and claim reserve provisions. The Company's mortgage guaranty premiums principally stem from monthly installments paid on long-duration, guaranteed renewable insurance policies. Substantially all such premiums are written and earned in the month coverage is effective. With respect to relatively few annual or single premium policies, earned premiums are largely recognized on a pro-rata basis over the terms of the policies. Recognition of normal or catastrophic claim costs, however, occurs only upon an instance of default, defined as the occurrence of two or more consecutively missed monthly payments. Accordingly, GAAP revenue recognition for insured loans is not appropriately matched to the risk exposure and the consequent recognition of both normal and most significantly, future catastrophic loss occurrences for which current reserve provisions are not permitted. As a result, mortgage guaranty GAAP earnings for any individual year or series of years may be materially adversely affected, particularly by cyclical catastrophic loss events such as the mortgage insurance industry experienced between 2007 and 2012. Reported GAAP earnings and financial condition form, in part, the basis for significant judgments and strategic evaluations made by management, analysts, investors, and other users of the financial statements issued by mortgage guaranty companies. The risk exists that such judgments and evaluations are at least partially based on GAAP financial information that does not match revenues and expenses and is therefore not reflective of the long-term normal and catastrophic risk exposures assumed by mortgage guaranty insurers at any point in time. In May 2014, the FASB issued a comprehensive revenue recognition standard which is effective in 2018 and applies to all entities that have contracts with customers, except for those that fall within the scope of other standards, such as insurance contracts. The Company is currently evaluating the guidance, however, it does not expect that its adoption will have a material impact on the consolidated financial statements. (f) Deferred Policy Acquisition Costs - Various insurance subsidiaries of the Company defer direct costs related to the successful production of business. Deferred costs consist principally of commissions, premium taxes, marketing, and policy issuance expenses. With respect to most coverages, deferred acquisition costs are amortized on the same basis as the related premiums are earned or, alternatively, over the periods during which premiums will be paid. To the extent that future revenues on existing policies are not adequate to cover related costs and expenses, deferred policy acquisition costs are charged to earnings. The following table shows a reconciliation of deferred acquisition costs between succeeding balance sheet dates. (g) Unearned Premiums - Unearned premium reserves are generally calculated by application of pro-rata factors to premiums in force. At December 31, 2016 and 2015, unearned premiums consisted of the following: (h) Losses, Claims and Settlement Expenses - The establishment of claim reserves by the Company's insurance subsidiaries is a reasonably complex and dynamic process influenced by a large variety of factors. These factors principally include past experience applicable to the anticipated costs of various types of claims, continually evolving and changing legal theories emanating from the judicial system, recurring accounting, statistical, and actuarial studies, the professional experience and expertise of the Company's claim departments' personnel or attorneys and independent claim adjusters, ongoing changes in claim frequency or severity patterns such as those caused by natural disasters, illnesses, accidents, work-related injuries, and changes in general and industry-specific economic conditions. Consequently, the reserves established are a reflection of the opinions of a large number of persons, of the application and interpretation of historical precedent and trends, of expectations as to future developments, and of management's judgment in interpreting all such factors. At any point in time, the Company is exposed to the risk of possibly higher or lower than anticipated claim costs due to all of these factors, and to the evolution, interpretation, and expansion of tort law, as well as the effects of unexpected jury verdicts. All reserves are therefore based on estimates which are periodically reviewed and evaluated in the light of emerging claim experience and changing circumstances. The resulting changes in estimates are recorded in operations of the periods during which they are made. Return and additional premiums and policyholders' dividends, all of which tend to be affected by development of claims in future years, may offset, in whole or in part, developed claim redundancies or deficiencies for certain coverages such as workers' compensation, portions of which are written under loss sensitive programs that provide for such adjustments. The Company believes that its overall reserving practices have been consistently applied over many years, and that its aggregate net reserves have generally resulted in reasonable approximations of the ultimate net costs of claims incurred. However, no representation is made nor is any guaranty given that ultimate net claim and related costs will not develop in future years to be greater or lower than currently established reserve estimates. General Insurance reserves are established to provide for the ultimate expected cost of settling unpaid losses and claims reported at each balance sheet date. Such reserves are based on continually evolving assessments of the facts available to the Company during the settlement process which may stretch over long periods of time. Long-term disability or pension type workers' compensation reserves are discounted to present value based on interest rates ranging from 3.5% to 4.0%. The amount of discount reflected in the year end net reserves totaled $231.9, $228.6, and $240.7 as of December 31, 2016, 2015, and 2014, respectively. Interest accretion of $24.2, $36.7 and $26.2 for the years ended December 31, 2016, 2015, and 2014, respectively, was recognized within benefits, claims and settlement expenses in the consolidated statements of income. Losses and claims incurred but not reported ("IBNR"), as well as expenses required to settle losses and claims are established on the basis of a large number of formulas that take into account various criteria, including historical cost experience and anticipated costs of servicing reinsured and other risks. As applicable, estimates of possible recoveries from salvage or subrogation opportunities are considered in the establishment of such reserves. Overall claim and claim expense reserves incorporate amounts covering net estimates of unusual claims such as those emanating from asbestosis and environmental ("A&E") exposures as discussed below. Such reserves can affect claim costs and related loss ratios for such insurance coverages as general liability, commercial automobile (truck), workers' compensation, and property. Early in 2001, the Federal Department of Labor revised the Federal Black Lung Program regulations. The revisions basically require a reevaluation of previously settled, denied, or new occupational disease claims in the context of newly devised, more lenient standards when such claims are resubmitted. Following a number of challenges and appeals by the insurance and coal mining industries, the revised regulations were, for the most part, upheld in June, 2002 and are to be applied prospectively. Since the final quarter of 2001 black lung claims filed or refiled pursuant to these revised regulations have increased, though the volume of new claim reports has abated in recent years. In March 2010, federal regulations were revised once again as part of the Patient Protection and Affordability Act that reinstates two provisions that can potentially benefit claimants. In response to this most recent legislation and the above noted 2001 change, black lung claims filed or refiled have risen once increased. The vast majority of claims filed to date against Old Republic pertain to business underwritten through loss sensitive programs that permit the charge of additional or refund of return premiums to wholly or partially offset changes in estimated claim costs, or to business underwritten as a service carrier on behalf of various industry-wide involuntary market (i.e. assigned risk) pools. A much smaller portion pertains to business produced on a traditional risk transfer basis. The Company has established applicable reserves for claims as they have been reported and for claims not as yet reported on the basis of its historical experience as well as assumptions relative to the effect of the revised regulations. The potential impact on reserves, gross and net of reinsurance or retrospective premium adjustments, resulting from such regulations cannot be estimated with reasonable certainty. Old Republic's reserve estimates also include provisions for indemnity and settlement costs for various asbestosis and environmental impairment ("A&E") claims that have been filed in the normal course of business against a number of its insurance subsidiaries. Many such claims relate to policies incepting prior to 1985, including many issued during a short period between 1981 and 1982 pursuant to an agency agreement canceled in 1982. Over the years, the Company's property and liability insurance subsidiaries have typically issued general liability insurance policies with face amounts ranging between $1.0 and $2.0 and rarely exceeding $10.0. Such policies have, in turn, been subject to reinsurance cessions which have typically reduced the subsidiaries' net retentions to $.5 or less as to each claim. Old Republic's exposure to A&E claims cannot, however, be calculated by conventional insurance reserving methods for a variety of reasons, including: a) the absence of statistically valid data inasmuch as such claims generally involve long reporting delays and very often uncertainty as to the number and identity of insureds against whom such claims have arisen or will arise; and b) the litigation history of such or similar claims for insurance industry members which has produced inconsistent court decisions with regard to such questions as when an alleged loss occurred, which policies provide coverage, how a loss is to be allocated among potentially responsible insureds and/or their insurance carriers, how policy coverage exclusions are to be interpreted, what types of environmental impairment or toxic tort claims are covered, when the insurer's duty to defend is triggered, how policy limits are to be calculated, and whether clean-up costs constitute property damage. Over time, the Executive Branch and/or the Congress of the United States have proposed or considered changes in the legislation and rules affecting the determination of liability for environmental and asbestosis claims. As of December 31, 2016, however, there is no solid evidence to suggest that possible future changes might mitigate or reduce some or all of these claim exposures. Because of the above issues and uncertainties, estimation of reserves for losses and allocated loss adjustment expenses for A&E claims in particular is much more difficult or impossible to quantify with a high degree of precision. Accordingly, no representation can be made that the Company's reserves for such claims and related costs will not prove to be overstated or understated in the future. At December 31, 2016 and 2015, Old Republic's aggregate indemnity and loss adjustment expense reserves specifically identified with A&E exposures amounted to $121.2 and $130.9 gross, respectively, and $97.1 and $100.6 net of reinsurance, respectively. Old Republic's average five year paid loss survival ratios stood at 4.3 years (gross) and 6.3 years (net of reinsurance) as of December 31, 2016 and 4.7 years (gross) and 6.2 years (net of reinsurance) as of December 31, 2015. Fluctuations in this ratio between years can be caused by the inconsistent pay out patterns associated with these types of claims. Title insurance and related escrow services loss and loss adjustment expense reserves are established as point estimates to cover the projected settlement costs of known as well as IBNR losses related to premium and escrow service revenues of each reporting period. Reserves for known claims are based on an assessment of the facts available to the Company during the settlement process. The point estimates covering all claim reserves inherently take into account IBNR claims based on past experience and evaluations of such variables as changing trends in the types of policies issued, changes in real estate markets and interest rate environments, and changing levels of loan refinancing, all of which can have a bearing on the emergence, number, and ultimate cost of claims. RFIG Run-off mortgage guaranty insurance reserves for unpaid claims and claim adjustment expenses are recognized only upon an instance of default, defined as an insured mortgage loan for which two or more consecutive monthly payments have been missed. Loss reserves are based on statistical calculations that take into account the number of reported insured mortgage loan defaults as of each balance sheet date, as well as experience-based estimates of loan defaults that have occurred but have not as yet been reported. Further, the loss reserve estimating process takes into account a large number of variables including trends in claim severity, potential salvage recoveries, expected cure rates for reported loan delinquencies at various stages of default, the level of coverage rescissions and claims denials due to material misrepresentation in key underwriting information or non-compliance with prescribed underwriting guidelines, and management judgments relative to future employment levels, housing market activity, and mortgage loan interest costs, demand, and extensions. The Company has the legal right to rescind mortgage insurance coverage unilaterally as expressly stated in its policy. Moreover, two federal courts that have considered that policy wording have each affirmed that right (See First Tennessee Bank N.A. v. Republic Mortg. Ins. Co., Case No. 2:10-cv-02513-JPM-cgc (W.D. Tenn., Feb. 25, 2011) and JPMorgan Chase Bank N.A. v. Republic Mortg. Ins. Co., Civil Action No. 10-06141 (SRC) (D. NJ, May 4, 2011), each decision citing supporting state law legal precedent). RMIC's mortgage insurance policy provides that the insured represents that all statements made and information provided to it in an application for coverage for a loan, without regard to who made the statements or provided the information, have been made and presented for and on behalf of the insured; and that such statements and information are neither false nor misleading in any material respect, nor omit any fact necessary to make such statements and information not false or misleading in any material respect. According to the policy, if any of those representations are materially false or misleading with respect to a loan, the Company has the right to cancel or rescind coverage for that loan retroactively to commencement of the coverage. Whenever the Company determines that an application contains a material misrepresentation, it either advises the insured in writing of its findings prior to rescinding coverage or exercises its unilateral right to rescind coverage for that loan, stating the reasons for that action in writing and returning the applicable premium. The rescission of coverage in instances of materially faulty representations or warranties provided in applications for insurance is a necessary and prevailing practice throughout the insurance industry. In the case of mortgage guaranty insurance, rescissions have occurred regularly over the years but have been generally immaterial. Since 2008, however, the Company has experienced a much greater incidence of rescissions due to increased levels of observed fraud and misrepresentations in insurance applications pertaining to business underwritten between 2004 and the first half of 2008. As a result, the Company has incorporated certain assumptions regarding the expected levels of coverage rescissions and claim denials in its reserving methodology since 2008. Such estimates, which are evaluated at each balance sheet date, take into account observed as well as historical trends in rescission and denial rates. The table below shows the estimated effects of coverage rescissions and claim denials on loss reserves and settled and incurred losses. As above-noted, the estimated reduction in ending loss reserves reflects, in large measure, a variety of judgments relative to the level of expected coverage rescissions and claim denials on loans that are in default as of each balance sheet date. The provision for insured events of the current year resulted from actual and anticipated rescissions and claim denials attributable to newly reported delinquencies in each respective year. The provision for insured events of prior years resulted from actual rescission and claim denial activity, reinstatement of previously rescinded or denied claims, or revisions in assumptions regarding expected rescission or claim denial rates on outstanding prior year delinquencies. The trends since 2010 reflect a continuing reduction in the level of actual and anticipated rescission and claim denial rates on total outstanding delinquencies. Claims not paid by virtue of rescission or denial represent the Company's estimated contractual risk, before consideration of the impacts of any reinsurance and deductibles or aggregate loss limits, on cases that are settled by the issuance of a rescission or denial notification. Variances between the estimated rescission and actual claim denial rate are reflected in the periods during which they occur. Although the insured has no right under the policy to appeal a Company claim decision, the insured may, at any time, contest in writing the Company's findings or action with respect to a loan or a claim. In such cases, the Company considers any additional information supplied by the insured. This consideration may lead to further investigation, retraction or confirmation of the initial determination. If the Company concludes that it will reinstate coverage, it advises the insured in writing that it will do so immediately upon receipt of the premium previously returned. Reserves are not adjusted for potential reversals of rescissions or adverse rulings for loans under dispute since such reversals of claim rescissions and denials have historically been immaterial to the reserve estimation process. In addition to the above reserve elements, the Company establishes reserves for loss settlement costs that are not directly related to individual claims. Such reserves are based on prior years' cost experience and trends, and are intended to cover the unallocated costs of claim departments' administration of known and IBNR claims. The following table shows an analysis of changes in aggregate reserves for the Company's losses, claims and settlement expenses for each of the years shown. __________ Excluding the reclassification of CCI from the General Insurance to the RFIG Run-off Business segment, certain elements shown in the preceding table would have been as follows: (a) In common with all other insurance lines, RFIG Run-off mortgage guaranty settled and incurred claim and claim adjustment expenses include only those costs actually or expected to be paid by the Company. As previously noted, changes in mortgage guaranty aggregate case, IBNR, and loss adjustment expense reserves shown below and entering into the determination of incurred claim costs, take into account, among a large number of variables, claim cost reductions for anticipated coverage rescissions and claims denials. The RFIG Run-off mortgage guaranty provision for insured events of the current year was reduced by estimated coverage rescissions and claims denials of $8.3, $18.8 and $47.1, respectively, for 2016, 2015 and 2014. The provision for insured events of prior years in 2016, 2015 and 2014 was (increased) reduced by estimated coverage rescissions and claims denials of $(24.8), $(17.6) and $10.4, respectively. Prior year development was also affected in varying degrees by differences between actual claim settlements relative to expected experience, by reinstatement of previously rescinded or denied claims, and by subsequent revisions of assumptions in regards to claim frequency, severity or levels of associated claim settlement costs which result from consideration of underlying trends and expectations. The following table reflects the changes in net reserves between succeeding balance sheet dates. (b) Rescissions reduced the Company's paid losses by an estimated $1.4, $33.0, and $93.5 for 2016, 2015, and 2014, respectively. In mid July 2014, in furtherance of a Final Order received from the NCDOI, RMIC and RMICNC processed payments of their accumulated deferred payment obligation balances of approximately $657.0. Refer to Note 1(s). (c) Year end net IBNR reserves for each segment were as follows: For the three most recent calendar years, the above table indicates that the one-year development of consolidated reserves at the beginning of each year produced favorable developments of 1.3% and 1.6% for 2016 and 2015, respectively, and unfavorable development of (.3)% for 2014, with average favorable annual developments of .8%. The Company believes that the factors most responsible, in varying and continually changing degrees, for reserve redundancies or deficiencies include, as to many general insurance coverages, the effect of reserve discounts applicable to workers' compensation claims, higher than expected severity of litigated claims in particular, governmental or judicially imposed retroactive conditions in the settlement of claims such as noted above in regard to black lung disease claims, greater than anticipated inflation rates applicable to repairs and the medical portion of claims in particular, and higher than expected claims incurred but not reported due to the slower and highly volatile emergence patterns applicable to certain types of claims such as those stemming from litigated, assumed reinsurance, or the A&E types of claims noted above. In 2016, 2015 and 2014, the Company experienced unfavorable developments of previously established reserves for accidents or events which occurred in 2014 and prior years in particular. These adverse developments were concentrated in workers' compensation and general liability case reserves and resulted from settlements or reserve additions exceeding the previously established indemnity and/or allocated loss adjustment expense provisions. As to mortgage guaranty and the CCI coverage, changes in reserve adequacy or deficiency result from differences in originally estimated salvage and subrogation recoveries, sales and prices of homes that can impact claim costs upon the disposition of foreclosed properties, changes in regional or local economic conditions and employment levels, greater numbers of coverage rescissions and claims denials due to material misrepresentation in key underwriting information or non-compliance with prescribed underwriting guidelines, the extent of loan refinancing activity that can reduce the period of time over which a policy remains at risk, and lower than expected frequencies of claims incurred but not reported. In May 2015, the FASB issued guidance requiring additional disclosures about short-duration insurance contracts which the Company has adopted for purposes of its 2016 Annual Report on Form 10-K. The new disclosures, which are included below, are intended to provide additional information about insurance liabilities including the nature, amount, timing, and uncertainty of future cash flows related to those liabilities. The information about incurred and paid claims development for the years ended December 31, 2007 to 2015 is presented as supplementary information. The following represents the Company's incurred and paid loss development tables for the major types of insurance coverages as of December 31, 2016. The following represents a reconciliation of the incurred and paid loss development tables to total claim and loss adjustment expense reserves as reported in the consolidated balance sheet. __________ (a) The amount of discount reflected in the year end net reserves totaled $231.9 as of December 31, 2016. The table below is supplementary information and presents the historical average annual percentage payout of incurred claims by age, net of reinsurance. (i) Reinsurance - The cost of reinsurance is recognized over the terms of reinsurance contracts. Amounts recoverable from reinsurers for loss and loss adjustment expenses are estimated in a manner consistent with the claim liability associated with the reinsured business. The Company evaluates the financial condition of its reinsurers on a regular basis. Allowances are established for amounts deemed uncollectible and are included in the Company's net claim and claim expense reserves. (j) Income Taxes - The Company and most of its subsidiaries file a consolidated tax return and provide for income taxes payable currently. Deferred income taxes included in the accompanying consolidated financial statements will not necessarily become payable or recoverable in the future. The Company uses the asset and liability method of calculating deferred income taxes. This method results in the establishment of deferred tax assets and liabilities, calculated at currently enacted tax rates that are applied to the cumulative temporary differences between financial statement and tax bases of assets and liabilities. The provision for combined current and deferred income taxes (credits) reflected in the consolidated statements of income does not bear the usual relationship to income before income taxes (credits) as the result of permanent and other differences between pretax income or loss and taxable income or loss determined under existing tax regulations. The more significant differences, their effect on the statutory income tax rate (credit), and the resulting effective income tax rates (credits) are summarized below: The tax effects of temporary differences that give rise to significant portions of the Company's net deferred tax assets (liabilities) are as follows at the dates shown: At December 31, 2016, the Company had available net operating loss ("NOL") carryforwards of $95.3 which will expire in years 2021 through 2029, and a $9.6 alternative minimum tax ("AMT") credit carryforward which does not expire. The NOL carryforward is subject to the limitations set by Section 382 of the Internal Revenue Code and is available to reduce future years' taxable income by a maximum of $9.8 each year until expiration. A valuation allowance was held against deferred tax assets as of December 31, 2014 related to certain tax credit carryforwards which the Company did not expect to realize. In 2015, the Company released the valuation allowance previously established. In valuing the deferred tax assets, the Company considered certain factors including primarily the scheduled reversals of certain deferred tax liabilities, estimates of future taxable income, the impact of available carryback and carryforward periods, as well as the availability of certain tax planning strategies. The Company estimates that all gross deferred tax assets at year end 2016 will more likely than not be fully realized. Pursuant to special provisions of the Internal Revenue Code pertaining to mortgage guaranty insurers, a contingency reserve (established in accordance with insurance regulations designed to protect policyholders against extraordinary volumes of claims) is deductible from gross income. The deduction is allowed only to the extent that U.S. government non-interest bearing tax and loss bonds are purchased and held in an amount equal to the tax benefit attributable to such deduction. For Federal income tax purposes, amounts deducted from the contingency reserve are taken into gross statutory taxable income in the period in which they are released. Contingency reserves may be released when incurred losses exceed thresholds established under state law or regulation, upon special request and approval by state insurance regulators, or in any event, upon the expiration of ten years. For 2016 tax purposes, the Company recognized a contingency reserve deduction of $91.0. Consequently, $31.8 of U.S. Treasury Tax and Loss Bonds will be acquired during the first quarter of 2017. Tax positions taken or expected to be taken in a tax return by the Company are recognized in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. To the best of management's knowledge there are no tax uncertainties that are expected to result in significant increases or decreases to unrecognized tax benefits within the next twelve month period. The Company views its income tax exposures as primarily consisting of timing differences whereby the ultimate deductibility of a taxable amount is highly certain but the timing of its deductibility is uncertain. Such differences relate principally to the timing of deductions for loss and premium reserves. As in prior examinations, the Internal Revenue Service (IRS) could assert that claim reserve deductions were overstated thereby reducing the Company's statutory taxable income in any particular year. The Company believes that it establishes its reserves fairly and consistently at each balance sheet date, and that it would succeed in defending its tax position in these regards. Because of the impact of deferred tax accounting, the possible accelerated payment of tax to the IRS would not necessarily affect the annual effective tax rate. The Company classifies interest and penalties as income tax expense in the consolidated statement of income. During 2016, the IRS completed an examination of the Company's consolidated Federal income tax returns for the years 2011 through 2013, which produced no material change to the Company's net income. (k) Property and Equipment - Property and equipment is generally depreciated or amortized over the estimated useful lives of the assets, (2 to 27 years), substantially by the straight-line method. Depreciation and amortization expenses related to property and equipment were $29.6, $26.6 and $26.1 in 2016, 2015, and 2014, respectively. Expenditures for maintenance and repairs are charged to income as incurred, and expenditures for major renewals and additions are capitalized. (l) Title Plants and Records - Title plants and records are carried at original cost or appraised value at the date of purchase. Such values represent the cost of producing or acquiring interests in title records and indexes and the appraised value of purchased subsidiaries' title records and indexes at dates of acquisition. The cost of maintaining, updating, and operating title records is charged to income as incurred. Title records and indexes are ordinarily not amortized unless events or circumstances indicate that the carrying amount of the capitalized costs may not be recoverable. (m) Goodwill and Intangible Assets - The following table presents the components of the Company's goodwill balance: Goodwill resulting from business combinations is not amortizable against operations but must be tested annually for possible impairment of its continued value. Intangible assets with definitive lives are amortized against future operating results; whereas indefinite-lived intangibles are tested annually for impairment. There are no significant goodwill balances within reporting units with estimated fair values not significantly in excess of their carrying values. (n) Employee Benefit Plans - The Company has a pension plan (the "Plan") covering a portion of its work force. The Plan is a defined benefit plan pursuant to which pension payments are based primarily on years of service and employee compensation near retirement. It is the Company's policy to fund the Plan's costs as they accrue. The Plan is closed to new participants and benefits were frozen as of December 31, 2013. As a result, eligible employees retain all of the vested rights as of the effective date of the freeze, while additional benefits no longer accrue. The funded status of a pension plan is measured as of December 31 of each year, as the difference between the fair value of plan assets and the projected benefit obligation. The underfunded status of the Plan is recognized as a net pension liability; offsetting entries are reflected as a component of shareholders' equity in accumulated other comprehensive income, net of deferred taxes. The effects of these measurements and the resulting funded status of the Plan are reflected below. The Company expects to make cash contributions of $2.8 in calendar year 2017. The components of aggregate annual net periodic pension costs consisted of the following: The projected benefit obligation and net periodic benefit cost for the Plan were determined using the following weighted-average assumptions: The assumed settlement discount rates were determined by matching the current estimate of the Plan's projected cash outflows against spot rate yields on a portfolio of high quality bonds as of the measurement date. To develop the expected long-term rate of return on assets assumption, historical returns and the future return expectations for each asset class, as well as the target asset allocation of the pension portfolio were considered. The investment policy of the Plan takes into account the matching of assets and liabilities, appropriate risk aversion, liquidity needs, the preservation of capital, and the attainment of modest growth. The weighted-average asset allocations of the Plan were as follows: Quoted values and other data provided by the respective investment custodians are used as inputs for determining fair value of the Plan's debt and equity securities. The custodians are understood to obtain market quotations and actual transaction prices for securities that have quoted prices in active markets and use their own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of "matrix pricing" in which the investment custodian uses observable inputs, including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. The following tables present a summary of the Plan's assets segregated among the various input levels described in Note 1(d). Level 1 assets include U.S. Treasury notes, publicly traded common stocks, mutual funds and certain short-term investments. Level 2 assets generally include corporate and government agency bonds, common collective trusts, and a limited partnership investment. Level 3 assets primarily consist of an immediate participation guaranteed fund. The benefits expected to be paid as of December 31, 2016 for the next 10 years are as follows: 2017: $25.5; 2018: $26.9; 2019: $28.5; 2020 $29.7; 2021: $30.8 and for the five years after 2021: $163.5. The Company has a number of profit sharing and other incentive compensation programs for the benefit of a substantial number of its employees. The costs related to such programs are summarized below: A majority of the Company's employees participate in the ESSOP. Company contributions are provided in the form of Old Republic common stock. Dividends on shares are allocated to participants as earnings, and likewise invested in Company stock; dividends on unallocated shares are used to pay debt service costs. The Company's annual contributions are based on a formula that takes the growth in net operating income per share over consecutive five year periods into account. During 2015, the Employee Savings and Stock Ownership Plan purchased 2,200,000 shares of Old Republic common stock for $34.0. The purchases were financed by a loan from the Company. As of December 31, 2016, there were 13,975,662 Old Republic common shares owned by the ESSOP, of which 10,467,158 were allocated to employees' account balances. There are no repurchase obligations in existence. See Note 3(b). (o) Escrow Funds - Segregated cash deposit accounts and the offsetting liabilities for escrow deposits in connection with Title Insurance Group real estate transactions in the same amounts ($1,447.0 and $1,570.7 at December 31, 2016 and 2015, respectively) are not included as assets or liabilities in the accompanying consolidated balance sheets as the escrow funds are not available for regular operations. (p) Earnings Per Share - Consolidated basic earnings per share excludes the dilutive effect of common stock equivalents and is computed by dividing income (loss) available to common stockholders by the weighted-average number of common shares actually outstanding for the year. Diluted earnings per share are similarly calculated with the inclusion of dilutive common stock equivalents. The following table provides a reconciliation of net income (loss) and the number of shares used in basic and diluted earnings per share calculations. __________ (a) In calculating earnings per share, pertinent accounting rules require that common shares owned by the Company's Employee Savings and Stock Ownership Plan that are as yet unallocated to participants in the plan be excluded from the calculation. Such shares are issued and outstanding, and have the same voting and other rights applicable to all other common shares. (q) Concentration of Credit Risk - The Company is not exposed to material concentrations of credit risks as to any one issuer of investment securities. (r) Stock Based Compensation - As periodically amended, the Company has had a stock option plan in effect for certain eligible key employees since 1978. Under the plan amended in 2010, the maximum number of common shares available for 2010 and future years' grants was originally set at 14.5 million shares through February 2016. The 2016 Incentive Compensation Plan (the "2016 Plan") was approved by shareholders in 2015 and became effective on February 24, 2016. On the effective date of the 2016 Plan, 15.0 million shares became available for future awards. The maximum number of options available as of December 31, 2016 for future issuance under this amended plan was approximately 13.7 million shares. The exercise price of stock options is equal to the closing market price of the Company's common stock on the date of grant, and the contractual life of the grant is generally ten years from the date of the grant. Options granted may be exercised to the extent of 10% of the number of shares covered thereby as of December 31st of the year of the grant and, cumulatively, to the extent of an additional 15%, 20%, 25% and 30% on and after the second through fifth calendar years, respectively. Effective in 2014, options granted to employees who meet certain retirement eligibility provisions are fully vested on the date of grant. The following table presents the stock based compensation expense and income tax benefit recognized in the financial statements: The fair value of each stock option award is estimated on the date of grant using the Black-Scholes-Merton Model. The following table presents the key assumptions used to value the awards granted during the periods presented. Expected volatilities are based on the historical experience of Old Republic's common stock. The expected term of stock options represents the period of time that stock options granted are assumed to be outstanding. The Company uses historical data to estimate the effect of stock option exercise and employee departure behavior; groups of employees that have similar historical behavior are considered separately for valuation purposes. The risk-free rate of return for periods within the contractual term of the share option is based on the U.S. Treasury rate in effect at the time of the grant. A summary of stock option activity under the plan as of December 31, 2016, 2015 and 2014, and changes in outstanding options during the years then ended is presented below: __________ (a) Based on the Black-Scholes option pricing model and the assumptions outlined above. A summary of stock options outstanding and exercisable at December 31, 2016 follows: As of December 31, 2016, there was $2.4 of total unrecognized compensation cost related to nonvested stock-based compensation arrangements granted under the plan. That cost is expected to be recognized over a weighted average period of approximately 3 years. The cash received from stock option exercises, the total intrinsic value of stock options exercised, and the actual tax benefit realized for the tax deductions from option exercises are as follows: At December 31, 2016, the Company had restricted common stock issued to certain employees which are expected to vest over the next 3 years. During the vesting period, restricted shares are nontransferable and subject to forfeiture. Compensation expense for the restricted stock award is recognized over the vesting period of the award and was immaterial for the years ended December 31, 2016, 2015 and 2014. In March 2016, the FASB issued guidance intended to simplify certain aspects of accounting for share-based payment award transactions which will be effective beginning in 2017. The Company's adoption of this guidance is not expected to have a material impact on the consolidated financial statements. (s) Regulatory Matters - The material increases in mortgage guaranty insurance claims and loss payments that began in 2007 gradually depleted RMIC's statutory capital base and forced it to discontinue writing new business in 2011. The insurance laws of 16 jurisdictions, including RMIC and RMICNC’s domiciliary state of North Carolina, require a mortgage insurer to maintain a minimum amount of statutory capital relative to risk in force (or a similar measure) in order to continue to write new business. The formulations currently allow for a maximum risk-to-capital ratio of 25 to 1, or alternatively stated, a “minimum policyholder position” (“MPP”) of one-twenty-fifth of the total risk in force. The failure to maintain the prescribed minimum capital level in a particular state generally requires a mortgage insurer to immediately stop writing new business until it reestablishes the required level of capital or receives a waiver of the requirement from a state's insurance regulatory authority. RMIC breached the minimum capital requirement during the third quarter of 2010. RMIC had previously requested and, subsequently received waivers or forbearance of the minimum policyholder position requirements from the regulatory authorities in substantially all affected states. Following several brief extensions, the waiver from its domiciliary state of North Carolina expired on August 31, 2011, and RMIC and its sister company, RMICNC, discontinued writing new business in all states and limited themselves to servicing the run-off of their existing business. They were placed under administrative supervision by the North Carolina Department of Insurance ("NCDOI") the following year and ultimately ordered to defer the payment of 40% of all settled claims as a deferred payment obligation ("DPO"). On July 1, 2014, the NCDOI issued a Final Order approving an Amended and Restated Corrective Plan (the "Amended Plan") submitted jointly on April 16, 2014, by RMIC and RMICNC. Under the Amended Plan, RMIC and RMICNC were authorized to pay 100% of their DPOs accrued as of June 30, 2014, and to settle all subsequent valid claims entirely in cash, without establishing any DPOs. In anticipation of receiving this Final Order, ORI invested $125.0 in cash and securities to RMIC in June 2014. In mid-July 2014, in furtherance of the Final Order, RMIC and RMICNC processed payments of their accumulated DPO balances of approximately $657.0 relating to fully settled claims charged to periods extending between January 19, 2012 and June 30, 2014. Both subsidiaries remain under the supervision of the NCDOI as they continue to operate in run-off mode. The approval of the Amended Plan notwithstanding, the NCDOI retains its regulatory supervisory powers to review and amend the terms of the Amended Plan in the future as circumstances may warrant. RMIC has continually evaluated the potential long-term underwriting performance of the run-off book of business based on various modeling techniques. The resulting models take into account actual premium and paid claim experience of prior periods, together with a large number of assumptions and judgments about future outcomes that are highly sensitive to a wide range of estimates. Many of these estimates and underlying assumptions relate to matters over which the Company has no control, including: 1) The conflicted interests, as well as the varying mortgage servicing and foreclosure practices of a large number of insured lending institutions; 2) General economic and industry-specific trends and events; and 3) The evolving or future social and economic policies of the U.S. Government vis-à-vis such critical sectors as the banking, mortgage lending, and housing industries, as well as its policies for resolving the insolvencies and assigning a possible future role to Fannie Mae and Freddie Mac. These matters notwithstanding, RMIC's analysis did not indicate that the establishment of a premium deficiency was warranted as of December 31, 2016, 2015, or 2014. In this regard, a long-used RMIC standard model indicates that underwriting performance of the book of business should, in the aggregate be positive over the extended ten year run-off period assumed to end on or about December 31, 2022. As of December 31, 2016, it is nonetheless possible that MI operating results could be negative in the near term. As of December 31, 2016, RFIG's mortgage insurance subsidiaries were statutorily solvent. The total statutory capital, inclusive of a contingency reserve of $340.9, was $420.6, which was $231.9 above the required MPP of $188.7. As of the same date, RFIG's consolidated GAAP capitalization amounted to $330.6. Note 2 - Debt - Consolidated debt of Old Republic and its subsidiaries is summarized below: On August 26, 2016, the Company completed a public offering of $550.0 aggregate principal amount of Senior Notes. The notes bear interest at a rate of 3.875% per year and mature on August 26, 2026. On September 23, 2014, the Company completed a public offering of $400.0 aggregate principal amount of Senior Notes. The notes bear interest at a rate of 4.875% per year and mature on October 1, 2024. The Company completed a public offering of $550.0 aggregate principal amount of Convertible Senior Notes in early March, 2011. The notes bear interest at a rate of 3.75% per year, mature on March 15, 2018, and are convertible at any time prior to maturity by the holder into 64.3407 shares (subject to periodic adjustment under certain circumstances) of common stock per one thousand dollar note. Scheduled maturities of the above debt at the respective year ends are as follows: 2017: $3.9; 2018: $554.1; 2019: $6.5; 2020: $6.5; 2021 and after: $969.5. During 2016, 2015 and 2014, $50.9, $42.9 and $28.3, respectively, of interest expense on debt was charged to consolidated operations. Old Republic's 3.75% Convertible Senior Notes, 4.875% Senior Notes, and 3.875% Senior Notes ("the Notes") contain provisions defining certain events of default, among them a court ordered proceeding due to the insolvency of a Significant Subsidiary. The Notes define Significant Subsidiary in accordance with the paragraph (w) of Rule 1-02 of the SEC's Regulation S-X. The Company's flagship mortgage guaranty insurance carrier, RMIC qualifies as a Significant Subsidiary for purposes of the Notes. If RMIC were to become statutorily impaired, its insolvency could trigger a receivership proceeding which, in turn could ultimately result in an event of default. If this were to occur, the outstanding principal of the Notes could become immediately due and payable. Management believes the Final Order by the North Carolina Department of Insurance to RMIC has precluded such an event of default from occurring in the foreseeable future. Moreover, RMIC was statutorily solvent at December 31, 2016 and management has every expectation that its solvent state is likely to prevail. RMIC is expected to be an increasingly less significant subsidiary over time as its in force business declines. Fair Value Measurements - The Company utilizes indicative market prices, which incorporate recent actual market transactions and current bid/ask quotations to estimate the fair value of outstanding debt securities that are classified within Level 2 of the fair value hierarchy as presented below. The Company uses an internally generated interest yield market matrix table, which incorporates maturity, coupon rate, credit quality, structure and current market conditions to estimate the fair value of its outstanding debt securities that are classified within Level 3. The following table shows a summary of financial liabilities disclosed, but not carried, at fair value, segregated among the various input levels described in Note 1(d) above: Note 3 - Shareholders' Equity (a) Preferred Stock - At December 31, 2016, there were 75,000,000 shares of preferred stock authorized. The Company has designated one series of preferred stock: 10,000,000 shares of Series A Junior Participating Preferred Stock (Series A). No shares have been issued or are outstanding. The Series A Stock, if and when issued, shall pay a dividend of the greater of $1.00 or 100 times (subject to adjustment) the aggregate per share amount (payable in kind) of all non-cash dividend or other distributions, other than a dividend payable in shares of common stock declared on the common stock of the Company. Each share of Series A stock shall have 100 votes on each matter submitted to a vote of the shareholders. (b) Common Stock - At December 31, 2016, there were 500,000,000 shares of common stock authorized. At the same date, there were 100,000,000 shares of Class "B" common stock authorized, though none were issued or outstanding. Class "B" common shares have the same rights as common shares except for being entitled to 1/10th of a vote per share. During 2008, the Company issued 5,488,475 shares to the ESSOP for consideration of $50.0. The ESSOP's common stock purchases were financed by a $30.0 bank loan and by $20.0 of pre-fundings from ESSOP participating subsidiaries. During 2015, the ESSOP purchased 2,200,000 shares of Old Republic common stock for $34.0. The purchases were financed by a loan from the Company. Common stock held by the ESSOP is classified as a charge to the common shareholders' equity account until it is allocated to participating employees' accounts contemporaneously with the repayment of the ESSOP debt incurred for its acquisition. Such unallocated shares are not considered outstanding for purposes of calculating earnings per share. Dividends on unallocated shares are used to pay debt service costs. Dividends on allocated shares are credited to participants' accounts. (c) Cash Dividend Restrictions - The payment of cash dividends by the Company is principally dependent upon the amount of its insurance subsidiaries' statutory policyholders' surplus available for dividend distribution. The insurance subsidiaries' ability to pay cash dividends to the Company is in turn generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. These authorities recognize only statutory accounting practices for determining financial position, results of operations, and the ability of an insurer to pay dividends to its shareholders. Based on year end 2016 data, the maximum amount of dividends payable to the Company by its insurance and a small number of non-insurance company subsidiaries during 2017 without the prior approval of appropriate regulatory authorities is approximately $473.3. Cash dividends declared during 2016, 2015 and 2014 to the Company by its subsidiaries amounted to $317.6, $326.0 and $281.1, respectively. Note 4 - Commitments and Contingent Liabilities: (a) Reinsurance and Retention Limits - In order to maintain premium production within their capacity and to limit maximum losses for which they might become liable under policies they've underwritten, Old Republic's insurance subsidiaries, as is the common practice in the insurance industry, may cede all or a portion of their premiums and related liabilities on certain classes of business to other insurers and reinsurers. Although the ceding of insurance does not ordinarily discharge an insurer from liability to a policyholder, it is industry practice to establish the reinsured part of risks as the liability of the reinsurer. Old Republic also employs retrospective premium and a large variety of risk-sharing procedures and arrangements for parts of its business in order to reduce underwriting losses for which it might become liable under insurance policies it issues. To the extent that any reinsurance companies, assured or producer might be unable to meet their obligations under existing reinsurance, retrospective insurance and production agreements, Old Republic would be liable for the defaulted amounts. As deemed necessary, reinsurance ceded to other companies is secured by letters of credit, cash, and/or securities. Except as noted in the following paragraph, reinsurance protection on property and liability coverages generally limits the net loss on most individual claims to a maximum of: $5.2 for workers' compensation; $5.0 for commercial auto liability; $5.0 for general liability; $12.0 for executive protection (directors & officers and errors & omissions); $2.0 for aviation; and $5.0 for property coverages. Title insurance risk assumptions are generally limited to a maximum of $500.0 as to any one policy. The vast majority of title policies issued, however, carry exposures of less than $1.0. An immaterial amount of the mortgage guaranty traditional primary risk in force is subject to lender sponsored captive reinsurance arrangements structured primarily on an excess of loss basis. All bulk and other insurance risk in force is retained. Exclusive of reinsurance, the average direct primary mortgage guaranty exposure is (in whole dollars) $38,200 per insured loan. Since January 1, 2005, the Company has had maximum reinsurance coverage of up to $200.0 for its workers' compensation exposures. Pursuant to regulatory requirements, however, all workers' compensation primary insurers such as the Company remain liable for unlimited amounts in excess of reinsured limits. Other than the substantial concentration of workers' compensation losses caused by the September 11, 2001 terrorist attack on America, to the best of the Company's knowledge there had not been a similar accumulation of claims in a single location from a single occurrence prior to that event. Nevertheless, the possibility continues to exist that non-reinsured losses could, depending on a wide range of severity and frequency assumptions, aggregate several hundred million dollars to an insurer such as the Company. Such aggregation of losses could occur in the event of a catastrophe such as an earthquake that could lead to the death or injury of a large number of persons concentrated in a single facility such as a high rise building. As a result of the September 11, 2001 terrorist attack on America, the reinsurance industry eliminated coverage from substantially all contracts for claims arising from acts of terrorism. Primary insurers like the Company thus became fully exposed to such claims. Late in 2002, the Terrorism Risk Insurance Act of 2002 (the "TRIA") was signed into law, immediately establishing a temporary federal reinsurance program administered by the Secretary of the Treasury. The program applied to insured commercial property and casualty losses resulting from an act of terrorism, as defined in the TRIA. Congress extended and modified the program in late 2005 through the Terrorism Risk Insurance Revision and Extension Act of 2005 (the "TRIREA"). TRIREA expired on December 31, 2007. Congress enacted a revised program in December 2007 through the Terrorism Risk Insurance Program Reauthorization Act (the "TRIPRA") of 2007, a seven year extension that expired December 2014. In January 2015, Congress passed the TRIPRA of 2015 that extended TRIPRA through 2020. The TRIA automatically voided all policy exclusions which were in effect for terrorism related losses and obligated insurers to offer terrorism coverage with most commercial property and casualty insurance lines. The TRIREA revised the definition of "property and casualty insurance" to exclude commercial automobile, burglary and theft, surety, professional liability and farm owners multi-peril insurance. TRIPRA did not make any further changes to the definition of property and casualty insurance, however, it did include domestic acts of terrorism within the scope of the program. Although insurers are permitted to charge an additional premium for terrorism coverage, insureds may reject the coverage. Under TRIPRA, the program's protection is not triggered for losses arising from an act of terrorism until the industry first suffers losses in excess of a prescribed aggregate deductible during any one year. The program deductible trigger is $140, $160, $180, and $200 for 2017, 2018, 2019, and 2020, respectively. Once the program trigger is met, TRIPRA will be responsible for a fixed percentage of the Company's terrorism losses that exceed its deductible which ranges from 85% in 2015 and declines by one percentage point per year until it reaches 80% in 2020. The Company's deductible amounts to 20% of direct earned premium on eligible property and casualty insurance coverages. The Company currently reinsures limits on a treaty basis of $195.0 in excess of $5.0 for claims arising from certain acts of terrorism for casualty clash and catastrophe workers' compensation liability insurance coverages. The Company also purchases facultative reinsurance on certain accounts in excess of $200.0 to manage the Company's net exposure. Reinsurance ceded by the Company's insurance subsidiaries in the ordinary course of business is typically placed on an excess of loss basis. Under excess of loss reinsurance agreements, the companies are generally reimbursed for losses exceeding contractually agreed-upon levels. Quota share reinsurance is most often effected between the Company's insurance subsidiaries and industry-wide assigned risk plans or captive insurers owned by assureds. Under quota share reinsurance, the Company remits to the assuming entity an agreed-upon percentage of premiums written and is reimbursed for underwriting expenses and proportionately related claims costs. Reinsurance recoverable asset balances represent amounts due from or credited by assuming reinsurers for paid and unpaid claims and premium reserves. Such reinsurance balances are recoverable from non-admitted foreign and certain other reinsurers such as captive insurance companies owned by assureds, as well as similar balances or credits arising from policies that are retrospectively rated or subject to assureds' high deductible retentions, are substantially collateralized by letters of credit, securities, and other financial instruments. Old Republic evaluates on a regular basis the financial condition of its assuming reinsurers and assureds who purchase its retrospectively rated or self-insured deductible policies. Estimates of unrecoverable amounts totaling $15.9 at both December 31, 2016 and 2015 are included in the Company's net claim and claim expense reserves since reinsurance, retrospectively rated, and self-insured deductible policies and contracts do not relieve Old Republic from its direct obligations to assureds or their beneficiaries. At December 31, 2016, the Company's General Insurance Group's ten largest reinsurers represented approximately 53% of the total consolidated reinsurance recoverable on paid and unpaid losses, with Munich Re America, Inc. the largest reinsurer representing 14.5% of the total recoverable balance. Of the balances due from these ten reinsurers, 64.4% was recoverable from A or better rated reinsurance companies, 6.9% from an industry-wide insurance assigned risk pool, 24.1% from foreign unrated companies, and 4.6% from domestic unrated companies. The following information relates to reinsurance and related data for the General Insurance and RFIG Run-off Groups for the three years ended December 31, 2016. Reinsurance transactions of the Title Insurance Group and small life and accident insurance operation are not material. (b) Leases - Some of the Company's subsidiaries maintain their offices in leased premises. Some of these leases provide for the payment of real estate taxes, insurance, and other operating expenses. Rental expenses for operating leases amounted to $55.7, $54.7 and $51.4 in 2016, 2015 and 2014, respectively. These expenses relate primarily to building leases of the Company. A number of the Company's subsidiaries also lease other equipment for use in their businesses. At December 31, 2016, aggregate minimum rental commitments (net of expected sub-lease receipts) under noncancellable operating leases are summarized as follows: 2017: $56.3; 2018: $49.7; 2019: $41.0; 2020: $29.8; 2021: $22.2; 2022 and after: $114.7. In February 2016, the FASB issued guidance on lease accounting. Among other changes, the new standard requires balance sheet recognition of all leases with a term of greater than 12 months. The new accounting standard will be effective in 2019. (c) General - In the normal course of business, the Company and its subsidiaries are subject to various contingent liabilities, including possible income tax assessments resulting from tax law interpretations or issues raised by taxing or regulatory authorities in their regular examinations, catastrophic claim occurrences not indemnified by reinsurers such as noted at 4(a) above, or failure to collect all amounts on its investments or balances due from assureds and reinsurers. The Company does not have a basis for anticipating any significant losses or costs that could result from any known or existing contingencies. From time to time, in order to assure possible liquidity needs, the Company may guaranty the timely payment of principal and/or interest on certain intercompany balances, debt, or other securities held by some of its insurance, non-insurance, and ESSOP affiliates. At December 31, 2016, the aggregate principal amount of such guaranties was $117.9. (d) Legal Proceedings - Legal proceedings against the Company and its subsidiaries routinely arise in the normal course of business and usually pertain to claim matters related to insurance policies and contracts issued by its insurance subsidiaries. Other, non-routine legal proceedings which may prove to be material to the Company or a subsidiary are discussed below. On December 19, 2008, Old Republic Insurance Company and Republic Insured Credit Services, Inc., ("Old Republic") filed suit against Countrywide Bank FSB, Countrywide Home Loans, Inc. ("Countrywide") and Bank of New York Mellon, BNY Mellon Trust of Delaware ("BNYM") in the Circuit Court, Cook County, Illinois (Old Republic Insurance Company, et al. v. Countrywide Bank FSB, et al.) seeking rescission of various credit indemnity policies issued to insure home equity loans and home equity lines of credit which Countrywide had securitized or held for its own account, a declaratory judgment and money damages based upon systemic material misrepresentations and fraud by Countrywide as to the credit characteristics of the loans or by the borrowers in their loan applications. Countrywide filed a counterclaim alleging a breach of contract, bad faith and seeking a declaratory judgment challenging the factual and procedural bases that Old Republic had relied upon to deny or rescind coverage for individual defaulted loans under those policies, as well as unspecified compensatory and punitive damages. The Court ruled that Countrywide does not have standing to counterclaim with respect to the policies insuring the securitized loans because those policies were issued to BNYM. In response, Countrywide and BNYM jointly filed a motion asking the Court to allow an amended counterclaim in which BNYM would raise substantially similar allegations as those raised by Countrywide and make substantially similar requests but with respect to the policies issued to BNYM. The Court dismissed their motion, with leave to re-plead the counterclaim. BNYM's subsequent attempt to re-plead was granted by the Court and BNYM has re-pleaded its counterclaim. Pursuant to a revised case management order, a multi-phase trial is set to begin September 25, 2017. On December 30, 2011 and on January 4, 2013, purported class action suits alleging RESPA violations were filed in the Federal District Court, for the Eastern District of Pennsylvania targeting RMIC, other mortgage guaranty insurance companies, PNC Financial Services Group (as successor to National City Bank) and HSBC Bank USA, N.A., and their wholly-owned captive insurance subsidiaries. (White, Hightower, et al. v. PNC Financial Services Group (as successor to National City Bank) et al.), (Ba, Chip, et al. v. HSBC Bank USA, N.A., et al.). The lawsuits are two of twelve against various lenders, their captive reinsurers and the mortgage insurers, filed by the same law firms. All of these lawsuits were substantially identical in alleging that the mortgage guaranty insurers had reinsurance arrangements with the defendant banks' captive insurance subsidiaries under which payments were made in violation of the anti-kickback and fee splitting prohibitions of Sections 8(a) and 8(b) of RESPA. Ten of the twelve suits have been dismissed. A class has not been certified in either remaining suit. Those two remaining suits seeking unspecified damages, costs, fees and the return of the allegedly improper payments were settled with an agreement to make nominal payments. Ba has been dismissed with prejudice and White is awaiting the Court's dismissal. On October 9, 2014, Intellectual Ventures I LLC and Intellectual Ventures II LLC (collectively, "IV") served a complaint naming as defendants Old Republic National Title Insurance Company, Old Republic Title Insurance Group, Inc., Old Republic Insurance Company and Old Republic General Insurance Group, Inc. (collectively, "Old Republic")(Intellectual Ventures I LLC et al. v. Old Republic General Insurance Group, Inc. et al.). The lawsuit was brought in the United States District Court for the Western District of Pennsylvania. IV alleged that Old Republic has infringed three patents and sought damages, costs, expenses, and pre-judgment and post-judgment interest for the alleged infringement, in addition to injunctive relief. On October 14, 2014, Old Republic filed a motion to dismiss each count of the complaint on the grounds that the patents fail to meet the patentability test established by the United States Supreme Court in Alice Corp. Pty. Ltd. v. CLS Bank, 134 S.Ct. 2347 (2014). The Court granted Old Republic’s motion to dismiss on all three patents on September 25, 2015. Concurrently, Old Republic filed inter partes review petitions challenging validity of the patents before the United States Patent & Trademark Office ("USPTO") in late September and early October, 2015. In late October, 2015, IV filed notice of its appeal of the District Court’s dismissal of its claims. The appeal has been argued before the United States Court of Appeal for the Federal Circuit and a decision is pending. The Patent Trial and Appeal Board ("PTAB") of the USPTO has accepted the petitions challenging the validity of all three patents and has until early April, 2017, to rule. On January 20, 2015, Intellectual Ventures II LLC filed two complaints in the United States District Court for the Eastern District of Texas naming as defendants Great West Casualty Company and BITCO General Insurance Corporation and BITCO National Insurance Company. (Intellectual Ventures II LLC v. Great West Casualty Company) and (Intellectual Ventures II LLC v. BITCO General Insurance Corporation et al.) The plaintiff alleges a single patent infringement and seeks damages, costs, expenses, and pre-judgment and post-judgment interest in addition to injunctive relief. On April 9, 2015, plaintiff amended each complaint to allege a second patent infringement claim. The District Court set a trial date in September, 2016. In August and September, 2015, Great West and BITCO filed inter partes review petitions challenging the validity of claims under the patents before the PTAB. Both petitions were accepted for review. On May 11, 2016, the parties filed a stipulation of dismissal on one of the patent infringement claims in the District Court. On June 29, 2016, IV disclaimed all claims it asserted against Great West and BITCO on that patent and, accordingly, the inter partes review was terminated by the PTAB. With respect to the remaining single patent infringement claim, on May 12, 2016, the District Court issued a stay on the suit until such time as the PTAB issues its ruling on the inter partes review. On January 17, 2017, the PTAB issued its ruling, finding all but one claim under the patent to be unpatentable. Further, on February 6, 2017, noting that a separate inter partes review for all claims under the patent, including the single claim remaining in the BITCO and Great West lawsuits, is ongoing between IV and another party, the District Court extended the stay until January 20, 2018. On July 5, 2016, Ocwen Loan Servicing, LLC and Homeward Residential, Inc. (collectively, "Ocwen") filed an amendment to an initial complaint against Republic Mortgage Insurance Company and Republic Mortgage Insurance Company of North Carolina (collectively, "RMIC"). The suit, which is captioned Ocwen et al. v. RMIC et al., is pending in the General Court of Justice, Superior Court Division for Forsyth County, North Carolina. The amendment for the first time identifies specific mortgage insurance certificates as to which Ocwen alleges breaches of contract, bad faith and violations of certain fair claims settlement practices laws and seeks declaratory relief in regard to certain claims handling practices on future claims. RMIC believes the suit is without merit and intends to defend vigorously. Under GAAP, an estimated loss is accrued only if the loss is probable and reasonably estimable. The Company and its subsidiaries have defended and intend to continue defending vigorously against each of the aforementioned actions. The Company does not believe it probable that any of these actions will have a material adverse effect on its consolidated financial position, results of operations, or cash flows, though there can be no assurance in those regards. The Company has made an estimate of its potential liability under certain of these lawsuits and the counterclaim, all of which seek unquantified damages, attorneys' fees, and expenses. Because of the uncertainty of the ultimate outcomes of the aforementioned disputes, additional costs may arise in future periods beyond the Company's current reserves. It is also unclear what effect, if any, the run-off operations of RMIC and its limited capital will have in the actions against it. Note 5 - Consolidated Quarterly Results - Unaudited - Old Republic's consolidated quarterly operating data for the two years ended December 31, 2016 is presented below. In management's opinion, however, quarterly operating data for insurance enterprises such as the Company is not indicative of results to be achieved in succeeding quarters or years. The long-term nature of the insurance business, seasonal and cyclical factors affecting premium production, the fortuitous nature and, at times, delayed emergence of claims, and changes in yields on invested assets are some of the factors necessitating a review of operating results, changes in shareholders' equity, and cash flows for periods of several years to obtain a proper indicator of performance trends. The data below should be read in conjunction with the "Management Analysis of Financial Position and Results of Operations". In management's opinion, all adjustments consisting of normal recurring adjustments necessary for a fair statement of quarterly results have been reflected in the data which follows. Note 6 - Information About Segments of Business - The Company is engaged in the single business of insurance underwriting and related services. It conducts its' operations through a number of regulated insurance company subsidiaries organized into three major segments, namely its' General Insurance Group (property and liability insurance), Title Insurance Group and the Republic Financial Indemnity Group Run-off Business. The results of a small life & accident insurance business are included with those of its holding company parent and minor corporate services operations. Each of the Company's segments underwrites and services only those insurance coverages which may be written by it pursuant to state insurance regulations and corporate charter provisions. The Company does not derive over 10% of its consolidated revenues from any one customer. Revenues and assets connected with foreign operations are not significant in relation to consolidated totals. The General Insurance Group provides property and liability insurance primarily to commercial clients. Old Republic does not have a meaningful participation in personal lines of insurance. Workers' compensation is the largest type of coverage underwritten by the General Insurance Group, accounting for 35.4% of the Group's direct premiums written in 2016. The remaining premiums written by the General Insurance Group are derived largely from a wide variety of coverages, including commercial automobile (principally trucking), general liability, general aviation, directors and officers indemnity, fidelity and surety indemnities, and home and auto warranties. The title insurance business consists primarily of the issuance of policies to real estate purchasers and investors based upon searches of the public records which contain information concerning interests in real property. The policy insures against losses arising out of defects, loans and encumbrances affecting the insured title and not excluded or excepted from the coverage of the policy. Private mortgage insurance produced by the RFIG Run-off Business protects mortgage lenders and investors from default related losses on residential mortgage loans made primarily to homebuyers who make down payments of less than 20% of the home's purchase price. The RFIG Run-off mortgage guaranty operations insures only first mortgage loans, primarily on residential properties having one-to-four family dwelling units. CCI policies provide limited indemnity coverage to lenders and other financial intermediaries. The coverage is for the risk of non-payment of loan balances by individual buyers and borrowers. The accounting policies of the segments parallel those described in the summary of significant accounting policies pertinent thereto. __________ In the above tables, net premiums earned on a GAAP basis differ slightly from statutory amounts due to certain differences in calculations of unearned premium reserves under each accounting method. (a) Income (loss) before taxes (credits) is reported net of interest charges on intercompany financing arrangements with Old Republic's holding company parent for the following segments: General - $51.9, $41.6 and $32.0 for the years ended December 31, 2016, 2015, and 2014, respectively; Title - $8.4, $8.1 and $7.9 for the years ended December 31, 2016, 2015, and 2014, respectively. (b) Represents amounts for Old Republic's holding company parent, minor corporate services subsidiaries, and a small life and accident insurance operation. Note 7 - Transactions with Affiliates: The Company is affiliated with a policyholder owned mutual insurer, American Business & Mercantile Insurance Mutual, Inc. ("AB&M" or "the Mutual") whose formation it sponsored in 1981. The Mutual is managed through a service agreement with several Old Republic subsidiaries. AB&M's underwriting operations are limited to certain types of coverages not provided by Old Republic, and to a small amount of intercompany reinsurance placements. The following table shows certain unaudited information reflective of such business: As of December 31, 2016 and 2015, the Mutual's statutory capital included surplus notes due to Old Republic of $10.5 out of total statutory capital of $30.6 and $29.9, respectively. AB&M's accounts are not consolidated with Old Republic's since it is owned by its policyholders and, in any event, their inclusion would not have a significant effect on Old Republic's consolidated financial statements. ACCOUNTING FIRM To the Board of Directors and Shareholders of Old Republic International Corporation: We have audited the accompanying balance sheets of Old Republic International Corporation and subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, preferred stock and common shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. We also have audited the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting under Item 9A of the 2016 Annual Report on Form 10-K. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Old Republic International Corporation and subsidiaries as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, Old Republic International Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) . /s/ KPMG LLP Chicago, Illinois February 28, 2017 Management's Responsibility for Financial Statements Management is responsible for the preparation of the Company's consolidated financial statements and related information appearing in this report. Management believes that the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements reasonably present the Company's financial position and results of operations in conformity with generally accepted accounting principles. Management also has included in the Company's financial statement amounts that are based on estimates and judgments which it believes are reasonable under the circumstances. The independent registered public accounting firm has advised that they audit the Company's consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board, as stated in its reports, included herein. The Board of Directors of the Company has an Audit Committee composed of five non-management Directors. The committee meets periodically with financial management, the internal auditors and the independent registered public accounting firm to review accounting, control, auditing and financial reporting matters. Item 9
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Based on the provided text, here's a summary of the financial statement excerpt:
Key Financial Accounting Characteristics:
1. Profit/Loss Handling:
- Losses are established as a liability through a charge to earned surplus
- Does not follow GAAP standards for provisions of future catastrophic losses
2. Expense Recognition:
- Liabilities are recorded directly in earned surplus
- Not processed through the income statement
3. Revenue Recognition:
- General insurance premiums for annual policies recognized pro-rata
- Earned but unbilled premiums recognized on billing date
- Adjustments for premiums, commissions made through periodic evaluations
- Title premium and fee revenues from direct operations represent 28% (incomplete percentage)
The statement highlights differences in accounting treatment between the company's practices and standard GAAP guidelines, particularly in how losses, expenses, and revenues are recognized and recorded.
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Claude
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Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Morningstar, Inc.: We have audited the accompanying consolidated balance sheets of Morningstar, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, equity, and cash flows for each of the years in the three-year period ended December 31, 2016. In connection with our audits of the consolidated financial statements, we also have audited the financial statement Schedule II - Valuation and Qualifying Accounts. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Morningstar, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Morningstar, Inc.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) , and our report dated February 28, 2017, expressed an unqualified opinion on the effectiveness of Morningstar Inc.’s internal control over financial reporting. /s/ KPMG LLP Chicago, Illinois February 28, 2017 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Morningstar, Inc.: We have audited Morningstar, Inc.’s (the Company) internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Morningstar, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Morningstar, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Morningstar, Inc. acquired PitchBook Data, Inc. (PitchBook) during 2016, and management excluded from its assessment of internal control over financial reporting as of December 31, 2016, PitchBook’s internal control over financial reporting associated with total assets of $283,346,000 and total revenue of $4,109,000, included in the consolidated financial statements of Morningstar, Inc. and subsidiaries as of and for the year ended December 31, 2016. Our audit of internal control over financial reporting of the Company also excluded an evaluation of the internal control over financial reporting of PitchBook. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Morningstar, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, equity, and cash flows for each of the years in the three-year period ended December 31, 2016, and the financial statement schedule, and our report dated February 28, 2017, expressed an unqualified opinion on those consolidated financial statements and accompanying schedule. /s/ KPMG LLP Chicago, Illinois February 28, 2017 Morningstar, Inc. and Subsidiaries Consolidated Statements of Income See notes to consolidated financial statements. Morningstar, Inc. and Subsidiaries Consolidated Statements of Comprehensive Income See notes to consolidated financial statements. Morningstar, Inc. and Subsidiaries Consolidated Balance Sheets See notes to consolidated financial statements. Morningstar, Inc. and Subsidiaries Consolidated Statements of Equity See notes to consolidated financial statements. Morningstar, Inc. and Subsidiaries Consolidated Statements of Cash Flows See notes to consolidated financial statements. MORNINGSTAR, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Description of Business Morningstar, Inc. and its subsidiaries (Morningstar, we, our, the company), provides independent investment research for investors around the world. We offer an extensive line of products and services for financial advisors, asset managers, retirement plan providers and sponsors, and individual investors. We have operations in 27 countries. 2. Summary of Significant Accounting Policies The acronyms that appear in these Notes to our Consolidated Financial Statements refer to the following: ASC Accounting Standards Codification ASU Accounting Standards Update EITF Emerging Issues Task Force FASB Financial Accounting Standards Board SEC Securities and Exchange Commission Principles of Consolidation. We conduct our business operations through wholly owned or majority-owned operating subsidiaries. The accompanying consolidated financial statements include the accounts of Morningstar, Inc. and our subsidiaries. We consolidate assets, liabilities, and results of operations of subsidiaries in which we have a controlling interest and eliminate all significant intercompany accounts and transactions. We account and report the noncontrolling (minority) interest in our Consolidated Financial Statements in accordance with FASB ASC 810, Consolidation. A noncontrolling interest is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to the parent company. We report the noncontrolling interest in our Consolidated Balance Sheet within equity separate from the shareholders' equity attributable to Morningstar, Inc. In addition, we present the net income (loss) and comprehensive income (loss) attributable to Morningstar, Inc.'s shareholders and the noncontrolling interest in our Consolidated Statements of Income, Consolidated Statements of Comprehensive Income, and Consolidated Statements of Equity. We account for investments in entities in which we exercise significant influence, but do not control, using the equity method. As part of our investment management operations, we manage certain funds outside of the United States that are considered variable interest entities. For the majority of these variable interest entities, we do not have a variable interest in them. In cases where we do have a variable interest, we are not the primary beneficiary. Accordingly, we do not consolidate any of these variable interest entities. Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses during the reporting period. Actual results may differ from these estimates. Reclassifications. Certain amounts reported in prior years have been reclassified to conform to the current year presentation. Cash and Cash Equivalents. Cash and cash equivalents consists of cash and investments with original maturities of three months or less. We state them at cost, which approximates fair value. We state the portion of our cash equivalents that are invested in money market funds at fair value, as these funds are actively traded and have quoted market prices. Investments. We account for our investments in accordance with FASB ASC 320, Investments-Debt and Equity Securities. We classify our investments into three categories: held-to-maturity, trading, and available-for-sale. • Held-to-maturity: We classify certain investments, primarily certificates of deposit, as held-to-maturity securities, based on our intent and ability to hold these securities to maturity. We record held-to-maturity investments at amortized cost in our Consolidated Balance Sheets. • Trading: We classify certain other investments, primarily equity securities, as trading securities as these relate mainly to investments tracking the strategies of our newsletter portfolios. We include realized and unrealized gains and losses associated with these investments as a component of our operating income in our Consolidated Statements of Income. We record these securities at their fair value in our Consolidated Balance Sheets. • Available-for-sale: Investments not considered held-to-maturity or trading securities are classified as available-for-sale securities. Available-for-sale securities primarily consist of equity securities, exchange-traded funds, and mutual funds. We report unrealized gains and losses for available-for-sale securities as other comprehensive income (loss), net of related income taxes. We record these securities at their fair value in our Consolidated Balance Sheets. Fair Value Measurements. We follow FASB ASC 820, Fair Value Measurements. FASB ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Under FASB ASC 820, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances and does not require any new fair value measurements. FASB ASC 820 uses a fair value hierarchy based on three broad levels of valuation inputs: • Level 1: Valuations based on quoted prices in active markets for identical assets or liabilities that the company has the ability to access. • Level 2: Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. • Level 3: Valuations based on inputs that are unobservable and significant to the overall fair value measurement. We provide additional information about our cash equivalents and investments that are subject to valuation under FASB ASC 820 in Note 6. Concentration of Credit Risk. No single customer is large enough to pose a significant credit risk to our operations or financial condition. For the years ended December 31, 2016, 2015, and 2014, no single customer represented 5% or more of our consolidated revenue. If receivables from our customers become delinquent, we begin a collections process. We maintain an allowance for doubtful accounts based on our estimate of the probable losses of accounts receivable. Property, Equipment, and Depreciation. We state property and equipment at historical cost, net of accumulated depreciation. We depreciate property and equipment primarily using the straight-line method based on the useful life of the asset, which generally is three years. We amortize leasehold improvements over the lease term or their useful lives, whichever is shorter. Computer Software and Internal Product Development Costs. We capitalize certain costs in accordance with FASB ASC 350-40, Internal-Use Software, FASB ASC 350-50, Website Development Costs, and FASB ASC 985, Software. Internal product development costs mainly consist of employee costs for developing new web-based products and certain major enhancements of existing products. We amortize these costs on a straight-line basis over the estimated economic life, which is generally three to five years. We include capitalized software development costs related to projects that have not been placed into service in our construction in progress balance. The table below summarizes our depreciation expense related to internally developed software for the past three years: The table below summarizes our capitalized software development costs for the past three years: Business Combinations. When we make acquisitions, we allocate the purchase price to the assets acquired, liabilities assumed, and goodwill. We follow FASB ASC 805, Business Combinations. We recognize and measure the fair value of the acquired operation as a whole, as well as the assets acquired and liabilities assumed, at their full fair values as of the date we obtain control, regardless of the percentage ownership in the acquired operation or how the acquisition was achieved. We expense direct costs related to the business combination, such as advisory, accounting, legal, valuation, and other professional fees, as incurred. We recognize restructuring costs, including severance and relocation for employees of the acquired entity, as post-combination expenses unless the target entity meets the criteria of FASB ASC 420, Exit or Disposal Cost Obligations, on the acquisition date. As part of the purchase price allocation, we follow the requirements of FASB ASC 740, Income Taxes. This includes establishing deferred tax assets or liabilities reflecting the difference between the values assigned for financial statement purposes and income tax purposes. In certain acquisitions, the goodwill resulting from the purchase price allocation may not be deductible for income tax purposes. FASB ASC 740 prohibits recognition of a deferred tax asset or liability for temporary differences in goodwill if goodwill is not amortizable and deductible for tax purposes. Goodwill. Changes in the carrying amount of our recorded goodwill are mainly the result of business acquisitions, divestitures, and the effect of foreign currency translations. In accordance with FASB ASC 350, Intangibles-Goodwill and Other, we do not amortize goodwill; instead, goodwill is subject to an impairment test annually, or whenever indicators of impairment exist. An impairment would occur if the carrying amount of a reporting unit exceeded the fair value of that reporting unit. We performed annual impairment reviews in the fourth quarter of 2016, 2015, and 2014. We did not record any impairment losses in 2016, 2015, or 2014. Intangible Assets. We amortize intangible assets using the straight-line method over their estimated useful lives, which range from one to 25 years. We have no intangible assets with indefinite useful lives. In accordance with FASB ASC 360-10-35, Subsequent Measurement-Impairment or Disposal of Long-Lived Assets, we review intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If the value of future undiscounted cash flows is less than the carrying amount of an asset group, we record an impairment loss based on the excess of the carrying amount over the fair value of the asset group. We did not record any impairment losses in 2016, 2015, or 2014. Revenue Recognition. We recognize revenue in accordance with SEC SAB Topic 13, Revenue Recognition, ASC 605-25, Revenue Recognition: Multiple Element Arrangements, and ASC 985-605, Software: Revenue Recognition. We recognize revenue when all of the following conditions are met: • There is persuasive evidence of an arrangement, as evidenced by a signed contract; • Delivery of our products and services has taken place. If arrangements include an acceptance provision, we generally begin recognizing revenue when we receive customer acceptance; • The amount of fees to be paid by the customer is fixed or determinable; and • The collectibility of the fees is reasonably assured. We generate revenue through sales of Morningstar Data, Morningstar Advisor Workstation (including Morningstar Office), Morningstar Direct, Morningstar Research, Premium Membership subscriptions for Morningstar.com, our structured credit ratings offerings, and a variety of other investment-related products and services. We generally structure the revenue agreements for these offerings as licenses or subscriptions. We recognize revenue from licenses and subscription sales ratably as we deliver the product or service and over the service obligation period defined by the terms of the customer contract. For new-issue ratings and analysis for commercial mortgage-backed securities (CMBS), we charge asset-based fees that are paid by the issuer on the rated balance of the transaction and recognize the revenue immediately upon issuance. We also generate revenue from Internet advertising, primarily from “impression-based” contracts. For advertisers who use our cost-per-impression pricing, we charge fees each time we display their ads on our site. Our Investment Management business includes a broad range of services. Pricing for consulting services is based on the scope of work and the level of service provided, and includes asset-based fees for work we perform that involves investment management or acting as a subadvisor to investment portfolios. In arrangements that involve asset-based fees, we generally invoice clients quarterly in arrears based on average assets for the quarter. We recognize asset-based fees once the fees are fixed and determinable assuming all other revenue recognition criteria are met. Our Workplace Solutions offerings help retirement plan participants plan and invest for retirement. We offer these services both through retirement plan providers (typically third-party asset management companies that provide administrative and record-keeping services) and directly to plan sponsors (employers that offer retirement plans to their employees). For our Workplace Solutions offerings, we provide both a hosted solution as well as proprietary installed software advice solution. Clients can integrate the installed customized software into their existing systems to help investors accumulate wealth, transition into retirement, and manage income during retirement. The revenue arrangements for Workplace Solutions generally extend over multiple years. Our contracts may include one-time setup fees, implementation fees, technology licensing and maintenance fees, asset-based fees for managed retirement accounts, fixed and variable fees for advice and guidance, or a combination of these fee structures. Upon customer acceptance, we recognize revenue ratably over the term of the agreement. We recognize asset-based fees and variable fees in excess of any minimum once the value is fixed and determinable. Some of our revenue arrangements combine multiple products and services. These products and services may be provided at different points in time or over different time periods within the same arrangement. We allocate fees to the separate deliverables based on the deliverables’ relative selling price, which is generally based on the price we charge when the same deliverable is sold separately. We record taxes imposed on revenue-producing transactions (such as sales, use, value-added, and some excise taxes) on a net basis; therefore, we exclude such taxes from revenue in our Consolidated Statements of Income. Deferred revenue represents the portion of licenses or subscriptions billed or collected in advance of the service being provided which we expect to recognize as revenue in future periods. Certain arrangements may have cancellation or refund provisions. If we make a refund, it typically reflects the amount collected from a customer for which we have not yet provided services. The refund therefore results in a reduction of deferred revenue. Sales Commissions. Through December 31, 2013, we paid sales commissions based on a formula driven by the total contract value of sales opportunities closed, with any subsequent adjustments (such as clawbacks for contract cancellations) reflected in future commission payouts. We considered the corresponding commission expense an incremental direct acquisition cost and treated it as a deferred charge, which we expensed over the term of the underlying sales contracts. In the first quarter of 2014, we modified our sales incentive plan. The revised plan is based on a combination of net new sales and specific business objectives not solely tied to revenue growth. Because of this new structure and the discretion involved in determining the related incentives, we started expensing sales commissions as incurred instead of amortizing them over the contract terms. However, we continued to amortize the deferred charge capitalized in connection with sales commissions paid in 2013 and previous periods as part of the previous incentive plan. This amortization added $0.6 million, $3.5 million, and $9.8 million of sales commission cost in 2016, 2015, and 2014, respectively. Advertising Costs. Advertising costs include expenses incurred for various print and Internet ads, search engine fees, and direct mail campaigns. We expense advertising costs as incurred. The table below summarizes our advertising expense for the past three years: Stock-Based Compensation Expense. We account for our stock-based compensation expense in accordance with FASB ASC 718, Compensation-Stock Compensation. Our stock-based compensation expense reflects grants of restricted stock units, restricted stock, performance share awards, and stock options. We measure the fair value of our restricted stock units, restricted stock, and performance share awards on the date of grant based on the closing market price of Morningstar's common stock on the day prior to grant. For stock options, we estimate the fair value of our stock options on the date of grant using a Black-Scholes option-pricing model. We amortize the fair values to stock-based compensation expense, net of estimated forfeitures, ratably over the vesting period. We estimate expected forfeitures of all employee stock-based awards and recognize compensation cost only for those awards expected to vest. We determine forfeiture rates based on historical experience and adjust the estimated forfeitures to actual forfeiture experience as needed. Liability for Sabbatical Leave. In some of our operations, we offer employees a sabbatical leave. Although the sabbatical policy varies by region, Morningstar's full-time employees are generally eligible for six weeks of paid time off after four years of continuous service. We account for our sabbatical liability in accordance with FASB ASC 710-10-25, Compensated Absences. We record a liability for employees' sabbatical benefits over the period employees earn the right for sabbatical leave and include this liability in Accrued Compensation in our Consolidated Balance Sheet. Income Taxes. We record deferred income taxes for the temporary differences between the carrying amount of assets and liabilities for financial statement purposes and tax purposes in accordance with FASB ASC 740, Income Taxes. FASB ASC 740 prescribes the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, and disclosure for uncertain tax positions. We recognize interest and penalties related to unrecognized tax benefits as part of income tax expense in our Consolidated Statements of Income. We classify liabilities related to unrecognized tax benefits as either current or long-term liabilities in our Consolidated Balance Sheet, depending on when we expect to make payment. 3. Credit Arrangements In November 2016, we amended and restated our credit agreement, which now provides us with a three-year credit facility with a borrowing capacity of up to $300.0 million. The credit agreement also provides for issuance of up to $25.0 million of letters of credit under the revolving credit facility. The interest rate applicable to any loan under the credit agreement is, at our option, either: (i) the applicable London interbank offered rate (LIBOR) plus an applicable margin for such loans, which ranges between 1.00% and 1.75%, based on our consolidated leverage ratio or (ii) the lender's base rate plus the applicable margin for such loans, which ranges between 2.00% and 2.75%, based on our consolidated leverage ratio. The credit agreement also contains financial covenants under which we: (i) may not exceed a maximum consolidated leverage ratio of 3.00 to 1.00 and (ii) are required to maintain a minimum consolidated interest coverage ratio of not less than 3.00 to 1.00. We were in compliance with the financial covenants as of December 31, 2016. We had an outstanding principal balance of $250.0 million at a one-month LIBOR interest rate plus 100 basis points as of December 31, 2016, leaving borrowing availability of $50.0 million. 4. Income Per Share The following table shows how we reconcile our net income and the number of shares used in computing basic and diluted income per share: The following table shows the number of weighted average restricted stock units and performance share awards excluded from our calculation of diluted earnings per share because their inclusion would have been anti-dilutive: 5. Segment and Geographical Area Information Segment Information We report our results in a single reportable segment, which reflects how our chief operating decision maker allocates resources and evaluates our financial results. Because we have a single reportable segment, all required financial segment information can be found directly in the Consolidated Financial Statements. The accounting policies for our reportable segment are the same as those described in Note 2. We evaluate the performance of our reporting segment based on revenue and operating income. Geographical Area Information The tables below summarize our revenue and long-lived assets by geographical area: 6. Investments and Fair Value Measurements We classify our investments into three categories: available-for-sale, held-to-maturity, and trading. Our investment portfolio consists of stocks, bonds, options, mutual funds, money market funds, or exchange-traded products that replicate the model portfolios and strategies created by Morningstar. These investment accounts may also include exchange-traded products where Morningstar is an index provider. We classify our investment portfolio as shown below: The following table shows the cost, unrealized gains (losses), and fair values related to investments classified as available-for-sale and held-to-maturity: As of December 31, 2016 and December 31, 2015, investments with unrealized losses for greater than a 12-month period were not material to the Consolidated Balance Sheets and were not deemed to have other than temporary declines in value. The table below shows the cost and fair value of investments classified as available-for-sale and held-to-maturity based on their contractual maturities as of December 31, 2016 and December 31, 2015. The following table shows the realized gains and losses arising from sales of our investments classified as available-for-sale recorded in our Consolidated Statements of Income: We determine realized gains and losses using the specific identification method. The following table shows the net unrealized losses on trading securities as recorded in our Consolidated Statements of Income: The table below shows the fair value of our assets subject to fair value measurements that are measured at fair value on a recurring basis using a fair value hierarchy: Level 1: Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Level 2: Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 3: Valuations based on inputs that are unobservable and significant to the overall fair value measurement. Based on our analysis of the nature and risks of our investments in equity securities and mutual funds, we have determined that presenting each of these investment categories in the aggregate is appropriate. We measure the fair value of money market funds, mutual funds, equity securities, and exchange-traded funds based on quoted prices in active markets for identical assets or liabilities. We did not hold any securities categorized as Level 2 or Level 3 as of December 31, 2016 and December 31, 2015. 7. Acquisitions, Goodwill, and Other Intangible Assets 2016 Acquisitions Increased Ownership Interest in PitchBook Data, Inc. (PitchBook) In December 2016, we acquired an additional 78% interest in PitchBook Data, Inc. (PitchBook), increasing our ownership to 100% from 22%. PitchBook delivers data, research, and technology covering the private capital markets, including venture capital, private equity, and mergers and acquisitions. We began consolidating the financial results of this acquisition in our Consolidated Financial Statements on December 1, 2016. PitchBook contributed $4.1 million of revenue and $7.5 million of operating expense during the one-month period that PitchBook was included in our consolidated results for 2016. PitchBook's total preliminary estimated fair value of $235.1 million includes $188.2 million in cash paid to acquire the remaining 78% interest in PitchBook as well as a $46.9 million fair value related to our previous 22% ownership interest. The book value of this ownership immediately prior to the acquisition date was $9.8 million, and we recorded a preliminary non-cash holding gain of $37.1 million for the difference between the fair value and the book value of our previously held investment. We used the income approach and a discounted cash flow analysis of PitchBook’s projected revenue, operating expense, and other amounts to arrive at the estimated fair value. The gain is classified as "Holding gain upon acquisition of additional ownership of equity-method investments" in our Consolidated Statement of Income for the year ended December 31, 2016. The transaction has been accounted for using the acquisition method of accounting, which requires that assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The values assigned to the assets acquired and liabilities assumed are based on preliminary estimates of fair value available as of the date of this Annual Report on Form 10-K, and may be adjusted during the measurement period of up to 12 months from the date of acquisition as further information becomes available. Any changes in the fair values of the assets acquired and liabilities assumed during the measurement period may result in adjustments to goodwill. As of December 31, 2016, the primary areas that are not yet finalized due to information that may become available subsequently and may result in changes in the values assigned to various assets and liabilities, include the fair values of acquired intangible assets and related deferred tax liabilities, assumed deferred revenue, as well as assumed tax assets and liabilities. The following table summarizes our preliminary allocation of the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, all of which are preliminary pending completion of the final valuation: Accounts receivable acquired were recorded at gross contractual amounts receivable, which approximates fair value. We expect to collect substantially all of the gross contractual amounts receivable within a reasonable period of time after the acquisition date. The preliminary allocation includes $60.7 million of acquired intangible assets, as follows: We recognized a preliminary net deferred tax liability of $12.8 million mainly because the amortization expense related to certain intangible assets is not deductible for income tax purposes. Preliminary goodwill of $193.6 million represents the excess over the fair value of the net tangible and intangible assets acquired with this acquisition. We paid this premium for a number of reasons, including the opportunity to offer comprehensive data coverage across the full life cycle of private market transactions. The preliminary goodwill is not deductible for income tax purposes. Unaudited Pro Forma Information for PitchBook Acquisition The following unaudited pro forma information presents a summary of our Consolidated Statements of Income for the years ended December 31, 2016 and 2015 as if we had completed the PitchBook acquisition as of January 1, 2015. This unaudited pro forma information is presented for illustrative purposes and is not intended to represent or be indicative of the actual results of operations of the combined company that would have been achieved had the acquisition occurred at the beginning of the earliest period presented, nor is it intended to represent or be indicative of future results of operations. In calculating the pro forma information below, we included an estimate of amortization expense related to the intangible assets acquired, stock-based compensation expense related to the PitchBook bonus plan (see Note 11 for additional information), and interest expense incurred on the long-term debt. The 2016 pro forma net income excludes the $37.1 million non-cash holding gain generated in connection with the transaction. RequiSight, LLC (RightPond) On March 31, 2016, we acquired RequiSight, LLC, which does business as RightPond, a provider of business intelligence data and analytics on defined contribution and defined benefit plans for financial services firms. We began consolidating the financial results of RightPond in our Consolidated Financial Statements on March 31, 2016. InvestSoft Technology, Inc. (InvestSoft) On May 31, 2016, we acquired InvestSoft Technology, Inc. (InvestSoft), a provider of fixed-income analytics. We began consolidating the financial results of InvestSoft in our Consolidated Financial Statements on May 31, 2016. 2015 Acquisitions Increased Ownership Interest in Ibbotson Associates Japan K.K. (IAJ) In July 2015, we acquired an additional 28.9% interest in Ibbotson Associates Japan K.K. (IAJ), increasing our ownership to 100% from 71.1%. Because we previously owned more than 50% of the company, IAJ's financial results were consolidated in our Consolidated Financial Statements prior to acquiring the remaining interest. Total Rebalance Expert (tRx) In November 2015, we acquired Total Rebalance Expert (tRx), an automated, tax-efficient investment portfolio rebalancing platform for financial advisors. tRx streamlines the rebalancing process for advisors and automates the complexities involved in rebalancing and managing portfolios. We began consolidating the financial results of tRx in our Consolidated Financial Statements on November 2, 2015. 2014 Acquisitions Increased Ownership Interest in HelloWallet Holdings, Inc. In June 2014, we acquired an additional 81.3% interest in HelloWallet Holdings, Inc. (HelloWallet), increasing our ownership to 100% from 18.7%. HelloWallet combines behavioral economics and the psychology of decision-making with sophisticated technology to provide personalized, unbiased financial guidance to U.S. workers and their families through their employer benefit plans. We began consolidating the financial results of this acquisition in our Consolidated Financial Statements on June 3, 2014. HelloWallet's total estimated fair value of $54.0 million includes $40.5 million in cash paid to acquire the remaining 81.3% interest in HelloWallet and pay off HelloWallet's indebtedness as well as $13.5 million related to the 18.7% of HelloWallet we previously held. We recorded a non-cash holding gain of $5.2 million for the difference between the fair value and the book value of our previously held investment. The gain is classified as "Holding gain upon acquisition of additional ownership of equity-method investments" in our Consolidated Statement of Income for the year ended December 31, 2014. The following table summarizes our allocation of the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition: The allocation includes $9.5 million of acquired intangible assets, as follows: We recognized a deferred tax liability of $3.6 million mainly because the amortization expense related to certain intangible assets is not deductible for income tax purposes. We recognized a deferred tax asset of $8.6 million mainly because of net operating losses of HelloWallet which will become available to Morningstar. Goodwill of $39.2 million represents the premium over the fair value of the net tangible and intangible assets acquired. We paid this premium for a number of reasons, including the opportunity to bring together HelloWallet's comprehensive financial wellness expertise with Morningstar's independent, research-based retirement advice to create a holistic retirement savings and advice offering. ByAllAccounts, Inc. In April 2014, we acquired ByAllAccounts, Inc. (ByAllAccounts), a provider of innovative data aggregation technology for financial applications for $27.9 million in cash. ByAllAccounts uses a knowledge-based process, including patented artificial intelligence technology, to collect, consolidate, and enrich financial account data and deliver it to virtually any platform. We began including the financial results of this acquisition in our Consolidated Financial Statements on April 1, 2014. The following table summarizes our allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition: The allocation includes $8.7 million of acquired intangible assets, as follows: We recognized a deferred tax liability of $3.3 million mainly because the amortization expense related to certain intangible assets is not deductible for income tax purposes. We recognized a deferred tax asset of $4.0 million mainly because of net operating losses of ByAllAccounts which will become available to Morningstar. Goodwill of $18.5 million represents the premium we paid over the fair value of the acquired net tangible and intangible assets. We paid this premium for a number of reasons, including the opportunity to integrate the service into our offerings as well as expand and develop ByAllAccounts' third-party distribution relationships. Goodwill The following table shows the changes in our goodwill balances from January 1, 2015 to December 31, 2016: We did not record any impairment losses in 2016, 2015, or 2014, as the estimated fair values of our reporting unit exceeded its carrying value. We perform our annual impairment testing during the fourth quarter of each year. Intangible Assets The following table summarizes our intangible assets: The following table summarizes our amortization expense related to intangible assets: We did not record any impairment losses involving intangible assets in 2016, 2015, or 2014. We amortize intangible assets using the straight-line method over their expected economic useful lives. Based on acquisitions and divestitures completed through December 31, 2016, we expect intangible amortization expense for 2017 and subsequent years to be as follows: Our estimates of future amortization expense for intangible assets may be affected by additional acquisitions, divestitures, changes in the estimated average useful life, and foreign currency translation. 8. Investments in Unconsolidated Entities Our investments in unconsolidated entities consist primarily of the following: Morningstar Japan K.K. Morningstar Japan K.K. (MJKK) develops and markets products and services customized for the Japanese market. MJKK’s shares are traded on the Tokyo Stock Exchange under the ticker 47650. We account for our investment in MJKK using the equity method. The following table summarizes our ownership percentage in MJKK and the market value of this investment based on MJKK’s publicly quoted share price: Other Equity Method Investments. As of December 31, 2016 and 2015, other equity method investments consist of our investment in Inquiry Financial Europe AB (Inquiry Financial) and YCharts, Inc. (YCharts). Inquiry Financial is a provider of sell-side consensus estimate data. Our ownership interest in Inquiry Financial was approximately 34% as of December 31, 2016 and 2015. YCharts is a technology company that provides stock research and analysis. Our ownership interest in YCharts was approximately 22% as of December 31, 2016 and 2015. As of December 31, 2016, other equity method investments also includes our investment in Ellevate Financial, Inc. (Ellevest) and United Income, Inc. (United Income). In March 2016, we acquired a minority equity stake in Ellevest. Previously, Ellevest was accounted for as a cost-method investment. Ellevest provides an engaging investing experience to help women meet their financial goals. Our ownership interest in Ellevest was approximately 22% as of December 31, 2016. In June 2016, we acquired a minority equity stake in United Income, which helps investors transition to retirement and manage their retirement income. Our ownership interest in United Income was approximately 38% as of December 31, 2016. As of December 31, 2015, our cost-method investments also included a minority investment in PitchBook Data, Inc.(PitchBook). In December 2016, we purchased the remaining ownership interest in PitchBook. See Note 7 for additional information concerning our acquisition of PitchBook. During 2014, we recorded an impairment loss of $1.7 million on our investment in an unconsolidated entity. We did not record any impairment losses on these investments in 2016 or 2015. 9. Property, Equipment, and Capitalized Software The following table shows our property, equipment, and capitalized software summarized by major category: The following table summarizes our depreciation expense: 10. Operating Leases The following table shows our minimum future rental commitments due in each of the next five years and thereafter for all non-cancelable operating leases, consisting primarily of commitments for office space: The following table summarizes our rent expense, including taxes, insurance, and related operating costs: Deferred rent includes build-out and rent abatement allowances received, which are amortized over the remaining portion of the original term of the lease as a reduction in office lease expense. We include deferred rent, as appropriate, in “Accounts payable and accrued liabilities” and “Deferred rent, noncurrent” on our Consolidated Balance Sheets. 11. Stock-Based Compensation Stock-Based Compensation Plans Our shareholders approved the Morningstar 2011 Stock Incentive Plan (the 2011 Plan) on May 17, 2011. As of that date, we stopped granting awards under the Morningstar 2004 Stock Incentive Plan (the 2004 Plan). The 2004 Plan amended and restated the Morningstar 1993 Stock Option Plan, the Morningstar 2000 Stock Option Plan, and the Morningstar 2001 Stock Option Plan. The 2011 Plan provides for a variety of stock-based awards, including, among other things, restricted stock units, restricted stock, performance share awards, and stock options. We granted restricted stock units, restricted stock, and stock options under the 2004 Plan. All of our employees and our non-employee directors are eligible for awards under the 2011 Plan. Grants awarded under the 2011 Plan or the 2004 Plan that are forfeited, canceled, settled, or otherwise terminated without a distribution of shares, or shares withheld by us in connection with the exercise of options, will be available for awards under the 2011 Plan. Any shares subject to awards under the 2011 Plan, but not under the 2004 Plan, that are withheld by us in connection with the payment of any required income tax withholding will be available for awards under the 2011 Plan. The following table summarizes the number of shares available for future grants under our 2011 Plan: Accounting for Stock-Based Compensation Awards The following table summarizes our stock-based compensation expense and the related income tax benefit we recorded in the past three years: The following table summarizes the stock-based compensation expense included in each of our operating expense categories for the past three years: The following table summarizes the amount of unrecognized stock-based compensation expense as of December 31, 2016 and the expected number of months over which the expense will be recognized: In accordance with FASB ASC 718, Compensation-Stock Compensation, we estimate forfeitures of employee stock-based awards and recognize compensation cost only for those awards expected to vest. Most of our larger annual equity grants typically have vesting dates in the second quarter. We adjust the stock-based compensation expense annually in the third quarter to reflect those awards that ultimately vested and update our estimate of the forfeiture rate that will be applied to awards not yet vested. Restricted Stock Units Restricted stock units represent the right to receive a share of Morningstar common stock when that unit vests. Restricted stock units granted to employees vest ratably over a four-year period. Restricted stock units granted to non-employee directors vest ratably over a three-year period. We measure the fair value of our restricted stock units on the date of grant based on the closing market price of the underlying common stock on the day prior to grant. We amortize that value to stock-based compensation expense, net of estimated forfeitures, ratably over the vesting period. The following table summarizes restricted stock unit activity during the past three years: Performance Share Awards In 2014, we introduced a long-term incentive award program consisting of performance shares. In March 2015 and 2016, executive officers, other than Joe Mansueto, and certain other employees, were granted performance share awards. These awards entitle the holder to a number of shares of Morningstar common stock equal to the number of notional performance shares that become vested. Each award specifies a number of performance shares that will vest if pre-established target performance goals are attained. The number of performance shares that actually vest may be more or less than the specified number of performance shares to the extent Morningstar exceeds or fails to achieve, respectively, the target performance goals over a three-year performance period. We base the grant date fair value for these awards on the closing market price of the underlying common stock on the day prior to the grant date. We amortize that value to stock-based compensation expense ratably over the vesting period based on the satisfaction of the performance condition that is most likely to be satisfied over the three-year performance period. The table below shows target performance share awards granted and shares that would be issued at current performance levels for performance share awards granted as of December 31, 2016: PitchBook Bonus Plan In connection with our acquisition of PitchBook, we adopted a management bonus sub-plan under the 2011 Plan for certain employees of PitchBook (the PitchBook Plan). Pursuant to the terms of the PitchBook Plan, awards having an aggregate target value equal to $30.0 million will be available for issuance with annual grants of $7.5 million for 2017, $7.5 million in 2018, and $15.0 million in 2019. Each grant will consist of performance-based share unit awards which will vest over a one-year period and will be measured primarily based on the achievement of certain annual revenue targets specifically related to PitchBook’s business. Upon achievement of these targets, earned performance units will be settled in shares of our common stock on a one-for-one basis. If PitchBook exceeds certain performance conditions, the PitchBook Plan participants may receive payment for performance units in excess of the aggregate target values described above. If PitchBook fails to meet threshold performance conditions, the PitchBook Plan participants will not be entitled to receive payment for any performance units. In certain circumstances, the PitchBook Plan participants may be able to receive a catch-up award with respect to 2017 or 2018 if certain additional performance conditions are met in a subsequent year. The table below shows target performance share awards granted and shares that would be issued at current performance levels for performance share awards granted as of December 31, 2016: Stock Options Stock options granted to employees vest ratably over a four-year period. Grants to our non-employee directors vest ratably over a three-year period. All grants expire 10 years after the date of grant. In May 2011, we granted 86,106 stock options under the 2004 Stock Incentive Plan. In November 2011, we granted 6,095 stock options under the 2011 Plan. All options granted in 2011 have an exercise price equal to the fair market value on the grant date. We estimated the fair value of the options on the grant date using a Black-Scholes option-pricing model. The weighted average fair value of options granted during 2011 was $23.81 per share, based on the following assumptions: The following tables summarize stock option activity in the past three years for our various stock option grants. The first table includes activity for options granted at an exercise price below the fair value per share of our common stock on the grant date; the second table includes activity for all other option grants. The following table summarizes the total intrinsic value (difference between the market value of our stock on the date of exercise and the exercise price of the option) of options exercised: The table below shows additional information for options outstanding and exercisable as of December 31, 2016: The aggregate intrinsic value in the table above represents the total pretax intrinsic value all option holders would have received if they had exercised all outstanding options on December 31, 2016. The intrinsic value is based on our closing stock price of $73.56 on December 30, 2016. 12. Defined Contribution Plan We sponsor a defined contribution 401(k) plan, which allows our U.S.-based employees to voluntarily contribute pre-tax dollars up to a maximum amount allowable by the U.S. Internal Revenue Service. In 2016, 2015, and 2014, we made matching contributions to our 401(k) plan in the United States in an amount equal to 75 cents for every dollar of an employee's contribution, up to a maximum of 7% of the employee's compensation in the pay period. The following table summarizes our matching contributions: 13. Income Taxes Income Tax Expense and Effective Tax Rate The following table shows our income tax expense and our effective tax rate for the years ended December 31, 2016, 2015, and 2014: The following table reconciles our income tax expense at the U.S. federal income tax rate of 35% to income tax expense as recorded: Income tax expense consists of the following: The following table provides our income before income taxes and equity in net income (loss) of unconsolidated entities, generated by our U.S. and non-U.S. operations: Deferred Tax Assets and Liabilities We recognize deferred income taxes for the temporary differences between the carrying amount of assets and liabilities for financial statement purposes and their tax basis. The tax effects of the temporary differences that give rise to the deferred income tax assets and liabilities are as follows: The deferred tax assets and liabilities are presented in our Consolidated Balance Sheets as follows: The following table summarizes our U.S. net operating loss (NOL) carryforwards: The net increase in the U.S. federal NOL carryforwards as of December 31, 2016 compared with 2015 primarily reflects $23.9 million of acquired U.S federal NOLs from the acquisition of PitchBook in 2016 offset by $8.6 million of utilization of U.S. federal NOLs from prior acquisitions during 2016. We have not recorded a valuation allowance against the U.S. federal NOLs of $36.9 million because we expect the benefit of the U.S. federal NOLs to be fully utilized before expiration. The following table summarizes our NOL carryforwards for our non-U.S. operations: The decrease in non-U.S. NOL carryforwards as of December 31, 2016 compared with 2015 primarily reflects the use of NOL carryforwards. We have not provided federal and state income taxes on accumulated undistributed earnings of certain foreign subsidiaries aggregating approximately $171.6 million as of December 31, 2016, because these earnings have been permanently reinvested. It is not practicable to determine the amount of the unrecognized deferred tax liability related to the undistributed earnings. In assessing the realizability of our deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We have recorded a valuation allowance against all but approximately $6.8 million of the non-U.S. NOLs, reflecting the likelihood that the benefit of these NOLs will not be realized. Uncertain Tax Positions We conduct business globally and as a result, we file income tax returns in U.S. federal, state, local, and foreign jurisdictions. In the normal course of business we are subject to examination by tax authorities throughout the world. The open tax years for our U.S. Federal tax returns and most state tax returns include the years 2008 to the present. We are currently under audit by federal, state and local tax authorities in the United States as well as tax authorities in certain non-U.S. jurisdictions. It is likely that the examination phase of some of these U.S. federal, state, local, and non-U.S. audits will conclude in 2017. It is not possible to estimate the effect of current audits on previously recorded unrecognized tax benefits. As of December 31, 2016, our Consolidated Balance Sheet included a current liability of $8.9 million and a non-current liability of $5.4 million for unrecognized tax benefits. As of December 31, 2015, our Consolidated Balance Sheet included a current liability of $4.2 million and a non-current liability of $6.0 million for unrecognized tax benefits. These amounts include interest and penalties, less any associated tax benefits. The table below reconciles the beginning and ending amount of the gross unrecognized tax benefits as follows: In 2016, we recorded a net increase of $4.5 million of gross unrecognized tax benefits before settlements and lapses of statutes of limitations, of which $3.1 million increased our income tax expense by $2.8 million. In addition, we reduced our unrecognized tax benefits by $0.6 million for settlements and lapses of statutes of limitations, of which $0.6 million decreased our income tax expense by $0.4 million. As of December 31, 2016, we had $18.4 million of gross unrecognized tax benefits, of which $14.4 million, if recognized, would reduce our effective income tax rate and decrease our income tax expense by $13.3 million. We record interest and penalties related to uncertain tax positions as part of our income tax expense. The following table summarizes our gross liability for interest and penalties: We recorded the decrease in the liability, net of any tax benefits, to income tax expense in our Consolidated Statement of Income in 2016. 14. Contingencies We are involved in legal proceedings and litigation that have arisen in the normal course of our business. While it is difficult to predict the outcome of any particular proceeding, we do not believe the result of any of these matters will have a material adverse effect on our business, operating results, or financial position. 15. Share Repurchase Program We have an ongoing authorization, originally approved by our board of directors in September 2010 and subsequently amended, to repurchase up to $1.0 billion in shares of our outstanding common stock. The authorization expires on December 31, 2017. We may repurchase shares from time to time at prevailing market prices on the open market or in private transactions in amounts that we deem appropriate. As of December 31, 2016, we had repurchased a total of 10,028,125 shares for $672.9 million under this authorization, leaving approximately $327.1 million available for future repurchases. 16. Recently Issued Accounting Pronouncements On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The original effective date for ASU 2014-09 would have required us to adopt it beginning on January 1, 2017. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers-Deferral of the Effective Date, which defers the effective date of ASU 2014-09 for one year and permits early adoption as early as the original effective date of ASU 2014-09. We elected the deferral, and the new standard is effective for us on January 1, 2018. The company has obtained an understanding of ASU No. 2014-09 and has begun to analyze the impact of the new standard on its financial results. We have completed a high-level assessment of the attributes within the company’s contracts for its major products and services, and we have started assessing potential impacts to our internal processes, control environment, and disclosures. While the company does not currently anticipate that the adoption of ASU 2014-09 will result in a material change to the timing of when revenue is recognized and believes that it will retain similar accounting treatment used to recognize revenue under current standards, we are continuing to evaluate the impact of the new standard on our financial results and other possible impacts. The standard allows for both retrospective and modified retrospective methods of adoption. The company is in the process of determining the method of adoption it will elect and the impact on our consolidated financial statements and footnote disclosures. We will continue to provide enhanced disclosures as we continue our assessment. On March 17, 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which provides guidance on assessing whether an entity is a principal or an agent in a revenue transaction and whether an entity reports revenue on a gross or net basis. On April 14, 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers: Identifying Performance Obligations and Licensing, which provides guidance on identifying performance obligations and accounting for licenses of intellectual property. On May 6, 2016, the FASB issued ASU No. 2016-11, Revenue Recognition and Derivatives and Hedging: Rescission of SEC guidance because of ASU No. 2014-09 and ASU No. 2014-16 pursuant to staff announcements at the March 3, 2016 EITF Meeting, which rescinds the following SEC Staff Observer comments from ASC 605, Revenue Recognition, upon an entity's early adoption of ASC 606, Revenue from Contracts with Customers: Revenue and expense recognition for freight services in process, accounting for shipping and handling fees and costs, and accounting for consideration given by a vendor to a customer (including reseller of the vendor's products). On May 9, 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients, which makes narrow-scope amendments to ASU No. 2014-09 and provides practical expedients to simplify the transition to the new standard and clarify certain aspects of the standard. On December 21, 2016, the FASB issued ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers, which makes narrow-scope amendments to ASU No. 2014-09. The effective date and transition requirements for ASU No. 2016-08, ASU No. 2016-10, ASU No. 2016-11, ASU No. 2016-12, and ASU No. 2016-20 are the same as the effective date and transition requirements of ASU No. 2014-09. We are evaluating the effect that ASU No. 2016-08, ASU No. 2016-10, ASU No. 2016-11, ASU No. 2016-12, and ASU No. 2016-20 will have on our consolidated financial statements and related disclosures. On February 25, 2016, the FASB issued ASU No. 2016-02, Leases, which will require lessees to recognize almost all leases on their balance sheet as a right-of-use asset and a lease liability. The new standard is effective for us on January 1, 2019. The new standard must be adopted using a modified retrospective transition, and provides for certain practical expedients. Transition will require application of the new guidance at the beginning of the earliest comparative period presented. We are evaluating the effect that ASU No. 2016-02 will have on our consolidated financial statements and related disclosures. On March 15, 2016, the FASB issued ASU No. 2016-07, Investments-Equity Method and Joint Ventures: Simplifying the Transition to the Equity Method of Accounting, which eliminates the requirement to apply the equity method of accounting retrospectively when a reporting entity obtains significant influence over a previously held investment. The new standard is effective for us on January 1, 2017. Early adoption is permitted. The new standard should be applied prospectively for investments that qualify for the equity method of accounting after the effective date. We elected to early adopt ASU No. 2016-07 in the quarter ended March 31, 2016. The adoption of ASU No. 2016-07 did not have a material effect on our consolidated financial statements. On March 30, 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which includes amendments to accounting for income taxes at settlement, forfeitures, and net settlements to cover withholding taxes. The new standard is effective for us on January 1, 2017. Early adoption is permitted but requires all elements of the amendments to be adopted at once rather than individually. We elected to early adopt ASU No. 2016-09 in the quarter ended June 30, 2016, which requires us to reflect any adjustments as of January 1, 2016, the beginning of the annual period that includes the interim period of adoption. The primary impact of adoption was the recognition of excess tax benefits in our provision for income taxes rather than paid-in capital for all periods in 2016. Additional amendments to the accounting for income taxes and minimum statutory withholding tax requirements had no impact to retained earnings as of January 1, 2016, where the cumulative effective of these changes are required to be recorded. We have elected to continue to estimate forfeitures expected to occur to determine the amount of compensation cost to be recognized in each period. We elected to apply the presentation requirements for cash flows related to excess tax benefits retrospectively to all periods presented, which resulted in an increase to both net cash provided by operating activities and net cash used for financing activities of $2.6 million and $4.4 million for the years ended December 31, 2015 and December 31, 2014, respectively. The presentation requirements for cash flows related to employee taxes paid for withheld shares had no impact to any of the periods presented in our consolidated cash flow statements because such cash flows have historically been presented as a financing activity. Adoption of the new standard resulted in the recognition of excess tax benefits in our provision for income taxes rather than paid-in capital of $0.8 million for the year ended December 31, 2016. On August 26, 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments, which reduces diversity in practice of how certain transactions are classified in the statement of cash flows. The new guidance clarifies the classification of cash activities related to debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate and bank-owned life insurance policies, distributions received from equity-method investments, and beneficial interests in securitization transactions. The guidance also describes a predominance principle in which cash flows with aspects of more than one class that cannot be separated should be classified based on the activity that is likely to be the predominant source or use of cash flow. The new standard is effective for us on January 1, 2018. Early adoption is permitted, including adoption in an interim period, but requires all elements of the amendments to be adopted at once rather than individually. The new standard must be adopted using a retrospective transition method. We are evaluating the effect that ASU No. 2016-15 will have on our consolidated financial statements and related disclosures. On January 5, 2017, the FASB issued ASU No. 2017-01, Business Combinations: Clarifying the Definition of a Business, which revises the definition of a business. When substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. To be considered a business, an acquisition would have to include an input and a substantive process that together significantly contribute to the ability to create outputs. The new guidance provides a framework to evaluate when an input and substantive process are present (including for early-stage companies that have not generated outputs). To be a business without outputs, there will now need to be an organized workforce. The new guidance also narrows the definition of the term outputs to be consistent with how it is described in Topic 606, Revenue from Contracts with Customers. The new standard is effective for us on January 1, 2018. Early adoption is permitted. We are evaluating the effect that ASU No. 2017-01 will have on our consolidated financial statements and related disclosures. On January 26, 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other, which simplifies the accounting for goodwill impairment. The guidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. All other goodwill impairment guidance will remain largely unchanged. Entities will continue to have the option to perform a qualitative assessment to determine if a quantitative impairment test is necessary. The same one-step impairment test will be applied to goodwill at all reporting units, even those with zero or negative carrying amounts. Entities will be required to disclose the amount of goodwill at reporting units with zero or negative carrying amounts. The new standard is effective for us on January 1, 2020. The new standard should be applied prospectively. Early adoption is permitted for any impairment tests performed after January 1, 2017. We are evaluating the effect that ASU No. 2017-05 will have on our consolidated financial statements and related disclosures. 17. Selected Quarterly Financial Data (unaudited) (1) Non-operating income in the fourth quarter of 2016 included a $37.1 million holding gain related to the purchase of the remaining ownership interest in PitchBook, which was previously a minority investment.
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Here's a summary of the financial statement:
Financial Overview:
- Total Revenue: $4,109,000
- Total Assets: $283,346,000
Key Accounting Practices:
1. Investment Management:
- Manages funds outside the US
- Uses equity method for significant influence investments
- Does not consolidate variable interest entities
2. Investment Classification:
- Held-to-maturity: Primarily certificates of deposit, recorded at amortized cost
- Trading: Mainly equity securities, recorded at fair value with gains/losses in operating income
- Available-for-sale: Equity securities, ETFs, mutual funds, recorded at fair value with unrealized gains/losses in comprehensive income
3. Financial Reporting Principles:
- Uses US Generally Accepted Accounting Principles (GAAP)
- Requires estimates and assumptions in financial reporting
- Eliminates intercompany accounts and transactions
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARE.COM, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Comprehensive Income (Loss) Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders' (Deficit) Equity Consolidated Statements of Cash Flows ACCOUNTING FIRM The Board of Directors and Stockholders of Care.com, Inc. We have audited the accompanying consolidated balance sheets of Care.com, Inc. as of December 31, 2016 and December 26, 2015, and the related consolidated statements of operations, comprehensive income (loss), redeemable convertible preferred stock and stockholders’ (deficit) equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Care.com, Inc. at December 31, 2016 and December 26, 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Boston, Massachusetts March 9, 2017 CARE.COM, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except par value) (1) Includes accounts receivable due from related parties of $150 at December 31, 2016 (Note 12) (2) Includes unbilled accounts receivable due from related parties of $286 at December 31, 2016 (Note 12) (3) Includes accounts payable due to related parties of $107 at December 31, 2016 (Note 12) See accompanying notes to the consolidated financial statements (4) Includes accrued expenses and other current liabilities due to related parties of $1,055 at December 31, 2016 (Note 12) (5) Includes deferred revenue associated with related parties of $151 at December 31, 2016 (Note 12) See accompanying notes to the consolidated financial statements CARE.COM, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (1) Includes related parties revenue of $1,593 for the year ended December 31, 2016 (Note 12) (2) Includes related parties expenses of $14,724 for the year ended December 31, 2016 (Note 12) See accompanying notes to the consolidated financial statements CARE.COM, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (in thousands) See accompanying notes to the consolidated financial statements CARE.COM, INC. CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ (DEFICIT) EQUITY (In thousands, except per share data) See accompanying notes to the consolidated financial statements (1) Related expense was recognized in discontinued operations (2) Common stock repurchased was subsequently retired in fiscal 2016. See accompanying notes to the consolidated financial statements CARE.COM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See accompanying notes to the consolidated financial statements See accompanying notes to the consolidated financial statements CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 1. Organization and Description of Business Care.com, Inc. (the “Company”, “we”, “us”, and “our”), a Delaware corporation, was incorporated on October 27, 2006. We are the world’s largest online marketplace for finding and managing family care. Our consumer matching solutions enable families to connect to caregivers and caregiving services in a reliable and easy way and our payment solutions enable families to pay caregivers electronically online or via their mobile device and to manage their household payroll and tax matters with Care.com HomePay. We also serve employers through Care@Work by providing access to certain of our products and services and back-up care for children and seniors to employer-sponsored families. In addition, we serve employers by providing access to our platform to employer-sponsored families and care-related businesses-such as day care centers, nanny agencies and home care agencies-who wish to market their services to our care-seeking families and recruit our caregiver members. Certain Significant Risks and Uncertainties We operate in a dynamic industry and, accordingly, our business is affected by a variety of factors. For example, we believe that negative changes in any of the following areas could have a significant negative effect on our future financial position, results of operations or cash flows: rates of revenue growth; member engagement and usage of our existing and new products; protection of our brand; retention of qualified employees and key personnel; management of our growth; scaling and adaptation of existing technology and network infrastructure; competition in our market; performance of acquisitions and investments; protection of our intellectual property; protection of customers’ information and privacy concerns; security measures related to our website; and access to capital at acceptable terms, among other things. 2. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and our wholly owned subsidiaries, after elimination of all intercompany balances and transactions. We have prepared the accompanying financial statements in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”). Fiscal Year-End For periods prior to fiscal 2013, we operated and reported on a calendar basis fiscal year. Beginning in the third quarter of fiscal 2013, we operate and report using a 52 or 53-week fiscal year ending on the Saturday in December closest and prior to December 31. Fiscal 2016 had 53 weeks. Accordingly, our fiscal quarters end on the Saturday that falls closest to the last day of the third month of each quarter. Discontinued Operations To be reported within discontinued operations, we must dispose of a component or a group of components that represents a strategic shift which will have a major effect on our operations and financial results. We aggregate the results of operations for discontinued operations within a single line item on the income statement. General corporate overhead is not allocated to discontinued operations. We disclose any gain or loss that is recognized upon the disposition of a discontinued operation. During the fourth quarter of fiscal 2015, we made the decision to shut down the Citrus Lane business and had substantially completed our plans for ceasing the operation of the business. We completed the plans to cease operation of the business in the fourth quarter of 2016. This represented a strategic shift that will have a major effect on our operations and financial results. As such, financial results of Citrus Lane have been presented as net income (loss) from discontinued operations on the consolidated statements of operations for the years ended December 31, 2016, December 26, 2015 and December 27, 2014. Assets and liabilities of Citrus Lane to be disposed of are presented as assets from discontinued operations and liabilities from discontinued operations on the consolidated balance sheets as of December 31, 2016 and December 26, 2015 (see Note 3, “Discontinued Operations”). CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Use of Estimates The preparation of our consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable and revenue allowances, intangible asset valuations, expected future cash flows used to evaluate the recoverability of long-lived assets, the useful lives of long-lived assets including property and equipment and intangible assets, fair value of stock-based awards, goodwill, income taxes, and contingencies. We base our estimates of the carrying value of certain assets and liabilities on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, when these carrying values are not readily available from other sources. These estimates are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from the estimates. Revenue Recognition In general, we recognize revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered to the customer, (iii) the fee is fixed or determinable, and (iv) collectability is reasonably assured. We derive our revenue primarily from on-going subscription fees. Revenue from subscription fees is recognized on a daily basis over the subscription term or on a pro-rata basis as the services are delivered. Revenue from background checks, lead generation and advertising is recognized in the period earned. Other service revenues are recognized as the services are performed. Taxes that are collected from customers and remitted to government authorities are presented on a net basis and are excluded from revenue. We recognize revenue net of a reserve for refunds based on our actual refund history. During fiscal 2016, fiscal 2015, and fiscal 2014, we recorded $6.1 million, $5.5 million, and $3.8 million in refunds to customers. As it relates to our Citrus Lane business, which is presented within discontinued operations, for product sales, these criteria are deemed to have been met when the items are delivered to the end customer. Shipping and handling charges are included in revenue on a gross basis. Certain of our arrangements provide companies the opportunity to purchase Care.com services on behalf of their employees. These arrangements typically include a subscription to our consumer matching solutions for their employees. These arrangements are accounted for as multiple element arrangements. We have concluded that each element in the arrangement has stand-alone value as the individual services can be sold separately. In addition, there is no right of refund once a service has been delivered. Therefore, we have concluded each element of the arrangement is a separate unit of accounting. In accordance with the authoritative guidance on revenue recognition, we allocate consideration at the inception of an arrangement to each unit of accounting based on the relative selling price method in accordance with the selling price hierarchy. The objective of the hierarchy is to determine the price at which we would transact a sale if the service were sold on a stand-alone basis, and requires the use of: (1) vendor-specific objective evidence (‘‘VSOE’’), if available; (2) third-party evidence (‘‘TPE’’), if VSOE is not available; and (3) best estimate of selling price (‘‘BESP’’), if neither VSOE nor TPE is available. Since VSOE or TPE are not typically available, BESP is generally used to allocate the selling price to each unit of accounting. We determine BESP for units of account by considering multiple factors including, but not limited to, prices we charge for similar offerings, sales volumes, geographies and other factors contemplated in negotiating multiple element transactions. While we have multiple elements in these arrangements, the recognition of the majority of these elements follows a consistent ratable recognition given the pattern over which services are provided. Deferred Revenue Deferred revenue primarily consists of payments received in advance of revenue recognition of the services described above, and is recognized as the revenue recognition criteria are met. Our customers pay for most services in advance on a monthly, quarterly or annual basis. Amounts expected to be recognized within the twelve months following the balance sheet date are classified within current liabilities in the accompanying consolidated balance sheets. Accounts Receivable and Allowance for Doubtful Account Accounts receivable primarily represent the net cash due from the Company’s payment processors for cleared transactions and amounts owed from corporate customers. Accounts receivable are carried at the original invoiced amount less an allowance for doubtful accounts based on the probability of future collection. When management becomes aware of circumstances that may decrease the likelihood of collection, it records a specific allowance against amounts due. The allowance is recorded through a charge to bad debt expense which is recognized within general and administrative expense in the consolidated statements of operations. The amounts charged also include expenses for uncollected credit card receivables (or “chargebacks”). The following is a roll forward of the Company’s allowance for doubtful accounts (in thousands): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 (1) Deductions include actual accounts written-off, net of recoveries. Unbilled Receivables Unbilled receivables consist of amounts earned upon satisfying the revenue recognition criteria in advance of billing. Subscribers to our Care.com HomePay solution are billed quarterly in arrears at the beginning of the subsequent calendar quarter to which the services related. Additionally, there are instances in which we have met revenue recognition criteria in advance of billing schedules for our Care@Work employer solutions customers. Cost of Revenue Cost of revenue primarily consists of expenses that are directly related, or closely correlated, to revenue generation, including matching and payments member variable servicing costs such as personnel costs for customer support, transaction fees related to credit card payments, the cost of background checks run on both families and caregivers, and back-up care costs related to our Care@Work contracts. Additionally, cost of revenue includes website hosting fees and amortization expense related to caregiver relationships, proprietary software acquired as part of acquisitions and website intangible assets. As it relates to our Citrus Lane business, which is presented within discontinued operations, we have product fulfillment costs, largely consisting of product, shipping and costs associated with our third-party fulfillment providers. Concentrations of Credit Risk Financial instruments, which potentially subject us to concentrations of credit risk, consist primarily of cash and cash equivalents, short-term investments, and accounts receivable. We place our cash and cash equivalents and short-term investments with major financial institutions throughout the world that management assesses to be of high-credit quality in order to limit exposure of each investment. As of December 31, 2016 and December 26, 2015, substantially all of our cash had been invested in money market funds and certificates of deposit. Credit risk with respect to accounts receivable is dispersed due to the large number of customers. During the year ended December 31, 2016, one customer accounted for more than 14% of total unbilled accounts receivable and no customer accounted for more than 10% of revenue or accounts receivable. During the year ended December 26, 2015, one customer accounted for more than 13% of total accounts receivable and no customer accounted for more than 10% of revenue. In addition, our credit risk is mitigated by a relatively short collection period. Collateral is not required for accounts receivable. We record our accounts receivable in our consolidated balance sheets at net realizable value. We perform on-going credit evaluations of our customers and maintain allowances for potential credit losses, based on management’s best estimates. Amounts determined to be uncollectible are written off against this reserve. Our allowance for doubtful accounts totaled $0.2 million and $0.1 million as of December 31, 2016 and December 26, 2015, respectively. Foreign Currency Translation We determine the functional currency for our foreign subsidiaries by reviewing the currencies in which their respective operating activities occur. Financial information is translated from the functional currency to the U.S. dollar, the reporting currency, for inclusion in our consolidated financial statements. Income, expenses, and cash flows are translated at average exchange rates prevailing during each month of the fiscal year, and assets and liabilities are translated at fiscal period end exchange rates. Foreign exchange transaction gains and losses are included in other expense, net in the accompanying consolidated statements of operations. The effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income in the accompanying consolidated balance sheets. For the years ended December 31, 2016, December 26, 2015, and December 27, 2014, we recorded foreign currency transaction losses of approximately $1.3 million, $1.3 million and $1 million, respectively, included in other expense, net in the accompanying consolidated statements of operations. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Cash Equivalents We consider highly liquid investments purchased with an original maturity of 90 days or less at the time of purchase to be cash equivalents. As of December 31, 2016 and December 26, 2015, cash equivalents consisted of money market funds. Investments Investments consist of certificates of deposit (“CDs”). CDs having remaining maturities of more than three months at the date of purchase and less than one year from the date of the balance sheet are classified as short-term. We classify our CDs with readily determinable market values as available-for-sale. The CDs are classified as short-term investments on the consolidated balance sheets and are carried at fair market value, with unrealized gains and losses considered to be temporary in nature reported as accumulated other comprehensive income (loss), a separate component of stockholders’ equity. We review all investments for reductions in fair value that are other-than-temporary. When such reductions occur, the cost of the investment is adjusted to fair value through recording a loss on investments in the consolidated statements of operations. Gains and losses on investments are calculated on the basis of specific identification. Recurring Fair Value Measurement Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures, establishes a three-level valuation hierarchy for disclosure of fair value measurements. The categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the measurement of fair value. The three levels of the hierarchy are defined as follows: • Level 1 inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. • Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.), or inputs that are derived principally from or corroborated by market data by correlation or other means. • Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. Recurring Fair Value Measurements Assets Cash equivalents - Cash equivalents include money market mutual funds with original maturities of three months or less. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and, therefore, these assets are recorded at fair value on a recurring basis and classified as Level 1 in the fair value hierarchy. Short-term Investments - Short-term investments include certificates of deposit with original maturities of six months or less. The fair value measurement of these assets is based on quoted market prices in active markets for identical assets and therefore, these assets are recorded at fair value on a recurring basis and classified as Level 1 in the fair value hierarchy. Liabilities Contingent Acquisition Consideration - Contingent acquisition consideration includes the fair value of contingent consideration paid by us in connection with corporate acquisitions based on the likelihood of issuing preferred and common stock and paying cash related to certain revenue and other milestones. We recorded our estimate of the fair value of this contingent consideration based on the evaluation of the likelihood of the achievement of the contractual conditions that would result in the payment of the contingent consideration and weighted probability assumptions of these outcomes. The fair value of the liability was estimated using a discounted cash flow technique with significant inputs that are not observable in the market and thus represents a Level 3 fair value measurement as defined in ASC 820. The cash portion of the contingent consideration liability has been discounted to reflect the time value of money, and therefore, as the milestone date approaches, the fair value of this liability will increase. This increase in fair value was recorded in general and administrative expenses in the accompanying consolidated statements of operations. The preferred stock portion of the contingent consideration represented a liability in accordance with ASC 480-10, Distinguishing Liabilities from Equity, and was marked-to-market each reporting period with changes in market value recognized in other expense, net in the accompanying consolidated statements of operations. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 During the year ended December 27, 2014, in connection with our acquisition of Citrus Lane, we recognized acquisition consideration payable in cash and shares totaling $17.5 million. The probability of achievement of this earn-out was assessed at 100%. Current contingent consideration liabilities from the acquisition of Citrus Lane of $0.0 million and $16.0 million were included in current liabilities from discontinued operations as of December 31, 2016 and December 26, 2015, respectively. The significant inputs in the Level 3 measurement not supported by market activity included our probability assessments of expected future cash flows related to our acquisition of Citrus Lane during the applicable earn-out period, appropriately discounted considering the uncertainties associated with the applicable obligation, and calculated in accordance with the terms of the applicable transaction agreement. As such, the cash portion of the contingent consideration liability has been discounted to reflect the time value of money, and therefore, as the milestone date approaches, the fair value of this liability will increase. The following table presents information about our assets and liabilities, including those from our discontinued operations, measured at fair value on a recurring basis as of December 31, 2016 and December 26, 2015 and indicates the fair value hierarchy of the valuation techniques we utilized to determine such fair value (in thousands): The following table sets forth a summary of changes in the fair value of our contingent acquisition consideration, which represent the recurring measurement that is classified within Level 3 of the fair value hierarchy wherein fair value is estimated using significant unobservable inputs (in thousands): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 During the first quarter of fiscal 2016, we entered into a settlement agreement with the previous shareholders of Citrus Lane. The settlement agreement relates to our acquisition of Citrus Lane and the merger agreement pursuant to which the acquisition was consummated. Under the terms of the settlement agreement, we paid the previous shareholders of Citrus Lane $15.6 million of contingent consideration payments that were valued at $16.0 million as of December 26, 2015 ($16.4 million was the undiscounted value at the time of the acquisition) that was otherwise payable to them in the event Citrus Lane achieved certain milestones in 2015 and 2016. Refer to Note 3 for further discussion on the impact of the settlement in the first quarter of 2016. Non-Recurring Fair Value Measurements We remeasure the fair value of certain assets and liabilities upon the occurrence of certain events. Such assets are comprised of long-lived assets, including property and equipment, intangible assets and goodwill. No remeasurement of long-lived assets occurred as of December 31, 2016 or December 26, 2015, aside from those detailed below pertaining to goodwill and intangible assets. Other financial instruments not measured or recorded at fair value in the accompanying consolidated balance sheets principally consist of accounts receivable, accounts payable, and accrued liabilities. The estimated fair values of these instruments approximate their carrying values due to their short-term nature. Business Combinations We determine and allocate the purchase price of an acquired company to the tangible and intangible assets acquired and liabilities assumed based on their fair values as of the business combination date, including identifiable intangible assets, which either arise from a contractual or legal right or are separable from goodwill. We base the fair value of identifiable intangible assets acquired in a business combination on detailed valuations that use information and assumptions provided by management, which consider management’s best estimates of inputs and assumptions that a market participant would use. We allocate any excess purchase price over the fair value of the net tangible and identifiable intangible assets acquired to goodwill. The use of alternative valuation assumptions, including estimated revenue projections, growth rates, cash flows, discount rates, estimated useful lives and probabilities surrounding the achievement of revenue-based milestones, could result in different purchase price allocations and amortization expense in current and future periods. Transaction costs associated with these acquisitions are expensed as incurred through general and administrative costs. In those circumstances where an acquisition involves a contingent consideration arrangement, we recognize a liability equal to the fair value of the contingent payments we expect to make as of the acquisition date. We re-measure this liability at each reporting period and record changes in the fair value as a component of operating expenses. Increases or decreases in the fair value of the contingent consideration liability can result from changes in discount periods and rates, as well as changes in the timing and amount of revenue estimates or in the timing or likelihood of achieving revenue-based milestones. Results of operations and cash flows of acquired companies are included in our operating results from the date of acquisition. Goodwill Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. We evaluate goodwill for impairment at the reporting unit level (operating segment or one level below an operating segment) annually or more frequently if we believe indicators of impairment exist. In accordance with the guidance, we are permitted to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then a two-step goodwill impairment test is performed. In performing the test, we utilize the two-step approach prescribed under Accounting Standards Codification, or ASC, 350, Intangibles - Goodwill and Other. The first step requires a comparison of the reporting unit against its aggregate carrying value, including goodwill. If the carrying amount exceeds the reporting unit’s carrying value to its fair value. We consider a number of factors to determine the fair value of a reporting unit, including an independent valuation to conduct this test. The valuation is based upon expected future discounted operating cash flows of the reporting unit. We base the discount rate on the weighted average cost of capital, or WACC, of market participants. If the carrying value of a reporting unit exceeds its estimated fair value, we will perform the second step of the goodwill impairment test to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of a reporting unit’s goodwill to its carrying value. The second step requires us to perform a hypothetical purchase allocation as of the measurement date and estimate the fair value of net tangible and intangible assets. The fair value of intangible assets is determined as described below and is subject to significant judgment. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Since the fair value of our reporting units was determined by use of the discounted cash flows, or DCF, and the key assumptions that drive the fair value in this model are the WACC, terminal values, growth rates, and the amount and timing of expected future cash flows, significant judgment is applied in determining fair value. If the current economic environment were to deteriorate, this would likely result in a higher WACC because market participants would require a higher rate of return. In the DCF as the WACC increases, the fair value decreases. The other significant factor in the DCF is our projected financial information (i.e., amount and timing of expected future cash flows and growth rates) and if these assumptions were to be adversely impacted, this could result in a reduction of the fair value of this reporting unit. We conducted our fiscal 2016 annual impairment test as of September 25, 2016 (the first day of our fourth fiscal quarter). We utilized DCF and market approaches to estimate the fair value of our reporting units as of September 25, 2016 and ultimately used the fair value determined by the DCF in making our impairment test conclusions. We believe we used reasonable estimates and assumptions about future revenue, cost projections, cash flows, market multiples and discount rates as of the measurement date. As a result of completing Step 1, all of the reporting units had fair values exceeding their carrying values, and as such, Step 2 of impairment test was not required for those reporting units. Additionally, during the third quarter of fiscal 2015, we determined that we should consider the advisability of a sale or wind down of the Citrus Lane business. As a result of this determination, we concluded that indicators of impairment existed in the Citrus Lane business and began an analysis of whether any material impairment charges would be required. We completed step one of our goodwill impairment testing with the assistance of an independent valuation firm and determined that the fair value of this business was lower than its carrying value. As a result of this analysis and our decision during the fourth quarter of 2015 to exit the business, we recorded a goodwill impairment loss of $8.0 million within loss from discontinued operations. During the fourth quarter of fiscal 2014, primarily as a result of unexpected changes, both internal and external, we determined that indicators of impairment existed at our Citrus Lane Reporting Unit. The fair value of reporting unit was deemed to be below its carrying value and Step 2 of the goodwill impairment test was performed. Step 2 of the goodwill impairment test requires the completion of a hypothetical purchase price allocation to determine the fair value of the implied goodwill. Upon completion of the Step 2 analysis, we determined that the Citrus Lane goodwill was impaired and recorded a goodwill impairment loss of $33.8 million within loss from discontinued operations. Amortization and Impairment of Intangible Assets We amortize our intangible assets that have finite lives over their estimated useful lives. We use a straight-line method of amortization, unless a method that better reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up can be reliably determined. Amortization is recorded over the estimated useful lives ranging from one to ten years. We review our intangible assets subject to amortization to determine if any adverse conditions exist, or a change in circumstances has occurred that would indicate impairment or a change in the remaining useful life. If the carrying value of an asset exceeds its undiscounted cash flows, we will write-down the carrying value of the intangible asset, or asset group, to its fair value in the period identified. In assessing fair value, we must make assumptions regarding estimated future cash flows and discount rates. If these estimates or related assumptions change in the future, we may be required to record impairment charges. We generally calculate fair value as the present value of estimated future cash flows to be generated by the asset using a risk-adjusted discount rate. If the estimate of an intangible asset’s remaining useful life is changed, we will amortize the remaining carrying value of the intangible asset prospectively over the revised remaining useful life. During the third quarter of fiscal 2015, we determined that we should consider the advisability of a sale or wind down of the Citrus Lane business. As a result of this determination, we concluded that indicators of impairment existed in the Citrus Lane business and began an analysis of whether any material impairment charges would be required. We completed step one of our goodwill impairment testing with the assistance of an independent valuation firm and determined that the fair value of this business was lower than its carrying value. As a result of this analysis and our decision during the fourth quarter of 2015 to exit the business, we recorded an intangible asset impairment of $1.7 million within loss from discontinued operations. During the fourth quarter of fiscal 2014, in connection with our goodwill impairment analysis, we performed a Step 2 test of recoverability of finite lived intangibles in accordance with ASC 360, indicating that our undiscounted future cash flows would not recover the carrying value of the Citrus Lane proprietary software and trade name intangible assets. We then performed a Step 3 impairment analysis of finite lived intangible assets under ASC 360 and determined that the carrying value of the Citrus Lane proprietary software and trade name exceeded the fair value of those assets as of the end of the fourth quarter and recognized an intangible asset impairment of $2.4 million within loss from discontinued operations. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Software Development Costs Internal and external software development costs associated with the development of software for internal use, including website development costs, are expensed to research and development during the preliminary project stage and capitalized during the application development stage. Costs incurred during the application development stage and capitalized totaled $0.4 million and $0.9 million for the fiscal years ended December 26, 2015 and December 27, 2014, respectively. There were no such costs capitalized in the fiscal year ended December 31, 2016, as the substantial majority of our development efforts were either in the preliminary stage of development or were for maintenance of, and minor upgrades and enhancements to internal-use software and, accordingly, application development costs were insignificant. Property and Equipment Property and equipment are stated at cost, and are depreciated using the straight-line method over the estimated useful life of the assets or, where applicable and if shorter, over the lease term. The following table presents the detail of property and equipment, net for the periods presented (in thousands): Property and equipment are depreciated over the following estimated useful lives: Depreciation expense for the years ended December 31, 2016, December 26, 2015, and December 27, 2014 was $1.6 million, $1.6 million and $0.9 million, respectively. Expenditures for maintenance and repairs are charged to expense as incurred, whereas major betterments are capitalized as additions to property and equipment. In accordance with ASC 360-10-35-15, Property, Plant and Equipment-Impairment or Disposal of Long-Lived Assets, we review the carrying value of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, then an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or the fair value less costs to sell, and are not depreciated. Assets and liabilities that are part of a disposal group and classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. During the year ended December 26, 2015, we recorded an impairment charge associated with certain capitalized software development costs of $0.1 million. We have not recognized any impairment losses during the years ended December 31, 2016 and December 27, 2014 with respect to property and equipment or capitalized software. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Redeemable Convertible Preferred Stock We classify redeemable convertible preferred stock as temporary equity in the consolidated balance sheet due to certain contingent redemption clauses that are at the election of the holder. We will accrete the carrying value of the redeemable convertible preferred stock to the redemption value through June 20, 2023, which is the seventh anniversary of the Closing Date (June 29, 2016), at a rate of 5.50% per annum, which represents the cumulative dividends owed on the convertible preferred stock, using the interest rate method. We elected to accrete the carrying value of the redeemable convertible preferred stock on the issuance date to the redemption value as it relates to the issuance costs that were netted against the proceeds of issuance of the redeemable convertible preferred stock. Income (Loss) per Share Basic net income (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the number of common shares outstanding during the period, including issued and outstanding participating securities on an as-converted basis. We apply the two-class method to calculate basic and diluted net income (loss) per share of common stock, as our Series A Redeemable Convertible Preferred Stock (Series A Preferred Stock) is a participating security. The two-class method is an earnings allocated formula that treats a participating security as having rights to earnings that otherwise would have been available to common stockholders. We compute diluted net income (loss) per common share using income (loss) from continuing operations as the “control number” in determining whether potential common shares are dilutive, after giving consideration to all potentially dilutive common shares, including stock options, unvested restricted stock outstanding during the period and potential issuance of stock upon the conversion of the our Series A Redeemable Convertible Preferred Stock issued and outstanding during the period, except where the effect of such securities would be antidilutive. Please refer to Note 8 for further detail. Income Taxes We account for income taxes in accordance with ASC 740, Income Taxes. ASC 740 is an asset and liability approach that requires recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax basis, and for operating loss and tax credit carryforwards. ASC 740 requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We recognize the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the tax authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such position are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. At December 31, 2016 and December 26, 2015, we did not have any uncertain tax positions. Interest and penalty charges, if any, related to uncertain tax positions would be classified as income tax expense in the accompanying consolidated statements of operations. As of December 31, 2016, December 26, 2015, and December 27, 2014, we had no accrued interest or penalties related to uncertain tax positions. Presentation of Taxes in the Consolidated Statements of Operations We present taxes that are collected from customers and remitted to government authorities on a net basis in the consolidated statements of operations. Stock-Based Compensation We account for all stock-based awards to employees and members of our board of directors, to the extent such awards were issued in connection with their services as directors, in accordance with ASC 718, Compensation-Stock Compensation. ASC 718 requires that all share-based payments, including grants of stock options, be recognized in the statement of operations as an operating expense based on their fair value. For stock options issued under the Company’s stock-based compensation plans, the fair value of each option grant is estimated on the date of grant, and an estimated forfeiture rate is used when calculating stock-based compensation expense for the period. For restricted stock units (“RSUs”) and performance RSUs issued under the Company’s stock-based compensation plans, the fair value of each grant is calculated based on the Company’s stock price on the date of grant. In accordance with ASC 718, we recognize the compensation cost of share-based awards on a straight-line basis over the vesting period of the award. We use the Black-Scholes-Merton option-pricing model to determine the fair value for option awards. In valuing our option awards, we make assumptions about risk-free interest rates, dividend yields, volatility, and weighted-average expected lives, including estimated forfeiture rates. Risk-free interest rates are derived from U.S. Treasury securities as of the option award grant date. Expected dividend yield is based on our historical dividend payments, which have been zero to date. The expected volatility for our common stock is estimated taking the average historic price volatility for a group of similarly CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 situated publicly traded companies based on daily price observations over a period equivalent to the expected term of the stock option grants. These publicly traded companies were selected based on comparable characteristics to us and consist of several companies in the technology industry that are similar in enterprise value, stage of life cycle, risk profile, financial leverage and with historical share price information sufficient to meet the expected life of our stock-based awards. We estimate the weighted-average expected life of the option awards as the average of the option vesting schedule and the term of the award, since we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time share-based awards have been exercisable. The term of the award is estimated using the simplified method, as awards are plain vanilla option awards. Forfeiture rates are estimated using historical actual forfeiture trends as well as our judgment of future forfeitures. These rates are evaluated at least quarterly and any change in compensation expense is recognized in the period of the change. The estimation of option awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period the estimates are revised. Actual results, and future changes in estimates, may differ substantially from management’s current estimates. Stock-based awards issued to non-employees, are accounted for using the fair value method in accordance with ASC 505-50, Equity-Based Payments to Non-Employees. These stock options are typically granted in exchange for consulting services to be rendered, and vest over periods of up to four years. In accordance with authoritative guidance, the fair value of non-employee stock-based awards is estimated on the date of grant, and subsequently revalued at each reporting period over their vesting period using the Black-Scholes option-pricing model. Advertising Costs We expense advertising costs as incurred when the advertisement is run. We incurred advertising expenses from continuing operations of $51.5 million, $54.5 million, and $57.8 million for the years ended December 31, 2016, December 26, 2015, and December 27, 2014, respectively. Accumulated Other Comprehensive Income As of December 31, 2016 and December 26, 2015, accumulated other comprehensive income was comprised solely of cumulative foreign currency translation adjustments. Recently Issued and Adopted Accounting Pronouncements In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” To simplify the subsequent measurement of goodwill, the Board eliminated Step 2 from the goodwill impairment test. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The Board also eliminated the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. Therefore, the same impairment assessment applies to all reporting units. An entity is required to disclose the amount of goodwill allocated to each reporting unit with a zero or negative carrying amount of net assets. The guidance is effective for us in our annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted. ASU 2017-04 must be applied prospectively. We are currently evaluating what impact the adoption of this update will have on our consolidated financial statements and the impact will depend on what reporting units, if any, have a zero or negative carrying value or would fail Step 1 of the impairment test following the date of adoption. In November, 2016, the FASB issued ASU No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash.” ASU 2016-18 requires that a statement of cash flows explain the change during the period in the total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning and ending balances shown on the statement of cash flows. The guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. ASU 2016-18 must be applied retrospectively to all periods presented. We are currently evaluating what impact the adoption of this update will have on our consolidated financial statements. In August 2016, FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230). ASU 2016-15 amends ASC 230 to add or clarify guidance on the classification of certain cash receipts and payments in the statement of cash flows. The guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The updated guidance requires a retrospective transition method to each period presented. We are currently evaluating the impact of the adoption of ASU 2016-15 on our statements of consolidated operations and cash flows. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 In March 2016, the FASB issued ASU No. 2016-09, Compensation- Stock Compensation (Topic 718). The guidance changes how companies account for certain aspects of share-based payments to employees. Entities will be required to recognize income tax effects of awards in the income statement when the awards vest or are settled. The guidance also allows an employer to repurchase more of an employee's shares than it can today for tax withholding purposes providing for withholding at the employee's maximum rate as opposed to the minimum rate without triggering liability accounting and to make a policy election to account for forfeitures as they occur. This new standard will be effective for us on January 1, 2017. Under today’s guidance, we do not recognize the income tax effects of awards that have vested or are settled until they actually reduce taxes payable. This standard will require us to recognize these effects when they are vested or are settled, subject to the assessment of the need for a valuation allowance. The adoption of this standard is not expected to have a material impact on our financial position, results of operations or statements of cash flows upon adoption, primarily because any tax effects we may be required to realize are expected to be subject to a full valuation allowance. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The guidance requires an entity to recognize a right-of-use asset and a lease liability for virtually all of its leases with terms of more than 12 months. Recognition, measurement and presentation of expenses will depend on classification as a finance or operating lease. The amendments also require certain quantitative and qualitative disclosures about leasing arrangements. The guidance is effective for annual periods beginning after December 15, 2018. Early adoption is permitted. The updated guidance requires a modified retrospective adoption. We are currently evaluating the impact of the adoption of ASU 2016-02 on our consolidated financial position and results of operations. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers , which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which deferred the effective date of ASU 2014-09 by one year to December 15, 2017 for interim and annual reporting periods beginning after that date. Early adoption is permitted but not before the original effective date of December 15, 2016. Since ASU 2014-09 was issued, several additional ASUs have been issued and incorporated within ASC 606 to clarify various elements of the guidance. As of the date of this filing, our evaluation of the effects of Topic 606 are in process and our assessment is preliminary and subject to change. With respect to our consumer matching business, we do not expect the standard to have a material effect on our revenue recognition. Our Care@Work contracts have multiple elements, including subscriptions to our website and services, access to back-up care, and access to other services we offer. We are currently evaluating if the standard will affect how we recognize revenue on any elements of these contracts. We are continuing to assess all potential impacts of the standard, including the impact to the pattern with which we recognize revenue for our revenue streams and the impact to the capitalization of costs of commissions. We anticipate to adopt the ASU using the cumulative effect transition method. 3. Discontinued Operations During the third quarter of fiscal 2015 we made the decision to exit the Citrus Lane business through either a sale or wind-down as it was no longer a strategic priority. In the fourth quarter of fiscal 2015, we made the decision to shut down the business and had substantially completed our plans for exiting the business. In the fourth quarter of fiscal 2016, we completed the plans to exit the business. As such, financial results of Citrus Lane have been presented as loss from discontinued operations, net of tax on the consolidated statements of operations for the fiscal years ended December 31, 2016, December 26, 2015, and December 27, 2014. Assets and liabilities of Citrus Lane to be disposed of are presented as assets from discontinued operations and liabilities from discontinued operations on the consolidated balance sheet as of December 31, 2016 and December 26, 2015. In February 2016, we entered into a settlement agreement with the previous shareholders of Citrus Lane. The settlement agreement related to our acquisition of Citrus Lane and the merger agreement pursuant to which the acquisition was consummated. Under the terms of the settlement agreement, we paid the previous shareholders of Citrus Lane $15.6 million in contingent consideration payments that were valued at $16.0 million as of December 26, 2015 ($16.4 million was the undiscounted value at the time of the acquisition) that was otherwise payable to them in the event Citrus Lane achieved certain milestones in 2015 and 2016. In exchange, the former shareholders forfeited the $5.0 million in original cash consideration that was being held in an escrow account, as well as the 0.4 million shares of common stock issued at closing (valued at $2.0 million as of the February 2016 settlement date and $3.9 million as of the original closing date) and 0.1 million shares of common stock which was subject to the achievement of certain milestones in 2015 and 2016 (valued at $0.6 million as of the February 2016 settlement date and $1.1 million as of the original closing date) offered as part of the deal consideration. We retired these shares of common stock as of December 31, 2016. As a result of this settlement, and based on our assessment that CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 there was not a clear and direct link to the original consideration transferred at the acquisition date, we have recognized a gain within income (loss) from discontinued operations on the consolidated statements of operations for fiscal 2016 of $8.0 million. The following table presents financial results of the Citrus Lane business included in loss from discontinued operations, net of tax for the fiscal years ended December 31, 2016 and December 26, 2015 (in thousands): For further details on the impairment of goodwill and intangible assets please refer to Note 2 of these . The major components of current assets and current liabilities of the Citrus Lane business were as follows (in thousands): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 4. Goodwill and Intangible Assets The following table presents the change in goodwill for our single reportable segment during the periods presented (in thousands): The following table presents the detail of intangible assets for the periods presented (dollars in thousands): Amortization expense was $2.1 million and $3.6 million for the fiscal years ended December 31, 2016 and December 26, 2015, respectively. Of these amounts $1.3 million and $2.9 million was classified as a component of depreciation and amortization, and $0.8 million and $0.7 million was classified as a component of cost of revenue in the consolidated statements of operations for the fiscal years ended December 31, 2016 and December 26, 2015, respectively. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 As of December 31, 2016, the estimated future amortization expense related to current intangible assets for future fiscal years was as follows (in thousands): 5. Accrued Expenses and Other Current Liabilities The following table presents the detail of accrued expenses and other current liabilities for the periods presented (in thousands): 6. Commitments and Contingencies Leases We have entered into various operating lease agreements, primarily covering certain of our offices throughout the world, with original lease periods expiring between 2015 and 2024. Facilities rent expense under these operating leases was $4.9 million, $5.2 million, and $3.7 million for the years ended December 31, 2016, December 26, 2015, and December 27, 2014, respectively. We are responsible for paying our share of the actual operating expenses and real estate taxes under certain of these lease agreements. Certain of these arrangements have renewal or expansion options, as well as adjustments for market provisions, such as free or escalating base monthly rental payments. We recognize rent expense under such arrangements on a straight-line basis over the initial term of the lease. The difference between the straight-line expense and the cash paid for rent has been recorded as deferred rent in the consolidated balance sheets. At December 31, 2016, minimum future lease commitments under all non-cancelable operating leases (including rent escalation clauses) were as follows (in millions): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 In July 2014, we entered into a lease agreement pursuant to which we agreed to lease office space to be used for our new headquarters (the “Prime Lease”). The Prime Lease is for 108,743 square feet of office space, comprising of the entire fourth, fifth, and sixth floors of the building located at 77 Fourth Avenue, Waltham, Massachusetts, or the Building. The term of the Prime Lease commences on August 4, 2014 and expires 120 months from the date base rent payments first become due, which date is the earlier of January 1, 2015 and the date we commence operations in the space. We recorded deferred rent on the consolidated balance sheet. We recognize rent expense on a straight-line basis over the expected lease term. The total cash obligation for the base rent over the term of the Prime Lease will be $42.9 million, and is included in the table above. We received $2.3 million as tenant improvements allowance under the terms of our new operating lease, which we recorded as deferred rent are amortizing on a straight-line basis over the term of the lease as an offset to rent expense. In connection with the Prime Leases, we paid $2.8 million in security deposits recorded within other non-current assets on our consolidated balance sheet as of December 31, 2016. On April 14, 2016, we entered into a sublease agreement to lease approximately 10,362 square feet of our 108,743 square foot Prime Lease. Please refer to Note 14 for further detail on the restructuring charges incurred by us as a result of this sublease. Our short term and long term deferred rent liability, which are included in accrued expenses and other current liabilities and other non-current liabilities, respectively, on our accompanying consolidated balance sheets, are presented net of the approximate $1.2 million sublease income. The sublease income is not netted against the future lease commitments table presented above. We recognized total rent expense related to the current and new headquarters of approximately $3.9 million, $4.2 million and $2.7 million for the years ended December 31, 2016, December 26, 2015, and December 27, 2014, respectively. In March 2016, we entered into a 5-year property lease for a facility in San Mateo, California, consisting of approximately 2,100 square feet. The lease commenced on April 1, 2016, and we will pay an aggregate of approximately $0.8 million over the 5-year lease period. Legal matters From time to time we are involved in legal proceedings and other regulatory matters arising in the ordinary course of our business. Each reporting period, we evaluate whether or not a loss contingency related to such matters is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. If a loss is probable and the potential estimate of the loss is a range, we evaluate if there is a point within the range that appears at the time to be a better estimate than any other point in the range, and if so, that amount is accrued. If we conclude that no amount in the range appears to be a better estimate than any other, we accrue the minimum amount in the range. We monitor developments in legal matters that could affect estimates we have previously accrued and update our estimates as appropriate based on subsequent developments. In the first quarter of fiscal 2017, we received a demand for payments totaling approximately $1.5 million relating to a government inquiry which commenced in 2016. The Company determined that it is probable that it will incur a loss in connection with this matter and has accrued an amount as of December 31, 2016 based on its reasonable estimate of this loss. The amount accrued was not material to our financial statements for the year ended December 31, 2016. 7. Stockholders’ Equity (Deficit) Initial Public Offering (IPO) On January 29, 2014, we closed our IPO in which we sold and issued 6,152,500 shares of common stock, including 802,500 shares of common stock pursuant to the exercise of the underwriters’ option to purchase additional shares, which were sold to the public at a price of $17.00 per share. We received net proceeds of approximately $94.8 million from the IPO, including the exercise of the underwriters’ over-allotment option, net of underwriters’ discounts and commissions, and after deducting offering expenses of approximately $2.4 million. Upon the closing of the IPO, all shares of our outstanding redeemable convertible preferred stock automatically converted into 21,490,656 shares of common stock and our outstanding warrant to purchase redeemable convertible preferred stock automatically converted into a warrant to purchase 40,697 shares of common stock at $1.72 per share. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Stock-Based Compensation Stock Option Plans On November 15, 2006, we adopted our 2006 Stock Incentive Plan (‘‘the 2006 Plan’’), which provides for the issuance of incentive and non-qualified stock options, restricted stock and other stock-based awards to employees and non-employees of the Company. We reserved 4,567,500 shares of common stock for issuance under the 2006 Plan. Options generally vest over four years, with 25% vesting upon the one year anniversary of the date of hire, and the remaining 75% vesting quarterly over the next 3 years. Options granted to consultants or other non-employees generally vest over the expected service period to the Company. The options expire ten years from the date of grant. We issue new shares to satisfy stock option exercises. Only stock options have been issued under the 2006 Plan. No grants have been made under the 2006 Plan since our IPO, and no further awards will be granted under the 2006 Plan. However, the 2006 Plan will continue to govern outstanding awards granted under the 2006 Plan. On January 23, 2014, we adopted our 2014 Incentive Award Plan (‘‘the 2014 Plan’’), which provides for the issuance of incentive and non-qualified stock options, restricted stock, restricted stock units (“RSUs”) and other stock-based awards to employees, directors and non-employees of the Company and our subsidiaries. We initially reserved 4,112,048 shares of common stock for issuance under the 2014 Plan. The number of shares initially available for issuance will be increased by (i) the number of shares represented by awards outstanding under the 2006 Plan that are forfeited, lapse unexercised or are settled in cash and which following the effective date of the 2014 Plan are not issued under the 2006 Plan and (ii) an annual increase on January 1 of each calendar year beginning in 2015 and ending in 2019, equal to the lesser of (A) 4% of the shares of common stock outstanding (on an as-converted basis) on the final day of the immediately preceding calendar year and (B) an amount as determined by our board of directors. No more than 5,002,935 shares of common stock may be issued upon the exercise of incentive stock options. Options generally vest over four years, with 25% vesting upon the one-year anniversary of the date of hire, and the remaining 75% vesting quarterly over the next 3 years. Options granted to consultants or other non-employees generally vest over the expected service period to the Company. The options expire ten years from the date of grant. To date stock options, RSUs, and performance-based RSUs have been issued under the 2014 Plan. We assumed certain other plans in connection with the Citrus Lane acquisition and no shares are available for future grant under these plans. Stock-Based Compensation The following table summarizes stock-based compensation in our accompanying condensed consolidated statements of operations (in thousands): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Included in income (loss) from discontinued operations for the fiscal year ended December 27, 2014 is approximately $1.4 million related to the acceleration of vesting of certain equity awards assumed as part of the Citrus Lane acquisition. Pursuant to our 2014 Incentive Award Plan (the “2014 Plan”), during fiscal 2016, we granted 0.7 million restricted stock units (RSUs) to certain employees, directors, and consultants and 0.5 million performance based RSUs to certain members of senior management. Each recipient of performance based RSUs was eligible to receive up to 100% of the shares granted on the achievement of certain financial targets for fiscal 2016, and we determined that a portion of the financial targets were met as of the end of fiscal 2016. The award will vest over a four-year period retroactive to March 2016 as continued services are performed. Management is recognizing expense straight-line over the required service period based on the number of shares that are probable of vesting in accordance with the financial targets met during fiscal 2016. Pursuant to the 2014 Plan, during fiscal 2015 we granted 1.7 million time-based RSUs to certain employees and directors and 0.3 million performance based RSUs to certain members of senior management. Each recipient of performance based RSUs is eligible to receive up to 100% of the shares granted on the achievement of certain financial targets for fiscal 2015 and which will vest over a four-year period retroactive to either March or April 2015. As we did not meet the performance targets, no expense has been recognized on these awards and they were canceled as of December 26, 2015. RSUs are not included in issued and outstanding common stock until the shares are vested and released. The fair value of the RSUs is measured based on the market price of the underlying common stock as of the date of grant, reduced by the purchase price of $0.001 per share. The weighted average grant-date fair value per vested RSU share and the total fair value of vested shares from the RSU grants was $7.29 and $3.6 million, respectively, for the year ended December 31, 2016. The weighted average grant-date fair value per vested RSU share and the total fair value of vested shares from the RSU grants was $7.78 and $1.7 million, respectively, for the year ended December 26, 2015. During the years ended December 31, 2016 and December 27, 2014, we granted 1.5 million and 1.6 million stock options, respectively with weighted-average exercise price per share of $6.95 and $11.15, respectively. During the year ended December 26, 2015, no stock options were granted. The following table presents the assumptions used to estimate the fair value of options granted during the periods presented: CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 A summary of stock option activity for the year ended December 31, 2016 was as follows (in thousands for shares and intrinsic value): ____________________________ (1) For RSUs, includes both time-based and performance-based restricted stock units (2) Options and RSUs expected to vest reflect an estimated forfeiture rate Aggregate intrinsic value represents the difference between the closing stock price of our common stock and the exercise price of outstanding, in-the-money options. Our closing stock price as reported on the New York Stock Exchange as of December 31, 2016 was $8.57. The total intrinsic value of options exercised and RSUs vested was approximately $5.8 million, for the year ended December 31, 2016. The aggregate fair value of the options that vested during the year ended December 31, 2016 was $4.3 million. As of December 31, 2016, total unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock options and RSUs, including performance RSUs, was approximately $3.7 million and $8.2 million, respectively, which is expected to be recognized over a weighted-average period of 2.8 years and 2.6 years, respectively, to the extent they are probable of vesting. As of December 31, 2016, we had 2.5 million shares available for grant under the 2014 Plan. Common Stock As of December 31, 2016, we had reserved the following shares of common stock for future issuance in connection with the following: CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 8. Net Income (Loss) Per Share Basic net income (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the number of common shares outstanding during the period, including issued and outstanding participating securities on an as-converted basis. We apply the two-class method to calculate basic and diluted net income (loss) per share of common stock, as our Series A Redeemable Convertible Preferred Stock (Series A Preferred Stock) is a participating security. The two-class method is an earnings allocated formula that treats a participating security as having rights to earnings that otherwise would have been available to common stockholders. For fiscal 2016, fiscal 2015, and fiscal 2014, we were in a loss position from continuing operations for each of these periods, and the Series A Preferred Stockholders do not contractually participate in losses, as such, we added the Series A Preferred Stock dividends to the loss from continuing operations to calculate the loss attributable to common stockholders in order to calculate the numerator used in the net income (loss) per share. We compute diluted net income (loss) per common share using income (loss) from continuing operations as the “control number” in determining whether potential common shares are dilutive, after giving consideration to all potentially dilutive common shares, including stock options, unvested restricted stock outstanding during the period and potential issuance of stock upon the conversion of the our Series A Preferred Stock issued and outstanding during the period, except where the effect of such securities would be antidilutive. For fiscal 2016, fiscal 2015, and fiscal 2014, we incurred a loss from continuing operations, and as such, there are no potential common shares with a dilutive impact. The calculations of basic and diluted net income (loss) per share and basic and dilutive weighted-average shares outstanding for fiscal 2016, fiscal 2015, and fiscal 2014 were as follows (in thousands, except per share data): The following equity shares were excluded from the calculation of diluted net loss per share attributable to common stockholders because their effect would have been anti-dilutive for the periods presented (in thousands): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 9. Preferred Stock Preferred Stock consists of the following at December 31, 2016 (in thousands, except shares): There was no Preferred Stock outstanding at December 26, 2015. Please refer to the Certificate of Designations filed as Exhibit 3.1 to our Current Report on Form 8-K, filed on June 29, 2016, for definitions of all capitalized terms not otherwise defined below. Series A Redeemable Convertible Preferred Stock (Series A Preferred Stock) On June 29, 2016 (the “Closing Date”), we announced the entry into an Investment Agreement, dated as of June 29, 2016 with CapitalG LP (“CapitalG”) relating to the issuance and sale to CapitalG of 46.4 thousand shares of our Series A Redeemable Convertible Preferred Stock, par value $0.001 per share (“Series A Preferred Stock”), for an aggregate purchase price of $46.4 million, or $1,000 per share. We incurred issuance costs of $2.1 million. We elected to accrete all issuance costs that were netted against the proceeds upon issuance of the Series A Preferred Stock. The Series A Preferred Stock has the following rights and preferences: Voting The holders of Series A Preferred Stock have full voting rights and powers equal to the rights and powers of holders of shares of Common Stock, with respect to any matters upon which holders of shares of Common Stock have the right to vote. Holders of Series A Preferred Stock are entitled to the number of votes equal to the number of whole shares of Common Stock into which such share of Series A Preferred Stock could be converted at the record date for determination of the stockholders entitled to vote on such matters. Additionally, at any time when at least 50% of the shares of the Series A Preferred Stock purchased from the Company pursuant to the Investment Agreement are outstanding, the Company cannot, without the written consent or affirmative vote of the holders of a majority of the then outstanding shares of preferred stock, (a) amend the Certificate of Incorporation in a manner that adversely affects the preferences or rights of the preferred stock; (b) authorize or issue capital stock unless it ranks equal to or junior to the preferred stock, or increase the authorized number of shares of preferred stock; or (c) reclassify or amend any existing security of the Company that is equal to or junior to the preferred stock to render such security senior to the Series A Preferred Stock. Dividends The Series A Preferred Stock ranks senior to the shares of our Common Stock with respect to dividend rights and rights on the distribution of assets on any voluntary or involuntary liquidation, dissolution or winding up of the affairs of the Company. Holders of the Series A Preferred Stock are entitled to a cumulative dividend at a rate of 5.50% per annum during the period CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 from the Closing Date to the seventh anniversary of the Closing Date, payable semi-annually in arrears. Dividends are paid in additional Liquidation Preference per share of Series A Preferred Stock. Liquidation Preference The Series A Preferred Stock has a Liquidation Preference of $1,000 per share plus all Accrued and Unpaid Dividends. The Series A Preferred Stock ranks senior to the Common Stock with respect to rights upon liquidation, winding-up and dissolution. Conversion The Series A Preferred Stock is convertible at the option of the holders at any time into shares of Common Stock at an initial Conversion Price of $10.50 per share, which rate is subject to adjustment upon the occurrence of certain events. At any time after the seventh anniversary of the Closing Date, and if between the fifth anniversary and the seventh anniversary of the Closing Date, the consolidated closing price of the Common Stock equals or exceeds 150% of the then prevailing Conversion Price for at least 20 trading days in any period of 30 consecutive trading days, including the last trading day of such 30-day period, then following such time, all or some of the Series A Preferred Stock may be converted, at our election, into the relevant number of shares of Common Stock. Redemption At our option, at any time after the seventh anniversary of the Closing Date, all of the Series A Preferred Stock may be redeemed by us at the then current Liquidation Preference plus Accrued and Unpaid Dividends after giving the holders of Series A Preferred Stock the ability to convert their shares into Common Stock. At any point after the seventh anniversary of the Closing Date, each holder of the Series A Preferred Stock may cause us to redeem all of such holder’s Series A Preferred Stock at the then current Liquidation Preference plus Accrued and Unpaid Dividends. We elected to accrete all issuance costs that were netted against the proceeds upon issuance of the Series A Preferred Stock. We will accrete the carrying value of the Series A Preferred Stock to the redemption value through June 29, 2023, which is the seventh anniversary of the Closing Date, at a rate of 5.50% per annum, which represents the cumulative dividends owed on the Series A Preferred Stock, using the interest rate method. Change in Control Events Upon certain change of control events involving the Company, holders of Series A Preferred Stock can elect to either (1) convert the Series A Preferred Stock to Common Stock at the then current Conversion Price or (2) require us to redeem the Series A Preferred Stock for 150% of the then current Liquidation Preference plus Accrued and Unpaid Dividends, provided that in the case of a change of control event in which the Common Stock is converted into or canceled for cash or publicly traded securities, such conversion or redemption will be mandatory, with the selection deemed to be in favor of the alternative that would result in holders of Series A Preferred Stock receiving the greatest consideration. Board of Directors Seat Pursuant to the Investment Agreement and the Certificate of Designations, we have agreed that, so long as CapitalG or its affiliates beneficially own at least 50% of the shares of Series A Preferred Stock purchased in the transaction, the holders of Series A Preferred Stock shall have the right to elect one member of the board of directors, and CapitalG has the right to designate the nominee for such position. Standstill Restrictions Pursuant to the Investment Agreement, CapitalG is subject to certain standstill restrictions, including, among other things, that CapitalG is restricted from acquiring additional securities of the Company until the later of (a) the 18 month anniversary of the Closing Date and (b) the date that no CapitalG designee serves on the Company’s board of directors. Subject to certain customary exceptions, CapitalG is restricted from transferring the Series A Preferred Stock or, if converted, any shares of Common Stock underlying the Series A Preferred Stock until the earlier of the 18 month anniversary of the Closing Date or immediately prior to a change of control of the Company. 10. Income Taxes The following table presents domestic and foreign components of loss from continuing operations before income taxes for the periods presented (in thousands): The following table presents the components of the provision for (benefit from) income taxes for the periods presented (in thousands): See Note 3 - Discontinued Operations for the losses from discontinued operations before income taxes and related income taxes reported for the years ended December 31, 2016, December 26, 2015, and December 27, 2014, respectively. All pre-tax income (loss) presented in discontinued operations for these periods were related to U.S. operations. The following table presents a reconciliation of the statutory federal rate, and our effective tax rate on losses from continuing operations, for the periods presented: During fiscal 2016 we recorded an income tax expense of $1.3 million, primarily related to amortization of certain goodwill for tax purposes for which there is no corresponding book deduction and certain state and foreign taxes based on operating income that are payable without regard to our tax loss carry forwards. During fiscal 2015 we recorded an income tax expense of $1.2 million, primarily related to amortization of certain goodwill for tax purposes for which there is no corresponding book deduction and certain state taxes based on operating income that are payable without regard to our tax loss carry forwards. During fiscal 2014 we recorded an income tax benefit of $0.8 million, primarily related to the reversal of our valuation allowance against the deferred tax liabilities recorded in purchase accounting, partially offset by the income tax expense related to the amortization of goodwill for tax purposes for which there is no corresponding book deduction and certain state taxes based on operating income that are payable without regard to our tax loss carry forwards. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The following table presents the significant components of our deferred tax assets and liabilities, including those related to discontinued operations for the periods presented (in thousands): ASC 740 requires a valuation allowance to reduce the deferred tax assets if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. After consideration of all the evidence, both positive and negative, we have recorded a valuation allowance of $64.2 million and $56.3 million at December 31, 2016 and December 26, 2015, respectively, because our management has determined that is it more likely than not that these assets will not be fully realized. The increase of $7.9 million in the overall valuation allowance relates primarily to U.S. and certain foreign net operating losses for which we currently provide no tax benefit. As of December 31, 2016, we had federal net operating loss carryforwards of $132.8 million and state net operating loss carryforwards of $110.2 million, which may be available to reduce future taxable income. The net operating losses (‘‘NOL’’) will expire at various dates through 2036. Included in the federal and state net operating losses are deductions attributable to excess tax benefits from the exercises of stock compensation of $2.2 million and $1.9 million, respectively. The tax benefits attributable to these deductions would have been credited directly to additional paid-in capital upon utilization of these deferred tax assets to reduce taxes payable. However, we will adopt ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, during the quarter ended March 25, 2017 upon which the net operating loss carryforward deferred tax assets will be increased by the excess tax benefits with a corresponding increase to our valuation allowance. The adoption of ASU 2016-09 will have not have a material impact to the Company’s consolidated statement of operations, consolidated balance sheet, or accumulated deficit. As of December 31, 2016, we had foreign net operating losses primarily related to our German operations of $9.3 million, our U.K. operations of $3.4 million, and our Australia operations of $0.3 million that have an unlimited carryforward period under German, U.K. and Australia tax law. We also had foreign net operating losses in our Canadian operation of $0.1 million that have a twenty-year carryforward. The NOLs are subject to review and possible adjustment by the Internal Revenue Service and state tax authorities. NOL carryforwards may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant shareholders over a three-year period in excess of 50%, as defined under Sections 382 and 383 of the Internal Revenue Code, respectively, as well as similar state provisions. This could limit the amount of tax attributes that can be utilized annually to offset future taxable income or tax liabilities. The amount of the annual limitation is determined based on the value of the company immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. We have not, as yet, conducted a study to determine if any such changes have occurred that could limit our ability to use the net operating losses and tax credit carryforwards. We will complete a full analysis of the tax attribute carryforwards prior to any utilization. As of December 31, 2016 and December 26, 2015, the Company had no recorded liabilities for uncertain tax positions. Interest and penalty charges, if any, related to uncertain tax positions would be classified as income tax expense in the accompanying consolidated statements of operations. As of December 31, 2016, December 26, 2015, and December 27, 2014, we had no accrued interest or penalties related to uncertain tax positions. We file U.S. federal income tax returns and returns in various state, local, and foreign jurisdictions. Since we are in a loss carryforward position, the statute of limitations generally remains open for all tax years. Currently, we are not under examination relating to tax returns that have been previously filed. Our current intentions are to indefinitely reinvest the earnings of our foreign subsidiaries, if any, or to repatriate only when tax-effective. Accordingly, we have not provided for U.S. taxes on the unremitted earnings of our international subsidiaries, which are not significant as of December 31, 2016. In addition, we do not believe it is practicable to estimate the amount of income taxes payable on the earnings that are indefinitely reinvested in foreign operations. 11. Segment and Geographical Information We consider operating segments to be components of the Company in which separate financial information is available that is evaluated regularly by our chief operating decision maker in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is the CEO. The CEO reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance. Prior to our decision to exit the Citrus Lane business in fiscal 2015, we had determined that we had two operating and reporting segments, CRCM Businesses, Excluding Citrus Lane and Citrus Lane. Subsequent to our decision to exit the Citrus Lane business, we have concluded that we have a single operating and reportable segment comprised of the following product lines (dollars in thousands): No country outside of the United States provided greater than 10% of our total revenue. Revenue is classified by the major geographic areas in which our customers are located. The following table summarizes total revenue generated by our geographic locations (dollars in thousands): CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Our long-lived assets are primarily located in the United States and are not allocated to any specific region. Therefore, geographic information is presented only for total revenue. 12. Related Party Transactions We had the following transactions with related parties during the period: Series A Preferred Stock Issuance to CapitalG LP On June 29, 2016, we issued Series A Preferred Stock to CapitalG LP, as described in Note 9. As a result of this transaction, Alphabet Inc., the ultimate parent of CapitalG LP (“CapitalG”), and all related affiliates of Alphabet Inc. are considered to be related parties. During fiscal 2016, we had recorded $1.6 million of revenue from Care@Work arrangements with Alphabet Inc. and its affiliates. During fiscal 2016, we incurred $14.5 million of selling and marketing expenses for internet based marketing services with Alphabet Inc. and its affiliates. As of December 31, 2016, we had $0.1 million and $0.3 million of accounts receivable and unbilled accounts receivable, respectively, recorded with Alphabet Inc. and its affiliates. As of December 31, 2016, we had $0.2 million, $0.1 million, and $1.1 million of deferred revenue, accounts payable, and accrued expenses and other current liabilities, respectively, recorded with Alphabet Inc. and its affiliates. Repurchase of Common Stock from Matrix Partners VII, L.P. and Weston & Co. VII LLC On June 27, 2016, we entered into a Stock Repurchase Agreement (the “Stock Repurchase Agreement”) to repurchase an aggregate of 3.7 million shares of common stock at a price of $8.25 per share (the “Stock Repurchase”) from Matrix Partners VII, L.P. and Weston & Co. VII LLC, as Nominee (together, the “Sellers”). The Stock Repurchase closed on June 29, 2016. Pursuant to the Stock Repurchase Agreement, the Sellers were subject to a 90-day lock-up provision related to the remaining shares of common stock they held following the closing of the Stock Repurchase. Professional Services Agreement with West Studios, LLC In fiscal 2016, we entered into a professional services agreement with West Studios, LLC (“West”). One of our board members is acting as a Managing Director of West. As a result, we consider West to be a related party. Under the terms of the agreement, we have agreed to pay West an aggregate of $1.3 million in service fees over a nine-month period subject to certain termination rights by either party. During fiscal 2016, we incurred $0.2 million of selling and marketing expenses related to our West relationship. 13. Employee Benefit Plans We have established a 401(k) tax-deferred savings plan covering all employees who satisfy certain eligibility requirements. The 401(k) plan allows each participant to defer a percentage of their eligible compensation subject to applicable annual limits pursuant to the limits established by the Internal Revenue Service. We may, at our discretion, make contributions in the form of matching contributions or profit sharing contributions. During the years ended December 31, 2016 and December 26, 2015, we contributed a 401(k) match of $0.2 million and $0.2 million, respectively. 14. Restructuring Charges On April 14, 2016, we entered into a sublease agreement to lease approximately 10,362 square feet of our 108,743 square foot headquarters facility located in Waltham, Massachusetts. During the quarter ended June 25, 2016, we recorded a $0.5 million sublease loss liability and related expenses of $0.2 million for the expected loss on the sublease, in accordance with ASC 840-20 Leases, because the monthly payments we expect CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 to receive under the sublease are less than the amounts that we will owe the lessor for the sublease space. The sublease term is less than the remaining term under the original lease, and thus we do not believe we have met a cease use date as we may re-enter the space following the sublease. The fair value of the liability was determined using the estimated future net cash flows, consisting of the minimum lease payments to the lessor for the sublease space and payments we will receive under the sublease. The sublease loss was recorded as part of restructuring expense in the consolidated statement of operations. The following table presents the change in restructuring liability from December 26, 2015 to December 31, 2016 (in thousands): 15. Other Expense, Net Other expense, net consisted of the following (in thousands): 16. Quarterly Financial Information (Unaudited) The tables below sets forth unaudited selected quarterly financial data for each of the last two fiscal years (dollars in thousands, except per share data). For the quarter ended December 31, 2016, net income per share attributable to common stockholders for basic and diluted was calculated using the two-class method because we have income from continuing operations for this quarter. Please refer to Note 8 for additional information on the two-class method of accounting for net income per share attributable to common stockholders. CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Information in any one quarterly period should not be considered indicative of annual results due to the effects of seasonality on our business. We have determined that the net loss attributable to common stockholders and net loss per share attributable to common stockholders (Basic and Diluted) for the three- and nine-month periods ended September 24, 2016 were incorrectly stated in the CARE.COM, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2016, DECEMBER 26, 2015 AND DECEMBER 27, 2014 Form 10-Q for the period ended September 24, 2016, resulting from an error in the presentation of Accretion of Series A Redeemable Convertible Preferred Stock issuance costs, which was incorrectly excluded from the Company’s calculation of net loss attributable to common stockholders. We determined that these errors are not material to the respective interim financial statements and has corrected the amounts in the unaudited quarterly financial information presented above. The net loss per share from continuing operations applicable to common stockholders (basic and diluted) for the three- and nine-month periods ended September 24, 2016 were previously reported as $(0.06) and $(0.20), respectively, while the corrected amounts are $(0.14) and $(0.27), respectively. The net income (loss) per share applicable to common stockholders (basic and diluted) for the three- and nine-month periods ended September 24, 2016 were previously reported as $(0.06) and $0.05, respectively, while the corrected amounts are $(0.14) and $(0.02), respectively.
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I apologize, but the financial statement excerpt you've provided seems incomplete and fragmented, making it difficult to provide a comprehensive summary. The text appears to be partially cut off and lacks clear, complete financial details.
From the available fragments, I can only discern a few disconnected pieces of information:
- The document relates to Care.com, Inc.
- There's a mention of current liabilities due to related parties of $1,055
- The statement covers financial information for the years ended December 31st
To provide a meaningful summary, I would need a more complete and coherent financial statement with full revenue, expense, asset, and liability details.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. Report of Independent Registered Public Accounting Firm Board of Directors and Shareholders Ellie Mae, Inc. We have audited the accompanying consolidated balance sheets of Ellie Mae, Inc. (a Delaware corporation) and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ellie Mae, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in the 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 21, 2017 expressed an unqualified opinion. /s/ GRANT THORNTON LLP San Francisco, CA February 21, 2017 Report of Independent Registered Public Accounting Firm Board of Directors and Shareholders Ellie Mae, Inc. We have audited the internal control over financial reporting of Ellie Mae, Inc. (a Delaware corporation) and subsidiaries (the “Company”) as of December 31, 2016, based on criteria established in the 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting (“Management’s Report”). Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in the 2013 Internal Control - Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company as of and for the year ended December 31, 2016, and our report dated February 21, 2017 expressed an unqualified opinion on those financial statements. /s/ GRANT THORNTON LLP San Francisco, CA February 21, 2017 See accompanying notes to these consolidated financial statements. See accompanying notes to these consolidated financial statements. Ellie Mae, Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands, except share amounts) See accompanying notes to these consolidated financial statements. Ellie Mae, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Ellie Mae, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS - (continued) (in thousands) See accompanying notes to these consolidated financial statements. Ellie Mae, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1-Description of Business Ellie Mae, Inc. (“Ellie Mae,” “the Company,” “we,” “our” or “us”) is a leading provider of innovative on-demand software solutions and services for the residential mortgage industry in the United States. Banks, credit unions and mortgage lenders use the Company’s Encompass® all-in-one mortgage management solution to originate and fund mortgages and improve compliance, loan quality, and efficiency. NOTE 2-Basis of Presentation and Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Applicable Accounting Guidance Any reference in these notes to applicable accounting guidance is meant to refer to the authoritative generally accepted accounting principles in the United States (“U.S. GAAP”), as found in the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”). Use of Estimates The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management evaluates estimates on a regular basis including those relating to revenue recognition, allowance for doubtful accounts, goodwill, intangible assets, valuation of deferred income taxes, stock-based compensation, and unrecognized tax benefits, among others. Actual results could differ from those estimates and such differences may have a material impact on the Company’s consolidated financial statements and footnotes. Cash and Cash Equivalents All highly liquid investments with original maturities of 90 days or less are considered to be cash equivalents. Cash equivalents are recorded at cost, which approximates fair value. Investments and Fair Value Measurement of Financial Instruments The fair values of the Company’s cash equivalents, accounts receivable, and accounts payable approximate their carrying values due to the short maturities of the instruments. The fair value of the Company’s capital lease obligations approximates the carrying value due to the terms continuing to approximate prevailing market terms. All of the Company’s investments that have maturities of greater than 90 days are classified as available-for-sale and are carried at fair value. The Company invests excess cash primarily in investment-grade interest-bearing securities, such as money market accounts, certificates of deposit, commercial paper, corporate bonds, municipal and government agency obligations, and guaranteed obligations of the U.S. government. Fair value is determined based on quoted market rates when observable or utilizing data points that are observable, such as quoted prices, interest rates, and yield curves. The cost of available-for-sale marketable securities sold is based on the specific identification method. Unrealized gains and losses are reported in stockholders’ equity as accumulated other comprehensive income (loss). Realized gains and losses are included in other income (expense), net. Interest and dividends are included in other income (expense), net when they are earned. Accounts Receivable and Allowance for Doubtful Accounts Trade accounts receivable consist of amounts billed to customers in connection with sale of services. The Company analyzes individual trade accounts receivable by considering historical bad debts, customer creditworthiness, current economic trends, changes in customer payment terms, and collection trends when evaluating the adequacy of the allowance for doubtful accounts. Allowances for doubtful accounts are recognized in the period in which the associated receivable balance is not considered recoverable. Any change in the assumptions used in analyzing accounts receivable may result in changes to the allowance for doubtful accounts and is recognized in the period in which the change occurs. The Company writes off a receivable when all rights, remedies, and recourse against the account and its principals are exhausted and records a benefit when previously reserved accounts are collected. Concentration of Credit Risk The financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash and cash equivalents, investments, and accounts receivable. The Company’s cash and cash equivalents are deposited with major financial institutions in the United States. At times, such deposits may be in excess of federally insured limits. Management believes that the Company’s investments in cash equivalents and available-for-sale investments are financially sound. The Company’s accounts receivable are derived from revenue earned from customers located in the United States. The Company had no customers that represented 10% or more of revenues for the years ended December 31, 2016, 2015, and 2014. No customer represented more than 10% of accounts receivable as of December 31, 2016 and 2015. Software and Website Development Costs The Company capitalizes internal and external costs incurred to develop internal-use software and website applications. Capitalized internal costs include salaries, benefits, and stock-based compensation charges for employees that are directly involved in developing the software or website application, and depreciation of assets used in the development process. Capitalized external costs include third-party consultants involved in the development process, as well as other direct costs incurred therein. Capitalization of costs begins when the preliminary project stage has been completed, management authorizes and commits to funding a project and it is probable that the project will be completed and the software or website application will be used to perform the function intended. Internal and external costs incurred as part of the preliminary project stage are expensed as incurred. Capitalization ceases at the point at which the project is substantially complete and ready for its intended use. Internal and external training costs and maintenance costs during the post-implementation operation stage are expensed as incurred. Internal-developed core software is amortized on a straight-line basis over its estimated useful life, generally three to five years. Amortization of product related internal-use software and website applications is typically recorded to cost of revenues, and amortization of other internal-use software and website applications is typically recorded to the operating expense line to which it most closely relates. Management evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. The capitalized costs are included in property and equipment, net in the accompanying consolidated balance sheets. For the years ended December 31, 2016, 2015 and 2014, the Company capitalized software and website application development costs of $38.5 million, $29.4 million, and $15.9 million, respectively. During the year ended December 31, 2014, the Company recorded a $0.7 million impairment loss on the write-off of internal-use software. There were no such write-offs during the years ended December 31, 2016 and 2015. Property and Equipment Property and equipment are stated at cost less accumulated depreciation and are depreciated on a straight-line basis over their estimated useful lives, which is generally three to seven years. Leasehold improvements are amortized on a straight-line basis over their estimated useful lives or over the term of the lease, whichever is shorter. Business Combinations The Company recognizes and measures the identifiable assets acquired in a business combination, the liabilities assumed and any non-controlling interest in the acquiree, at their fair values as of the acquisition date. The Company recognizes contingent consideration arrangements at their acquisition-date fair values with subsequent changes in fair value reflected in earnings, recognizes pre-acquisition loss and gain contingencies at their acquisition-date fair values, capitalizes in-process research and development assets and expenses acquisition-related transaction costs as incurred. Due to the inherent uncertainty in the estimates and assumptions used by the Company in its fair value measurements, recorded amounts may be subject to refinement. During the measurement period, which may be up to one year from the acquisition date, the Company may record adjustments to the fair value of assets acquired and liabilities assumed, with the corresponding offset to goodwill. Any subsequent adjustments, including changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period, are recognized in current period earnings. Goodwill The Company records goodwill in a business combination when the consideration paid exceeds the fair value of the identifiable net assets acquired. Goodwill is not amortized, but is tested for impairment at least annually, or whenever changes in circumstances indicate that the fair value of a reporting unit is less than its carrying amount, including goodwill. The annual test is performed at the reporting unit level using a fair-value based approach. The Company’s operations are organized as one reporting unit. In testing for a potential impairment of goodwill, the Company first compares the net aggregate carrying value of assets and liabilities to the aggregate estimated fair value of the Company. If estimated fair value is less than carrying value, then potential impairment exists. The amount of any impairment is then calculated by determining the implied fair value of goodwill using a hypothetical purchase price allocation. Impairment is equivalent to any excess of goodwill carrying value over its implied fair value. There were no impairment charges related to goodwill during the years ended December 31, 2016, 2015, and 2014. The process of evaluating the potential impairment of goodwill requires significant judgment at many points during the analysis, including calculating fair value of the reporting unit based on estimated future cash flows and discount rates to be applied. Intangible Assets Intangible assets are stated at cost less accumulated amortization. Intangible assets include developed technology, trade names, and customer lists and contracts. Intangible assets with finite lives are amortized on a straight-line basis over the estimated periods of benefit, as follows: The AllRegs tradename is the only intangible asset with an indefinite useful life. The Company evaluates the remaining useful life of indefinite-lived intangible assets each reporting period to determine whether events and circumstances continue to support an indefinite useful life. The Company test intangible assets with indefinite lives at least annually or if events or circumstances indicate that such assets might be impaired. If potential impairment exists, the amount of any impairment is calculated by using a discounted cash flow model, which is based on the assumptions the Company believe hypothetical marketplace participants would use. For indefinite-lived intangible assets, other than goodwill, if the carrying amount exceeds the fair value, an impairment charge is recognized in an amount equal to that excess. The Company evaluates its finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to future undiscounted net cash flows expected to be generated by the asset or asset group. If such assets or asset groups are considered to be impaired, the impairment loss to be recognized is measured by the amount by which the carrying amounts of the assets or asset groups exceed the fair value of the assets or asset groups. Assets to be disposed of are reported at the lower of the carrying amount and fair value less costs to sell. Except as described in Note 6, there has been no loss on impairment or disposal of intangible assets. Impairment of Long-Lived Assets The Company evaluates its long-lived assets for indications of possible impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Except for the impairment losses recorded on internal-use software and intangible assets described elsewhere in this note, there has been no loss on impairment or disposal of long-lived assets. Revenue Recognition The Company generates revenue primarily from transaction-based fees and fees for software and related services, including its annual user conference and fees from professional services. On-demand revenue is generated from company-hosted software subscriptions that customers access through the Internet. On-demand revenue is comprised of fees for software services sold both as a subscription and transactionally, including fees based on a per closed loan, or success basis, subject to monthly base fees, which the Company refers to as Success Based Pricing; Ellie Mae Network fees; education and training, loan product, policy and guideline data and analytics services under the AllRegs brand; and professional services which include consulting, implementation, and training services. On-premise revenue is generated from maintenance services, sales of customer-hosted Encompass software licenses, and related professional services. As of June 30, 2016, the Company completed the migration of customers to its on-demand Encompass offering, and the Company does not expect on-premise revenues in the future. Sales taxes assessed by governmental authorities are excluded from revenue. The Company commences revenue recognition when all of the following conditions are satisfied: •There is persuasive evidence of an arrangement; •The service has been or is being provided to the customer; •The collection of the fees is reasonably assured; and •The amount of fees to be paid by the customer is fixed or determinable. On-Demand Revenues Subscription Services and Usage-Based Fee Arrangements. Subscription services and usage-based fee arrangements generally include a combination of the Company’s products delivered as software-as-a-service (“SaaS”) and support services. These arrangements are generally non-cancelable and do not contain refund-type provisions. This revenue typically includes the following: Encompass Revenue. The Company offers web-based, on-demand access to Encompass software for a monthly recurring fee. The Company provides the right to access its loan origination software and handles the responsibility of managing the servers, providing security, backing up the data and applying updates. Customers under SaaS arrangements do not take possession of the software at any time during the term of the agreement. Subscription revenue is recognized ratably over the contract terms as subscription services are provided, beginning on the commencement date of each contract, which is the date the Company’s service is made available to customers. Contracts generally range from one year to five years. Alternatively, customers can elect to pay on a success basis. Success basis contracts generally have a term of one to five years and are subject to monthly base fees, which enable customers to close loans up to a contractually agreed-to minimum number of transactions, and additional closed loan fees, which are assessed for loans closed in excess of the minimum. Revenue is earned from both base fees and additional closed loan fees as the result of the customer’s usage of Encompass. Monthly base fees are recognized over the respective monthly service period as the subscription services are provided. Additional closed loans fees are recognized when the loans are reported as closed. This offering also includes Encompass CenterWise, Encompass Compliance Service, and Encompass Docs Solution as integrated components, which are combined elements of the arrangement that are delivered in conjunction with the Encompass offering and therefore are not accounted for separately. Services Revenue. The Company provides a variety of mortgage-related and other business services, including automated documentation; fraud detection, valuation, validation, and risk analysis; income verification; marketing and customer relationship management; product and pricing; flood zone certifications; website and electronic document management; and compliance reports. Services revenue is recognized upon completion of the services. Transactional and Other Revenue. The Company has entered into agreements with various lenders, service providers and certain government-sponsored entities participating in the mortgage origination process that provide them access to, and ability to interoperate with, mortgage originators on the Ellie Mae Network. Under these agreements, the Company earns transaction fees when transactions are processed through the Ellie Mae Network. Transactional revenue is recognized upon completion of the services. Professional Services Revenue. Professional services revenue is generally recognized upon delivery or completion of performance milestones for fixed price contracts or as the services are rendered for time and material contracts. The majority of the Company’s professional services contracts are on a fixed price basis. Training revenue is recognized as the services are rendered. Subscriptions to Online Research and Data Resources. The Company provides mortgage originators and underwriters with access to online databases of various federal and state laws and regulations and forms as well as mortgage investor product guidelines. Subscription fees are recognized ratably over the subscription term as subscription services are provided, which is typically one year. On-Premise Revenue Revenue from the sale of software licenses is recognized in the month in which the required revenue recognition criteria are met, generally in the month in which the software is delivered. Revenue from the sale of maintenance services and professional services is recognized over the period in which the services are provided. As of June 30, 2016, the Company completed the migration of customers to its on-demand Encompass offering, and the Company does not expect on-premise revenues in the future. Multiple Element Arrangements The Company enters into arrangements with multiple elements that generally include multiple subscriptions and professional services. For arrangements with multiple deliverables, the Company evaluates whether the individual deliverables qualify as separate units of accounting. In order to treat deliverables in a multiple-deliverable arrangement as separate units of accounting, the deliverables must have standalone value upon delivery. Subscription services have standalone value as such services are often sold separately. Additionally, the Company concluded that professional services included in multiple element arrangements also have standalone value. In establishing standalone value, the Company considered the following factors for each professional services agreement: availability of the services from other vendors, the nature of the professional services, and the timing of when the professional services contract was signed in comparison to the subscription service start date. When subscription services agreements involve multiple elements that qualify as separate units of accounting, the Company allocates arrangement consideration to all deliverables at the inception of an arrangement based on the relative selling price method in accordance with the selling price hierarchy, which includes: (i) vendor specific objective evidence (“VSOE”) if it is available; (ii) third-party evidence (“TPE”) if VSOE is not available; and (iii) the best estimate of selling price (“BESP”) if neither VSOE nor TPE is available. The Company has determined that TPE is not a practical alternative as the Company’s go-to-market strategy and offerings contain a significant level of differentiation such that the comparable pricing of services with similar functionality cannot be obtained. Furthermore, the Company is unable to reliably determine what similar competitor services’ selling prices are on a standalone basis. The amount of revenue allocated to delivered items is limited by contingent revenue, if any. The Company has not historically priced its services within a narrow range. As a result, the Company has not been able to establish VSOE for its services. Accordingly, the Company uses its BESP to determine the relative selling price for its services. The objective of BESP is to determine the price at which the Company would transact a sale if the service was sold on a standalone basis. When establishing BESP, the Company reviews company specific factors used to determine list price and makes adjustments as appropriate to reflect current market conditions and pricing behavior. The Company’s process for establishing list price includes assessing the cost to provide a particular product or service, surveying customers to determine market expectations, analyzing customer demographics, and taking into account similar products and services historically sold by the Company. The Company continues to review the factors used to establish list price and adjusts BESP as necessary. For software arrangements with multiple elements (e.g., maintenance and support contracts bundled with licenses), revenue is allocated to the delivered elements of the arrangement when VSOE is determinable, using the residual value method based on objective evidence of the fair value of the undelivered elements, which is specific to us. When VSOE is not determinable, the entire arrangement is recognized ratably over the term of the contract. Revenue is recognized under this model upon receipt of cash payment from the customer if collectability is not reasonably assured and when other revenue recognition criteria have been met. The VSOE of fair value for maintenance and support obligations related to licenses is based upon the prices paid for the separate renewal of these services by customers. Maintenance revenues are recognized ratably over the period of the maintenance contract. Deferred Revenue Deferred revenue represents billings or payments received in advance of revenue recognition and is recognized as the revenue recognition criteria are met. Balances consist primarily of prepaid subscription services and professional and training services not yet provided as of the balance sheet date. Deferred revenue that will be recognized during the succeeding 12 month period is recorded as current deferred revenue, and the remaining portion is recorded as other long-term liabilities. Long-term deferred revenue at December 31, 2016 and 2015 was not material. Deferred Commission Expense Deferred commission expenses are the incremental costs that are directly associated with non-cancelable subscription contracts with customers and consist of sales commissions paid to the Company’s direct sales force. Commissions are calculated based on a percentage of the revenues for the non-cancelable term of subscription contracts, which are typically one to five years. The deferred commission expense amounts are recoverable through the future revenue streams under the non-cancelable customer contracts. During the years ended December 31, 2016, 2015, and 2014, the Company deferred $4.9 million, $3.6 million, and $2.5 million of commission expense, respectively. At December 31, 2016 and 2015, $7.8 million and $5.3 million of deferred commission remained on the Company’s consolidated balance sheets, respectively. Warranties and Indemnification The Company provides a warranty for its software products and services to its customers and accounts for its warranties as a contingent liability. The Company’s software is generally warranted to perform substantially as described in the associated product documentation and to satisfy defined levels of uptime reliability. The Company’s services are generally warranted to be performed consistent with industry standards. The Company has not provided for a warranty accrual as of December 31, 2016 or 2015. To date, the Company’s product warranty expense has not been significant. The Company generally agrees to indemnify its customers against legal claims that the Company’s software products infringe certain third-party intellectual property rights and accounts for its indemnification obligations as a contingent liability. In addition, the Company may also incur liability under its contracts if it breaches its warranties as well as certain data security and/or confidentiality obligations. To date, the Company has not been required to make any payment resulting from either infringement claims asserted against its customers or from claims in connection with a breach of the data security and/or confidentiality obligations in the Company’s contracts. The Company has not recorded a liability for related costs as of December 31, 2016 or 2015. The Company has obligations under certain circumstances to indemnify each executive officer and member of the Company’s board of directors against judgments, fines, settlements, and expenses related to claims against such executive officer or director and otherwise to the fullest extent permitted under Delaware law and the Company’s bylaws and certificate of incorporation. Cost of Revenues The Company’s cost of revenues consists primarily of: salaries and benefits, including stock-based compensation expense; data center operating costs; depreciation on data center computer equipment; amortization of internal-use software and acquired intangible assets such as developed technology and trade names; customer support; professional services associated with implementation of the Company’s software; third-party royalty expenses; and allocated facilities costs. Research and Development Costs The Company’s research and development expenses consist primarily of: salaries and benefits, including bonuses and stock-based compensation expense; fees to contractors engaged in the development and support of the Ellie Mae Network, Encompass software and other products; and allocated facilities costs. Research and development costs that are not capitalized as internal-use software are expensed as they are incurred. Advertising Expenses The Company expenses advertising costs as incurred. Advertising expenses for the years ended December 31, 2016, 2015, and 2014 were $1.0 million, $0.7 million, and $0.4 million, respectively. Stock-Based Compensation The Company recognizes stock-based compensation related to awards granted under its 2009 Stock Option and Incentive Plan (the “2009 Plan”), 2011 Equity Incentive Award Plan (the “2011 Plan”), and Employee Stock Purchase Plan (“ESPP”). The Company recognizes compensation expense related to Restricted Stock Units (“RSUs”), Performance-Vesting Restricted Stock Units and Performance Awards (“Performance Awards”) based on the fair market value of the underlying shares of common stock as of the date of grant. Expense related to the RSUs is recognized on a straight-line basis over the requisite service period of the award, which generally equals the vesting period. Expense related to the Performance Awards and performance-vesting RSUs is recognized under the graded vesting method over the requisite service period of the award, which results in the recognition of a larger portion of the expense during the beginning of the vesting period than in the end of the vesting period. Management evaluates the probability of performance attainment and estimates the probable number of shares of common stock that will be granted and records the expense accordingly, if probable. The Company recognizes compensation expense related to stock option grants that are ultimately expected to vest based on estimated fair values on the date of grant using the Black-Scholes option-pricing model. Such expense is recognized on a straight-line basis over the requisite service period of the award, which generally equals the vesting period. The date of grant is the date at which the Company and the employee reach a mutual understanding of the key terms and conditions of the award, appropriate approvals are received by the equity incentive committee of the board of directors and the Company becomes contingently obligated to issue equity instruments to the employee who renders the requisite service. The Company is required to estimate potential forfeitures of stock grants and adjust recorded compensation cost accordingly. The estimate of forfeitures is based on historical experience and is adjusted over the requisite service period to the extent that actual forfeitures differ, or are expected to differ, from the prior estimates. Changes in estimated forfeitures will be recognized in the period of change and will impact the amount of stock-based compensation expense to be recognized in future periods. Income Taxes The Company accounts for income taxes under the asset and liability method, which requires the recognition of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that the Company believes is more likely than not to be realized. The Company’s determination of its valuation allowance is based upon a number of assumptions, judgments, and estimates, including forecasted earnings, future taxable income, and the relative proportions of revenue and income before taxes in the various jurisdictions in which it operates. The Company operates in various tax jurisdictions and is subject to audit by various tax authorities. Tax positions are based upon their technical merits, relevant tax law, and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax positions. A tax position is only recognized in the financial statements if it is “more likely than not” to be sustained based solely on its technical merits as of the reporting date. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments that could result in recognition of additional tax benefits or additional charges to the tax provision and may not accurately reflect actual outcomes. The Company has a policy to classify accrued interest and penalties associated with uncertain tax positions together with the related liability, and the expenses incurred related to such accruals are included in the provision for income taxes. Comprehensive Income Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes certain changes in equity that are excluded from net income, specifically unrealized gains (losses) on marketable securities. Except for net realized gain (loss) on investments which was not significant, there were no reclassifications out of accumulated other comprehensive income that affected net income during the years ended December 31, 2016, 2015, and 2014. Geographical Information The Company is domiciled in the United States and had no international operations or sales to customers outside of the United States for the years ended December 31, 2016, 2015, and 2014. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This standard also requires significantly expanded disclosures about revenue recognition. In August 2015, the FASB deferred the effective date of this standard by one year. The effective date for public entities is for fiscal years beginning after December 15, 2017 and early adoption is allowed. The Company will adopt the new standard as of January 1, 2018. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the modified retrospective method). The Company is evaluating the impact of the new standard on its accounting policies, processes, and systems including impacts from guidance issued by the FASB Transition Resource Group as part of their November 2016 meeting. The Company has assigned internal resources, engaged a third party service provider, and has a preliminary project plan to finalize the evaluation and complete the implementation. The Company has preliminarily identified potential impacts to the timing of revenue recognition and the amortization period of costs to obtain contracts. The Company’s decision on the adoption method will be based on various factors including the significance of the impact of the new standard on the Company’s financial results and system capabilities. The Company has not yet completed the evaluation of these impacts and the adoption method has not been determined. In April 2015, the FASB issued ASU No. 2015-05, Intangibles-Goodwill and Other-Internal-Use Software: Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement (“ASU 2015-05”), which clarifies the circumstances under which a cloud computing customer would account for the arrangement as a license of internal-use software. On January 1, 2016, the Company adopted ASU 2015-05 on a prospective basis. The adoption did not impact the Company’s consolidated financial statements. In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, and early adoption is not permitted. The Company is currently evaluating the impact of this accounting standard updated on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which requires lessees to put most leases on their balance sheets but recognize the expenses on their income statements in a manner similar to current practice. ASU 2016-02 states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. The standard is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. The Company currently does not intend to early adopt and is evaluating the impact of this accounting standard update on its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Shared-Based Payment Accounting (“ASU 2016-09”), which simplifies and makes several modifications to Topic 718 related to the accounting of share-based payment transactions. The standard requires companies to record excess tax benefits and tax deficiencies as income tax benefit or expense in the income statement when stock awards vest or are settled. This change is required to be applied prospectively. The standard also allows the employer tax withholding on share-based compensation to increase (up to the employee’s maximum statutory rates) without triggering liability accounting and provides an accounting policy election to allow the recognition of forfeitures when they are incurred. The standard is effective for interim and annual reporting periods beginning after December 15, 2016, and early adoption is permitted. The Company will adopt the standard as of January 1, 2017. The Company has elected to continue estimating forfeitures, and is expected to record previously unrecognized tax benefits to retained earnings upon adoption. The Company will adopt the above on a modified retrospective basis. The standard also eliminates the requirement to separately classify excess tax benefits as a financing activity in the statement of cash flows and the Company will adopt on a retrospective basis. In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-01”). This standard clarifies the definition of a business and is intended to help companies evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The standard is effective for interim and annual periods beginning after December 15, 2017 and early adoption is permitted under certain circumstances. The standard should be applied prospectively as of the beginning of the period of adoption. The Company currently does not intend to early adopt and is evaluating the impact of this accounting standard update on its consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). The standard eliminates Step 2 from the goodwill impairment test, which requires a hypothetical purchase price allocation. The Company will continue to have the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The standard is effective for interim and annual periods beginning after December 15, 2019 and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The standard should be applied on a prospective basis. The Company is currently evaluating the impact of this accounting standard update on its consolidated financial statements. NOTE 3-Net Income Per Share of Common Stock Net income per share of common stock is calculated by dividing net income by the weighted average shares of common stock outstanding during the period. Diluted net income per share of common stock is calculated by dividing net income by the weighted average shares of common stock outstanding and potential shares of common stock during the period. Potential shares of common stock include dilutive shares attributable to the assumed exercise of stock options, RSUs, performance-vesting RSUs, Performance Awards, and ESPP shares using the treasury stock method, if dilutive. The components of net income per share of common stock were as follows: The following potential weighted average common shares were excluded from the computation of diluted net income per share, as their effect would have been anti-dilutive: Performance-vesting RSUs and Performance Awards are included in the diluted shares outstanding for each period if the established performance criteria have been met at the end of the respective periods. However, if none of the required performance criteria have been met for such awards, the Company includes the number of shares that would be issuable if the end of the reporting period were the end of the contingency period. Accordingly, in addition to the employee stock options and awards noted above, 20,304 shares underlying performance-vesting RSUs and Performance Awards were excluded from the dilutive shares outstanding for the year ended December 31, 2016. No shares were excluded from the dilutive shares outstanding for the years ended December 31, 2015 or 2014. NOTE 4-Financial Instruments and Fair Value Measurements Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are classified and disclosed in one of the following three categories: Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities. Level 2 - Valuations based on other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - Valuations based on inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the assets or liabilities. The following tables set forth by level within the fair value hierarchy the Company’s financial assets that were accounted for at fair value on a recurring basis: Financial instruments include cash, cash equivalents, and investments, including investment-grade interest-bearing securities, such as money market accounts, certificates of deposit, commercial paper, corporate bonds, municipal and government agency obligations, and guaranteed obligations of the U.S. government. The Company classifies its money market funds that are specifically backed by debt securities and U.S. government obligations as Level 1 instruments, due to the use of observable market prices for identical securities that are traded in active markets. When the Company uses observable market prices for identical securities that are traded in less active markets, the Company classifies its marketable financial instruments as Level 2. When observable market prices for identical securities are not available, the Company prices its marketable financial instruments using non-binding market consensus prices that are corroborated with observable market data; quoted market prices for similar instruments; or pricing models with all significant inputs derived from or corroborated with observable market data. Non-binding market consensus prices are based on the proprietary valuation models of pricing providers. These valuation models incorporate a number of inputs, including non-binding and binding broker quotes; observable market prices for identical or similar securities; and the internal assumptions of pricing providers or brokers that use observable market inputs and, to a lesser degree, unobservable market inputs. The Company corroborates non-binding market consensus prices with observable market data as such data exists. At December 31, 2016 and December 31, 2015, the Company did not have any assets or liabilities that were valued using Level 3 inputs. For the years ended December 31, 2016, 2015, and 2014, there were no transfers of financial instruments between the levels. For the years ended December 31, 2016, 2015, and 2014, the Company recognized interest income from financial instruments of $1.1 million, $0.7 million, and $0.6 million, respectively. Gross realized gains and gross realized losses from the sale of investments were not significant during the years ended December 31, 2016, 2015, and 2014. The carrying amounts, gross unrealized gains and losses and estimated fair value of cash and cash equivalents and both short-term and long-term investments consisted of the following: The following table shows the gross unrealized losses and the related fair values of the Company’s investments that have been in a continuous unrealized loss position. The Company did not identify any investments as other-than-temporarily impaired at December 31, 2016 or December 31, 2015. The following table summarizes the maturities of the Company’s investments at December 31, 2016: Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations. NOTE 5-Acquisitions Mortgage Returns On October 23, 2015, the Company acquired substantially all the assets of Mortgage Returns, LLC (“Mortgage Returns”), a provider of on-demand customer relationship management, and marketing automation solutions for the mortgage industry. The Company acquired the Mortgage Returns business in order to add functionality to its product offerings. The transaction was accounted for as a business combination and, accordingly, the total purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. The Company expensed all transaction costs, which were insignificant, in the period in which they were incurred. The total purchase consideration was $16.3 million in cash, of which $2.4 million was placed in escrow to cover closing capital settlement adjustments and any indemnity claims. In October 2016, $0.8 million was paid to the seller, in accordance with the agreement. Any amount remaining in escrow 18 months after the date of acquisition will be paid to the seller. The allocation of the consideration of $16.3 million to the identifiable tangible and intangible assets acquired and liabilities assumed under the purchase method of accounting, based on their estimated fair values as of the acquisition date, is summarized in the following table (in thousands): Developed technology consists of the technology underlying Mortgage Returns’ existing products and has an estimated useful life of four years. The value of the developed technology was determined by discounting the estimated net future cash flows of these products. Customer relationships relate to the Company’s ability to sell existing and future versions of the Company’s products and services to existing Mortgage Returns customers and have an estimated useful life of seven years. The fair value of the customer relationships was determined by using an income approach, in which fair value was determined using discounted cash flows associated with lost revenue and lost profits over the life of the customer relationships. Trade name represents the right to use the Mortgage Returns’ name and has a useful life of one year. The fair value of the trade name was determined by estimating the benefit from owning the asset rather than paying a royalty to a third party for the use of the asset. Order backlog represents estimated net discounted future cash flows associated with service contracts that were outstanding as of the acquisition date and expected to be executed within four years. Goodwill, which is deductible for tax purposes, represents the excess of the purchase price over the fair value of the identifiable assets acquired. Among the factors that contributed to a purchase price in excess of the fair value of the identifiable assets was the acquisition of an assembled workforce and synergies between the Company’s products and Mortgage Return’s products. Mortgage Returns’ results of operations since the closing date of October 23, 2015, have been included in the Company’s consolidated statements of comprehensive income. If the acquisition had occurred as of January 1, 2014, the impact on reported revenues and earnings of the Company for the years ended December 31, 2015 and 2014 would not have been significant. AllRegs On October 1, 2014, the Company acquired substantially all the assets of Mortgage Resource Center, Inc. (dba AllRegs) (“AllRegs”), a provider of research and reference, education, documentation, and data analytics products relating to the mortgage industry. The Company acquired the AllRegs business in order to strengthen the Company’s products through product integration and to introduce new products related to training, compliance management systems and product eligibility. The transaction was accounted for as a business combination and, accordingly, the total purchase price was allocated to the assets acquired based on their respective fair values. The Company expensed all transactions costs, which were insignificant, in the period in which they were incurred. The total purchase consideration was $28.1 million in cash, of which $3.0 million was placed in escrow to cover closing capital settlement adjustments and any indemnity claims. Any amount remaining in escrow 18 months after the date of acquisition was paid to the seller. AllReg’s results of operations since the closing date of October 1, 2014, have been included in the Company’s consolidated statements of comprehensive income. The following unaudited pro forma combined results of operations give effect to the acquisition of AllRegs as if it had occurred on January 1, 2014. The unaudited pro forma combined results of operations are provided for informational purposes only and do not purport to represent the Company’s actual consolidated results of operations or consolidated financial position had the acquisition occurred on the dates assumed, nor are these financial statements necessarily indicative of the Company’s future consolidated results of operations or consolidated financial position. The Company expects to incur costs and realize benefits associated with integrating the operations of the Company and AllRegs. The unaudited pro forma combined results of operations do not reflect the costs of any integration activities or any benefits that may result from operating efficiencies or revenue synergies. The pro forma combined results of operations for the year ended December 31, 2014 include non-recurring adjustments relating to the reduction of AllRegs deferred revenue to its estimated fair value as of the acquisition date and the corresponding impact on subsequently recognized revenue, direct acquisition costs and changes to AllRegs employee compensation subsequent to the date of acquisition. MortgageCEO On January 15, 2014, the Company acquired substantially all the assets of ARG Interactive, LLC (dba MortgageCEO) (“MortgageCEO”), a SaaS company specializing in customer relationship management and marketing solutions for the residential mortgage industry. The Company acquired the MortgageCEO business in order to add functionality to its product offerings. The transaction was accounted for as a business combination and, accordingly, the total purchase price was allocated to the assets acquired based on their respective fair values. The Company expensed all transaction costs, which were insignificant, in the period in which they were incurred. The total purchase consideration was $5.0 million in cash, of which $4.5 million was paid at the time of closing. The remaining $0.5 million (the “holdback funds”) was retained from the purchase consideration to cover working capital adjustments and any indemnity claims. The holdback amount was applied to an arbitration settlement reached with the founder of MortgageCEO resulting in a credit to general and administrative expenses in the consolidated statements of comprehensive income for the year ended December 31, 2015. MortgageCEO’s results of operations since the closing date of January 15, 2014 have been included in the Company’s consolidated statements of comprehensive income for the year ended December 31, 2014 and were not significant. If the acquisition had occurred as of January 1, 2014, the revenue and earnings of the combined entity for the current reporting period would have been approximately the same. As described in Note 6, the Company recorded a non-cash impairment charge of $0.3 million to customer relationships and $1.7 million to developed technology for the year ended December 31, 2014 and a non-cash impairment charge of $0.6 million to developed technology for the year ended December 31, 2015. NOTE 6-Balance Sheet Components Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets consisted of the following: ________________ (1) Certain reclassifications of prior period amounts have been made to conform to the current period presentation, such reclassification did not materially change previously reported consolidated financial statements. Property and Equipment Property and equipment, net, consisted of the following: ________________ (1) Includes computer equipment and software under capital leases Computer equipment and software under capital leases, net, consisted of the following: At December 31, 2016 and 2015, the Company had unamortized internal-use software costs of $77.2 million and $47.0 million, respectively. Amortization of internal-use software for the years ended December 31, 2016, 2015, and 2014 was $8.3 million, $2.4 million, and $0.7 million, respectively. Depreciation expense for the years ended December 31, 2016, 2015, and 2014 was $20.5 million, $10.8 million, and $5.6 million, respectively. Amortization of assets under capital leases, which is included in depreciation expense, was $3.2 million, $2.5 million, and $0.7 million for the years ended December 31, 2016, 2015, and 2014. During the year ended December 31, 2014, the Company recorded a $0.7 million impairment loss to general and administrative expenses on the write-off of internal-use software. There were no impairment loss for the years ended December 31, 2015 and 2016. Intangible Assets Intangible assets, net, consisted of the following: During the fourth quarter of 2014, the Company identified certain indicators of impairment for both the customer relationships and developed technology acquired in the MortgageCEO acquisition. Specifically, the Company determined it would need to make additional investments in the Encompass CRM product in order to attract new customers (which were not expected and therefore not contemplated in the valuation of customer relationships and developed technology in the purchase price allocation at the acquisition date), which resulted in a significant delay in the Company’s ability to release an integrated Encompass CRM product to its customers. As a result, the Company determined it was necessary to assess the recoverability of the customer relationships and developed technology associated with generating Encompass CRM cash flows. The Company used an income approach to determine if the sum of the undiscounted cash flows expected to result from the use and eventual disposition of each asset exceeded the carrying amount of that asset. As a result of this assessment, it was determined that the sum of undiscounted cash flows was less than the carrying amount for each of the two assets. In order to determine the amount of impairment to each asset, the Company performed an analysis to determine the fair value of each asset, which was determined using the present value of expected future cash flows which were based on estimates, assumptions and judgments. These include the forecast of future cash flows related to each asset, the discount rate used in discounting those cash flows, and the expected remaining useful life of each asset. This analysis resulted in a non-cash impairment charge of $0.3 million to customer relationships and a non-cash impairment charge of $1.7 million to developed technology, which were included in sales and marketing expenses and research and development expenses, respectively, in the consolidated statements of comprehensive income for the year ended December 31, 2014. In October 2015, the Company acquired Mortgage Returns. As a result of the acquisition, the Company discontinued the use of the acquired MortgageCEO technology and migrated substantially all of the existing customers to the Mortgage Returns CRM platform in 2016. The Company recorded a non-cash impairment charge of $0.6 million to developed technology, which were included in cost of revenues, in the consolidated statements of comprehensive income for the year ended December 31, 2015. Amortization expense associated with intangible assets was $5.5 million, $5.2 million, and $2.8 million for the years ended December 31, 2016, 2015, and 2014, respectively. Minimum future amortization expense for intangible assets at December 31, 2016 was as follows: Goodwill The Company completed its annual impairment tests during the fourth quarters of 2016, 2015, and 2014 and determined that goodwill was not impaired. There was no change to goodwill for the year ended December 31, 2016. The changes in the carrying value of goodwill during the year ended December 31, 2015 were as follows (in thousands): Accrued and Other Current Liabilities Accrued and other current liabilities consisted of the following: ________________ (1) Certain reclassifications of prior period amounts have been made to conform to the current period presentation, such reclassification did not materially change previously reported consolidated financial statements. Deferred Revenue Deferred revenues consisted of the following: Other Long-Term Liabilities Other long-term liabilities consisted of the following: ________________ (1) Certain reclassifications of prior period amounts have been made to conform to the current period presentation, such reclassification did not materially change previously reported consolidated financial statements. NOTE 7-Income Taxes The components of the provision for income taxes were as follows: The provision for income taxes differed from the amount of income taxes determined by applying the U.S. statutory federal income tax rate as follows: Excess tax benefits associated with stock option exercises and other equity awards were credited to stockholders’ equity. The income tax benefits resulting from stock awards that were credited to stockholders’ equity were $10.0 million, $11.4 million, and $5.9 million for the years ended December 31, 2016, 2015, and 2014. The components of net deferred tax assets (liabilities) were as follows: At December 31, 2016, the Company had recorded $5.6 million of net long-term deferred tax liabilities in other long-term liabilities on the consolidated balance sheet. At December 31, 2015, the Company had recorded $2.2 million of net long-term deferred tax assets in deposits and other assets on the consolidated balance sheet. The Company continues to maintain a valuation allowance against the deferred tax assets related to certain state research and development tax credits, the realization of which is uncertain as the Company expects to generate additional such credits at a faster rate than it is able to utilize them. The valuation allowance increased by $1.2 million, $1.0 million, $0.8 million in 2016, 2015 and 2014, respectively. As of December 31, 2016, the Company had federal net operating loss (“NOL”) carryforwards of $15.0 million, available to reduce future taxable income and $7.2 million of state NOL carryforwards. These federal and state NOL carryforwards will begin to expire commencing 2035 and 2017, respectively. As of December 31, 2016, the Company also had federal and state research and development tax credit carryforwards of $8.9 million and $6.2 million, respectively. If it were to be utilized, the related federal tax benefit of $8.9 million would be credited to additional paid-in capital. The federal tax credit carryforwards begin to expire commencing in 2035. The state tax credit carryforwards may be carried forward indefinitely. Internal Revenue Code Section 382 places a limitation (the “Section 382 Limitation”) on the amount of taxable income that can be offset by NOL carryforwards after a change in control (generally greater than 50% change in ownership) of a loss corporation. California has similar rules. The Company’s capitalization as described herein may have created such a change. Generally, after a control change, a loss corporation cannot deduct NOL carryforwards in excess of the Section 382 Limitation. Due to these “change in ownership” provisions, utilization of the NOL carryforwards may be subject to an annual limitation regarding their utilization against taxable income in future periods. The Company has prepared a Section 382 Limitation analysis and does not believe that any of its NOL carryforwards are subject to expiration prior to utilization. Limitations have been imposed on the Company’s acquired subsidiaries. At December 31, 2016, the Company had $4.6 million of cumulative unrecognized tax benefits. If the benefits were to be recognized, $2.4 million would affect the effective tax rate and $2.2 million would reverse the valuation allowance against the deferred tax assets. The Company does not expect a significant change to its unrecognized tax benefits over the next twelve months. The unrecognized tax benefits may increase or change during the year for items that arise in the ordinary course of business. A reconciliation of the beginning and ending balance of unrecognized tax benefits is as follows: The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. The Company’s tax years for 2007 and forward are subject to examination by the U.S. tax authorities and for 2000 and forward are subject to examination by the California tax authorities due to the carryforward of unutilized net operating losses and research and development credits. The Company believes that it has provided adequate reserves for its income tax uncertainties in all open tax years, and that it does not have any tax positions that it is reasonably possible would materially increase or decrease the gross unrecognized tax benefits within the next twelve months. The Company has a policy to classify accrued interest and penalties associated with uncertain tax positions together with the related liability, and the expenses incurred related to such accruals are included in the provision for income taxes. The Company did not incur any interest expense or penalties associated with unrecognized tax benefits during the years ended December 31, 2016, 2015, and 2014. The Company is currently under examination by the U.S. Internal Revenue Service for the 2013 tax year. At this time, the Company is not able to estimate the potential impact that the examination may have on income tax expense. If the examination is resolved unfavorably, it may have a negative impact on the Company’s results of operations. NOTE 8-Commitments and Contingencies Leases As of December 31, 2016, the Company leased eight facilities under operating lease arrangements. The lease expiration dates range from August 2017 to December 2025. Certain leases contain escalation clauses calling for increased rents. The Company recognizes rent expense on a straight-line basis over the lease period and has recorded deferred rent for the difference between rent payments and rent expense recognized. Rent expense was $5.4 million, $4.2 million, and $2.1 million for the years ended December 31, 2016, 2015, and 2014, respectively. Pursuant to the expiration of the Company’s Irvine office lease, in February 2016, the Company entered into a new lease agreement for approximately 4,600 square feet of office space in Irvine, California. The term of the lease commenced on June 1, 2016 with an initial term of 60 months, with payments ranging from $12,800 per month to $15,000 per month. In July 2016, the Company entered into an amendment to its existing office lease in Pleasanton, California to expand office space by four floors, approximately 143,500 square feet and extend the term of the lease of the existing premises by one year to December 31, 2025. The term of the lease for two of the four floors will commence on April 1, 2017 and for the remaining two floors, will commence on February 1, 2018. The term of the lease for the aggregate leased space ends on December 31, 2025 with payments ranging from approximately $201,600 per month to $527,300 per month during the lease period. Pursuant to the expiration of the Company’s Omaha office lease, in August 2016, the Company entered into a new lease agreement for approximately 20,100 square feet of office space in Omaha, Nebraska. The term of the lease commenced on February 28, 2017 with an initial term of 68 months, with payments ranging from $25,600 per month to $37,900 per month. Future minimum lease payments under non-cancelable operating and capital leases at December 31, 2016 consisted of the following: Purchase Commitments Commitments for the purchase of services, licenses of third-party software, and construction commitments totaled $11.4 million at December 31, 2016 and are to be paid as follows: $6.2 million in 2017, $4.8 million in 2018 and $0.4 million in 2019. Legal Proceedings From time to time, the Company is involved in litigation that it believes is of the type common to companies engaged in the Company’s line of business, including commercial and employment disputes. As of the date of this Annual Report on Form 10-K, the Company is not involved in any pending legal proceedings whose outcome the Company expects to have a material adverse effect on its financial position, results of operations or cash flows. However, litigation is unpredictable and excessive verdicts, both in the form of monetary damages and injunctions, could occur. In the future, litigation could result in substantial costs and diversion of resources and the Company could incur judgments or enter into settlements of claims that could have a material adverse effect on its business. NOTE 9-Stockholders' Equity Common Stock The amended and restated certificate of incorporation of the Company authorizes 140,000,000 shares of common stock, $0.0001 par value per share and 10,000,000 shares of undesignated preferred stock, $0.0001 par value per share. The following number of shares of common stock were reserved and available for future issuance at December 31, 2016: Stock Offering In August 2016, the Company completed a public offering of common stock and sold a total of 3,162,500 shares of its common stock for total cash proceeds of approximately $271.4 million, net of underwriting discounts, and offering costs and expenses of approximately $13.2 million. Stock Repurchase Program In May 2014, the board of directors approved a repurchase program authorizing to repurchase up to $75.0 million of the Company’s common stock over a 36-month period. As of December 31, 2016, $42.8 million remained available for future stock repurchases under this repurchase program. The Company repurchased the following shares of common stock under the repurchase program: For the year ended 2014, there were no shares repurchased under the repurchase program. NOTE 10-Equity and Stock Incentive Plans The Company recognized stock-based compensation expense related to awards granted under the 2009 Plan, the 2011 Plan, and ESPP. 2009 Stock Option and Incentive Plan and 2011 Equity Incentive Award Plan Stock Options In March 2011, the Company adopted the 2011 Plan, which was approved by the Company’s stockholders on March 24, 2011. Under the 2011 Plan, 2,666,666 shares of the Company’s common stock were initially reserved. Any shares of common stock that were available for issuance under prior plans, including the 2009 Plan, were transferred to the 2011 Plan. As of December 31, 2016, 987,657 shares of the Company’s common stock previously available for issuance under the 2009 Plan were available for issuance under the 2011 Plan. The majority of stock options issued under the plan have a maximum contractual term of ten years, the options generally vest over a four-year period. The number of common shares reserved for issuance under the 2011 Plan increase automatically in January of each year by the least of (a) 1,666,666 shares, (b) five percent (5%) of the shares of common stock outstanding on the last day of the immediately preceding fiscal year and (c) such smaller number of shares of common stock as determined by the Company’s board of directors; provided, however that no more than 23,333,333 shares of common stock may be issued upon the exercise of incentive stock options. The following table summarizes the Company’s stock option activity under the 2009 Plan and 2011 Plan: The aggregate intrinsic value of the stock options outstanding at December 31, 2016 based on the Company’s closing stock price of $83.68 is presented above. Intrinsic value of an option is the difference between the fair value of the Company’s common stock at the time of exercise and the exercise price to be paid. Options outstanding that are expected to vest are net of estimated future forfeitures. For the majority of stock options outstanding, the options vest over a four-year period and have a maximum contractual term of ten years. Following is additional information pertaining to the Company’s stock option activity: As of December 31, 2016, total unrecognized stock-based compensation expense related to unvested stock options, adjusted for estimated forfeitures, was $8.5 million and is expected to be recognized over a weighted average period of 1.72 years. Restricted Stock Units, Performance-Vesting Restricted Stock Units, and Performance Awards The fair value of the Company’s RSUs and Performance Awards is measured based upon the closing price of its underlying common stock as of the grant date and is recognized over the vesting term. Upon vesting, RSUs convert into an equivalent number of shares of common stock. Restricted shares vest in full after four years. The estimated fair value of restricted shares under the Company's stock plans is determined by the product of the number of shares granted and the grant date market price of the Company's common stock. The estimated fair value of restricted shares is expensed on a straight-line basis over the requisite service period. Performance Awards and performance-vesting RSUs are granted to certain executives under the 2011 Plan, which represent common stock potentially issuable in the future. Performance stock awards and units vest over a four-year period and the number of shares to be awarded is determined based on the achievement of specific performance goals. Based on the extent to which the targets are achieved at the end of the performance period, vested shares may range from 0 percent to 200 percent of the target award amount. The fair value of performance stock awards and units is determined by the grant date market price of the Company's common stock, and the compensation expense associated with nonvested performance stock awards and units is recognized over the requisite service period and is dependent on the Company's periodic assessment of the probability of the targets being achieved and its estimate of the number of shares that will ultimately be issued. During the fiscal years ended December 31, 2016, 2015 and 2014, the Company recognized $8.3 million, $7.4 million, and $4.5 million of compensation expense, respectively, related to these performance stock awards and units. In October 2015, in connection with the acquisition of Mortgage Returns, the Company agreed to grant up to 29,006 of performance-vesting RSUs for a total value of $2.0 million to the former Chief Executive Officer of Mortgage Returns. The performance-vesting RSUs granted represent the right to receive shares of the Company’s common stock upon achievement of certain performance criteria and a service requirement during the performance period of October 23, 2015 through October 23, 2019. The performance-vesting RSUs will vest annually based on the achievement of the performance criteria and the service requirement. In December 2016, a modification was made to a performance criteria of the award to align certain performance metrics to the Company’s targets. The modification resulted in an incremental value of approximately $0.2 million that will be recognized over the remaining requisite period; dependent on the Company’s periodic assessment of the probability of achievement. The following table summarizes the Company’s RSU, Performance Award and performance-vesting RSU activity: RSUs, performance-vesting RSUs and Performance Awards that are expected to vest are presented net of estimated future forfeitures. RSUs released during the years ended December 31, 2016 and 2015 had an aggregate intrinsic value of $20.1 million and $11.1 million, respectively, and an aggregate grant-date fair value of $10.2 million and $4.7 million, respectively. Performance-vesting RSUs and Performance Awards released during the years ended December 31, 2016 and 2015 had an aggregate intrinsic value of $21.8 million and $13.2 million, respectively, and an aggregate grant-date fair value of $7.0 million and $4.5 million, respectively. The number of RSUs released includes shares that the Company withheld on behalf of employees to satisfy the minimum statutory tax withholding requirements. As of December 31, 2016, total unrecognized compensation expense related to unvested RSUs, performance-vesting RSUs and Performance Awards was $54.4 million and is expected to be recognized over a weighted average period of 2.4 years. Executive Incentive Plan On March 14, 2016, the Compensation Committee adopted the Ellie Mae, Inc. Executive Incentive Plan (the “Executive Incentive Plan”). The Executive Incentive Plan was approved by the Company’s stockholders on May 25, 2016. The Executive Incentive Plan has a term of five years from the date of approval by the stockholders, expiring May 25, 2021, and may be terminated, amended or suspended by the Compensation Committee at any prior time, and may also be reinstated. The Company currently expects to issue cash bonus and performance-based equity awards under the Executive Incentive Plan to the Company’s executive officers commencing in 2017. Shares underlying equity awards from the Executive Incentive Plan will be issued from the Company’s 2011 Plan. The equity awards have the following limitations: Stock Option Limitations. The maximum number of shares that may be granted as an incentive stock option under the Executive Incentive Plan is 70,000,000. No participant will be eligible to receive a stock option covering more than 1,000,000 shares in any calendar year. Performance Units/Performance Share Limitations. No participant will be eligible to receive performance units or performance shares having a grant date value (assuming maximum payout) greater than $10,000,000 or covering more than 1,000,000 shares, whichever is greater, in any calendar year. There have been no shares issued under this plan as of December 31, 2016. Employee Stock Purchase Plan Under the ESPP, qualified employees are permitted to purchase the Company’s common stock at 85% of the fair market value of the common stock as of the commencement date of the offering period or as of the specified purchase date, whichever is lower. The ESPP is deemed compensatory and stock-based compensation is recognized in accordance with ASC 718, Stock Compensation. The ESPP is designed to allow eligible employees and the eligible employees of the Company’s participating subsidiaries to purchase shares of common stock, at semi-annual intervals, with their accumulated payroll deductions. The weighted-average grant-date fair value of awards issued pursuant to the ESPP during the years ended December 31, 2016, 2015, and 2014 were $24.11, $16.12, and $8.38 per share, respectively. For the years ended December 31, 2016, 2015 and 2014, employees purchased 101,816, 110,598, and 102,111 shares under the ESPP for a total of $6.7 million, $4.1 million, and $2.6 million, respectively. As of December 31, 2016, unrecognized compensation cost related to the current ESPP period which ends on February 27, 2017 was approximately $0.4 million and is expected to be recognized over the next 2 months. Stock-Based Compensation Expense Total stock-based compensation expense recognized by the Company consisted of: The Company capitalized $2.8 million, $1.1 million, and $0.5 million of stock compensation costs as software and website application development costs for the years ended December 31, 2016, 2015, and 2014, respectively. Valuation Information The fair value of stock options and stock purchase rights granted under the 2009 Plan, the 2011 Plan and the ESPP were estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions: Due to the Company’s limited trading history as a publicly held company, the simplified method was used to estimate the expected term of options granted by taking the average of the vesting term and the contractual term of the option. To estimate volatility, management identified a group of publicly traded peer companies that operate in a similar industry. An estimate was determined based on a weighted average of the historical volatilities of these peer companies and the Company’s common stock during the period of time since the Company’s initial public offering. The risk-free interest rate used was the Federal Reserve Bank’s constant maturities interest rate commensurate with the expected life of the options. The expected dividend yield was zero, as the Company does not anticipate paying a dividend within the relevant time frame. NOTE 11-Employee Benefit Plan The Company offers a qualified 401(k) defined contribution plan to substantially all of the Company’s employees. Eligible employees may contribute up to the annual amount allowed pursuant to the Internal Revenue Code. In the years ended December 31, 2016, 2015, and 2014, the Company matched 50% of each dollar of employee contribution, up to a maximum match of three percent of the employee’s compensation. The Company’s contributions to the 401(k) plan for the years ended December 31, 2016, 2015, and 2014 were $2.8 million, $2.0 million, and $1.3 million, respectively, which were recognized as expense in the consolidated statements of comprehensive income. NOTE 12-Segment Information The Company operates in one industry-mortgage-related software and services. The Company’s chief operating decision maker is its chief executive officer, who makes decisions about resource allocation and reviews financial information presented on a consolidated basis. Accordingly, the Company has determined that it has a single reporting segment and operating unit structure, specifically technology-enabled solutions to help streamline and automate the residential mortgage origination process for its network participants. The Company is organized primarily on the basis of service lines. Supplemental disclosure of revenues by type is as follows: ________________ (1) Certain reclassifications of prior period amounts have been made to conform to the current period presentation, such reclassification did not materially change previously reported consolidated financial statements. NOTE 13-Quarterly Results of Operations Data (Unaudited) SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 and 2014 (in thousands)
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From the provided financial statement excerpts, here's a summary of the key points:
1. Profit/Loss Management:
- Losses are recorded in stockholders' equity as accumulated other comprehensive income/loss
- Realized gains/losses are included in other income/expense
- Interest and dividends are recorded as other income when earned
2. Accounts Receivable Management:
- Based on billed customer services
- Evaluated using factors like:
* Historical bad debts
* Customer creditworthiness
* Current economic trends
* Payment terms
* Collection trends
3. Risk Management:
- Main credit risk sources:
* Cash and cash equivalents
* Investments
* Accounts receivable
- Cash deposits are with major US financial institutions
- May exceed federally insured limits
- Accounts receivable from US-based customers
- No single customer represents more than 10% of business
4. Financial Practices:
- Highly liquid investments with 90-day maturities are considered
- Regular evaluation of estimates for:
* Revenue recognition
* Doubtful accounts
* Goodwill
* Intangible assets
* Deferred income taxes
* Stock-based compensation
* Unrecognized tax benefits
The statement suggests a conservative financial management approach with established procedures for handling accounts and risk management.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statement Page Management’s Report Reports of Independent Registered Public Accounting Firm Consolidated Financial Statements: Consolidated Statements of Income Consolidated Statements of Comprehensive Income Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Shareholders’ Equity 33 POLYONE CORPORATION MANAGEMENT’S REPORT The management of PolyOne Corporation is responsible for preparing the consolidated financial statements and disclosures included in this Annual Report on Form 10-K. The consolidated financial statements and disclosures included in this Annual Report fairly present in all material respects the consolidated financial position, results of operations, shareholders’ equity and cash flows of PolyOne Corporation as of and for the year ended December 31, 2016. Management is responsible for establishing and maintaining disclosure controls and procedures designed to ensure that the information required to be disclosed by the Company is captured and reported in a timely manner. Management has evaluated the design and operation of the Company’s disclosure controls and procedures at December 31, 2016 and found them to be effective. Management is also responsible for establishing and maintaining a system of internal control over financial reporting that is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that provide reasonable assurance that: PolyOne Corporation’s accounting records accurately and fairly reflect the transactions and dispositions of the assets of the Company; unauthorized or improper acquisition, use or disposal of Company assets will be prevented or timely detected; the Company’s transactions are properly recorded and reported to permit the preparation of the Company’s consolidated financial statements in conformity with generally accepted accounting principles; and the Company’s receipts and expenditures are made only in accordance with authorizations of management and the Board of Directors of the Company. Management has assessed the effectiveness of PolyOne’s internal control over financial reporting as of December 31, 2016 and has prepared Management’s Annual Report On Internal Control Over Financial Reporting contained on page 66 of this Annual Report, which concludes that as of December 31, 2016, PolyOne’s internal control over financial reporting is effective and that no material weaknesses were identified. /s/ ROBERT M. PATTERSON /s/ BRADLEY C. RICHARDSON Robert M. Patterson Bradley C. Richardson Chairman, President and Chief Executive Officer Executive Vice President, Chief Financial Officer February 16, 2017 34 POLYONE CORPORATION ACCOUNTING FIRM The Board of Directors and Shareholders of PolyOne Corporation We have audited PolyOne Corporation’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). PolyOne Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying “Management’s Annual Report on Internal Control over Financial Reporting”. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, PolyOne Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of PolyOne Corporation as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2016 and our report dated February 16, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Cleveland, Ohio February 16, 2017 35 POLYONE CORPORATION ACCOUNTING FIRM The Board of Directors and Shareholders of PolyOne Corporation We have audited the accompanying consolidated balance sheets of PolyOne Corporation as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of PolyOne Corporation at December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), PolyOne Corporation’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 16, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Cleveland, Ohio February 16, 2017 36 POLYONE CORPORATION Consolidated Statements of Income The accompanying notes to the consolidated financial statements are an integral part of these statements. 37 POLYONE CORPORATION Consolidated Statements of Comprehensive Income The accompanying notes to the consolidated financial statements are an integral part of these statements. 38 POLYONE CORPORATION Consolidated Balance Sheets The accompanying notes to the consolidated financial statements are an integral part of these statements. 39 POLYONE CORPORATION Consolidated Statements of Cash Flows The accompanying notes to the consolidated financial statements are an integral part of these statements. 40 POLYONE CORPORATION Consolidated Statements of Shareholders' Equity The accompanying notes to the consolidated financial statements are an integral part of these statements. 41 POLYONE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business We are a premier provider of specialized polymer materials, services and solutions with operations in specialty engineered materials, color and additive systems, plastic sheet and packaging solutions, and polymer distribution. We are also a highly specialized developer and manufacturer of performance enhancing additives, liquid colorants, and fluoropolymer and silicone colorants. Headquartered in Avon Lake, Ohio, we have employees at manufacturing sites and distribution facilities in North America, South America, Europe, Asia and Africa. We provide value to our customers through our ability to link our knowledge of polymers and formulation technology with our manufacturing and supply chain to provide value added solutions to designers, assemblers and processors of plastics (our customers). When used in these notes to the consolidated financial statements, the terms “we,” “us,” “our”, "PolyOne" and the “Company” mean PolyOne Corporation and its consolidated subsidiaries. Our operations are located primarily in North America, South America, Europe and Asia. Our operations are reported in five reportable segments: Color, Additives and Inks; Specialty Engineered Materials; Designed Structures and Solutions; Performance Products and Solutions; and PolyOne Distribution. See Note 14, Segment Information, for more information. Accounting Standards Adopted In May 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2015-07, Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent) (ASU 2015-07). ASU 2015-07 amended Accounting Standards Codification (ASC) 820, Fair Value Measurements, and removed the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value (NAV) per share. The amendment also limits certain disclosures for investments for which the entity has elected to measure at fair value using the NAV per share. We adopted this standard as of December 31, 2016 and reflected the required retrospective application to the disclosures in Note 10, Employee Benefit Plans. Accounting Standards Not Yet Adopted In May 2014, the FASB issued Auditing Standards Update 2014-09, Revenue from Contracts with Customers (ASU 2014-09). Under this standard, a company recognizes revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The standard implements a five-step process for customer contract revenue recognition that focuses on transfer of control. We are analyzing the impact of the standard on our contract portfolio and reviewing our current accounting policies and practices to identify potential differences that would result from applying the requirements of the new standard. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The implementation team is currently assessing the adoption method and impact that ASU 2014-09, along with the subsequent updates and clarifications, will have on our Consolidated Financial Statements. The Company will adopt ASU 2014-09 no later than the required date of January 1, 2018. In July 2015, the FASB issued Accounting Standards Update 2015-11, Inventory (Topic 300): Simplifying the Measurement of Inventory (ASU 2015-11), which applies to inventory measured using first-in, first out (FIFO) or average cost. This update requires that an entity should measure inventory that is within scope at the lower of cost and net realizable value, which is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. This update is effective for annual and interim periods beginning after December 15, 2016, and should be applied prospectively with early adoption permitted at the beginning of an interim or annual reporting period. The Company will adopt ASU 2015-11 no later than the required date of January 1, 2017. We do not expect this standard to have a material impact on our Consolidated Financial Statements. In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842) (ASU 2016-02), which requires a lessee to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases with a lease term of more than twelve months. Leases will continue to be classified as either financing or operating, with classification affecting the recognition, measurement and presentation of expenses and cash flows arising from a lease. The Company will adopt ASU 2016-02 no later than the required date of January 1, 2019. We are currently assessing the impact this standard will have on our Consolidated Financial Statements. 42 POLYONE CORPORATION In March 2016, the FASB issued Accounting Standards Update 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09), which simplifies the accounting for share-based payment transactions. This update requires that excess tax benefits and tax deficiencies be recognized as income tax expense or benefit in the Consolidated Statements of Income rather than additional paid-in capital. Additionally, the excess tax benefits will be classified along with other income tax cash flows as an operating activity, rather than a financing activity, on the Statement of Cash Flows. Further, the update allows an entity to make a policy election to recognize forfeitures as they occur or estimate the number of awards expected to be forfeited. ASU 2016-09 is effective for annual and interim periods beginning after December 15, 2016, and should be applied prospectively, with certain cumulative effect adjustments. The Company will adopt ASU 2016-09 no later than the required date of January 1, 2017. Upon adoption, we will assess the impact of any share price movement on the income tax expense or benefit recognized, but we do not expect this standard to have a material impact on our Consolidated Financial Statements. In June 2016, the FASB issued Accounting Standards Update 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13), which requires the allowance recorded for trade receivables to be measured by expected loss rather than incurred loss. Expected loss measurement will be based on historical experience, current conditions and reasonable and supportable forecasts. The Company will adopt ASU 2016-13 no later than the required date of January 1, 2020. We do not expect this standard to have a material impact on our Consolidated Financial Statements. In October 2016, the FASB issued Accounting Standards Update 2016-16, Income Taxes (Topic 740), Intra-Entity Transfers of Assets Other Than Inventory (ASU 2016-16), which requires companies to recognize the income tax effects of intercompany sales or transfers of assets, other than inventory, in the income statement as income tax expense (or benefit) in the period the sale or transfer occurs. There would be no material impact on our Consolidated Financial Statements from intercompany transactions completed as of December 31, 2016. We will continue to assess the impact of ASU 2016-16 on future transactions and the Company will adopt ASU 2016-16 no later than the required date of January 1, 2018. In January 2017, the FASB issued Auditing Standards Update 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Accounting for Goodwill Impairment. This standard removes the second step of the goodwill impairment test, where a determination of the fair value of individual assets and liabilities of a reporting unit were needed to measure the goodwill impairment. Under this updated standard, goodwill impairment will now be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. We will adopt this update for any impairment test performed after January 1, 2017 as permitted under the standard. Consolidation and Basis of Presentation The consolidated financial statements include the accounts of PolyOne and its subsidiaries. All majority-owned affiliates over which we have control are consolidated. Transactions with related parties, including joint ventures, are in the ordinary course of business. Reclassifications Certain reclassifications of the prior period amounts and presentation have been made to conform to the presentation for the current period. Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying consolidated financial statements and notes. Actual results could differ from these estimates. Cash and Cash Equivalents We consider all highly liquid investments purchased with a maturity of less than three months to be cash equivalents. Cash equivalents are stated at cost, which approximates fair value. Allowance for Doubtful Accounts We evaluate the collectability of receivables based on a combination of factors. We regularly analyze significant customer accounts and, when we become aware of a specific customer’s inability to meet its financial obligations to us, such as in the case of a bankruptcy filing or deterioration in the customer’s operating results or financial position, we record a specific allowance for bad debt to reduce the related receivable to the amount we reasonably believe is collectible. We also record bad debt allowances for all other customers based on a variety of factors 43 POLYONE CORPORATION including the length of time the receivables are past due, the financial health of the customer, economic conditions and historical experience. In estimating the allowances, we take into consideration the existence of credit insurance. If circumstances related to specific customers change, our estimates of the recoverability of receivables could be adjusted further. Accounts receivable balances are written off against the allowance for doubtful accounts after a final determination of uncollectability has been made. The allowance for doubtful accounts was $2.6 million and $3.0 million as of December 31, 2016 and 2015, respectively. Inventories External purchases of raw materials and finished goods are valued at weighted average cost. Manufactured finished goods are stated at the lower of cost or market using the first-in, first-out (FIFO) method. Long-lived Assets Property, plant and equipment is carried at cost, net of depreciation and amortization that is computed using the straight-line method over the estimated useful lives of the assets, which generally ranges from three to 15 years for machinery and equipment and up to 40 years for buildings. During 2016, 2015 and 2014, we depreciated certain assets associated with closing manufacturing locations over a shortened life (through a cease-use date). Software is amortized over periods not exceeding 10 years. Property, plant and equipment is generally depreciated on accelerated methods for income tax purposes. We expense repair and maintenance costs as incurred. We capitalize replacements and betterments that increase the estimated useful life of an asset. We retain fully depreciated assets in property and accumulated depreciation accounts until we remove them from service. In the case of sale, retirement or disposal, the asset cost and related accumulated depreciation balance is removed from the respective account, and the resulting net amount, less any proceeds, is included as a component of income from continuing operations in the accompanying Consolidated Statements of Income. We account for operating and capital leases under the provisions of FASB Accounting Standards Codification (ASC) Topic 840, Leases. Finite-lived intangible assets, which consist primarily of customer relationships, patents and technology are amortized over their estimated useful lives. The remaining useful lives range up to 20 years. We assess the recoverability of long-lived assets when events or changes in circumstances indicate that we may not be able to recover the assets’ carrying amount. We measure the recoverability of assets to be held and used by a comparison of the carrying amount of the asset to the expected future undiscounted cash flows associated with the asset. We measure the amount of impairment of long-lived assets as the amount by which the carrying value of the asset exceeds the fair value of the asset, which is generally determined based on projected discounted future cash flows or appraised values. No such impairments were recognized during 2016, 2015 or 2014. Goodwill and Indefinite Lived Intangible Assets Goodwill is the excess of the purchase price paid over the fair value of the net assets of the acquired business. Goodwill is tested for impairment at the reporting unit level. Our reporting units have been identified at the operating segment level, or in most cases, one level below the operating segment level. Goodwill is allocated to the reporting units based on the estimated fair value at the date of acquisition. Our annual measurement date for testing impairment of goodwill and indefinite-lived intangibles is October 1. We completed our testing of impairment as of October 1, noting no impairment in 2016, 2015 or 2014. Additionally, as noted within our "Critical Accounting Policies and Estimates" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations", our Customer Engineered Services reporting unit, which is included in our Designed Structures and Solutions segment, is at-risk of future impairment. The future occurrence of a potential indicator of impairment would require an interim assessment for some or all of the reporting units prior to the next required annual assessment on October 1, 2017. Refer to Note 16, Fair Value, for further discussion of our approach for assessing the fair value of goodwill. Litigation Reserves FASB ASC Topic 450, Contingencies, requires that we accrue for loss contingencies associated with outstanding litigation, claims and assessments for which management has determined it is probable that a loss contingency exists and the amount of loss can be reasonably estimated. We recognize expense associated with professional fees related to litigation claims and assessments as incurred. Refer to Note 11, Commitments and Contingencies, for further information. 44 POLYONE CORPORATION Derivative Financial Instruments FASB ASC Topic 815, Derivative and Hedging, requires that all derivative financial instruments, such as foreign exchange contracts, be recognized in the financial statements and measured at fair value, regardless of the purpose or intent in holding them. We are exposed to foreign currency changes in the normal course of business. We have established policies and procedures that manage this exposure through the use of financial instruments. By policy, we do not enter into these instruments for trading purposes or speculation. These instruments are not designated as hedges and, as a result, are adjusted to fair value, with the resulting gains and losses recognized in the accompanying Consolidated Statements of Income immediately. Pension and Other Post-retirement Plans We account for our pensions and other post-retirement benefits in accordance with FASB ASC Topic 715, Compensation - Retirement Benefits. We immediately recognize actuarial gains and losses in our operating results in the year in which the gains or losses occur. Refer to Note 10, Employee Benefit Plans, for more information. Accumulated Other Comprehensive Loss Changes in accumulated other comprehensive loss in 2016, 2015 and 2014 were as follows: Fair Value of Financial Instruments FASB ASC Topic 820, Fair Value Measurements and Disclosures, requires disclosures of the fair value of financial instruments. The estimated fair values of financial instruments were principally based on market prices where such prices were available and, where unavailable, fair values were estimated based on market prices of similar instruments. See Note 16, Fair Value, for further discussion. Foreign Currency Translation Revenues and expenses are translated at average currency exchange rates during the related period. Assets and liabilities of foreign subsidiaries are translated using the exchange rate at the end of the period. The resulting translation adjustments are recorded as accumulated other comprehensive income or loss. Gains and losses resulting from foreign currency transactions, including intercompany transactions that are not considered permanent investments, are included in Other income (expense), net in the accompanying Consolidated Statements of Income. Revenue Recognition We recognize revenue when the revenue is realized or realizable and has been earned. We recognize revenue when a firm sales agreement is in place, shipment has occurred and collectability is reasonably assured. Shipping and Handling Costs Shipping and handling costs are included in cost of sales. 45 POLYONE CORPORATION Research and Development Expense Research and development costs of $54.5 million in 2016, $53.0 million in 2015 and $53.4 million in 2014, are charged to expense as incurred. Environmental Costs We expense costs that are associated with managing hazardous substances and pollution in ongoing operations on a current basis. Costs associated with environmental contamination are accrued when it becomes probable that a liability has been incurred and our proportionate share of the cost can be reasonably estimated. Any such provision is recognized using the Company's best estimate of the amount of loss incurred, or at the lower end of an estimated range, when a single best estimate is not determinable. In some cases, the Company may be able to recover a portion of the costs relating to these obligations from insurers or other third parties; however, the Company records such amounts only when it is probable that they will be collected. Share-Based Compensation We account for share-based compensation under the provisions of FASB ASC Topic 718, Compensation - Stock Compensation, which requires us to estimate the fair value of share-based awards on the date of grant. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the accompanying Consolidated Statements of Income. As of December 31, 2016, we had one active share-based employee compensation plan, which is described more fully in Note 13, Share-Based Compensation. Income Taxes Deferred income tax liabilities and assets are determined based upon the differences between the financial reporting and tax basis of assets and liabilities and are measured using the tax rate and laws currently in effect. In accordance with FASB ASC Topic 740, Income Taxes, we evaluate our deferred income taxes to determine whether a valuation allowance should be established against the deferred tax assets or whether the valuation allowance should be reduced based on consideration of all available evidence, both positive and negative, using a “more likely than not” standard. Note 2 - BUSINESS COMBINATIONS 2016 Significant Acquisitions On January 29, 2016, the Company completed the acquisition of certain technologies and assets from Kraton Performance Polymers, Inc. (Kraton), to expand its global footprint and expertise in thermoplastic elastomer (TPE) innovation and design, for approximately $72.8 million. The results of operations of Kraton are included in the Company's Consolidated Statements of Income for the period subsequent to the date of the acquisition and are reported in the Specialty Engineered Materials segment. The purchase price allocation for Kraton is final. On July 26, 2016, the Company completed the acquisition of substantially all of the assets of Gordon Composites, Inc. (Gordon Composites), Polystrand, Inc. (Polystrand) and Gordon Holdings, Inc. (Gordon Holdings). Gordon Composites develops high strength profiles and laminates for use in vertical and crossbow archery, sports and recreation equipment, prosthetics and office furniture systems. Polystrand operates in the advanced area of continuous reinforced thermoplastic composite technology space, a next generation material science that delivers the high strength and lightweight characteristics of composites, further enhanced with the design flexibility to form more complex shapes. The purchase price was $85.5 million and the results of operations of the acquired businesses are included in the Company's Consolidated Statements of Income for the period subsequent to the date of the acquisition and are reported in the Specialty Engineered Materials segment. The preliminary purchase price allocation is subject to change and not yet finalized. The purchase price allocation for the acquisitions of Gordon Composites, Polystrand and Kraton resulted in goodwill of $74.9 million, $41.3 million in intangible assets, $31.7 million in property, plant and equipment, $27.8 million in inventory and $17.4 million of capital lease obligations. Goodwill, intangible assets and property, plant and equipment recognized as a result of these acquisitions are deductible for tax purposes. Sales and operating income for Gordon Composites, Polystrand and Kraton recognized in the results of operations, subsequent to the acquisition date, were $48.7 million and $4.8 million, respectively, for the year ended December 31, 2016. 46 POLYONE CORPORATION The fair value of the intangible assets acquired during the year ended December 31, 2016, including their estimated useful lives and valuation methodology are as follows: Note 3 - GOODWILL AND INTANGIBLE ASSETS The total purchase price associated with acquisitions is allocated to the fair value of assets acquired and liabilities assumed based on their fair values at the acquisition date, with excess amounts recorded as goodwill. Goodwill as of December 31, 2016 and 2015, and changes in the carrying amount of goodwill by segment were as follows: At December 31, 2016, PolyOne had $100.3 million of indefinite-lived intangible assets that are not subject to amortization, consisting of a trade name of $33.2 million acquired as part of the acquisition of GLS Corporation (GLS), trade names of $63.1 million acquired as part of the acquisition of ColorMatrix Group, Inc. (ColorMatrix) and a trade name of $4.0 million acquired as part of the acquisition of Gordon Composites. Indefinite and finite-lived intangible assets consisted of the following: Amortization of finite-lived intangible assets for the years ended December 31, 2016, 2015 and 2014 was $22.0 million, $19.9 million and $19.2 million, respectively. We expect finite-lived intangibles amortization expense for the next five years as follows: 47 POLYONE CORPORATION Note 4 - EMPLOYEE SEPARATION AND RESTRUCTURING COSTS Employee separation and restructuring charges recognized in 2016, 2015 and 2014 were as follows: These charges are primarily associated with the current Designed Structures and Solutions (DSS) segment and the former Spartech Corporation (Spartech) businesses, which are further detailed below. In the second half of 2015, PolyOne determined it would close two manufacturing facilities within the DSS segment and take other corporate actions to reduce administrative costs. These actions were taken as a result of Designed Structures and Solutions' declining results and near term outlook. During the years ended December 31, 2016 and 2015, we recognized charges of $10.0 million and $17.1 million, respectively. Total costs for these actions to-date has been $27.1 million, which includes $8.0 million of severance costs, $13.5 million of asset-related charges, including accelerated depreciation of $9.3 million, and $5.6 million of other ongoing costs associated with exiting these plants and transferring equipment. Of the total charges, approximately $13.6 million were cash costs. These actions are substantially complete as of December 31, 2016. In addition to the actions noted above, we recognized $9.0 million of charges during 2016, primarily related to restructuring actions taken at other North American locations. In June 2014, PolyOne determined it would close its Diadema and Joinville, Brazil facilities that were acquired in 2011 with the acquisition of Uniplen Industria de Polimeros Ltda. These actions were taken to streamline operations and improve our financial performance in Brazil. We recognized $1.3 million and $17.0 million related to these actions in 2015 and 2014, respectively. Total costs of $18.3 million in connection with these actions include $11.2 million of asset-related charges, including accelerated depreciation, $2.7 million of severance and $4.4 million of other associated costs. Of the total charges, approximately $7.0 million were cash costs. During 2014, in addition to the actions noted above, we recognized $17.4 million of employee separation and restructuring costs primarily in Europe related to the closure of our Bendorf, Germany manufacturing plant along with other reductions in force across Europe. In 2013, PolyOne determined it would close seven former Spartech manufacturing facilities and one administrative office and relocate operations to other PolyOne facilities. The closure of these manufacturing facilities was part of the Company’s efforts to improve service, on time delivery and quality as we align assets with our customers' needs. In addition to these actions, PolyOne incurred severance costs related to former Spartech executives and other employees, as well as fixed asset-related charges and other ongoing costs associated with restructuring actions that were underway prior to PolyOne's acquisition of Spartech. From the date of the Spartech acquisition to December 31, 2015, the Company incurred $123.4 million of charges in connection with the 2013 Spartech actions. Costs include $47.2 million of asset-related charges, including accelerated depreciation and asset write-offs, and total cash charges of $76.2 million, including $25.9 million for severance and $50.3 million of other associated costs. Of the total cash charges, approximately $64.0 million relates to manufacturing realignment actions initiated by PolyOne. We recognized $19.6 million and $59.7 million related to these actions and incurred $15.9 million and $44.8 million of cash payments during the years ended December 31, 2015 and 2014, respectively. There were no charges related to the Spartech actions during the year ended December 31, 2016 as these actions were complete as of December 31, 2015. 48 POLYONE CORPORATION Note 5 - FINANCING ARRANGEMENTS Total debt consisted of the following: (1) Other debt includes capital lease obligations of $17.8 million and $0.4 million as of December 31, 2016 and 2015, respectively. On November 12, 2015, PolyOne entered into a senior secured term loan having an aggregate principal amount of $550.0 million. On June 15, 2016, the Company entered into an amendment to its senior secured term loan. Under the terms of the amended senior secured term loan, the margin was reduced by 25 basis points to 275 basis points. At the Company's discretion, interest is based upon (i) a margin rate of 275 basis points plus the 1-, 2-, 3-, or 6-month LIBOR, subject to a floor of 75 basis points or (ii) a margin rate of 175 basis points plus a Prime rate, subject to a floor of 175 basis points. In connection with the amendment, the Company recognized $0.4 million of Debt extinguishment costs in our Consolidated Statements of Income. On August 3, 2016, the Company increased the senior secured term loan due 2022 by $100.0 million in connection with the acquisition of substantially all of the assets of Gordon Composites, Polystrand and Gordon Holdings. Repayments in the amount of one percent of the aggregate principal amount as of August 3, 2016 are payable annually, while the remaining balance matures on November 12, 2022. The total aggregate principal repayments as of December 31, 2016 was $6.0 million. The weighted average annual interest rate for the senior secured term loan for the years ended December 31, 2016 and 2015 was 3.61% and 3.75%, respectively. PolyOne has outstanding $600.0 million aggregate principal amount of senior notes, which mature on March 15, 2023. The senior notes bear an interest rate of 5.25% per year, payable semi-annually, in arrears, on March 15 and September 15 of each year. The Company maintains a senior secured revolving credit facility, which matures on March 1, 2018, which provides a maximum borrowing facility size of $400.0 million, subject to a borrowing base with advances against certain U.S. and Canadian accounts receivable, inventory and other assets as specified in the agreement. We have the option to increase the availability under the facility to $450.0 million, subject to meeting certain requirements and obtaining commitments for such increase. The revolving credit facility has a U.S. and a Canadian line of credit. Currently there are no borrowings on the U.S. or Canadian portion of the facility. Advances under the U.S. portion of our revolving credit facility bear interest, at the Company’s option, at a Base Rate or a LIBOR Rate plus an applicable margin. The Base Rate is a fluctuating rate equal to the greater of (i) the Federal Funds Rate plus one-half percent, (ii) the prevailing LIBOR Rate plus one percent, and (iii) the prevailing Prime Rate. The applicable margins vary based on the Company’s daily average excess availability during the previous quarter. The weighted average annual interest rate under this facility for the year ended December 31, 2016 and 2015 were 3.15% and 2.46%, respectively. As of December 31, 2016 and 2015, we had no borrowings under our revolving credit facility, which had availability of $382.7 million and $338.7 million, respectively. The agreements governing our revolving credit facility and our senior secured term loan, and the indentures and credit agreements governing other debt, contain a number of customary financial and restrictive covenants that, among other things, limit our ability to: consummate asset sales, incur additional debt or liens, consolidate or merge with any entity or transfer or sell all or substantially all of our assets, pay dividends or make certain other restricted payments, make 49 POLYONE CORPORATION investments, enter into transactions with affiliates, create dividend or other payment restrictions with respect to subsidiaries, make capital investments and alter the business we conduct. As of December 31, 2016, we were in compliance with all covenants. The Company also has a credit line of $16.0 million with Saudi Hollandi Bank. The credit line has an interest rate equal to the Saudi Arabia Interbank Offered Rate plus a fixed rate of 0.85% and is subject to annual renewal. Borrowings under the credit line were primarily used to fund capital expenditures related to the manufacturing facility in Jeddah, Saudi Arabia. As of December 31, 2016, letters of credit under the credit line were $0.2 million and borrowings were $12.3 million with an interest rate of 2.84%. As of December 31, 2015, letters of credit under the credit line were $0.2 million and borrowings were $12.6 million with an interest rate of 1.78%. As of December 31, 2016 and 2015, there was remaining availability on the credit line of $3.5 million and $3.2 million, respectively. Aggregate maturities of the principal amount of debt for the next five years and thereafter are as follows: Included in Interest expense, net for the years ended December 31, 2016, 2015 and 2014 was interest income of $0.8 million, $1.0 million and $1.1 million, respectively. Total interest paid on debt was $56.3 million in 2016, $65.9 million in 2015 and $59.8 million in 2014. Note 6 - LEASING ARRANGEMENTS We lease certain manufacturing facilities, warehouse space, machinery and equipment, automobiles, railcars, computers and software under operating leases. Rent expense from continuing operations was $27.0 million in 2016, $27.1 million in 2015 and $30.4 million in 2014. Future minimum lease payments under non-cancelable operating leases with initial lease terms longer than one year as of December 31, 2016 are as follows: Note 7 - INVENTORIES, NET Components of Inventories, net are as follows: 50 POLYONE CORPORATION Note 8 - PROPERTY, NET Components of Property, net are as follows: (1) Land and land improvements include properties under capital leases of $1.8 million as of December 31, 2016. As of December 31, 2015, the value of the land and land improvements associated with properties under capital leases was less than $0.1 million. (2) Buildings include properties under capital leases of $16.9 million and $0.5 million as of December 31, 2016 and 2015, respectively. Depreciation expense from continuing operations was $82.0 million in 2016, $84.4 million in 2015 and $104.7 million in 2014. Included in depreciation expense from continuing operations was accelerated depreciation of $3.5 million, $6.2 million and $23.1 million during 2016, 2015 and 2014, respectively, related to restructuring actions. Note 9 - OTHER BALANCE SHEET LIABILITIES Other liabilities at December 31, 2016 and 2015 consist of the following: Note 10 - EMPLOYEE BENEFIT PLANS We recognize actuarial gains and losses in our operating results in the year in which the gains or losses occur. These gains and losses are generally only measured annually as of December 31 and, accordingly, are recorded during the fourth quarter of each year. We recognized a benefit of $8.4 million in the fourth quarter of 2016 related to the actuarial gain during the year. We recognized a charge of $11.6 million and $56.5 million in the fourth quarter of 2015 and 2014, respectively, related to the actuarial losses during the year. All U.S. qualified defined benefit pension plans are frozen, no longer accrue benefits and are closed to new participants. We have foreign pension plans that accrue benefits. The plans generally provide benefit payments using a formula that is based upon employee compensation and length of service. 51 POLYONE CORPORATION The following tables present the change in benefit obligation, change in plan assets and components of funded status for defined benefit pension and post-retirement health care benefit plans. Amounts included in the accompanying Consolidated Balance Sheets as of December 31 are as follows: As of December 31, 2016 and 2015, we had plans with total projected and accumulated benefit obligations in excess of the related plan assets as follows: Weighted-average assumptions used to determine benefit obligations at December 31: 52 POLYONE CORPORATION The following table summarizes the components of net periodic benefit cost or gain that was recognized during each of the years in the three-year period ended December 31, 2016. In 2016, we recognized an $8.4 million mark-to-market gain that was primarily a result of actual asset returns that were $5.7 million higher than our assumed returns and updated mortality assumptions. Partially offsetting these gains was the decrease in our year end discount rates, from 4.10% to 3.97%. In 2015, we recognized an $11.6 million mark-to-market charge that was primarily a result of actual asset returns that were $33.9 million lower than our assumed returns. Partially offsetting the lower asset returns was the increase in our year end discount rates, from 3.88% to 4.10%, and updated mortality assumptions. Weighted-average assumptions used to determine net periodic benefit cost for the years ended December 31: * The mark-to-market component of net periodic costs is determined based on discount rates as of year-end and actual asset returns during the year. The expected long-term rate of return on pension assets was determined after considering the historical and forward looking long-term asset returns by asset category and the expected investment portfolio mix. Our pension investment strategy is to diversify the portfolio among asset categories to enhance the portfolio’s risk-adjusted return as well as insulate it from exposure to changes in interest rates. Our asset mix considers the duration of plan liabilities, historical and expected returns of the investments, and the funded status of the plan. The pension asset allocation is reviewed and actively managed based on the funded status of the plan. As the funded status of the plan increases, the asset allocation is adjusted to increase the mix of fixed income investments and match the duration of those investments with the duration of the plan liabilities. Based on the current funded status of the plan, our pension asset investment allocation guidelines are to invest 70% to 80% in fixed income securities and 20% to 30% in equity securities. The plan keeps a minimal amount of cash available to fund benefit payments. These alternative investments may include funds of multiple asset investment strategies and funds of hedge funds. 53 POLYONE CORPORATION The fair values of pension plan assets at December 31, 2016 and 2015, by asset category, are as follows: 2016 Pension Plan Assets Other assets are primarily insurance contracts for international plans. The U.S. equity common collective funds are predominately invested in equity securities actively traded in public markets. The international and global equity common collective funds have broadly diversified investments across economic sectors and focus on low volatility, long-term investments. The fixed income common collective funds consist primarily of publicly traded United States fixed interest obligations (principally investment grade bonds and government securities). 54 POLYONE CORPORATION 2015 Pension Plan Assets Equities represent U.S. publicly-traded equity securities of companies, varying in size, with a focus on growth and value. The registered investment company non-US equity funds invest in underlying securities that are actively traded in public, non-US markets. The United States treasuries and fixed income securities consist of publicly traded United States and non-United States fixed interest obligations (principally corporate and government bonds and debentures). Other assets are primarily insurance contracts for international plans. Short-term investments in common collective funds represent cash and other short-term investments. The U.S. equity and fixed income common collective funds are invested in equity and investment grade fixed income securities, respectively, and these securities are actively traded in public markets. Level 1 assets are valued based on quoted market prices. Level 2 investments are valued based on quoted market prices and/or other market data for the same or comparable instruments and transactions of the underlying fixed income investments. The insurance contracts included in the other asset category are valued at the transacted price. Common collective funds are valued at the net asset value of units held by the fund at year end. The unit value is determined by the total value of fund assets divided by the total number of units of the fund owned. The estimated future benefit payments for our pension and health care plans are as follows: We currently estimate that 2017 employer contributions will be $4.4 million to all qualified and non-qualified pension plans and $1.2 million to all healthcare benefit plans. PolyOne sponsors various voluntary retirement savings plans (RSP). Under the provisions of the plans, eligible employees receive defined Company contributions and are eligible for Company matching contributions based on their eligible earnings contributed to the plan. In addition, we may make discretionary contributions to the plans for eligible employees based on a specific percentage of each employee’s compensation. Following are our contributions to the RSP: Note 11 - COMMITMENTS AND CONTINGENCIES Environmental - We have been notified by federal and state environmental agencies and by private parties that we may be a potentially responsible party (PRP) in connection with the environmental investigation and remediation of certain sites. While government agencies frequently assert that PRPs are jointly and severally liable at these sites, in our experience, the interim and final allocations of liability costs are generally made based on the relative contribution of waste. We may also initiate corrective and preventive environmental projects of our own to ensure safe and lawful activities at our operations. We believe that compliance with current governmental regulations at all levels will not have a material adverse effect on our financial position, results of operations or cash flows. In September 2007, we were informed of rulings by the United States District Court for the Western District of Kentucky on several pending motions in the case of Westlake Vinyls, Inc. v. Goodrich Corporation, et al., which had been pending since 2003. The Court held that PolyOne must pay the remediation costs at the former Goodrich Corporation Calvert City facility (now largely owned and operated by Westlake Vinyls), together with certain defense costs of Goodrich Corporation. The rulings also provided that PolyOne can seek indemnification for contamination attributable to Westlake Vinyls. The environmental obligation at the site arose as a result of an agreement between The B.F.Goodrich Company (n/k/a Goodrich Corporation) and our predecessor, The Geon Company, at the time of the initial public offering in 1993, by which The Geon Company became a public company, to indemnify Goodrich Corporation for environmental costs at the site. At the time, neither PolyOne nor The Geon Company ever owned or operated the 55 POLYONE CORPORATION facility. Following the Court rulings, the parties to the litigation entered into settlement negotiations and agreed to settle all claims regarding past environmental costs incurred at the site. The settlement agreement provides a mechanism to pursue allocation of future remediation costs at the Calvert City site to Westlake Vinyls. While we do not currently assume any allocation of costs in our current accrual, we will adjust our accrual, in the future, consistent with any such future allocation of costs. A remedial investigation and feasibility study (RIFS) is underway at Calvert City. During the third quarter of 2013, we submitted a remedial investigation report to the United States Environmental Protection Agency (USEPA). The USEPA required certain changes to the remedial investigation report and provided a final report in the third quarter of 2015. Additionally, in the third quarter of 2015, the USEPA assumed responsibility for the completion of the feasibility study. In 2016, the USEPA conducted additional site investigations from which results are still being reviewed. We continue to pursue available insurance coverage related to this matter and recognize gains as we receive reimbursement. No receivable has been recognized for future recoveries. On March 13, 2013, PolyOne acquired Spartech. One of Spartech's subsidiaries, Franklin-Burlington Plastics, Inc. (Franklin-Burlington), operated a plastic resin compounding facility in Kearny, New Jersey, located adjacent to the Passaic River. The USEPA has requested that companies located in the area of the lower Passaic River, including Franklin-Burlington, cooperate in an investigation of contamination of approximately 17 miles of the lower Passaic River (the lower Passaic River Study Area). In response, Franklin-Burlington and approximately 70 other companies (collectively, the Cooperating Parties) agreed, pursuant to an Administrative Order on Consent (AOC) with the USEPA, to assume responsibility for development of a RIFS of the lower Passaic River Study Area. The RIFS costs are exclusive of any costs that may ultimately be required to remediate the lower Passaic River Study Area or costs associated with natural resource damages that may be assessed. By agreeing to bear a portion of the cost of the RIFS, Franklin-Burlington did not admit to any liability or agree to bear any such remediation or natural resource damage costs. In February 2015, the Cooperating Parties submitted to the USEPA a remedial investigation report for the lower Passaic River Study Area. In March 2015, Franklin-Burlington, along with nine other PRPs, submitted a de minimis settlement petition to the USEPA, asserting the ten entities contributed little or no impact to the lower Passaic River and seeking a meeting to commence settlement discussions. In April 2015, the Cooperating Parties submitted a feasibility study to the USEPA. The feasibility study does not contemplate who is responsible for remediation nor does it determine how such costs will be allocated to PRPs. The Cooperating Parties are currently revising their RIFS, which has not yet been approved by the USEPA, as part of continuing technical discussions with the USEPA. On March 4, 2016, the USEPA issued a Record of Decision selecting a remedy for an eight-mile portion of the lower Passaic River Study Area at an estimated and discounted cost of $1.4 billion. On March 31, 2016, the USEPA sent a Notice of Potential Liability (the Notice) to over 100 companies, including Franklin-Burlington, and several municipalities for this eight-mile portion, in which the USEPA stated it intended to negotiate an AOC for Remedial Design with Occidental Chemical Corporation (OCC) and, upon signature, planned to negotiate a consent decree with other major PRPs to perform remedial actions. The Notice did not identify the “other major PRPs.” Further, the Notice communicated that the USEPA will provide to certain parties separate notice of the opportunity to discuss a cash-out settlement at a later date. On September 30, 2016, the USEPA reached an agreement with OCC, which orders OCC to perform the remedial design for the lower eight mile portion of the Passaic River. Based on the currently available information, we have found no evidence that Franklin-Burlington contributed any of the primary contaminants of concern to the lower Passaic River. Any allocation to Franklin-Burlington, including a final resolution of our de minimis petition or other opportunity for cash-out settlement, or further appropriate legal actions has not been determined. As a result of these uncertainties, we are unable to estimate a liability, if any, related to this matter. As of December 31, 2016, we have not accrued for costs of remediation related to the lower Passaic River. Our Consolidated Balance Sheet includes accruals totaling $117.3 million and $119.9 million as of December 31, 2016 and 2015, respectively, based on our estimates of probable future environmental expenditures relating to previously contaminated sites. These undiscounted amounts are included in Accrued expenses and other liabilities and Other non-current liabilities on the accompanying Consolidated Balance Sheets. The accruals represent our best estimate of probable future costs that we can reasonably estimate, based upon currently available information and technology and our view of the most likely remedy. Depending upon the results of future testing, completion and results of remedial investigation and feasibility studies, the ultimate remediation alternatives undertaken, changes in regulations, technology development, new information, newly discovered conditions and other factors, it is reasonably possible that we could incur additional costs in excess of the amount accrued at December 31, 2016. However, such additional costs, if any, cannot be currently estimated. 56 POLYONE CORPORATION The following table details the changes in the environmental accrued liabilities: Included in Cost of sales in the accompanying Consolidated Statements of Income are insurance recoveries received for previously incurred environmental costs of $6.1 million, $3.5 million and $3.7 million in 2016, 2015 and 2014, respectively. Such insurance recoveries are recognized as a gain when received. Other Litigation - We are involved in various pending or threatened claims, lawsuits and administrative proceedings, all arising from the ordinary course of business concerning commercial, product liability, employment and environmental matters that seek remedies or damages. We believe that the probability is remote that losses in excess of the amounts we have accrued would be materially adverse to our financial position, results of operations or cash flows. Note 12 - INCOME TAXES Income from continuing operations, before income taxes is summarized below based on the geographic location of the operation to which such earnings are attributable. Income from continuing operations, before income taxes consists of the following: A summary of income tax expense (benefit) from continuing operations is as follows: A reconciliation of the U.S. federal statutory tax rate to the consolidated effective income tax rate along with a description of significant or unusual reconciling items is included below. 57 POLYONE CORPORATION The effective tax rates for all periods differed from the U.S. federal statutory tax rate as a result of permanent items, state and local income taxes, differences in foreign tax rates and certain unusual items. Permanent items primarily consist of income or expense not taxable or deductible. Significant or unusual items impacting the effective income tax rate are described below. 2015 Significant items Amending U.S. federal income tax returns for 2004 through 2012 to use foreign tax credits decreased the effective tax rate by 18.3% ($30.7 million). Uncertain tax positions increased the effective tax rate by 0.6% ($1.0 million). The reversal of an uncertain tax position due to the expiration of the statute of limitations decreased the effective tax rate by 5.9% ($9.9 million). A foreign court ruling, which settled an uncertain position taken in a prior year, increased the effective tax rate by 4.7% ($7.9 million). Other unfavorable uncertain tax positions more than offset the net decrease in the effective tax rate of these two items. 2014 Significant items Tax benefits on certain foreign investments decreased the effective tax rate by 17.0% ($15.0 million) related to the write-off of our investment in certain Brazil subsidiaries for tax purposes and operating losses primarily as a result of restructuring actions to close certain Brazil facilities discussed in Note 4, Employee Separation and Restructuring Costs. Permanent tax differences decreased the effective tax rate by 2.1% ($1.9 million) primarily related to foreign tax law changes and the utilization of foreign tax credits. Changes in valuation allowances increased the effective tax rate by 7.8% ($6.9 million) primarily related to certain Brazilian subsidiaries as a result of cumulative operating losses. Components of our deferred tax assets (liabilities) as of December 31, 2016 and 2015 were as follows: As of December 31, 2016, the Company had $23.0 million of U.S. foreign tax credit carryforwards that expire between 2018 and 2025. The Company plans to utilize all U.S. foreign tax credits prior to the expiration period. As of December 31, 2016, we had gross state net operating loss carryforwards of $173.2 million that expire between 2017 and 2032. Various foreign subsidiaries have gross net operating loss carryforwards totaling $85.2 million that expire between 2017 and 2036 with limited exceptions that have indefinite carryforward periods. We have provided valuation allowances of $17.5 million against certain foreign and state net operating loss carryforwards that are expected to expire prior to utilization. In addition, we have valuation allowances of $2.3 million against other net deferred tax assets. 58 POLYONE CORPORATION No provision has been made for income taxes on undistributed earnings of consolidated non-U.S. subsidiaries of $336.9 million as of December 31, 2016, because our intention is to reinvest indefinitely undistributed earnings of our foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable foreign withholding taxes that would be payable on the remittance of such undistributed earnings. We made worldwide income tax payments of $50.3 million and received refunds of $2.4 million in 2016. We made worldwide income tax payments of $57.7 million and $70.0 million in 2015 and 2014, respectively, and received refunds of $2.6 million and $4.2 million in 2015 and 2014, respectively. Payments made in 2014 included U.S. federal tax payments related to 2013 U.S. federal income of $9.7 million. The Company records provisions for uncertain tax positions in accordance with ASC Topic 740, Income Taxes. A reconciliation of unrecognized tax benefits is as follows: We recognize interest and penalties related to uncertain tax positions in the provision for income taxes. As of December 31, 2016 and 2015, we had $3.3 million and $4.5 million accrued for interest and penalties, respectively. Although the timing and outcome of tax settlements are uncertain, it is reasonably possible that during the next twelve months a reduction in unrecognized tax benefits may occur up to $0.7 million based on the outcome of tax examinations and the expiration of statutes of limitations. If all unrecognized tax benefits were recognized, the net impact on the provision for income tax expense would be a benefit of $5.8 million. The Company is currently being audited by federal, state and foreign taxing jurisdictions. With the exception of amended tax returns for 2004 to 2012, which are limited in scope to foreign tax credits, we are no longer subject to U.S. federal income tax examinations for periods preceding 2013. With limited exceptions, we are no longer subject to state tax and foreign tax examinations for periods preceding 2012. Note 13 - SHARE-BASED COMPENSATION Share-based compensation cost is based on the value of the portion of share-based payment awards that are ultimately expected to vest during the period. Share-based compensation cost recognized in the accompanying Consolidated Statements of Income includes compensation cost for share-based payment awards based on the grant date fair value estimated in accordance with the provision of FASB ASC Topic 718, Compensation - Stock Compensation. Share-based compensation expense is based on awards expected to vest and therefore has been reduced for estimated forfeitures. Equity and Performance Incentive Plans The PolyOne Corporation 2010 Equity and Performance Incentive Plan (2010 EPIP), as amended and restated in 2015, reserved 6.2 million common shares for the award of a variety of share-based compensation alternatives, including non-qualified stock options, incentive stock options, restricted stock, restricted stock units (RSUs), performance shares, performance units and stock appreciation rights (SARs). It is anticipated that all share-based grants and awards that are earned and exercised will be issued from PolyOne common shares that are held in treasury. 59 POLYONE CORPORATION Share-based compensation is included in Selling and administrative expense in the accompanying Consolidated Statements of Income. A summary of compensation expense by type of award follows: Stock Appreciation Rights During the years ended December 31, 2016, 2015 and 2014, the total number of SARs granted were 0.5 million, 0.3 million and 0.3 million, respectively. Awards vest in one-third increments upon the later of the attainment of time-based vesting over a three-year service period and stock price targets. Awards granted in 2016, 2015 and 2014 are subject to an appreciation cap of 200% of the base price. Outstanding SARs have contractual terms ranging from seven to ten years from the date of the grant. The SARs were valued using a Monte Carlo simulation method as the vesting is dependent on the achievement of certain stock price targets. The SARs have time and market-based vesting conditions but vest no earlier than their three year graded vesting schedule. The expected term is an output from the Monte Carlo model, and are derived from employee exercise assumptions that are based on PolyOne historical exercise experience. The expected volatility was determined based on the average weekly volatility for our common shares for the contractual life of the awards. The expected dividend assumption was determined based upon PolyOne's dividend yield at the time of grant. The risk-free rate of return was based on available yields on U.S. Treasury bills of the same duration as the contractual life of the awards. Forfeitures were estimated at 3% per year based on our historical experience. The following is a summary of the weighted average assumptions related to the grants issued during 2016, 2015 and 2014: A summary of SAR activity for 2016 is presented below: The total intrinsic value of SARs exercised during 2016, 2015 and 2014 was $2.8 million, $9.7 million and $15.0 million, respectively. As of December 31, 2016, there was $2.1 million of total unrecognized compensation cost related to SARs, which is expected to be recognized over the weighted average remaining vesting period of 22 months. Restricted Stock Units RSUs represent contingent rights to receive one common share at a future date provided certain vesting criteria are met. During 2016, 2015 and 2014, the total number of RSUs granted were 0.2 million, 0.1 million and 0.2 million, respectively. These RSUs, which vest on the third anniversary of the grant date, were granted to executives and other key employees. Compensation expense is measured on the grant date using the quoted market price of our common shares and is recognized on a straight-line basis over the requisite service period. 60 POLYONE CORPORATION As of December 31, 2016, 0.5 million RSUs remain unvested with a weighted-average grant date fair value of $32.86. Unrecognized compensation cost for RSUs at December 31, 2016 was $5.4 million, which is expected to be recognized over the weighted average remaining vesting period of 22 months. Note 14 - SEGMENT INFORMATION A segment is a component of an enterprise whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. Operating income is the primary measure that is reported to our chief operating decision maker for purposes of allocating resources to the segments and assessing their performance. Operating income at the segment level does not include: corporate general and administrative expenses that are not allocated to segments; intersegment sales and profit eliminations; charges related to specific strategic initiatives such as the consolidation of operations; restructuring activities, including employee separation costs resulting from personnel reduction programs, plant closure and phase-in costs; executive separation agreements; share-based compensation costs; asset impairments; environmental remediation costs and other liabilities for facilities no longer owned or closed in prior years; gains and losses on the divestiture of joint ventures and equity investments; actuarial gains and losses associated with our pension and other post-retirement benefit plans; and certain other items that are not included in the measure of segment profit or loss that is reported to and reviewed by our chief operating decision maker. These costs are included in Corporate and eliminations. Segment assets are primarily customer receivables, inventories, net property, plant and equipment, intangible assets and goodwill. Intersegment sales are generally accounted for at prices that approximate those for similar transactions with unaffiliated customers. Corporate and eliminations assets and liabilities primarily include cash, debt, pension and other employee benefits, environmental liabilities, retained assets and liabilities of discontinued operations, and other unallocated corporate assets and liabilities. The accounting policies of each segment are consistent with those described in Note 1, Description of Business and Summary of Significant Accounting Policies. The following is a description of each of our five reportable segments. Color, Additives and Inks Color, Additives and Inks is a leading provider of specialized custom color and additive concentrates in solid and liquid form for thermoplastics, dispersions for thermosets, as well as specialty inks, plastisols, and vinyl slush molding solutions. Color and additive solutions include an innovative array of colors, special effects and performance-enhancing and eco-friendly solutions. When combined with polymer resins, our solutions help customers achieve differentiated specialized colors and effects targeted at the demands of today’s highly design-oriented consumer and industrial end markets. Our additive concentrates encompass a wide variety of performance and process enhancing characteristics and are commonly categorized by the function that they perform, including UV light stabilization and blocking, antimicrobial, anti-static, blowing or foaming, antioxidant, lubricant, oxygen and visible light blocking and productivity enhancement. Our colorant and additives concentrates are used in a broad range of polymers, including those used in medical and pharmaceutical devices, food packaging, personal care and cosmetics, transportation, building products, wire and cable markets. We also provide custom-formulated liquid systems that meet a variety of customer needs and chemistries, including polyester, vinyl, natural rubber and latex, polyurethane and silicone. Our offerings also include proprietary inks and latexes for diversified markets such as recreational and athletic apparel, construction and filtration, outdoor furniture and healthcare. Our liquid polymer coatings and additives are largely based on vinyl and are used in a variety of markets, including building and construction, consumer, healthcare, industrial, packaging, textiles, appliances, transportation, and wire and cable. Color, Additives and Inks has manufacturing, sales and service facilities located throughout North America, South America, Europe, Asia and Africa. Specialty Engineered Materials Specialty Engineered Materials is a leading provider of specialty polymer formulations, services and solutions for designers, assemblers and processors of thermoplastic materials across a wide variety of markets and end-use applications. Our product portfolio, which we believe to be one of the most diverse in our industry, includes specialty formulated high-performance polymer materials that are manufactured using thermoplastic resins and elastomers, which are then combined with advanced polymer additives, reinforcement, filler, colorant and/or biomaterial technologies. We also have what we believe is the broadest composite platform of solutions, which include a full range of products from long glass and carbon fiber technology to thermoset and thermoplastic composites. These solutions meet a wide variety of unique customer requirements for light weighting. Our technical and market expertise enables us to expand the performance range and structural properties of traditional engineering-grade 61 POLYONE CORPORATION thermoplastic resins to meet evolving customer needs. Specialty Engineered Materials has manufacturing, sales and service facilities located throughout North America, Europe, and Asia. Our product development and application reach is further enhanced by the capabilities of our Innovation Centers in the United States, Germany and China, which produce and evaluate prototype and sample parts to help assess end-use performance and guide product development. Our manufacturing capabilities are targeted at meeting our customers’ demand for speed, flexibility and critical quality. Designed Structures and Solutions The Designed Structures and Solutions segment was created on March 13, 2013, as a result of the acquisition of Spartech Corporation (Spartech). PolyOne's Designed Structures and Solutions segment utilizes a variety of polymers, specialty additives and processing technologies to produce a complete portfolio of sheet, custom rollstock and specialty film, laminate and acrylic solutions. Our solutions can be engineered to provide structural or functional performance in an application or design and visual aesthetics to meet our customers’ needs. Our offerings also include a wide range of sustainable, cost-effective stock and custom packaging solutions for various industry processes used in the food, medical and consumer markets. In addition to packaging, we also work closely with customers to provide solutions for transportation, building and construction, healthcare and consumer markets. Designed Structures and Solutions has manufacturing, sales and service facilities located throughout North America. Performance Products and Solutions Performance Products and Solutions is comprised of the Geon Performance Materials (Geon) and Producer Services business units. The Geon business delivers an array of products and services for vinyl molding and extrusion processors located in North America and Asia. The GeonTM brand name carries strong recognition globally. Geon's products are sold to manufacturers of durable plastic parts and consumer-oriented products. We also offer a wide range of services including materials testing, component analysis, custom formulation development, colorant and additive services, part design assistance, structural analysis, process simulations, mold design and flow analysis and extruder screw design. Vinyl is used across a broad range of markets and applications, including, but not limited to: healthcare, wire and cable, building and construction, consumer and recreational products and transportation and packaging. The Producer Services business unit offers contract manufacturing and outsourced polymer manufacturing services to resin producers and polymer marketers, primarily in the United States and Mexico, as well as its own proprietary formulations for certain applications. As a strategic and integrated supply chain partner, Producer Services offers resin producers a capital-efficient way to effectively develop custom products for niche markets by leveraging its extensive process technology expertise, broad manufacturing capabilities and geographic locations. PolyOne Distribution The PolyOne Distribution business distributes more than 4,000 grades of engineering and commodity grade resins, including PolyOne-produced solutions, principally to the North American and Asian markets. These products are sold to over 6,500 custom injection molders and extruders who, in turn, convert them into plastic parts that are sold to end-users in a wide range of industries. Representing over 25 major suppliers, we offer our customers a broad product portfolio, just-in-time delivery from multiple stocking locations and local technical support. Recent expansion in Central America and Asia have bolstered PolyOne Distribution's ability to serve the specialized needs of customers globally. 62 POLYONE CORPORATION Financial information by reportable segment is as follows: (1) Corporate and eliminations includes accelerated depreciation associated with restructuring actions of $3.5 million. (1) Corporate and eliminations includes accelerated depreciation associated with restructuring actions of $6.2 million. (1) Corporate and eliminations includes accelerated depreciation associated with restructuring actions of $23.1 million. 63 POLYONE CORPORATION Our sales are primarily to customers in the United States, Canada, Mexico, Europe, South America and Asia, and the majority of our assets are located in these same geographic areas. Following is a summary of sales and long-lived assets based on the geographic areas where the sales originated and where the assets are located: Note 15 - COMMON SHARE DATA Weighted-average shares used in computing net income per share are as follows: Outstanding share-based awards with exercise prices greater than the average price of the common shares are anti-dilutive and are not included in the computation of diluted net income per share. The number of anti-dilutive options and awards was 0.2 million and 0.4 million at December 31, 2016 and 2014, respectively. Less than 0.1 million options and awards were anti-dilutive for the computation of diluted earnings per common share at December 31, 2015. We purchased 3.0 million, 4.5 million and 6.3 million shares in 2016, 2015 and 2014, respectively, at an aggregate cost of $86.2 million, $156.1 million and $233.2 million, respectively. Note 16 - FAIR VALUE Fair value is measured based on an exit price, representing the amount that would be received to sell an asset or paid to satisfy a liability in an orderly transaction between market participants. Fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, a fair value hierarchy is established, which categorizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. The estimated fair value of PolyOne’s debt instruments at December 31, 2016 and 2015 was $1,272.1 million and $1,136.2 million, respectively, compared to carrying values of $1,258.3 million and $1,146.6 million as of December 31, 2016 and 2015, respectively. The fair value of PolyOne’s debt instruments was estimated using prevailing market interest rates on debt with similar creditworthiness, terms and maturities and represent Level 2 measurements within the fair value hierarchy. In accordance with the provisions of FASB ASC Topic 350, Intangibles - Goodwill and Other, we assess the fair value of goodwill on an annual basis or at an interim date if potential impairment indicators are present. The implied fair value of goodwill is determined based on significant unobservable inputs. Accordingly, these inputs fall within Level 3 of the fair value hierarchy. We use an income approach to estimate the fair value of our reporting units. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted 64 POLYONE CORPORATION using a weighted-average cost of capital that is determined based on current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in sales, costs and number of units, estimates of future expected changes in operating margins and cash expenditures. Other significant estimates and assumptions include terminal value growth rates, terminal value margin rates, future capital expenditures and changes in future working capital requirements. We validate our estimates of fair value under the income approach by considering the implied control premium and conclude whether the implied control premium is reasonable based on other recent market transactions. No impairment charges were required in 2016, 2015 or 2014. Indefinite-lived intangible assets primarily consist of the GLS, ColorMatrix and Gordon Composites trade names. Indefinite-lived intangible assets are tested for impairment annually at the same time we test goodwill for impairment. The implied fair value of indefinite-lived intangible assets is determined based on significant unobservable inputs, as summarized below. Accordingly, these inputs fall within Level 3 of the fair value hierarchy. The fair value of the trade names is calculated using a “relief from royalty” methodology. This approach involves two steps (1) estimating reasonable royalty rates for the trade name and (2) applying this royalty rate to a net sales stream and discounting the resulting cash flows to determine fair value. This fair value is then compared with the carrying value of the trade name. No impairment charges were required in 2016, 2015 or 2014. Note 17 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (1) Per share amounts for the quarter and the full year have been computed separately. The sum of the quarterly amounts may not equal the annual amounts presented because of differences in the average shares outstanding during each period. (2) Included for the fourth quarter 2016 are: 1) a mark-to-market pension and other post-retirement gain of $8.4 million, 2) employee separation and restructuring costs of $2.5 million and 3) environmental remediation costs of $2.2 million. (3) Included for the third quarter 2016 are: 1) employee separation and restructuring costs of $4.6 million, 2) acquisition related costs and adjustments of $2.5 million and 3) environmental remediation costs of $2.3 million. (4) Included for the second quarter 2016 are: 1) employee separation and restructuring costs of $4.8 million, 2) environmental remediation costs of $2.1 million and 3) a gain related to the reimbursement of previously incurred environmental costs of $5.3 million. (5) Included for the first quarter 2016 are employee separation and restructuring costs of $7.1 million. (6) Included for the fourth quarter 2015 are: 1) a mark-to-market pension and other post-retirement charge of $11.6 million, 2) employee separation and restructuring costs of $10.1 million and 3) $16.4 million of debt extinguishment costs primarily due to the repayment in full of $316.6 million aggregate principal amount of our 7.375% senior notes due 2020. (7) Included for the third quarter 2015 are: 1) employee separation and restructuring costs of $13.7 million and 2) a $7.5 million benefit related to the reversal of an uncertain tax position due to the expiration of the statute of limitations. (8) Included for the second quarter 2015 are: 1) employee separation and restructuring costs of $7.5 million and 2) a $26.0 million tax benefit as a result of amending U.S. federal income tax returns from 2005 to 2012 to use foreign tax credits. (9) Included for the first quarter 2015 are employee separation and restructuring costs of $10.6 million. 65 POLYONE CORPORATION
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I apologize, but the text you've provided appears to be a fragmented and incomplete financial statement excerpt. It seems to contain partial references to accounting standards (ASU 2016, Topic 326) and some notes about liabilities and bad debt allowances, but lacks complete context or clear financial details. Without a more comprehensive document, I cannot provide a meaningful summary. If you have the full financial statement, I'd be happy to help you summarize it.
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Claude
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. MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management has prepared and is responsible for our consolidated financial statements and related notes. Management is also responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Viacom Inc. and its subsidiaries’ (the “Company”) internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with the authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements prepared for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Under the supervision and with the participation of management, including our personal participation, we conducted an assessment of the effectiveness of internal control over financial reporting based on the framework in Internal Control - Integrated Framework (2013) as issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management determined that as of September 30, 2016, Viacom maintained effective internal control over financial reporting. The effectiveness of our internal control over financial reporting as of September 30, 2016 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report included herein. VIACOM INC. By: /S/ THOMAS E. DOOLEY Thomas E. Dooley President and Chief Executive Officer By: /S/ WADE DAVIS Wade Davis Executive Vice President, Chief Financial Officer By: /S/ KATHERINE GILL-CHAREST Katherine Gill-Charest Senior Vice President, Controller (Chief Accounting Officer) ACCOUNTING FIRM To the Board of Directors and Stockholders of Viacom Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 8 present fairly, in all material respects, the financial position of Viacom Inc. and its subsidiaries (the “Company”) at September 30, 2016 and 2015 and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2016, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 8 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP New York, New York November 9, 2016 VIACOM INC. CONSOLIDATED STATEMENTS OF EARNINGS See accompanying notes to Consolidated Financial Statements VIACOM INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME See accompanying notes to Consolidated Financial Statements VIACOM INC. CONSOLIDATED BALANCE SHEETS See accompanying notes to Consolidated Financial Statements VIACOM INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to Consolidated Financial Statements VIACOM INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY See accompanying notes to Consolidated Financial Statements VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. BASIS OF PRESENTATION Description of Business Viacom is home to premier global media brands that create compelling television programs, motion pictures, short-form content, applications (“apps”), games, consumer products, social media experiences and other entertainment content for audiences in more than 180 countries. Viacom operates through two reporting segments: Media Networks and Filmed Entertainment. The Media Networks segment provides entertainment content and related branded products for consumers in targeted demographics attractive to advertisers, content distributors and retailers through three brand groups: the Global Entertainment Group, the Nickelodeon Group and BET Networks. On October 31, 2016, we announced that the Global Entertainment Group had been established to combine Viacom International Media Networks, our former Music & Entertainment Group (which included MTV, Comedy Central, VH1, Spike and Logo), as well as TV Land and CMT (which had previously been part of our Kids & Family Group). We also announced that our former Kids & Family Group would be reestablished as the Nickelodeon Group. The Filmed Entertainment segment produces, finances, acquires and distributes motion pictures, television programming and other entertainment content under the Paramount Pictures, Paramount Animation, Nickelodeon Movies, MTV Films and Paramount Television brands. References in this document to “Viacom,” “Company,” “we,” “us” and “our” mean Viacom Inc. and our consolidated subsidiaries, unless the context requires otherwise. The consolidated financial statements present the Company’s financial results for the years ended September 30, 2016 (“2016”), September 30, 2015 (“2015”) and September 30, 2014 (“2014”). Use of Estimates Preparing financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the dates presented and the reported amounts of revenues and expenses during the periods presented. Significant estimates inherent in the preparation of the accompanying Consolidated Financial Statements include estimates of film ultimate revenues, product returns, potential outcome of uncertain tax positions, fair value of acquired assets and liabilities, fair value of equity-based compensation and pension benefit assumptions. Estimates are based on past experience and other considerations reasonable under the circumstances. Actual results may differ from these estimates. Reclassifications Certain prior year amounts have been reclassified to conform to the 2016 presentation. Recent Accounting Pronouncements Income Taxes In October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16 - Income Taxes: Intra-Entity Transfers of Assets Other Than Inventory. ASU 2016-16 will require the tax effects of intercompany transactions, other than sales of inventory, to be recognized currently, eliminating an exception under current GAAP in which the tax effects of intra-entity asset transfers are deferred until the transferred asset is sold to a third party or otherwise recovered through use. The guidance will be effective for the first interim period of our 2019 fiscal year, with early adoption permitted. We are currently evaluating the impact of the new standard. Statement of Cash Flows In August 2016, the FASB issued ASU 2016-15 - Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 addresses how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The guidance will be effective for the first interim period of our 2019 fiscal year, with early adoption permitted. We are currently evaluating the impact of the new standard. Financial Instruments In connection with its financial instruments project, the FASB issued ASU 2016-13 - Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments in June 2016 and ASU 2016-01 - Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities in January 2016. • ASU 2016-13 introduces a new impairment model for most financial assets and certain other instruments. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a forward-looking “expected loss” model that will replace the current “incurred loss” model and generally will result in VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) earlier recognition of allowances for losses. The guidance will be effective for the first interim period of our 2021 fiscal year, with early adoption in fiscal year 2020 permitted. • ASU 2016-01 addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Among other provisions, the new guidance requires the fair value measurement of investments in certain equity securities. For investments without readily determinable fair values, entities have the option to either measure these investments at fair value or at cost adjusted for changes in observable prices minus impairment. All changes in measurement will be recognized in net income. The guidance will be effective for the first interim period of our 2019 fiscal year. Early adoption is not permitted, except for certain provisions relating to financial liabilities. We are currently evaluating the impact of the new standards. Equity-Based Compensation In March 2016, the FASB issued ASU 2016-09 - Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 includes provisions intended to simplify various aspects related to how share-based payments are accounted for and presented in the financial statements, such as requiring all income tax effects of awards to be recognized in the income statement when the awards vest or are settled and allowing a policy election to account for forfeitures as they occur. In addition, all related cash flows resulting from share-based payments will be reported as operating activities on the statement of cash flows. The guidance will be effective for the first interim period of our 2018 fiscal year, with early adoption permitted. The new standard will impact our financial statements by increasing or decreasing our income tax provision and increasing cash flow from operating activities. Leases In February 2016, the FASB issued ASU 2016-02 - Leases. ASU 2016-02 requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for most leases. For income statement purposes, leases will be classified as either operating or finance, generally resulting in straight-line expense recognition for operating leases (similar to current operating leases) and accelerated expense recognition for financing leases (similar to current capital leases). The guidance will be effective for the first interim period of our 2020 fiscal year, with early adoption permitted. We are currently evaluating the impact of the new standard. Revenue Recognition In May 2014, the FASB issued ASU 2014-09 - Revenue from Contracts with Customers, a comprehensive revenue recognition model that supersedes the current revenue recognition requirements and most industry-specific guidance. Subsequent accounting standard updates have also been issued which amend and/or clarify the application of ASU 2014-09. The guidance provides a five step framework to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration it expects to be entitled to in exchange for those goods or services. The guidance will be effective for the first interim period of our 2019 fiscal year (with early adoption permitted beginning with our 2018 fiscal year), and allows adoption either under a full retrospective or a modified retrospective approach. We are currently evaluating the impact of the new standard. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation Our consolidated financial statements include the accounts of Viacom Inc., its subsidiaries and variable interest entities (“VIEs”) where we are considered the primary beneficiary, after elimination of intercompany accounts and transactions. Investments in business entities in which Viacom lacks control but does have the ability to exercise significant influence over operating and financial policies are accounted for using the equity method. Our proportionate share of net income or loss of the entity is recorded in Equity in net earnings of investee companies in the Consolidated Statements of Earnings. Related party transactions between the Company and CBS Corporation (“CBS”) and National Amusements, Inc. (“National Amusements”) have not been eliminated. Business Combinations We account for business combinations using the acquisition method of accounting. Under the acquisition method, once control is obtained of a business, 100% of the assets, liabilities and certain contingent liabilities acquired, including amounts attributed to noncontrolling interests, are recorded at fair value. Any transaction costs are expensed as incurred. Foreign Currency Translation and Remeasurement Assets and liabilities of subsidiaries with a functional currency other than the United States (“U.S.”) Dollar are translated into U.S. Dollars using period-end exchange rates, while results of operations are translated at exchange rates during the period. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Foreign currency translation gains and losses are included as a component of Accumulated other comprehensive loss in the Consolidated Balance Sheets. Substantially all of our foreign operations use the local currency as the functional currency. Subsidiaries that enter into transactions denominated in currencies other than their functional currency will result in remeasurement gains and losses which are reflected within Other items, net in the Consolidated Statements of Earnings. Revenue Recognition We recognize revenue when it is realized or realizable and earned. We consider revenue realized or realizable and earned when there is persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. Determining whether some or all of these criteria have been met involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report. This includes the evaluation of multiple element arrangements for bundled advertising sales and content licenses, which involves allocating the consideration among individual deliverables within the bundled arrangement. Advertising Revenues: Revenue from the sale of advertising earned by the Media Networks segment is recognized, net of agency commissions, when the advertisement is aired and the contracted audience rating is met. For advertising sold based on impression guarantees, audience deficiency may result in an obligation to deliver additional units. To the extent we do not satisfy contracted audience ratings, we record deferred revenue until such time that the audience rating has been satisfied. Film and Television Production Revenues: Theatrical revenue is recognized from theatrical distribution of motion pictures upon exhibition. For sales of DVDs and Blue-ray discs to wholesalers and retailers, revenue is recognized upon the later of delivery or the date that those products are made widely available for sale by retailers. Revenue for transactional video-on-demand and similar arrangements are recognized as the films are exhibited based on end-customer purchases as reported by the distributor. Revenue from the licensing of film and television exhibition rights is recognized upon availability for airing by the licensee. Affiliate Revenues: Affiliate revenues from cable television operators, direct-to-home satellite television operators and mobile networks are recognized by the Media Networks segment as the service is provided to the distributor. Fees associated with arrangements with subscription video-on-demand (“SVOD”) and other over-the-top (“OTT”) services are recognized upon program availability. Ancillary Revenues: Revenue associated with consumer products and brand licensing is typically recognized utilizing contractual royalty rates applied to sales amounts reported by licensees. Revenue from licensing of our programming content for download-to-own and download-to-rent services is recognized when we are notified by the multi-platform retailer that the product has been downloaded and all other revenue recognition criteria are met. Multiple-Element Arrangements: We enter into arrangements under which we perform multiple revenue-generating activities. We must allocate consideration to separate units of account in the arrangement, which could impact the timing of revenue recognition. Advertising revenues are principally generated from the sale of advertising time comprised of multiple commercial units. Each advertising spot comprises a deliverable for accounting purposes. Consideration for these arrangements is allocated among the individual advertising spots based on relative fair value using Viacom-specific prices. SVOD and other OTT arrangements include multiple programs made available to distributors on one or more dates for a fixed fee. Consideration for such arrangements is allocated among the programs based on relative fair value using management’s best estimate considering viewing performance and other factors. Gross versus Net Revenue: We earn and recognize revenues as a distributor on behalf of third parties and through outsourced agency agreements. In such cases, determining whether revenue should be reported on a gross or net basis is based on management’s assessment of who our customer is in the transaction. To the extent the end consumer is our customer, we act as the principal in a transaction and revenues earned from the end user are reported on a gross basis. This determination involves judgment and is based on an evaluation of whether we have the substantial risks and rewards under the terms of an arrangement. Revenue Allowances: We record a provision for sales returns and allowances at the time of sale based upon an estimate of future returns, rebates and other incentives (“estimated returns”). In determining estimated returns, we consider numerous sources of qualitative and quantitative evidence including forecasted sales data, customers’ rights of return, units shipped and units remaining at retail, historical return rates for similar product, current economic trends, competitive environment, promotions and sales strategies. Reserves for accounts receivable are based on amounts estimated to be uncollectible. Our reserve for sales VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) returns and allowances was $93 million and $126 million at September 30, 2016 and 2015, respectively. Our allowance for doubtful accounts was $44 million and $37 million at September 30, 2016 and 2015, respectively. Advertising Expense We expense advertising costs as they are incurred. We incurred total advertising expenses of $987 million in 2016, $748 million in 2015 and $1.020 billion in 2014. Equity-Based Compensation We measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. The fair value received is recognized in earnings over the period during which an employee is required to provide service. Income Taxes Our provision for income taxes includes the current tax owed on the current period earnings, as well as a deferred provision which reflects the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Changes in existing tax laws and rates, their related interpretations, as well as the uncertainty generated by the prospect of tax legislation in the future may affect the amounts of deferred tax liabilities or the realizability of deferred tax assets. Deferred tax assets and deferred tax liabilities are classified as noncurrent and are included in Other Assets and Deferred tax liabilities, net, respectively, within the Consolidated Balance Sheets. For tax positions we have taken or expect to take in a tax return, we apply a more likely than not assessment (i.e., there is a greater than 50 percent chance) about whether the tax position will be sustained upon examination by the appropriate tax authority with full knowledge of all relevant information. Amounts recorded for uncertain tax positions are periodically assessed, including the evaluation of new facts and circumstances, to ensure sustainability of the position. Interest and penalties related to uncertain tax positions are included in the Provision for income taxes in the Consolidated Statements of Earnings. Liabilities for uncertain tax positions are classified as Other liabilities - noncurrent in the Consolidated Balance Sheets. Earnings per Common Share Basic earnings per common share is computed by dividing Net earnings attributable to Viacom by the weighted average number of common shares outstanding during the period. The determination of diluted earnings per common share includes the weighted average number of common shares plus the dilutive effect of equity awards based upon the application of the treasury stock method. Anti-dilutive common shares are excluded from the calculation of diluted earnings per common share. Comprehensive Income Comprehensive income includes net earnings, foreign currency translation adjustments, amortization of amounts related to defined benefit plans, unrealized gains and losses on certain derivative financial instruments, and unrealized gains and losses on investments in equity securities which are publicly traded. Cash and Cash Equivalents All highly liquid investments with maturities of three months or less at the date of purchase are considered to be cash equivalents. Inventory Inventories related to film and television productions (which include direct production costs, production overhead, acquisition costs and development costs) are stated at the lower of amortized cost or fair value. Acquired program rights and obligations are recorded based on the gross amount of the liability when the license period has begun, and when the program is accepted and available for airing. Acquired programming is stated at the lower of unamortized cost or net realizable value. Film, television and acquired programming inventories are included as a component of Inventory, net, in the Consolidated Balance Sheets. Film, television and acquired programming costs, including inventory amortization, development costs, residuals and participations and impairment charges, if any, are included within Operating expenses in the Consolidated Statements of Earnings. Film and Television production costs: We use an individual-film-forecast-computation method to amortize film costs and to accrue estimated liabilities for residuals and participations over the applicable title’s life cycle based upon the ratio of current period to estimated remaining total gross revenues (“ultimate revenues”) for each title. The estimate of ultimate revenues impacts the timing of amortization and accrual of residuals and participations. Our estimate of ultimate revenues for feature films includes revenues from all sources that are estimated to be earned within 10 years from the date of a film’s initial theatrical release. For acquired film libraries, our estimate of ultimate revenues is for a period within 20 years from the date of VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) acquisition. These estimates are periodically reviewed and adjustments, if any, will result in changes to inventory amortization rates, estimated accruals for residuals and participations or possibly the recognition of an impairment charge to operating income. Film development costs that have not been set for production are expensed within three years unless they are abandoned earlier, in which case these projects are written down to their estimated fair value in the period the decision to abandon the project is determined. We have a rigorous greenlight process designed to manage the risk of loss or abandonment. We have entered into film financing arrangements that involve the sale of a partial copyright interest in a film. Amounts received under these arrangements are deducted from the film’s cost. Capitalized original programming costs are amortized utilizing an individual-film-forecast-computation method over the applicable title’s ultimate revenues based on genre and historical experience, beginning with the month of initial exhibition. Original programming costs that have not been greenlit for production are expensed. An impairment charge is recorded when the fair value of the television program is less than the unamortized production cost or abandoned. Acquired programming: Costs incurred in acquiring program rights, including advances, are capitalized and amortized over the license period or projected useful life of the programming, if shorter, commencing upon availability, based on estimated future airings. If initial airings are expected to generate higher revenues an accelerated method of amortization is used. Net realizable value of acquired rights programming is evaluated quarterly by us on a daypart basis, which is defined as an aggregation of programs broadcast during a particular time of day or an aggregation of programs of a similar type. We aggregate similar programming based on the specific demographic targeted by each respective program service. Net realizable value is determined by estimating advertising revenues to be derived from the future airing of the programming within the daypart as well as an allocation of affiliate revenue to the programming. An impairment charge may be necessary if our estimates of future cash flows of similar programming are insufficient or if programming is abandoned. Home entertainment inventory: Home entertainment inventory is valued at the lower of cost or net realizable value. Cost is determined using the average cost method. Property and Equipment Property and equipment is stated at cost. Depreciation is calculated using the straight-line method. Leasehold improvements are amortized using the straight-line method over the shorter of their useful lives or the life of the lease. Costs associated with repairs and maintenance of property and equipment are expensed as incurred. Goodwill, Intangible Assets and Other Long-Lived Assets Goodwill represents the residual difference between the consideration paid for a business and the fair value of the net assets acquired. Goodwill is not amortized, but rather is tested annually for impairment, on August 31 each year, or sooner when circumstances indicate impairment may exist. Goodwill is tested for impairment at the reporting unit level, which is an operating segment, or a business which is one level below that operating segment. Identifiable intangible assets with finite lives are amortized over their estimated useful lives, which range up to 20 years, and identifiable intangible assets with indefinite lives are not amortized, but rather are tested annually for impairment, or sooner when circumstances indicate impairment may exist. Amortizable intangible assets and other long-lived assets are tested for impairment utilizing an income approach based on undiscounted cash flows upon the occurrence of certain triggering events and, if impaired, are written down to fair value. The impairment test is performed at the lowest level of cash flows associated with the asset. Investments Our investments primarily consist of investments in equity. Investments in which we have a significant influence, but not a controlling interest, are accounted for using the equity method. Other investments are carried at fair value, to the extent publicly traded, with unrealized gains and losses recorded in other comprehensive income, or at cost. We monitor our investments for impairment at least annually and make appropriate reductions in carrying values if we determine that an impairment charge is required based on qualitative and quantitative information. Our investments are included in Other assets - noncurrent in the Consolidated Balance Sheets. Guarantees At the inception of a guarantee, we recognize a liability for the fair value of an obligation assumed by issuing the guarantee. The related liability is subsequently reduced as utilized or extinguished and increased if there is a probable loss associated with the guarantee which exceeds the value of the recorded liability. Treasury Stock Treasury stock is accounted for using the cost method. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Fair Value Measurements Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The framework for measuring fair value provides a hierarchy that prioritizes the inputs to valuation techniques used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). The three levels of the fair value hierarchy are as follows: • Level 1 - Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets. • Level 2 - Inputs to the valuation methodology include: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; inputs other than quoted prices that are observable for the asset or liability; inputs that are derived principally from or corroborated by observable market data by correlation or other means. • Level 3 - Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Our recurring fair value measures include marketable securities and derivative instruments and our non-recurring fair value measures include goodwill and intangible assets. Derivative Financial Instruments Derivative financial instruments are recorded on the Consolidated Balance Sheets as assets or liabilities and measured at fair value. For derivatives designated as hedges of the fair value of assets or liabilities, the changes in fair value of both the derivatives and the hedged items are recorded in current earnings as part of Other items, net in the Consolidated Statements of Earnings. For derivatives designated as cash flow hedges, the effective portion of the changes in fair value of the derivatives is recorded in Accumulated other comprehensive loss in the Consolidated Balance Sheets and subsequently recognized in earnings when the hedged items impact income. The fair value of derivative financial instruments is included in Prepaid and other assets and Other liabilities - current in the Consolidated Balance Sheets. Changes in the fair value of derivatives not designated as hedges and the ineffective portion of cash flow hedges are recorded in earnings. We do not hold or enter into financial instruments for speculative trading purposes. Pension Benefits Our defined benefit pension plans principally consist of both funded and unfunded noncontributory plans covering the majority of domestic employees and retirees. The funded defined benefit pension plan and unfunded pension plans are currently frozen to future benefit accruals. The expense we recognize is determined using certain assumptions, including the expected long-term rate of return and discount rate, among others. We recognize the funded status of our defined benefit plans (other than a multiemployer plan) as an asset or liability in the Consolidated Balance Sheets and recognize the changes in the funded status in the year in which the changes occur through Accumulated other comprehensive loss in the Consolidated Balance Sheets. NOTE 3. ACCOUNTS RECEIVABLE We had $547 million and $577 million of noncurrent trade receivables as of September 30, 2016 and 2015, respectively. Accounts receivables are principally related to long-term television license arrangements at Filmed Entertainment and content distribution arrangements at Media Networks. These amounts are included within Other assets - noncurrent in our Consolidated Balance Sheets. Such amounts are due in accordance with the underlying terms of the respective agreements with companies that are investment grade or with which we have historically done business under similar terms. We have determined that credit loss allowances are generally not considered necessary for these amounts. NOTE 4. INVESTMENTS Our equity method investments total $542 million and $434 million, as of September 30, 2016 and 2015, respectively. We hold an equity interest of 50% in Viacom 18, a joint venture in India that owns and operates regional entertainment channels. In July 2015, we acquired a 50% interest in Prism TV Private Limited (“Prism”) for 9.4 billion rupees ($149 million). The purchase price substantially represents the difference between the carrying amount of our investment and our share of the underlying net assets of Prism. The difference includes other intangible assets that will be amortized over their estimated useful lives of 7 to 20 years. Prism has been merged into Viacom 18. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) We also hold an equity interest of approximately 50% in EPIX, a joint venture formed with Lionsgate and Metro-Goldwyn-Mayer to exhibit certain motion pictures on behalf of the equity partners’ movie studios through a premium pay television channel and video-on-demand services available on multiple platforms. Our cost method investments total $96 million and $71 million as of September 30, 2016 and 2015, respectively. Variable Interest Entities In the normal course of business, we enter into joint ventures or make investments with business partners that support our underlying business strategy and provide us the ability to enter new markets to expand the reach of our brands, develop new programming and/or distribute our existing content. In certain instances, an entity in which we make an investment may qualify as a VIE. In determining whether we are the primary beneficiary of a VIE, we assess whether we have the power to direct matters that most significantly impact the activities of the VIE and have the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. Our Consolidated Balance Sheets include amounts related to consolidated VIEs totaling $190 million in assets and $57 million in liabilities as of September 30, 2016, and $207 million in assets and $54 million in liabilities as of September 30, 2015. We have certain rights and obligations related to our investments, including the guarantee of certain third-party bank debt. The consolidated VIEs’ revenues, expenses and operating income were not significant for all periods presented. NOTE 5. PROPERTY AND EQUIPMENT Depreciation expense, including assets under capital leases, was $188 million in 2016 and 2015, and $177 million in 2014. Depreciation expense related to capital leases was $18 million in 2016, $20 million in 2015 and $21 million in 2014. Accumulated depreciation of capital leases was $147 million and $171 million at September 30, 2016 and 2015, respectively. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 6. INVENTORY We expect to amortize approximately $1.5 billion of film and television costs, including released and completed, not yet released, during the fiscal year ending September 30, 2017 using the individual-film-forecast-computation method. In addition, we expect to amortize 90% of unamortized released film and television costs, excluding acquired film libraries, at September 30, 2016, within the next three years. NOTE 7. GOODWILL AND INTANGIBLES Goodwill The following table details the change in goodwill by segment for 2016 and 2015: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Intangibles The following table details our intangible asset balances by major asset classes: Amortization expense relating to intangible assets was $33 million for 2016, $34 million for 2015 and $40 million for 2014. We expect our aggregate annual amortization expense for existing intangible assets subject to amortization at September 30, 2016 to be as follows for each of the next five fiscal years: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 8. DEBT Our total debt consists of the following: The amounts classified in the current portion of debt consist of the portion of capital leases payable in the next twelve months. Senior Notes and Debentures In the third quarter of fiscal 2016, we repaid the $368 million aggregate principal amount of our 6.250% Senior Notes due April 2016. Our outstanding senior notes and debentures provide for certain covenant packages typical for an investment grade company. There is one acceleration trigger for certain of the senior notes and debentures in the event of a change in control under certain specified circumstances coupled with ratings downgrades due to the change in control. At September 30, 2016 and 2015, the total unamortized discount and issuance fees and expenses related to the fixed rate senior notes and debentures was $459 million and $478 million, respectively. The fair value of our senior notes and debentures was approximately $12.8 billion and $12.0 billion as of September 30, 2016 and 2015, respectively. The valuation of our publicly traded debt is based on quoted prices in active markets. On October 4, 2016, we issued a total of $1.3 billion of senior notes as follows: • $400 million in aggregate principal amount of 2.250% senior notes due 2022 at a price equal to 99.692% of the principal amount (the “2022 Senior Notes”); and VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) • $900 million in aggregate principal amount of 3.450% senior notes due 2026 at a price equal to 99.481% of the principal amount (the “2026 Senior Notes” and, together with the 2022 Senior Notes, the “Senior Notes”). The interest rate payable on the Senior Notes will be subject to adjustment from time to time if Moody’s Investors Services, Inc. or S&P Global Ratings downgrades (or downgrades and subsequently upgrades) the credit rating assigned to the Senior Notes. The interest rate on the Senior Notes would increase by 0.25% upon each credit agency downgrade up to a maximum of 2.00%, and would similarly be decreased for subsequent upgrades. The proceeds, net of discount and other issuance fees and expenses, from the issuance of the Senior Notes were $1.285 billion. As discussed below, a portion of the proceeds will be used to redeem the senior notes due in December 2016 and April 2017 and therefore, the senior notes were classified as long-term debt as of September 30, 2016. In October 2016, we delivered notices of redemption to redeem all $400 million of our outstanding 2.500% senior notes due December 2016 and all $500 million of our outstanding 3.500% senior notes due April 2017. The redemption is expected to take place on November 14, 2016. Credit Facility At September 30, 2016 and 2015, there were no amounts outstanding under our $2.5 billion revolving credit facility due November 2019. The credit facility is used for general corporate purposes and to support commercial paper outstanding, if any. The borrowing rate under the credit facility is LIBOR plus a margin ranging from 1.25% to 2.25% based on our current public debt rating. The credit facility has one principal financial covenant that requires our interest coverage for the most recent four consecutive fiscal quarters to be at least 3.0x, which we met as of September 30, 2016. Commercial Paper At September 30, 2016 and 2015, there was no commercial paper outstanding. Scheduled Debt Maturities Our scheduled maturities of debt at face value for each of the next five fiscal years and thereafter, excluding capital leases, outstanding at September 30, 2016 are as follows: NOTE 9. PENSION AND OTHER POSTRETIREMENT BENEFITS Our defined benefit pension plans principally consist of both funded and unfunded noncontributory plans covering the majority of domestic employees and retirees. The funded plan provides a defined benefit based on a percentage of eligible compensation for periods of service. The funded defined benefit pension plan and unfunded pension plans are currently frozen to future benefit accruals. The following tables summarize changes in the benefit obligation, the plan assets and the funded status of our pension plans utilizing a measurement date as of September 30, 2016 and 2015, respectively: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Substantially all of the unfunded amounts are included within Other liabilities in the Consolidated Balance Sheets as of September 30, 2016 and September 30, 2015. In December 2014, we offered certain participants of our funded pension plan the option to receive a one-time lump-sum payment equal to the present value of their respective pension benefit. The settlement triggered a remeasurement of the net pension obligation and settlement accounting. The settlement resulted in the recognition of a non-cash settlement loss of $24 million reclassified from unrecognized actuarial loss included within Accumulated other comprehensive loss in the Consolidated Balance Sheets. The amount paid to the participants making the one-time election totaled $90 million which is included within Benefits paid in the 2015 table above. Accumulated Benefit Obligation The accumulated benefit obligation includes no assumption about future compensation levels since our plans are frozen. Included in the change in benefit obligation tables above are the following funded and unfunded plans with an accumulated benefit obligation equal to or in excess of plan assets at the end of the fiscal year. Net Periodic Benefit Costs Our net periodic benefit cost under Viacom’s pension plans consists of the following: The items reflected in Accumulated other comprehensive loss in the Consolidated Balance Sheets and not yet recognized as a component of net periodic benefit cost are: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Unrecognized actuarial loss of $7 million is expected to be recognized as a component of net periodic benefit cost during the fiscal year ended September 30, 2017. The amounts recognized in other comprehensive income during the year are: Two key assumptions used in accounting for pension liabilities and expenses are the discount rate and expected rate of return on plan assets. The discount rate reflects the estimated rate at which the pension benefit obligations could effectively be settled. We used investment grade corporate bond yields to support our discount rate assumption. Interest cost in 2016 is measured by applying the specific spot rates along the yield curve to the corresponding cash flows. The expected long-term returns on plan assets were based upon the target asset allocation and return estimates for equity and debt securities. The expected rate of return for equities was based upon the risk-free rate plus a premium for equity securities. The expected return on debt securities was based upon an analysis of current and historical yields on portfolios of similar quality and duration. The estimated impact of a 25 basis point change in the discount rate would change the accumulated benefit obligation by approximately $43 million. The impact of a 25 basis point change in the discount rate or expected rate of return on plan assets would change net periodic benefit cost by approximately $1 million. Investment Policies and Strategies The Viacom Investments Committee is responsible for managing the investment of assets under the funded pension plan in a prudent manner with regard to preserving principal while providing reasonable returns. The Viacom Investments Committee has established an investment policy through careful study of the returns and risks associated with alternative investment strategies in relation to the current and projected liabilities of the plan, after consulting with an outside investment advisor as it deems appropriate. The investment advisor’s role is to provide guidance to the Viacom Investments Committee on matters pertaining to the investment of plan assets including investment policy, investment selection, monitoring the plan’s performance and compliance with the plan’s investment policies. The investment policy establishes target asset allocations based upon an analysis of the timing and amount of projected benefit payments, the expected returns and risk of the asset classes and the correlation of those returns. Our practice is to review asset allocations regularly with our investment advisor and rebalance as necessary. The range of target asset allocations under our investment policy are 55-75% domestic and non-U.S. equity securities, 25-40% domestic and non-U.S. debt securities and 0-10% in cash and other instruments. The investment advisor implements the investment policy through investments in mutual funds and other pooled asset portfolios. Investments will be diversified within asset classes with the intent to minimize the risk of large losses to the plan. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The percentage of asset allocations of our funded pension plan at September 30, 2016 and 2015, by asset category were as follows: Viacom Class B common stock represents approximately 2% of the fair value of plan assets at September 30, 2016 and 2015. Fair Value Measurement of Plan Assets The following table sets forth the plan’s assets at fair value as of September 30, 2016 and 2015. For investments held at the end of the reporting period that are measured at fair value on a recurring basis, there were no transfers between levels from 2015 to 2016. The funded pension plan has no investments classified within level 3 of the valuation hierarchy. (1) Assets categorized as Level 2 reflect investments in money market funds. (2) Assets reflect common/collective trust funds. (3) Assets reflect mutual funds. (4) Reflects investments in common/collective trust funds and limited partnerships. Money market funds are carried at amortized cost which approximates fair value due to the short-term maturity of these investments. Common and preferred stocks are reported at fair value based on quoted market prices on national securities exchanges. Investments in registered investment companies (mutual funds) are stated at the respective funds’ net asset value (“NAV”), which is determined based on market values at the closing price on the last business day of the year and is a quoted price in an active market. The fair value of common/collective trust funds are based on their NAV at period-end. The fair value of U.S. Treasury securities and bonds is determined based on quoted market prices on national security exchanges, when available, or using valuation models which include certain other observable inputs including recent trading activity and broker quoted prices. Corporate bonds include securities of diverse industries, substantially all investment grade. Mortgage-backed and asset-backed securities are valued using valuation models which incorporate available dealer quotes and market information. The fair value of limited partnerships is valued at period-end based on its underlying investments. Future Benefit Payments The estimated future benefit payments for the next ten fiscal years are as follows: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Postretirement Health Care and Life Insurance Plans Eligible employees participate in Viacom-sponsored health and welfare plans that provide certain postretirement health care and life insurance benefits to retired employees and their covered dependents. Most of the health and welfare plans are contributory and contain cost-sharing features such as deductibles and coinsurance which are adjusted annually. Claims are paid either through certain trusts funded by Viacom or by our own funds. The amounts related to these plans were not material for all periods presented. 401(k) Plans Viacom has defined contribution (401(k)) plans for the benefit of substantially all our employees meeting certain eligibility requirements. Our costs recognized for such plans were $44 million in 2016, $46 million in 2015 and $47 million in 2014. Multiemployer Benefit Plans We contribute to various multiemployer pension plans under the terms of collective bargaining agreements that cover its union-represented employees. The risks of participating in these multiemployer plans are different from single-employer plans such that (i) contributions made by us to these plans may be used to provide benefits to employees of other participating employers; (ii) if a participating employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers; and (iii) if we choose to stop participating in some of our multiemployer plans, we may be required to pay those plans an amount based on the underfunded status of the plan, referred to as a withdrawal liability. While no multiemployer pension plan that we contributed to is considered individually significant to us, we were listed on two Form 5500s as providing more than 5% of total contributions to each plan based on current information available. The most recent filed zone status (which denotes the financial health of a plan) under the Pension Protection Act of 2006 for these two plans is green, indicating that the plans are at least 80% funded. Total contributions that we made to multiemployer pension plans were $48 million in 2016, $54 million in 2015 and $52 million in 2014. We also contribute to various other multiemployer benefit plans that provide health and welfare benefits to active and retired participants. Total contributions that we made to these non-pension multiemployer benefit plans were $73 million in 2016, $77 million in 2015 and $74 million in 2014. NOTE 10. REDEEMABLE NONCONTROLLING INTEREST We are subject to a redeemable put option, payable in a foreign currency, with respect to an international subsidiary. The put option expires in December 2022 and is classified as Redeemable noncontrolling interest in the Consolidated Balance Sheets. The activity reflected within redeemable noncontrolling interest for the fiscal years 2016, 2015 and 2014 is presented below. NOTE 11. COMMITMENTS AND CONTINGENCIES Commitments Our commitments primarily consist of programming and talent commitments, operating and capital lease arrangements, and purchase obligations for goods and services. These arrangements result from our normal course of business and represent obligations that may be payable over several years. Our programming and talent commitments that are not recorded on the balance sheet, which aggregated to approximately $1.550 billion as of September 30, 2016, included $1.191 billion relating to media networks programming and $359 million for talent contracts. At September 30, 2016, we have recorded, on the balance sheet, programming commitments of $1.003 billion. Amounts expected to be paid over the next five fiscal years, beginning with fiscal year 2017, are as follows: $692 million, $198 million, $84 million, $25 million and $4 million. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) We have long-term noncancelable operating and capital lease commitments for office space, equipment, transponders, studio facilities and vehicles. At September 30, 2016, minimum rental payments under noncancelable leases by fiscal year are as follows: Future minimum operating lease payments have been reduced by future minimum sublease income of $20 million. Rent expense amounted to $266 million in 2016, $268 million in 2015 and $227 million in 2014. We also have purchase obligations which include agreements to purchase goods or services in the future that totaled $1.211 billion as of September 30, 2016. Our collaborative arrangements principally relate to contractual arrangements with other studios to jointly finance and distribute theatrical productions (“co-financing arrangements”). A co-financing arrangement typically involves joint ownership of the film asset with each partner responsible for distribution of the film in specific territories. The partners share in the profits and losses of the film in accordance with their respective ownership interest. The amounts recorded in the Consolidated Statements of Earnings related to collaborative arrangements were not material. Contingencies Guarantees: In the course of our business, we both provide and receive the benefit of indemnities that are intended to allocate certain risks associated with business transactions. Leases - We have certain indemnification obligations with respect to leases primarily associated with the previously discontinued operations of Famous Players Inc. (“Famous Players”). In addition, we have certain indemnities provided by the acquirer of Famous Players. These lease commitments amounted to approximately $230 million as of September 30, 2016. The amount of lease commitments varies over time depending on expiration or termination of individual underlying leases, or of the related indemnification obligation, and foreign exchange rates, among other things. We may also have exposure for certain other expenses related to the leases, such as property taxes and common area maintenance. We have recorded a liability of $190 million with respect to such obligations as of September 30, 2016. We believe our accrual is sufficient to meet any future obligations based on our consideration of available financial information, the lessees’ historical performance in meeting their lease obligations and the underlying economic factors impacting the lessees’ business models. Other - We have indemnification obligations with respect to letters of credit and surety bonds primarily used as security against non-performance in the normal course of business. The outstanding letters of credit and surety bonds at September 30, 2016 were $34 million and are not recorded on our Consolidated Balance Sheet. Legal Matters: Settlement of Various Litigations Involving National Amusements and the Sumner M. Redstone National Amusements Trust Effective August 18, 2016, Viacom entered into an agreement (the “Settlement Agreement”) with National Amusements and NAI Entertainment Holdings LLC (together, “NAI”), various members of the Redstone family and related parties, the directors of the Company, and certain other parties. Pursuant to the Settlement Agreement, which was unanimously approved by our Board, among other matters, all claims among Viacom, NAI and the other parties to the Settlement Agreement that are the subject matter of the Settlement Agreement were dismissed and terminated. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Purported Class and Derivative Actions Between June 17, 2016 and August 1, 2016, three substantially similar purported class action complaints were filed in the Delaware Chancery Court by purported Viacom stockholders, against Viacom, Viacom’s directors and NAI and were subsequently consolidated into one action. The action - brought on behalf of the class of all holders of Viacom Class B common stock except the named defendants and any person or entity affiliated with any of the defendants - alleges claims for breaches of fiduciary duty against the incumbent director defendants and NAI, and alleges that Viacom’s new directors aided and abetted these breaches. In addition to damages and attorneys’ fees, the action seeks “such relief as the Court deems just and proper.” All defendants, including Viacom and certain of its directors, have moved to dismiss the action. On July 20, 2016, a purported derivative action was commenced in Delaware Chancery Court by a purported Viacom stockholder against Viacom and its directors. The complaint alleges that Viacom’s directors breached their fiduciary duties to Viacom in connection with compensation paid to Mr. Redstone. These breaches, it is alleged, permitted a waste of corporate assets and the unjust enrichment of Mr. Redstone. We intend to move to dismiss the action. NOTE 12. STOCKHOLDERS’ EQUITY Common Stock The Viacom Board of Directors has the power to issue shares of authorized but unissued Class A common stock and Class B common stock without further stockholder action, subject to the requirements of applicable law and stock exchanges. Viacom’s certificate of incorporation authorizes 375 million shares of Class A common stock and 5 billion shares of Class B common stock. The number of authorized shares of Class A common stock and Class B common stock could be increased with the approval of the stockholders of a majority of the outstanding shares of Class A common stock and without any action by the holders of shares of Class B common stock. The following is a description of the material terms of Viacom’s capital stock. The following description is not meant to be complete and is qualified by reference to Viacom’s certificate of incorporation and bylaws and Delaware General Corporation Law. Voting Rights: Holders of Class A common stock are entitled to one vote per share. Holders of Class B common stock do not have any voting rights, except as required by Delaware law. Generally, all matters to be voted on by Viacom stockholders must be approved by a majority of the aggregate voting power of the shares of Class A common stock present in person or represented by proxy at a meeting of stockholders, except in certain limited circumstances and as required by Delaware law. Dividends: Stockholders of Class A common stock and Class B common stock will share ratably in any cash dividend declared by the Board of Directors, subject to any preferential rights of any outstanding preferred stock. Conversion: So long as there are 5,000 shares of Class A common stock outstanding, each share of Class A common stock will be convertible at the option of the holder of such share into one share of Class B common stock. Liquidation Rights: In the event of liquidation, dissolution or winding-up of Viacom, all stockholders of common stock, regardless of class, will be entitled to share ratably in any assets available for distributions to stockholders of shares of Viacom common stock subject to the preferential rights of any outstanding preferred stock. Split, Subdivisions or Combination: In the event of a split, subdivision or combination of the outstanding shares of Class A common stock or Class B common stock, the outstanding shares of the other class of common stock will be divided proportionally. Preemptive Rights: Shares of Class A common stock and Class B common stock do not entitle a stockholder to any preemptive rights enabling a stockholder to subscribe for or receive shares of stock of any class or any other securities convertible into shares of stock of any class of Viacom. Preferred Stock Our capital stock includes 25 million authorized shares of preferred stock with a par value of $0.001 per share. At September 30, 2016 and 2015, none of the 25 million authorized shares of the preferred stock were issued and outstanding. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Stock Repurchase Program During 2016, we repurchased 2.1 million shares of Class B common stock for an aggregate price of $100 million, leaving $4.9 billion of remaining capacity under our $20.0 billion stock repurchase program. During 2015 and 2014, we repurchased 21.1 million and 40.7 million shares under the program for an aggregate price of $1.5 billion and $3.4 billion, respectively. Accumulated Other Comprehensive Loss The components of Accumulated other comprehensive loss are as follows: NOTE 13. EQUITY-BASED COMPENSATION Our 2016 Long-Term Management Incentive Plan, (the “LTMIP”), provides for various types of equity awards, including stock options, stock appreciation rights, restricted shares, unrestricted shares of Class B common stock, phantom shares, dividend equivalents, time-vested and performance-based share units, and other awards, or a combination of any of the above. In addition, our equity plans for outside directors provide for an annual grant of time-vested restricted share units (“RSUs”). We have primarily granted stock options and RSUs to employees. Certain senior executives have also received performance-based share units. Stock options generally vest ratably over a four-year period from the date of grant and expire eight to ten years after the date of grant. Employee RSUs typically vest ratably over a four-year period from the date of the grant. Director RSUs typically vest one year from the date of grant. The target number of performance share units (“PSUs”) granted to an executive represents the right to receive a corresponding number of shares of Class B common stock, subject to adjustment depending on the total shareholder return (“TSR”) of our Class B common stock measured against the TSR of the common stock of the companies comprising the S&P 500 Index at the start of the measurement period. The measurement period is generally three years. The number of shares of Class B common stock an executive is entitled to receive at the end of the applicable measurement period ranges from 0% to 300% of the target PSU award. If Viacom’s percentile rank of TSR relative to the TSR for the companies in the S&P 500 Index is less than the 25th percentile, the target grant is forfeited unless we have achieved a specified level of earnings per share set in advance for the measurement period, in which case the executive would receive a percentage of the target award. No other performance-based share units were outstanding as of September 30, 2016. Previously granted performance-based share units were designed to vest over three or four years and deliver, at the time of vesting, 75% to 125% of the target number of shares of Class B common stock underlying the awards based on the achievement of certain financial targets. Outstanding share units accrue dividends each time we declare a quarterly cash dividend, which are paid upon vesting on the number of shares delivered and are forfeited if the award does not vest. Upon the exercise of a stock option award or the vesting of share units, shares of Class B common stock are issued from authorized but unissued shares or from treasury stock. At September 30, 2016, we had 399.4 million shares in treasury. The aggregate number of equity awards authorized and available under the LTMIP for future grants as of September 30, 2016 was approximately 17 million, assuming that outstanding PSU awards are paid at target except for those awards for which the measurement period has been completed. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Presented below is a summary of the compensation cost we recognized in the accompanying Consolidated Statements of Earnings: Stock Options The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The determination of volatility is principally based upon implied volatilities from traded options. The expected term, representing the period of time that options granted are expected to be outstanding, is estimated using a lattice-based model incorporating historical post vest exercise and employee termination behavior. The risk-free rate assumed in valuing the options is based on the U.S. Treasury Yield curve in effect applied against the expected term of the option at the time of the grant. The expected dividend yield is estimated by dividing the expected annual dividend by the market price of our common stock at the date of grant. Below are the weighted average fair value of awards granted in the periods presented and the weighted average of the applicable assumptions used to value stock options at grant date. The following table summarizes information about our stock option transactions: The weighted average remaining contractual life of stock options outstanding and exercisable at September 30, 2016 was 4 years and 3 years, respectively. The aggregate intrinsic value of stock options outstanding and exercisable at September 30, 2016 was $17 million. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following table summarizes information relating to stock option exercises during the periods presented: Total unrecognized compensation cost related to unvested stock option awards at September 30, 2016 was approximately $41 million and is expected to be recognized on a straight-line basis over a weighted-average period of 3 years. Share Unit Awards The grant date fair value for the PSUs subject to the market and performance condition indicated earlier in this note is computed using a Monte Carlo model to estimate the total return ranking of Viacom among the S&P 500 Index companies on the date of grant over the measurement periods. Compensation cost for PSUs is being recognized as the requisite service period is fulfilled and assumes all performance goals will be met. The grant date fair value for RSUs and other performance-based share units is based on our stock price on the date of the grant. The following table summarizes activity relating to our share unit transactions: * Grant activity includes 0.4 million, 0.4 million and 0.2 million of performance-based share units at target for 2016, 2015 and 2014, respectively. The total weighted average remaining contractual life and aggregate intrinsic value of unvested share units at September 30, 2016 was 2 years and $96 million, respectively. The fair value of share units vested was $46 million in 2016, $110 million in 2015 and $212 million in 2014. Total unrecognized compensation cost related to these awards at September 30, 2016 was approximately $104 million and is expected to be recognized over a weighted-average period of 3 years. NOTE 14. RESTRUCTURING AND PROGRAMMING CHARGES In 2016, we recognized a restructuring charge of $206 million in connection with the separation of certain senior executives. The restructuring charge includes the cost of separation payments of $138 million and the acceleration of equity-based compensation expense of $68 million. Separation payments of $48 million were paid in 2016 with the majority of the remaining amount scheduled to be paid in fiscal 2017. We established grantor trusts in our name and funded the trusts with approximately $69 million to facilitate the administration of certain payments. The assets held in the grantor trusts are Company assets and are therefore included in our Consolidated Balance Sheet within Prepaid and other assets and Other assets - noncurrent as of September 30, 2016. In 2015, we recognized a charge consisting of $578 million of programming charges and a $206 million restructuring charge associated with workforce reductions. The programming charges are included within Operating expenses in the Consolidated Statement of Earnings. These charges were recognized in connection with a company-wide review across our worldwide Media Networks, Filmed Entertainment operations and corporate functions. The company-wide review resulted in the implementation of significant strategic and operational improvements aimed at addressing the ratings challenges experienced by our networks and enhancing the effectiveness and efficiency of our operations, including a new programming strategy shifting focus away from repeated acquired programming and toward fresher, first-run original programming specifically targeted to appeal to our youth and family-oriented demographics. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) As a result of the review, we reorganized our operating segments and the newly structured operating segment management performed a comprehensive strategic review of existing programming, resulting in the identification of programming not aligned with the Company’s new strategy. Decisions were made to cease airing certain programs, alter future airing patterns of certain other programs, and move some programming to secondary networks that would not generate sufficient revenues to support their carrying value. Our restructuring liability for the workforce reductions in 2015 by reporting segment is as follows: The liability as of September 30, 2016 is related to future severance payments in connection with the restructuring plan undertaken in fiscal 2015. We anticipate that substantially all of the remaining liability associated with the restructuring plan will be paid during fiscal 2017. NOTE 15. INCOME TAXES Earnings from continuing operations before provision for income taxes consist of the following: The provision for income taxes from continuing operations consists of the following: A reconciliation of the effective income tax rate on continuing operations to the U.S. federal statutory income tax rate is as follows: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) We recognized a net discrete tax benefit of $102 million in 2016, $258 million in 2015 and $49 million in 2014, which served to reduce the provision for income taxes for those periods. The benefit in 2016 is principally related to a tax accounting method change granted by the Internal Revenue Service (“IRS”), the release of tax reserves with respect to certain effectively settled tax positions and the recognition of capital loss carryforwards, partially offset by a reduction in qualified production activity tax benefits as a result of retroactively reenacted legislation. During 2015, we reorganized certain non-U.S. subsidiaries in order to facilitate a more efficient movement of non-U.S. cash and to support the expansion of key areas for growth internationally. The benefit in 2015 was principally related to excess foreign tax credits attributable to a taxable repatriation of non-U.S. earnings from reorganized entities and the release of tax reserves with respect to certain effectively settled tax positions. The benefit in 2014 was principally related to the reversal of deferred taxes on earnings deemed permanently reinvested and the recognition of capital loss carryforwards. The tax effects of the items recorded as deferred tax assets and liabilities are: We have recorded valuation allowances for certain deferred tax assets, which are primarily related to capital losses in the U.S. and net operating losses in foreign jurisdictions, as sufficient uncertainty exists regarding the future realization of these assets. We have $178 million of U.S. tax capital loss carryforwards at September 30, 2016. The utilization of these carryforwards as an available offset to future taxable income is subject to limitations under U.S. federal income tax laws. These carryforwards begin to expire in fiscal year 2018. In addition, we have $324 million of tax losses in various international jurisdictions that are primarily from countries with unlimited carry forward periods and $426 million of tax losses that expire in the fiscal years 2017 through 2036. The pre-valuation allowance deferred tax asset amount related to these U.S. and international tax loss carryforwards is $223 million. In November 2015, the FASB issued new guidance which requires that all deferred taxes be classified as noncurrent in the balance sheet. We adopted the new guidance on a retrospective basis. The net deferred tax assets and deferred tax liabilities included in the Consolidated Balance Sheets were as follows: Deferred tax assets are included within Other assets in the Consolidated Balance Sheets. As of September 30, 2016, we have not made any provision for U.S. income taxes on approximately $2.2 billion of unremitted earnings of our international subsidiaries since these earnings are permanently reinvested outside the U.S. If these earnings were to be remitted in the future, the related U.S. income tax liability may be reduced by any foreign income taxes previously VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) paid on these earnings. Under current U.S. tax laws, repatriating unremitted earnings could result in incremental taxes of 10% -15% on the repatriated amounts depending on the territory. To the extent that any tax reform legislation were to lower the U.S. federal statutory income tax rate from its current 35%, there could be a corresponding reduction in the estimate of incremental taxes that would result from repatriating unremitted earnings. A reconciliation of the beginning and ending amounts of unrecognized tax benefits, excluding interest and penalties, is as follows: The total amount of unrecognized tax benefits at September 30, 2016, if recognized, would favorably affect the effective tax rate. As discussed in Note 2, we recognize interest and penalties accrued related to unrecognized tax benefits as a component of the Provision for income taxes in the Consolidated Statements of Earnings. We recognized interest and penalties of $11 million in 2016, $8 million in 2015 and $10 million in 2014. We had accruals of $37 million and $35 million related to interest and penalties recorded as a component of Other liabilities - noncurrent in the Consolidated Balance Sheets at September 30, 2016 and 2015, respectively. We and our subsidiaries file income tax returns with the IRS and various state and international jurisdictions. Tax authorities are conducting examinations of Viacom subsidiaries in various international and state and local jurisdictions, including New York State and New York City. Due to potential resolution of unrecognized tax positions involving multiple tax periods and jurisdictions, it is reasonably possible that a reduction of up to $100 million of unrecognized income tax benefits may occur within 12 months, some of which, depending on the nature of the settlement, may affect our income tax provision and therefore benefit the resulting effective tax rate. The majority of these uncertain tax positions, when recognized in the financial statements, would be recorded in the Consolidated Statements of Earnings as part of the Provision for income taxes. The actual amount could vary significantly depending on the ultimate timing and nature of any settlements. NOTE 16. EARNINGS PER SHARE The following table sets forth the weighted average number of common shares outstanding used in determining basic and diluted earnings per common share and anti-dilutive shares: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 17. SUPPLEMENTAL CASH FLOW Our supplemental cash flow information is as follows: Cash paid for income taxes in the years ended September 30, 2016 and 2015 includes a benefit from the retroactive reenactment of legislation allowing for accelerated tax deductions on certain qualified film and television productions. NOTE 18. FAIR VALUE MEASUREMENTS Assets/Liabilities Measured and Recorded at Fair Value on a Recurring Basis The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2016 and 2015: The fair value for marketable securities is determined utilizing a market approach based on quoted market prices in active markets at period end. These investments are included within Prepaid and other assets in the Consolidated Balance Sheets. The fair value for derivatives is determined utilizing a market-based approach. We use derivative financial instruments to modify our exposure to market risks from changes in foreign exchange rates and interest rates. We conduct business in various countries outside the U.S., resulting in exposure to movements in foreign exchange rates when translating from the foreign local currency to the U.S. Dollar. We use foreign currency forward contracts to economically hedge anticipated cash flows and foreign currency balances in such currencies as the British Pound, the Euro, the Brazilian Real, the Japanese Yen, the Australian Dollar, the Singapore Dollar and the Canadian Dollar. We also enter into forward contracts to hedge future production costs or programming obligations. We manage the use of foreign exchange derivatives centrally. At September 30, 2016 and 2015, the notional value of all foreign exchange contracts was $1.149 billion and $1.040 billion, respectively. In 2016, $874 million related to our foreign currency balances and $275 million related to future production costs. In 2015, $769 million related to our foreign currency balances and $271 million related to future production costs. Assets Measured and Recorded at Fair Value on a Non-Recurring Basis Certain assets, such as intangible assets and investments, are recorded at fair value only if an impairment charge is recognized. In 2016, we recognized an impairment charge of $115 million related to the expected performance of an unreleased film and, as described in Note 14, in 2015, we recognized charges related to the write-down of certain programming and films. The charges reflect the excess of the unamortized cost of the programs and films over their estimated fair value using discounted cash flows, which is a Level 3 valuation technique. In 2014, we recognized an impairment charge of $43 million related to an international trade name at Media Networks. The fair value of the trade name (Level 3) was $28 million calculated utilizing the relief-from-royalty method. Under this method, fair VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) value is calculated as the discounted cash flows based on applying a royalty rate to the revenues derived from the trade name. The royalty rate was derived from market data. NOTE 19. REPORTING SEGMENTS The following tables set forth our financial performance by reporting segment. Our reporting segments have been determined in accordance with our internal management structure. We manage our operations through two reporting segments: (i) Media Networks and (ii) Filmed Entertainment. Typical intersegment transactions include the purchase of advertising by the Filmed Entertainment segment on Media Networks’ properties and the purchase of Filmed Entertainment’s feature films exhibition rights by Media Networks. The elimination of such intercompany transactions in the Consolidated Financial Statements is included within eliminations in the tables below. Our measure of segment performance is adjusted operating income. Adjusted operating income is defined as operating income, before equity-based compensation and certain other items identified as affecting comparability, including restructuring and programming charges, when applicable. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Revenues generated from international markets were approximately 25%, 25% and 26% of total consolidated revenues in 2016, 2015, and 2014, respectively. Our principal international businesses are in Europe. The United Kingdom and Germany together accounted for approximately 57%, 55%, and 45% of total revenues in the Europe, Middle East and Africa (“EMEA”) region in 2016, 2015, and 2014, respectively. *Revenue classifications are based on customers’ locations. Transactions within Viacom between geographic areas are not significant. **Excludes deferred tax assets, goodwill, other intangible assets and investments. NOTE 20. RELATED PARTY TRANSACTIONS National Amusements, directly and indirectly, is the controlling stockholder of both Viacom and CBS. National Amusements owns shares in Viacom representing approximately 79.8% of the voting interest in Viacom and approximately 10% of Viacom’s combined common stock. National Amusements is controlled by Sumner M. Redstone, our Chairman Emeritus, who is the Chairman and Chief Executive Officer of National Amusements, through the Sumner M. Redstone National Amusements Trust (the “SMR Trust”), which owns shares in National Amusements representing 80% of the voting interest of National Amusements. The shares representing the other 20% of the voting interest of National Amusements are held through a trust controlled by Shari E. Redstone, who is Mr. Redstone’s daughter and the non-executive Vice Chair of Viacom and the President and a member of the Board of Directors of National Amusements. The shares of National Amusements held by the SMR Trust are voted solely by Mr. Redstone until such time as his incapacity or death. Upon Mr. Redstone’s incapacity or death, (1) Ms. Redstone will also become a trustee of the SMR Trust and (2) the shares of National Amusements held by the SMR Trust will be voted by the trustees of the SMR Trust. The current trustees include Mr. Redstone and David R. Andelman, a member of the boards of directors of National Amusements and CBS. The current Board of Directors of National Amusements includes Mr. Redstone, Ms. Redstone and Mr. Andelman. In addition, Mr. Redstone serves as Chairman Emeritus of CBS and Ms. Redstone serves as non-executive Vice Chair of CBS. Transactions between Viacom and related parties are overseen by our Governance and Nominating Committee. On September 29, 2016, our Board of Directors received a letter from National Amusements requesting that our Board explore a potential combination of Viacom and CBS. Subsequently, the Board formed a special committee of independent directors to consider the request from National Amusements and any proposed transaction, and the special committee has hired independent legal and financial advisers. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Viacom and National Amusements Related Party Transactions National Amusements licenses films in the ordinary course of business for its motion picture theaters from all major studios, including Paramount. During the years ended September 30, 2016, 2015 and 2014, Paramount earned revenues from National Amusements in connection with these licenses in the aggregate amounts of approximately $8 million, $10 million and $15 million, respectively. Viacom and CBS Corporation Related Party Transactions In the ordinary course of business, we are involved in transactions with CBS and its various businesses that result in the recognition of revenues and expenses by us. Transactions with CBS are settled in cash. Our Filmed Entertainment segment earns revenues and recognizes expenses associated with its distribution of certain television products into the home entertainment market on behalf of CBS. Pursuant to its agreement with CBS, Paramount distributes CBS’s library of television and other content on DVD and Blu-ray disc on a worldwide basis. Under the terms of the agreement, Paramount is entitled to retain a fee based on a percentage of gross receipts and is generally responsible for all out-of-pocket costs, which are recoupable prior to any participation amounts paid. Paramount also earns revenues from CBS through leasing of studio space and licensing of certain film products. Our Media Networks segment recognizes advertising revenues and purchases television programming from CBS. The cost of the programming purchases is initially recorded as acquired program rights inventory and amortized over the estimated period that revenues will be generated. Both of our segments recognize advertising expenses related to the placement of advertisements with CBS. The following table summarizes the transactions with CBS as included in our Consolidated Financial Statements: VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Other Related Party Transactions In the ordinary course of business, we are involved in related party transactions with equity investees. These related party transactions primarily relate to the provision of advertising services, licensing of film and programming content, distribution of films and provision of certain administrative support services, for which the impact on our Consolidated Financial Statements is as follows: All other related party transactions are not material in the periods presented. NOTE 21. QUARTERLY FINANCIAL DATA (unaudited): The following are certain items identified as affecting comparability in 2016: • A pre-tax restructuring charge of $206 million ($131 million after tax) in the fourth quarter in connection with the separation of certain senior executives. • A net discrete tax expense of $21 million in the first quarter and a net discrete tax benefit of $13 million in the third quarter and $110 million in the fourth quarter. Discrete tax items relate to certain events, such as a change in tax law, tax accounting method change or release of reserves that occurred in the respective period. VIACOM INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following are certain items identified as affecting comparability in 2015: • A pre-tax non-cash charge of $24 million ($15 million after tax) in the first quarter in connection with the settlement of pension benefits of certain participants of our funded pension plan. • A pre-tax charge of $784 million ($520 million after tax) in the second quarter reflecting $578 million of programming charges and a $206 million restructuring charge associated with workforce reductions. • A pre-tax charge of $18 million ($11 million after tax) in the fourth quarter in connection with a debt extinguishment loss on the redemption of $550 million of the total $918 million outstanding of our 6.250% Senior Notes due April 2016. • A net discrete tax expense of $23 million in the first quarter and a net discrete tax benefit of $281 million in the fourth quarter.
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Based on the provided financial statement excerpt, here's a summary:
Revenue Recognition:
- Revenue is earned through distribution and agency agreements
- Revenues are reported gross or net based on management's assessment of the customer
- Revenue is recognized when the company acts as the principal in a transaction
Revenue Allowances:
- Provisions for sales returns and allowances are recorded at the time of sale
- Estimates are based on:
* Forecasted sales data
* Customer return rights
* Historical return rates
* Economic trends
* Competitive environment
* Promotions and sales strategies
Financial Reporting Characteristics:
- Sales returns and allowances reserve was $93
- Significant estimates include:
* Film ultimate revenues
* Product returns
* Uncertain tax positions
* Fair value of assets and liabilities
* Equity-based compensation
* Pension benefit assumptions
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES ACCOUNTING FIRM Shareholders and Board of Trustees Urban Edge Properties New York, New York We have audited the accompanying consolidated balance sheets of Urban Edge Properties (the "Company") as of December 31, 2016 and 2015, and the related consolidated and combined statements of income, changes in equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedules listed in the Index at These consolidated and combined financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated and combined financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated and combined financial statements present fairly, in all material respects, the financial position of Urban Edge Properties as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated and combined financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated and combined financial statements, the combined financial statements of the Company include allocations of certain expenses from Vornado Realty Trust. These costs may not be reflective of the actual costs which would have been incurred had the Company operated as an independent, stand-alone entity separate from Vornado Realty Trust. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 16, 2017 expressed an unqualified opinion on the Company's internal control over financial reporting. /s/ DELOITTE & TOUCHE LLP New York, New York February 16, 2017 ACCOUNTING FIRM Partners of Urban Edge Properties LP New York, New York We have audited the accompanying consolidated balance sheets of Urban Edge Properties LP (the "Operating Partnership") as of December 31, 2016 and 2015, and the related consolidated and combined statements of income, changes in equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedules listed in the Index at These consolidated and combined financial statements and financial statement schedules are the responsibility of the Operating Partnership's management. Our responsibility is to express an opinion on the consolidated and combined financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated and combined financial statements present fairly, in all material respects, the financial position of Urban Edge Properties LP as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated and combined financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated and combined financial statements, the combined financial statements of the Operating Partnership include allocations of certain expenses from Vornado Realty Trust. These costs may not be reflective of the actual costs which would have been incurred had the Operating Partnership operated as an independent, stand-alone entity separate from Vornado Realty Trust. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Operating Partnership's internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 16, 2017 expressed an unqualified opinion on the Operating Partnership's internal control over financial reporting. /s/ DELOITTE & TOUCHE LLP New York, New York February 16, 2017 URBAN EDGE PROPERTIES CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts) See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES CONSOLIDATED AND COMBINED STATEMENTS OF INCOME (In thousands, except share and per share data) See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES CONSOLIDATED AND COMBINED STATEMENTS OF CHANGES IN EQUITY (In thousands, except share and per share amounts) (1) Net loss earned from January 1, 2015 through January 15, 2015 is attributable to Vornado as it was the sole shareholder prior to January 15, 2015. Refer to Note 1 - Organization. See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS (In thousands) See notes to consolidated and combined financial statements. See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES LP CONSOLIDATED BALANCE SHEETS (In thousands, except unit and per unit amounts) See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES LP CONSOLIDATED AND COMBINED STATEMENTS OF INCOME (In thousands, except unit and per unit amounts) See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES LP CONSOLIDATED AND COMBINED STATEMENT OF CHANGES IN EQUITY (In thousands, except unit and per unit amounts) (1) Limited partners have a 6.0% common limited partnership interest in the Operating Partnership as of December 31, 2016 in the form of units of interest in the Operating Partnership (“OP Units”) and Long Term Incentive Plan (“LTIP”) units. (2) Net loss earned from January 1, 2015 through January 15, 2015 is attributable to Vornado as it was the sole unitholder prior to January 15, 2015. Refer to Note 1 - Organization. See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES LP CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS (In thousands) See notes to consolidated and combined financial statements. URBAN EDGE PROPERTIES AND URBAN EDGE PROPERTIES LP NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS 1. ORGANIZATION Urban Edge Properties (“UE”, “Urban Edge” or the “Company”) (NYSE: UE) is a Maryland real estate investment trust that owns, manages, acquires, develops, redevelops and operates retail real estate in high barrier-to-entry markets. Urban Edge Properties LP (“UELP” or the “Operating Partnership”) is a Delaware limited partnership formed to serve as the Company’s majority-owned partnership subsidiary and to own, through affiliates, all of the Company’s real estate properties and other assets. Prior to its separation on January 15, 2015, UE was a wholly owned subsidiary of Vornado Realty Trust (“Vornado”) (NYSE: VNO). UE and UELP were created to own the majority of Vornado’s former shopping center business. Prior to the separation, the portfolio is referred to as “UE Businesses.” Unless the context otherwise requires, references to “we”, “us” and “our” refer to Urban Edge Properties and UELP and their consolidated entities/subsidiaries after giving effect to the transfer of assets and liabilities from Vornado as well as to UE Businesses prior to the date of the separation. Pursuant to a separation and distribution agreement between UE and Vornado (the “Separation Agreement”), the interests in certain properties held by Vornado’s operating partnership, Vornado Realty L.P. (“VRLP”), were contributed or otherwise transferred to UE in exchange for 100% of our outstanding common shares. Following that contribution, VRLP distributed 100% of our outstanding common shares to Vornado and the other common limited partners of VRLP, pro rata with respect to their ownership of common limited partnership units in VRLP. Vornado then distributed all of the UE common shares it had received from VRLP to Vornado common shareholders on a pro rata basis. As a result, VRLP common limited partners and Vornado common shareholders all received common shares of UE in the spin-off at a ratio of one common share of UE to every two VRLP common units and every two common shares of Vornado. Substantially concurrently with such distribution, the interests in certain properties held by VRLP, including interests in entities holding properties, were contributed or otherwise transferred to UELP in exchange for 5.4% of UELP’s outstanding common limited partnership interests in the Operating Partnership (“OP Units”). The Operating Partnership’s capital includes OP Units. As of December 31, 2016, Urban Edge owned approximately 94.0% of the outstanding common OP Units with the remaining limited OP Units held by VRLP, and members of management and our Board of Trustees. Urban Edge serves as the sole general partner of the Operating Partnership. The third party unitholders have limited rights over the Operating Partnership such that they do not have characteristics of a controlling financial interest. As such, the Operating Partnership is considered a variable interest entity (“VIE”), and the Company is the primary beneficiary which consolidates it. The Company’s only investment is the Operating Partnership. As part of the separation, Vornado capitalized UE with $225 million of cash. Vornado also paid $21.9 million of the transaction costs incurred in connection with the separation, which is reflected within non-cash separation costs paid by Vornado within the statement of cash flows. Of the $21.9 million transaction costs, $17.4 million were contingent on the completion of the separation. The remaining $4.5 million of transaction costs were allocated to Vornado on the separation date. As of December 31, 2016 our portfolio consisted of 79 shopping centers, three malls and a warehouse park totaling 14.8 million square feet. 2. BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION AND COMBINATION The accompanying consolidated and combined financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for annual financial information and with the instructions of Form 10-K. The consolidated financial statements as of and for the year ended December 31, 2016 reflect the consolidation of the Company, the Operating Partnership, wholly-owned subsidiaries and those entities in which we have a controlling financial interest, including entities where we have been determined to be a primary beneficiary of a variable interest entity (“VIE”). The results presented for the year ended December 31, 2015 reflect the operations and changes in cash flows on a carved-out and combined basis for the period from January 1, 2015 through the date of separation and on a consolidated basis subsequent to the date of separation. The financial statements for the periods prior to the separation date are prepared on a carved-out and combined basis from the consolidated financial statements of Vornado as UE Businesses were under common control of Vornado prior to January 15, 2015. Such carved-out and combined amounts were determined using the historical results of operations and carrying amounts of the assets and liabilities transferred to UE Businesses. The financial statements reflect the common shares as of the date of the separation as outstanding for all periods prior to the separation. All intercompany transactions have been eliminated in consolidation and combination. For periods presented prior to the date of the separation, our historical combined financial results for UE Businesses reflect charges for certain corporate costs which we believe are reasonable. These charges were based on either actual costs incurred by Vornado or a proportion of costs estimated to be applicable to UE Businesses based on an analysis of key metrics including total revenues, real estate assets, leasable square feet and operating income. Such costs do not necessarily reflect what the actual costs would have been if the Company were operating as a separate stand-alone public company. These charges are discussed further in Note 5 - Related Party Transactions. Our primary business is the ownership, management, redevelopment, development and operation of retail shopping centers. We do not distinguish our primary business or group our operations on a geographical basis for purposes of measuring performance. We review operating and financial information for each property on an individual basis and therefore, each property represents an individual operating segment. None of our tenants accounted for more than 10% of our revenue or property operating income. We aggregate all of our properties into one reportable segment due to their similarities with regard to the nature and economics of the properties, tenants and operations, as well as long-term average financial performance. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Real Estate - Real estate is carried at cost, net of accumulated depreciation and amortization. Expenditures for ordinary maintenance and repairs are expensed to operations as they are incurred. Significant renovations and improvements that improve or extend the useful lives of assets are capitalized. As real estate is undergoing redevelopment activities, all property operating expenses directly associated with and attributable to the redevelopment, including interest, are capitalized to the extent the capitalized costs of the property do not exceed the estimated fair value of the redeveloped property when completed. If the cost of the redeveloped property, including the net book value of the existing property, exceeds the estimated fair value of redeveloped property, the excess is charged to impairment expense. We capitalize all property operating expenses directly associated with and attributable to the development of a project, including interest expense. The capitalization period begins when redevelopment activities are underway and ends when the project is substantially complete. Depreciation is recognized on a straight-line basis over estimated useful lives which range from 3 to 40 years. Tenant related intangibles and improvements are amortized on a straight-line basis over the lease term, including any bargain renewal options. Upon the acquisition of real estate, we assess the fair value of acquired assets (including land, buildings and improvements, identified intangibles, such as acquired above and below-market leases, acquired in-place leases and tenant relationships) and acquired liabilities and we allocate the purchase price based on these assessments. We assess fair value based on estimated cash flow projections utilizing appropriate discount and capitalization rates and available market information. Estimates of future cash flows are based on a number of factors including historical operating results, known trends, and market/economic conditions. We record acquired intangible assets (including acquired above-market leases, acquired in-place leases and tenant relationships) and acquired intangible liabilities (including below-market leases) at their estimated fair value separate and apart from goodwill. We amortize identified intangibles that have finite lives over the period they are expected to contribute directly or indirectly to the future cash flows of the property or business acquired. Our properties are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the aggregate projected future cash flows over the anticipated holding period on an undiscounted basis. An impairment loss is measured based on the excess of the property’s carrying amount over its estimated fair value. Impairment analyses are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. If our estimates of the projected future cash flows, anticipated holding periods, or market conditions change, our evaluation of impairment losses may be different and such differences could be material to our consolidated and combined financial statements. The evaluation of anticipated cash flows is subjective and is based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Cash and Cash Equivalents - Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less and are carried at cost, which approximates fair value due to their short-term maturities. The majority of our cash and cash equivalents consists of (i) deposits at major commercial banks, which may at times exceed the Federal Deposit Insurance Corporation limit and (ii) United States Treasury Bills. To date we have not experienced any losses on our invested cash. Restricted Cash - Restricted cash consists of security deposits and cash escrowed under loan agreements for debt service, real estate taxes, property insurance, tenant improvements, leasing commissions and capital expenditures. Accounts Receivable and Allowance for Doubtful Accounts - Accounts receivable includes unpaid amounts billed to tenants and accrued revenues for future billings to tenants for property expenses. We periodically evaluate the collectibility of amounts due from tenants and maintain an allowance for doubtful accounts for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We also maintain an allowance for receivables arising from the straight-lining of rents. These receivables arise from earnings recognized in excess of amounts currently due under the lease agreements. Management exercises judgment in establishing these allowances and considers payment history and current credit status in developing these estimates. Accounts receivable are written-off when they are deemed to be uncollectible and we are no longer actively pursuing collection. Deferred Leasing Costs - Deferred leasing costs include direct salaries, third-party fees and other costs incurred by us to originate a lease. Such costs are capitalized and amortized on a straight-line basis over the term of the related leases. Deferred Financing Costs - Deferred financing costs include fees associated with our revolving credit agreement. Such fees are amortized on a straight-line basis over the terms of the related revolving credit agreement as a component of interest expense, which approximates the effective interest rate method, in accordance with the terms of the agreement. No amounts have been drawn to date under the agreement. Revenue Recognition - We have the following revenue sources and revenue recognition policies: • Base Rent - income arising from minimum lease payments from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis which includes the effects of rent steps and rent abatements under the leases. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a lease incentive to tenants, we recognize the incentive as a reduction of rental revenue on a straight-line basis over the term of the lease. • Percentage Rent - income arising from retail tenant leases that is contingent upon tenant sales exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). • Expense Reimbursements - revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses, real estate taxes and capital improvements of the respective property. This revenue is accrued in the same periods as the expenses are incurred. • Management, Leasing and Other Fees - income arising from contractual agreements with third parties. This revenue is recognized as the related services are performed under the respective agreements. Noncontrolling Interests - Noncontrolling interests represent the portion of equity that we do not own in those entities that we consolidate. We identify our noncontrolling interests separately within the equity section on the consolidated balance sheets. Redeemable Noncontrolling Interests - Redeemable noncontrolling interests include OP units and limited partnership interests in the Operating Partnership in the form of long-term incentive plan (“LTIP”) unit awards. Variable Interest Entities - Certain entities that do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest qualify as VIEs. VIEs are required to be consolidated by their primary beneficiary. The primary beneficiary of a VIE has both the power to direct the activities that most significantly impact economic performance of the VIE and the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE. The consolidated and combined financial statements reflect the consolidation of VIEs in which the Company is the primary beneficiary. Earnings Per Share and Unit - Basic earnings per common share and unit is computed by dividing net income attributable to common shareholders and unitholders by the weighted average common shares and units outstanding during the period. Unvested share-based payment awards that entitle holders to receive non-forfeitable dividends, such as our restricted stock awards, are classified as “participating securities.” Because the awards are considered participating securities, the Company and the Operating Partnership are required to apply the two-class method of computing basic and diluted earnings that would otherwise have been available to common shareholders and unitholders. Under the two-class method, earnings for the period are allocated between common shareholders and unitholders and other shareholders and unitholders, based on their respective rights to receive dividends. During periods of net loss, losses are allocated only to the extent the participating securities are required to absorb their share of such losses. Diluted earnings per common share and unit reflects the potential dilution of the assumed exercises of shares including stock options and unvested restricted shares to the extent they are dilutive. Share-Based Compensation - We grant stock options, LTIP units, OP units, restricted share awards and performance-based units to our officers, trustees and employees. The term of each award is determined by the compensation committee of our Board of Trustees (the “Compensation Committee”), but in no event can such term be longer than ten years from the date of grant. The vesting schedule of each award is determined by the Compensation Committee, in its sole and absolute discretion, at the date of grant of the award. Dividends are paid on certain shares of unvested restricted stock, which makes the restricted stock a participating security. Fair value is determined, depending on the type of award, using either the Black-Scholes option-pricing model or the Monte Carlo method, both of which are intended to estimate the fair value of the awards at the grant date. In using the Black-Scholes option-pricing model, expected volatilities and dividend yields are primarily based on available implied data and peer group companies historical data. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Compensation expense for restricted share awards is based on the fair value of our common shares at the date of the grant and is recognized ratably over the vesting period. For grants with a graded vesting schedule or a cliff vesting schedule, we have elected to recognize compensation expense on a straight-line basis. Also included in Share-based compensation expense is the unrecognized compensation expense of awards issued under Vornado’s outperformance plan (“OPP”) prior to the separation for the Company’s employees who were previously Vornado employees. The OPP unrecognized compensation expense is recognized on a straight-line basis over the remaining life of the OPP awards issued. Share-based compensation expense is included in general and administrative expenses on the consolidated and combined statements of income. When the Company issues common shares as compensation, it receives a like number of common units from the Operating Partnership. Accordingly, the Company’s ownership in the Operating Partnership will increase based on the number of common shares awarded under our 2015 Omnibus Share Plan. As a result of the issuance of common units to the Company for share-based compensation, the Operating Partnership accounts for share-based compensation in the same manner as the Company. Income Taxes - Our two Puerto Rico malls are subject to income taxes which are based on estimated taxable income and are included in income tax expense in the consolidated and combined statements of income. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted tax rates in effect for the year in which these temporary differences are expected to be recovered or settled. Earnings and profits, which determine the taxability of dividends to shareholders, differs from net income reported for financial reporting purposes primarily because of differences in depreciable lives and cost bases of the malls, as well as other timing differences. Concentration of Credit Risk - A concentration of credit risk arises in our business when a national or regionally-based tenant occupies a substantial amount of space in multiple properties owned by us. In that event, if the tenant suffers a significant downturn in its business, it may become unable to make its contractual rent payments to us, exposing us to potential losses in rental revenue, expense recoveries, and percentage rent. Further, the impact may be magnified if the tenant is renting space in multiple locations. Generally, we do not obtain security from our national or regionally-based tenants in support of their lease obligations to us. We regularly monitor our tenant base to assess potential concentrations of credit risk. None of our tenants accounted for more than 10% of total revenues in the year ended December 31, 2016. As of December 31, 2016, The Home Depot was our largest tenant with 7 stores which comprised an aggregate of 920,000 square-feet and accounted for approximately $20.2 million, or 6.2% of our total revenue for the year ended December 31, 2016. Recently Issued Accounting Literature In January 2017, the FASB issued an update (“ASU 2017-01”) Clarifying the Definition of a Business, which introduces amendments that are intended to make the guidance on the definition of a business more consistent and cost-efficient. The objective of the update is to add further guidance that assists entities in evaluating whether a transaction will be accounted for as an acquisition of an asset or a business by providing a screen to determine when the set of assets and activities acquired is not a business. ASU 2017-01 is effective for annual periods beginning after December 15, 2017, with early adoption permitted. Early adoption is permitted as of the beginning of a reporting period for which financial statements have not yet been issued. The ASU must be applied prospectively on or after the effective date. The adoption of this standard will result in less real estate acquisitions qualifying as businesses and, accordingly, acquisition costs for those acquisitions that are not businesses will be capitalized rather than expensed. In November 2016, the FASB issued an update (“ASU 2016-18”) Statement of Cash Flows - Restricted Cash, that requires entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. As a result, entities will no longer present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the statement of cash flows. ASU 2016-18 is effective for annual periods beginning after December 15, 2017, with early adoption permitted. We elected to early adopt ASU 2016-18 including retrospective adoption for all prior periods. The impact of the adoption of ASU 2016-18 is the addition of a reconciliation of the totals in the statement of cash flows to the related captions in the balance sheet. In August 2016, the FASB issued an update (“ASU 2016-15”) Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments, which addresses specific cash flow classification issues where there is currently diversity in practice including debt prepayment and proceeds from the settlement of insurance claims. ASU 2016-15 is effective for annual periods beginning after December 15, 2017, with early adoption permitted. We elected to early adopt ASU 2016-15 effective as of September 30, 2016. The adoption of ASU 2016-15 did not impact our results of operations or cash flows. In June 2016, the FASB issued an update (“ASU 2016-13”) Measurement of Credit Losses on Financial Instruments, which replaces the incurred impairment methodology in current GAAP with a methodology that reflects expected credit losses. The update is intended to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. ASU 2016-13 is effective for annual periods beginning after December 15, 2019, with early adoption permitted for annual periods beginning after December 15, 2018. We are evaluating the impact this standard will have on our consolidated and combined financial statements. In February 2016, the FASB issued an update (“ASU 2016-02”) Leases, which revises the accounting related to lease accounting. Under the new guidance, lessees will be required to recognize a lease liability and a right-of-use asset for all leases with terms greater than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The provisions of ASU 2016-02 are effective for fiscal years beginning after December 15, 2018 and should be applied through a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. Early adoption is permitted. We elected the modified retrospective transition approach and expects to adopt the standard beginning January 1, 2019. This standard will impact our consolidated financial statements by the recording of right-of-use assets and lease liabilities on our consolidated balance sheets for operating and finance leases where we are the lessee. In addition, leases where we are the lessor that meet the criteria of a finance lease will be amortized using the effective interest method with corresponding charges to interest expense and amortization expense. Leases where we are the lessor that meet the criteria of an operating lease will continue to be amortized on a straight-line basis. Lastly, internal leasing department overhead previously capitalized will be expensed. In April 2015, the FASB issued an update (“ASU 2015-03”) Simplifying the Presentation of Debt Issuance Costs to ASC Topic 835-30 Interest - Imputation of Interest. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from that debt liability, consistent with the presentation of a debt discount. The recognition and measurement guidance for debt issuance costs is not affected by the amendments in ASU 2015-03. ASU 2015-03 is effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2015 with early adoption permitted. We elected to early adopt ASU 2015-03 effective as of December 31, 2015. The effect of ASU 2015-03 was to reclassify the net unamortized balance of debt issuance costs of $10.0 million as of December 31, 2015 from deferred financing costs to a contra liability deduction of mortgages payable. Mortgages payable as of December 31, 2016 are presented net of $8.0 million of unamortized debt issuance costs. The adoption of ASU 2015-03 did not impact our results of operations or cash flows. In February 2015, the FASB issued an update (“ASU 2015-02”) Amendments to the Consolidation Analysis to ASC Topic 810 Consolidation. Under amendments in this update, all reporting entities are within the scope of Subtopic 810-10 Consolidation - Overall, including limited partnerships and similar legal entities, unless a scope exception applies. The presumption that a general partner controls a limited partnership has been eliminated. Overall the amendments in this update are to simplify the codification and reduce the number of consolidation models and place more emphasis on risk of loss when determining controlling financial interests. ASU 2015-02 is effective for public businesses for interim and annual periods beginning after December 15, 2015. We adopted ASU 2015-02 as of March 31, 2016. Under ASU 2015-02 the Company’s Operating Partnership is considered a variable interest entity (“VIE”). The Company is the primary beneficiary of the VIE, the VIE’s assets can be used for purposes other than the settlement of the VIE’s obligations and the Company’s partnership interest is considered a majority voting interest. The Operating Partnership was formed to serve as the Company’s majority-owned partnership subsidiary and to own, through affiliates, all of the Company’s real estate properties and other assets. The Company consolidates the Operating Partnership as it is the primary beneficiary of the VIE. In May 2014, the FASB issued an update (“ASU 2014-09”) Revenue from Contracts with Customers to ASC Topic 606, which supersedes the revenue recognition requirements in ASC Topic 605, Revenue Recognition. ASU 2014-09 requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. During the year ended December 31, 2016, the FASB issued the following updates to ASC Topic 606 to clarify and/or amend the guidance in ASU 2014-09: (i) ASU 2016-08 Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which clarifies the implementation guidance on principal versus agent considerations, (ii) ASU 2016-10 Identifying Performance Obligations and Licensing, which clarifies guidance related to identifying performance obligations and licensing implementation guidance and (iii) ASU 2016-12 Narrow-Scope Improvements and Practical Expedients, which amends certain aspects of ASU 2014-09. In August 2015, the FASB issued an update (“ASU 2015-09”) Revenue from Contracts with Customers to ASC Topic 606, which defers the effective date of ASU 2014-09 for all entities by one year. ASU 2015-09 is effective beginning after December 15, 2017, including interim reporting periods within that reporting period. Early adoption is permitted only for annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. We are permitted to use either the modified retrospective or the retrospective method for adopting this standard. We are currently evaluating the impact of the adoption on our consolidated and combined financial statements including gain recognition on real estate sales and the presentation of tenant reimbursement income. 4. ACQUISITIONS AND DISPOSITIONS During the year ended December 31, 2016, we purchased land that is the site of a future 2,000 sf Popeye’s for $2.7 million. During the year ended December 31, 2015, we acquired three properties with existing leases. All acquisitions have been accounted for as business combinations. The purchase prices were allocated to the acquired assets based on their estimated fair values at date of acquisition. The following table provides a summary of acquisition activity in 2016 and 2015: (1) In acres. The aggregate purchase price of the above property acquisitions have been allocated as follows: We expensed approximately $1.2 million of transaction-related costs in connection with completed or pending property acquisitions that were closed subsequent to December 31, 2016 which are included in Transaction costs in the consolidated and combined statements of operations. In conjunction with the acquisition of Cross Bay Commons on December 23, 2015, we entered into a reverse like-kind exchange agreement under Section 1031 of the Internal Revenue Code with a third party intermediary. The exchange agreement was for a maximum of 180 days and allowed us, for tax purposes, to defer gains on the sale of other properties sold within 180 days after the acquisition date. On June 9, 2016, we completed the sale of a shopping center located in Waterbury, CT. The sales price of this property of $21.6 million, less costs to sell, resulted in net proceeds of $19.9 million. Accordingly, we recorded a gain on sale of $15.6 million. The sale completed the reverse Section 1031 tax deferred exchange transaction with the acquisition of Cross Bay Commons. From December 23, 2015 to June 9, 2016, a third party intermediary was the legal owner of Cross Bay Commons, although we controlled the activities that most significantly impacted the property and retained all of the economic benefits and risks associated with it, and therefore we concluded it was a VIE and we were the primary beneficiary of the VIE. Accordingly, effective December 23, 2015, we consolidated Cross Bay Commons and its operations even during the period it was held by a third party intermediary. The consolidated balance sheets included total assets and liabilities of Cross Bay Commons of $29.5 million and $2.5 million, respectively, as of December 31, 2015. Refer to Note 19 - Subsequent Events for acquisitions closed subsequent to December 31, 2016. 5. RELATED PARTY TRANSACTIONS In connection with the separation, the Company and Vornado entered into a transition services agreement under which Vornado provided transition services to the Company including human resources, information technology, risk management, tax services and office space and support. The fees charged to us by Vornado for those transition services approximated the actual cost incurred by Vornado in providing such services. On June 28, 2016, the Company executed an amendment to the transition services agreement, extending Vornado’s provision of information technology, risk management services and the portion of the human resources service related to health and benefits through July 31, 2018, unless terminated earlier. Fees for these services remain the same except that they may be adjusted for inflation. As of December 31, 2016 there were no amounts due to Vornado related to such services. During the twelve months ended December 31, 2016 and 2015 there were $1.7 million and $2.4 million of costs paid to Vornado included in general and administrative expenses, respectively, which consisted of $0.9 million and $0.4 million of rent expense for two of our office locations and $0.8 million and $2.0 million of transition services fees, respectively. Management and Development Fees In connection with the separation, the Company and Vornado entered into a property management agreement under which the Company provides management, development, leasing and other services to certain properties owned by Vornado and its affiliates, including Interstate Properties (“Interstate”) and Alexander’s, Inc. (NYSE:ALX). Interstate is a general partnership that owns retail properties in which Steven Roth, Chairman of Vornado’s Board and Chief Executive Officer of Vornado, and a member of our Board of Trustees, is the managing general partner. Interstate and its partners beneficially owned an aggregate of approximately 7.1% of the common shares of beneficial interest of Vornado as of December 31, 2016. As of the year ended December 31, 2016, Vornado owned 32.4% of Alexander’s, Inc. During the twelve months ended December 31, 2016, 2015, and 2014 we recognized management and development fee income of $1.8 million, $2.3 million, and $0.5 million respectively. As of December 31, 2016 and December 31, 2015, there were $0.3 million and $0.7 million of fees, respectively, due from Vornado included in tenant and other receivables in our consolidated balance sheets. 6. IDENTIFIED INTANGIBLE ASSETS AND LIABILITIES The following table summarizes our identified intangible assets and liabilities: (1) Intangible assets related to below-market leases where the Company is a lessee under a ground lease. Amortization of acquired below-market leases, net of acquired above-market leases resulted in additional rental income of $7.8 million, $7.9 million and $8.8 million for the years ended December 31, 2016, 2015 and 2014, respectively. Amortization of acquired in-place leases and customer relationships resulted in additional depreciation and amortization expense of $2.0 million, $1.5 million and $1.6 million for the years ended December 31, 2016, 2015 and 2014, respectively. Certain shopping centers were acquired subject to ground leases or ground and building leases. Amortization of these acquired below-market leases resulted in additional rent expense of $1.0 million in each of the years ended December 31, 2016, 2015 and 2014. The following table sets forth the estimated annual amortization related to intangible assets and liabilities for the five succeeding years commencing January 1, 2017: (1) Estimated annual amortization of acquired below-market leases, net of acquired above-market leases. (2) Estimated annual amortization of acquired in-place leases and customer relationships. (3) The annual amortization of the below-market intangible liabilities in the table above includes $1.6 million associated with our ground lease for the Shops at Bruckner which was sold subsequent to December 31, 2016. Refer to Note 19 - Subsequent Events for further information. (4) Estimated annual amortization of below-market leases where the Company is a lessee under a ground lease. 7. MORTGAGES PAYABLE The following is a summary of mortgages payable as of December 31, 2016 and December 31, 2015. (1) Subject to a LIBOR floor of 1.00%, bears interest at LIBOR plus 136 bps. In June 2016, in connection with the sale of our property in Waterbury, CT, we prepaid $21.2 million of the variable rate portion of our cross collateralized mortgage loan to maintain compliance with covenant requirements. (2) On January 6, 2015, we completed the modification of the $120.0 million, 6.04% mortgage loan secured by Montehiedra Town Center. Refer to “Troubled Debt Restructuring” disclosure below. (3) On March 30, 2015, we notified the lender that due to tenants vacating, the property’s operating cash flow would be insufficient to pay its debt service. As of December 31, 2016 we were in default and the property was transferred to receivership. Urban Edge no longer manages the property but will remain its title owner until the receiver disposes of the property. We have determined this property is held in a VIE for which we are the primary beneficiary. Accordingly, as of December 31, 2016 we consolidated Englewood and its operations. The consolidated balance sheet included total assets and liabilities of $12.4 million and $14.2 million, respectively. (4) The mortgage payable balance secured by Montehiedra was presented net of unamortized fees of $1.7 million as of December 31, 2015 in our Form 10-K as filed with SEC for Urban Edge Properties. The net unamortized fees of $1.7 million were revised to be presented with the unamortized debt issuance costs. (5) The mortgage payable balance on the loan secured by Mt. Kisco (Target) includes $1.1 million of unamortized debt discount as of December 31, 2016 and December 31, 2015. The effective interest rate including amortization of the debt discount is 7.26% as of December 31, 2016. The net carrying amount of real estate collateralizing the above indebtedness amounted to approximately $859.2 million as of December 31, 2016. Our mortgage loans contain covenants that limit our ability to incur additional indebtedness on these properties and in certain circumstances, require lender approval of tenant leases and/or yield maintenance upon repayment prior to maturity. Our property in Waterbury, CT was held as collateral in our cross collateralized mortgage loan. In connection with the sale of our property in Waterbury, CT on June 9, 2016, we prepaid $21.2 million of the variable rate component of our cross collateralized mortgage loan in order to maintain compliance with covenant requirements. As of December 31, 2016, we were in compliance with all debt covenants. As of December 31, 2016, the principal repayments for the next five years and thereafter are as follows: On January 15, 2015, we entered into a $500 million Revolving Credit Agreement (the “Agreement”) with certain financial institutions. The Agreement has a four-year term with two six-month extension options. Borrowings under the Agreement are subject to interest at LIBOR plus 1.15% and we are required to pay an annual facility fee of 20 basis points which is expensed as incurred. Both the spread over LIBOR and the facility fee are based on our current leverage ratio and are subject to increase if our leverage ratio increases above predefined thresholds. The Agreement contains customary financial covenants including a maximum leverage ratio of 60% and a minimum fixed charge coverage ratio of 1.5x. No amounts have been drawn to date under the Agreement. Financing fees associated with the Agreement of $1.9 million and $2.8 million as of December 31, 2016 and December 31, 2015, respectively, are included in deferred financing fees in the consolidated balance sheets. Troubled Debt Restructuring During the year ended December 31, 2014, Montehiedra Town Center (“Montehiedra”), our property in the San Juan area of Puerto Rico, was experiencing financial difficulties which resulted in a substantial decline in its net operating cash flows. As such, we transferred the mortgage loan secured by Montehiedra to the special servicer and discussed restructuring the terms of the mortgage loan. In January 2015 we completed the modification of the $120.0 million, 6.04% mortgage loan. The loan was extended from July 2016 to July 2021 and separated into two tranches, a senior $90.0 million position with interest at 5.33% to be paid currently and a junior $30.0 million position with interest accruing at 3.0%. As part of the planned redevelopment of the property, we committed to fund $20.0 million through an intercompany loan for leasing and capital expenditures of which $16.9 million has been funded as of December 31, 2016. This $20.0 million intercompany loan is senior to the $30.0 million mortgage position noted above and accrues interest at 10%. Both the intercompany loan and related interest are eliminated in our consolidated and combined financial statements. We incurred $2.0 million of debt issuance costs in connection with the loan modification. 8. INCOME TAXES The Company has elected to qualify as a REIT under sections 856-860 of the Internal Revenue Code of 1986, as amended, commencing with the filing of our tax return for the 2015 fiscal year. Under those sections, a REIT, which distributes at least 90% of its REIT taxable income as a dividend to its shareholders each year and which meets certain other conditions, will not be taxed on that portion of its taxable income which is distributed to its shareholders. Prior to the separation from Vornado, UE Businesses historically operated under Vornado’s REIT structure. As Vornado operates as a REIT and distributes 100% of taxable income, no provision for federal income taxes has been made in the accompanying consolidated and combined financial statements for periods prior to the separation. If we fail to qualify as a REIT for any taxable year, we will be subject to federal income taxes at regular corporate rates (including any alternative minimum tax) and may not be able to qualify as a REIT for the four subsequent taxable years. The following summarizes the tax status of dividends paid for the years ended December 31, 2016 and 2015: The REIT and the other minority members are partners in the Operating Partnership. As such, the partners are required to report their share of taxable income on their tax returns. We are also subject to certain other taxes, including state and local taxes and franchise taxes which are included in general and administrative expenses in the consolidated and combined statements of income. Our two Puerto Rico malls are subject to a 29% non-resident withholding tax which is included in income tax expense in the consolidated and combined statements of income. The Puerto Rico tax expense recorded was $0.8 million, $1.3 million, and $1.7 million for the twelve months ended December 31, 2016, 2015, and 2014 respectively. Both properties are held in a special partnership for Puerto Rico tax reporting (the general partner being a qualified REIT subsidiary or “QRS”). Income tax expense consists of the following: (1) Current income tax expense for the year ended December 31, 2016 is net of a $0.6 million reduction to the accrued income tax liability recorded in the second quarter of 2016. (2) The deferred portion of income tax expense related to temporary differences for periods prior to the separation date are reflected as contributions from Vornado in the consolidated and combined statement of changes in equity. A net deferred tax liability of $3.8 million is included in our consolidated balance sheet within Other Liabilities as of December 31, 2016, comprised of temporary differences related to our two Puerto Rico properties, a deferred tax liability of $4.5 million offset by a deferred tax asset of $0.7 million. The deferred tax liability of $4.5 million is comprised of $2.3 million of tax depreciation in excess of GAAP depreciation, $1.9 million straight-line rents and $0.3 million of amortization of acquired leases not recorded for tax purposes. The deferred tax asset of $0.7 million is comprised of $0.3 million of GAAP to tax depreciation adjustment, $0.2 million of amortization of deferred financing fees not recorded for tax purposes and $0.2 million excess of bad debt expense for tax purposes. The temporary differences resulting from activity during the years ended December 31, 2016 and 2015 is recorded within Income Tax Expense on the consolidated and combined statements of income. Below is a table summarizing the net deferred income tax liability balance as of December 31, 2016 and 2015: The Operating Partnership is organized as limited partnership and is generally not subject to federal income tax. Accordingly, no provision for federal income taxes has been reflected in the accompanying consolidated and combined financial statements. The Operating Partnership, however, is subject to the non-resident withholding tax at our two Puerto Rico malls. 9. FAIR VALUE MEASUREMENTS ASC 820, Fair Value Measurement and Disclosures defines fair value and establishes a framework for measuring fair value. The objective of fair value is to determine the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price). ASC 820 establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three levels: Level 1 - quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities; Level 2 - observable prices based on inputs not quoted in active markets, but corroborated by market data; and Level 3 - unobservable inputs used when little or no market data is available. The fair value hierarchy gives the highest priority to Level 1 inputs and the lowest priority to Level 3 inputs. In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as consider counterparty credit risk in our assessment of fair value. Financial Assets and Liabilities Measured at Fair Value on a Recurring or Non-Recurring Basis There were no financial assets or liabilities measured at fair value on a recurring or non-recurring basis as of December 31, 2016 and December 31, 2015. Financial Assets and Liabilities not Measured at Fair Value Financial assets and liabilities that are not measured at fair value on the consolidated balance sheets include cash and cash equivalents and mortgages payable. Cash and cash equivalents are carried at cost, which approximates fair value. The fair value of mortgages payable is calculated by discounting the future contractual cash flows of these instruments using current risk-adjusted rates available to borrowers with similar credit ratings, which are provided by a third-party specialist. The fair value of cash and cash equivalents is classified as Level 1 and the fair value of mortgages payable is classified as Level 2. The table below summarizes the carrying amounts and fair value of these financial instruments as of December 31, 2016 and December 31, 2015. (1) Excludes unamortized debt issuance costs. The following interest rates were used by the Company to estimate the fair value of mortgages payable: 10. LEASES As Lessor We lease space to tenants under operating leases which expire from 2017 to 2072. The leases provide for the payment of fixed base rents payable monthly in advance as well as reimbursements of real estate taxes, insurance and maintenance costs. Retail leases may also provide for the payment by the lessee of additional rents based on a percentage of their sales. Future base rental revenue under these non-cancelable operating leases excluding extension options is as follows: These future minimum amounts do not include additional rents based on a percentage of tenants’ sales or reimbursements. For the years ended December 31, 2016, 2015 and 2014, these additional rents were $0.8 million, $1.2 million, and $1.5 million respectively. As Lessee We are a tenant under long-term ground leases or ground and building leases for certain of our properties. Lease expirations range from 2017 to 2102. Future lease payments under these agreements, excluding extension options, are as follows: 11. COMMITMENTS AND CONTINGENCIES Legal Matters: There are various legal actions against us in the ordinary course of business. In our opinion, after consultation with legal counsel, the outcome of such matters will not have a material adverse effect on our financial condition, results of operations or cash flows. Loan Commitments: In January 2015 we completed the modification of the $120.0 million, 6.04% mortgage loan secured by Montehiedra. As part of the planned redevelopment of the property, we committed to fund $20.0 million for leasing and building capital expenditures of which $16.9 million has been funded as of December 31, 2016. Redevelopment: As of December 31, 2016, we had approximately $191.7 million of active development, redevelopment and anchor repositioning projects underway of which $110.5 million remains to be funded as of December 31, 2016. Based on current plans and estimates we anticipate the remaining amounts will be expended over the next three years. Insurance: We maintain general liability insurance with limits of $200 million per occurrence for properties in the U.S. and Puerto Rico, and all-risk property and rental value insurance coverage with limits of $500 million for properties in the U.S. and $139 million for properties in Puerto Rico per occurrence, with sub-limits for certain perils such as floods and earthquakes on each of our properties. We also maintain coverage for terrorism acts with limits of $500 million for properties in the U.S. and $139 million for properties in Puerto Rico per occurrence and in the aggregate excluding coverage for nuclear, biological, chemical or radiological terrorism events as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. In addition, we maintain coverage for cybersecurity with limits of $5 million in the aggregate providing first and third party coverage including network interruption, event management, cyber extortion and claims for media content, security and privacy liability. Insurance premiums are charged directly to each of the retail properties and warehouses. We will be responsible for deductibles and losses in excess of insurance coverage, which could be material. We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. Our mortgage loans are non-recourse and contain customary covenants requiring adequate insurance coverage. Although we believe that we currently have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain it could adversely affect our ability to finance our properties and expand our portfolio. Environmental Matters: Each of our properties has been subjected to varying degrees of environmental assessment at various times. Based on these assessments and the projected remediation costs, we have accrued costs of $1.4 million on our consolidated balance sheets for potential remediation costs for environmental contamination at two properties. While this accrual reflects our best estimates of the potential costs of remediation at these properties, $0.1 million has currently been expended and there can be no assurance that the actual costs will not exceed this amount. With respect to our other properties, the environmental assessments did not reveal any material environmental contamination. However, there can be no assurance that the identification of new areas of contamination, changes in the extent or known scope of contamination, the discovery of additional sites, or changes in cleanup requirements would not result in significant costs to us. 12. PREPAID EXPENSES AND OTHER ASSETS The following is a summary of the composition of the prepaid expenses and other assets in the consolidated balance sheets: 13. OTHER LIABILITIES The following is a summary of the composition of other liabilities in the consolidated balance sheets: 14. INTEREST AND DEBT EXPENSE The following table sets forth the details of interest and debt expense. 15. EQUITY AND NONCONTROLLING INTEREST At-The-Market Program On August 8, 2016, the Company established an at-the-market (“ATM”) equity program, pursuant to which the Company may offer and sell its common shares, par value $0.01 per share, with an aggregate gross sales price of up to $250.0 million through a consortium of broker-dealers acting as sales agents. Sales of common shares may be made, as needed, from time to time in ATM offerings as defined in Rule 415 of the Securities Act of 1933, including by means of ordinary brokers’ transactions on the NYSE or otherwise (i) at market prices prevailing at the time of sale (ii) at prices related to prevailing market prices or (iii) as otherwise agreed to with the applicable sales agent. From September 2016 to December 31, 2016, the Company issued 307,342 common shares at a weighted average price of $28.45 under its ATM equity program, generating cash proceeds of $8.7 million. We paid $0.1 million of commissions to distribution agents and $0.4 million in additional offering expenses related to the issuance of these common shares. We used the net proceeds to fund acquisition opportunities and fund our development and redevelopment pipeline. Actual future sales will depend on a variety of factors including, but not limited to, market conditions, the trading price of our common shares and our capital needs. We have no obligation to sell the remaining shares available under the active ATM equity program. Common Units of the Operating Partnership Operating Partnership units were issued by the Operating Partnership to the Company in connection with the issuance of common shares by the Company under its ATM equity program, as discussed above. Dividends and Distributions During the twelve months ended December 31, 2016 and 2015, the Company declared dividends on our common shares and OP unit distributions of $0.82 per share/unit, and $0.80 per share/unit, respectively. Redeemable Noncontrolling Interests Redeemable noncontrolling interests reflected on the consolidated balance sheets of the Company are comprised of OP Units and limited partnership interests in the Operating Partnership in the form of LTIP unit awards. In connection with the separation, the Company issued 5.7 million OP units, representing a 5.4% interest in the Operating Partnership to VRLP in exchange for interests in VRLP properties contributed by VRLP. LTIP unit awards were granted to certain executives pursuant to our Omnibus Share Plan (the “Omnibus Share Plan”). The total of the OP units and LTIP units represent a 6.0% weighted-average interest in the Operating Partnership for twelve months ended December 31, 2016. Holders of outstanding vested LTIP units may, from and after two years from the date of issuance, redeem their LTIP units for cash, or for the Company’s common shares on a one-for-one basis, solely at the Company’s election. Holders of outstanding OP units may, at a determinable date, redeem their units for cash or the Company’s common shares on a one-for-one basis solely at our election. Noncontrolling Interest The noncontrolling interest relates to the 5% interest held by others in our property in Walnut Creek, CA (Mt. Diablo). The net income attributable to noncontrolling interest is presented separately in our consolidated and combined statements of income. 16. SHARE-BASED COMPENSATION On January 7, 2015 our board and initial shareholder approved the Urban Edge Properties Omnibus Share Plan, under which awards may be granted up to a maximum of 15,000,000 of our common shares or share equivalents. Pursuant to the Omnibus Share Plan, stock options, LTIP units, operating partnership units and restricted shares were granted. We have a Dividend Reinvestment Plan (the “DRIP”), whereby shareholders may use their dividends to purchase shares. During the twelve months ended December 31, 2016 and 2015, 12,564 and 11,407 shares were issued under the DRIP, respectively. On November 3, 2015, the Compensation Committee of the Board of Trustees of the Company approved the Company’s 2015 Outperformance Plan (“OPP”). The OPP is a multi-year, performance-based equity compensation plan under which participants, including our Chairman and Chief Executive Officer, have the opportunity to earn awards in the form of LTIP Units if, and only if, we outperform a predetermined total shareholder return (“TSR”) and/or outperform the market with respect to a relative TSR in any year during the requisite performance periods as described below. The aggregate notional amount of the 2015 OPP grant was $10.2 million. Awards under the 2015 OPP may be earned if we (i) achieve a TSR level greater than 7% per annum, or 21% over the three-year performance measurement period (the “Absolute Component”), and/or (ii) achieve a TSR equal to or above, that of the 50th percentile of a retail REIT peer group (“Peer Group”) comprised of 15 of our peer companies, over a three-year performance measurement period (the “Relative Component”). Dividends on awards accrue during the measurement period. If the designated performance objectives are achieved, LTIP Units are also subject to time-based vesting requirements. Awards earned under the 2015 OPP vest 50% in year three, 25% in year four and 25% in year five. Our executive officers are required to hold earned 2015 OPP awards for one year following vesting. The fair value of the 2015 OPP on the date of grant was $3.9 million using a Monte Carlo simulation to estimate the fair value based on the probability of satisfying the market conditions and the projected share price at the time of payment, discounted to the valuation date over a three-year performance period. Assumptions include historic volatility (25.0%), risk-free interest rates (1.2%), and historic daily return as compared to our Peer Group (which ranged from 19.0% to 27.0%). Such amount is being amortized into expense over a five-year period from the date of grant, using a graded vesting attribution model. In the twelve months ended December 31, 2016 and 2015, we recognized $1.1 million and $0.2 million of compensation expense related to the OPP’s LTIP Units, respectively. As of December 31, 2016 there was $2.6 million of total unrecognized compensation cost related to the OPP’s LTIP Units, which will be recognized over a weighted-average period of 2.6 years. All stock options granted have ten-year contractual lives, containing vesting terms of three to five years. As of December 31, 2016, the weighted average contractual term of shares under option outstanding at the end of the period is 8.3 years. The following table presents stock option activity for the twelve months ended December 31, 2016 and 2015: During the twelve months ended December 31, 2016 and 2015, the fair value of the options granted was estimated on the grant date using the Black-Scholes pricing model with the following assumptions: The options were granted with an exercise price equivalent to the average of the high and low share price on the grant date. No options were granted during the year ended December 31, 2014. The following table presents information regarding restricted share activity during the twelve months ended December 31, 2016 and 2015: During the twelve months ended December 31, 2016 and 2015, we granted 117,399 and 35,460 restricted shares, respectively, that are subject to forfeiture and vest over periods ranging from one to four years. The total grant date value of the 15,977 and 1,022 restricted shares vested during the years ended December 31, 2016 and 2015 was $0.4 million and $25 thousand, respectively. There were 433,040 LTIP units issued to executives during the year ended December 31, 2015, 343,232 of which were issued in connection with the separation transaction and were immediately vested. During the year ended December 31, 2016, 39,439 units vested. The remaining 50,369 units vest over a weighted average period of 2.2 years. Share-based compensation expense, which is included in general and administrative expenses in our consolidated and combined statements of income, is summarized as follows: (1) OPP Expense for the years ended December 31, 2016 and 2015 includes $0.1 million and $0.2 million, respectively, of unrecognized compensation expense of awards issued under Vornado’s OPP for UE employees who were previously Vornado employees. The remaining OPP unrecognized compensation expense was transferred from Vornado to UE as of the separation date and is amortized on a straight-line basis over the remaining life of the OPP awards issued. (2) We did not have any equity awards issued prior to the date of the separation. $3.9 million of share-based compensation expense is included in general and administrative expenses in our combined statements of income for the year ended December 31, 2014 and is related to Vornado equity awards issued prior to the separation for Vornado employees. (3) LTIP expense excludes the expense associated with LTIP units under the 2015 OPP. As of December 31, 2016, we had a total of $11.0 million of unrecognized compensation expense related to unvested and restricted share-based payment arrangements including unvested stock options, LTIP units, and restricted share awards which were granted under our Omnibus Share Plan as well as OPP awards issued by Vornado. This expense is expected to be recognized over a weighted average period of 1.8 years. 17. EARNINGS PER SHARE AND UNIT Urban Edge Earnings per Share The Company has calculated earnings per share (“EPS”) under the two-class method. The two-class method is an earnings allocation methodology whereby EPS for each class of Urban Edge common shares and participating securities is calculated according to dividends declared and participating rights in undistributed earnings. Restricted shares issued pursuant to our share-based compensation program are considered participating securities, and as such have non-forfeitable rights to receive dividends. The computation of diluted EPS reflects potential dilution of securities by adding potential common shares, including stock options and unvested restricted shares, to the weighted average number of common shares outstanding for the period. For the year ended December 31, 2015, there were options outstanding for 2,289,139 shares, that potentially could be exercised for common shares. These options, with exercise prices ranging from $24.46 to $22.83, have been excluded from the diluted EPS calculation, as their effect is anti-dilutive to the Company’s net income because the option prices were greater than the average market prices of our common shares during 2015. In addition, there were 129,395 unvested restricted shares outstanding that potentially could become unrestricted common shares. The computation of diluted EPS for the years ended December 31, 2016 and 2015 included the 114,354 and 25,829 weighted average unvested restricted shares outstanding, respectively, as their effect is dilutive. The effect of the redemption of OP and vested LTIP units is not reflected in the computation of basic and diluted earnings per share, as they are redeemable for common shares on a one-for-one basis. The income allocable to such units is allocated on this same basis and reflected as noncontrolling interests in the accompanying consolidated and combined financial statements. As such, the assumed redemption of these units would have no net impact on the determination of diluted earnings per share since they would be anti-dilutive. As described in Note 2, the common shares outstanding at the date of the separation are reflected as outstanding for all periods prior to the separation. The following table sets forth the computation of our basic and diluted earnings per share: Operating Partnership Earnings per Unit As described in Note 2, the units outstanding at the date of the separation are reflected as outstanding for all periods prior to the separation. The following table sets forth the computation of basic and diluted earnings per unit: 18. QUARTERLY FINANCIAL DATA (unaudited) The following tables summarize the quarterly results of operations of Urban Edge Properties and Urban Edge Properties LP for the years ended December 31, 2016 and 2015: 19. SUBSEQUENT EVENTS Pursuant to the Subsequent Events Topic of the FASB ASC, we have evaluated subsequent events and transactions that occurred after our December 31, 2016 consolidated balance sheet date for potential recognition or disclosure in our consolidated and combined financial statements. Subsequent to December 31, 2016, we completed the acquisition of the following properties: (1) On January 4, 2017 we acquired interests in Yonkers Gateway Center. Consideration for this purchase consisted of the issuance of $48.8 million in OP units and $2.9 million of cash. The total number of OP units issued was 1.8 million. (2) On January 17, 2017, we acquired the leasehold interest in the Shops at Bruckner for $32.0 million, consisting of the assumption of the existing debt of $12.6 million and $19.4 million of cash. The property is a 114,000 sf retail center in the Bronx, NY directly across from the Company’s 375,000 sf Bruckner Commons. The Company owns the land under the Shops at Bruckner and has been leasing it to the seller under a ground lease. Concurrent with the acquisition, the Company has written-off the existing intangible balance related to the below-market ground lease. As a result, the Company will recognize lease settlement income in the first quarter of 2017. (3) On February 2, 2017, we acquired Hudson Mall, a 383,000 sf retail center in Jersey City, NJ adjacent to our existing Hudson Commons shopping center. Consideration for this purchase consisted of the assumption of the existing debt of $23.8 million and $19.9 million of cash. The above acquisitions were funded using a combination of available cash on hand, equity and the assumption of existing mortgage debt. Acquisition related expenses totaling $0.5 million were expensed as incurred. We have not yet measured the fair value of the tangible and identified intangible assets and liabilities nor the proforma results of operations.
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Here's a summary of the key points from this financial statement:
Revenue:
- Includes real estate assets, leasable square feet, and operating income
- Multiple revenue streams: Base Rent, Percentage Rent, Expense Reimbursements, and Management/Leasing Fees
Profit/Loss:
- Shows losses from January 1 (specific amount not provided)
Expenses:
- Includes liabilities from Vornado and UE Businesses
- Covers debt service, real estate taxes, property insurance, tenant improvements, leasing commissions, and capital expenditures
Assets:
- Includes Cross Bay Commons valued at $29.5 (currency not specified)
Liabilities:
- Accounts receivable system with allowances for doubtful accounts
- Deferred leasing and financing costs
- Various revenue recognition policies
Additional Notable Elements:
- Noncontrolling interests and Variable Interest Entities (VIEs)
- Share-based compensation structure
- Earnings per share calculation methods
- Complex ownership structure involving Operating Partnership units
The statement appears to be from a real estate investment company with a focus on commercial properties and includes detailed accounting policies and procedures.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements All other schedules have been omitted because they are not applicable or the required information is shown in the Financial Statements or the Notes thereto. Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Stereotaxis, Inc. We have audited the accompanying balance sheets of Stereotaxis, Inc. (the Company) as of December 31, 2016 and 2015, and the related statements of operations, convertible preferred stock and stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2016. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Stereotaxis, Inc. at December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP St. Louis, Missouri March 16, 2017 STEREOTAXIS, INC. BALANCE SHEETS See accompanying notes. STEREOTAXIS, INC. STATEMENTS OF OPERATIONS (Unaudited) See accompanying notes. STEREOTAXIS, INC. STATEMENTS OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY See accompanying notes. STEREOTAXIS, INC. STATEMENTS OF CASH FLOWS (Unaudited) See accompanying notes. STEREOTAXIS, INC. NOTES TO FINANCIAL STATEMENTS Notes to Financial Statements In this report, “Stereotaxis”, the “Company”, “Registrant”, “we”, “us”, and “our” refer to Stereotaxis, Inc. and its wholly owned subsidiaries. Epoch®, Niobe®, Odyssey®, Odyssey Cinema™, Vdrive®, Vdrive Duo™, V-CAS™, V-Loop™, V-Sono™, V-CAS Deflect™, QuikCAS™, Cardiodrive®, and Pegasus™ are trademarks of Stereotaxis, Inc. All other trademarks that appear in this report are the property of their respective owners. 1. Description of Business Stereotaxis designs, manufactures and markets the Epoch Solution, which is an advanced remote robotic navigation system for use in a hospital’s interventional surgical suite, or “interventional lab”, that we believe revolutionizes the treatment of arrhythmias and coronary artery disease by enabling enhanced safety, efficiency and efficacy for catheter-based, or interventional, procedures. The Epoch Solution is comprised of the Niobe ES Remote Magnetic Navigation System (“Niobe ES system”), Odyssey Information Management Solution (“Odyssey Solution”), and the Vdrive Robotic Navigation System (“Vdrive system”), and related devices. The Niobe system is designed to enable physicians to complete more complex interventional procedures by providing image-guided delivery of catheters and guidewires through the blood vessels and chambers of the heart to treatment sites. This is achieved using externally applied magnetic fields that govern the motion of the working tip of the catheter or guidewire, resulting in improved navigation, efficient procedures and reduced x-ray exposure. As of December 31, 2016, the Company had an installed base of 129 Niobe ES systems. In addition to the Niobe system and its components, Stereotaxis also has developed the Odyssey Solution, which consolidates all lab information enabling doctors to focus on the patient for optimal procedure efficiency. The system also features a remote viewing and recording capability called Odyssey Cinema, which is an innovative solution delivering synchronized content for optimized workflow, advanced care and improved productivity. This tool includes an archiving capability that allows clinicians to store and replay entire procedures or segments of procedures. This information can be accessed from locations throughout the hospital local area network and over the global Odyssey Network providing physicians with a tool for clinical collaboration, remote consultation and training. Our Vdrive system provides navigation and stability for diagnostic and therapeutic devices designed to improve interventional procedures. The Vdrive system complements the Niobe ES system control of therapeutic catheters for fully remote procedures and enables single-operator workflow and is sold as two options, the Vdrive system and the Vdrive Duo system. In addition to the Vdrive system and the Vdrive Duo system, we also manufacture and market various disposable components which can be manipulated by these systems. We promote the full Epoch Solution in a typical hospital implementation, subject to regulatory approvals or clearances. The full Epoch Solution implementation requires a hospital to agree to an upfront capital payment and recurring payments. The upfront capital payment typically includes equipment and installation charges. The recurring payments typically include disposable costs for each procedure, equipment service costs beyond warranty period, and software licenses. In hospitals where the full Epoch Solution has not been implemented, equipment upgrade or expansion can be implemented upon purchasing of the necessary upgrade or expansion. The core components of Stereotaxis systems, such as Niobe system, Odyssey Solution, Cardiodrive and various disposable interventional devices have received regulatory clearance in the U.S., Europe, Canada, China, Japan and various other countries. We have received the regulatory clearance, licensing and/or CE Mark approvals that allow us to market the Vdrive and Vdrive Duo systems with the V-CAS, V-Loop and V-Sono devices in the U.S., Canada and European Union. The V-CAS Deflect catheter advancement system has been CE Marked for sale in the European Union. The Company believes the cash on hand at December 31, 2016 as well as expected borrowing capacity available will be sufficient to meet its obligations as they become due in the ordinary course of business for at least 12 months following the date these financial statements are issued. However, this evaluation assumes the Company’s ability to borrow under its asset based revolving credit facility which matures on March 31, 2018. The Company expects to be able to renew this facility at similar terms, as it has successfully done so in the past. However, there is no assurance that the revolving credit facility will be renewed in a timely manner, in amounts that are sufficient to meet the Company’s obligations as they become due, or on terms acceptable to the Company, or at all. The Company has sustained operating losses throughout its corporate history and expects that its 2017 expenses will exceed its 2017 gross margin. The Company expects to continue to incur operating losses and negative cash flows until revenues reach a level sufficient to support ongoing operations or expense reductions are in place. Accordingly, management has analyzed its planned operations to evaluate the Company’s ability to continue as a going concern. The Company’s liquidity needs will be largely determined by the success of clinical adoption within the installed base of Niobe systems as well as by new placements of capital systems. The Company’s plans, which are probable of effectively being implemented and improving the liquidity conditions, primarily include its ability to control the timing and spending of its operating expenses and raising additional funds through capital transactions. Specifically, cash outflows for operating expenses could be reduced or delayed by transitioning certain cash payments to stock payments, by reducing project expenses, or by reducing headcount. The Company also may consider raising cash through capital transactions, which could include either debt or equity financing. 2. Summary of Significant Accounting Policies Cash and Cash Equivalents The Company considers all short-term investments purchased with original maturities of three months or less to be cash equivalents. The Company places its cash with high-credit-quality financial institutions and invests primarily in money market accounts. No cash was restricted at December 31, 2016 or 2015. Accounts Receivable and Allowance for Uncollectible Accounts Accounts receivable primarily include amounts due from hospitals and distributors for acquisition of magnetic systems, associated disposable device sales and service contracts. Credit is granted on a limited basis, with balances due generally within 30 days of billing. The provision for bad debts is based upon management’s assessment of historical and expected net collections considering business and economic conditions and other collection indicators. Financial Instruments Financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and debt. The carrying value of such amounts reported at the applicable balance sheet dates approximates fair value. See Note 9 for disclosure of the fair value of debt. The Company measures certain financial assets and liabilities at fair value on a recurring basis, including warrants. General accounting principles for fair value measurement established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets and liabilities (“Level 1”) and the lowest priority to unobservable inputs (“Level 3”). See Note 12 for disclosure of fair value measurements. Inventory The Company values its inventory at the lower of cost, as determined using the first-in, first-out (FIFO) method, or market. The Company periodically reviews its physical inventory for obsolete items and provides a reserve upon identification of potential obsolete items. Property and Equipment Property and equipment consist primarily of leasehold improvements, computer, office, research and demonstration equipment, and equipment held for lease and are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives or life of the base lease term, ranging from three to ten years. Long-Lived Assets If facts and circumstances suggest that a long-lived asset may be impaired, the carrying value is reviewed. If this review indicates that the carrying value of the asset will not be recovered, as determined based on projected undiscounted cash flows related to the asset over its remaining life, the carrying value of the asset is reduced to its estimated fair value, which in most cases is estimated based upon Level 2 or Level 3 inputs. Intangible Assets Intangible assets consist of purchased technology and intellectual property rights valued at cost on the acquisition date and amortized over their estimated useful lives of 10-15 years. If facts and circumstances suggest that an intangible asset may be impaired, the carrying value is reviewed. If this review indicates that the carrying value of the asset will not be recovered, as determined based on projected undiscounted cash flows related to the asset over its remaining life, the carrying value of the asset is reduced to its estimated fair value, which in most cases is estimated based upon Level 2 or Level 3 inputs. Use of Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and loss during the reporting period. Actual results could differ from those estimates. Revenue and Costs of Revenue The Company recognizes revenue based on the Multiple-Deliverable Revenue Arrangements guidance (“ASU 2009-13”). ASU 2009-13 permits management to estimate the selling price of undelivered components of a bundled sale for which it is unable to establish vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”). This requires management to record revenue for certain elements of a transaction even though it might not have delivered other elements of the transaction, for which it was unable to meet the requirements for establishing VSOE or TPE. The Company believes that the guidance significantly improves the reporting of these types of transactions to more closely reflect the underlying economic circumstances. This guidance also prohibits the use of the residual method for allocating revenue to the various elements of a transaction and requires that the revenue be allocated proportionally based on the relative estimated selling prices. Under our revenue recognition policy, a portion of revenue for Niobe systems, Vdrive systems and certain Odyssey systems is recognized upon delivery, provided that title has passed, there are no uncertainties regarding acceptance, persuasive evidence of an arrangement exists, the sales price is fixed and determinable, and collection of the related receivable is reasonably assured. Revenue is recognized for other types of Odyssey systems upon completion of installation, since there are no qualified third party installers. When installation is the responsibility of the customer, revenue from system sales is recognized upon shipment since these arrangements do not include an installation element or right of return privileges. The Company does not recognize revenue in situations in which inventory remains at a Stereotaxis warehouse or in situations in which title and risk of loss have not transferred to the customer. Amounts collected prior to satisfying the above revenue recognition criteria are reflected as deferred revenue. Revenue from services and license fees, whether sold individually or as a separate unit of accounting in a multiple-deliverable arrangement, is deferred and amortized over the service or license fee period, which is typically one year. Revenue from services is derived primarily from the sale of annual product maintenance plans. We recognize revenue from disposable device sales or accessories upon shipment and establish an appropriate reserve for returns. The return reserve, which is applicable only to disposable devices, is estimated based on historical experience which is periodically reviewed and updated as necessary. In the past, changes in estimate have had only a de minimus effect on revenue recognized in the period. We believe that the estimate is not likely to change significantly in the future. Costs of systems revenue include direct product costs, installation labor and other costs, estimated warranty costs, and initial training and product maintenance costs. These costs are recorded at the time of sale. Costs of disposable revenue include direct product costs and estimated warranty costs and are recorded at the time of sale. Cost of revenue from services and license fees are recorded when incurred. Research and Development Costs Internal research and development costs are expensed in the period incurred. Amounts receivable from strategic alliances under research reimbursement agreements are recorded as a contra-research and development expense in the period reimbursable costs are incurred. There were no material receivables at December 31, 2016 or 2015 under these types of agreements. Advance receipts or other unearned reimbursements are included in accrued liabilities on the accompanying balance sheet until earned. Share-Based Compensation Stock options or stock appreciation rights issued to certain non-employees are recorded at their fair value as determined in accordance with general accounting principles for share-based payments and accounting for equity instruments that are issued to other than employees for acquiring, or in conjunction with selling, goods or services, and recognized over the service period. Deferred compensation for options granted to non-employees is remeasured on a quarterly basis through the vesting or forfeiture date. The Company utilized the Black-Scholes valuation model to determine the fair value of share-based payments at the date of previously issued grant using risk-free interest rate based on the Treasury yield on the date of the grant and expected volatility based on the Company’s historical volatility over the expected term of the option. The resulting compensation expense is recognized over the requisite service period, generally one to four years. Compensation expense is recognized only for those awards expected to vest, with forfeitures estimated based on the Company’s historical experience and future expectations. Restricted shares and units granted to employees are valued at the fair market value at the date of grant. The Company amortizes the amount to expense over the service period on a straight-line basis for those shares with graded vesting. If the shares are subject to performance objectives, the resulting compensation expense is amortized over the anticipated vesting period and is subject to adjustment based on the actual achievement of objectives. Shares purchased by employees under the 2004 Employee Stock Purchase Plan were considered to be compensatory and were accounted for in accordance with general accounting principles for share-based payments. Shares purchased by employees under the 2009 Employee Stock Purchase Plan are considered to be non-compensatory. Net Earnings (Loss) per Common Share Basic earnings (loss) per common share are computed by dividing the net earnings (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share are computed by dividing the earnings (loss) for the period by the weighted average number of common and common equivalent shares outstanding during the period. In addition, the application of the two-class method of computing earnings per share under general accounting principles for participating securities is not applicable because the Company’s unearned restricted shares do not contractually participate in its losses. In addition, the net loss attributable to common stockholders’ is adjusted for the convertible preferred stock deemed dividends related to the beneficial conversion feature on this instrument at inception, as well as the annual dividends for the periods in which the convertible preferred stock is outstanding. The Company did not include any portion of unearned restricted shares, outstanding options, stock appreciation rights, warrants or convertible preferred stock in the calculation of diluted loss per common share because all such securities are anti-dilutive for all periods presented. The application of the two-class method of computing earnings per share under general accounting principles for participating securities is not applicable during these periods because those securities do not contractually participate in its losses. As of December 31, 2016, the Company had 671,887 shares of common stock issuable upon the exercise of outstanding options and stock appreciation rights at a weighted average exercise price of $8.77 per share, 38,963,443 shares of common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $0.84 per share, and 37,335,618 shares of our common stock issuable upon conversion of our Series A Convertible Preferred Stock. The Company had no unearned restricted shares outstanding for the period ended December 31, 2016. Income Taxes In accordance with general accounting principles for income taxes, a deferred income tax asset or liability is determined based on the difference between the financial statement and tax basis of assets and liabilities as measured by the enacted tax rates that will be in effect when these differences reverse. The Company provides a valuation allowance against net deferred income tax assets unless, based upon available evidence, it is more likely than not the deferred income tax assets will be realized. Product Warranty Provisions The Company’s standard policy is to warrant all systems against defects in material or workmanship for one year following installation. The Company’s estimate of costs to service the warranty obligations is based on historical experience and current product performance trends. A regular review of warranty obligations is performed to determine the adequacy of the reserve and adjustments are made to the estimated warranty liability (included in other accrued liabilities) as appropriate. Patent Costs Costs related to filing and pursuing patent applications are expensed as incurred, as recoverability of such expenditures is uncertain. Concentrations of Risk The majority of the Company’s cash, cash equivalents and investments are deposited with one major financial institution in the U.S. Deposits in this institution exceed the amount of insurance provided on such deposits. Biosense Webster Inc. accounted for $4,099,075 and $3,514,897 or 13%, and 9%, of total net revenue for the years ended December 31, 2016, and 2015, respectively. No other single customer accounted for more than 10% of total revenue for the year ended December 31, 2016. Reclassifications Certain amounts in the prior period financial statements have been reclassified to conform to the current period presentation. These reclassifications had no effect on reported losses. Recently Issued Accounting Pronouncements In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU” or “Update”) No. 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting”. This amendment is intended to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, forfeitures, and classification on the statement of cash flows. This update is effective for fiscal years beginning after December 15, 2016 (January 1, 2017 for the Company) and interim periods within those fiscal years, with earlier application permitted. The Company will adopt this guidance in the first quarter of 2017 and does not expect the adoption of ASU 2016-09 to materially impact the Company’s consolidated financial position, results of operations, equity or cash flows. In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-02-Leases (ASC 842), which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract (i.e. lessees and lessors). The new standard requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease, respectively. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. The new standard requires lessors to account for leases using an approach that is substantially equivalent to existing guidance for sales-type leases, direct financing leases and operating leases. ASC 842 supersedes the previous leases standard, ASC 840 Leases. The standard is effective for interim and annual periods beginning after December 31, 2018 (January 1, 2019 for the Company), with early adoption permitted. The Company is in the process of evaluating the impact of this accounting standard update. In November 2015, the FASB issued Accounting Standards Update (“ASU” or “Update”) No. 2015-17, “Income Taxes (Topic 740): To simplify the presentation of deferred income taxes”. The amendments in this Update require that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. The amendments in this Update apply to all entities that present a classified statement of financial position. The current requirement that deferred tax liabilities and assets of a tax-paying component of an entity be offset and presented as a single amount is not affected by the amendments in this Update. This standard is effective for public companies for financial statements issued for annual periods beginning after December 15, 2016 (January 1, 2017 for the Company), and interim periods within those annual periods. We have adopted this accounting standard update and there was no impact to the results of operations or cash flows. In July 2015, the FASB issued ASU No. 2015-11, “Inventory (Topic 330): Simplifying the Measurement of Inventory” regarding the subsequent measurement of inventory as part of its Simplification Initiative. This standard is effective for public companies for fiscal years beginning after December 15, 2016 (January 1, 2017 for the Company), including interim periods within those fiscal years. This Update should be applied prospectively, and early application is permitted as of the beginning of an interim or annual reporting period. We are currently evaluating the impact of adopting this accounting standard update but do not expect this to significantly impact the results of operations, financial conditions, cash flows, or financial statement presentation. In April 2015, the FASB issued ASU No. 2015-03, “Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs”. To simplify the presentation of debt issuance costs, the amendments in this Update require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from that debt liability, consistent with the presentation of a debt discount. In August 2015, the FASB issued ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements-Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting (SEC Update), which adds the SEC staff’s guidance on the presentation of debt issuance costs associated with lines of credit to the Codification. The SEC staff stated it will not object to an entity presenting the costs of securing line-of-credit arrangements as an asset, regardless of whether there are any outstanding borrowings. The Standard is effective for financial statements issued for fiscal years beginning after December 15, 2015 (January 1, 2016 for the Company), and interim periods within those fiscal years. Early adoption of the amendments in this Update is permitted for financial statements that have not been previously issued. We have adopted this accounting standard update. The Company’s balance sheet as of December 31, 2015 included $349,018 of deferred financing costs that were, under the new guidance, presented as a direct reduction to debt liabilities. In September 2016, the company extinguished the remainder of the debt upon an agreement entered into with Healthcare Royalty Partners. See Note 9 for additional details. In August 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU” or “Update”) No. 2014-15, to communicate amendments to FASB Account Standards Codification Subtopic 205-40, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” The ASU requires management to evaluate relevant conditions, events and certain management plans that are known or reasonably knowable as of the evaluation date when determining whether substantial doubt about an entity’s ability to continue as a going concern exists. Management will be required to make this evaluation for both annual and interim reporting periods. Management will have to make certain disclosures if it concludes that substantial doubt exists or when it plans to alleviate substantial doubt about the entity’s ability to continue as a going concern. The standard is effective for annual periods ending after December 15, 2016 and for interim reporting periods starting in the first quarter of 2017 (December 31, 2016 for the Company). Early adoption is permitted. We have adopted this accounting standard update and provided the relevant disclosures in Note 1. In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers,” which converges the FASB’s and the International Accounting Standards Board’s current standards on revenue recognition. The standard provides companies with a single model to use in accounting for revenue arising from contracts with customers and supersedes current revenue guidance. The standard is effective for annual and interim periods beginning after December 15, 2017 (January 1, 2018 for the Company). Early adoption is not permitted. The standard permits companies to either apply the adoption to all periods presented, or apply the requirements in the year of adoption through a cumulative adjustment. The Company will adopt ASU 2014-09 during the first quarter of 2018 and anticipates using the modified retrospective method that will result in a cumulative effect adjustment as of the date of adoption. Upon initial evaluation, management does not anticipate a significant change to its existing units of accounting which include systems, disposables and other accessories, royalty and other recurring revenue. The Company continues to evaluate other areas of the standard and its effect on the Corporation’s financial statements. 3. Inventory Inventory consists of the following: 4. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets consist of the following: Certain prior year amounts have been reclassified to conform to the 2016 presentation. 5. Property and Equipment Property and equipment consist of the following: 6. Intangible Assets As of December 31, 2016 and 2015, the Company had total intangible assets of $3,221,069. Accumulated amortization at December 31, 2016 and 2015 was $2,784,500 and $2,585,180, respectively. Amortization expense for the years 2016 and 2015 was $199,320 and $299,833, respectively, as determined under the straight-line method. The estimated future amortization of intangible assets is $199,320 annually through July 2018, decreasing thereafter to $143,765 in 2018, $65,988 in 2019 and $27,496 through May 2020. The Company also recognized impairment charges of $443,931 during 2015 on certain 2010 intellectual property rights relating to the Company’s Odyssey Solution due to uncertainty around forecasted revenue under the Odyssey system distribution agreement beyond May 2016. The impairment is the result of a decline in forecasted revenue attributable to this intellectual property that indicated it was probable the undiscounted future cash flows would not exceed the book value of the intellectual property. As a result, the book value of the intellectual property was reduced to its fair value as estimated using a discounted cash flow analysis. The Company evaluated the discount rate in the fair value calculation with the assistance of a third party valuation specialist (Level 3). 7. Accrued Liabilities Accrued liabilities consist of the following: 8. Deferred Revenue Deferred revenue consists of the following: 9. Long-Term Debt and Credit Facilities Debt outstanding consists of the following: As of December 31, 2016, there were no contractual principal maturities of debt. Certain prior year amounts have been reclassified to conform to the 2016 presentation. In accordance with general accounting principles for fair value measurement, the Company’s debt and credit facilities were measured at fair value as of December 31, 2016 and December 31, 2015. Long-term debt fair value estimates are based on estimated borrowing rates to discount the cash flows to their present value (Level 3). The revolving line of credit is secured by substantially all of the Company’s assets. The Company is required under the Credit Agreements to maintain its primary operating account and the majority of its cash and investment balances in accounts with the primary lender. Revolving line of credit The Company has had a working capital line of credit with its primary lender, Silicon Valley Bank, since 2004. The revolving line of credit is secured by substantially all of the Company’s assets. The maximum available under the line is $10.0 million subject to the value of collateralized assets. The Company is required under the revolving line of credit to maintain its primary operating account and the majority of its cash and investment balances in accounts with its primary lender. The facility was amended on March 27, 2015, extending the maturity date to March 31, 2018 and on May 10, 2016, the Company and the primary lender agreed to modify certain financial covenants. The amended agreement requires the Company to maintain a liquidity ratio greater than 1.50:1.00, excluding certain short term advances from the calculation, and a minimum tangible net worth of not less than (no worse than) negative $24.0 million for the quarters ended June 30, 2016, September 30, 2016, December 31, 2016, March 31, 2017, June 30, 2017, and September 30, 2017; and not less than (no worse than) negative $24.5 million for the quarters ended December 31, 2017 and March 31, 2018. As of December 31, 2016, the Company had no outstanding debt under the revolving line of credit. Draws on the line of credit are made based on the borrowing capacity one week in arrears. As of December 31, 2016 the Company had a borrowing capacity of $3.8 million based on the Company’s collateralized assets. The Company’s total liquidity as of December 31, 2016, was $12.3 million which included cash and cash equivalents of $8.5 million. As of December 31, 2016, we were in compliance with all financial covenants of this agreement and we anticipate continued compliance throughout the remainder of 2017. Healthcare Royalty Partners Debt In November 2011, the Company entered into a loan agreement with Healthcare Royalty Partners (formerly “Cowen Healthcare Royalty Partners II, L.P.”). Under the agreement the Company borrowed from Healthcare Royalty Partners $15 million. The Company was permitted to borrow up to an additional $5 million in the aggregate based on the achievement by the Company of certain milestones related to Niobe system sales in 2012. On August 8, 2012, the Company borrowed an additional $2.5 million based upon achievement of a milestone related to Niobe system sales for the nine months ended June 30, 2012. On January 31, 2013, the Company borrowed an additional $2.5 million based upon achievement of a milestone related to Niobe system sales for the twelve months ended December 31, 2012. The loan was to be repaid through, and secured by, royalties payable to the Company under its Development, Alliance and Supply Agreement with Biosense Webster, Inc. The Biosense Agreement relates to the development and distribution of magnetically enabled catheters used with Stereotaxis’ Niobe system in cardiac ablation procedures. Under the terms of the Agreement, Healthcare Royalty Partners was entitled to receive 100% of all royalties due to the Company under the Biosense Agreement until the loan is repaid. The loan was a full recourse loan, scheduled to mature on December 31, 2018, and bore interest at an annual rate of 16% payable quarterly with royalties received under the Biosense Agreement. If the payments received by the Company under the Biosense Agreement had been insufficient to pay all amounts of interest due on the loan, then such deficiency would have increased the outstanding principal amount on the loan. After the loan obligation was repaid, the royalties under the Biosense Agreement are paid to the Company. The loan was also secured by certain assets and intellectual property of the Company. The Agreement contained customary affirmative and negative covenants. The use of payments due to the Company under the Biosense Agreement was approved by our primary lender. In September 2016, the Company extinguished the remainder of the debt of $18.1 million, net of deferred financing costs of approximately $0.3 million, as well as accrued interest of $0.5 million for $13.0 million based upon an agreement entered into with Healthcare Royalty Partners. After the loan obligation was repaid, the royalties under the Biosense Agreement will again be paid to the Company. As a result of the debt extinguishment, the company recognized a net gain of $5.6 million. 10. Lease Obligations The Company leases its facilities under operating leases. For the years ended December 31, 2016 and 2015 rent expense was $1,187,989 and $1,205,338, respectively. The rent expense for the years ended December 31, 2016 and 2015 is net of sublease income of $91,579 and $18,912, respectively. In January 2006, the Company moved its primary operations into its current facilities. The facility is subject to a lease which expires in December 31, 2018. Under the terms of the lease, the Company has options to renew for up to three additional years. The lease contains an escalating rent provision which the Company has straight-lined over the term of the lease. In the third quarter of 2013, the Company modified the existing lease agreement to terminate approximately 13,000 square feet of unimproved space. The costs associated with the termination were $515,138, and were accrued as a rent liability as of September 30, 2013. As of December 31, 2016, the remaining accrued costs associated with the termination were $181,601. In the fourth quarter of 2015, the Company entered a sublease agreement to sublease 3,152 square feet of the first floor office space through December 31, 2018. In July 2016, the Company and the subtenant mutually agreed to an early termination of the sublease, effective July 31, 2016. In August 2016 the Company entered into an agreement to sublease approximately 11,000 square feet of office space through December 31, 2018. The costs associated with the sublease were $40,972 and were accrued as a rent liability as of August 31, 2016. As of December 31, 2016, the remaining accrued costs associated with the termination were $21,286. As part of the sublease agreement, the Company will sublease an additional 16,000 square feet beginning in January 2017. The future minimum lease payments under non-cancelable leases as of December 31, 2016 are as follows (excluding sublease income): 11. Convertible Preferred Stock and Stockholders’ Equity The holders of common stock are entitled one vote for each share held and to receive dividends whenever funds are legally available and when declared by the Board of Directors subject to the prior rights of holders of all classes of stock having priority rights as dividends and the conditions of the Revolving Credit Agreement. No dividends have been declared or paid as of December 31, 2016. Convertible Preferred Stock and Warrants On September 26, 2016, the Company entered into a Securities Purchase Agreement with certain institutional and other accredited investors whereby it agreed to sell, for an aggregate purchase price of $24.0 million, (i) an aggregate of 24,000 shares of Series A Convertible Preferred Stock, par value $0.001 with a stated value of $1,000 per share which are convertible into shares of the Company’s common stock and (ii) warrants to purchase an aggregate of 36,923,078 shares of common stock. The transaction closed on September 29, 2016. The Company received net proceeds from the sale of the convertible preferred stock and warrants of $23.0 million, after offering expenses. The Company used $13.0 million of the funds to satisfy in full all amounts outstanding under the Loan Agreement with Healthcare Royalty Partners, as noted above, and anticipates using the remaining proceeds for general corporate purposes. The designations, preferences, powers and rights of the convertible preferred shares are set forth in a Certificate of Designations, Preferences and Rights of Series A Convertible Preferred Stock (“Certificate of Designations”) filed with the Delaware Secretary of State. The convertible preferred shares are entitled to vote on an as-converted basis with the common stock, subject to specified beneficial ownership issuance limitations. The convertible preferred shares bear dividends at a rate of six percent (6%) per annum, which are cumulative and accrue daily from the date of issuance on the $1,000 stated value. Such dividends will not be paid in cash except in connection with any liquidation, dissolution or winding up of the Company or any redemption of the convertible preferred shares. Instead the value of the accrued dividends is added to the liquidation preference of the convertible preferred shares and will increase the number of shares of common stock issuable upon conversion. Each convertible preferred share is convertible at the option of the holder from and after the date of issuance with no expiration date, at an initial conversion price of $0.65 per share, subject to adjustment in the event of stock splits, dividends, mergers, sales of all or substantially all of our assets or similar transactions, subject to specified beneficial ownership issuance limitations. Each holder of convertible preferred shares has the right to require us to redeem such holder’s convertible preferred shares upon the occurrence of specified events, which include certain business combinations, the sale of all or substantially all of the Company’s assets or the sale of more than 50% of the outstanding shares of the Company’s common stock. In addition, the Company has the right to redeem the convertible preferred shares in the event of a change of control as defined in the Certificate of Designations. The convertible preferred shares rank senior to our common stock as to distributions and payments upon the liquidation, dissolution and winding up of the Company. No such distributions or payments upon the liquidation, dissolution and winding up of the Company may be made to the holders of common stock unless and until the holders of convertible preferred shares have received the stated value of $1,000 per share plus any accrued and unpaid dividends. Until all convertible preferred shares have been converted or redeemed, no dividends may be paid on the common stock without the express written consent of the holders of a majority of the outstanding convertible preferred shares. In the event that dividends or other distributions of assets are made or paid by the Company to the holders of the common stock, the holders of convertible preferred shares are entitled to participate in such dividend or distribution on an as-converted basis. On the date of the issuance, the fair value of the convertible preferred stock was greater than the allocated proceeds received for the Series A convertible preferred stock. As such, the Company accounted for the beneficial conversion feature under ASC 470-20, Debt with Conversion feature under ASC 470-20, Debt with Conversion and Other Options. The Company recorded a deemed dividend charge of $6.1 million for the accretion of a discount on the Series A convertible preferred stock. The deemed dividend was a non-cash transaction and is reflected below net loss to arrive at net loss available to common stockholders. Since the convertible preferred shares are subject to conditions for redemption that are outside the Company’s control, the convertible preferred shares are presently reported in the mezzanine section of the balance sheet. The warrants issued in conjunction with the convertible preferred stock have an exercise price equal to $0.70 per share subject to adjustments as provided under the terms of the warrants. The warrants are exercisable through September 29, 2021, subject to specified beneficial ownership issuance limitations. The warrants may be exercised by any holder on a cashless basis if, at any time after the date that is 180 days after the closing, the registration statement required by the Registration Rights Agreement described below is not effective and available for resale of all of the shares of common stock issuable upon exercise of such holder’s warrants. Due to the fact that the warrants are puttable upon the occurrence of certain events outside of the Company’s control, the warrants qualify as liabilities under ASC 480-10. The calculated fair value of the warrants is classified as a liability and is periodically re-measured with any changes in value recognized in “Other income (expense)” in the Statements of Operations. See Note 12 for additional details. On December 2, 2016 100 shares of convertible preferred stock plus accumulated dividends were converted into 155,439 common shares. Listing Transfer to OTCQX® Best Market On August 2, 2016, the Company received a determination letter from the Nasdaq Hearings Panel (the “Panel”) notifying the Company that its common stock would be delisted from The Nasdaq Capital Market (“Nasdaq”) and that suspension of trading in the shares would be effective at the open of business on August 4, 2016. The determination letter also indicated that Nasdaq would complete the delisting by filing a Form 25 Notification of Delisting with the Securities Exchange Commission, after applicable appeal periods have lapsed. The Panel made the determination to delist the Company’s common stock because the Company did not demonstrate compliance with the minimum $35 million market value of listed securities requirement for a period of ten consecutive trading days by August 1, 2016, as required by a decision previously issued by the Panel on May 2, 2016. The Company’s shares of common stock commenced trading on the OTCQX® Best Market on August 4, 2016 under the Company’s current ticker symbol of “STXS.” Controlled Equity Offering The Company entered into a Controlled Equity OfferingSM sales agreement (the “Sales Agreement”) in May 2014, as amended on March 26, 2015, with Cantor Fitzgerald & Co. (“Cantor”), as agent and/or principal, pursuant to which the Company could issue and sell, from time to time, shares of its common stock having an aggregate gross sales price of up to $18.0 million. The Company paid Cantor a commission of 3.0% of the gross proceeds from any common stock sold through the Sales Agreement. There were no proceeds from the Controlled Equity Offering during the twelve months ended December 31, 2016. The Sales Agreement expired in November 2016 upon the expiration of our Registration Statement on Form S-3. The Company has reserved shares of common stock for conversion of convertible preferred stock, exercise of warrants, and the issuance of options granted under the Company’s stock option plan and its stock purchase plan as follows: Stock Award Plans The Company has various stock plans that permit the Company to provide incentives to employees and directors of the Company in the form of equity compensation. In August 2012, the Board of Directors adopted a stock incentive plan (the 2012 Stock Incentive Plan) which was subsequently approved by the Company’s stockholders. This plan replaces the 2002 Stock Incentive Plan which expired on March 25, 2012. The 2012 Stock Incentive Plan allows for the grant of incentive stock options, non-qualified stock options, stock appreciation rights, restricted shares and restricted share units to employees, directors, and consultants. Options granted under the 2012 Stock Incentive Plan expire no later than ten years from the date of grant. The exercise price of each incentive stock option shall not be less than 100% of the fair value of the stock subject to the option on the date the option is granted. The vesting provisions of individual options may vary, but incentive stock options generally vest 25% on the first anniversary of each grant and 1/48 per month over the next three years. Stock appreciation rights are rights to acquire a calculated number of shares of the Company’s common stock upon exercise of the rights. The number of shares to be issued is calculated as the difference between the exercise price of the right and the aggregate market value of the underlying shares on the exercise date divided by the market value as of the exercise date. Stock appreciation rights granted under the 2012 Stock Incentive Plan generally vest 25% on the first anniversary of such grant and 1/48 per month over the next three years and expire no later than ten years from the date of grant. The Company generally issues new shares upon the exercise of stock options and stock appreciation rights. Restricted share grants are either time-based or performance-based. Time-based restricted shares generally cliff vest three years after grant. Performance-based restricted shares vest upon the achievement of performance objectives which are determined by the Company’s Board of Directors. Restricted stock unit grants are time-based and generally vest over a period of four years. Options granted to non-employee directors expire no later than ten years from the date of grant. The exercise price of options to non-employee directors shall not be less than 100% of the fair value of the stock subject to the option on the date the option is granted. Initial grants of options to new directors generally vest over a two year period. Annual grants to directors generally vest upon the earlier of one year or the next stockholder meeting. A summary of the option and stock appreciation rights activity for the year ended December 31, 2016 is as follows: As of December 31, 2016, the weighted average remaining contractual life of the options and stock appreciation rights outstanding was 7.06 years. Of the 671,887 options and stock appreciation rights that were outstanding as of December 31, 2016, 429,029 were vested and exercisable with a weighted average exercise price of $12.15 per share and a weighted average remaining term of 6.64 years. A summary of the options and stock appreciation rights outstanding by range of exercise price is as follows: The intrinsic value of options and stock appreciation rights is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock for the options and stock appreciation rights that were in-the-money at December 31, 2016. The intrinsic value of the options and stock appreciation rights outstanding at December 31, 2016 and the intrinsic value of fully vested options and stock appreciation rights outstanding at December 31, 2016 were zero based on a closing share price of $0.65 on December 31, 2016. No options or stock appreciation rights were exercised under the Company’s stock option plans during the years ended December 31, 2015 or 2016 and the Company realized no proceeds during these periods. The weighted average grant date fair value of options and stock appreciation rights granted during the year ended December 31, 2016 was $1.55 per share. A summary of the restricted stock unit activity for the year ended December 31, 2016 is as follows: The intrinsic value of restricted stock units outstanding at December 31, 2016 was $0.8 million based on a closing share price of $0.65 as of December 31, 2016. During the year ended December 31, 2016, the aggregate intrinsic value of restricted stock units vested was $0.3 million determined at the date of vesting. During the fourth quarter of 2016, the Company adjusted its estimated forfeiture rates based on historical information, which resulted in an increase to share-based compensation of approximately $0.2 million for the year ended December 31, 2016. As of December 31, 2016, the total compensation cost related to options, stock appreciation rights and non-vested stock granted to employees under the Company’s stock award plans but not yet recognized was approximately $1.8 million, net of estimated forfeitures of approximately $0.3 million. This cost will be amortized over a weighted average period of approximately one and a half years on a straight-line basis over the underlying estimated service periods and will be adjusted for subsequent changes in forfeitures. 2009 Employee Stock Purchase Plan In 2009, the Company adopted its 2009 Employee Stock Purchase Plan (“ESPP”). In June 2014, our shareholders approved a proposal to amend the ESPP to increase the number of shares authorized for issuance under the ESPP by 250,000 shares. Eligible employees have the opportunity to participate in a new purchase period every 3 months. Under the terms of the plan, employees can purchase up to 15% of their compensation of the Company’s common stock, subject to an annual maximum of $25,000, at 95% of the fair market value of the stock at the end of the purchase period, subject to certain plan limitations. As of December 31, 2016, there were 192,290 remaining shares available for issuance under the Employee Stock Purchase Plan. 12. Fair Value Measurements The Company measures certain financial assets and liabilities at fair value on a recurring basis, including cash equivalents and warrants. General accounting principles for fair value measurement established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets and liabilities (“Level 1”) and the lowest priority to unobservable inputs (“Level 3”). The three levels of the fair value hierarchy are described below: The following table sets forth the Company’s assets and liabilities measured at fair value on a recurring basis by level within the fair value hierarchy. As required by the Fair Value Measurements and Disclosures topic of the Accounting Standards Codification, assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Level 1 The Company’s financial assets consist of cash equivalents invested in money market funds in the amount of $524,083 at December 31, 2015. There were no cash equivalents invested in money market funds at December 31, 2016. These assets are classified as Level 1 as described above and total interest income recorded for these investments was insignificant during both the years ended December 31, 2016 and December 31, 2015. There were no transfers in or out of Level 1 during the year ended December 31, 2016. Level 2 The Company does not have any financial assets or liabilities classified as Level 2. Level 3 In conjunction with the Company’s May 2012, August 2013 and September 2016 financing transactions, the Company issued warrants to purchase shares of the Company’s common stock. Due to the provisions included in the warrant agreements, the warrants did not meet the exemptions for equity classification and as such, the Company accounts for these warrants as derivative instruments. The calculated fair value of the warrants is classified as a liability and is periodically re-measured with any changes in value recognized in “Other income (expense)” in the Statements of Operations. The remaining warrants from the May 2012 transaction (PIPE Warrants) expire in May 2018 and were valued using an option pricing model as of December 31, 2015 using the following assumptions: 1) volatility of 113.4%; 2) risk-free interest rate of 1.06%; and 3) a closing stock price of $0.74. The PIPE warrants were revalued using an option pricing model as of December 31, 2016 using the following assumptions: 1) volatility of 121.12%; 2) risk-free interest rate of 1.20%; and 3) a closing stock price of $0.65. The remaining warrants from the August 2013 transaction (Exchange warrants) expire in November 2018 and were valued using an option pricing model as of December 31, 2015 using the following assumptions: 1) volatility of 182.94%; 2) risk-free interest rate of 1.31%; and 3) a closing stock price of $0.74. The Exchange warrants were revalued using an option pricing model as of December 31, 2016 using the following assumptions: 1) volatility of 110.32%; 2) risk-free interest rate of 1.20%; and 3) a closing stock price of $0.65. The September 2016 warrants expire in September 2021 and were valued as of September 30, 2016 using the following assumptions: 1) volatility of 120.43%; 2) risk-free interest rate of 1.14%; and 3) a closing stock price of $0.87. These warrants were revalued using an option pricing model as of December 31, 2016 using the following assumptions: 1) volatility of 121.31%; 2) risk-free interest rate of 1.93%; and 3) a closing stock price of $0.65. The significant unobservable input used in the fair value measurement of the Company’s warrants is volatility. Significant increases (decreases) in the volatility in isolation would result in a significantly higher (lower) liability fair value measurement. The following table sets forth a summary of changes in the fair value of the Company’s Level 3 financial liabilities for the year ended December 31, 2016: The Company currently does not have derivative instruments to manage its exposure to currency fluctuations or other business risks. The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. All derivative financial instruments are recognized in the balance sheet at fair value. 13. Income Taxes The provision for income taxes consists of the following: The provision for income taxes varies from the amount determined by applying the U.S. federal statutory rate to income before income taxes as a result of the following: Included in permanent differences between book and tax in the above table are the impacts of the non-deductible mark-to-market activity associated with convertible debt and warrants as well as permanent differences such as nondeductible meals and entertainment. The state rate adjustments are a result of changes in apportionment and various state rate law changes. The components of the deferred tax asset are as follows: Under Section 382 and 383 of the Internal Revenue Code of 1986, as amended, or the “Code”, if a corporation undergoes an “ownership change,” the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change tax attributes, such as research tax credits, to offset its post-change income may be limited. In general, an “ownership change” will occur if there is a cumulative change in our ownership by “5-percent shareholders” that exceeds 50 percentage points over a rolling three-year period. Similar rules may apply under state tax laws. Following significant ownership changes during 2013, the Company initiated a review of the availability of its U.S. net operating loss carryforwards. As a result of this review, it was determined that approximately $290 million of the Company’s federal net operating loss carryovers would expire unused due to the limitation under IRC Section 382. The Company reduced the net operating loss carryover and corresponding valuation allowance as a result of these limitations. The remaining net operating loss carryforwards following the ownership change have been assigned a full valuation allowance against all deferred tax assets. In assessing the realizability of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company considers projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable losses, and projections for future periods over which the deferred tax assets are deductible, the Company determined that a 100% valuation allowance of deferred tax assets was appropriate. The valuation allowance for deferred tax assets includes amounts for which subsequently recognized tax benefits will be applied directly to the contributed capital. As of December 31, 2016, we had gross federal net operating loss carryforwards of approximately $95.6 million. The federal net operating loss carryforwards reflect accumulated book losses reduced for the 2013 IRC Section 382 ownership change limitation of $290 million and approximately $86 million of book/ tax differences and expiration of unused carryforwards. The federal net operating loss carryforwards will expire between 2030 and 2036. As of December 31, 2016, we had state net operating loss deferred tax assets of approximately $1.5 million which will expire at various dates between 2017 and 2036 if not utilized. The Company files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. As the Company has a federal net operating loss carryforward from the year ended December 31, 1997 forward, all tax years from 1997 forward are subject to examination. As states have varying carryforward periods, and the Company has recently entered into additional states, the states are generally subject to examination for the previous 10 years or less. The Company recognizes interest accrued, if any, net of tax and penalties, related to unrecognized tax benefits as components of income tax provision as applicable. As of December 31, 2016 accrued interest and penalties were less than $0.1 million. At December 31, 2016 and 2015, the Company had approximately $0.1 million and $0.3 million, respectively, in reserves for uncertain tax positions. 14. Net Loss per Share The following is a reconciliation of the numerator (net loss) and the denominator (number of shares) used in the basic and diluted earnings per share calculations: The following table sets forth the number of common shares that were excluded from the computation of diluted earnings per share because their inclusion would have been anti-dilutive as follows: 15. Employee Benefit Plan The Company offers employees the opportunity to participate in a 401(k) plan. Employer contributions are discretionary under the 401(k) plan. Currently the Company does not match employee contributions. 16. Product Warranty Provisions The Company’s standard policy is to warrant all Niobe, Odyssey and Vdrive systems against defects in material or workmanship for one year following installation. The Company’s estimate of costs to service the warranty obligations is based on historical experience and current product performance trends. A regular review of warranty obligations is performed to determine the adequacy of the reserve and adjustments are made to the estimated warranty liability as appropriate. Accrued warranty, which is included in other accrued liabilities, consists of the following: 17. Related Party Transactions In September 2016, the Company entered into a Securities Purchase Agreement with certain institutional and other accredited investors whereby it agreed to sell, for an aggregate purchase price of $24.0 million, (i) an aggregate of 24,000 shares of Series A Convertible Preferred Stock, and (ii) warrants to purchase an aggregate of 36,923,078 shares of common stock (see Note 11 to the accompanying financial statements for further information). Pursuant to the transaction agreements, the Company reimbursed transaction related legal fees of $85,000 to a law firm engaged by DAFNA Capital Management. Funds managed by DAFNA Capital Management own more than 5% of the outstanding shares of the Company. Also, pursuant to the Securities Purchase Agreement, the Board appointed David Fischel, Principal at DAFNA Capital Management, and Joe Kiani, also an investor in the offering, to the Board, effective as of the closing of the Offering. Subsequent to the transaction, the Company reimbursed an additional $120,367 in transaction-related legal fees incurred by law firms engaged by these investors. In February, 2017, David Fischel was appointed acting Chief Executive Officer of Stereotaxis, Inc. 18. Commitments and Contingencies The Company at times becomes a party to claims in the ordinary course of business. Management believes that the ultimate resolution of pending or threatened proceedings will not have a material effect on the financial position, results of operations or liquidity of the Company. 19. Segment Information The Company considers reporting segments in accordance with general accounting principles for disclosures about segments of an enterprise and related information. The Company’s system and disposable devices are developed and marketed to a broad base of hospitals in the United States and internationally. The Company considers all such sales to be part of a single operating segment. Geographic revenues for the years ended December 31, 2016 and 2015 were as follows: All of the Company’s long-lived assets are located in the United States. Revenues are attributed to countries based on the location of the customer. 20. Subsequent Events None.
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I apologize, but the financial statement excerpt you've provided appears to be incomplete and fragmented, making it difficult to provide a comprehensive summary. The text seems to be missing key sections and appears to be a partial or truncated financial statement.
From the available information, I can only discern a few general points:
1. The statement references a period ending December 31st (likely a specific year)
2. The company has historically experienced losses
3. The company is considering strategies to manage cash flow, such as:
- Potentially converting cash payments to stock payments
- Reducing project expenses
- Reducing headcount
- Exploring debt or equity financing options
To provide a meaningful summary, I would need the complete financial statement with full details about revenue, expenses, assets, liabilities, and other financial metrics.
Would you be able to provide the full financial statement or clarify the document?
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. PREMIER PACIFIC CONSTRUCTION, INC. Audited Financial Statements For the Period Ending December 31, 2016 ACCOUNTING FIRM To the Board of Directors and Stockholders Premier Pacific Construction, Inc. Poway, California We have audited the accompanying balance sheets of Premier Pacific Construction, Inc. as of December 31, 2016 and 2015 and the related statements of operations, stockholders' equity (deficit) and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Premier Pacific Construction, Inc. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that Premier Pacific Construction, Inc. will continue as a going concern. As discussed in Note 1 to the financial statements, the Company's income has come from five major clients and there can be no assurance that there will be a continuance in their business, which raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to this matter are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ MaloneBailey, LLP www.malonebailey.com Houston, Texas April 17, 2017 The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. PREMIER PACIFIC CONSTRUCTION INC. Statements of Cash Flows The accompanying notes are an integral part of these financial statements. PREMIER PACIFIC CONSTRUCTION, INC. NOTES TO FINANCIAL STATEMENTS December 31, 2016 and 2015 1. ORGANIZATION AND BASIS OF PRESENTATION Premier Pacific Construction, Inc. ("The Company") was originally incorporated in the State of California on July 28, 2000 in the name of Francella's Kitchen and Bath Refinishing Inc. to engage in the business of small scale construction, repairs and alterations for residential clients. On August 8, 2008 the Company changed its name to Premier Pacific Construction, Inc., a California Corporation ("PPC-CA"). The Company merged with Premier Pacific Construction Inc., a Nevada Corporation ("PPC-NV") in March of 2012. Going Concern Consideration These financial statements have been prepared on a going concern basis which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future. The Company anticipates future losses in the development of its business raising substantial doubt about the Company's ability to continue as a going concern. The ability to continue as a going concern is dependent upon the Company generating profitable operations in the future and/or to obtain the necessary financing to meet its obligations and repay its liabilities arising from normal business operations when they come due. Management intends to finance operating costs over the next twelve months with existing cash on hand, loans from directors and/or issuance of common shares. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Recently issued Accounting Pronouncements We have reviewed the FASB issued Accounting Standards Update ("ASU") accounting pronouncements and interpretations thereof that have effectiveness dates during the periods reported and in future periods. The Company has carefully considered the new pronouncements that alter previous generally accepted accounting principles and does not believe that any new or modified principles will have a material impact on the corporation's reported financial position or operations in the near term. The applicability of any standard is subject to the formal review of our financial management and certain standards are under consideration. Basis of Presentation The financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States of America. The Company's year -end is December 31. Cash and Cash Equivalents The Company considers all highly liquid investments with original maturity of three months or less to be cash equivalents. As of December 31, 2016, the Company did not have cash balances in excess of the Federal Deposit Insurance Corporation limit. As of December 31, 2016, the Company did not have any cash equivalents. Use of Estimates and Assumptions The preparation of financial statements in conformity with generally accepted accounting principles requires that management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates Revenue Recognition The Company recognizes revenue from the sale of products or services in accordance with ASC 605-35-25-1" Revenue Recognition in Financial Statements". The Company has adopted the "Completed Contract Method of Accounting". Revenue will consist of services income and will be recognized only when the following criteria have been met: i) Persuasive evidence of an agreement has been met; ii) Service has occurred; iii) The fee is fixed or determinable; iv) the collection is reasonably assured. PREMIER PACIFIC CONSTRUCTION, INC. NOTES TO FINANCIAL STATEMENTS December 31, 2016 and 2015 We receive payments from customers as down payments and record them as progress billings. The revenue related to these progress billings is recognized as revenue in accordance with our revenue recognition policies as above. The revenue for the year ending December 31, 2016 is from two customers. Income Taxes The Company follows the accrual method of accounting for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the estimated tax consequences attributable to differences between the financial statement carrying values and their respective income tax basis (temporary differences). The effect on the deferred income tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. At December 31, 2016 a full deferred tax asset valuation allowance has been provided and no deferred tax asset has been recorded. Loss per Common Shares The Company computes net income (loss) per share in accordance with ASC 260, "Earnings per Share" which requires presentation of both basic and diluted earnings per share (EPS) on the face of the income statement. Basic EPS is computed by dividing net income (loss) available to common shareholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period including stock options, using the treasury stock method, and convertible preferred stock, using the if-converted method. In computing diluted EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Diluted EPS excludes all dilutive potential common shares if their effect is anti-dilutive. As of December 31, 2016, there are no dilutive securities. 3. INCOME TAXES Realization of deferred tax assets is dependent upon sufficient future taxable income during the period that deductible temporary differences and carry-forwards are expected to be available to reduce taxable income. As the achievement of required future taxable income is uncertain, the Company recorded a valuation allowance. The tax return that is open for IRS examination is for the year ending December 31, 2016. As of December 31, 2016, the Company has a net operating loss of $95,725. A net operating loss expires twenty years from the date the loss was incurred. 4. STOCKHOLDERS' EQUITY On March 12, 2016, the Company's Board of Directors approved the sale of 25,000 common shares of $0.001 par value for net proceeds to the Company of $25,000. On March 1, 2016, the Company agreed to pay its outstanding Note Payable being the principal sum of $21, 193 plus the accrued interest of 5% ($888) totalling $21,081 in full payment of all outstanding loans made to the Company between March and June, 2015. As of December 31, 2016, there are 75,000,000 shares authorized and 5,169,000 issued and outstanding. PREMIER PACIFIC CONSTRUCTION, INC. NOTES TO FINANCIAL STATEMENTS December 31, 2016 and 2015 5. NOTES PAYABLE On March 1, 2016, the Company agreed to pay its outstanding Note Payable being the principal sum of $21, 193 plus the accrued interest of 5% ($888) totalling $21,081 in full payment of all outstanding loans made to the Company between March and June, 2015. 6. RELATED PARTY TRANSACTIONS During the year ending December 31, 2016, the President of the Company provided management fees and office premises to the Company for a fee of $925 per month, the right to which the President agreed to assign to the Company until such time as the Company closes on an equity or debt financing of not less than $200,000. The $11,100 for donated management fees were charged to operating and general expenses and recorded as donated capital (Additional Paid in Capital). . In the year ending December 31, 2016, the majority shareholder loaned the Company an amount of $19,586, in order for the Company to remain in business. $12,988 was repaid in 2016 and at December 31, 2016 $6,958 is outstanding. These loans carry no interest and no time repayment.
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Summary of Financial Statement:
The company is experiencing significant financial challenges:
1. Profitability: Currently experiencing losses that raise doubts about its ability to continue operating.
2. Financing Strategy:
- Intends to cover operating costs through:
- Existing cash reserves
- Loans from directors
- Potential issuance of common shares
3. Financial Outlook:
- Anticipates continued losses
- Dependent on generating profitable operations or securing additional financing
- Total debt financing of at least $200,000 is noted
4. Risk Warning:
- Substantial uncertainty about the company's long-term viability
- Financial statements do not include potential adjustments if the company cannot continue operations
Overall, the company is in a precarious financial position and is actively seeking ways to maintain its operational status.
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Claude
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RELIANCE STEEL & ALUMINUM CO. AUDITED CONSOLIDATED FINANCIAL STATEMENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA All other schedules are omitted because either they are not applicable, not required or the information required is included in the Consolidated Financial Statements, including the notes thereto. Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Reliance Steel & Aluminum Co.: We have audited the accompanying consolidated balance sheets of Reliance Steel & Aluminum Co. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, equity, and cash flows for each of the years in the three-year period ended December 31, 2016. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule of valuation and qualifying accounts. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Reliance Steel & Aluminum Co. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Reliance Steel & Aluminum Co.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 24, 2017 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/ KPMG LLP Los Angeles, California February 24, 2017 RELIANCE STEEL & ALUMINUM CO. CONSOLIDATED BALANCE SHEETS (in millions, except share amounts) See accompanying notes to consolidated financial statements. RELIANCE STEEL & ALUMINUM CO. CONSOLIDATED STATEMENTS OF INCOME (in millions, except per share amounts) See accompanying notes to consolidated financial statements. RELIANCE STEEL & ALUMINUM CO. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in millions) See accompanying notes to consolidated financial statements. RELIANCE STEEL & ALUMINUM CO. CONSOLIDATED STATEMENTS OF EQUITY (in millions, except share and per share amounts) See accompanying notes to consolidated financial statements. RELIANCE STEEL & ALUMINUM CO. CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) See accompanying notes to consolidated financial statements. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2016 Note 1. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Reliance Steel & Aluminum Co. and its subsidiaries (collectively referred to as “Reliance”, “the Company”, “we”, “our” or “us”). Our consolidated financial statements include the assets, liabilities and operating results of majority-owned subsidiaries. The ownership of the other interest holders of consolidated subsidiaries is reflected as noncontrolling interests. Our investments in unconsolidated subsidiaries are recorded under the equity method of accounting. All significant intercompany accounts and transactions have been eliminated. Business We operate a metals service center network of more than 300 locations in 39 states in the U.S. and in 12 other countries (Australia, Belgium, Canada, China, France, Malaysia, Mexico, Singapore, South Korea, Turkey, the United Arab Emirates and the United Kingdom) that provides value-added metals processing services and distributes a full line of more than 100,000 metal products. Since our inception in 1939, we have not diversified outside our core business as a metals service center operator. Accounting Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, such as accounts receivable collectability, valuation of inventories, goodwill, long-lived assets, income tax and other contingencies, and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Accounts Receivable and Concentrations of Credit Risk Concentrations of credit risk with respect to trade receivables are limited due to the geographically diverse customer base and various industries into which our products are sold. Trade receivables are typically non-interest bearing and are initially recorded at cost. Sales to our recurring customers are generally made on open account terms while sales to occasional customers may be made on a C.O.D. basis when collectability is not assured. Past due status of customer accounts is determined based on how recently payments have been received in relation to payment terms granted. Credit is generally extended based upon an evaluation of each customer’s financial condition, with terms consistent in the industry and no collateral is required. Losses from credit sales are provided for in the financial statements and consistently have been within the allowance provided. The allowance is an estimate of the uncollectability of accounts receivable based on an evaluation of specific customer risks along with additional reserves based on historical and probable bad debt experience. Amounts are written-off against the allowance in the period we determine that the receivable is uncollectible. As a result of the above factors, we do not consider ourselves to have any significant concentrations of credit risk. Inventories The majority of our inventory is valued using the last-in, first-out (“LIFO”) method, which is not in excess of market. Under this method, older costs are included in inventory, which may be higher or lower than current costs. This method of valuation is subject to year-to-year fluctuations in cost of material sold, which is influenced by the inflation or deflation existing within the metals industry as well as fluctuations in our product mix and on-hand inventory levels. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Fair Values of Financial Instruments Fair values of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other current liabilities, and the current portion of long-term debt approximate carrying values due to the short period of time to maturity. Fair values of long-term debt, which have been determined based on borrowing rates currently available to us or to other companies with comparable credit ratings, for loans with similar terms or maturity, approximate the carrying amounts in the consolidated financial statements, with the exception of our publicly traded senior unsecured notes of $750.0 million and $1.1 billion as of December 31, 2016 and 2015, respectively. The fair values of these senior unsecured notes based on quoted market prices as of December 31, 2016 and 2015, were $773.2 million and $1.08 billion, respectively, compared to their carrying values of $743.2 million and $1.09 billion as of the end of each respective fiscal year. These estimated fair values are based on Level 2 inputs. Cash Equivalents We consider all highly liquid instruments with an original maturity of three months or less when purchased to be cash equivalents. We maintain cash and cash equivalents with high-credit, quality financial institutions. The Company, by policy, limits the amount of credit exposure to any one financial institution. Goodwill Goodwill is the excess of cost over the fair value of net assets of businesses acquired. Goodwill is not amortized but is tested for impairment at least annually. We have one operating segment and one reporting unit for goodwill impairment purposes. We test for impairment of goodwill by assessing qualitative factors to determine if the fair value of the reporting unit is more likely than not below the carrying value of the reporting unit. We also calculate the fair value of the reporting unit using our market capitalization or the discounted cash flow method, as necessary, and compare the fair value to the carrying value of the reporting unit to determine if impairment exists. We perform the required annual goodwill impairment evaluation on November 1 of each year. No impairment of goodwill was determined to exist in any of the years presented. Long-Lived Assets Property, plant and equipment is recorded at cost (or at fair value for assets acquired in connection with business combinations) and the provision for depreciation of these assets is generally computed on the straight-line method at rates designed to distribute the cost of assets over the useful lives, estimated as follows: buildings, including leasehold improvements, over five to 50 years and machinery and equipment over three to 20 years. Other intangible assets with finite useful lives are amortized over their useful lives. Other intangible assets deemed to have indefinite lives are not amortized but are subject to annual impairment tests. We review the recoverability of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We recognized impairment losses of $14.4 million on our other intangible assets with finite lives in 2015 and $36.4 million and $21.2 million related to our other intangible assets with indefinite lives in 2016 and 2015, respectively. We recognized impairment losses of $16.0 million and $17.7 million for property, plant, and equipment in 2016 and 2015, respectively. See Note 17 - “Impairment and Restructuring Charges” for further discussion of our impairment losses. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Revenue Recognition We recognize revenue from product or processing sales upon concluding that all of the fundamental criteria for product revenue recognition have been met, such as a fixed or determinable sales price; reasonable assurance of collectability; and passage of title and risks of ownership to the buyer. Such criteria are usually met upon delivery to the customer for orders with FOB destination terms or upon shipment for orders with FOB shipping point terms, or after toll processing services are performed. Considering the close proximity of our customers to our metals service center locations, shipment and delivery of our orders generally occur on the same day. Billings for orders where the revenue recognition criteria are not met, which primarily include certain bill and hold transactions (in which our customers request to be billed for the material but request delivery at a later date), are recorded as deferred revenue. Shipping and handling charges to our customers are included in Net sales. Costs incurred in connection with shipping and handling our products that are performed by third-party carriers and costs incurred by our personnel are typically included in operating expenses. In 2016, 2015 and 2014, shipping and handling costs included in Warehouse, delivery, selling, general and administrative expenses were $346.2 million, $319.1 million, and $312.6 million, respectively. Stock-Based Compensation All of our stock-based compensation plans are considered equity plans. We calculate the fair value of stock option awards on the grant date based on the closing market price of our common stock, using a Black-Scholes option-pricing model. The fair value of restricted stock grants is determined based on the fair value of our common stock on the grant date. The fair value of stock option and restricted stock awards is expensed on a straight-line basis over their respective vesting periods, net of forfeitures when they occur. The stock-based compensation expense recorded was $24.4 million, $21.3 million, and $22.8 million in 2016, 2015 and 2014, respectively, and is included in the Warehouse, delivery, selling, general and administrative expense caption of our consolidated statements of income. Environmental Remediation Costs We accrue for losses associated with environmental remediation obligations when such losses are probable and reasonably estimable. Accruals for estimated losses from environmental remediation obligations generally are recognized no later than completion of the remediation feasibility study. Such accruals are adjusted as further information develops or circumstances change. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. We are not aware of any environmental remediation obligations that would materially affect our operations, financial position or cash flows. See Note 14 - “Commitments and Contingencies” for further discussion on our environmental remediation matters. Income Taxes We file a consolidated U.S. federal income tax return with our wholly owned domestic subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes from a change in tax rates is recognized in income in the period that includes the enactment date of the change. The provision for income taxes reflects the taxes to be paid for the period and the change during the period in the deferred tax assets and liabilities. We evaluate on a quarterly basis whether, based on all available evidence, it is probable that the deferred income tax assets are realizable. Valuation allowances are established when it is estimated that it is more likely than not that the tax benefit of the deferred tax asset will not be realized. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 We make a comprehensive review of our uncertain tax positions on a quarterly basis. Tax benefits are recognized when it is more-likely-than-not that a tax position will be sustained upon examination by the authorities. The benefit from a position that has surpassed the more-likely-than-not threshold is the largest amount of benefit that is more than 50% likely to be realized upon settlement. We recognize interest and penalties accrued related to unrecognized tax benefits as a component of income tax expense. Foreign Currencies The currency effects of translating the financial statements of our foreign subsidiaries, which operate in local currency environments, are included in other comprehensive income (loss). Gains and losses resulting from foreign currency transactions are included in the results of operations in the Other income (expense), net caption and amounted to net gains of $1.8 million and $3.1 million in 2016 and 2014, respectively. Gains and losses resulting from foreign currency transactions were insignificant in 2015. Impact of Recently Issued Accounting Standards-Adopted Improvements to Employee Share-Based Payment Accounting-In March 2016, the Financial Accounting Standards Board (“FASB”) issued accounting changes intended to improve various aspects of the accounting for share-based payment transactions as part of its simplification initiative. We adopted these changes as of January 1, 2016. The adoption of these changes did not have a material impact on our consolidated financial statements. For further discussion of our adoption of these accounting changes, see Note 12 - “Equity”. Impact of Recently Issued Accounting Standards-Not Yet Adopted Classification of Certain Cash Receipts and Cash Payments-In August 2016, the FASB issued accounting changes that clarifies the presentation and classification of certain cash receipts and payments in the statement of cash flows with the objective of reducing the existing diversity in practice with respect to eight types of cash flows. The guidance will be effective for fiscal years and interim periods beginning after December 15, 2017. Early adoption is permitted. The adoption of this standard will not have a material impact on our consolidated financial statements. Leases-In February 2016, the FASB issued accounting changes which will require lessees to recognize most long-term leases on-balance sheet through the recognition of a right-of-use asset and a lease liability. The guidance will be effective for fiscal years and interim periods beginning after December 15, 2018. Early adoption is permitted. We have implemented a lease management system and are developing processes necessary to implement these accounting changes. We expect the adoption of these accounting changes will materially increase our assets and liabilities, but will not have a material impact on equity. We have not yet made any decision with respect to the timing or method of adoption of these accounting changes. Revenue from Contracts with Customers-In May 2014, the FASB issued accounting changes, which replace most of the detailed guidance on revenue recognition that currently exists under U.S. GAAP. Under the new guidance an entity should recognize revenue in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance will be effective for fiscal years beginning after December 15, 2017. Early adoption is permitted after December 15, 2016. We primarily sell our inventories in the “spot market” pursuant to fixed price purchase orders and do not enter into transactions with multiple performance obligations. As such, even though we are evaluating the impact of the adoption of the new standard, we do not expect this standard to have a material impact on our consolidated financial statements. We have not yet made any decision with respect to the timing or method of adoption of these accounting changes. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Note 2. Acquisitions 2016 Acquisitions On August 1, 2016, through our wholly owned subsidiary American Metals Corporation, we acquired Alaska Steel Company (“Alaska Steel”), a full-line metal distributor headquartered in Anchorage, Alaska. Our acquisition of Alaska Steel was our first entry into the Alaska market. Alaska Steel provides steel, aluminum, stainless and specialty metals and related processing services to a variety of customers in diverse industries including infrastructure and energy throughout Alaska. Net sales of Alaska Steel during the period from August 1, 2016 to December 31, 2016 were $8.5 million. On April 1, 2016, we acquired Best Manufacturing, Inc. (“Best Manufacturing”), a custom sheet metal fabricator of steel and aluminum products on both a direct and toll basis. Best Manufacturing, headquartered in Jonesboro, Arkansas, provides various precision fabrication services including laser cutting, shearing, computer numerated control (“CNC”) punching, CNC forming and rolling, as well as welding, assembly, painting, inventory management and engineering expertise. Net sales of Best Manufacturing during the period from April 1, 2016 to December 31, 2016 were $13.8 million. On January 1, 2016, we acquired Tubular Steel, Inc. (“Tubular Steel”), a distributor and processor of carbon, alloy and stainless steel pipe, tubing and bar products. Tubular Steel, headquartered in St. Louis, Missouri, has six locations and a fabrication business that supports its diverse customer base. Net sales of Tubular Steel for the year ended December 31, 2016 were $116.0 million. We funded our 2016 acquisitions with borrowings on our revolving credit facility and cash on hand. The preliminary allocation of the total purchase price of our 2016 acquisitions to the fair values of the assets acquired and liabilities assumed was as follows: 2014 Acquisitions On December 1, 2014, we acquired Fox Metals and Alloys, Inc. (“Fox Metals”), a Houston, Texas-based steel distributor specializing in alloy, carbon and stainless steel bar and plate products, primarily servicing original equipment manufacturers (“OEM”s) and machine shops that manufacture or support the manufacturing of equipment for the oil, gas RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 and petrochemical industries. Fox Metals' in-house processing services include saw cutting, plate burning and testing. Net sales of Fox Metals in 2016 were $8.2 million. On August 1, 2014, we acquired Aluminium Services UK Limited, the parent holding company of All Metal Services (“AMS”). AMS provides comprehensive materials management solutions to aerospace and defense OEMs and their subcontractors on a global basis, supporting customers in more than 40 countries worldwide. AMS offers a broad range of aerospace metals including aluminum, steel, titanium, nickel alloys and aluminum bronze, offering full or cut to size materials. AMS also offers in-house machining and water-jet cutting for more complex requirements. AMS has eight locations in four countries including China, France, Malaysia, and the United Kingdom. Net sales of AMS in 2016 were $268.7 million. On August 1, 2014, we acquired Northern Illinois Steel Supply Co. (“NIS”), a value-added distributor and fabricator of a variety of steel and non-ferrous metal products, primarily structural steel components and parts, located in Channahon, Illinois. Net sales of NIS in 2016 were $18.7 million. We funded our 2014 acquisitions with borrowings on our revolving credit facility and cash on hand. The allocation of the total purchase price of our acquisitions completed in 2014 to the fair values of the assets acquired and liabilities assumed was as follows: Summary purchase price allocation information for all acquisitions All of the acquisitions discussed in this note have been accounted for under the acquisition method of accounting and, accordingly, each purchase price has been allocated to the assets acquired and liabilities assumed based on the estimated fair values at the date of each acquisition. The accompanying consolidated statements of income include the revenues and expenses of each acquisition since its respective acquisition date. The consolidated balance sheets reflect the allocations of each acquisition’s purchase price as of December 31, 2016 or 2015, as applicable. The purchase price allocations for the 2016 acquisitions of Alaska Steel and Best Manufacturing are preliminary and are pending the completion of various pre-acquisition income tax returns. The measurement periods for purchase price allocations do not exceed 12 months from the acquisition date. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 As part of the purchase price allocations of the acquisitions completed in 2016 and 2014, $38.2 million and $39.0 million, respectively, were allocated to the trade names acquired. We determined that substantially all of the trade names acquired in connection with these acquisitions had indefinite lives since their economic lives are expected to approximate the life of each company acquired. Additionally, we recorded other identifiable intangible assets related to customer relationships for the 2016 and 2014 acquisitions of $76.8 million and $37.3 million, respectively, with weighted average lives of 15.5 and 13.6 years, respectively. The goodwill arising from our 2016 and 2014 acquisitions consists largely of expected strategic benefits, including enhanced financial and operational scale, as well as expansion of acquired product and processing know-how across our enterprise. Tax deductible goodwill from our 2016 and 2014 acquisitions amounted to $103.4 million and $20.3 million, respectively. Total tax deductible goodwill amounted to $662.5 million as of December 31, 2016. Note 3. Joint Ventures and Noncontrolling Interests The equity method of accounting is used where our investment in voting stock gives us the ability to exercise significant influence over the investee, generally 20% to 50%. The financial results of investees are generally consolidated when the ownership interest is greater than 50%. We have two joint venture arrangements with noncontrolling interests: Oregon Feralloy Partners LLC (40%-owned) and Eagle Steel Products, Inc. (45%-owned). These investments are accounted for using the equity method. The corresponding investments in these entities are reflected in the Other assets caption of the consolidated balance sheets. Equity in earnings of these entities and related distribution of earnings have not been material to our results of operations or cash flows. Operations that are majority owned by us are as follows: Acero Prime S. de R.L. de C.V. (60%-owned), Feralloy Processing Company (51%-owned), Indiana Pickling and Processing Company (56%-owned), and Valex Corp.’s operations in South Korea, in which Valex Corp. has 95% ownership. The results of these majority-owned operations are consolidated in our financial results. The portion of the earnings related to the noncontrolling shareholder interests has been reflected in the Net income attributable to noncontrolling interests caption in the accompanying consolidated statements of income. On December 15, 2015, we purchased the noncontrolling interest of Valex Corp., which increased our ownership from 97% to 100%, and on September 11, 2015 Valex Corp. purchased the noncontrolling interest in its operation in the People’s Republic of China, which increased its ownership interest from 92% to 100%. On October 1, 2014, we acquired a controlling interest in our joint venture partnership Acero Prime S. de R.L. de C.V. (“Acero Prime”), a toll processor in Mexico, and subsequently purchased additional interests on November 3, 2014, which, together, increased our ownership from 40% to 60%. Concurrent with this acquisition achieved in stages, we recognized an $11.4 million gain on our previously held equity interest remeasured at fair value. The allocation of the total purchase price to the fair values of the assets acquired and liabilities assumed included $57.6 million of total assets and noncontrolling interest of $22.6 million. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Note 4. Inventories Our inventories are primarily stated on the LIFO method, which is not in excess of market. We use the LIFO method of inventory valuation because it results in a better matching of costs and revenues. The cost of inventories stated on the FIFO method is not in excess of realizable value. Inventories consisted of the following: The lower of cost or market charges in 2016 and 2015 were due to a significant decline in metals pricing that resulted in our LIFO inventory valuation exceeding current replacement cost. In 2016, we also recorded a lower of cost or market charge of $7.6 million relating to certain inventories of a foreign subsidiary that are remeasured into the U.S. dollar. The changes in the LIFO valuation reserve and impact of LIFO liquidations were as follows: ** Insignificant liquidations of LIFO inventory quantities. Cost decreases for the majority of our products were the primary cause of the 2016 and 2015 reductions in the LIFO valuation reserve. Cost increases for the majority of our products were the primary cause of the 2014 increase in the LIFO valuation reserve. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Note 5. Goodwill The changes in the carrying amount of goodwill are as follows: All of the goodwill recorded from our 2016 acquisitions is tax deductible. We had no accumulated impairment losses related to goodwill at December 31, 2016. Note 6. Intangible Assets, net Intangible assets, net, consisted of the following: Intangible assets recorded in connection with our 2016 acquisitions were $115.3 million (see Note 2 - “Acquisitions”). A total of $38.2 million was allocated to the trade names acquired, which is not subject to amortization. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Impairment losses of $36.4 million related to eight of our trade names were recognized in 2016. Impairment losses of $21.2 million related to five of our trade name intangible assets and $14.4 million related to two of our customer relationship intangible assets were recognized in 2015. See Note 17 - “Impairment and Restructuring Charges” for further discussion of our impairment losses. Amortization expense for intangible assets amounted to $54.1 million, $53.7 million and $56.7 million in 2016, 2015 and 2014, respectively. Foreign currency translation gains related to intangible assets, net in 2016 were $1.1 million. The following is a summary of estimated aggregate amortization expense for each of the next five years: Note 7. Cash Surrender Value of Life Insurance Policies, net The cash surrender value of all life insurance policies held by us, net of loans and related accrued interest, was $46.9 million and $45.8 million as of December 31, 2016 and 2015, respectively. Our wholly owned subsidiary, Earle M. Jorgensen Company (“EMJ”), is the owner and beneficiary of life insurance policies on all former nonunion employees of a predecessor company, including certain current employees of EMJ. These policies, by providing payments to EMJ upon the death of covered individuals, were designed to provide cash to EMJ in order to repurchase shares held by employees in EMJ’s former employee stock ownership plan and shares held individually by employees upon the termination of their employment. We are also the owner and beneficiary of key man life insurance policies on certain current and former executives of the Company, its subsidiaries and predecessor companies. Cash surrender value of the life insurance policies increases by a portion of the amount of premiums paid and by investment income earned under the policies and decreases by the amount of cost of insurance charges, investment losses and interest on policy loans, as applicable. Income earned on all of our life insurance policies is recorded in the Other income (expense), net caption in the accompanying consolidated statements of income (see Note 13 - “Other Income (Expense), net”). Annually, we borrow against the cash surrender value of policies to pay a portion of the premiums and accrued interest on loans against those policies. We borrowed $51.3 million, $47.9 million and $44.5 million against the cash surrender value of certain policies, which was used to partially pay premiums and accrued interest owed of $64.7 million, $60.4 million and $56.0 million in 2016, 2015 and 2014, respectively. Interest rates on borrowings under some of the EMJ life insurance policies are fixed at 11.76% and the portion of the policy cash surrender value that the borrowings relate to earns interest and dividend income at 11.26%. The unborrowed portion of the policy cash surrender value earns income at rates commensurate with certain risk-free U.S. Treasury bond yields but not less than 4.0%. All other life insurance policies earn investment income or incur losses based on the performance of the underlying investments held by the policies. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 As of December 31, 2016 and 2015, loans and accrued interest outstanding on EMJ’s life insurance policies were $577.6 million and $535.2 million, respectively. There were no borrowings available as of December 31, 2016 and December 31, 2015. Interest expense on borrowings against cash surrender values is included in the Other income (expense), net caption in the accompanying consolidated statements of income (see Note 13 - “Other Income (Expense), net”). Note 8. Debt Debt consisted of the following: Unsecured Credit Facility On September 30, 2016, we entered into a $2.1 billion unsecured five-year credit agreement (“Credit Agreement”) comprised of a $1.5 billion unsecured revolving credit facility and a $600.0 million unsecured term loan, with an option to increase the revolving facility for up to $500.0 million at our request, subject to approval of the lenders and certain other customary conditions. The term loan due September 30, 2021 amortizes in quarterly installments, with an annual amortization of 5% through September 2018 and 10% thereafter until June 2021, with the balance to be paid at maturity. Interest on borrowings from the revolving credit facility and term loan at December 31, 2016 was at variable rates based on LIBOR plus 1.25% or the bank prime rate plus 0.25% and included a commitment fee at an annual rate of 0.15% on the unused portion of the revolving credit facility. The applicable margins over LIBOR rate and base rate borrowings, along with commitment fees, are subject to adjustment every quarter based on our leverage ratio, as defined in the Credit Agreement. All borrowings under the Credit Agreement may be repaid without penalty. Weighted average interest rates on borrowings outstanding on the revolving credit facility were 2.16% and 1.81% as of December 31, 2016 and December 31, 2015, respectively. Weighted average interest rates on borrowings outstanding on the term loan were 2.02% and 1.67% as of December 31, 2016 and December 31, 2015, respectively. As of December 31, 2016, we had $540.0 million of outstanding borrowings, $62.6 million of letters of credit issued and $897.4 million available for borrowing on the revolving credit facility. Senior Unsecured Notes On November 20, 2006, we entered into an indenture (the “2006 Indenture”), for the issuance of $600.0 million of unsecured debt securities. The total debt issued was comprised of two tranches, (a) $350.0 million aggregate principal amount of senior unsecured notes bearing interest at the rate of 6.20% per annum, matured and repaid on November 15, RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 2016 and (b) $250.0 million aggregate principal amount of senior unsecured notes bearing interest at the rate of 6.85% per annum, maturing on November 15, 2036. On April 12, 2013, we entered into an indenture (the “2013 Indenture” and, together with the 2006 Indenture, the “Indentures”), for the issuance of $500.0 million aggregate principal amount of senior unsecured notes at the rate of 4.50% per annum, maturing on April 15, 2023. Under the Indentures, the notes are senior unsecured obligations and rank equally in right of payment with all of our existing and future unsecured and unsubordinated obligations. The subsidiary guarantors guaranteeing the notes under the Indentures were automatically released on September 30, 2016 upon entering into the Credit Agreement, which does not require subsidiary guarantees. The senior unsecured notes include provisions that require us to make an offer to repurchase the notes at a price equal to 101% of their principal amount plus accrued and unpaid interest in the event of both a change in control and a downgrade of our credit rating. Other Notes and Revolving Credit Facilities Revolving credit facilities with a combined credit limit of approximately $64.9 million are in place for operations in Asia and Europe with combined outstanding balances of $44.4 million and $59.9 million as of December 31, 2016 and December 31, 2015, respectively. Various industrial revenue bonds had combined outstanding balances of $10.6 million and $11.0 million as of December 31, 2016 and December 31, 2015, respectively, and maturities through 2027. Additionally, we assumed mortgage obligations pursuant to our acquisition of a portfolio of real estate properties that we were leasing, which had outstanding balances of $40.4 million as of December 31, 2015. The mortgages, which were secured by the underlying properties, had a fixed interest rate of 6.40% and scheduled amortization payments with a lump sum payment of $39.2 million due October 2016. We repaid all of the mortgage obligations without penalty on July 1, 2016 with borrowings on our revolving credit facility. Covenants The Credit Agreement includes customary representations, warranties and covenants, and acceleration, indemnity and events of default provisions, including, among other things, two financial covenants. The financial covenants require us to maintain an interest coverage ratio and a maximum leverage ratio. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Debt Maturities The following is a summary of aggregate maturities of long-term debt for each of the next five years and thereafter: Note 9. Income Taxes Reliance and its subsidiaries file numerous consolidated and separate income tax returns in the United States federal jurisdiction and in many state and foreign jurisdictions. We are no longer subject to U.S. federal tax examinations for years before 2013 and state and local tax examinations before 2012. Significant components of the provision for income taxes attributable to continuing operations were as follows: Components of U.S. and international income before income taxes were as follows: RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 The reconciliation of income tax at the U.S. federal statutory tax rates to income tax expense is as follows: Significant components of our deferred tax assets and liabilities are as follows: As of December 31, 2016, we had available state net operating loss carryforwards (“NOL”) of $6.3 million to offset future income taxes expiring in years 2017 through 2036. We believe that it is more likely than not that we will be able to realize these NOL’s within their respective carryforward periods. The Company believes it is more likely than not that it will generate sufficient future taxable income to realize its deferred tax assets. Taxes on Foreign Income Unremitted earnings of foreign subsidiaries on which no U.S. taxes have been provided were $209.3 million as of December 31, 2016. Our intention is to indefinitely reinvest these earnings outside the United States. It is not practicable to estimate the amount of additional taxes that would be payable upon repatriation of foreign earnings. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Unrecognized Tax Benefits We are under audit by various state jurisdictions but do not anticipate any material adjustments from these examinations. Reconciliation of the beginning and ending balances of the total amounts of unrecognized tax benefits is as follows: As of December 31, 2016, $5.2 million of unrecognized tax benefits would impact the effective tax rate if recognized. Accrued interest and penalties, net of applicable tax effect, related to uncertain tax positions were $0.7 million and $1.3 million as of December 31, 2016 and 2015, respectively. Note 10. Stock-Based Compensation Plans We grant stock-based compensation to our employees and directors. At December 31, 2016, an aggregate of 2,000,955 shares were authorized for future grant under our various stock-based compensation plans, including stock options, restricted stock units, and restricted stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. Upon exercises of stock options, vesting of restricted stock units and vesting of restricted shares under all of our stock plans, we issue new shares of Reliance common stock. Stock Options Stock option activity under all the plans is as follows: RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 All options outstanding at December 31, 2016 had four-year vesting periods and seven-year terms, with the exception of 54,000 options granted to our non-employee directors that had one-year vesting periods and ten-year terms. There were no unvested stock options at December 31, 2016 and 2015. Proceeds from stock options exercised under all stock option plans in 2016, 2015 and 2014 were $37.5 million, $15.1 million and $28.8 million, respectively. The total intrinsic values of all options exercised in 2016, 2015 and 2014 were $16.3 million, $4.8 million and $13.5 million, respectively. The tax benefit realized from option exercises during the years ended December 31, 2016, 2015 and 2014 were $14.3 million, $7.6 million and $10.7 million, respectively. The following tabulation summarizes certain information concerning outstanding and exercisable options as of December 31, 2016: Restricted Stock In 2016, 2015 and 2014, we granted 512,895, 507,760 and 349,380, respectively, restricted stock units (“RSUs”) to key employees pursuant to the Amended and Restated Stock Option and Restricted Stock Plan. Each RSU consists of the right to receive one share of our common stock and dividend equivalent rights, subject to forfeiture, equal to the accrued cash or stock dividends where the record date for such dividends is after the grant date but before the shares vest. Additionally, each 2016, 2015 and 2014 RSU granted has a service-based condition and cliff vests at December 31, 2018, December 31, 2017 and December 31, 2016, respectively, if the recipient is an employee on those dates. In addition to the service-based condition, 190,175, 185,450, and 136,162 of the RSUs granted in 2016, 2015 and 2014, respectively, also have performance goals and vest only upon the satisfaction of the service-based condition and certain three-year performance targets. In addition to the 2015 RSUs described above, we also granted 10,000 service-based and 40,000 performance-based RSUs to our former CEO as a result of his planned retirement in July 2016 that had a service-based condition and eighteen-month performance targets ended June 30, 2016. The fair value of the 2016, 2015 and 2014 RSUs granted was $69.16 per share, $59.27 per share and $71.15 per share, respectively, determined based on the closing price of our common stock on the grant date. In 2016, 2015 and 2014, 11,851, 12,719, and 11,830 shares of restricted stock, respectively, were granted to the non-employee members of the Board of Directors pursuant to the Directors Equity Plan. The fair value of the restricted stock granted in 2016, 2015, and 2014, was $70.88 per share, $66.03 per share, and $70.99 per share, respectively, determined based on the closing price of our common stock on the grant date. The awards include dividend rights and vest immediately upon grant. The recipients are restricted from trading the restricted stock for one year from date of grant. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 In 2016, 2015 and 2014, we made payments of $6.4 million, $4.5 million and $0.5 million, respectively, to tax authorities on our employees’ behalf for shares withheld related to net share settlements. These payments are reflected in the Stock-based compensation caption of the statement of equity. A summary of the status of our unvested restricted stock grants and service and performance based RSUs as of December 31, 2016 and changes during the year then ended is as follows: Unrecognized Compensation Cost As of December 31, 2016, there was $34.6 million of total unrecognized compensation cost related to unvested stock-based compensation awards granted under all stock-based compensation plans. That cost is expected to be recognized over a weighted average period of 1.12 years. Note 11. Employee Benefits Employee Stock Ownership Plan We have a tax-qualified employee stock ownership plan (the “ESOP”) that is a noncontributory plan that covers certain salaried and hourly employees of the Company. The amount of the annual contribution is at the discretion of the Board, except that the minimum amount must be sufficient to enable the ESOP trust to meet its current obligations. Defined Contribution Plans Effective in 1998, the Reliance Steel & Aluminum Co. Master 401(k) Plan (the “Master Plan”) was established, which combined several of the various 401(k) and profit-sharing plans of the Company and its subsidiaries into one plan. Salaried and certain hourly employees of the Company and its participating subsidiaries are covered under the Master Plan. The Master Plan allows each subsidiary’s Board to determine independently the annual matching percentage and maximum compensation limits or annual profit-sharing contribution. Eligibility occurs after three months of service, and the Company contribution vests at 25% per year, commencing one year after the employee enters the Master Plan. Other 401(k) and profit-sharing plans exist as certain subsidiaries have not combined their plans into the Master Plan as of December 31, 2016. Supplemental Executive Retirement Plans Effective January 1996, we adopted a Supplemental Executive Retirement Plan (“SERP”), which is a nonqualified pension plan that provides postretirement pension benefits to certain key officers of the Company. The SERP is administered by the Compensation Committee of the Board. Benefits are based upon the employees’ earnings. Life insurance policies were purchased for most individuals covered by the SERP. Separate SERP’s exist for certain wholly RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 owned subsidiaries of the Company, each of which provides postretirement pension benefits to certain current and former key employees. All of the plans have been frozen to include only existing participants. Deferred Compensation Plan In December 2008, a deferred compensation plan was put in place for certain officers and key employees of the Company. Account balances from various compensation plans of subsidiaries were transferred and consolidated into this new deferred compensation plan. The balance in the Reliance Deferred Compensation Plan as of December 31, 2016 and 2015 was $16.6 million and $16.0 million, respectively. The balance of the assets set aside for funding future payouts under the deferred compensation plan amounted to $15.8 million as of December 31, 2016. Defined Benefit Plans We, through certain subsidiaries, maintain qualified defined benefit pension plans for certain of our union employees. These plans generally provide benefits of stated amounts for each year of service or provide benefits based on the participant's hourly wage rate and years of service. The plans permit the sponsor, at any time, to amend or terminate the plans subject to union approval, if applicable. Certain of these plans are frozen as of December 31, 2016. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 We use a December 31 measurement date for our plans. The following is a summary of the status of the funding of the various SERP’s and Defined Benefit Plans: As of December 31, 2016 and 2015, the following amounts were recognized in the balance sheet: RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 The accumulated benefit obligation for all SERP’s was $44.2 million and $44.7 million as of December 31, 2016 and 2015, respectively. The accumulated benefit obligation for all defined benefit pension plans was $95.9 million and $96.3 million as of December 31, 2016 and 2015, respectively. Following are the details of net periodic benefit cost related to the SERP’s and Defined Benefit Plans: Assumptions used to determine net periodic benefit cost are detailed below: Assumptions used to determine the benefit obligation are detailed below: Employer contributions to the SERP’s and Defined Benefit Plans during 2017 are expected to be $14.8 million and $3.2 million, respectively. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Plan Assets and Investment Policy The weighted-average asset allocations of our Defined Benefit Plans by asset category are as follows: Plan assets are invested in various asset classes that are expected to produce a sufficient level of diversification and investment return over the long term. The investment goal is a return on assets that is at least equal to the assumed actuarial rate of return over the long-term within reasonable and prudent levels of risk. Investment policies reflect the unique circumstances of the respective plans and include requirements designed to mitigate risk including quality and diversification standards. Asset allocation targets are reviewed periodically with investment advisors to determine the appropriate investment strategies for acceptable risk levels. Our target allocation ranges are as follows: equity securities 50% to 80%, debt securities 20% to 60% and other assets of 0% to 10%. We establish our estimated long-term return on plan assets considering various factors including the targeted asset allocation percentages, historic returns and expected future returns. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 The fair value measurements of our Defined Benefit Plan assets fall within the following levels of the fair value hierarchy as of December 31, 2016 and 2015: (1) Comprised primarily of securities of large domestic and foreign companies. Valued at the closing price reported on the active market on which the individual securities are traded. (2) Valued using a combination of inputs including: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. (3) Level 1 assets are comprised of exchange traded funds, money market funds, and stock and bond funds. These assets are valued at closing price for exchange traded funds and Net Asset Value (NAV) for open-end and closed-end mutual funds. Level 2 assets are comprised of fixed income funds and pooled separate accounts and are valued at the net asset value per unit based on either the observable net asset value of the underlying investment or the net asset value of the underlying pool of securities. Summary Disclosures for All Defined Benefit Plans The following is a summary of benefit payments under our various defined benefit plans, which reflect expected future employee service, as appropriate, expected to be paid in the periods indicated: RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 The amounts in accumulated other comprehensive loss that are expected to be recognized as components of net periodic benefit cost during 2017 are as follows: Supplemental Bonus Plan In connection with the acquisition of EMJ in April 2006, Reliance assumed the obligation resulting from EMJ’s settlement with the U.S. Department of Labor to contribute 258,006 shares of Reliance common stock to EMJ’s Supplemental Bonus Plan, a phantom stock bonus plan supplementing the EMJ Retirement Savings Plan. In 2005, EMJ had reached a settlement with the U.S. Department of Labor regarding a change in its methodology for annual valuations of its stock while it was a private company, for the purpose of making contributions in stock to its retirement plan. As of December 31, 2016, the remaining obligation to the EMJ Supplemental Bonus Plan consisted of the cash equivalent of 82,354 shares of Reliance common stock totaling $6.6 million. The adjustments to reflect this obligation at fair value based on the closing price of our common stock at the end of each reporting period are included in Warehouse, delivery, selling, general and administrative expense. The expense (income) from mark to market adjustments to this obligation in each of the years ended December 31, 2016, 2015 and 2014 amounted to $2.1 million, $(0.2) million and $(1.3) million, respectively. This obligation will be satisfied by future cash payments to participants upon their termination of employment. Contributions to Reliance Sponsored Retirement Plans Our expense for Reliance-sponsored retirement plans was as follows: Note 12. Equity Reincorporation During the second quarter of 2015, the Company’s shareholders approved the reincorporation of the Company from California to Delaware by means of a merger with and into a wholly owned Delaware subsidiary. The reincorporation did not result in any change in the Company’s business, physical location, management, assets, liabilities, net worth or number of authorized shares. In the reincorporation, the Company’s Restated Certificate of Incorporation established par value of the Company’s common stock and unissued preferred stock of $0.001 per share. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Common Stock We paid regular quarterly cash dividends on our common stock in 2016 and have done so for the past 57 years. Our Board of Directors increased the quarterly dividend to $0.35 per share from $0.33 per share in February 2014, increased it to $0.40 per share in February 2015 and increased it again in July 2016 to $0.425 per share. In February 2017, the Board further increased the quarterly dividend rate to $0.45 per share. The holders of Reliance common stock are entitled to one vote per share on each matter submitted to a vote of stockholders. Share Repurchase Plan On October 21, 2014, our Board of Directors extended our share repurchase plan to December 31, 2017. On October 20, 2015, our Board of Directors again amended our share repurchase plan increasing by 7,500,000 shares the total number of shares authorized to be repurchased and extending the program through December 31, 2018. We did not repurchase any of our common stock in 2016. In 2015, we repurchased 6,194,641 shares of our common stock at an average cost of $57.39, per share, for a total of $355.5 million, through open market purchases under a plan complying with Rule10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We repurchased 759,800 shares of our common stock at an average cost of $65.80 per share for $50.0 million through open market purchases in 2014. Since initiating the share repurchase plan in 1994 we have purchased approximately 22.1 million shares at an average cost of $30.93 per share. As of December 31, 2016, we had authorization to purchase an additional 8,428,592 shares under our existing share repurchase plan. Preferred Stock We are authorized to issue 5,000,000 shares of preferred stock, $0.001 per share. No shares of our preferred stock are issued and outstanding. Our restated articles of incorporation provide that shares of preferred stock may be issued from time to time in one or more series by the Board. The Board can fix the preferences, conversion and other rights, voting powers, restrictions, limitations as to dividends, qualifications and terms and conditions of redemption of each series of preferred stock. The rights of preferred stockholders may supersede the rights of common stockholders. Stock-Based Compensation Effective January 1, 2016, we adopted accounting changes issued by the FASB for stock-based compensation that allow us to account for forfeitures of RSUs as they occur rather than estimating the number of forfeitures. As a result of the adoption, we recorded a cumulative-effect adjustment that reduced beginning retained earnings by $0.6 million, net of tax. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Accumulated Other Comprehensive Loss Accumulated other comprehensive loss included the following: Foreign currency translation adjustments are not generally adjusted for income taxes as they relate to indefinite investments in foreign subsidiaries. Pension and postretirement benefit adjustments are net of taxes of $14.9 million and $15.6 million as of December 31, 2016 and December 31, 2015, respectively. See Note 11 - “Employee Benefits” for information regarding reclassification of amounts from accumulated comprehensive loss to net income. Note 13. Other Income (Expense), net Significant components of Other income (expense), net are as follows: RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Note 14. Commitments and Contingencies Lease Commitments We lease land, buildings and equipment under non-cancelable operating leases expiring in various years through 2028. Rent expense for leases that contain scheduled rent increases are recorded on a straight-line basis. Several of the leases have renewal options providing for additional lease periods. Future minimum payments, by year and in the aggregate, under the non-cancelable leases with initial or remaining terms of one year or more, consisted of the following as of December 31, 2016: Total rental expense amounted to $78.9 million, $80.0 million and $79.3 million in 2016, 2015 and 2014, respectively. Included in the amounts for operating leases are lease payments to various related parties, who are not executive officers of the Company, in the amounts of $3.6 million, $5.2 million and $5.5 million in 2016, 2015 and 2014, respectively. These related party leases are for buildings leased to certain of the companies we have acquired and expire in various years through 2021. Purchase Commitments As of December 31, 2016, we had commitments to purchase minimum quantities of certain metal products, which we entered into to secure material for corresponding long-term sales commitments we have entered into with our customers. The total amount of the minimum commitments based on current pricing is estimated at approximately $124.4 million, with amounts in 2017, 2018 and thereafter being $18.1 million, $15.1 million, and $91.2 million, respectively. Collective Bargaining Agreements As of December 31, 2016, approximately 11%, or 1,640, of our total employees are covered by 41 collective bargaining agreements at 52 of our different locations, which expire at various times over the next five years. Approximately 600 of our employees are covered by 21 different collective bargaining agreements that will expire during 2017. Environmental Contingencies We are subject to extensive and changing federal, state, local and foreign laws and regulations designed to protect the environment, including those relating to the use, handling, storage, discharge and disposal of hazardous substances and the remediation of environmental contamination. Our operations use minimal amounts of such substances. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 We believe we are in material compliance with environmental laws and regulations; however, we are from time to time involved in administrative and judicial proceedings and inquiries relating to environmental matters. Some of our owned or leased properties are located in industrial areas with histories of heavy industrial use. We may incur some environmental liabilities because of the location of these properties. In addition, we are currently involved with a certain environmental remediation project related to activities at former manufacturing operations of EMJ, our wholly owned subsidiary, that were sold many years prior to Reliance’s acquisition of EMJ in 2016. Although the potential cleanup costs could be significant, EMJ had maintained insurance policies during the time it owned the manufacturing operations that have covered costs incurred to date, and are expected to continue to cover the majority of the related costs. We do not expect that these obligations will have a material adverse impact on our consolidated financial position, results of operations or cash flows. Legal Matters In 2014, Reliance and its wholly owned subsidiary Chapel Steel Corp. (“Chapel”) were defendants in an antitrust lawsuit filed in the United States District Court for the Southern District of Texas brought by two former employees who claimed that Reliance, Chapel and the co-defendants engaged in anticompetitive activities. Following a judgment against all the defendants, Reliance and Chapel settled all claims against them relating to this matter for $23.0 million. From time to time, we are named as a defendant in legal actions. Generally, these actions arise out of our normal course of business. We are not currently a party to any pending legal proceedings other than routine litigation incidental to the business. We expect that these matters will be resolved without having a material adverse effect on our results of operations or financial condition. We maintain liability insurance against risks arising out of our normal course of business. Note 15. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share: Potentially dilutive securities whose effect would have been antidilutive were not significant for 2016, 2015, and 2014. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Note 16. Segment Information We have one reportable segment, metals service centers. All of our recent acquisitions were metals service centers and did not result in new reportable segments. Although a variety of products or services are sold at our various locations, in total, sales were comprised of the following in each of the three years ended December 31: The following table summarizes consolidated financial information of our operations by geographic location based on where sales originated from: Note 17. Impairment and Restructuring Charges We recorded impairment and restructuring charges of $69.1 million and $56.3 million in the years ended December 31, 2016 and 2015, respectively. These charges mainly relate to certain of our energy-related businesses as a result of the impact to our businesses from continued low crude oil prices that reduced drilling activity and the resulting decline in demand for the products we sell to the energy market (oil and gas). Also included are charges relating to the planned closure or sale of certain locations. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 The impairment and restructuring charges consisted of the following: The property, plant and equipment and restructuring - cost of sales charges relate to the planned closure or sale of certain locations where we anticipate losses on disposition of certain real property, machinery and equipment and inventories. The intangible assets, net charge is due to lowered expectations of future profitability of certain of our energy-related businesses. Note 18. Condensed Consolidating Financial Statements In November 2006 and April 2013, we issued senior unsecured notes in the aggregate principal amount of $1.1 billion, at fixed interest rates that were guaranteed by certain of our 100%-owned domestic subsidiaries that also guaranteed borrowings under our then existing credit agreement. We previously provided consolidated financial statements pursuant to Rule 3-10 of Regulation S-X “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered.” The subsidiary guarantors guaranteeing the notes issued under the Indentures were automatically released on September 30, 2016 upon entering into the Credit Agreement, which does not require subsidiary guarantees. RELIANCE STEEL & ALUMINUM CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2016 Note 19. Quarterly Financial Information (Unaudited) The following is a summary of the unaudited quarterly results of operations for 2016 and 2015: (1) Gross profit, calculated as net sales less cost of sales, is a non-GAAP financial measure as it excludes depreciation and amortization expense associated with the corresponding sales. The majority of our orders are basic distribution with no processing services performed. For the remainder of our sales orders, we perform “first-stage” processing, which is generally not labor intensive as we are simply cutting the metal to size. Because of this, the amount of related labor and overhead, including depreciation and amortization, are not significant and are excluded from our cost of sales. Therefore, our cost of sales is substantially comprised of the cost of the material we sell. We use gross profit as shown above as a measure of operating performance. Gross profit is an important operating and financial measure, as fluctuations in gross profit can have a significant impact on our earnings. Gross profit, as presented, is not necessarily comparable with similarly titled measures for other companies. Quarterly and year-to-date computations of per share amounts are made independently. Therefore, the sum of per share amounts for the quarters may not agree with per share amounts for the years shown elsewhere in this Annual Report on Form 10-K. RELIANCE STEEL & ALUMINUM CO. SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS (in millions) (1) Uncollectible accounts written off. See accompanying report of independent registered public accounting firm.
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Based on the provided financial statement excerpt, here's a summary:
Company: Reliance Steel & Aluminum Co.
Key Financial Highlights:
1. Credit Sales and Risk Management:
- Losses from credit sales are consistently within the allowance provided
- Allowance is based on specific customer risks and historical bad debt experience
- No significant concentrations of credit risk identified
2. Inventory Valuation:
- Majority of inventory valued using Last-In, First-Out (LIFO) method
- Inventory valuation subject to year-to-year fluctuations based on:
* Inflation/deflation in metals industry
* Product mix changes
* Inventory level variations
3. Business Overview:
- Operates a metals service center network of over 300 locations
- Consolidated financial statements include majority-owned subsidiaries
- Unconsolidated subsidiaries recorded using equity method of
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Claude
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FS BANCORP, INC. AND SUBSIDIARY Report of Independent Registered Public Accounting Firm To the Board of Directors FS Bancorp, Inc. Mountlake Terrace, Washington We have audited the accompanying consolidated balance sheets of FS Bancorp, Inc. and subsidiary (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of FS Bancorp, Inc. and subsidiary as of December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Moss Adams LLP Everett, Washington March 16, 2017 See accompanying notes to these consolidated financial statements. See accompanying notes to these consolidated financial statements. See accompanying notes to these consolidated financial statements. See accompanying notes to these consolidated financial statements. See accompanying notes to these consolidated financial statements. NOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations - FS Bancorp, Inc. (the “Company”) was incorporated in September 2011 as the proposed holding company for 1st Security Bank of Washington (the “Bank” or “1st Security Bank”) in connection with the Bank’s conversion from the mutual to stock form of ownership which was completed on July 9, 2012. The Bank is a community-based savings bank with 11 branches and seven loan production offices in suburban communities in the greater Puget Sound area which includes Snohomish, King, Pierce, Jefferson, Kitsap, and Clallam counties, and one loan production office in the market area of the Tri-Cities, Washington. The Bank provides loan and deposit services to customers who are predominantly small and middle-market businesses and individuals. The Bank acquired four retail bank branches from Bank of America (two in Clallam and two in Jefferson counties) on January 22, 2016, and these branches opened as 1st Security Bank branches on January 25, 2016. The Company and its subsidiary are subject to regulation by certain federal and state agencies and undergo periodic examination by these regulatory agencies. Pursuant to the Plan of Conversion (the “Plan”), the Company’s Board of Directors adopted an employee stock ownership plan ( “ESOP”) which purchased 8% of the common stock in the open market or 259,210 shares. As provided for in the Plan, the Bank also established a liquidation account in the amount of retained earnings at December 31, 2011. The liquidation account is maintained for the benefit of eligible savings account holders at June 30, 2007 and supplemental eligible account holders as of March 31, 2012, who maintain deposit accounts at the Bank after the conversion. The conversion was accounted for as a change in corporate form with the historic basis of the Company’s assets, liabilities, and equity unchanged as a result. Financial Statement Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) and with prevailing practices within the banking and securities industries. In preparing such financial statements, management is required to make certain estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses, fair value of financial instruments, the valuation of servicing rights, and the deferred income taxes. Amounts presented in the consolidated financial statements and footnote tables are rounded and presented in thousands of dollars except per share amounts. In the narrative footnote discussion, amounts are rounded and presented in millions of dollars to one decimal point if the amounts are above $1.0 million. Amounts below $1.0 million are rounded and presented in dollars to the nearest thousands. Certain prior year amounts have been reclassified to conform to the 2016 presentation with no change to consolidated net income or stockholders’ equity previously reported. Principles of Consolidation - The consolidated financial statements include the accounts of FS Bancorp, Inc. and its wholly owned subsidiary, 1st Security Bank of Washington. All material intercompany accounts have been eliminated in consolidation. Segment Reporting - The Company’s major lines of business are community banking. Management has determined that the Company operates as a single operating segment based on U.S. GAAP. Subsequent Events - The Company has evaluated events and transactions subsequent to December 31, 2016, for potential recognition or disclosure. Cash and Cash Equivalents - Cash and cash equivalents include cash and due from banks, and interest-bearing balances due from other banks and the Federal Reserve Bank of San Francisco (“FRB”) and have a maturity of 90 days or less at the time of purchase. The Company had $7.8 million of cash and due from banks and interest-bearing deposits at other financial institutions in excess of Federal Deposit Insurance Corporation (“FDIC”) insured limits at December 31, 2016, and none at December 31, 2015. Because the Company places these deposits with major financial institutions and monitors the financial condition of these institutions, management believes the risk of loss to any deposits in excess of FDIC limits to be minimal. Securities Available-for-Sale - Securities available-for-sale consist of debt securities that the Company has the intent and ability to hold for an indefinite period, but not necessarily to maturity. Such securities may be sold to implement the Company’s asset/liability management strategies and in response to changes in interest rates and similar factors. Securities available-for-sale are reported at fair value. Realized gains and losses on securities available-for-sale, determined using the specific identification method, are included in results of operations. Amortization of premium and accretion of discounts are recognized in interest income over the period to maturity. Unrealized holding gains and losses, net of the related deferred tax effect, are reported as a net amount in a separate component of equity entitled accumulated other comprehensive income. Unrealized losses that are deemed to be other than temporary are reflected in results of operations. Any declines in the values of these securities that are considered to be other-than-temporary-impairment (“OTTI”) and credit-related are recognized in earnings. Noncredit-related OTTI on securities not expected to be sold is recognized in other comprehensive income. The review for OTTI is conducted on an ongoing basis and takes into account the severity and duration of the impairment, recent events specific to the issuer or industry, fair value in relationship to cost, extent and nature of change in fair value, creditworthiness of the issuer including external credit ratings and recent downgrades, trends and volatility of earnings, current analysts’ evaluations, and other key measures. In addition, the Company does not intend to sell the securities and it is more likely than not that we will not be required to sell the securities before recovery of their amortized cost basis. In doing this, we take into account our balance sheet management strategy and consideration of current and future market conditions. Dividends and interest income are recognized when earned. Federal Home Loan Bank Stock - The Bank’s investment in FHLB stock is carried at cost, which approximates fair value. As a member of the FHLB system, the Bank is required to maintain an investment in capital stock of the FHLB in an amount of $813,000 and 4.0% of advances from the FHLB. The Bank’s required minimum level of investment in FHLB stock is based on specific percentages of its outstanding mortgages, total assets, or FHLB advances. At December 31, 2016 and 2015, the Bank’s minimum level of investment requirement in FHLB stock was $2.7 million and $4.6 million, respectively. The Bank was in compliance with the FHLB minimum investment requirement at December 31, 2016 and 2015. Management evaluates FHLB stock for impairment as needed. Management’s determination of whether these investments are impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared with the capital stock amount for the FHLB and the length of time this situation has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB; and (4) the liquidity position of the FHLB. Based on its evaluation, management determined that there was no impairment of FHLB stock at December 31, 2016 and 2015, respectively. Loans Held for Sale - The Bank records all mortgage loans held-for-sale at fair value. Fair value is determined by outstanding commitments from investors or current investor yield requirements calculated on the aggregate loan basis. Origination fees and costs are recognized in earnings at the time of origination. Mortgage loans held-for-sale are sold with the mortgage service rights either released or retained by the Bank. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold. All sales are made with limited recourse against the Company. Derivatives - Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free-standing derivatives. The fair value of the interest rate lock is recorded at the time the commitment to fund the mortgage loan is executed and is adjusted for the expected exercise of the commitments to fund the loans, the Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked. Changes in the fair values of these derivatives are reported in “Gain on sale of loans” on the Consolidated Statements of Income. Loans Receivable - Loans receivable, are stated at the amount of unpaid principal reduced by an allowance for loan losses and net deferred fees or costs. Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned. Loan fees, net of direct origination costs, are deferred and amortized over the life of the loan using the effective yield method. Interest on loans is accrued daily based on the principal amount outstanding. Generally, the accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due or when they are past due 90 days as to either principal or interest (based on contractual terms), unless they are well secured and in the process of collection. All interest accrued but not collected for loans that are placed on non-accrual status or charged off are reversed against interest income. Subsequent collections on a cash basis are applied proportionately to past due principal and interest, unless collectability of principal is in doubt, in which case all payments are applied to principal. Loans are returned to accrual status when the loan is deemed current, and the collectability of principal and interest is no longer doubtful, or, generally, when the loan is less than 90 days delinquent, and performing according to its contractual terms after a period of six months performance. The Company charges fees for originating loans. These fees, net of certain loan origination costs, are deferred and amortized to income, on the level-yield basis, over the loan term. If the loan is repaid prior to maturity, the remaining unamortized net deferred loan origination fee is recognized in income at the time of repayment. Impaired Loans - A loan is considered impaired when it is probable the Company will be unable to collect all contractual principal and interest payments due in accordance with the original or modified terms of the loan agreement. Impaired loans are measured on a loan by loan basis based on the estimated fair value of the collateral less estimated cost to sell if the loan is considered collateral dependent. Impaired loans not considered to be collateral dependent are measured based on the present value of expected future cash flows. Impairment is measured for each loan in the portfolio except for the smaller groups of homogeneous consumer loans. The categories of non-accrual loans and impaired loans overlap, although they are not coextensive. The Company considers all circumstances regarding the loan and borrower on an individual basis when determining whether an impaired loan should be placed on non-accrual status, such as the financial strength of the borrower, the collateral value, reasons for delay, payment record, the amount of past due and the number of days past due. Loans that experience insignificant payment delays and payment shortfalls are generally not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed. Troubled Debt Restructured Loans - Troubled debt restructured (“TDR”) loans are loans for which the Company, for economic or legal reasons related to the borrower’s financial condition, has granted a significant concession to the borrower that it would otherwise not consider. The loan terms which have been modified or restructured due to a borrower’s financial difficulty include but are not limited to: a reduction in the stated interest rate; an extension of the maturity at an interest rate below current market; a reduction in the face amount of the debt; a reduction in the accrued interest; or re-aging, extensions, deferrals and renewals. TDR loans are considered impaired loans and are individually evaluated for impairment and can be classified as either accrual or non-accrual. TDR loans are classified as non-performing loans unless they have been performing in accordance with their modified terms for a period of at least six months in which case they are placed on accrual status. Allowance for Loan Losses - The allowance for loan losses is maintained at a level considered adequate to provide for probable losses on existing loans based on evaluating known and inherent risks in the loan portfolio. The allowance is reduced by loans charged-off and increased by provisions charged to earnings and recoveries on loans previously charged-off. The allowance is based on management’s periodic, systematic evaluation of factors underlying the quality of the loan portfolio including changes in the size and composition of the loan portfolio, the estimated value of any underlying collateral, actual loan loss experience, current economic conditions, and detailed analysis of individual loans for which full collectability may not be assured. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses the best information available to make its estimates, future adjustments to the allowance may be necessary if there is a significant change in economic and other conditions. The appropriateness of the allowance for loan losses is estimated based on these factors and trends identified by management at the time the financial statements are prepared. When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged-off against the allowance for loan losses. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not evidenced the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; the estimated fair value of the loan collateral is significantly below the current loan balance, and there is little or no near-term prospect for improvement. A provision of loan losses is charged against income and added to the allowance for loan losses based on regular assessment of the loan portfolio. The allowance for loan losses is allocated to certain loan categories based on the relative risk characteristics, asset classifications, and actual loss experience within the loan portfolio. Although management has allocated the allowance for loan losses to various loan portfolio segments, the allowance is general in nature and is available for the loan portfolio in its entirety. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control. These factors may result in losses or recoveries differing significantly from those provided for in the financial statements. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations. Reserve for Unfunded Loan Commitments - The reserve for unfunded loan commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to these unfunded credit facilities. The determination of the adequacy of the reserve is based on periodic evaluations of the unfunded credit facilities including an assessment of the probability of commitment usage, credit risk factors for loans outstanding to these same customers, and the terms and expiration dates of the unfunded credit facilities. The reserve for unfunded loan commitments is included in other liabilities on the consolidated balance sheet, with changes to the balance charged against noninterest expense. Premises and Equipment, Net - Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation include building and building improvements from 25 to 40 years and furniture, fixtures, and equipment from 3 to 10 years. Leasehold and tenant improvements are amortized using the straight-line method over the lesser of useful life or the life of the related lease. Gains or losses on dispositions are reflected in results of operations. Management reviews buildings, improvements and equipment for impairment on an annual basis or whenever events or changes in the circumstances indicate that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property. Transfers of Financial Assets - Transfers of an entire financial asset, a group of entire financial assets, or participating interest in an entire financial asset are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Servicing Rights - Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage, commercial and consumer loans, a portion of the cost of originating the loan is allocated to the servicing right based on relative fair value. Fair value is based on market prices for comparable mortgage, commercial, or consumer servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses. Servicing assets are evaluated quarterly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranches. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income. Capitalized servicing rights are stated separately on the consolidated balance sheets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Income Taxes - The Company files a consolidated federal income tax return. Deferred federal income taxes result from temporary differences between the tax basis of assets and liabilities, and their reported amounts in the financial statements. These will result in differences between income for tax purposes and income for financial reporting purposes in future years. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established to reduce the net recorded amount of deferred tax assets if it is determined to be more likely than not, that all or some portion of the potential deferred tax asset will not be realized. The Financial Accounting Standards Board (“FASB”) issued guidance related to accounting for uncertainty in income taxes. The guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It is the Company’s policy to record any penalties or interest arising from federal or state taxes as a component of income tax expense. Employee Stock Ownership Plan (“ESOP”) - Compensation expense recognized for the Company’s ESOP equals the fair value of shares that have been allocated or committed to be released for allocation to participants. Any difference between the fair value of the shares at the time and the ESOP’s original acquisition cost is charged or credited to stockholders’ equity (additional paid-in capital). The cost of ESOP shares that have not yet been allocated or committed to be released is deducted from stockholders’ equity. Earnings Per Share - Basic earnings per share (“EPS”) are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. For purposes of computing basic and dilutive EPS, ESOP shares that have been committed to be released are outstanding and ESOP shares that have not been committed to be released shall not be considered outstanding. Comprehensive Income (Loss) - Comprehensive income (loss) is comprised of net income and other comprehensive income (loss). Other comprehensive income (loss) includes items recorded directly to equity, such as unrealized holding gains and losses on securities available-for-sale. Financial Instruments - In the ordinary course of business, the Company has entered into agreements for off-balance-sheet financial instruments consisting of commitments to extend credit and stand-by letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received. Restricted Assets - Federal Reserve regulations require that the Bank maintain reserves in the form of cash on hand and deposit balances with the FRB, based on a percentage of deposits. The amounts of such balances for the years ended December 31, 2016 and 2015 were $10.7 million and $3.0 million, respectively, included in interest-bearing deposits at other financial institutions on the balance sheet. Marketing and Advertising Costs - The Company records marketing and advertising costs as expenses as they are incurred. Total marketing and advertising expense was $710,000 and $709,000 for the years ended December 31, 2016 and 2015, respectively. Stock-Based Compensation - Compensation cost is recognized for stock options and restricted stock awards, based on the fair value of these awards at the grant date. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the grant date is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. Goodwill - Goodwill is recorded upon completion of a business combination as the difference between the purchase price and the fair value of net identifiable assets acquired. Goodwill was not recorded until the first quarter of 2016 in recognition of the four retail branches purchased from Bank of America. Subsequent to initial recognition, the Company tests goodwill for impairment during the fourth quarter of each fiscal year, or more often if events or circumstances, such as adverse changes in the business climate indicate there may be impairment. There was no goodwill impairment at December 31, 2016 and there was no goodwill at December 31, 2015. Application of New Accounting Guidance At October 1, 2016, the Company adopted FASB Accounting Standards Update (“ASU”) No 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. ASU 2016-09, seeks to simplify several aspects of the accounting for employee share-based payment transactions, including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. As required by ASU 2016-09, all adjustments are reflected as of the beginning of the fiscal year, January 1, 2016. By applying this ASU, the Company no longer adjusts common stock for the tax impact of shares released, instead the tax impact is recognized as tax expense in the period the shares are released. This simplifies the tracking of the excess tax benefits and deficiencies, but could cause volatility in tax expense for the periods presented. The statement of cash flows has been adjusted to reflect the provisions of this ASU. The application of this ASU did not have a material impact on the consolidated financial statements. RECENT ACCOUNTING PRONOUNCEMENTS In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which creates Topic 606 and supersedes Topic 605, Revenue Recognition. In August 2015, FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606), which postponed the effective date of 2014-09. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which amended the principal versus agent implementation guidance set for in ASU 2014-09. Among other things, ASU 2016-08 clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. The ASU amends certain aspects of the guidance set forth in the FASB's new revenue standard related to identifying performance obligations and licensing implementation. The core principle of Topic 606 is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In general, the new guidance requires companies to use more judgment and make more estimates than under current guidance, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, which provides clarifying guidance in certain narrow areas and adds some practical expedients, but does not change the core revenue recognition principle in Topic 606. The ASU is effective for public entities for interim and annual periods beginning after December 15, 2017; early adoption is not permitted. For financial reporting purposes, the ASU allows for either full retrospective adoption, meaning the ASU is applied to all of the periods presented, or modified retrospective adoption, meaning the ASU is applied only to the most current period presented in the financial statements with the cumulative effect of initially applying the standard recognized at the date of initial application. As a bank holding company, key revenue sources, such as interest income have been identified as out of the scope of this new guidance. The Company’s preliminary analysis suggests that the adoption of this accounting standard is not expected to have a material impact on the Company’s consolidated financial statements as substantially all of the Company’s revenues are excluded from the scope of the new guidance. New accounting guidance related to the adoption of this standard continues to be released by the FASB, which could impact the Company’s preliminary analysis of materiality and may change the preliminary conclusions reached as to the application of this new guidance. In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. The new guidance is intended to improve the recognition and measurement of financial instruments. This ASU requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. In addition, the amendments in this ASU require the exit price notion be used when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements. This ASU also eliminates the requirement to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The ASU also requires a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument specific credit risk (also referred to as “own credit”) when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. ASU No. 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted for certain provisions. The Company is currently evaluating the impact of this ASU on the Company’s consolidated financial statements. In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize on the balance sheet the assets and liabilities arising from operating leases. A lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. The amendments in ASU 2016-02 are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application of the amendments in the ASU is permitted. Once adopted, we expect to report higher assets and liabilities as a result of including additional lease information on the consolidated balance sheets, however, the adoption of ASU 2016-02 is expected to increase our balance sheets by less than 5% and not to have a material impact on our regulatory capital ratios. In March 2016, the FASB issued ASU No. 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments. The ASU simplifies the embedded derivative analysis for debt instruments containing contingent call or put options by removing the requirement to assess whether a contingent event is related to interest rates or credit risks. The ASU is effective for annual periods beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption of the ASU is permitted. The Company does not expect this ASU to have a material impact on the Company’s consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-07, Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting. The ASU eliminates the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an adjustment must be made to the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The ASU is effective for annual periods beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption of the ASU is permitted. The Company does not expect this ASU to have a material impact on the Company’s consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The amendments in this ASU seek to simplify several aspects of the accounting for employee share-based payment transactions, including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company for annual periods beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption of the update is permitted. The early adoption of ASU 2016-09 did not have a material impact on the Company’s consolidated financial statements. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early application will be permitted for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating the impact of this ASU on the Company’s consolidated financial statements. Once adopted, we expect our allowance for loan losses to increase, however, until our evaluation is complete the magnitude of the increase will be unknown. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Receipts and Cash Payments, a consensus of the FASB’s Emerging Issues Task Force. The ASU is intended to reduce diversity in practice in how certain transactions are presented and classified in the statement of cash flows. The standard will take effect for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company does not expect this ASU to have a material impact on the Company’s consolidated financial statements. In January 2017, the FASB issued ASU 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments-Equity Method and Joint Ventures (Topic 323). The ASU amends the Codification for SEC staff announcements made at recent Emerging Issues Task Force (EITF) meetings. The SEC guidance that specifically relates to our Consolidated Financial Statement was from the September 2016 meeting, where the SEC staff expressed their expectations about the extent of disclosures registrants should make about the effects of the new FASB guidance as well as any amendments issued prior to adoption, on revenue (ASU 2014-09), leases (ASU 2016-02) and credit losses on financial instruments (ASU 2016-13) in accordance with SAB Topic 11.M. Registrants are required to disclose the effect that recently issued accounting standards will have on their financial statements when adopted in a future period. In cases where a registrant cannot reasonably estimate the impact of the adoption, then additional qualitative disclosures should be considered. The ASU incorporates these SEC staff views into ASC 250 and adds references to that guidance in the transition paragraphs of each of the three new standards. The adoption of this ASU did not have a material effect on the company's consolidated financial statements. In January 2017, the FASB issued ASU 2017-04 - Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The ASU was issued to simplify the subsequent measurement of goodwill and the amendment eliminates Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. This ASU is effective for annual reporting periods beginning after December 31, 2019. Early adoption is of the update is permitted. The Company does not expect this ASU to have a material impact on the Company's consolidated financial statements. NOTE 2 - BUSINESS COMBINATION On January 22, 2016, the Company’s wholly-owned subsidiary, 1st Security Bank, completed the purchase of four branches (“Branch Purchase”) from Bank of America, National Association (“Bank of America”). The Branch Purchase included four retail bank branches located in the communities of Port Angeles, Sequim, Port Townsend, and Hadlock, Washington. In accordance with the Purchase and Assumption Agreement, dated as of September 1, 2015, between Bank of America and 1st Security Bank, the Bank acquired $186.4 million of deposits, a small portfolio of performing loans, two owned bank branches, three leases for the bank branches and parking facilities and certain other assets of the branches effective January 22, 2016. As of December 31, 2016, approximately $162.2 million of the acquired deposits remain at 1st Security Bank. These banks attracted new deposits with an aggregated total of $195.5 million, including public funds at year ended December 31, 2016. In consideration of the purchased assets and transferred liabilities, 1st Security Bank paid (a) the unpaid principal balance and accrued interest of $419,000 for the loans acquired, (b) the net book value, or approximately $778,000, for the bank facilities and certain other assets associated with the acquired branches, and (c) a deposit premium of 2.50% on substantially all of the deposits assumed, which equated to approximately $4.8 million. The transaction was settled with Bank of America paying cash of $180.4 million to 1st Security Bank for the difference between these amounts and the total deposits assumed. The Branch Purchase was accounted for under the acquisition method of accounting and accordingly, the assets and liabilities were recorded at their fair values on January 22, 2016, the date of acquisition. Determining the fair value of assets and liabilities is a complicated process involving significant judgment regarding methods and assumptions used to calculate estimated fair values. Fair values are preliminary and subject to refinement for up to one year after the closing date of the acquisition as information relative to closing date fair values become available. During the second quarter of 2016, the Company completed a re-evaluation of the core deposit intangible because a portion of core deposits were excluded from the original valuation. The updated valuation of the core deposit intangible increased the fair value adjustment by $100,000 to $2.2 million from $2.1 million resulting in a decrease of $100,000 to the fair value adjustment of goodwill. The impact to consolidated net income was an increase in the amortization of the core deposit intangible for the six months ended June 30, 2016 of $6,000 and was not considered material to the consolidated financial statements. The following table summarizes the estimated fair values of assets acquired and liabilities assumed at the date of acquisition: Explanation of Fair Value Adjustments (1) The fair value adjustment represents the difference between the fair value of the acquired branches and the book value of the assets acquired. The Company utilized third-party valuations but did not receive appraisals to assist in the determination of fair value. (2) The fair value adjustment represents the value of the core deposit base assumed in the Branch Purchase based on a study performed by an independent consulting firm. This amount was recorded by the Company as an identifiable intangible asset and will be amortized as an expense on an accelerated basis over the average life of the core deposit base, which is estimated to be nine years. (3) The fair value adjustment represents the value of the goodwill calculated from the purchase based on the purchase price, less the fair value of assets acquired net of liabilities assumed. Goodwill - The acquired goodwill represents the excess purchase price over the estimated fair value of the net assets acquired and was recorded at $2.3 million on January 22, 2016. The following table summarizes the aggregate amount recognized for each major class of assets acquired and liabilities assumed by 1st Security Bank in the Branch Purchase on January 22, 2016: (1) Purchase price includes premium paid on the deposits, the aggregate net book value of all assets acquired, and the unpaid principal and accrued interest on loans acquired. Core deposit intangible The core deposit intangible represents the fair value of the acquired core deposit base. The core deposit intangible will be amortized on an accelerated basis over approximately nine years. Total amortization expense was $522,000 for the year ended December 31, 2016, and none for the same period in 2015. Amortization expense for core deposit intangible is expected to be as follows: NOTE 3 - SECURITIES AVAILABLE-FOR-SALE The following tables present the amortized costs, unrealized gains, unrealized losses, and estimated fair values of securities available-for-sale at December 31, 2016 and 2015: The Bank pledged 12 securities held at the FHLB with a carrying value of $14.2 million to secure Washington State public deposits of $5.5 million with a $550,000 collateral requirement by the Washington Public Deposit Protection Commission at December 31, 2016. Investment securities that were in an unrealized loss position at December 31, 2016 and 2015 are presented in the following tables, based on the length of time individual securities have been in an unrealized loss position. Management believes that these securities are only temporarily impaired due to changes in market interest rates or the widening of market spreads subsequent to the initial purchase of the securities, and not due to concerns regarding the underlying credit of the issuers or the underlying collateral. There were 48 investments with unrealized losses of less than one year and two investments with unrealized losses of more than one year at December 31, 2016. There were 17 investments with unrealized losses of less than one year and eight investments with unrealized losses of more than one year at December 31, 2015. The unrealized losses associated with these investments are believed to be caused by changing market conditions that are considered to be temporary and the Company does not intend to sell these securities, and it is not likely to be required to sell these securities prior to maturity. No other-than-temporary impairment was recorded for the years ended December 31, 2016 and 2015. The contractual maturities of securities available-for-sale at December 31, 2016 and 2015 are listed below. Expected maturities of mortgage-backed securities may differ from contractual maturities because borrowers may have the right to call or prepay the obligations; therefore, these securities are classified separately with no specific maturity date. The proceeds and resulting gains and losses, computed using specific identification from sales of securities available-for-sale for the years ended December 31, 2016 and 2015 were as follows: NOTE 4 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES The composition of the loan portfolio was as follows at December 31: The Company has defined its loan portfolio into three segments that reflect the structure of the lending function, the Company’s strategic plan and the manner in which management monitors performance and credit quality. The three loan portfolio segments are: (a) Real Estate Loans, (b) Consumer Loans and (c) Commercial Business Loans. Each of these segments is disaggregated into classes based on the risk characteristics of the borrower and/or the collateral type securing the loan. The following is a summary of each of the Company’s loan portfolio segments and classes: Real Estate Loans Commercial Lending. Loans originated by the Company primarily secured by income producing properties, including retail centers, warehouses and office buildings located in our market areas. Construction and Development Lending. Loans originated by the Company for the construction of, and secured by, commercial real estate, one-to-four-family, and multi-family residences and tracts of land for development that are not pre-sold. Home Equity Lending. Loans originated by the Company secured by second mortgages on one-to-four-family residences in our market areas. One-to-Four-Family Real Estate Lending. One-to-four-family residential loans include owner occupied properties (including second homes), and non-owner occupied properties. These loans originated by the Company are secured by first mortgages on one-to-four-family residences in our market areas that the Company intends to hold (excludes loans held for sale). Multi-family Lending. Apartment term lending (five or more units) to current banking customers and community reinvestment loans for low to moderate income individuals in the Company’s footprint. Consumer Loans Indirect Home Improvement. Fixture secured loans are originated by the Company for home improvement and are secured by the personal property installed in, on, or at the borrower’s real property, and may be perfected with a UCC-2 financing statement filed in the county of the borrower’s residence. These indirect home improvement loans include replacement windows, siding, roofing, and other home fixture installations. Solar. Fixture secured loans are originated by the Company for home improvement and are secured by the personal property installed in, on, or at the borrower’s real property, and may be perfected with a UCC-2 financing statement filed in the county of the borrower’s residence. Marine. Loans originated by the Company secured by boats to borrowers primarily located in its market areas. Other Consumer. Loans originated by the Company, including automobiles, recreational vehicles, direct home improvement loans, loans on deposits and other consumer loans, primarily consisting of personal lines of credit. Commercial Business Loans Commercial and Industrial Lending. Loans originated by the Company to local small and mid-sized businesses in our Puget Sound market area are secured primarily by accounts receivable, inventory, or personal property, plant and equipment. Commercial and industrial loans are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Warehouse Lending. Loans originated by the Company’s mortgage and construction warehouse lending program through which the Company funds third-party bankers originating residential mortgage and construction loans for sale into the secondary market and speculative construction loans for sale to single family households. These loans are secured by the notes and assigned deeds of trust associated with the residential mortgage and construction loans on properties primarily located in the Company’s market areas. The following tables detail activities in the allowance for loan losses by loan categories for the years shown: Nonaccrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are automatically placed on nonaccrual once the loan is 90 days past due or sooner if, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, or as required by regulatory authorities. The following tables provide information pertaining to the aging analysis of contractually past due loans and nonaccrual loans for the years ended December 31, 2016 and 2015: There were no loans 90 days or more past due and still accruing interest at December 31, 2016 and 2015. The following tables provide additional information about our impaired loans that have been segregated to reflect loans for which an allowance for credit losses has been provided and loans for which no allowance was provided for the years ended December 31, 2016 and 2015: The following table presents the average recorded investment in loans individually evaluated for impairment and the interest income recognized and received for the years ended December 31, 2016 and 2015: Credit Quality Indicators As part of the Company’s on-going monitoring of credit quality of the loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grading of loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) non-performing loans and (v) the general economic conditions in the Company’s markets. The Company utilizes a risk grading matrix to assign a risk grade to its real estate and commercial business loans. Loans are graded on a scale of 1 to 10, with loans in risk grades 1 to 6 considered “Pass” and loans in risk grades 7 to 10 are reported as classified loans in the Company’s allowance for loan loss analysis. A description of the 10 risk grades is as follows: • Grades 1 and 2 - These grades include loans to very high quality borrowers with excellent or desirable business credit. • Grade 3 - This grade includes loans to borrowers of good business credit with moderate risk. • Grades 4 and 5 - These grades include “Pass” grade loans to borrowers of average credit quality and risk. • Grade 6 - This grade includes loans on management’s “Watch” list and is intended to be utilized on a temporary basis for “Pass” grade borrowers where frequent and thorough monitoring is required due to credit weaknesses and where significant risk-modifying action is anticipated in the near term. • Grade 7 - This grade is for “Other Assets Especially Mentioned (OAEM)” in accordance with regulatory guidelines and includes borrowers where performance is poor or significantly less than expected. • Grade 8 - This grade includes “Substandard” loans in accordance with regulatory guidelines which represent an unacceptable business credit where a loss is possible if loan weakness is not corrected. • Grade 9 - This grade includes “Doubtful” loans in accordance with regulatory guidelines where a loss is highly probable. • Grade 10 - This grade includes “Loss” loans in accordance with regulatory guidelines for which total loss is expected and when identified are charged off. Consumer, Home Equity and One-to-Four-Family Real Estate Loans Homogeneous loans are risk rated based upon the FDIC’s Uniform Retail Credit Classification and Account Management Policy. Loans classified under this policy at the Company are consumer loans which include indirect home improvement, solar, marine, other consumer, and one-to-four-family first and second liens. Under the Uniform Retail Credit Classification Policy, loans that are current or less than 90 days past due are graded “Pass” and risk graded “4” or “5”internally. Loans that are past due more than 90 days are classified “Substandard” risk graded “8” internally until the loan has demonstrated consistent performance, typically six months of contractual payments. Closed-end loans that are 120 days past due and open-end loans that are 180 days past due are charged off based on the value of the collateral less cost to sell. The following tables summarize risk rated loan balances by category at the dates indicated: Troubled Debt Restructured Loans The Company had one TDR loan on accrual and included in impaired loans with a balance of $57,000 at December 31, 2016. At December 31, 2015, the Company had three TDR loans totaling $734,000, of which one TDR loan with a balance of $525,000 was on non-accrual and included in impaired loans, and the remaining two TDR loans totaling $209,000 were on accrual. The Company had no commitments to lend additional funds on the one TDR loan at December 31, 2016. At December 31, 2016 and 2015, all of the Company’s TDR loans consisted of one-to-four-family loans. The following table summarizes TDR loan balances at the dates indicated: For the years ended December 31, 2016 and 2015 there were no reported TDR loans that were modified in the previous 12 months that subsequently defaulted in the reporting year. There was a $43,000 and a $525,000 mortgage loan collateralized by residential real estate property in the process of foreclosure at December 31, 2016 and 2015, respectively. Related Party Loans Certain directors and executive officers or their related affiliates are customers of and have had banking transactions with the Company. Total loans to directors, executive officers, and their affiliates are subject to regulatory limitations. Outstanding loan balances were as follows and were within regulatory limitations: Aggregate loan balances of extended credit were $469,000 and $200,000 at December 31, 2016 and 2015, respectively. These loans and lines of credit were made in compliance with applicable laws on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons and do not involve more than the normal risk of collectability. NOTE 5 - SERVICING RIGHTS Loans serviced for others are not included on the Consolidated Balance Sheets. The unpaid principal balances of loans serviced for others were $977.1 million and $636.1 million at December 31, 2016 and 2015, respectively and are carried at the lower of cost or market. The following table summarizes servicing rights activity for the years ended December 31, 2016 and 2015: The fair market value of the servicing rights’ assets was $11.7 million and $6.8 million at December 31, 2016 and December 31, 2015, respectively. Fair value adjustments to servicing rights are mainly due to market based assumptions associated with discounted cash flows, loan prepayment speeds, and changes in interest rates. A significant change in prepayments of the loans in the servicing portfolio could result in significant changes in the valuation adjustments, thus creating potential volatility in the carrying amount of servicing rights. The following provides valuation assumptions used in determining the fair value of mortgage servicing rights (“MSR”) at the dates indicated: Key economic assumptions and the sensitivity of the current fair value for single family mortgage servicing rights to immediate adverse changes in those assumptions at December 31, 2016 and December 31, 2015 were as follows: The above tables show the sensitivity to market rate changes for the par rate coupon for a conventional one-to-four-family FNMA/FHLMC/GNMA/FHLB serviced home loan. The above tables reference a 50 basis point and 100 basis point decrease in note rate. These sensitivities are hypothetical and should be used with caution as the tables above demonstrate the Company’s methodology for estimating the fair value of MSR is highly sensitive to changes in key assumptions. For example, actual prepayment experience may differ and any difference may have a material effect on MSR fair value. Changes in fair value resulting from changes in assumptions generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, in these tables, the effects of a variation in a particular assumption on the fair value of the MSR is calculated without changing any other assumption; in reality, changes in one factor may be associated with changes in another (for example, decreases in market interest rates may provide an incentive to refinance; however, this may also indicate a slowing economy and an increase in the unemployment rate, which reduces the number of borrowers who qualify for refinancing), which may magnify or counteract the sensitivities. Thus, any measurement of MSR fair value is limited by the conditions existing and assumptions made as a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time. The Company recorded $2.0 million and $1.3 million of contractually specified servicing fees, late fees, and other ancillary fees resulting from servicing of mortgage, commercial and consumer loans for the years ended December 31, 2016 and 2015, respectively. The income, net of amortization, is reported in noninterest income. NOTE 6 - PREMISES AND EQUIPMENT Premises and equipment at December 31, 2016 and 2015 were as follows: Depreciation and amortization expense for these assets totaled $1.4 million and $1.2 million for the years ended December 31, 2016 and 2015, respectively. The Company leases premises and equipment under operating leases. Minimum net rental commitments under non-cancelable leases, having an original or remaining term of more than one year for future years, were as follows: Certain leases contain renewal options from five to ten years and escalation clauses based on increases in property taxes and other costs. Rental expense of leased premises and equipment was $977,000 and $839,000 for the years ended December 31, 2016 and 2015, respectively, which is included in occupancy expense. NOTE 7 - OTHER REAL ESTATE OWNED The following table presents the activity related to OREO at and for the years ended December 31: At December 31, 2016 and 2015, there were no OREO properties. There were no holding costs associated with OREO for the years ended December 31, 2016 and 2015, respectively. NOTE 8 - DEPOSITS Deposits are summarized as follows at December 31: (1) Includes $162.2 million of deposits acquired in the Branch Purchase. (2) Includes $47.1 million and $27.9 million of brokered deposits at December 31, 2016 and 2015, respectively. (3) Time deposits that meet or exceed the FDIC insurance limit. Scheduled maturities of time deposits at December 31, 2016 for future years ending are as follows: Interest expense by deposit category for the years ended December 31, 2016 and 2015 is as follows: The Company had related party deposits of approximately $976,000 and $584,000 at December 31, 2016 and 2015, respectively, which includes deposits held for directors and executive officers. NOTE 9 - DEBT Borrowings The Bank is a member of the FHLB of Des Moines, which entitles it to certain benefits including a variety of borrowing options consisting of a secured credit line that allows both fixed and variable rate advances. The FHLB borrowings at December 31, 2016 and 2015, consisted of a warehouse securities credit line (“securities line”), which allows advances with interest rates fixed at the time of borrowing and a warehouse Federal Funds (“Fed Funds”) advance, which allows daily advances at variable interest rates. Credit capacity is primarily determined by the value of assets collateralized at the FHLB, funds on deposit at the FHLB, and stock owned by the Bank. Credit is limited to 35% of the Company’s total assets. The Bank entered into an Advanced, Pledges and Security Agreement with the FHLB for which specific loans are pledged to secure these credit lines. At December 31, 2016, loans of approximately $249.8 million were pledged to the FHLB with a borrowing capacity, net of advances of $177.5 million. In addition, all FHLB stock owned by the Company is collateral for credit lines. The Bank maintains a short-term borrowing line with the FRB with total credit based on eligible collateral. The Bank can borrow under the Term Auction or Term Facility at rates published by the San Francisco FRB. At December 31, 2016 and 2015, the Bank had approximately $170.1 million in pledged consumer loans with a Term Auction or Term Facility borrowing capacity of $85.9 million and $79.5 million, respectively, of which none was outstanding at either date. The Bank also had $40.0 million unsecured Fed Funds lines of credit with other large financial institutions of which none was outstanding at December 31, 2016. Advances on these lines at December 31, 2016 and 2015 were as follows: Subordinated Note On October 15, 2015 (the “Closing Date”), FS Bancorp, Inc. issued an unsecured subordinated term note in the aggregate principal amount of $10.0 million due October 1, 2025 (the “Subordinated Note”) pursuant to a Subordinated Loan Agreement with Community Funding CLO, Ltd. The Subordinated Note bears interest at an annual interest rate of 6.50%, payable by the Company quarterly in arrears on January 1, April 1, July 1 and October 1 of each year, commencing on the first such date following the Closing Date and on the maturity date. The Subordinated Note will mature on October 1, 2025 but may be prepaid at the Company’s option and with regulatory approval at any time on or after five years after the Closing Date or at any time upon certain events, such as a change in the regulatory capital treatment of the Subordinated Note or the interest on the Subordinated Note no longer being deductible by the Company for United States federal income tax purposes. The Company contributed $9.0 million of the proceeds from the Subordinated Note as additional capital to the Bank in the fourth quarter of 2015 and used the balance to fund general working capital and operating expenses. The maximum and average outstanding and weighted average interest rates on debt during the years ended December 31, 2016 and 2015 were as follows: Scheduled maturities of Federal Home Loan Bank advances were as follows: NOTE 10 - EMPLOYEE BENEFITS Employee Stock Ownership Plan On January 1, 2012, the Company established an ESOP for eligible employees of the Company and the Bank. Employees of the Company and the Bank who have been credited with at least 1000 hours of service during a 12-month period are eligible to participate in the ESOP. The ESOP borrowed $2.6 million from FS Bancorp, Inc. and used those funds to acquire 259,210 shares of FS Bancorp, Inc. common stock in the open market at an average price of $10.17 per share during the second half of 2012. It is anticipated that the Bank will make contributions to the ESOP in amounts necessary to amortize the ESOP loan payable to FS Bancorp, Inc. over a period of 10 years, bearing interest at 2.30%. Intercompany expenses associated with the ESOP are eliminated in consolidation. Shares purchased by the ESOP with the loan proceeds are held in a suspense account and allocated to ESOP participants on a pro rata basis as principal and interest payments are made by the ESOP to FS Bancorp, Inc. The loan is secured by shares purchased with the loan proceeds and will be repaid by the ESOP with funds from the Bank’s discretionary contributions to the ESOP and earnings on the ESOP assets. Payments of principal and interest are due annually on December 31, the Company’s fiscal year end. On December 31, 2016, the ESOP made the fifth annual installment payment of principal in the amount of $257,000, plus accrued interest of $38,000 pursuant to the ESOP loan agreement. As shares are committed to be released from collateral, the Company reports compensation expense equal to the average daily market prices of the shares at December 31, 2016 for the prior 90 days. These shares become outstanding for earnings per share computations. The compensation expense is accrued monthly throughout the year. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings; dividends on unallocated ESOP shares are recorded as a reduction of debt and accrued interest. Compensation expense related to the ESOP for the years ended December 31, 2016 and 2015, was $832,000 and $652,000, respectively. Shares held by the ESOP at December 31, 2016 and December 31, 2015, were as follows (shown as actual): 401(k) Plan The Company has a salary deferral 401(k) Plan covering substantially all of its employees. Employees are eligible to participate in the 401(k) plan at the date of hire if they are 18 years of age. Eligible employees may contribute through payroll deductions and are 100% vested at all times in their deferral contributions account. The Company matches 100% for contributions between 1% and 3%, and 50% for contributions between 4% and 5%. There was a $759,000 and $589,000 matching contribution for the years ended December 31, 2016 and 2015, respectively. NOTE 11 - INCOME TAXES The components of income tax expense for the years ended December 31, 2016 and 2015, were as follows: A reconciliation of the effective income tax rate with the federal statutory tax rates at December 31, 2016 and 2015 was as follows: Total deferred tax assets and liabilities at December 31, 2016 and 2015 were as follows: The Company files a U.S. Federal income tax return and Oregon State return, which are subject to examination by tax authorities for years 2013 and later. At December 31, 2016 and 2015, the Company had no uncertain tax positions. The Company recognizes interest and penalties in tax expense and at December 31, 2016 and 2015, the Company recognized no interest and penalties. NOTE 12 - COMMITMENTS AND CONTINGENCIES Commitments - The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The following table provides a summary of the Company’s commitments at December 31, 2016 and 2015: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the amount of the total commitments do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties. Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized and usually do not contain a specified maturity date and ultimately may not be drawn upon to the total extent to which the Company is committed. The Company has established reserves for estimated losses from unfunded commitments of $179,000 and $147,000 at December 31, 2016 and 2015, respectively. One-to-four-family commitments included in the table above are accounted for as fair value derivatives and do not carry an associated loss reserve. The Company has entered into a severance agreement with its Chief Executive Officer. The severance agreement, subject to certain requirements, generally includes a lump sum payment to the Chief Executive Officer equal to 24 months of base compensation in the event their employment is involuntarily terminated, other than for cause or the executive terminates his employment with good reason, as defined in the severance agreement. The Company has entered into change of control agreements with its Chief Financial Officer, Chief Operating Officer, Chief Lending Officer, and two Executive Vice Presidents of Home Lending. The change of control agreements, subject to certain requirements, generally remain in effect until canceled by either party upon at least 24 months prior written notice. Under the change of control agreements, the executive generally will be entitled to a change of control payment from the Company if the executive is involuntarily terminated within six months preceding or 12 months after a change in control (as defined in the change of control agreements). In such an event, the executives would each be entitled to receive a cash payment in an amount equal to 12 months of their then current salary, subject to certain requirements in the change of control agreements. Because of the nature of our activities, the Company is subject to various pending and threatened legal actions, which arise in the ordinary course of business. From time to time, subordination liens may create litigation which requires us to defend our lien rights. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on our financial position. The Company had no material pending legal actions at December 31, 2016. Contingent liabilities for loans held for sale - In the ordinary course of business, loans are sold with limited recourse against the Company and may have to subsequently be repurchased due to defects that occurred during the origination of the loan. The defects are categorized as documentation errors, underwriting errors, early payoff, early payment defaults, breach of representation or warranty, servicing errors, and/or fraud. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred. If a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, the Company has no commitment to repurchase the loan. The Company has recorded reserves of $955,000 and $561,000 to cover loss exposure related to these guarantees for one-to-four-family loans sold into the secondary market at December 31, 2016 and 2015, respectively, which is included in other liabilities in the Consolidated Balance Sheets. NOTE 13 - SIGNIFICANT CONCENTRATION OF CREDIT RISK Most of the Company’s business and lending activities are primarily with customers located in the greater Puget Sound area and one loan production office located in the Tri-Cities, Washington. The Company originates real estate and consumer loans and has concentrations in these areas, however, indirect home improvement loans are originated through a network of home improvement contractors and dealers located throughout Washington, Oregon, Idaho, and California. The Company also originates solar loans through contractors and dealers in the state of California. Generally, loans are secured by deposit accounts, personal property, or real estate. Rights to collateral vary and are legally documented to the extent practicable. Local economic conditions may affect borrowers’ ability to meet the stated repayment terms. NOTE 14 - REGULATORY CAPITAL The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines of the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of Tier 1 capital (as defined in the regulations) to total average assets (as defined), and minimum ratios of Tier 1 total capital (as defined) and common equity Tier 1 (“CET 1”) capital to risk-weighted assets (as defined). The Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table below to be categorized as well capitalized. At December 31, 2016 and December 31, 2015, the Bank was categorized as well capitalized under applicable regulatory requirements. There are no conditions or events since that notification that management believes have changed the Bank’s category. Management believes, as of December 31, 2016, that the Company meets all capital adequacy requirements to which it is subject. The following tables compare the Bank’s actual capital amounts and ratios at December 31, 2016 and 2015 to their minimum regulatory capital requirements and well capitalized regulatory capital at those dates (dollars in thousands): In addition to the minimum CET 1, Tier 1 and total capital ratios, the Bank has to maintain a capital conservation buffer consisting of additional CET 1 capital above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. This new capital conservation buffer requirement was phased in beginning in January 2016 at 0.625% of risk-weighted assets and will increase each year until fully implemented to an amount equal to 2.5% of risk-weighted assets in January 2019. FS Bancorp, Inc. is a bank holding company subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. For a bank holding company with less than $1.0 billion in assets, the capital guidelines apply on a bank only basis and the Federal Reserve expects the holding company’s subsidiary banks to be well capitalized under the prompt corrective action regulations. If FS Bancorp Inc. was subject to regulatory guidelines for bank holding companies with $1.0 billion or more in assets, at December 31, 2016, the Company would have exceeded all regulatory capital requirements. The regulatory capital ratios calculated for FS Bancorp Inc. at December 31, 2016 were 9.5% for Tier 1 leverage-based capital, 11.6% for Tier 1 risk-based capital, 12.9% for total risk-based capital, and 11.6% for CET 1 capital ratio. NOTE 15 - FAIR VALUE OF FINANCIAL INSTRUMENTS The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. Consequently, the fair value of the Company’s consolidated financial instruments will change when interest rate levels change and that change may either be favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed interest rate obligations are less likely to prepay in a rising interest rate environment and more likely to prepay in a falling interest rate environment. Conversely, depositors who are receiving fixed interest rates are more likely to withdraw funds before maturity in a rising interest rate environment and less likely to do so in a falling interest rate environment. Management monitors interest rates and maturities of assets and liabilities, and attempts to minimize interest rate risk by adjusting terms of new loans, and deposits, and by investing in securities with terms that mitigate the Company’s overall interest rate risk. Accounting guidance regarding fair value measurements defines fair value and establishes a framework for measuring fair value in accordance with U.S. GAAP. Fair value is the exchange price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. The following definitions describe the levels of inputs that may be used to measure fair value: Level 1 - Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 - Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Determination of Fair Market Values: Securities Available-for-Sale - The fair value of securities available-for-sale are recorded on a recurring basis. The fair value of investments and mortgage-backed securities are provided by a third-party pricing service. These valuations are based on market data using pricing models that vary by asset class and incorporate available current trade, bid and other market information, and for structured securities, cash flow, and loan performance data. The pricing processes utilize benchmark curves, benchmarking of similar securities, sector groupings, and matrix pricing. Option adjusted spread models are also used to assess the impact of changes in interest rates and to develop prepayment scenarios. Transfers between the fair value hierarchy are determined through the third-party service provider which, from time to time will transfer between levels based on market conditions per the related security. All models and processes used take into account market convention (Level 2). Mortgage Loans Held for Sale - The fair value of loans held for sale reflects the value of commitments with investors and/or the relative price as delivered into a to be announced (“TBA”) mortgage-backed security (Level 2). Derivative Instruments - The fair value of the interest rate lock commitments and forward sales commitments are estimated using quoted or published market prices for similar instruments, adjusted for factors such as pull-through rate assumptions based on historical information, where appropriate. TBA mortgage-backed securities are fair valued using similar contracts in active markets (Level 2) while locks and forwards with customers and investors are fair valued using similar contracts in the market and changes in the market interest rates (Level 2 and 3). Impaired Loans - Fair value adjustments to impaired collateral dependent loans are recorded to reflect partial write-downs based on the current appraised value of the collateral or internally developed models, which contain management’s assumptions. Management will utilize discounted cashflow impairment for TDRs when the change in terms result in a discount to the overall cashflows to be received (Level 3). The following tables present securities available-for-sale measured at fair value on a recurring basis at December 31, 2016 and December 31, 2015: The following table presents mortgage loans held for sale measured at fair value on a recurring basis at December 31, 2016 and December 31, 2015: The following tables present the fair value of interest rate lock commitments with customers, individual forward sale commitments with investors and paired off commitments with investors measured at their fair value on a recurring basis at December 31, 2016 and December 31, 2015: The following table presents impaired loans measured at fair value on a nonrecurring basis for which a nonrecurring change in fair value has been recorded during the reporting period. The amounts disclosed below represent the fair values at the time the nonrecurring fair value measurements were made, and not necessarily the fair value as of the dates reported upon. Quantitative Information about Level 3 Fair Value Measurements - Shown in the table below is the fair value of financial instruments measured under a Level 3 unobservable input on a recurring and nonrecurring basis at December 31, 2016: An increase in the pull-through rate utilized in the fair value measurement of the interest rate lock commitments with customers and forward sale commitments with investors will result in positive fair value adjustments (and an increase in the fair value measurement). Conversely, a decrease in the pull-through rate will result in a negative fair value adjustment (and a decrease in the fair value measurement). The following table provides a reconciliation of assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the years ended December 31, 2016 and 2015. Gains (losses) on interest rate lock commitments carried at fair value are recorded in other noninterest income. Gains (losses) on forward sale commitments with investors carried at fair value are recorded within other noninterest income. Fair Values of Financial Instruments - The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these financial statements: Cash, and Cash Equivalents and Certificates of Deposit at Other Financial Institutions - The carrying amounts of cash and short-term instruments approximate their fair value (Level 1). Federal Home Loan Bank Stock - The par value of FHLB stock approximates its fair value (Level 2). Accrued Interest - The carrying amounts of accrued interest approximate its fair value (Level 2). Loans Receivable, Net - For variable rate loans that re-price frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers or similar credit quality (Level 3). Servicing Rights - The fair value of mortgage, commercial and consumer servicing rights are estimated using net present value of expected cash flows using a third party model that incorporates assumptions used in the industry to value such rights, adjusted for factors such as weighted average prepayments speeds based on historical information, where appropriate (Level 3). Deposits - The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation on interest rates currently offered on similar certificates (Level 2). Borrowings - The carrying amounts of advances maturing within 90 days approximate their fair values. The fair values of long-term advances are estimated using discounted cash flow analyses based on the Bank’s current incremental borrowing rates for similar types of borrowing arrangements (Level 2). Subordinated Note - The fair value of the Subordinated Note is based upon the average yield of debt issuances in the fourth quarter of 2016 for similarly sized issuances (Level 2). Off-Balance Sheet Instruments - The fair value of commitments to extend credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the customers. The majority of the Company’s off-balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a distinguishable fair value. The fair value of loan lock commitments with customers and investors reflect an estimate of value based upon the interest rate lock date, the expected pull through percentage for the commitment, and the interest rate at year end (Level 2 and 3). The following table provides estimated fair values of the Company’s financial instruments at December 31, 2016 and 2015: NOTE 16 - EARNINGS PER SHARE Basic earnings per share are computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the year. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The following table presents a reconciliation of the components used to compute basic and diluted earnings per share for the years ended December 31, 2016 and 2015. The Company purchased 259,210 shares in the open market during the year ended December 31, 2012, for the ESOP. For earnings per share calculations, the ESOP shares committed to be released are included as outstanding shares for both basic and diluted earnings per share. There were 129,605 shares in the ESOP that were not committed to be released at December 31, 2016. NOTE 17 - DERIVATIVES The Company regularly enters into commitments to originate and sell loans held for sale. The Company has established a hedging strategy to protect itself against the risk of loss associated with interest rate movements on loan commitments. The Company enters into contracts to sell forward TBA mortgage-backed securities. These commitments and contracts are considered derivatives but have not been designated as hedging instruments. Rather, they are accounted for as free-standing derivatives, or economic hedges, with changes in the fair value of the derivatives reported in noninterest income. The Company recognizes all derivative instruments as either other assets or other liabilities on the Consolidated Balance Sheets and measures those instruments at fair value. The following tables summarize the Company’s derivative instruments at the dates indicated: Changes in the fair value of the derivatives recognized in other noninterest income on the Consolidated Statements of Income and included in gain on sale of loans resulted in a net gain of $3.1 million and $1.9 million for the years ended December 31, 2016 and 2015, respectively. NOTE 18 - STOCK-BASED COMPENSATION Stock Options and Restricted Stock In September 2013, the shareholders of FS Bancorp, Inc. approved the FS Bancorp, Inc. 2013 Equity Incentive Plan (“Plan”). The Plan provides for the grant of stock options and restricted stock awards. Total share-based compensation expense for the Plan was $783,000 for the year ended December 31, 2016, and $746,000 for the year ended December 31, 2015. The related income tax benefit was $274,000 for the year ended December 31, 2016, and $265,000 for 2015. Stock Options The Plan authorizes the grant of stock options totaling 324,013 shares to Company directors and employees. Option awards are granted with an exercise price equal to the market price of FS Bancorp’s common stock at the grant date. May 8, 2014, of $16.89 per share. These option awards were granted as non-qualified stock options, having a vesting period of five years, with 20% vesting on the anniversary date of each grant date, and a contractual life of 10 years. Any unexercised stock options will expire 10 years after the grant date or sooner in the event of the award recipient’s termination of service with the Company or the Bank. There were no options granted in 2016 or 2015. The fair value of each option award is estimated on the grant date using a Black-Scholes Option pricing model that uses the following assumptions. The dividend yield is based on the current quarterly dividend in effect at the time of the grant. Historical employment data is used to estimate the forfeiture rate. The Company became a publicly held company in July 2012, therefore historical data was not available to calculate the volatility for FS Bancorp stock. Given this limitation, management utilized a proxy to determine the expected volatility of FS Bancorp’s stock. The proxy chosen was the NASDAQ Bank Index, or NASDAQ Bank (NASDAQ symbol: BANK). This index provides the volatility of the banking sector for NASDAQ traded banks. The majority of smaller banks are traded on the NASDAQ given the costs and daily interaction required with trading on the New York Stock Exchange. The Company utilized the comparable Treasury rate for the discount rate associated with the stock options granted. The Company elected to use Staff Accounting Bulletin 107, simplified expected term calculation for the “Share-Based Payments” method permitted by the SEC to calculate the expected term. This method uses the vesting term of an option along with the contractual term, setting the expected life at 6.5 years. The following table presents a summary of the Company’s stock option plan awards during the year ended December 31, 2016 (shown as actual): For the year ended December 31, 2016, there was $540,000 of total unrecognized compensation cost related to nonvested stock options granted under the Plan. The cost is expected to be recognized over the remaining weighted-average vesting period of 2.4 years. Restricted Stock Awards The Plan authorizes the grant of restricted stock awards totaling 129,605 shares to Company directors and employees, and all but 4,500 shares were granted on May 8, 2014 at a grant date fair value of $16.89 per share. The remaining 4,500 restricted stock awards were granted on January 1, 2016 at a grant date fair value of $26.00 per share. Compensation expense is recognized over the vesting period of the awards based on the fair value of the restricted stock. The restricted stock awards’ fair value is equal to the value on the grant date. Shares awarded as restricted stock vest ratably over a three-year period for directors and a five-year period for employees, beginning at the grant date. Any unexercised restricted stock awards will expire after vesting or sooner in the event of the award recipient’s termination of service with the Company or the Bank. The following table presents a summary of the Company’s nonvested awards during the year ended December 31, 2016 (shown as actual): For the year ended December 31, 2016, there was $832,000 of total unrecognized compensation costs related to nonvested shares granted as restricted stock awards. The cost is expected to be recognized over the remaining weighted-average vesting period of 2.1 years.
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Here's a summary of the financial statement:
Profit/Loss:
- Includes losses, fair value assessments of financial instruments
- Includes valuation of servicing rights and deferred income taxes
- Amounts shown in thousands of dollars (except per share)
- Amounts over $1.0M shown in millions with one decimal point in footnotes
Expenses:
- Follows U.S. GAAP and industry standards
- Management estimates affect reported amounts
- Key estimates include allowance for loan/lease losses
- Financial instrument valuations and deferred taxes included
Assets:
- Only mentioned in reference to total assets
- Specific figures not provided
- Referenced in relation to FHLB advances
Liabilities:
- Focuses on debt securities
- Securities available-for-sale reported at fair value
- Includes unrealized gains/losses
- FHLB membership requires $813,000 capital stock investment
- Other-than-temporary-impairment (OTTI) considerations included
Notable Points:
- Follows standard accounting principles
- Emphasis on securities and their valuation
- Detailed provisions for handling impairment
- Strong focus on fair value reporting
This appears to be a partial financial statement with emphasis on accounting policies rather than specific financial figures.
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Claude
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CONSOLIDATED FINANCIAL STATEMENTS Our consolidated financial statements have been examined to the extent indicated in their reports by Accell Audit & Compliance, P.A. for the years ended December 31, 2016 and 2015 and have been prepared in accordance with GAAP and pursuant to Regulation S-X as promulgated by the Securities and Exchange Commission and are included herein, on Page hereof in response to Part F/S of this Form 10-K. ACCOUNTING FIRM The Board of Directors and Stockholders World Health Energy Holdings, Inc. We have audited the accompanying consolidated balance sheets of World Health Energy Holdings, Inc. (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, stockholders’ deficit and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of World Health Energy Holdings, Inc. as of December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 4, the Company has incurred net losses and negative cash flow from operations since inception. These factors, and the need for additional financing in order for the Company to meet its business plans, raise substantial doubt about the Company’s ability to continue as a going concern. /s/ Accell Audit & Compliance, PA June 27, 2017 Tampa, Florida 4806 West Gandy Boulevard ● Tampa, Florida 33611 ● 813. 440.6380 WORLD HEALTH ENERGY HOLDINGS, INC. CONSOLIDATED BALANCE SHEETS See Accompanying and Report of Independent Registered Public Accounting Firm. WORLD HEALTH ENERGY HOLDINGS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See Accompanying and Report of Independent Registered Public Accounting Firm. WORLD HEALTH ENERGY HOLDINGS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT See Accompanying and Report of Independent Registered Public Accounting Firm. WORLD HEALTH ENERGY HOLDINGS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See Accompanying and Report of Independent Registered Public Accounting Firm. WORLD HEALTH ENERGY HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Nature of Business The Consolidated Financial Statements include the accounts of World Health Energy Holdings, Inc. (“WHEH”) and its wholly owned subsidiaries, World Health Energy, Inc. (“WHE”) and FSC Solutions, Inc. (“FSC”), an online software solutions trading company. WHE’s corporate offices are located in Aventura, Florida. World Health Energy’s primary focus is the production of algae using their proprietary GB3000 growth system. The system quickly and efficiently grows algae for the production of biofuels and food protein. Though the Company has been successful in demonstrating the effectiveness of the GB3000 system on a small-scale the company has not yet been able to raise the necessary capital to implement their technologies on a commercial scale. The Company continues to pursue all available options for raising the necessary capital in addition to exploring alternative revenue sources. FSC’s Financial Broker Service Companies will be www.onlinetrade.trade & www.stocks-4you.com. They will be competing with E Trade, www.etrade.com, (market cap $7.01 Billion) and Ameritrade, www.tdamerirade.com, (market cap $19.6 Billion). The online software trading Company, www.fsc.trade, is looking to compete in the financial software market and expects to generate revenues in the second half of 2017. The Company will provide cutting edge complete software solutions for financial institutions, banks and traders. (2) Basis of Presentation and Consolidation The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) on the accrual basis of accounting. All significant intercompany accounts and transactions have been eliminated in consolidation. The interim financial statements reflect all adjustments, which are, in the opinion of management, necessary in order to make the financial statements not misleading. (3) Significant Accounting Policies a) Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. b) Loss per share The Company has adopted Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 260-10-50, Earnings Per Share, which provides for calculation of "basic" and "diluted" earnings per share. Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted average common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Basic and diluted losses per share were the same at the reporting dates as there were no common stock equivalents outstanding at December 31, 2016 or 2015. c) Cash and Cash Equivalents The Company considers all highly-liquid investments with a maturity of three months or less when purchased to be cash equivalents. There were no cash equivalents as of December 31, 2016 or 2015. d) Property and Equipment Property and equipment is stated at cost and was depreciated using the straight line method over the estimated useful lives of the respective assets of three years. Routine maintenance, repairs and replacement costs are expensed as incurred and improvements that extend the useful life of the assets are capitalized. When office equipment is sold or otherwise disposed of, the cost and related accumulated depreciation are eliminated from the accounts and any resulting gain or loss is recognized in operations. As of December 31, 2016 and December 31, 2015, property and equipment was valued at $118,127 and had depreciation of $118,127. e) Revenue Recognition The Company recognizes revenue on arrangements in accordance with Securities and Exchange Commission Staff Accounting Bulletin Topic 13, Revenue Recognition and FASB ASC 605-15-25, Revenue Recognition. In all cases, revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed and collectability is reasonably assured. The Company did not report any revenues during the years ended December 31, 2016 or 2015. f) Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carry forwards, is required to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities result in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies. The Company’s income tax returns are subject to examination by tax authorities. Generally, the statute of limitations related to the Company’s federal and state income tax return is three years from the date of filing. The state impact of any federal changes for prior years remains subject to examination for a period up to five years after formal notification to the states. Management has evaluated tax positions in accordance with FASB ASC 740, Income Taxes, and has not identified any significant tax positions, other than those disclosed. g) Recently Issued Accounting Pronouncements The Company reviewed all recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA and the SEC and they did not or are not believed by management to have a material impact on the Company’s present or future financial statements. h) Subsequent Events In accordance with FASB ASC 855, Subsequent Events, the Company evaluated subsequent events through June 27, 2017, the date the consolidated financial statements were available for issue. (4) Going Concern The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company’s financial position and operating results raise substantial doubt about the Company’s ability to continue as a going concern, as reflected by the net losses of $26,120,406 accumulated through December 31, 2016. The consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. Management is presently seeking to raise permanent equity capital in the capital markets to eliminate negative working capital and provide working capital. Failure to raise equity capital or secure some other form of long-term debt arrangement will cause the Company to further increase its negative working capital deficit and could result in the Company having to curtail or cease operations. Additionally, even if the Company does raise sufficient capital to support its operating expenses and generate revenues, there can be no assurances that the revenue will be sufficient to enable it to develop business to a level where it will generate profits and cash flows from operations. (5) Income Taxes The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes as of December 31, 2016 and 2015 are as follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. As of December 31, 2016 and 2015, the Company’s only significant deferred income tax asset was a cumulative estimated net tax operating loss of approximately $26 million that is available to offset future taxable income, if any, in future periods, subject to expiration and other limitations imposed by the Internal Revenue Service. Management has considered the Company's operating losses incurred to date and believes that a full valuation allowance against the deferred tax assets is required as of December 31, 2016 and 2015. (6) Related Parties As of December 31, 2016 and 2015, the Company had $0 and $1,623, respectively, included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder. As of December 31, 2016 and 2015, the Company had $59,157 included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder for amounts paid to certain vendors for services rendered. The amount is non-interest bearing and due upon demand. As of December 31, 2016 and 2015, the Company had $280,336 and $177,133, respectively, included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder and consultant of the Company for services rendered as a business advisor and for amounts paid to certain vendors for services rendered. The amounts are non-interest bearing and due upon demand. As of December 31, 2016 and 2015, the Company had $64,000 included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder and consultant of the Company for services rendered in his former role as the Chief Executive Officer or the Company. The amount is non-interest bearing and due upon demand. As of December 31, 2016 and 2015, the Company had $117,598 included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder for amounts paid to certain vendors for services rendered. The amount is non-interest bearing and due upon demand. As of December 31, 2016 and 2015, the Company had $0 and $7,027, respectively, included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder and consultant of the Company for amounts paid to certain vendors for services rendered. The amounts are non-interest bearing and due upon demand. As of December 31, 2016 and 2015, the Company had $48,491 and $7,067, respectively, included in Due to affiliates in the accompanying consolidated balance sheets that is due to a stockholder and consultant of the Company for amounts paid to certain vendors for services rendered. The amounts are non-interest bearing and due upon demand. As of December 31, 2016 and 2015, the Company had $155,485 included in Due to affiliates in the accompanying consolidated balance sheets that is due to creditors of FSC, a business acquired by the Company during 2015 (see Note 9). The amounts are non-interest bearing and due upon demand. (7) Convertible Note Payable During 2015, the Company entered into a convertible note payable with a third party for $21,474. The note is non-interest bearing and is convertible to common stock at $0.0001 per share (or the comparable rate following any share split or reverse split) on the conversion date. During 2015 the note holder became the CEO and is now a related party. The note is due to be converted in the third Quarter of 2017. (8) Commitments & Contingencies During the normal course of business, the Company may be exposed to litigation. In the event the Company were to become aware of potential litigation, it would evaluate the merits of the case in accordance with ASC 450-20-50, Contingencies. The Company evaluates its exposure to the matter, possible legal or settlement strategies and the likelihood of an unfavorable outcome. If the Company determines that an unfavorable outcome is probable and can be reasonably estimated, it establishes the necessary accruals. As of December 31, 2016, the Company is not aware of any contingent liabilities that should be reflected in the accompanying Condensed Consolidated Financial Statements. (9) Business Acquisitions On June 26, 2015, WHEH entered into a Stock Purchase Agreement (the “Agreement”) with FSC. FSC is the owner of a proprietary trading platform and accompanying software. The Agreement was effective as of July 1, 2015. Pursuant to the terms of the Agreement, WHEH acquired all of the capital stock of FSC. In consideration, WHEH issued 70 Billion common shares at closing with the possibility of the issuance of an additional 130 billion common shares upon FSC meeting certain milestones as outlined in the Agreement. WHEH intended to employ FSC’s software and trading platform to enter the on-line trading industry. The acquisition was valued at the book value of FSC at the date of acquisition. During 2016, the value of the software to WHEH was tested for impairment and it was decided that it should be fully impaired in the year. The following table summarizes the assets acquired and liabilities assumed at the acquisition date: (10) Other Significant Events On March 13, 2016, FSC entered into a Stock Purchase Agreement (the “Agreement”) with Natalie Stock, Ltd. for the purchase of all of the outstanding shares of Amid Financial Centre, Ltd. (“Amid”), a Mauritius Company that operates as a broker-dealer. Pursuant to the terms of the Agreement, FSC was to acquire all of the capital stock of Natalie Stock, Ltd. In consideration, WHEH was to pay cash and other consideration to Natalie Stock, Ltd. WHEH intended to integrate FSC’s software and trading platform and Amid’s broker-dealer operations. The Agreement contained customary representations, warranties and covenants by Natalie Stock, Ltd. and FSC. The Closing of the Agreement was subject to customary closing conditions. Eli Gal Levy, was a director of WHEH and FSC, and is the owner of Natalie Stock, Ltd. During the first quarter of 2016, an initial deposit of $20,000 was made as part of the agreement. The likelihood of both the acquisition going ahead and repayment of the $20,000 deposit were deemed unlikely by December 31, 2016, and, as a result the $20,000 was written off as an expense in 2016. Management’s Report on Internal Control Over Financial Reporting (a) Evaluation of Disclosure Controls and Procedures. Management of the Company, with the participation of the Chief Executive Officer and Directors, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934) pursuant to Rule 13a-15 under the Exchange Act. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported on a timely basis and that such information is communicated to management, including the Chief Executive Officer and the Company’s Board of Directors, to allow timely decisions regarding required disclosure. Based upon that evaluation, the Chief Executive Officer concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2016. (b) Management’s Report on Internal Control over Financial Reporting. Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) under the Exchange Act. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. It should be noted that the Company’s management, including the Chief Executive Officer and Chief Financial Officer, do not expect that the Company’s internal controls will necessarily prevent all errors or fraud. A control system, no matter how well conceived or operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met, Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. We conducted an evaluation of the effectiveness of our internal controls over financial reporting based on the framework in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2016. This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. The Company’s internal controls over financial reporting was not subject to attestation by the Company’s independent registered public accounting firm pursuant to temporary rules if the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report. (c) Changes in Internal Control Over Financial Reporting. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fourth quarter of 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. ITEM 9B.
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Based on the provided financial statement excerpt, here's a summary:
Financial Health Overview:
- Consistent financial losses since company inception
- Negative cash flow from operations
- Significant doubt about the company's ability to continue operating
Key Financial Challenges:
- Substantial working capital deficit
- Potential need to curtail or cease operations due to financial constraints
- Uncertainty about raising sufficient capital to support expenses and generate revenue
Risk Factors:
- No guarantee of generating profitable revenues
- Potential inability to develop business to a sustainable level
- Reliance on additional financing to meet business plans
The statement suggests the company is in a precarious financial position with substantial financial risks and limited prospects for near-term profitability.
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Claude
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Consolidated . SIMPSON MANUFACTURING CO., INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders Simpson Manufacturing Co., Inc. We have audited the accompanying consolidated balance sheets of Simpson Manufacturing Co., Inc. (a Delaware corporation) and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for the years ended December 31, 2016 and 2015. Our audits of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under Item 15(a)2. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Simpson Manufacturing Co., Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for the years ended December 31, 2016 and 2015 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2017 expressed an unqualified opinion thereon. /s/ Grant Thornton LLP San Francisco, California February 28, 2017 Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders Simpson Manufacturing Co., Inc. We have audited the internal control over financial reporting of Simpson Manufacturing Co., Inc. (a Delaware corporation) and subsidiaries (the “Company”) as of December 31, 2016, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in the 2013 Internal Control-Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company as of and for the year ended December 31, 2016, and our report dated February 28, 2017 expressed an unqualified opinion on those financial statements. /s/ Grant Thornton LLP San Francisco, California February 28, 2017 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Simpson Manufacturing Co., Inc.: In our opinion, the consolidated statements of operations, comprehensive income, stockholders’ equity and cash flows for the year ended December 31, 2014 present fairly, in all material respects, the results of operations and cash flows of Simpson Manufacturing Co., Inc. and its subsidiaries for the year ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for the year ended December 31, 2014 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. PricewaterhouseCoopers LLP San Francisco, California March 2, 2015 Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Balance Sheets (In thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Statements of Operations (In thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (In thousands) The accompanying notes are an integral part of these consolidated financial statements Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Statements of Stockholders’ Equity For the years ended December 31, 2014, 2015 and 2016 (In thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements Simpson Manufacturing Co., Inc. and Subsidiaries Consolidated Statements of Cash Flows (In thousands) The accompanying notes are an integral part of these consolidated financial statements Simpson Manufacturing Co., Inc. and Subsidiaries 1. Operations and Summary of Significant Accounting Policies Nature of Operations Simpson Manufacturing Co., Inc., through its subsidiary Simpson Strong-Tie Company Inc. and its other subsidiaries (collectively, the “Company”), designs, engineers and is a leading manufacturer of wood construction products, including connectors, truss plates, fastening systems, fasteners and shearwalls, and concrete construction products, including adhesives, specialty chemicals, mechanical anchors, powder actuated tools and fiber reinforcing materials. The Company markets its products to the residential construction, industrial, commercial and infrastructure construction, remodeling and do-it-yourself markets. The Company operates exclusively in the building products industry. The Company’s products are sold primarily in the United States, Canada, Europe, the South Pacific and in Asia up until 2015 when the Company closed the sales offices there. Revenues have some geographic market concentration in the United States. A portion of the Company’s business is therefore dependent on economic activity within the North America segment. The Company is dependent on the availability of steel, its primary raw material. Out-of-Period Adjustment In the first quarter of 2014, the Company recorded an out-of-period adjustment, which increased gross profit, income from operations and net income in total by $2.3 million, $2.0 million and $1.3 million, respectively. The adjustment resulted from an over-statement of prior periods' workers compensation expense, net of cash profit sharing expense, and was not material to the current period's or any prior period's financial statements. Principles of Consolidation The consolidated financial statements include the accounts of Simpson Manufacturing Co., Inc. and its subsidiaries. Investments in 50% or less owned entities are accounted for using either cost or the equity method. The Company consolidates all variable interest entities ("VIEs") where it is the primary beneficiary. There were no VIEs as of December 31, 2016 or 2015. All significant intercompany transactions have been eliminated. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, as amended from time to time ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition The Company recognizes revenue when the earnings process is complete, net of applicable provision for discounts, returns and incentives, whether actual or estimated based on the Company’s experience. This generally occurs when products are shipped to the customer in accordance with the sales agreement or purchase order, ownership and risk of loss pass to the customer, collectability is reasonably assured and pricing is fixed or determinable. The Company’s general shipping terms are F.O.B. shipping point, where title is transferred and revenue is recognized when the products are shipped to customers. When the Company sells F.O.B. destination point, title is transferred and the Company recognizes revenue on delivery or customer acceptance, depending on terms of the sales agreement. Service sales, representing after-market repair and maintenance, engineering activities, software license sales and service and lease income, though significantly less than 1% of net sales and not material to the Consolidated Financial Statements, are recognized as the services are completed or the software products and services are delivered. If actual costs of sales returns, incentives and discounts were to significantly exceed the recorded estimated allowances, the Company’s sales would be adversely affected. Sales Incentive and Advertising Allowances The Company records estimated reductions to revenues for sales incentives, primarily rebates for volume discounts, and allowances for co-operative advertising. Allowances for Sales Discounts The Company records estimated reductions to revenues for discounts taken on early payment of invoices by its customers. Cash Equivalents The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the time of purchase to be cash equivalents. Allowance for Doubtful Accounts The Company assesses the collectability of specific customer accounts that would be considered doubtful based on the customer’s financial condition, payment history, credit rating and other factors that the Company considers relevant, or accounts that the Company assigns for collection. The Company reserves for the portion of those outstanding balances that the Company believes it is not likely to collect based on historical collection experience. The Company also reserves 100% of the amounts that it deems uncollectable due to a customer’s deteriorating financial condition or bankruptcy. If the financial condition of the Company’s customers were to deteriorate, resulting in probable inability to make payments, additional allowances may be required. Inventory Valuation Inventories are stated at the lower of cost or net realizable value. Cost includes all costs incurred in bringing each product to its present location and condition, as follows: • Raw materials and purchased finished goods for resale - principally valued at cost determined on a weighted average basis; and • In-process products and finished goods - cost of direct materials and labor plus attributable overhead based on a normal level of activity. The Company applies net realizable value and obsolescence to the gross value of the inventory. The Company estimates net realizable value based on estimated selling price less further costs to completion and disposal. The Company impairs slow-moving products by comparing inventories on hand to projected demand. If on-hand supply of a product exceeds projected demand or if the Company believes the product is no longer marketable, the product is considered obsolete inventory. The Company revalues obsolete inventory to its net realizable value. The Company has consistently applied this methodology. The Company believes that this approach is prudent and makes suitable impairments for slow-moving and obsolete inventory. When impairments are established, a new cost basis of the inventory is created. Unexpected change in market demand, building codes or buyer preferences could reduce the rate of inventory turnover and require the Company to recognize more obsolete inventory. Warranties and recalls The Company provides product warranties for specific product lines and records estimated recall expenses in the period in which the recall occurs, none of which has been material to the Consolidated Financial Statements. In a limited number of circumstances, the Company may also agree to indemnify customers against legal claims made against those customers by the end users of the Company’s products. Historically, payments made by the Company, if any, under such agreements have not had a material effect on the Company’s consolidated results of operations, cash flows or financial position Fair Value of Financial Instruments The “Fair Value Measurements and Disclosures” topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification™ (“ASC”) establishes a valuation hierarchy for disclosure of the inputs used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities; Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument; Level 3 inputs are unobservable inputs based on the Company’s assumptions used to measure assets and liabilities at fair value. A financial asset’s or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. As of December 31, 2016, the Company’s investments consisted of only money market funds, and as of December 31, 2015, its investments consisted of only United States Treasury securities and money market funds, which are the Company’s primary financial instruments, maintained in cash equivalents and carried at cost, approximating fair value, based on Level 1 inputs. The balance of the Company’s primary financial instruments was as follows: The carrying amounts of trade accounts receivable, accounts payable and accrued liabilities approximate fair value due to the short-term nature of these instruments. The fair value of the Company’s contingent consideration related to acquisitions is classified as Level 3 within the fair value hierarchy as it is based on unobserved inputs and assumptions. In 2014, the fair value of the contingent consideration related to the acquisition of Bierbach GmbH & Co. KG ("Bierbach"), a Germany company, was decreased from $0.8 million to $0.2 million as a result of not retaining Bierbach's historical customers and increased competition. Property, Plant and Equipment Property, plant and equipment are carried at cost. Major renewals and betterments are capitalized. Maintenance and repairs are expensed on a current basis. When assets are sold or retired, their costs and accumulated depreciation are removed from the accounts, and the resulting gains or losses are reflected in the accompanying Consolidated Statements of Operations. The “Intangibles-Goodwill and Other” topic of the FASB ASC provides guidance on capitalization of the costs incurred for computer software developed or obtained for internal use. The Company capitalizes qualified external costs and internal costs related to the purchase and implementation of software projects used for business operations and engineering design activities. Capitalized software costs primarily include purchased software and external consulting fees. Capitalized software projects are amortized over the estimated useful lives of the software. Depreciation and Amortization Depreciation of software, machinery and equipment is provided using accelerated methods over the following estimated useful lives: Buildings and site improvements are depreciated using the straight-line method over their estimated useful lives, which range from 15 to 45 years. Leasehold improvements are amortized using the straight-line method over the shorter of the expected life or the remaining term of the lease. Amortization of purchased intangible assets with finite useful lives is computed using the straight-line method over the estimated useful lives of the assets. In-Process Research and Development Assets In-process research and development (“IPR&D”) assets represent capitalized incomplete research projects that the Company acquired through business combinations. Such assets are initially measured at their acquisition-date fair values and are required to be classified as indefinite-lived assets until the successful completion of the associated research and development efforts. During the development period after the date of acquisition, these assets will not be amortized until the research and development projects are completed and the resulting assets are ready for their intended use. The Company performs an impairment test annually and more frequently if events or changes in circumstances indicate it that is more likely than not that the asset is impaired. On successful completion of the research and development project the Company makes a determination about the then-remaining useful life and begins amortization. As of December 31, 2016, the Company had no IPR&D assets. Cost of Sales The types of costs included in cost of sales include material, labor, factory and tooling overhead, shipping, and freight costs. Major components of these expenses are material costs, such as steel, packaging and cartons, personnel costs, and facility costs, such as rent, depreciation and utilities, related to the production and distribution of the Company’s products. Inbound freight charges, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs, and other costs of the Company’s distribution network are also included in cost of sales. Tool and Die Costs Tool and die costs are included in product costs in the year incurred. Shipping and Handling Fees and Costs The Company’s general shipping terms are F.O.B. shipping point. Shipping and handling fees and costs are included in revenues and product costs, as appropriate, in the year incurred. Product and Software Research and Development Costs Product research and development costs, which are included in operating expenses and are charged against income as incurred, were $9.9 million, $10.3 million and $11.2 million in 2016, 2015 and 2014, respectively. The types of costs included as product research and development expenses are typically related to salaries and benefits, professional fees and supplies. In 2016, 2015 and 2014, the Company incurred software development expenses related to its expansion into the plated truss market and some of the software development costs were capitalized. See "Note 5 - Property, Plant and Equipment." The Company amortizes acquired patents over their remaining lives and performs periodic reviews for impairment. The cost of internally developed patents is expensed as incurred. Selling Costs Selling costs include expenses associated with selling, merchandising and marketing the Company’s products. Major components of these expenses are personnel, sales commissions, facility costs such as rent, depreciation and utilities, professional services, information technology costs, sales promotion, advertising, literature and trade shows. Advertising Costs Advertising costs are included in selling expenses, are expensed when the advertising occurs, and were $7.1 million, $6.4 million and $7.3 million in 2016, 2015, and 2014, respectively. General and Administrative Costs General and administrative costs include personnel, information technology related costs, facility costs such as rent, depreciation and utilities, professional services, amortization of intangibles and bad debt charges. Income Taxes Income taxes are calculated using an asset and liability approach. The provision for income taxes includes federal, state and foreign taxes currently payable and deferred taxes, due to temporary differences between the financial statement and tax bases of assets and liabilities. In addition, future tax benefits are recognized to the extent that realization of such benefits is more likely than not. Sales Taxes The Company presents taxes collected and remitted to governmental authorities on a net basis in the accompanying Consolidated Statements of Operations. Foreign Currency Translation The local currency is the functional currency of most of the Company’s operations in Europe, Canada, Asia, Australia, New Zealand and South Africa. Assets and liabilities denominated in foreign currencies are translated using the exchange rate on the balance sheet date. Revenues and expenses are translated using average exchange rates prevailing during the year. The translation adjustment resulting from this process is shown separately as a component of stockholders’ equity. Foreign currency transaction gains or losses are included in general and administrative expenses. Sales Office Closing The Company substantially completed the liquidation of its Asia sales offices as of December 31, 2015, and does not expect to recognize significant additional costs in future periods related to this event. Accordingly, the Company reclassified $0.2 million of its accumulated other comprehensive income, related to foreign exchange losses from its Asia sales offices, to its consolidated statement of operations. This amount is classified as a loss on disposal of assets and was recorded in the Asia/Pacific segment. The following table provides a rollforward of the liability balance for such expenses, as well as other non-employee costs associated with the Asia sales office closing, as of December 31, 2016: For the year ended December 31, 2016, the Company had recorded employee severance obligation expenses of $0.4 million and made corresponding payments totaling $0.7 million. In addition, during 2016, the Company incurred operating leases charges of $0.4 million and made corresponding payments for the closed sales offices. Common Stock Subject to the rights of holders of any preferred stock that may be issued in the future, holders of common stock are entitled to receive such dividends, if any, as may be declared from time to time by the Company’s Board of Directors out of legally available funds, and in the event of liquidation, dissolution or winding-up of the Company, to share ratably in all assets available for distribution. The holders of common stock have no preemptive or conversion rights. Subject to the rights of any preferred stock that may be issued in the future, the holders of common stock are entitled to one vote per share on any matter submitted to a vote of the stockholders, except that, subject to compliance with pre-meeting notice and other conditions pursuant to the Company’s Bylaws, stockholders currently may cumulate their votes in an election of directors, and each stockholder may give one candidate a number of votes equal to the number of directors to be elected multiplied by the number of shares held by such stockholder or may distribute such stockholder’s votes on the same principle among as many candidates as such stockholder thinks fit. A director in an uncontested election is elected if the votes cast “for” such director’s election exceed the votes cast “against” such director’s election, except that, if a stockholder properly nominates a candidate for election to the Board of Directors, the candidates with the highest number of affirmative votes (up to the number of directors to be elected) are elected. There are no redemption or sinking fund provisions applicable to the common stock. In 1999, the Company declared a dividend distribution of one right per share of our common stock to purchase Series A Participating preferred stock (each, a "Right," or collectively, the "Rights"). Pursuant to the Amended and Restated Rights Agreement dated as of June 15, 2009 (the "Rights Agreement"), by and between the Company and Computershare Trust Company, N.A,, a federally chartered trust company, as rights agent, the Rights would be exercisable, unless redeemed earlier by the Company, if a person or group acquired, or obtained the right to acquire, 15% or more of the outstanding shares of common stock or commenced a tender or exchange offer that would result in it acquiring 15% or more of the outstanding shares of common stock, either event occurring without the prior consent of the Company. The amount of Series A Participating preferred stock that the holder of a Right was entitled to receive and the purchase price payable on exercise of a Right were both subject to adjustment. Any person or group that would acquire 15% or more of the outstanding shares of common stock without the prior consent of the Company would not be entitled to this purchase. Any stockholder who held 25% or more of the Company’s common stock when the Rights were originally distributed would not be treated as having acquired 15% or more of the outstanding shares unless such stockholder’s ownership would be increased to more than 40% of the outstanding shares. Under the Rights Agreement, the Rights were scheduled to expire June 14, 2019 and might be redeemed by the Company at one cent per Right prior to their scheduled expiration. The Rights did not have voting or dividend rights and, until they become exercisable, had no dilutive effect on the earnings of the Company. One million shares of the Company’s preferred stock have been designated Series A Participating preferred stock and reserved for issuance on exercise of the Rights. No event has made the Rights exercisable. On October 25, 2016, the Company's Board of Directors voted to terminate the Rights Agreement. On November 9, 2016, the Company entered into an amendment (the “Rights Agreement First Amendment”) to the Rights Agreement. The Rights Agreement First Amendment amended the definition of “Final Expiration Date” under the Rights Agreement to mean “November 9, 2016.” Accordingly, the Rights Agreement First Amendment accelerated the final expiration of the Rights from June 14, 2019, to November 9, 2016. Preferred Stock The Board has the authority to issue the authorized and unissued preferred stock in one or more series with such designations, rights and preferences as may be determined from time to time by the Board. Accordingly, the Board is empowered, without stockholder approval, to issue preferred stock with dividend, redemption, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of the Company’s common stock. Stock Repurchase Program The Company announced a stock repurchase program in 2015. In 2015, the Company's Board of Directors authorized the Company to repurchase up to $50.0 million of the Company's common stock through December 31, 2015. For the fiscal year ended December 31, 2015, the Company purchased a total of 1,338,894 shares of its common stock, which included the 689,184 shares pursuant to the September 2015 $25 million accelerated share repurchase program ("2015 ASR Agreement") that the Company entered into with Wells Fargo Bank, National Association ("Wells Fargo"). As of December 31, 2015, the terms of the 2015 ASR Agreement were completed. The Company paid Wells Fargo $25 million and Wells Fargo delivered to the Company 689,184 shares of the Company’s common stock, which had an average share price of $36.27 per share. At an average price of $35.21, the Company spent approximately $47.1 million on the 1,338,894 shares repurchased during the twelve months ended December 31, 2015. All shares repurchased during 2015 were retired. At its meeting in August 2016, the Company’s Board of Directors authorized the Company to repurchase up to $125.0 million of the Company’s common stock. This authorization increased and extended the $50.0 million repurchase authorization from February 2016 and will remain in effect through December 31, 2017. For the fiscal year ended December 31, 2016, the Company purchased a total of 1,244,003 shares of its common stock, which included the 1,137,656 shares pursuant to the August 2016 $50 million accelerated share repurchase program ("2016 ASR Agreement") that the Company entered into with Wells Fargo. As of December 31, 2016, the terms of the 2016 ASR Agreement were completed. The Company paid Wells Fargo $50 million and Wells Fargo delivered to the Company 1,137,656 shares of the Company’s common stock, which had an average share price of $43.95 per share. At an average price of $43.01, the Company spent approximately $53.5 million on the 1,244,003 shares repurchased during the twelve months ended December 31, 2016. All shares repurchased during 2016 were retired. See the "Consolidated Statements of Stockholders’ Equity." Net Income per Common Share Basic net income per common share is computed based on the weighted average number of common shares outstanding. Potentially dilutive shares, using the treasury stock method, are included in the diluted per-share calculations for all periods when the effect of their inclusion is dilutive. The following shows a reconciliation of basic earnings per share (“EPS”) to diluted EPS: Anti-dilutive shares attributable to outstanding stock options were excluded from the calculation of diluted net income per share. The potential tax benefits derived from the amount of the average stock price for the period in excess of the grant date fair value of stock options, known as the windfall tax benefit, is added to the proceeds of stock option exercises under the treasury stock method for computing the amount of dilutive securities used to determine the outstanding shares for the calculation of diluted earnings per share. Comprehensive Income or Loss Comprehensive income is defined as net income plus other comprehensive income or loss. Other comprehensive income or loss consists of changes in cumulative translation adjustments and changes in unamortized pension adjustments recorded directly in accumulated other comprehensive income within stockholders’ equity. The following shows the components of accumulated other comprehensive income or loss as of December 31, 2016 and 2015, respectively: The 2015 translation adjustment of $0.2 million in cumulative currency translation adjustments was related to the liquidation of the Asia sales offices. This amount is classified as a net loss on disposal of assets in the accompanying Consolidated Statements of Operations. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash in banks, short-term investments in money market funds and trade accounts receivable. The Company maintains its cash in demand deposit and money market accounts held primarily at fifteen banks. Accounting for Stock-Based Compensation The Company currently maintains an equity incentive plan, the Simpson Manufacturing Co., Inc. Amended and Restated 2011 Incentive Plan (the “2011 Plan”), which was adopted on April 26, 2011 and amended and restated on April 21, 2015. The 2011 Plan amended and restated in their entirety, and incorporated and superseded, both the Simpson Manufacturing Co., Inc. 1994 Stock Option Plan (the “1994 Plan”), which was principally for the Company’s employees, and the Simpson Manufacturing Co., Inc. 1995 Independent Director Stock Option Plan (the “1995 Plan”), which was for its independent directors. Awards previously granted under the 1994 Plan or the 1995 Plan will not be affected by the adoption of the 2011 Plan and will continue to be governed by the 1994 Plan or the 1995 Plan, respectively. Under the 1994 Plan and the 1995 Plan, the Company could grant incentive stock options and non-qualified stock options, although the Company granted only non-qualified stock options thereunder. The Company generally granted options under each of the 1994 Plan and the 1995 Plan once each year. Options vest and expire according to terms established at the grant date. Stock options granted under the 1994 Plan typically vested evenly over the requisite service period of four years and have a term of seven years. Options granted under the 1995 Plan were fully vested on the date of grant. Shares of common stock issued on exercise of stock options under the 1994 Plan and the 1995 Plan are registered under the Securities Act of 1933, as amended (the "Securities Act"). Under the 2011 Plan, the Company may grant incentive stock options, non-qualified stock options, restricted stock and restricted stock units, although the Company currently intends to award primarily performance-based and/or time-based restricted stock units ("RSUs") and to a lesser extent, if at all, non-qualified stock options. The Company does not currently intend to award incentive stock options or restricted stock. Under the 2011 Plan, no more than 16.3 million shares of the Company’s common stock in aggregate (including shares already issued pursuant to prior awards) may be issued under the 2011 Plan, including shares reserved for issuance on exercise of options previously granted under the 1994 Plan and the 1995 Plan. Shares of common stock to be issued pursuant to the 2011 Plan are registered under the Securities Act. Subject to certain adjustment, the following limits shall apply with respect to any awards under the Plan that are intended to qualify for the performance-based exception from the tax deductibility limitations of section 162(m) of the U.S. Internal Revenue Code of 1986, as amended from time to time: (i) the maximum aggregate number of shares of the Company’s common stock that may be subject to stock options granted in any calendar year to any one participant shall be 150,000 shares; and (ii) the maximum aggregate number of shares of the Company’s common stock issuable or deliverable under RSUs granted in any calendar year to any one participant shall be 100,000 shares. The following table shows the Company’s stock-based compensation activity: The stock-based compensation expense included in cost of sales, research and development and engineering expense, selling expense, or general and administrative expense depends on the job functions performed by the employees to whom the stock options were granted, or the restricted stock units were awarded. The following table shows the expense related to the Company's stock-based compensation capitalized in inventory. The assumptions used to calculate the fair value of options or restricted stock units are evaluated and revised, as necessary, to reflect market conditions and the Company’s experience. See "Note 13 - Stock-Based Compensation." Goodwill Impairment Testing The Company tests goodwill for impairment at the reporting unit level on an annual basis (in the fourth quarter for the Company). The Company also reviews goodwill for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or disposition or relocation of a significant portion of a reporting unit. The reporting unit level is generally one level below the operating segment and is at the country level except for the United States, Denmark, Australia, and S&P Clever reporting units. The Company has determined that the United States reporting unit includes four components: Northwest United States, Southwest United States, Northeast United States and Southeast United States (collectively, the “U.S. Components”). The Company aggregates the U.S. Components into a single reporting unit because management concluded that they are economically similar and that the goodwill is recoverable from the U.S. Components working in concert. The U.S. Components are economically similar because of a number of factors, including, selling similar products to shared customers and sharing assets and services such as intellectual property, manufacturing assets for certain products, research and development projects, manufacturing processes, management of inventory excesses and shortages and administrative services. These activities are managed centrally at the U.S. Components level and costs are allocated among the four U.S. Components. The Company determined that the Australia reporting unit includes four components: Australia, New Zealand, South Africa and United Arab Emirates (collectively, the “AU Components”). The Company aggregates the AU Components into a single reporting unit because management concluded that they are economically similar and that the goodwill is recoverable from the AU Components working in concert. The AU Components are economically similar because of a number of factors, including that New Zealand, South Africa and United Arab Emirates operate as extensions of their Australian parent company selling similar products and sharing assets and services such as intellectual property, manufacturing assets for certain products, management of inventory excesses and shortages and administrative services. These activities are managed centrally at the AU Components level and costs are allocated among the AU Components. The Company has determined that the S&P Clever reporting unit includes eight components: S&P Switzerland, S&P Poland, S&P Austria, S&P The Netherlands, S&P Portugal, S&P Germany, S&P France and S&P Nordic (collectively, the "S&P Components”). The Company aggregates the S&P Components into a single reporting unit because management concluded that they are economically similar and that the goodwill is recoverable from the S&P Components working in concert. The S&P Components are economically similar because of a number of factors, including sharing assets and services such as intellectual property, manufacturing assets for certain products, research and development projects, manufacturing processes, management of inventory excesses and shortages and administrative services. These activities are managed centrally at the S&P Components level and costs are allocated among the S&P Components. For certain reporting units, the Company may first assess qualitative factors related to the goodwill of the reporting unit to determine whether it is necessary to perform a two-step impairment test. If the Company judges that it is more likely than not that the fair value of the reporting unit is greater than the carrying amount of the reporting unit, including goodwill, no further testing is required. If the Company judges that it is more likely than not that the fair value of the reporting unit is less than the carrying amount of the reporting unit, including goodwill, management will perform a two-step impairment test on goodwill. In the first step ("Step 1"), the Company compares the fair value of the reporting unit to its carrying value. The fair value calculation uses the income approach (discounted cash flow method) and the market approach, equally weighted. If the Company judges that the carrying value of the net assets assigned to the reporting unit, including goodwill, exceeds the fair value of the reporting unit, a second step of the impairment test must be performed to determine the implied fair value of the reporting unit’s goodwill. If the Company judges that the carrying value of a reporting unit’s goodwill exceeds its implied fair value, the Company would record an impairment charge equal to the difference between the implied fair value of the goodwill and the carrying value. Determining the fair value of a reporting unit or an indefinite-lived purchased intangible asset is a judgment involving significant estimates and assumptions. These estimates and assumptions include revenue growth rates, operating margins and working capital requirements used to calculate projected future cash flows, risk-adjusted discount rates, selected multiples, control premiums and future economic and market conditions (Level 3 fair value inputs). The Company bases its fair value estimates on assumptions that it believes to be reasonable, but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. Assumptions about a reporting unit’s operating performance in the first year of the discounted cash flow model used to determine whether or not the goodwill related to that reporting unit is impaired are derived from the Company’s budget. The fair value model considers such factors as macro-economic conditions, revenue and expense forecasts, product line changes, material, labor and overhead costs, tax rates, working capital levels and competitive environment. Future estimates, however derived, are inherently uncertain but the Company believes that this is the most appropriate source on which to base its fair value calculation. The Company uses these parameters only to provide a basis for the determination of whether or not the goodwill related to a reporting unit is impaired. No inference whatsoever should be drawn from these parameters about the Company’s future financial performance and they should not be taken as projections or guidance of any kind. The 2016, 2015 and 2014 annual testing of goodwill for impairment did not result in impairment charges. The impairment charge taken in the third quarter of 2014 was associated with assets in the Germany reporting unit acquired from Bierbach in 2013. The factors that led to the third quarter impairment were a failure to retain Bierbach's historical customers and increased competition, which led to the reduction in the contingent consideration liability related to the Bierbach acquisition and resulted in management performing an impairment test to evaluate the recoverability of the Germany reporting unit's goodwill. The test resulted in the impairment of all of the reporting unit’s goodwill in the amount of $0.5 million. In connection with the impairment of the goodwill, the Company also reviewed associated long-lived assets in Germany, such as property and equipment and intangible assets, for recoverability by comparing the projected undiscounted net cash flows associated with those assets to their carrying values. No impairment of long-lived assets was required as a result of that review during the third quarter of 2014. The annual changes in the carrying amount of goodwill, by segment, as of December 31, 2015 and 2016, were as follows, respectively: (1) Reclassifications in 2016 of $0.2 million in patents, $0.1 million in non-compete agreements, $46 thousand in customer relationships and other assets, with a corresponding $0.4 million decrease in goodwill related to the EBTY acquisition. Amortizable Intangible Assets The total gross carrying amount and accumulated amortization of intangible assets, most of which are or will be, subject to amortization at December 31, 2016, were $51.4 million and $28.6 million, respectively. The aggregate amount of amortization expense of intangible assets for the years ended December 31, 2016, 2015 and 2014 was $6.0 million, $6.1 million and $7.2 million, respectively. The annual changes in the carrying amounts of patents, unpatented technologies, customer relationships and non-compete agreements and other intangible assets subject to amortization as of December 31, 2015, and 2016 were as follows, respectively: (1) Reclassifications in 2016 of $0.2 million in patents, $0.1 million in non-compete agreements, $46 thousand in customer relationships and other assets, with a corresponding $0.4 million decrease in goodwill related to the EBTY acquisition. (2) Reclassifications in 2016 of $1.5 million in unpatented technology for completed IPR&D, with a corresponding reduction in indefinite-lived IPR&D intangibles. (1) Reclassifications in 2016 of $0.2 million in patents, $0.1 million in non-compete agreements, $46 thousand in customer relationships and other assets, with a corresponding $0.4 million decrease in goodwill related to the EBTY acquisition. (1) Reclassifications in 2016 of $0.2 million to patents, $0.1 million in non-compete agreements, $46 thousand in customer relationships and other assets, with a corresponding $0.4 million decrease in goodwill related to the EBTY acquisition. At December 31, 2016, estimated future amortization of intangible assets was as follows: (in thousands) Indefinite-Lived Intangible Assets The annual changes in the carrying amounts of indefinite-lived trade name and IPR&D assets not subject to amortization as of December 31, 2015 and 2016, respectively, were as follows: (2) Reclassifications in 2016 of $1.5 million to unpatented technology for completed IPR&D, with a corresponding reduction in indefinite-lived IPR&D intangibles. Amortizable and indefinite-lived assets, net, by segment, as of December 31, 2015 and 2016, respectively, were as follows: Recently Adopted Accounting Standards In August 2014, the FASB issued Accounting Standards Update No. 2014-15 (Topic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). ASU 2014-15 requires management to evaluate relevant conditions, events and certain management plans that are known or reasonably knowable as of the evaluation date when determining whether substantial doubt about an entity’s ability to continue as a going concern exists. Under ASU 2014-5, the emergence of substantial doubt about a company’s ability to continue as a going concern is the trigger for providing footnote disclosure. Therefore, for each annual and interim reporting period, management should evaluate whether there are conditions that give rise to substantial doubt within one year from the financial statement issuance date. During the fourth quarter of 2016, the Company adopted ASU 2014-15 and applied the guidance prospectively. Adoption of ASU 2014-15 has had no material effect on the Company’s consolidated financial statements and footnote disclosures. In July 2015, the FASB issued Accounting Standards Update No. 2015-11, (Topic 330), Simplifying the Measurement of Inventory (“ASU 2015-11”). The objective is to reduce the complexity related to inventory subsequent measurement and disclosure requirements. ASU 2015-11 amendments do not apply to inventory that is measured using last-in, first-out or the retail inventory method. The amendments apply to all other inventory, which includes inventory that is measured using first-in, first-out or average cost. Inventory within the scope of the new guidance should be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The amendments more closely align with the measurement of inventory in International Financial Reporting Standards. ASU 2015-11 will be effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The amendments in ASU 2015-11 should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. During the first quarter of 2016, the Company elected to adopt ASU 2015-11 ahead of its required effective date and applied the guidance prospectively. Early adoption of ASU 2015-11 has had no material effect on the Company's consolidated financial statements and footnote disclosures. In November 2015, the FASB issued Accounting Standards Update No. 2015-17, Income Taxes (Topic 740), Balance Sheet Classification of Deferred Taxes ("ASU 2015-17"). The objective is to simplify the presentation of deferred income taxes; the amendments require that deferred tax assets and liabilities be classified as noncurrent in a classified consolidated balance sheets. ASU 2015-17 will be effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Earlier application is permitted for all entities as of the beginning of an interim or annual reporting period. The amendment may be applied either prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. During the first quarter of 2016, the Company elected to adopt ASU 2015-17 ahead of its required effective date and applied the guidance prospectively with no change to prior period's amounts disclosed in our consolidated balance sheets and related notes to the consolidated financial statements. Early adoption of ASU 2015-17, in the first quarter of 2016, resulted in the Company offsetting all of its deferred income tax assets and liabilities, as of January 1, 2016, by taxing jurisdiction and classifying those balances as noncurrent. The result was a $4.1 million increase in "Other noncurrent assets," from $6.7 million to $10.8 million, and a $12.1 million decrease in "Deferred income tax and other long-term liabilities," from $16.5 million to $4.4 million. Recently Issued Accounting Standards Not Yet Adopted In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"). ASU 2014-09 supersedes nearly all existing revenue recognition guidance under GAAP. The amendments provide a revenue recognition five-step model to be applied to all revenue contracts with customers. In 2016, the FASB issued final amendments to clarify the implementation guidance for principal versus agent considerations, identifying performance obligations and the accounting for licenses of intellectual property. The standard is effective for annual and interim periods beginning after December 15, 2017. The Company expects to adopt the new standard effective January 1, 2018. The new standard also permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the modified retrospective method). The Company is currently in the process of determining its method of adoption, which depends in part upon the completion of the analysis on the impact this guidance has on the Company's revenue arrangements. The Company expects to complete its analysis of the impact of the updated revenue-recognition guidance on the Company's revenue arrangements by October of 2017. The Company’s approach includes performing a detailed review of key contracts representative of the Company’s products. In addition, comparing historical accounting policies and practices to the new standard on the Company’s revenue arrangements. Based on current information and subject to future events and circumstances, the Company does not know whether the new revenue recognition standard will have a material impact on its financial statements upon adoption. In February 2016, the FASB issued Accounting Standards Update No. 2016-02, (Topic 842), Leases (“ASU 2016-02”). ASU 2016-02 core requirement is to recognize the assets and liabilities that arise from leases including those leases classified as operating leases. The amendments require a lessee to recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term. The lessor accounting application is largely unchanged from that applied previously under GAAP. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application of the amendments in this Update is permitted for all entities. Based on current information and subject to future events and circumstances, the Company does not know whether the new operating lease standard will have a material impact on its financial statements upon adoption. In March 2016, the FASB issued Accounting Standards Update No. 2016-09 (Topic 718), Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). The amendments simplify several aspects of the accounting for employee share-based payment transactions including accounting for income taxes, forfeitures, statutory tax withholding requirements, and classification in the statement of cash flows. ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Based on current information and subject to future events and circumstances, the Company does not believe the improved stock compensation standard will have a material impact on its financial statements upon adoption. 2. Acquisitions In December 2015, the Company purchased all of the business assets including intellectual property from Blue Heron Enterprises, LLC, and Fox Chase Enterprises, LLC (collectively, "EBTY"), both New Jersey limited liability companies, for $3.4 million in cash. EBTY manufactured and sold hidden deck clips and products and systems using a patented design. EBTY's patented design for hidden deck clips and products and systems will complement the Company's line of hidden clips and fastener systems. The Company's measurement of assets acquired included goodwill of $2.0 million, which was assigned to the North America segment, and intangible assets of $1.1 million, both of which are subject to tax-deductible amortization. Net assets consisting of inventory and equipment accounted for the balance of the purchase price. The weighted-average amortization period for the intangible assets is 7 years. In August 2016, the Company purchased all of the outstanding shares of Multi Services Dêcoupe S.A. ("MS Decoupe"), a Belgium public limited company, for $6.9 million. MS Decoupe primarily manufactures and distributes wood construction, plastic and metal labeling products in Belgium and the Netherlands, including distributing the Company's products manufactured at the Company's production facility in France. With this acquisition, the Company could potentially offer the Belgium market a wider-range of its products, shorten delivery lead times, and expand the Company's sales presence into the Netherlands market. The Company's provisional measurement of assets acquired and liabilities assumed included cash and cash equivalents of $1.5 million, other current assets of $2.1 million, non-current assets of $5.0 million, current liabilities of $0.7 million and non-current deferred income tax liabilities of $1.0 million. Included in non-current assets was goodwill of $1.9 million, which was assigned to the Europe segment, and intangible assets of $1.2 million, both of which are not subject to tax-deductible amortization. The estimated weighted-average amortization period for the intangible assets is 7 years. Under the business combinations topic of the FASB ASC 805, the Company accounted for these acquisitions as business combinations and ascribed acquisition-date fair values to the acquired assets and assumed liabilities. Fair value of intangible assets was based on Level 3 inputs. The results of operations of the businesses acquired in 2014 through 2016 are included in the Company’s consolidated results of operations since the date of the acquisition. They were not material to the Company on an individual or aggregate basis, and accordingly, pro forma results of operations have not been presented. See “Note 15 - Subsequent Events” for the Company’s acquisitions that took place following December 31, 2016. 3. Trade Accounts Receivable, net Trade accounts receivable consisted of the following: The Company sells products on credit and generally does not require collateral. 4. Inventories The components of inventories consisted of the following: 5. Property, Plant and Equipment, net Property, plant and equipment consisted of the following: Included in property, plant and equipment at December 31, 2016 and 2015, are fully depreciated assets with an original cost of $166.7 million and $156.7 million, respectively. These fully depreciated assets are still in use in the Company’s operations. The Company capitalizes certain development costs associated with internal use software, including external direct costs of materials and services and payroll costs for employees devoting time to a software project. As of December 31, 2016 and 2015, depreciable capitalized software development costs were $4.6 million and $1.6 million, respectively, and included in capital projects in progress at December 31, 2016 and 2015, were software in development costs of $13.5 million and $12.2 million, respectively. Costs incurred during the preliminary project stage, as well as costs for maintenance and training, are expensed as incurred. Depreciation expense was $21.6 million for the year ended December 31, 2016 and $20.4 million for both of the years ended December 31, 2015 and 2014. In December 2015, the Company purchased for $12.6 million a manufacturing facility in West Chicago for the purposes of combining the operations of its two leased chemical facilities into one owned facility. During 2016, the Company incurred $7.3 million in improvement costs to build out of the new facility. In 2016, the Company approved the expansion of the McKinney facility, which it estimates will cost $17.0 million to $19.0 million. 6. Investments At December 23, 2016, the Company acquired a 25.0% equity interest in Ruby Sketch Pty Ltd. (“Ruby Sketch”), an Australian proprietary limited company, for $2.5 million, for which the Company accounts for its ownership interest using the equity accounting method. Ruby Sketch develops software that assists in designing residential structures, primarily used in Australia and potentially for the North America market. The Company’s future relationship with Ruby Sketch also could potentially include the specification of the Company’s products in the Ruby Sketch software. The Company has no obligation to make any additional capital contributions to Ruby Sketch. 7. Accrued Liabilities Accrued liabilities consisted of the following: 8. Debt The Company has revolving lines of credit with various banks in the United States and Europe. Total available credit at December 31, 2016 was $303.8 million, including revolving credit lines and an irrevocable standby letter of credit in support of various insurance deductibles. The Company’s primary credit facility is a revolving line of credit with $300.0 million in available credit. On July 25, 2016, the Company entered into a second amendment (the "Amendment") to the credit facility. For additional information about the Amendment, see the Company's Current Report on Form 8-K dated July 28, 2016. As amended, this credit facility expires on July 23, 2021. Amounts borrowed under this credit facility will bear interest at an annual rate equal to either, at the Company’s option, (a) the rate for Eurocurrency deposits for the corresponding deposits of United States dollars appearing on Reuters LIBOR1screen page (the “LIBOR Rate”), adjusted for any reserve requirement in effect, plus a spread of 0.60% to 1.45%, determined quarterly based on the Company’s leverage ratio (at December 31, 2016, the LIBOR Rate was 0.72% ), or (b) a base rate, plus a spread of 0.00% to 0.45%, determined quarterly based on the Company’s leverage ratio. The base rate is defined in a manner such that it will not be less than the LIBOR Rate. The Company will pay fees for standby letters of credit at an annual rate equal to the applicable spread described above, and will pay market-based fees for commercial letters of credit. The Company is required to pay an annual facility fee of 0.15% to 0.30% of the available commitments under the credit agreement, regardless of usage, with the applicable fee determined on a quarterly basis based on the Company’s leverage ratio. The Company was also required to pay customary fees as specified in a separate fee agreement between the Company and Wells Fargo Bank, National Association, in its capacity as the Administrative Agent under the credit facility. In addition to the $300.0 million credit facility, the Company’s borrowing capacity under other revolving credit lines totaled $3.8 million at December 31, 2016. The other revolving credit lines charge interest ranging from 0.48% to 7.75% and have maturity dates from March 2017 to December 2017. The Company had no outstanding balance on any of its revolving credit lines at December 31, 2016 and 2015, respectively. The Company and its subsidiaries are required to comply with various affirmative and negative covenants. The covenants include provisions that would limit the availability of funds as a result of a material adverse change to the Company’s financial position or results of operations. The Company was in compliance with its financial covenants under the loan agreement as of December 31, 2016. The Company incurs interest costs, which include interest, maintenance fees and bank charges. The amount of costs incurred, capitalized, and expensed for the years ended December 31, 2016, 2015 and 2014, consisted of the following: 9. Commitments and Contingencies Leases Certain properties occupied by the Company are leased. The leases expire at various dates through 2026 and generally require the Company to assume the obligations for insurance, property taxes and maintenance of the facilities. Rental expense for 2016, 2015 and 2014 with respect to all leased property was approximately $5.9 million, $6.6 million and $6.9 million, respectively. At December 31, 2016, minimum rental commitments under all non-cancelable leases were as follows: (in thousands) Some of these minimum rental commitments contain renewal options and provide for periodic rental adjustments based on changes in the consumer price index or current market rental rates. Other rental commitments provide options to cancel early without penalty. Future minimum rental payments, under the earliest cancellation options, are included in minimum rental commitments in the table above. Other Contractual Obligations Purchase obligations consist of commitments primarily related to the acquisition, construction or expansion of facilities and equipment, consulting agreements, and minimum purchase quantities of certain raw materials. The Company is not a party to any long-term supply contracts with respect to the purchase of raw materials or finished goods. Debt interest obligations include annual facility fees on the Company’s primary line-of-credit facility. Interest on line-of-credit facilities was estimated based on historical borrowings and repayment patterns. At December 31, 2016, other contractual obligations were as follows: (in thousands) Employee Relations Approximately 20% of the Company’s employees are represented by labor unions and are covered by collective bargaining agreements. The Company’s facility in Stockton, California, is also a union facility with two collective bargaining agreements, which also cover tool and die craftsmen and maintenance workers and sheetmetal workers, respectively. These two contracts will expire in July and September 2019, respectively. The Company’s facility in San Bernardino County, California, has two of the Company's collective bargaining agreements, one with tool and die craftsmen and maintenance workers, and the other with sheetmetal workers. These two contracts expire in February 2017 and June 2018, respectively. The Company expects to agree with the San Bernardino tool and die craftsmen and maintenance workers union to extend the existing labor union contract that expires in February 2017, while the parties are negotiating a new agreement. The Company has not begun negotiations to extend the sheetmetal workers union labor contract that expires in June 2018. The Company believes that, even if new agreements are not reached before the existing labor union contracts expire, it is not likely to have a material adverse effect on the Company’s ability to provide products to customers or on the Company’s profitability. Environmental The Company’s policy with regard to environmental liabilities is to accrue for future environmental assessments and remediation costs when information becomes available that indicates that it is probable that the Company is liable for any related claims and assessments and the amount of the liability is reasonably estimable. The Company does not believe that any such matters will have a material adverse effect on the Company’s financial condition, cash flows or results of operations. Litigation From time to time, the Company is involved in various legal proceedings and other matters arising in the normal course of business. Corrosion, hydrogen enbrittlement, cracking, material hardness, wood pressure-treating chemicals, misinstallations, misuse, design and assembly flaws, manufacturing defects, labeling defects, product formula defects, inaccurate chemical mixes, adulteration, environmental conditions, or other factors can contribute to failure of fasteners, connectors, anchors, adhesives, specialty chemicals, such as fiber reinforced polymers, and tool products. In addition, inaccuracies may occur in product information, descriptions and instructions found in catalogs, packaging, data sheets, and the Company’s website. As of February 28, 2017, the Company is not a party to any legal proceedings, other than ordinary routine litigation incidental to the Company’s business, which the Company expects individually or in the aggregate to have a material adverse effect on the Company’s financial condition, cash flows or results of operations. Nonetheless, the resolution of any claim or litigation is subject to inherent uncertainty and could have a material adverse effect on the Company’s financial condition, cash flows or results of operations. Potential Third-Party Claims Nishimura v. Gentry Homes, Ltd., Civil No. 11-1-1522-07, was filed in the Hawaii First Circuit court on July 20, 2011. The Nishimura case involves claims by homeowners at a Honolulu development, Ewa by Gentry, related to alleged corrosion of strap-tie holdowns and mud-sill anchor products supplied by the Company. Ewa by Gentry consists of approximately 2,400 homes. The Company is not currently a party to the Nishimura case. The plaintiff homeowners originally sued the developer Gentry Homes, Ltd. (“Gentry”) as well as the Company. In 2012 and 2013, the Hawaii First Circuit granted the Company’s motions to dismiss and for summary judgment, resulting in the dismissal of all of the plaintiff homeowners’ claims against the Company, and the Company is not currently a party to the proceedings. The dismissed claims against the Company remain subject to potential appeal by the plaintiffs. Further, Gentry may in the future seek to sue the Company for indemnity or contribution if Gentry is ultimately found liable for any loss suffered by the plaintiff homeowners. The Company initially understood from Gentry there were no significant damages claims related to Ewa by Gentry development. In May 2015, the plaintiff homeowners filed a second amended complaint to name a new representative plaintiff because the original representative plaintiffs had not suffered damage. In August 2016, Gentry advised the Company for the first time that other plaintiff homeowners had documented serious corrosion of mudsill anchors and strap-tie holdowns in a substantial number of homes. The plaintiff homeowners and Gentry are currently proceeding in arbitration and the Hawaii state court lawsuit has been stayed pending the conclusion of arbitration. Gentry has not asserted any third party claim against the Company, but has reserved the right to seek to do so. In the Nishimura case and in the arbitration, the plaintiff homeowners seek damages according to proof. At this time, the Company cannot reasonably ascertain the likelihood that Gentry will be found responsible for substantial damages to the homeowners; whether, if so, Gentry would proceed against the Company; whether any legal theory against the Company might be viable, or the extent of the liability the Company might face if Gentry were to proceed against it. The Company admits no liability in connection with the Nishimura case. It will vigorously defend any claims, whether appeal by the plaintiff homeowners, or third party claims by Gentry. Based on facts currently known to the Company and subject to future events and circumstances, the Company believes that all or part of any claims that any party might seek to allege against it related to the Nishimura case may be covered by its insurance policies. Charles Vitale, et al. v. D.R. Horton, Inc. and D.R. Horton-Schuler Homes, LLC, Civil No. 15-1-1347-07, a putative class action lawsuit, was filed in the Hawaii First Circuit on July 13, 2015, in which homeowner plaintiffs allege that all homes built by D.R Horton/D.R. Horton-Schuler Homes in the State of Hawaii have strap-tie holdowns that are suffering premature corrosion. The complaint alleges that various manufacturers make strap-tie holdowns that suffer from such corrosion, but does not identify the Company’s products specifically. The Company is not currently a party to the Vitale lawsuit, but the lawsuit in the future could potentially involve the Company’s strap-tie holdowns. Given the preliminary nature and the complexities involved in the Nishimura and Vitale proceedings, the Company is unable to estimate reasonably a likelihood of possible loss or range of possible loss until the Company knows, among other factors, (i) whether it will be named in the lawsuit by any party; (ii) the specific claims and the legal theories on which they are based (iii) what claims, if any, will survive dispositive motion practice, (iv) the extent of the claims, including the size of any potential class, particularly as damages are not specified or are indeterminate, (v) how the discovery process will affect the litigation, (vi) the settlement posture of the other parties to the litigation, (vii) the extent to which the Company’s insurance policies will cover the claims or any part thereof, if at all, (viii) whether class treatment is appropriate; and (ix) any other factors that may have a material effect on the litigation. While it is not feasible to predict the outcome of proceedings, to which the Company is not currently a party, or reasonably estimate a possible loss or range of possible loss for the Company related to such matters, in the opinion of the Company, either the likelihood of loss from such proceedings is remote or any reasonably possible loss associated with the resolution of such proceedings is not expected to be material to the Company’s financial position, results of operations or cash flows either individually or in the aggregate. Nonetheless, the resolution of any claim or litigation is subject to inherent uncertainty and could have a material adverse effect on the Company’s financial condition, cash flows or results of operations. 10. Income Taxes The provision for income taxes from operations consisted of the following: Income and loss from operations before income taxes for the years ended December 31, 2016, 2015, and 2014, respectively, consisted of the following: Reconciliations between the statutory federal income tax rates and the Company’s effective income tax rates as a percentage of income before income taxes for its operations were as follows: The tax effects of the significant temporary differences that constitute the deferred tax assets and liabilities at December 31, 2016 and 2015, respectively, were as follows: Prospective adoption of ASU 2015-17, in the first quarter of 2016, resulted in the Company offsetting all of its deferred income tax assets and liabilities, as of January 1, 2016, by taxing jurisdiction and classifying those balances as noncurrent. The result was $4.1 million being classified as "Other noncurrent assets," and a $1.9 million being classified as "Deferred income tax and other long-term liabilities." The offsetting of all of the Company's deferred income tax assets and liabilities as of December 31, 2016, by taxing jurisdiction, resulted in $4.3 million being classified as "Other noncurrent assets" and $2.4 million being classified as "Deferred income tax and other long-term liabilities." At December 31, 2016, the Company had $30.8 million of pre-tax loss carryforwards in various foreign taxing jurisdictions, which includes approximately $4.3 million that were generated by the Company’s Beijing and Thailand subsidiaries that are in the process of liquidating. Tax loss carryforwards of $1.5 million, $1.2 million, $1.7 million, $1.5 million, $0.3 million, $92 thousand and $0.3 million will expire in 2017, 2018, 2019, 2020, 2021, 2022, and 2023 respectively, if not used. The remaining tax losses can be carried forward indefinitely. At December 31, 2016, and 2015, the Company had deferred tax valuation allowances of $6.9 million and $7.6 million, respectively. The valuation allowance decreased $0.7 million and $0.8 million for the years ended December 31, 2016 and 2015, respectively. The Company does not provide for federal income taxes on the undistributed earnings of its international subsidiaries because such earnings are reinvested and, in the Company’s opinion, will continue to be reinvested indefinitely. At December 31, 2016, 2015 and 2014, the Company had not provided for federal income taxes on undistributed earnings of $57.7 million, $51.6 million and $45.6 million, respectively, from its international subsidiaries. Should these earnings be distributed in the form of dividends or otherwise, the Company would be subject to both United States income taxes and withholding taxes in various international jurisdictions. These taxes may be partially offset by United States foreign tax credits. Determination of the related amount of unrecognized deferred United States income taxes is not practicable because of the complexities associated with this hypothetical calculation. United States federal income taxes are provided on the earnings of the Company’s foreign branches, which are included in the United States federal income tax return. A reconciliation of the beginning and ending amounts of unrecognized tax benefits in 2016, 2015 and 2014, respectively, was as follows, including foreign translation amounts: There are no tax positions included in the balance of unrecognized tax benefits at December 31, 2016 and 2014. A tax position of $0.2 million is included at December 31, 2015, which, if recognized, would reduce the effective tax rate. The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense, which is a continuation of the Company’s historical accounting policy. During the years ended December 31, 2016, 2015 and 2014, accrued interest decreased by $61 thousand, $30 thousand and $0.2 million, respectively, as a result of the reversal of accrued interest associated with the lapses of statutes of limitations. The Company had accrued $0.2 million for each of the fiscal years ended 2016, 2015 and 2014, for the potential payment of interest, before income tax benefits. At December 31, 2016, the Company remained subject to United States federal income tax examinations for the tax years 2013 through 2016. In addition, the Company remained subject to state, local and foreign income tax examinations primarily for the tax years 2011 through 2016. 11. Retirement Plans The Company has five defined contribution retirement plans covering substantially all salaried employees and nonunion hourly employees. On January 1, 2015, the Simpson Manufacturing Co., Inc. 401(k) Profit Sharing Plan for Salaried Employees was amended, restated and superseded by the Simpson Manufacturing Co., Inc. 401(k) Profit Sharing Plan (the “Restated Plan”), and the Simpson Manufacturing Co., Inc. 401(k) Profit Sharing Plan for Hourly Employees was merged with and incorporated into the Restated Plan. The Restated Plan, covering United States employees, provides for quarterly contributions, limited to 3% of the employees quarterly eligible compensation, that does not require Board approval and for annual contributions in amounts that the Board authorizes, subject to certain limitations, but in no event are total contributions more than the amounts permitted under the Internal Revenue Code as deductible expense. The other four plans, covering the Company’s European and Canadian employees, require the Company to make contributions ranging from 3% to 15% of the employees’ compensation. The total cost for these retirement plans for the years ended December 31, 2016, 2015 and 2014, was $10.1 million, $9.5 million and $8.0 million, respectively. The Company also contributes to various industry-wide, union-sponsored pension funds for hourly employees who are union members and a statutorily required pension fund for employees in Switzerland. Payments to these funds aggregated $3.1 million, $2.5 million and $2.3 million for the years ended December 31, 2016, 2015 and 2014, respectively. Settlement of Pension Withdrawal Liability Under the Company's collective bargaining arrangement with the tool and die craftsman and maintenance union, the Company has been contributing to a defined-benefit pension plan. In 2014, the Company and the union formally notified the defined-benefit pension plan administrator of their intent to withdraw from the plan. In the third quarter of 2014, the plan administrator responded by issuing a demand letter informing the Company that the annual withdrawal liability payment to be made by the Company was $145,400 and the payments were to be made in perpetuity. Due to the amount and duration of payments, the Company was required to calculate and record a pension expense and liability based on the annual payments in perpetuity. At December 31, 2014, the Company discounted the payment estimate using a discount rate of 4.5%, which approximates the credit-adjusted risk-free rate for the Company and recorded a long-term liability of $3.3 million with a corresponding defined-benefit expense in cost of sales. On a quarterly basis, the Company re-evaluated the number of years that payments are required and the discount rate used to calculate the long-term liability and adjusted it as facts and circumstances changed. All adjustments to the long-term liability were charged to cost of sales in the accompanying Consolidated Statements of Operations. Because of the funding status of the plan, the annual withdrawal liability payments were recorded as interest expense on the long-term liability. In September of 2015, the defined-benefit pension plan trustees and the Company agreed to settle this long-term pension withdrawal liability, which at the time had a $3.0 million balance, for $2.0 million. As a result of the settlement, the Company reduced the long-term pension withdrawal liability by $1.0 million with a corresponding defined benefit expense reduction in cost of sales. The $2.0 million long-term pension withdrawal liability was fully paid as of September 30, 2015. 12. Related Party Transactions In March 2013, the Company extended its lease on a property in Addison, Illinois, which is co-owned by Gerald Hagel, a vice president of Simpson Strong-Tie Company Inc. since March 2007. The extension was for an additional five years through 2018. The Company paid $0.3 million in 2016 to lease the property from Mr. Hagel and his wife, Susan Hagel, a former employee of Simpson Strong-Tie Company Inc. In 2016, the Company paid Tacit Knowledge, Inc. ("Tacit Knowledge"), a consultant on a software implementation project, $1.9 million for its services. The project started in 2015 and is expected to be continuing in 2017. Chris Andrasick, the Company's Director James S. Andrasick’s son, co-founded Tacit Knowledge in 2002. Tacit Knowledge was sold to Newgistics, Inc. ("Newgistics") in 2013. Chris Andrasick was hired by Newgistics in 2013, as its Chief Strategy and Innovation Officer for Digital Commerce, but has had no financial interest in Tacit Knowledge since the 2013 acquisition, other than in his role as an officer of Newgistics. The payments that the Company made to Tacit Knowledge in 2016 were less than 0.5% of Newgistics' consolidated gross revenues for the fiscal year ended December 31, 2016. In 2016, Karen Colonias, the Company’s Chief Executive Officer, was named as a director of Reliance Steel & Aluminum Co. (“Reliance”). Reliance, through its subsidiaries, has been a provider of steel processing and handling services for the Company for several years. In 2016, the Company paid Reliance $0.7 million for its services. The relationship between the Company and Reliance is expected to be continuing in 2017. 13. Stock-Based Compensation The Company has one stock-based incentive plan, the 2011 Plan, which incorporates and supersedes its two previous plans except for awards previously granted under the two plans (see "Note 1 - Accounting for Stock-Based Compensation). Generally, participants of the 2011 Plan are granted stock-based awards, and among which the performance-based awards may vest, only if the applicable Company-wide or profit-center operating goals, or both, or strategic goals, established by the Compensation and Leadership Development Committee (the "Committee") of the Board of Directors at the beginning of the year, are met. The Company granted restricted stock units (“RSUs”) under the 2011 Plan in 2014, 2015 or 2016. The fair value of each restricted stock unit award is estimated on the measurement date as determined in accordance with GAAP and is based on the closing market price of the underlying stock on the day preceding the measurement date. The fair value excludes the present value of the dividends that the RSUs do not participate in. The RSUs may be time-based, performance-based or time- and performance-based. The restrictions on one quarter of the time-based RSUs generally lapse on the date of the award and each of the first, second and third anniversaries of the date of the award (the “Vesting Schedule”). The restrictions on the performance-based RSUs, which are made to the Company’s named executive officers and certain members of the Company’s senior management in addition to their time-based RSUs, generally lapse following a period set for the RSUs on the date of the award, and shares of the Company’s common stock underlying such awards are subject to performance-based adjustment before becoming vested. In addition, some of the time-based RSUs made to the Company’s employees require the underlying shares to be subject to performance-based adjustment before such awards may vest according to the Vesting Schedule. On February 4, 2017, 616,679 RSUs were awarded to the Company's employees, including officers, at an estimated value of $43.75 per share, based on the closing price on February 14, 2017. On April 20, 2016, 1,800 RSUs were awarded to each of the Company’s six non-employee directors at an estimated value of $38.00 per share based on the closing price on April 19, 2016. There were no restrictions on the non-employee directors’ RSUs granted on April 20, 2016. The following table summarizes the Company’s unvested restricted stock unit activity for the year ended December 31, 2016: * The intrinsic value is calculated using the closing price per share of $43.75, as reported by the New York Stock Exchange on December 31, 2016. The total intrinsic value of RSUs vested during the years ended December 31, 2016, 2015 and 2014 was $10.8 million, $10.3 million and $9.1 million respectively, based on the market value on the award date. No stock options were granted under the 2011 Plan in 2014, 2015 or 2016. The following table summarizes the Company’s stock option activity for the year ended December 31, 2016: * The intrinsic value represents the amount by which the fair market value of the underlying common stock exceeds the exercise price of the option, and is calculated using the closing price per share of $43.75, as reported by the New York Stock Exchange on December 31, 2016. The total intrinsic value of stock options exercised during each of the three years ended December 31, 2016, 2015 and 2014, was $3.1 million, $2.4 million and $0.8 million, respectively. As of January 1, 2015, there were 99 thousand unvested stock options with a weighted average grant-date fair value of $10.33 per share. These stock options vested in the first quarter of 2015 and, as of December 31, 2016, the Company had no unvested stock options. As of December 31, 2016, there was $24.8 million total unrecognized compensation cost related to unvested stock-based compensation arrangements under the 2011 Plan for awards made through February 2016 and those expected to be made through February 2017. The portion of this cost related to RSUs awarded through February 2016 is expected to be recognized over a weighted-average period of 1.7 years. The Company also maintains an employee stock bonus plan (the "Stock Bonus Plan"), which was adopted in 1994, amended on December 7, 2015, and approved by the Company's stockholders on April 20, 2016, whereby it awards shares of the Company's common stock to employees, who do not otherwise participate in any of the Company’s stock-based incentive plans and meet minimum service requirements as determined by the Committee. The number of shares awarded, as well as the period of service, is determined by the Committee. The Company committed to issuing 12 thousand shares for 2016 (3 thousand of which are expected to be settled in cash for the Company's foreign employees) and issued 10 thousand and 16 thousand shares for 2015 and 2014, respectively, which resulted in pre-tax compensation charges of $0.8 million, $0.7 million and $0.9 million for each of the years ended December 31, 2016, 2015 and 2014, respectively. These employees are also awarded cash bonuses, which are included in these charges, to compensate for their income taxes payable as a result of the stock bonuses. Shares have generally been issued under the Stock Bonus Plan following the year in which the respective employee reached his or her tenth anniversary of employment with the Company. 14. Segment Information The Company is organized into three reporting segments. The segments are defined by the regions where the Company’s products are manufactured, marketed and distributed to the Company’s customers. The three regional segments are the North America segment (comprising primarily the Company's operations in the United States and Canada), the Europe segment and the Asia/Pacific segment (comprising the Company’s operations in Asia, the South Pacific, South Africa and the Middle East). These segments are similar in several ways, including the types of materials used, the production processes, the distribution channels and the product applications. The Administrative & All Other column primarily includes expenses such as self-insured workers compensation claims for employees of the Company’s venting business, which was sold in 2010, stock-based compensation for certain members of management, interest expense, foreign exchange gains or losses and income tax expense, as well as revenues and expenses related to real estate activities, such as rental income and depreciation expense on the Company’s property in Vacaville, California, which the Company has leased to a third party for a 10-year term expiring in August 2020. The following table shows certain measurements used by management to assess the performance of the segments described above as of December 31, 2016, 2015 and 2014, respectively: * Sales to other segments are eliminated on consolidation. Cash collected by the Company’s United States subsidiaries is routinely transferred into the Company’s cash management accounts, and therefore has been included in the total assets of “Administrative & All Other.” Cash and short-term investment balances in “Administrative & All Other” were $137.4 million, $164.1 million and $167.4 million as of December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, the Company had $87.2 million, or 38.5%, of its cash and cash equivalents held outside the United States in accounts belonging to the Company’s various foreign operating entities. The majority of this balance is held in foreign currencies and could be subject to additional taxation if it were repatriated to the United States. The Company currently has no plans to repatriate cash and cash equivalents held outside the United States as the Company expects to use such funds for future international growth and acquisitions. The significant non-cash charges comprise compensation related to the awards under the Company's stock-based incentive plans and the Company's employee stock bonus plan. The Company’s measure of profit or loss for its reportable segments is income (loss) from operations. The reconciling amounts between consolidated income before tax and consolidated income from operations are net interest income, which is primarily attributed to “Administrative & All Other.” The following table shows the geographic distribution of the Company’s net sales and long-lived assets as of December 31, 2016, 2015 and 2014, respectively: Net sales and long-lived assets, net of intangible assets, are attributable to the country where the sales or manufacturing operations are located. Wood construction products include connectors, truss plates, fastening systems, fasteners and pre-fabricated shearwalls and are used for connecting and strengthening wood-based construction primarily in the residential construction market. Concrete construction products include adhesives, specialty chemicals, mechanical anchors, carbide drill bits, powder actuated tools and reinforcing fiber materials and are used for restoration, protection or strengthening concrete, masonry and steel construction in residential, industrial, commercial and infrastructure construction. The following table show the distribution of the Company’s net sales by product for the years ended December 31, 2016, 2015 and 2014, respectively: No customer accounted for as much as 10% of net sales for the years ended December 31, 2016, 2015 and 2014. 15. Subsequent Events Dividend Declaration At its meeting on January 30, 2017, the Company’s Board of Directors declared a cash dividend of $0.18 per share of our common stock, estimated to be $8.6 million in total. The record date for the dividend will be April 6, 2017, and it will be paid on April 27, 2017. Acquisition of Gbo Fastening Systems AB On January 3, 2017, the Company acquired Gbo Fastening Systems AB ("Gbo Fastening Systems"), a Sweden limited company, for approximately $10.2 million. Gbo Fastening Systems manufacturers and sells a complete line of CE-marked structural fasteners, unique fastener dimensioning software for wood construction applications currently sold mostly in northern and eastern Europe, which is expected to complement the Company's line of wood construction products in Europe. Acquisition of CG Visions, Inc. On January 9, 2017, the Company acquired CG Visions, Inc. ("CG Visions"), an Indiana company, for up to approximately $21.5 million, including an earn-out of $2.15 million, which is subject to meeting sales targets, and subject to specified holdback provisions and post-closing adjustment. CG Visions provides scalable technologies and services in building information modeling ("BIM") technologies, estimation tools and software solutions to a number of the top 100 mid-sized to large builders in the United States, which will complement and support the Company's sales in North America. Both acquisition transactions will be recorded as business combinations in accordance with the business acquisition method. Because the transactions were so recent, the Company is in the process of evaluating the information required to determine the preliminary purchase allocation for each acquisition. 16. Selected Quarterly Financial Data (Unaudited) The following table sets forth selected quarterly financial data for each of the quarters in 2016 and 2015, respectively: (in thousands, except per share amounts) Basic and diluted income per common share for each of the quarters presented above is based on the respective weighted average numbers of common and dilutive potential common shares outstanding for each quarter, and the sum of the quarters may not necessarily be equal to the full year basic and diluted net income per common share amounts. SCHEDULE II Simpson Manufacturing Co., Inc. and Subsidiaries VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 2016, 2015 and 2014
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Here's a summary of the financial statement:
Financial Performance:
- Net income: $2.3
- Revenue Recognition: Recognized when products are shipped, ownership transfers, and payment is assured
- Shipping terms: Primarily F.O.B. shipping point or destination point
Assets and Liabilities:
- Current assets: Decreased from $6.7
- Debt charges and liabilities noted
Taxation:
- Income taxes calculated using asset and liability approach
- Includes federal, state, and foreign taxes
- Deferred taxes considered for temporary differences
- Future tax benefits recognized if likely to be realized
Additional Notes:
- Taxes collected are reported on a net basis
- Foreign currency translation used for international operations
- Translation adjustments recorded in stockholders' equity
- Substantially completed liquidation of Asia sales offices by December 31
The statement provides an overview of the company's financial position, revenue recognition methods
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Claude
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CHEETAH ENTERPRISES, INC. Consolidated Financial Statements For the Year Ended November 30, 2016 and 2015: Index to the Audited Financial Statements Green & Company, CPAs A PCAOB Registered Accounting Firm ACCOUNTING FIRM The Board of Directors and Stockholders Cheetah Enterprises, Inc. We have audited the accompanying Consolidated Balance Sheet of Cheetah Enterprises, Inc. as of November 30, 2016 and 2015, and the related Consolidated Statement of Operations, Consolidated Statement of Stockholders’ Equity, and Consolidated Statement of Cash Flows for the years ended November 30, 2016 and 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cheetah Enterprises, Inc. as November 30, 2016 and 2015, and the results of its consolidated operations and its consolidated cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As shown in the accompanying consolidated financial statements, the Company has significant net losses and cash flow deficiencies. Those conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans regarding those matters are described in Note 3. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Green & Company, CPAs Green & Company, CPAs Tampa, Florida February 28th, 2017 10320 N 56th Street, Suite 330 Tampa, FL 33617 813.606.4388 CHEETAH ENTERPRISES, INC. Consolidated Balance Sheets See notes to the audited consolidated financial statements. CHEETAH ENTERPRISES, INC. Consolidated Statement of Operations See notes to the audited consolidated financial statements. CHEETAH ENTERPRISES, INC. Consolidated Statement of Stockholders' Equity For the Years Ended November 30, 2016 and 2015 See notes to the audited consolidated financial statement. CHEETAH ENTERPRISES, INC. Consolidated Statement of Cash Flows See notes to the audited consolidated financial statements. CHEETAH ENTERPRISES, INC. Notes to the Consolidated Financial Statements November 30, 2016 and 2015 NOTE 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS Cheetah Enterprises, Inc. (the “Company”) is a Nevada corporation incorporated on June 27, 2014. It is based in San Jose, Costa Rica. The Company incorporated a wholly-owned subsidiary, “Cheetah Autos S.A.” in Costa Rica on September 26, 2014. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America, and the Company’s fiscal year end is November 30. The Company buys and locally sells used automobiles in the Costa Rican market. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation These financial statements include the accounts of the Company and the wholly-owned subsidiary, Cheetah Autos S.A. All material intercompany balances and transactions have been eliminated. Basis of Presentation The Financial Statements and related disclosures have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The Financial Statements have been prepared using the accrual basis of accounting in accordance with Generally Accepted Accounting Principles (“GAAP”) of the United States. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. The estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from these good faith estimates and judgments. Cash and Cash Equivalents Cash and cash equivalents include cash in banks, money market funds, and certificates of term deposits with maturities of less than three months from inception, which are readily convertible to known amounts of cash and which, in the opinion of management, are subject to an insignificant risk of loss in value. The Company had $20,966 and $32,885 in cash and cash equivalents as of at November 30, 2016 and 2015, respectively. Inventory Inventory is stated at the lower of cost or market. Cost is determined using the first-in, first-out ("FIFO") method. As of November 30, 2016 and 2015, the Company had unsold inventory of $19,267 and $7,950, respectively. Net Loss Per Share of Common Stock The Company has adopted ASC Topic 260, “Earnings per Share,” (“EPS”) which requires presentation of basic EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation. In the accompanying financial statements, basic earnings (loss) per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period. The following table sets forth the computation of basic earnings per share, for the year ended November 30, 2016 and 2015: The Company has no potentially dilutive securities, such as options or warrants, currently issued and outstanding. Concentrations of Credit Risk The Company’s financial instruments that are exposed to concentrations of credit risk primarily consist of its cash and cash equivalents and related party payables that it will likely incur in the near future. The Company places its cash and cash equivalents with financial institutions of high credit worthiness. At times, its cash and cash equivalents with a particular financial institution may exceed any applicable government insurance limits. The Company’s management plans to assess the financial strength and credit worthiness of any parties to which it extends funds, and as such, it believes that any associated credit risk exposures are limited. Financial Instruments The Company follows ASC 820, “Fair Value Measurements and Disclosures,” which defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below: Level 1 Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities. Level 2 Level 2 applies to assets or liabilities for which there are inputs other than quoted prices that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data. Level 3 Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities. The Company's financial instruments consist principally of cash, inventory, prepaid and other current assets, and accounts payable. Pursuant to ASC 820, the fair value of these financial instruments are determined based on "Level 1" inputs, which consist of quoted prices in active markets for identical assets. The Company believes that the recorded values of all of the Company's other financial instruments approximate their current fair values because of their nature and respective maturity dates or durations. Foreign Currency Translations The Company’s functional and reporting currency is the U.S. dollar. Our subsidiary’s functional currency is the Costa Rican Colon. All transactions initiated in Costa Rican Colones are translated into U.S. dollars in accordance with ASC 830-30, “Translation of Financial Statements,” as follows: (i) Monetary assets and liabilities at the rate of exchange in effect at the balance sheet date. (ii) Equity at historical rates. (iii) Revenue and expense items at the average rate of exchange prevailing during the period. Adjustments arising from such translations are deferred until realization and are included as a separate component of stockholders’ equity as a component of comprehensive income or loss. Therefore, translation adjustments are not included in determining net income (loss) but reported as other comprehensive income. For foreign currency transactions, the Company translates these amounts to the Company’s functional currency at the exchange rate effective on the invoice date. If the exchange rate changes between the time of purchase and the time actual payment is made, a foreign exchange transaction gain or loss results which is included in determining net income for the period. No significant realized exchange gains or losses were recorded during the year ended November 30, 2016 and 2015. Related Parties The Company follows ASC 850, “Related Party Disclosures,” for the identification of related parties and disclosure of related party transactions. See note 6. Commitments and Contingencies The Company follows ASC 450-20, “Loss Contingencies,” to report accounting for contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. There were no commitments or contingencies as of November 30, 2016. Revenue Recognition The Company will recognize revenue from the sale of products and services in accordance with ASC 605, “Revenue Recognition.” The Company will recognize revenue only when all of the following criteria have been met: i) Persuasive evidence for an agreement exists; ii) Service has been provided; iii) The fee is fixed or determinable; and, iv) Collection is reasonably assured. Recent Accounting Pronouncements In January 2017, the FASB has issued Accounting Standards Update (ASU) No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” These amendments eliminate Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Effective for public business entities that are a SEC filers for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. ASU 2017-04 should be adopted on a prospective basis. In December 2016, the FASB has issued Accounting Standards Update (ASU) No. 2016-20, “Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers.” The amendments affect narrow aspects of the guidance issued in ASU 2014-09 including Loan Guarantee Fees, Contract Costs, Provisions for Losses on Construction-Type and Production-Type Contracts, Disclosure of Remaining Performance Obligations, Disclosure of Prior Period Performance Obligations, Contract Modifications, Contract Asset vs. Receivable, Refund Liability, Advertising Costs, Fixed Odds Wagering Contracts in the Casino Industry, and Costs Capitalized for Advisors to Private Funds and Public Funds. The effective date and transition requirements for the amendments are the same as the effective date and transition requirements for FASB Accounting Standards Codification Topic 606. Public entities should apply Topic 606 (and related amendments) for annual reporting periods beginning after December 15, 2017, including interim reporting periods therein. The Company is currently evaluating the potential impact that the adoption of this ASU may have on its financial statements. Management has considered all other recent accounting pronouncements issued since the last audit of our financial statements. The Company's management believes that these recent pronouncements will not have a material effect on the Company's financial statements. NOTE 3 - GOING CONCERN The accompanying financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the liquidation of liabilities in the normal course of business. As of November 30, 2016, the Company has a loss from operations of $35,212, an accumulated deficit of $66,722 and has earned minimal revenues since inception. The Company intends to fund operations through equity financing arrangements, which may be insufficient to fund its capital expenditures, working capital and other cash requirements for the year ended November 30, 2017. The ability of the Company to emerge from the development stage is dependent upon, among other things, obtaining additional financing to continue operations, and development of its business plan. In response to these problems, management intends to raise additional funds through public or private placement offerings and through loans from officers and directors. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. NOTE 4 - EQUITY Preferred Stock The Company has authorized 10,000,000 preferred shares with a par value of $0.001 per share. The Board of Directors are authorized to divide the authorized shares of Preferred Stock into one or more series, each of which shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. Common Stock The Company has authorized 125,000,000 common shares with a par value of $0.001 per share. Each common share entitles the holder to one vote, in person or proxy, on any matter on which action of the stockholders of the corporation is sought. During the year ended November 30, 2016, the Company issued to unaffiliated investors, 1,447,207 shares of common stock at $0.01 per share for $14,473. Since inception (June 27, 2014) to November 30, 2015, the Company has issued a total of 19,018,843 common shares for cash of $56,338, as follows: · On July 7, 2014, the Company issued to an officer and director, 12,500,000 shares of common stock at $0.001 per share for $12,500. · On October 23, 2014, the Company issued to an officer and director, 4,270,000 shares of common stock at $0.005 per share for $21,350. · During October and November, 2015, the Company issued to unaffiliated investors, 2,248,843 shares of common stock at $0.01 per share for $22,488. As of November 30, 2016 and 2015, 20,466,050 and 19,018,843 shares of common stock were issued and outstanding, respectively. NOTE 5 - PROVISION FOR INCOME TAXES The Company provides for income taxes under ASC 740, “Income Taxes.” Under the asset and liability method of ASC 740, deferred tax assets and liabilities are recorded based on the differences between the financial statement and tax basis of assets and liabilities and the tax rates in effect when these differences are expected to reverse. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that the Company will not realize tax assets through future operations. The provision for income taxes differs from the amounts which would be provided by applying the statutory federal income tax rate of 34% to the net loss before provision for income taxes for the following reasons: Net deferred tax assets consist of the following components as of: Due to the change in ownership provisions of the Income Tax laws of United States of America, net operating loss carry forwards of approximately $66,722 for federal income tax reporting purposes are subject to annual limitations. When a change in ownership occurs, net operating loss carry forwards may be limited as to use in future years. Net operating loss carry forwards begin to expire in 2034. Income taxes for November 30, 2016 and 2015 remain subject to examination. NOTE 6 - RELATED PARTY TRANSACTIONS Other The controlling shareholder has pledged his support to fund continuing operations during the development stage; however there is no written commitment to this effect. The Company is dependent upon the continued support. The officer and director of the Company may be involved in other business activities and may, in the future, become involved in other business opportunities that become available. He may face a conflict in selecting between the Company and other business interests. The Company has not formulated a policy for the resolution of such conflicts. The Company does not have employment contracts with its two key employees, the controlling shareholder, and the officers and director of the Company. During the year ended November 30, 2016 and 2015 the Company paid $1,200 and $1,693 to officers for commissions on the sale of vehicles. NOTE 7 - COMMITMENTS AND CONTINGENCIES The Company has no commitments or contingencies as of November 30, 2016 and 2015. From time to time the Company may become a party to litigation matters involving claims against the Company. Management believes that it is adequately insured for its operations and there are no current matters that would have a material effect on the Company’s financial position or results of operations. NOTE 8 - SUBSEQUENT EVENTS Management has evaluated subsequent events through the date these financial statements were available to be issued. Based on our evaluation no additional events have occurred that require disclosure.
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Based on the provided text, here's a summary of the financial statement:
Key Financial Highlights:
- The company is experiencing financial challenges, including:
* Losses
* Cash flow deficiencies
* Substantial doubt about its ability to continue operations
Financial Position:
- Cash and Cash Equivalents: $20,966
- Includes cash in banks, money market funds, and short-term deposits
- Management considers these assets to have minimal risk of value loss
Accounting Considerations:
- Financial estimates and judgments may impact reported revenues and expenses
- Actual results could differ from management's estimates
- Potential contingent assets and liabilities are noted
Management Response:
- Specific plans to address financial challenges are detailed in Note 3 of the full financial statement
Overall, the statement suggests the company is in a precarious financial position and is working on strategies to improve its financial stability.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Documents Page Report of Management on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm Statements of Financial Condition as of December 31, 2016 and 2015 Schedule of Investments as of December 31, 2016 Schedule of Investments as of December 31, 2015 Statements of Income and Expenses for the Years Ended December 31, 2016, 2015 and 2014 Statement of Changes in Shareholders’ Equity for the Year Ended December 31, 2016 Statement of Changes in Shareholders’ Equity for the Year Ended December 31, 2015 Statement of Changes in Shareholders’ Equity for the Year Ended December 31, 2014 Statements of Cash Flows for the Years Ended December 31, 2016, 2015 and 2014 Notes to Financial Statements Report of Management on Internal Control Over Financial Reporting Management of Invesco PowerShares Capital Management LLC, as managing owner (the “Managing Owner”) of PowerShares DB Oil Fund (the “Fund”), is responsible for establishing and maintaining adequate internal control over financial reporting, as defined under Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Fund; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Fund’s receipts and expenditures are being made only in accordance with appropriate authorizations of management; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Fund’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements, errors or fraud. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. We, Daniel Draper, Principal Executive Officer, and Steven Hill, Principal Financial and Accounting Officer, Investment Pools, of the Managing Owner, assessed the effectiveness of the Fund’s internal control over financial reporting as of December 31, 2016. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework (2013). The assessment included an evaluation of the design of the Fund’s internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting. Based on our assessment and those criteria, we have concluded that the Fund maintained effective internal control over financial reporting as of December 31, 2016. The Fund’s independent registered public accounting firm, PricewaterhouseCoopers LLP, has audited the Fund’s internal control over financial reporting as of December 31, 2016, as stated in their report on page 39 of the Fund’s Annual Report on Form 10-K. February 27, 2017 Report of Independent Registered Public Accounting Firm To the Board of Managers of PowerShares DB Multi-Sector Commodity Trust and the Shareholders of PowerShares DB Oil Fund: In our opinion, the accompanying statements of financial condition, including the schedules of investments, and the related statements of income and expenses, of changes in shareholders’ equity and of cash flows, present fairly, in all material respects, the financial position of PowerShares DB Oil Fund (a series of PowerShares DB Multi-Sector Commodity Trust, hereafter referred to as the “Fund”), at December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Fund maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Fund's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Annual Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Fund's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A fund’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A fund’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the fund; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the fund are being made only in accordance with authorizations of management of the fund; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the fund’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP Chicago, Illinois February 27, 2017 PowerShares DB Oil Fund Statements of Financial Condition December 31, 2016 and 2015 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Schedule of Investments December 31, 2016 (a) Security may be traded on a discount basis. The interest rate shown represents the discount rate at the most recent auction date of the security prior to period end. (b) United States Treasury Obligations of $54,873,500 are on deposit with the Commodity Broker and held as maintenance margin for open futures contracts. (c) The security and the Fund are advised by wholly-owned subsidiaries of Invesco Ltd. and are therefore considered to be affiliated. The rate shown is the 7-day SEC standardized yield as of December 31, 2016. (d) Unrealized appreciation/ (depreciation) is presented above, net by contract. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Schedule of Investments December 31, 2015 (a) Security may be traded on a discount basis. The interest rate shown represents the discount rate at the most recent auction date of the security prior to year end. (b) United States Treasury Obligations of $95,990,400 are on deposit with the Commodity Broker and held as maintenance margin for open futures contracts. (c) Unrealized appreciation/ (depreciation) is presented above, net by contract. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Statements of Income and Expenses For the Years Ended December 31, 2016, 2015 and 2014 (a) Interest Expense for the years ended December 31, 2016 and 2015 represents interest expense on overdraft balances. These amounts are included in Interest Income for the year ended December 31, 2014. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Statement of Changes in Shareholders’ Equity For the Year Ended December 31, 2016 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Statement of Changes in Shareholders’ Equity For the Year Ended December 31, 2015 See accompanying Notes to Financial Statements which are an integral part of the financial statements. . PowerShares DB Oil Fund Statement of Changes in Shareholders’ Equity For the Year Ended December 31, 2014 See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Statements of Cash Flows For the Years Ended December 31, 2016, 2015 and 2014 (a) Cash at December 31, 2014 and prior reflects cash held by the Predecessor Commodity Broker. (b) Cash at December 31, 2016 and 2015 reflects cash held by the Custodian. See accompanying Notes to Financial Statements which are an integral part of the financial statements. PowerShares DB Oil Fund Notes to Financial Statements December 31, 2016 (1) Background On October 24, 2014, DB Commodity Services LLC, a Delaware limited liability company (“DBCS”), DB U.S. Financial Markets Holding Corporation (“DBUSH”) and Invesco PowerShares Capital Management LLC (“Invesco”) entered into an Asset Purchase Agreement (the “Agreement”). DBCS is a wholly-owned subsidiary of DBUSH. DBCS agreed to transfer and sell to Invesco all of DBCS’ interest in the PowerShares DB Oil Fund (the “Fund”), a separate series of PowerShares DB Multi-Sector Commodity Trust (the “Trust”), a Delaware statutory trust organized in seven separate series, including the sole and exclusive power to direct the business and affairs of the Trust and the Fund, as well as certain other assets pertaining to the management of the Trust and the Fund, pursuant to the terms and conditions of the Agreement (the “Transaction”). The Transaction was consummated on February 23, 2015 (the “Closing Date”). Invesco now serves as the managing owner (the “Managing Owner”), commodity pool operator and commodity trading advisor of the Trust and the Fund, in replacement of DBCS (the “Predecessor Managing Owner”). (2) Organization The Fund is a separate series of the Trust. The Trust is a Delaware statutory trust organized in seven separate series and was formed on August 3, 2006. The Predecessor Managing Owner seeded the Fund with a capital contribution of $1,000 in exchange for 40 General Shares of the Fund. The General Shares were sold to the Managing Owner by the Predecessor Managing Owner pursuant to the terms of the Agreement. The fiscal year end of the Fund is December 31st. The term of the Fund is perpetual (unless terminated earlier in certain circumstances) as provided for in the Fifth Amended and Restated Declaration of Trust and Trust Agreement of the Trust, as amended (the “Trust Agreement”). The Fund has an unlimited number of shares authorized for issuance. The Fund offers common units of beneficial interest (the “Shares”) only to certain eligible financial institutions (the “Authorized Participants”) in one or more blocks of 200,000 Shares, called a Basket. The Fund commenced investment operations on January 3, 2007. The Fund commenced trading on the American Stock Exchange (which became the NYSE Alternext US LLC (the “NYSE Alternext”)) on January 5, 2007 and, as of November 25, 2008, is listed on the NYSE Arca, Inc. (the “NYSE Arca”). This Annual Report (the “Report”) covers the years ended December 31, 2016, 2015 and 2014(herein referred to as the “Year Ended December 31, 2016” ,the “Year Ended December 31, 2015” and the “Year Ended December 31, 2014”, respectively). The Fund’s performance information from inception up to and excluding the Closing Date is a reflection of the performance associated with the Predecessor Managing Owner. The Managing Owner has served as managing owner of the Fund since the Closing Date, and the Fund’s performance information since the Closing Date is a reflection of the performance associated with the Managing Owner. Past performance of the Fund is not necessarily indicative of future performance. (3) Fund Investment Overview The Fund seeks to track changes, whether positive or negative, in the level of the DBIQ Optimum Yield Crude Oil Index Excess Return™ (the “DBIQ-OY CL ER™”, or the “Index”) over time, plus the excess, if any, of the sum of the Fund’s interest income from its holdings of United States Treasury Obligations (“Treasury Income”) and dividends from its holdings in money market mutual funds (affiliated or otherwise) (“Money Market Income”) over the expenses of the Fund. Additionally, the Fund may also gain an exposure to United States Treasury Obligations through an investment in exchange-traded funds (affiliated or otherwise) that track indexes that measure the performance of United States Treasury Obligations with a maximum remaining maturity of up to 12 months (“T-Bill ETFs”), and the Fund may receive dividends or distributions of capital gains from such investment in T-Bill ETFs (“T-Bill ETF Income”). For the avoidance of doubt, the Fund invests in futures contracts in an attempt to track its Index. The Fund holds United States Treasury Obligations, money market mutual funds and may, in the future, hold T-Bill ETFs for margin and/or cash management purposes only. The Index is intended to reflect the change in market value of the crude oil sector. The single commodity comprising the Index is Light Sweet Crude Oil (WTI) (the “Index Commodity”). The Commodity Futures Trading Commission (the “CFTC”) and/or commodity exchanges, as applicable, impose position limits on market participants trading in the commodity included in the Index. The Index is comprised of futures contracts on the Index Commodity that expire in a specific month and trade on a specific exchange (the “Index Contracts”). If the Managing Owner determines in its commercially reasonable judgment that it has become impracticable or inefficient for any reason for the Fund to gain full or partial exposure to the Index Commodity by investing in the Index Contract, the Fund may invest in a futures contract referencing the Index Commodity other than the specific contract that comprises the Index or, in the alternative, invest in other futures contracts not based on the Index Commodity if, in the commercially reasonable judgment of the Managing Owner, such futures contracts tend to exhibit trading prices that correlate with a futures contract that comprises the Index. Should the Fund approach or reach position limits with respect to certain futures contracts comprising the Index, the Fund will commence investing in other futures contracts based on the commodity that comprises the Fund’s Index and in futures contracts based on commodities other than the commodity that comprises the Fund’s Index. (4) Service Providers and Related Party Agreements The Trustee Under the Trust Agreement, Wilmington Trust Company, the trustee of the Trust and the Fund (the “Trustee”), has delegated to the Managing Owner the exclusive management and control of all aspects of the business of the Trust and the Fund. The Trustee will have no duty or liability to supervise or monitor the performance of the Managing Owner, nor will the Trustee have any liability for the acts or omissions of the Managing Owner. The Managing Owner The Managing Owner serves as the Fund’s commodity pool operator, commodity trading advisor and managing owner. The Fund pays the Managing Owner a management fee, monthly in arrears, in an amount equal to 0.75% per annum of the daily net asset value of the Fund (the “Management Fee”). From inception up to and excluding the Closing Date, all Management Fees were payable to the Predecessor Managing Owner. The Managing Owner has served as managing owner of the Fund since the Closing Date and all Management Fee accruals since the Closing Date have been paid to the Managing Owner. The Fund may, for cash management purposes, invest in money market mutual funds that are managed by affiliates of the Managing Owner. The indirect portion of the management fee that the Fund may incur through such investment is in addition to the Management Fee paid to the Managing Owner. The Managing Owner has contractually agreed to waive the fees that it receives in an amount equal to the indirect management fees that the Fund incurs through its investments in affiliated money market mutual funds through June 30, 2018. The Fund may invest in affiliated T-Bill ETFs. The Managing Owner expects to enter into a similar agreement with respect to any indirect management fees incurred by the Fund through such investment in affiliated T-Bill ETFs, if any. The Managing Owner waived fees of $14,569 for the Year Ended December 31, 2016. The Commodity Broker Effective as of the Closing Date, Morgan Stanley & Co. LLC, a Delaware limited liability company, serves as the Fund’s futures clearing broker (the “Commodity Broker”). Deutsche Bank Securities Inc. (“DBSI”), a Delaware corporation, served as the Fund’s futures clearing broker up to and excluding the Closing Date (the “Predecessor Commodity Broker”). DBSI is an indirect wholly-owned subsidiary of Deutsche Bank AG and is an affiliate of the Predecessor Managing Owner. A variety of executing brokers execute futures transactions on behalf of the Fund. Such executing brokers give-up all such transactions to the Commodity Broker. In its capacity as clearing broker, the Commodity Broker may execute or receive transactions executed by others and clears all of the Fund’s futures transactions and performs certain administrative and custodial services for the Fund. The Commodity Broker is responsible, among other things, for providing periodic accountings of all dealings and actions taken by the Trust on behalf of the Fund during the reporting period, together with an accounting of all securities, cash or other indebtedness or obligations held by it or its nominees for or on behalf of the Fund. For the avoidance of doubt, from inception up to and excluding the Closing Date, commission payments were paid to the Predecessor Commodity Broker. The Commodity Broker has served as the Fund’s futures clearing broker since the Closing Date and all commission accruals since the Closing Date have been paid to the Commodity Broker. The Administrator, Custodian and Transfer Agent The Bank of New York Mellon (the “Administrator” and “Custodian”) is the administrator, custodian and transfer agent of the Fund. The Fund and the Administrator have entered into separate administrative, custodian, transfer agency and service agreements (collectively referred to as the “Administration Agreement”). Pursuant to the Administration Agreement, the Administrator performs or supervises the performance of services necessary for the operation and administration of the Fund (other than making investment decisions), including receiving and processing orders from Authorized Participants to create and redeem Baskets, net asset value calculations, accounting and other fund administrative services. The Administrator maintains certain financial books and records, including: Basket creation and redemption books and records, fund accounting records, ledgers with respect to assets, liabilities, capital, income and expenses, the registrar, transfer journals and related details, and trading and related documents received from the Commodity Broker. The Managing Owner pays the Administrator fees for its services out of the Management Fee. As of December 31, 2014, the Fund held $68,613,950 of cash and $280,990,311 of United States Treasury Obligations at the Predecessor Commodity Broker. In conjunction with the Transaction, during the three-day period from February 24, 2015 to February 26, 2015, the Fund transferred $21,627,202 of cash and $470,990,982 of United States Treasury Obligations from the Predecessor Commodity Broker to the Custodian. Additionally, during that same three-day period, the Fund transferred all of its open positions of commodity futures contracts from the Predecessor Commodity Broker to the Commodity Broker and accordingly, $3,341,590 of futures variation margin was credited to the Commodity Broker account. $67,993,200 of United States Treasury Obligations was also transferred from the Custodian to the Commodity Broker to satisfy maintenance margin requirements. Effective February 26, 2015, the Managing Owner began transferring cash daily from the Custodian to the Commodity Broker to satisfy the previous day’s variation margin on open futures contracts. The Distributor Effective June 20, 2016, Invesco Distributors, Inc. (the “Distributor”) became distributor and began providing certain distribution services to the Fund. Pursuant to the Distribution Services Agreement among the Managing Owner, the Fund and the Distributor, the Distributor assists the Managing Owner and the Administrator with certain functions and duties relating to distribution and marketing services to the Fund including reviewing and approving marketing materials. Prior to June 20, 2016, ALPS Distributors, Inc. provided distribution services to the Fund. The Managing Owner pays the Distributor a distribution fee out of the Management Fee. Index Sponsor Effective as of the Closing Date, the Managing Owner, on behalf of the Fund, has appointed Deutsche Bank Securities Inc. to serve as the index sponsor (the “Index Sponsor”). Prior to the Closing Date, the index sponsor was Deutsche Bank AG London. The Index Sponsor calculates and publishes the daily index levels and the indicative intraday index levels. Additionally, the Index Sponsor also calculates the indicative value per Share of the Fund throughout each business day. The Managing Owner pays the Index Sponsor a licensing fee and an index services fee out of the Management Fee for performing its duties. Marketing Agent Effective as of the Closing Date, the Managing Owner, on behalf of the Fund, has appointed Deutsche Bank Securities Inc. as the marketing agent (the “Marketing Agent”) to assist the Managing Owner by providing support to educate institutional investors about the DBIQ indices and to complete governmental or institutional due diligence questionnaires or requests for proposals related to the DBIQ indices. The Managing Owner pays the Marketing Agent a marketing services fee out of the Management Fee. The Marketing Agent will not open or maintain customer accounts or handle orders for the Fund. The Marketing Agent has no responsibility for the performance of the Fund or the decisions made or actions taken by the Managing Owner. (5) Summary of Significant Accounting Policies (a) Basis of Presentation The financial statements of the Fund have been prepared using U.S. generally accepted accounting principles (“U.S. GAAP”). The Fund has determined that it meets the definition of an investment company and has prepared the financial statements in conformity with U.S. GAAP for investment companies in conformity with the accounting and reporting guidance of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 946-Investment Companies. (b) Use of Estimates The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities during the reporting period of the financial statements and accompanying notes. Actual results could differ from those estimates. (c) Financial Instruments and Fair Value Investment transactions are recorded in the Statements of Financial Condition on a trade date basis at fair value with changes in fair value recognized in earnings in each period. U.S. GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, under current market conditions. U.S. GAAP establishes a hierarchy that prioritizes the inputs to valuation methods, giving the highest priority to readily available unadjusted quoted prices in an active market for identical assets (Level 1) and the lowest priority to significant unobservable inputs (Level 3), generally when market prices are not readily available or are unreliable. Based on the valuation inputs, the securities or other investments are tiered into one of three levels. Changes in valuation methods or market conditions may result in transfers in or out of an investment’s assigned level: Level 1-Prices are determined using quoted prices in an active market for identical assets. Level 2-Prices are determined using other significant observable inputs. Observable inputs are inputs that other market participants may use in pricing a security. These may include quoted prices for similar securities, interest rates, prepayment speeds, credit risk, yield curves, loss severities, default rates, discount rates, volatilities and others. Level 3-Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment at the end of the period), unobservable inputs may be used. Unobservable inputs reflect the Fund’s own assumptions about the factors market participants would use in determining fair value of the securities or instruments and would be based on the best available information. United States Treasury Obligations are fair valued using an evaluated quote provided by an independent pricing service. Evaluated quotes provided by the pricing service may be determined without exclusive reliance on quoted prices, and may reflect appropriate factors such as developments related to specific securities, yield, quality, type of issue, coupon rate, maturity, individual trading characteristics and other market data. All debt obligations involve some risk of default with respect to interest and/or principal payments. Futures contracts are valued at the final settlement price set by an exchange on which they are principally traded. Investments in open-end and closed-end registered investment companies that do not trade on an exchange are valued at the end of day NAV per share. Investments in open-end and closed-end registered investment companies that trade on an exchange are valued at the last sales price or official closing price as of the close of the customary trading session on the exchange where the security is principally traded. When market closing prices are not available, the Managing Owner may value an asset of the Fund pursuant to policies the Managing Owner has adopted, which are consistent with normal industry standards. The levels assigned to the securities valuations may not be an indication of the risk or liquidity associated with investing in those securities. Because of the inherent uncertainties of valuation, the values reflected in the financial statements may materially differ from the value received upon actual sale of those investments. The following is a summary of the tiered valuation input levels as of December 31, 2016: (a) Unrealized appreciation (depreciation). The following is a summary of the tiered valuation input levels as of December 31, 2015: (a) Unrealized appreciation (depreciation). (d) Deposits with Commodity Broker and Custodian The Fund deposits cash and United States Treasury Obligations with its Commodity Broker subject to CFTC regulations and various exchange and broker requirements. The combination of the Fund’s deposits with its Commodity Broker of cash and United States Treasury Obligations and the unrealized profit or loss on open futures contracts represents the Fund’s overall equity in its broker trading account. To meet the Fund’s maintenance margin requirements, the Fund holds United States Treasury Obligations. The Fund transfers cash to the Commodity Broker to satisfy variation margin requirements. The Fund earns interest on any excess cash deposited with the Commodity Broker and incurs interest expense on any deficit balance with the Commodity Broker. The Fund’s remaining cash, United States Treasury Obligations and money market mutual fund holdings are on deposit with its Custodian. The Fund is permitted to temporarily carry a negative or overdrawn balance in its account with the Custodian. Such balances, if any at period-end, are shown on the Statement of Financial Condition under the payable caption Due to Custodian. The Fund defines cash and cash equivalents to be cash and other highly liquid investments, with original maturities of three months or less when purchased. (e) Investment Transactions and Investment Income Investment transactions are accounted for on a trade date basis. Realized gains (losses) from the sale or disposition of securities or derivatives are determined on a specific identification basis and recognized in the Statements of Income and Expenses in the period in which the contract is closed or the sale or disposition occurs, respectively. Interest income on United States Treasury Obligations is recognized on an accrual basis when earned. Premiums and discounts are amortized or accreted over the life of the United States Treasury Obligations. Dividend income (net of withholding tax, if any) is recorded on the ex-dividend date. (f) Receivable/ (Payable) for Shares Issued and Redeemed On any business day, an Authorized Participant may place an order to create or redeem Shares of the Fund. Cash settlement occurs at the creation order settlement date or the redemption order settlement date as discussed in Note 7. (g) Cash Held by Commodity Broker The Fund’s arrangement with the Commodity Broker requires the Fund to meet its variation margin requirement related to the price movements on futures contracts held by the Fund by maintaining cash on deposit with the Commodity Broker. The Fund assesses its variation margin requirements on a daily basis by recalculating the change in value of the futures contracts based on price movements. Subsequent cash payments are made or received by the Fund each business day depending on whether unrealized gains or losses are incurred on the futures contracts. Effective February 24, 2015, only the current day’s variation margin receivable or payable is disclosed as an asset or liability on the Statements of Financial Condition. (h) Income Taxes The Fund is classified as a partnership for U.S. federal income tax purposes. Accordingly, the Fund will generally not incur U.S. federal income taxes. No provision for federal, state, and local income taxes has been made in the accompanying financial statements, as investors are individually liable for income taxes, if any, on their allocable share of the Fund’s income, gain, loss, deductions and other items. The Managing Owner has reviewed all of the Fund’s open tax years and major jurisdictions and concluded that there is no tax liability resulting from unrecognized tax benefits relating to uncertain tax positions taken or expected to be taken in future tax returns. The Fund is also not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly change in the next twelve months. On an ongoing basis, the Managing Owner will monitor the Fund’s tax positions taken under the interpretation (and consult with its tax counsel from time to time when appropriate) to determine if adjustments to conclusions are necessary based on factors including, but not limited to, on-going analysis of tax law, regulation, and interpretations thereof. The major tax jurisdiction for the Fund and the earliest tax year subject to examination: United States, 2013. (i) Commodity Futures Contracts The Fund utilizes derivative instruments to achieve its investment objective. A futures contract is an agreement between counterparties to purchase or sell a specified underlying security or index for a specified price at a future date. All of the Fund’s commodity futures contracts are held and used for trading purposes. During the period the futures contracts are open, changes in the value of the contracts are recognized as unrealized gains or losses by recalculating the value of the contracts on a daily basis. Subsequent or variation margin payments are received or made depending upon whether unrealized gains or losses are incurred. These amounts are reflected as a receivable or payable on the Statements of Financial Condition. When the contracts are closed or expire, the Fund recognizes a realized gain or loss equal to the difference between the proceeds from, or cost of, the closing transaction and the Fund’s basis in the contract. Realized gains (losses) and changes in unrealized appreciation (depreciation) on open positions are determined on a specific identification basis and recognized in the Statements of Income and Expenses in the period in which the contract is closed or the changes occur, respectively. The Fair Value of Derivative Instruments is as follows: (a) Includes cumulative appreciation (depreciation) of commodity futures contracts. Only the current day’s variation margin receivable (payable) is reported in the December 31, 2016 and 2015 Statements of Financial Condition. The Effect of Derivative Instruments on the Statements of Income and Expenses is as follows: The table below summarizes the average monthly notional value of futures contracts outstanding during the period: The brokerage agreement with the Commodity Broker provides for the net settlement of all financial instruments covered by the agreement in the event of default or termination of any one contract. The Managing Owner will utilize any excess cash held at the Commodity Broker to offset any realized losses incurred in the commodity futures contracts, if available. To the extent that any excess cash held at the Commodity Broker is not adequate to cover any realized losses, a portion of the United States Treasury Obligations on deposit with the Commodity Broker will be sold to make additional cash available. For financial reporting purposes, the Fund offsets financial assets and financial liabilities that are subject to netting arrangements. In order for an arrangement to be eligible for netting, the Fund must have a basis to conclude that such netting arrangements are legally enforceable. The following table presents derivative instruments that are either subject to an enforceable netting agreement or offset by collateral arrangements as of December 31, 2016, net by contract: The following table presents derivative instruments that are either subject to an enforceable netting agreement or offset by collateral arrangements as of December 31, 2015, net by contract: (a) As of December 31, 2016 and 2015, a portion of the Fund’s U.S. Treasury Obligations were required to be deposited as maintenance margin in support of the Fund’s futures positions. (j) Brokerage Commissions and Fees The Fund incurs all brokerage commissions, including applicable exchange fees, National Futures Association (“NFA”) fees, give-up fees, pit brokerage fees and other transaction related fees and expenses charged in connection with trading activities by the Commodity Broker. These costs are recorded as Brokerage Commissions and Fees in the Statements of Income and Expenses. The Commodity Broker’s brokerage commissions and trading fees are determined on a contract-by-contract basis. On average, total charges paid to the Commodity Broker and the Predecessor Commodity Broker, as applicable, were less than $6.00, $6.00 and $10.00 per round-turn trade during the Years Ended December 31, 2016, 2015 and 2014, respectively. (k) Routine Operational, Administrative and Other Ordinary Expenses After the Closing Date, the Managing Owner assumed all routine operational, administrative and other ordinary expenses of the Fund, including, but not limited to, computer services, the fees and expenses of the Trustee, legal and accounting fees and expenses, tax preparation expenses, filing fees and printing, mailing and duplication costs. Prior to the Closing Date, the Predecessor Managing Owner assumed all routine operational, administrative and other ordinary expenses of the Fund. Accordingly, such expenses are not reflected in the Statements of Income and Expenses of the Fund. For the avoidance of doubt, the Fund does not reimburse the Managing Owner for the routine operational, administrative and other ordinary expenses of the Fund. (l) Non-Recurring Fees and Expenses The Fund pays all non-recurring and unusual fees and expenses (referred to as extraordinary fees and expenses in the Trust Agreement), if any, of itself, as determined by the Managing Owner. Non-recurring and unusual fees and expenses are fees and expenses which are non-recurring and unusual in nature, such as legal claims and liabilities, litigation costs or indemnification or other unanticipated expenses. Such non-recurring and unusual fees and expenses, by their nature, are unpredictable in terms of timing and amount. For the Years Ended December 31, 2016, 2015 and 2014, the Fund did not incur such expenses. (6) Financial Instrument Risk In the normal course of its business, the Fund is a party to financial instruments with off-balance sheet risk. The term “off-balance sheet risk” refers to an unrecorded potential liability that, even though it does not appear on the balance sheet, may result in a future obligation or loss in excess of the amounts shown on the Statements of Financial Condition. The financial instruments used by the Fund are commodity futures contracts, whose values are based upon an underlying asset and generally represent future commitments that have a reasonable possibility of being settled in cash or through physical delivery. The financial instruments are traded on an exchange and are standardized contracts. Market risk is the potential for changes in the value of the financial instruments traded by the Fund due to market changes, including fluctuations in commodity prices. In entering into these futures contracts, there exists a market risk that such futures contracts may be significantly influenced by adverse market conditions, resulting in such futures contracts being less valuable. If the markets should move against all of the futures contracts at the same time, the Fund could experience substantial losses. Credit risk is the possibility that a loss may occur due to the failure of the Commodity Broker and/or clearinghouse to perform according to the terms of a futures contract. Credit risk with respect to exchange-traded instruments is reduced to the extent that an exchange or clearing organization acts as a counterparty to the transactions. The Commodity Broker, when acting as the Fund’s futures commission merchant in accepting orders for the purchase or sale of domestic futures contracts, is required by CFTC regulations to separately account for and segregate as belonging to the Fund all assets of the Fund relating to domestic futures trading and the Commodity Broker is not allowed to commingle such assets with other assets of the Commodity Broker. In addition, CFTC regulations also require the Commodity Broker to hold in a secure account assets of the Fund related to foreign futures trading. The Fund’s risk of loss in the event of counterparty default is typically limited to the amounts recognized in the Statements of Financial Condition and not represented by the futures contract or notional amounts of the instruments. The Fund has not utilized, nor does it expect to utilize in the future, special purpose entities to facilitate off-balance sheet financing arrangements and has no loan guarantee arrangements or off-balance sheet arrangements of any kind, other than agreements entered into in the normal course of business noted above. (7) Share Purchases and Redemptions (a) Purchases On any business day, an Authorized Participant may place an order with the Administrator who serves as the Fund’s transfer agent (“Transfer Agent”) to create one or more Baskets. For purposes of processing both creation and redemption orders, a “business day” means any day other than a day when banks in New York City are required or permitted to be closed. Creation orders must be placed by 10:00 a.m., Eastern Time. The day on which the Transfer Agent receives a valid creation order is the creation order date. The day on which a creation order is settled is the creation order settlement date. As provided below, the creation order settlement date may occur up to three business days after the creation order date. By placing a creation order, and prior to delivery of such Baskets, an Authorized Participant’s DTC account is charged the non-refundable transaction fee due for the creation order. Unless otherwise agreed to by the Managing Owner and the Authorized Participant as provided in the next sentence, Baskets are issued on the creation order settlement date as of 2:45 p.m., Eastern Time, on the business day immediately following the creation order date at the applicable net asset value per Share as of the closing time of the NYSE Arca or the last to close of the exchanges on which its futures contracts are traded, whichever is later, on the creation order date, but only if the required payment has been timely received. Upon submission of a creation order, the Authorized Participant may request the Managing Owner to agree to a creation order settlement date up to three business days after the creation order date. Creation orders may be placed either (i) through the Continuous Net Settlement (“CNS”) clearing processes of the National Securities Clearing Corporation (the “NSCC”) (the “CNS Clearing Process”) or (ii) if outside the CNS Clearing Process, only through the facilities of The Depository Trust Company (“DTC” or the “Depository”) (the “DTC Process”), or a successor depository. (b) Redemptions On any business day, an Authorized Participant may place an order with the Transfer Agent to redeem one or more Baskets. Redemption orders must be placed by 10:00 a.m., Eastern Time. The day on which the Managing Owner receives a valid redemption order is the redemption order date. The day on which a redemption order is settled is the redemption order settlement date. As provided below, the redemption order settlement date may occur up to three business days after the redemption order date. The redemption procedures allow Authorized Participants to redeem Baskets. Individual Shareholders may not redeem directly from the Fund. Instead, individual Shareholders may only redeem Shares in integral multiples of 200,000 and only through an Authorized Participant. Unless otherwise agreed to by the Managing Owner and the Authorized Participant as provided in the next sentence, by placing a redemption order, an Authorized Participant agrees to deliver the Baskets to be redeemed through DTC’s book-entry system to the Fund not later than the redemption order settlement date as of 2:45 p.m., Eastern Time, on the business day immediately following the redemption order date. Upon submission of a redemption order, the Authorized Participant may request the Managing Owner to agree to a redemption order settlement date up to three business days after the redemption order date. By placing a redemption order, and prior to receipt of the redemption proceeds, an Authorized Participant’s DTC account is charged the non-refundable transaction fee due for the redemption order. Redemption orders may be placed either (i) through the CNS Clearing Process or (ii) if outside the CNS Clearing Process, only through the DTC Process, or a successor depository, and only in exchange for cash. The redemption proceeds from the Fund consist of the cash redemption amount. The cash redemption amount is equal to the net asset value of the number of Basket(s) requested in the Authorized Participant’s redemption order as of the closing time of the NYSE Arca or the last to close of the exchanges on which the Fund’s futures contracts are traded, whichever is later, on the redemption order date. The Managing Owner will distribute the cash redemption amount at the redemption order settlement date as of 2:45 p.m., Eastern Time, on the redemption order settlement date through DTC to the account of the Authorized Participant as recorded on DTC’s book-entry system. The redemption proceeds due from the Fund are delivered to the Authorized Participant at 2:45 p.m., Eastern Time, on the redemption order settlement date if, by such time, the Fund’s DTC account has been credited with the Baskets to be redeemed. If the Fund’s DTC account has not been credited with all of the Baskets to be redeemed by such time, the redemption distribution is delivered to the extent of whole Baskets received. Any remainder of the redemption distribution is delivered on the next business day to the extent of remaining whole Baskets received if the Transfer Agent receives the fee applicable to the extension of the redemption distribution date which the Managing Owner may, from time-to-time, determine and the remaining Baskets to be redeemed are credited to the Fund’s DTC account by 2:45 p.m., Eastern Time, on such next business day. Any further outstanding amount of the redemption order will be cancelled. The Managing Owner is also authorized to deliver the redemption distribution notwithstanding that the Baskets to be redeemed are not credited to the Fund’s DTC account by 2:45 p.m., Eastern Time, on the redemption order settlement date if the Authorized Participant has collateralized its obligation to deliver the Baskets through DTC’s book-entry system on such terms as the Managing Owner may determine from time-to-time. (8) Profit and Loss Allocations and Distributions Pursuant to the Trust Agreement, income and expenses are allocated pro rata to the Managing Owner as holder of the General Shares and to the Shareholders monthly based on their respective percentage interests as of the close of the last trading day of the preceding month. Distributions (other than redemption of units) may be made at the sole discretion of the Managing Owner on a pro rata basis in accordance with the respective capital balances of the shareholders. No distributions were paid for the Years Ended December 31, 2016, 2015 and 2014. (9) Commitments and Contingencies The Managing Owner, either in its own capacity or in its capacity as the Managing Owner and on behalf of the Fund, has entered into various service agreements that contain a variety of representations, or provide indemnification provisions related to certain risks service providers undertake in performing services which are in the best interests of the Fund. As of December 31, 2016 and December 31, 2015, no claims had been received by the Fund. Further, the Fund has not had prior claims or losses pursuant to these contracts. Accordingly, the Managing Owner expects the risk of loss to be remote. (10) Net Asset Value and Financial Highlights The Fund is presenting the following net asset value and financial highlights related to investment performance for a Share outstanding for the Years Ended December 31, 2016, 2015 and 2014. An individual investor’s return and ratios may vary based on the timing of capital transactions. Net asset value per Share is the net asset value of the Fund divided by the number of outstanding Shares at the date of each respective period presented. (a) Based on average shares outstanding. (b) The mean between the last bid and ask prices. (c) Effective as of the Closing Date, the Fund changed the source of market value per share prices, resulting in a difference in the ending market value per share presented for the year ended December 31, 2014 and the beginning market value per share for the year ended December 31, 2015. (d) Total Return, at net asset value is calculated assuming an initial investment made at the net asset value at the beginning of the period, reinvestment of all dividends and distributions at net asset value during the period, and redemption of Shares on the last day of the period. Total Return, at net asset value includes adjustments in accordance with accounting principles generally accepted in the United States of America and as such, the net asset value for financial reporting purposes and the returns based upon those net asset values may differ from the net asset value and returns for shareholder transactions. Total Return, at market value is calculated assuming an initial investment made at the market value at the beginning of the period, reinvestment of all dividends and distributions at market value during the period, and redemption of Shares at the market value on the last day of the period. Not annualized for periods less than one year, if applicable.
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Based on the provided text, here's a summary of the financial statement:
Key Points:
1. Administrator and Custodian: The Bank of New York Mellon serves as the Fund's administrator, custodian, and transfer agent.
2. Administrative Services:
- Processes orders for creating and redeeming Baskets
- Calculates net asset value
- Maintains financial books and records
- Handles accounting and fund administrative services
3. Fee Structure:
- The Managing Owner pays the Administrator fees from the Management Fee
- Commission payments were initially made to the Predecessor Commodity Broker
- Since the Closing Date, commission accruals have been paid to the Commodity Broker
4. Record Keeping:
- Maintains records related to:
- Basket creation and redemption
- Fund accounting
- Assets, liabilities, capital
- Income and expenses
- Transfer
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Claude
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Item 8 - Report of Independent Registered Public Accounting Firm The Board of Directors Chugach Electric Association, Inc. We have audited the accompanying consolidated balance sheets of Chugach Electric Association, Inc. and subsidiary as of December 31, 2016 and 2015, and the related consolidated statements of operations, changes in equities and margins, and cash flows for each of the years in the three-year period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States) and in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chugach Electric Association, Inc. and subsidiary as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP March 24, 2017 Chugach Electric Association, Inc. Consolidated Balance Sheets December 31, 2016 and 2015 Chugach Electric Association, Inc. Consolidated Balance Sheets (continued) December 31, 2016 and 2015 See accompanying notes to financial statements. Chugach Electric Association, Inc. Consolidated Statements of Operations Years Ended December 31, 2016, 2015 and 2014 See accompanying notes to financial statements. Chugach Electric Association, Inc. Consolidated Statements of Changes in Equities and Margins Years Ended December 31, 2016, 2015 and 2014 See accompanying notes to financial statements. Chugach Electric Association, Inc. Consolidated Statements of Cash Flows Years Ended December 31, 2016, 2015 and 2014 See accompanying notes to financial statements. Chugach Electric Association, Inc. December 31, 2016 and 2015 (1) Description of Business Chugach Electric Association, Inc. (Chugach) is one of the largest electric utilities in Alaska. Chugach is engaged in the generation, transmission and distribution of electricity in the Anchorage and upper Kenai Peninsula areas. Chugach is on an interconnected regional electrical system referred to as the Alaska Railbelt, a 400-mile-long area stretching from the coastline of the southern Kenai Peninsula to the interior of the state, including Alaska's largest cities, Anchorage and Fairbanks. Chugach’s retail and wholesale members are the consumers of the electricity sold. Chugach supplies much of the power requirements to the City of Seward (Seward), as a wholesale customer. Chugach also served Matanuska Electric Association, Inc. (MEA) through their contract expiration on April 30, 2015. Through March 31, 2015, we sold economy (non-firm) energy to Golden Valley Electric Association, Inc. (GVEA), which used that energy to serve its own load. Periodically, Chugach sells available generation, in excess of its own needs, to MEA, GVEA and Anchorage Municipal Light & Power (ML&P). Chugach was organized as an Alaska electric cooperative in 1948 and operates on a not-for-profit basis and, accordingly, seeks only to generate revenues sufficient to pay operating and maintenance costs, the cost of purchased power, capital expenditures, depreciation, and principal and interest on all indebtedness and to provide for reserves. Chugach is subject to the authority of the Regulatory Commission of Alaska (RCA). The consolidated financial statements include the activity of Chugach and the activity of the Beluga River Unit (BRU). Chugach accounts for its share of BRU activity using proportional consolidation (see Note 15 - “Beluga River Unit”). Intercompany activity has been eliminated for presentation of the consolidated financial statements. (2) Significant Accounting Policies a. Management Estimates In preparing the financial statements in conformity with United States generally accepted accounting principles (GAAP), the management of Chugach is required to make estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the balance sheet and revenues and expenses for the reporting period. Estimates include the allowance for doubtful accounts, workers’ compensation liability, deferred charges and liabilities, unbilled revenue, estimated useful life of utility plant, cost of removal and asset retirement obligation (ARO), purchase price allocation for BRU, and remaining proved BRU reserves. Actual results could differ from those estimates. Chugach Electric Association, Inc. December 31, 2016 and 2015 b. Regulation The accounting records of Chugach conform to the Uniform System of Accounts as prescribed by the Federal Energy Regulatory Commission (FERC). Chugach meets the criteria, and accordingly, follows the accounting and reporting requirements of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 980, “Topic 980 - Regulated Operations.” FASB ASC 980 provides for the recognition of regulatory assets and liabilities as allowed by regulators for costs or credits that are reflected in current rates or are considered probable of being included in future rates. Our regulated rates are established to recover all of our specific costs of providing electric service. In each rate filing, rates are set at levels to recover all of our specific allowable costs and those rates are then collected from our retail and wholesale customers. The regulatory assets or liabilities are then reduced as the cost or credit is reflected in earnings and our rates, see Note (2n) - “Deferred Charges and Liabilities.” c. Utility Plant and Depreciation Additions to electric plant in service are recorded at original cost of contracted services, direct labor and materials, indirect overhead charges and capitalized interest. For property replaced or retired, the book value of the property, less salvage, is charged to accumulated depreciation. The removal cost is charged to cost of removal obligation. Renewals and betterments are capitalized, while maintenance and repairs are normally charged to expense as incurred. In accordance with FASB ASC 360, “Topic 360 - Property, Plant, and Equipment,” certain asset groups are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset group may not be recoverable in rates. Recoverability of asset groups to be held and used is measured by a comparison of the carrying amount of an asset group to estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of an asset group exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset group exceeds the fair value of the asset. Depreciation and amortization rates have been applied on a straight-line basis and at December 31, 2016 are as follows: Annual Depreciation Rate Ranges On November 1, 2010, the RCA approved revised depreciation rates effective November 1, 2010 in Docket U-09-097. Chugach’s depreciation rates include a provision for cost of removal. Chugach records a separate liability for the estimated obligation related to the cost of removal. Chugach Electric Association, Inc. December 31, 2016 and 2015 On August 31, 2012, in Docket U-12-009, the RCA approved Southcentral Power Project (SPP) depreciation rates effective February 1, 2013, the date the SPP plant was placed in service. Chugach records Depreciation, Depletion and Amortization (DD&A) expense on the BRU assets based on units of production using the following formula: ten percent of the total production from the BRU as provided by the operator divided by ten percent of the estimated remaining proved reserves (in thousand cubic feet (Mcf)) in the field multiplied by Chugach’s total assets in the BRU. d. Full Cost Method Pursuant to Accounting Standards Codification (ASC) 932-360-25, “Extractive Activities-Oil and Gas - Property, Plant and Equipment - Recognition,” Chugach has elected the Full Cost method, rather than the Successful Efforts method, to account for exploration and development costs of gas reserves. This is the first time Chugach has invested in oil or gas activities, so there is no prior policy of using the Successful Efforts method. e. Asset Retirement Obligation (ARO) Chugach calculated and recorded an Asset Retirement Obligation associated with the BRU. Chugach uses its BRU financing rate as its credit adjusted risk free rate and the expected cash flow approach to calculate the fair value of the ARO liability. The ARO asset is depreciated using the DD&A formula previously discussed. The ARO liability is accreted using the interest method of allocation. f. Investments in Associated Organizations The loan agreements with CoBank, ACB (CoBank) and National Rural Utilities Cooperative Finance Corporation (NRUCFC) requires as a condition of the extension of credit, that an equity ownership position be established by all borrowers. Chugach’s equity ownership in these organizations is less than one percent. These investments are non-marketable and accounted for at cost. Management evaluates these investments annually for impairment. No impairment was recorded during 2016, 2015 and 2014. g. Investments - Other Investments -other consists of certificates of deposit with an original maturity of 18 months. h. Cash and Cash Equivalents / Restricted Cash Equivalents For purposes of the statement of cash flows, Chugach considers all highly liquid instruments with a maturity of three months or less upon acquisition by Chugach to be cash equivalents. Chugach has a concentration account with First National Bank Alaska (FNBA). There is no rate of return or fees on this account. The concentration account had an average balance of $5,897,767 and $6,218,015 during the years ended December 31, 2016 and 2015, respectively. Chugach Electric Association, Inc. December 31, 2016 and 2015 Restricted cash equivalents include funds on deposit for future workers’ compensation claims. At December 31, 2016 and 2015, restricted cash equivalents included $0.8 million and $1.7 million, respectively, of funds on deposit for future workers’ compensation claims. i. Marketable Securities In September 2016, Chugach resumed its mutual fund investment portfolio. The investments are classified as trading securities, reported at fair value with gains and losses in earnings, and include bond funds. j. Accounts Receivable Trade accounts receivable are recorded at the invoiced amount. The allowance for doubtful accounts is management’s best estimate of the amount of probable credit losses in existing accounts receivable. Chugach determines the allowance based on its historical write-off experience and current economic conditions. Chugach reviews its allowance for doubtful accounts monthly. Past due balances over 90 days in a specified amount are reviewed individually for collectability. All other balances are reviewed in aggregate. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Chugach does not have any off-balance-sheet credit exposure related to its customers. Included in accounts receivable are invoiced amounts to Anchorage Municipal Light & Power (ML&P) for their proportionate share of current SPP costs, which amounted to $1.4 million and $1.1 million in 2016 and 2015, respectively. In addition, accounts receivable includes invoiced amounts for grants to support investigating means of mitigating the impact of renewable generation variability on the grid as well as the construction of facilities to divert water and safely transmit electricity, which amounted to $0.0 million and $0.2 million in 2016 and 2015, respectively. At December 31, 2016, accounts receivable also included $0.7 million from BRU operations primarily associated with gas sales to ENSTAR. k. Materials and Supplies Materials and supplies are stated at average cost. l. Fuel Stock Fuel Stock is the weighted average cost of fuel injected into Cook Inlet Natural Gas Storage Alaska (CINGSA), which began service in the second quarter of 2012. Chugach’s fuel balance in storage for the years ended December 31, 2016 and 2015 amounted to $6.3 million and $7.1 million, respectively. Chugach Electric Association, Inc. December 31, 2016 and 2015 m. Fuel and Purchased Power Cost Recovery Expenses associated with electric services include fuel purchased from others and produced from Chugach’s interest in the BRU, both of which are used to generate electricity, as well as power purchased from others. Chugach is authorized by the RCA to recover fuel and purchased power costs through the fuel and purchased power adjustment process, which is adjusted quarterly to reflect increases and decreases of such costs. We recognize differences between projected recoverable fuel costs and amounts actually recovered through rates. The fuel cost under/over recovery on our Balance Sheet represents the net accumulation of any under- or over-collection of fuel and purchased power costs. Fuel cost under-recovery will appear as an asset on our Balance Sheet and will be collected from our members in subsequent periods. Conversely, fuel cost over-recovery will appear as a liability on our Balance Sheet and will be refunded to our members in subsequent periods. n. Deferred Charges and Liabilities Included in deferred charges and liabilities on Chugach’s financial statements are regulatory assets and liabilities recorded in accordance with FASB ASC 980. See Note 8 - Deferred Charges and Liabilities. Continued accounting under FASB ASC 980 requires that certain criteria be met. We capitalize all or part of costs that would otherwise be charged to expense if it is probable that future revenue in an amount at least equal to the capitalized cost will result from inclusion of that cost in allowable costs for ratemaking purposes and future revenue will be provided to permit recovery of the previously incurred cost. Management believes Chugach’s operations currently satisfy these criteria. Chugach’s regulatory asset recoveries are embedded in base rates approved by the RCA. Specific costs incurred and recorded as Regulatory Assets, including the amortization period for recovery, are approved by the RCA either in standard Simplified Rate Filings (SRF), general rate case filings or specified independent requests. The rates approved related to the regulatory assets are matched to the amortization of actual expenses recognized. The regulatory assets are amortized and collected through rates over differing periods depending upon the period of benefit as established by the RCA. Deferred liabilities include refundable contributions in aid of construction, which are credited to the associated cost of construction of property units. Refundable contributions in aid of construction are held in deferred credits pending their return or other disposition. If events or circumstances should change so the criteria are not met, the write off of regulatory assets and liabilities could have a material effect on Chugach’s financial position, results of operations or cash flows. On December 29, 2016, Chugach made a prepayment of $7.9 million to the National Rural Electric Cooperative Association (NRECA) Retirement and Security (RS) Plan, which is included in deferred charges. Chugach recorded the long term prepayment in deferred charges and is amortizing the deferred charge to administrative, general and other expense, over 11 years, which represents the difference between the normal retirement age of 62 and the average age of Chugach’s employees in the RS Plan. Chugach Electric Association, Inc. December 31, 2016 and 2015 o. Patronage Capital Revenues in excess of current period costs (net operating margins and nonoperating margins) in any year are designated on Chugach’s statement of operations as assignable margins. These excess amounts (i.e. assignable margins) are considered capital furnished by the members, and are credited to their accounts and held by Chugach until such future time as they are retired and returned without interest at the discretion of the Board of Directors (Board). Retained assignable margins are designated on Chugach’s balance sheet as patronage capital. This patronage capital constitutes the principal equity of Chugach. The Board may also approve the return of capital to former members and estates who request early retirements at discounted rates under a discounted capital credits retirement plan authorized by the Board in September of 2002. p. Consumer Deposits Consumer deposits are the amounts certain customers are required to deposit to receive electric service. Consumer deposits for the years ended December 31, 2016 and 2015, totaled $3.3 million and $3.1 million, respectively. Consumer deposits also represent customer credit balances as a result of prepaid accounts. Credit balances totaled $1.9 million for the years ended December 31, 2016 and 2015. q. Fair Value of Financial Instruments FASB ASC 825, “Topic 825 - Financial Instruments,” requires disclosure of the fair value of certain on and off balance sheet financial instruments for which it is practicable to estimate that value. The following methods are used to estimate the fair value of financial instruments: Cash and cash equivalents - the carrying amount approximates fair value because of the short maturity of those instruments. Restricted cash - the carrying amount approximates fair value because of the short maturity of those instruments. Marketable securities - the carrying amount approximates fair value as changes in the market value are recorded monthly and gains or losses are reported in earnings (see note 2i and note 4). Long-term obligations - the fair value estimate is based on the quoted market price for same or similar issues (see note 11). Consumer deposits - the carrying amount approximates fair value because of the short refunding term. The fair value of accounts receivable and payable, and other short-term monetary assets and liabilities approximate carrying value due to their short-term nature. Chugach Electric Association, Inc. December 31, 2016 and 2015 r. Operating Revenues Revenues are recognized upon delivery of electricity. Operating revenues are based on billing rates authorized by the RCA, which are applied to customers’ usage of electricity. Chugach’s rates are established, in part, on test period sales levels that reflect actual operating results. Chugach calculates unbilled revenue at the end of each month to ensure the recognition of a calendar year’s revenue. Chugach accrued $10,940,274 and $10,531,377 of unbilled retail revenue at December 31, 2016 and 2015, respectively, which is included in accounts receivable on the balance sheet. Wholesale revenue is recorded from metered locations on a calendar month basis, so no estimation is required. Chugach's tariffs include provisions for the recovery of gas costs according to gas supply contracts, as well as purchased power costs. s. Capitalized Interest Allowance for funds used during construction (AFUDC) and interest charged to construction - credit (IDC) are the estimated costs of the funds used during the period of construction from both equity and borrowed funds. AFUDC and IDC are applied to specific projects during construction. AFUDC and IDC calculations use the net cost of borrowed funds when used and is recovered through RCA approved rates as utility plant is depreciated. For all projects Chugach capitalized such funds at the weighted average rate of 4.3% during 2016, 2015 and 2014. t. Environmental Remediation Costs Chugach accrues for losses and establishes a liability associated with environmental remediation obligations when such losses are probable and can be reasonably estimated. Such accruals are adjusted as further information develops or circumstances change. Estimates of future costs for environmental remediation obligations are not discounted to their present value. However, various remediation costs may be recoverable through rates and accounted for as a regulatory asset. u. Income Taxes Chugach is exempt from federal income taxes under the provisions of Section 501(c)(12) of the Internal Revenue Code and for the years ended December 31, 2016, 2015 and 2014 was in compliance with that provision. In addition, as described in Note (16) - “Commitments and Contingencies,” Chugach collects sales tax and is assessed gross revenue and excise taxes which are presented on a net basis in accordance with FASB ASC 605-45-50, “Topic 605 - Revenue Recognition - Subtopic 45 - Principal Agent Considerations - Section 50 - Disclosure.” Chugach applies a more-likely-than-not recognition threshold for all tax uncertainties. FASB ASC 740, “Topic 740 - Income Taxes,” only allows the recognition of those tax benefits that have a greater than fifty percent likelihood of being sustained upon examination by the taxing authorities. Chugach’s management reviewed Chugach’s tax positions and determined there were no outstanding or retroactive tax positions that were not highly certain of being sustained upon examination by the taxing authorities. Chugach Electric Association, Inc. December 31, 2016 and 2015 Management has concluded that there are no significant uncertain tax positions requiring recognition in its financial statements for all periods presented. Chugach’s evaluation was performed for the tax periods ended December 31, 2014 through December 31, 2016 for United States Federal Income Tax, the tax years which remain subject to examination by major tax jurisdictions as of December 31, 2016. v. Grants Chugach has received federal and state grants to offset storm related expenditures and to support investigating means of mitigating the impact of renewable generation variability on the grid as well as the construction of facilities to transport fuel, divert water and safely transmit electricity to its consumers. Grant proceeds used to construct or acquire equipment are offset against the carrying amount of the related assets while grant proceeds for storm related expenditures are offset against the actual expense incurred, both of which totaled $0.6 million and $1.6 million in 2016 and 2015, respectively. (3) Accounting Pronouncements Issued and adopted: ASC Update 2015-03 “Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs” In April of 2015, the FASB issued ASC Update 2015-03, “Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs.” ASC Update 2015-03 revised the presentation guidance for debt issuance costs related to a recognized debt liability. The effect of this update was to present the debt issuance costs as a direct deduction to the liability on the balance sheet and was adopted by retrospective application. This update did not change the recognition and measurement guidance for debt issuance costs. This update was effective for fiscal years beginning after December 15, 2015, and interim periods beginning after December 15, 2016, with early adoption permitted. Chugach began application of ASC 2015-03 with the fiscal year beginning January 1, 2016. Adoption did not have a material effect on its results of operations, financial position, and cash flows. ASC Update 2015-15 “Interest - Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements” In September of 2015, the FASB issued ASC Update 2015-15, “Interest - Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements.” ASC Update 2015-15 amended guidance related to the presentation and subsequent measurement of debt issuance costs associated with line-of-credit arrangements for SEC reporting. This update was effective for fiscal years beginning after December 15, 2015, and interim periods beginning after December 15, 2016, with early adoption permitted. Chugach began application of ASC 2015-15 with the fiscal year beginning January 1, 2016. Adoption did not have a material effect on its results of operations, financial position, and cash flows. Chugach Electric Association, Inc. December 31, 2016 and 2015 Adoption of this guidance was applied retrospectively and reduced deferred charges and long-term debt by the unamortized debt issuance costs of $2.7 million at December 31, 2016, and December 31, 2015. Issued, not yet adopted: ASC Update 2014-09 “Revenue from Contracts with Customers (Topic 606)” and Related Updates In May of 2014, the FASB issued ASC Update 2014-09, “Revenue from Contracts with Customers (Topic 606).” ASC Update 2014-09 provides guidance for the recognition, measurement and disclosure of revenue related to the transfer of promised goods or services to customers. This update was effective for fiscal years beginning after December 15, 2016, for which early adoption was prohibited. However, in August of 2015, the FASB issued ASC Update 2014-14, “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date,” deferring the effective date of ASC Update 2014-09 to fiscal years beginning after December 15, 2017, and permitting early adoption of this update, but only for annual reporting periods beginning after December 15, 2016, and interim reporting periods within that reporting period. The standard permits the use of either the retrospective or cumulative effect transition method. While Chugach has not yet selected a transition method, we currently expect to use the cumulative effect method. Our transition method, and the expected materiality of the impact of adopting this standard on our operations, financial position, and cash flows, will be determined after we further evaluate the impact of this update. We have evaluated our energy sales contracts, including retail, wholesale, and economy energy, and do not believe there will be a material impact to our recognition of revenue from energy sales. Energy sales are billed monthly per regulator approved tariffs based on the energy consumed by the customer. Total revenue derived from energy sales during 2016 was approximately 99% of our total operating revenue. The American Institute of Certified Public Accountants (AICPA) Power and Utilities Revenue Recognition Task Force is currently assessing the impact of this update on contributions in aid of construction (CIAC). CIAC represents the funds collected from customers and third parties and recorded as a reduction to the total cost of property, plant and equipment, per industry standard practice. If it is determined that CIAC is within the scope of this update, it could have a material impact on the amount of revenue we recognize. ASC Update 2016-01 “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” In January of 2016, the FASB issued ASC Update 2016-01, “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” ASC Update 2016-01 amends guidance related to certain aspects of the recognition, measurement, presentation and disclosure of financial instruments. This update is effective for fiscal years beginning after December 15, 2018, and interim periods beginning after December 15, 2019, with early adoption not permitted with certain exceptions. Chugach will begin application of ASC 2016-01 with the annual report for the year ended December 31, 2018. Chugach Electric Association, Inc. December 31, 2016 and 2015 Adoption is not expected to have a material effect on its results of operations, financial position, and cash flows. ASC Update 2016-02 “Leases (Topic 842): Section A - Leases: Amendments to the FASB Accounting Standards Codification; Section B - Conforming Amendments Related to Leases: Amendments to the FASB Accounting Standards Codification; Section C - Background Information and Basis for Conclusions” In February of 2016, the FASB issued ASC Update 2016-02, “Leases (Topic 842): Section A - Leases: Amendments to the FASB Accounting Standards Codification; Section B - Conforming Amendments Related to Leases: Amendments to the FASB Accounting Standards Codification; Section C - Background Information and Basis for Conclusions.” ASC Update 2016-02 amends guidance related to the recognition, measurement, presentation and disclosure of leases for lessors and lessees. This update is effective for fiscal years beginning after December 15, 2018, including the interim periods within those years, with early adoption permitted. Chugach will begin application of ASC 2016-02 on January 1, 2019. Chugach expects this update to increase the recorded amounts of assets and liabilities and we are evaluating the significance of the increase. We are also evaluating the impact of this update to our results of operations, financial position, and cash flows. ASC Update 2016-11 “Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Update 2014-09 and 2014-06 Pursuant to Staff Announcements at the March 3, 2016, EITF Meeting (SEC Update)” In May 2016, the FASB issued ASC Update 2016-11, “Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Update 2014-09 and 2014-06 Pursuant to Staff Announcements at the March 3, 2016, EITF Meeting (SEC Update).” ASC 2016-11 rescinds and supersedes SEC guidance previously governing revenue and expense recognition for freight services in process, accounting for shipping and handling fees and costs, consideration given by a vendor to a customer, and gas-balancing arrangements. This update affects the guidance in ASC Update 2014-09 and 2014-06 and follows the same effective date and transition requirements. While Chugach has not yet selected a transition method, we currently expect to use the cumulative effect method. Our transition method, and the expected materiality of the impact of adopting this standard on our operations, financial position, and cash flows, will be determined after we further evaluate the impact of this update. Chugach Electric Association, Inc. December 31, 2016 and 2015 ASC Update 2016-13 “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” In June 2016, the FASB issued ASC Update 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASC Update 2016-13 revised the criteria for the measurement, recognition, and reporting of credit losses on financial instruments to be recognized when expected. This update is effective for fiscal years beginning after December 15, 2019, including the interim periods within those years, with early adoption permitted for fiscal years beginning after December 15, 2018, including interim periods within those years. Chugach will begin application of ASC 2016-13 on January 1, 2020. Adoption is not expected to have a material effect on its results of operations, financial position, and cash flows. ASC Update 2016-15 “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force)” In August 2016, the FASB issued ASC Update 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). ASC Update 2016-15 clarifies how certain cash payments and cash proceeds should be classified on the statement of cash flows to limit the diversity in practice. This update is effective fiscal years beginning after December 15, 2017, including interim periods within those years, with early adoption permitted. Chugach will begin application of ASC 2016-15 on January 1, 2018. Adoption is not expected to have a material effect on its results of operations, financial position, and cash flows. (4) Fair Value of Assets and Liabilities Fair Value Hierarchy In accordance with FASB ASC 820, Chugach groups its financial assets and liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: Level 1 - Valuation is based upon quoted prices for identical instruments traded in active exchange markets, such as the New York Stock Exchange. Level 1 also includes United States Treasury and federal agency securities, which are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect Chugach’s estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques. Chugach Electric Association, Inc. December 31, 2016 and 2015 Chugach’s marketable securities classified as trading securities are outlined in the table below. Chugach had no other assets or liabilities measured at fair value on a recurring basis at December 31, 2016. At December 31, 2015, Chugach had no Level 1 or Level 2 assets or liabilities measured at fair value on a recurring basis. Fair Value of Financial Instruments Fair value estimates are dependent upon subjective assumptions and involve significant uncertainties resulting in variability in estimates with changes in assumptions. The fair value of cash and cash equivalents, accounts receivable and payable, and other short-term monetary assets and liabilities approximate carrying value due to their short-term nature. The fair value of investments - other approximate their carrying value due to the recency of their acquisition. The estimated fair values (in thousands) of long-term obligations included in the financial statements at December 31, 2016, are as follows: (5) Regulatory Matters Amended Eklutna Generation Station 2015 Dispatch Services Agreement On February 13, 2015, Chugach submitted the Amended Eklutna Generation Station 2015 Dispatch Services Agreement (Dispatch Services Agreement) to the RCA for dispatch services to be provided by Chugach to MEA for a one-year period. Under the Dispatch Services Agreement, Chugach provides electric and natural gas dispatch services for MEA’s Eklutna Generation Station (EGS), electric dispatch services for the Bradley Lake Hydroelectric Project (Bradley Lake), and electric dispatch coordination services for the Eklutna Hydroelectric Project (Eklutna Hydro) beginning with EGS’ full commercial operation. On March 23, 2015, the RCA approved the Dispatch Agreement, conditioned on the requirements that: 1) MEA and Chugach notify the RCA at least one month prior to forming separate Load Balancing Authorities and include in any such notification details on the tie points and any written agreements contemplated by the utilities; and, 2) Chugach file an update to its tariff to reflect any extension of the Dispatch Services Agreement one week from the receipt of such a request from MEA. The Dispatch Services Agreement was in effect through March 31, 2016. Chugach Electric Association, Inc. December 31, 2016 and 2015 In December of 2015, MEA notified Chugach that it would not be extending the Dispatch Services Agreement for the dispatch of electric service. Subsequently, Chugach and MEA entered into an agreement entitled, “Gas Dispatch Agreement” in which Chugach provides gas scheduling and dispatch services to MEA. The term of the agreement is April 1, 2016, through March 31, 2017. On April 18, 2016, Chugach requested RCA approval of the special contract. The RCA issued a letter order on June 8, 2016, approving the filing. This agreement was extended through March 31, 2018, in a letter agreement dated July 29, 2016, with a provision to extend the agreement through March 31, 2019, to be exercised on or before August 1, 2017. June 2014 Test Year General Rate Case Chugach’s June 2014 test year rate case was submitted to the RCA on February 13, 2015. Chugach requested a system base rate increase of approximately $21.3 million, or 20% on total base rate revenues for rates effective in April 2015. The filing also included updates to firm and non-firm transmission wheeling rates and attendant ancillary services in support of third-party transactions on the Chugach transmission system. The primary driver of the rate changes was the reduction in fixed-cost contributions resulting from the expiration of the Interim Power Sales Agreement between Chugach and MEA. In addition, Chugach submitted proposed adjustments to its fuel and purchased power rates under a separate tariff advice letter to become effective at the same time. This allows interim base rate increases to be synchronized with reductions in fuel costs resulting from system heat rate improvements and a greater share of hydroelectric generation used to meet the load requirements of the remaining customers on the system. Collectively, the effective increase to retail customer bills was approximately between two and five percent. The RCA issued Order U-15-081(1) on April 30, 2015, suspending the filing and granting Chugach’s request for interim and refundable rate increases effective May 1, 2015. A scheduling conference was held on May 27, 2015. On June 4, 2015, the RCA issued Order U-15-081(2), granting approval for intervention by HEA, MEA and GVEA. The RCA indicated that a final order in the case will be issued by May 8, 2016. Intervenor responsive testimony was filed by the Attorney General (AG) and MEA on October 28, 2015. The AG’s testimony focused on revenue requirement matters and MEA’s testimony focused on transmission cost allocation issues. Chugach’s responsive testimony was filed on December 15, 2015. In January of 2016, Chugach and the Attorney General (AG) for the State of Alaska entered into settlement discussions to resolve revenue requirement matters in the case, which resulted in settlement of all outstanding matters related to the determination of Chugach’s system revenue requirement for both the interim and permanent rate periods. As a result, Chugach agreed to reduce its revenue requirement by 0.5% (approximately $0.6 million). In addition, the stipulation provides for a permanent increase in Chugach’s system Times Interest Earned Ratio (TIER) from 1.30 to 1.35, which represents an approximate margin increase of $1.0 million per year. The stipulation was filed with the RCA on January 21, 2016. On May 2, 2016, the RCA issued Order U-15-081(8) accepting the stipulation between Chugach and the AG. On May 20, 2016, Chugach submitted updated revenue requirement, cost of service and tariffs reflecting the results of the stipulation, with proposed final rates effective July 5, 2016. On June 17, 2016, the RCA issued Order U-15-081(10) approving final permanent rates effective for Chugach retail Chugach Electric Association, Inc. December 31, 2016 and 2015 customers and the City of Seward (Seward). Refunds totaling $0.75 million were issued to Chugach retail customers in August 2016. The refund applied to purchases from May 2015 through July 2016. Chugach issued a refund to Seward totaling approximately $28,000 on July 8, 2016. On June 27, 2016, the RCA issued Order U-15-081(11) resolving the outstanding issues related to transmission and ancillary services. The RCA ruled in Chugach’s favor, affirming continued use of a postage stamp rate methodology for wheeling transactions on the Chugach system and denied MEA’s request for a separate rate for wheeling transactions based on MEA’s claim that it only used a small portion of Chugach’s transmission system. The order was consistent with previous orders on transmission and ancillary services that were issued by the RCA in Chugach’s 2012 and 2013 General Rate Case filings. On July 15, 2016, Chugach submitted updated tariff sheets and supporting exhibits for the calculation of transmission and ancillary service rates. On August 23, 2016, the RCA approved final rates contained in Chugach’s July 15, 2016, compliance filing. On September 15, 2016, Chugach notified the RCA that it completed the issuance of refunds resulting from settlement of the rate case. A final order closing the docket was issued on October 6, 2016. Simplified Rate Filing On June 30, 2016, the Chugach Board of Directors voted to re-enter the SRF process for adjustments to base demand and energy rates for Chugach retail customers and wholesale customer, Seward. SRF is an expedited base rate adjustment process available to electric cooperatives in the State of Alaska. On July 1, 2016, Chugach requested approval to implement the SRF process for energy and demand rate changes, and requested approval for a 4.2% system demand and energy rate increase, or approximately $4.8 million on an annual basis. On a total retail customer bill basis, which includes fuel and purchased power costs, the impact was approximately 2.5%. Chugach requested the proposed rate increase become effective August 15, 2016. Chugach plans to adjust rates through the SRF process on a quarterly basis going forward. On August 12, 2016, the RCA issued a letter order approving Chugach’s entry into the SRF process for quarterly adjustments to the demand and energy rates of Chugach retail customers and Seward. The RCA also approved Chugach’s request to increase demand and energy rates by 4.2%, effective August 15, 2016. On August 29, 2016, Chugach submitted its June 2016 test year SRF to the RCA with no changes to the demand and energy rates of Chugach retail and Seward. In the filing, Chugach requested approval to adopt the SRF process for quarterly rate adjustments for non-firm transmission wheeling and ancillary services, and approval to reduce these rates between 9.5% and 14.4% based on the current SRF. The RCA issued an order on October 13, 2016, denying Chugach’s request on the basis that the underlying premise of the SRF does not apply to rates for third-party use of Chugach’s transmission system. Revenues from these transactions do not impact Chugach margin levels, but instead are used to reduce fuel and purchased power costs that are recovered by Chugach retail and Seward. As a result, rate changes to third party transmission and ancillary services will be prospectively made through general rate case filings. This has no impact on Chugach’s continued Chugach Electric Association, Inc. December 31, 2016 and 2015 use of SRF for quarterly demand and energy rate adjustments to Chugach retail customers and Seward. Chugach submitted its June 2016 and September 2016 test year SRFs with the RCA on August 29, 2016 and December 1, 2016, respectively, as informational filings with no changes to the demand and energy rates of Chugach retail and Seward. Operation and Regulation of the Alaska Railbelt Electric and Transmission System The 2014 Alaska Legislature directed the RCA to provide a recommendation on whether creating an independent system operator or similar structure in the Railbelt area is the best option for effective and efficient electrical transmission. On February 11, 2015, the RCA voted in favor of opening a docket to investigate and receive input on alternative transmission structures for the Railbelt. On June 30, 2015, the RCA issued its report which recommended an independent transmission company, certificated and regulated as a public utility, be created to operate the transmission system reliably and transparently and to plan and execute major maintenance, transmission system upgrades, and new transmission projects necessary for the reliable delivery of electric power to Railbelt customers. The RCA opened Docket I-15-001 to gather information on power pooling and/or centralized transmission system planning and operation among the Railbelt electric utilities, including economic dispatch of the Railbelt’s electrical generation units. Initial progress reports were filed with the RCA on September 30, 2015. With the support of the RCA, Chugach and several other Railbelt utilities are evaluating possible transmission business model opportunities and associated economic dispatch models that Chugach believes may lead to more optimal Railbelt-wide system operations. On February 1, 2016, Chugach and the Municipality of Anchorage d/b/a Municipal Light and Power (ML&P) filed a joint report regarding the development of a power pooling and joint dispatch arrangement between the utilities. The filing summarized several of the projected qualitative and quantitative benefits of such an arrangement. Chugach and ML&P filed subsequent joint reports regarding their progress toward joint dispatch and power pooling arrangements on May 2, 2016, and August 10, 2016. On October 31, 2016, Chugach, ML&P, and MEA filed a joint report informing the RCA that they were negotiating a power pooling and joint dispatch agreement. On January 27, 2017, Chugach, ML&P, and MEA entered into an Amended and Restated Power Pooling and Joint Dispatch Agreement (Agreement) which provides for economic dispatch resulting from coordinated scheduling of generation and transmission assets, including scheduling, dispatch, and settlement transactions at the bulk power level of electric services. The Agreement was submitted to the RCA as an informational filing on January 30, 2017 under Docket I-15-001. The Agreement provides a contractual framework for coordinated scheduling, dispatch, and settlement transactions for the purchase, sale, or exchange of energy, capacity, reserves, and transmission ancillary services on an efficient and economic basis among the signatories to the Agreement. The Agreement provides for a one-year development period to develop and agree upon specific, detailed generation and transmission dispatch procedures, fuel supply dispatch procedures, and a settlement process. Upon finalization of dispatch procedures and the settlement process in 2018, Chugach Electric Association, Inc. December 31, 2016 and 2015 Chugach, ML&P and MEA will submit the Agreement to the RCA for approval. The total cost reductions resulting from the pool are estimated to be up to $16 million per year after the development period for all participants combined. Cook Inlet Natural Gas Alaska: Found Gas On January 30, 2015, CINGSA submitted a filing to the RCA providing notice that it had found 14.5 Bcf of gas as a result of directional drilling in the storage facility and now proposes to establish guidelines for commercial sales of at least 2 Bcf of this gas. Chugach submitted comments to the RCA regarding CINGSA’s proposed treatment of found gas. Chugach does not believe CINGSA’s proposal to retain revenues for the sale of found gas should be permitted in recognition of the risk-sharing agreements made by CINGSA and its storage customers that resulted in the development of the CINGSA storage facility. The RCA issued an order in March of 2015 suspending the filing for further investigation. CINGSA filed direct testimony in the case on April 13, 2015. Chugach and other interveners in the case submitted responsive testimony on June 5, 2015. CINGSA submitted its reply testimony on June 29, 2015. The evidentiary hearing was held in September of 2015. The RCA issued a final order in the case on December 4, 2015, ruling significantly in favor of the interveners in the case. The RCA granted approval for CINGSA to sell 2 Bcf with 87% of the proceeds allocated to CINGSA’s Firm Storage Service (FSS) customers and 13 percent to CINGSA. The RCA also required CINGSA to file a reservoir engineering study by June 30, 2016, and required CINGSA to file notice of all gas sales within 30 days of any sales, including the transaction price, purchaser, quantities, and the terms and conditions of the sale. The RCA also required that all proceeds to the FSS customers be treated as a reduction in fuel costs that are paid by CINGSA’s customers. On January 4, 2016, CINGSA filed an appeal in Superior Court to Order U-15-016(14), stating the RCA violated CINGSA’s right to due process of law, erred, and/or acted unreasonably, unfairly, arbitrarily, capriciously, or contrary to applicable law. CINGSA believes additional proceeds resulting from the sale of found native gas should remain with CINGSA. Chugach filed an entry of appearance in the case on January 14, 2016. CINGSA filed its brief on June 6, 2016. Chugach filed its reply brief on October 31, 2016. Oral argument was held on March 6, 2017. Beluga River Unit In July of 2015, ConocoPhillips Alaska, Inc. (CPAI) announced the marketing for sale of its North Cook Inlet Unit; its interest in the Beluga River Unit (BRU); and its interest in 5,700 acres of exploration prospects in the Cook Inlet region. In October of 2015, Chugach submitted a joint bid with ML&P for acquisition of CPAI’s one-third working interest in the BRU. Chugach entered into an agreement entitled, “Purchase and Sale Agreement between ConocoPhillips Alaska, Inc. and Municipality of Anchorage d/b/a Municipal Light & Power and Chugach Electric Association, Inc.” (Purchase and Sale Agreement) on February 4, 2016. The Purchase and Sale Agreement transfers CPAI’s interest in the BRU to Chugach and ML&P. The acquisition and attendant recovery of costs in electric rates was subject to RCA approval. Chugach Electric Association, Inc. December 31, 2016 and 2015 On March 11, 2016, Chugach and ML&P submitted a joint request to the RCA for approval of the acquisition of CPAI’s interest in the BRU and the attendant recovery of the acquisition costs in electric rates. Chugach and ML&P requested expedited consideration, asking the RCA to issue a bench ruling by April 21, 2016. The request for expedited consideration was made to provide additional certainty regarding Chugach’s eligibility for a State of Alaska production tax credit. The RCA opened docket U-15-081 and established an expedited procedural schedule for the case. The RCA held a hearing from April 18 through April 20, 2016, and issued a bench ruling on April 20, 2016, approving the joint request for approval of the Purchase and Sale Agreement. A written order affirming the bench ruling was issued on April 21, 2016. Separate filings detailing the specific rate recovery process were filed in the second quarter of 2016. The RCA approved the initial gas transfer price of $5.88 per Mcf. Under the recovery structure proposed by Chugach, costs associated with the BRU, including acquisition and on-going operations, maintenance and capital investment, will be recovered on a dollar-for-dollar basis through Chugach’s quarterly fuel adjustment process. Chugach recovers its fuel and purchased power costs as a direct pass-through from its retail and wholesale customers with minimal lag between cost incurrence and recovery. On June 29, 2016, Chugach filed a petition with the RCA for approval to create a regulatory asset for the deferral of expenses (financial/economic, engineering and legal services) associated with Chugach’s acquisition of the BRU, which was $1.5 million at December 31, 2016, and is included in deferred charges on Chugach’s balance sheet. See Note 8 - Deferred Charges and Liabilities. Chugach also requested approval to recover the deferred costs in the gas transfer price. On September 14, 2016, the RCA issued an order combining the BRU cost recovery process and the request to create a regulatory asset into a single docket. The RCA established a procedural schedule and indicated that a final order in the case would be issued by November 17, 2017. Depreciation Study Update In compliance with a previous order from the RCA (U-12-009(8)), Chugach submitted a 2015 Depreciation Study Update to the RCA, requesting approval of the depreciation rates resulting from the study for use in Chugach’s financial record keeping and for establishing electric rates. If approved, adoption of the updated depreciation rates would result in a $5.9 million reduction in annual depreciation expense. On a demand and energy rate basis, the impact is a 4.7% reduction to retail customers and a 4.6% reduction to Seward. The reductions on a total customer bill basis, which includes fuel and purchased power costs, are 3.2% and 1.9%, respectively. Chugach requested that the updated depreciation rates be implemented on July 1, 2017, for both accounting and ratemaking purposes. On October 11, 2016, the RCA issued Order U-16-081(1) to address the depreciation study update. The RCA indicated that a final order in the proceeding would be issued by March 29, 2017. Chugach Electric Association, Inc. December 31, 2016 and 2015 Beluga Parts Filing On November 18, 2016, Chugach submitted a petition to the RCA for approval to create a regulatory asset that would allow Chugach to amortize and recover in rates the value of certain plant needed to support power production equipment located at Beluga Power Plant. Specifically, Chugach requested RCA approval to recover approximately $11.4 million in equipment that supports Beluga generation units. Chugach requested that it be permitted to amortize the value of this plant over a period of 30 months for plant associated with Units 1 and 2 (approximately $0.3 million), and 108 months for all other parts (approximately $11.1 million). The amortization periods are consistent with the proposed depreciation rates for the Beluga units contained in Chugach’s depreciation study that was submitted to the RCA on September 30, 2016. Furie Agreement On March 16, 2017, Chugach submitted a request to the RCA for approval of the agreement entitled, “Firm and Interruptible Gas Sale and Purchase Agreement between Furie Operating Alaska, LLC and Chugach Electric Association, Inc.” (Furie Agreement) dated March 3, 2017. As part of the filing, Chugach also requested RCA approval to recover both firm and interruptible purchases under the agreement and all attendant transportation and storage costs through its quarterly fuel and purchased power cost adjustment process. The Furie Agreement provides Chugach with both firm and non-firm gas supplies over a 16-year period, with firm purchases beginning on April 1, 2023, and ending on March 31, 2033, and interruptible gas purchases available to Chugach immediately upon RCA approval and ending on March 31, 2033. With respect to firm purchases beginning on April 1, 2023, and ending on March 31, 2033, the Furie Agreement provides an Annual Gas Commitment by Furie to sell and Chugach to purchase approximately 1.8 Bcf of gas each year, which represents approximately 20% to 25% of Chugach’s projected gas requirements during this period. The Furie Agreement also provides Chugach with additional purchase options, with on a firm and interruptible basis. The initial price for firm gas is $7.16 per Mcf beginning April 1, 2023 and escalates annually, rising to $7.98 per Mcf on April 1, 2032, the last year of the contract. Chugach Electric Association, Inc. December 31, 2016 and 2015 (6) Utility Plant Major classes of utility plant as of December 31 are as follows: 1Unclassified electric plant in service consists of complete unclassified general plant, generation plant, transmission plant and distribution plant. Depreciation of unclassified electric plant in service has been included in functional plant depreciation accounts in accordance with the anticipated eventual classification of the plant investment. Intangible plant represents Chugach's share of a Bradley Lake transmission line financed internally. Other represents Electric Plant Held for Future Use. (7) Investments in Associated Organizations Investments in associated organizations include the following at December 31: The Farm Credit Administration, CoBank's federal regulators, requires minimum capital adequacy standards for all Farm Credit System institutions. Loan agreements and financing arrangements with CoBank and NRUCFC require, as a condition of the extension of credit, that an equity ownership position be established by all borrowers. Chugach Electric Association, Inc. December 31, 2016 and 2015 (8) Deferred Charges and Liabilities Deferred Charges Deferred charges, net of amortization, consisted of the following at December 31: Deferred charges, not currently being recovered in rates charged to consumers, consisted of the following at December 31: Chugach Electric Association, Inc. December 31, 2016 and 2015 We believe all regulatory assets not currently being recovered in rates charged to consumers are probable of recovery in the future based upon prior recovery of similar costs allowed by our regulator. The recovery of regulatory assets is approved by the RCA either in standard SRFs, general rate case filings or specified independent requests. In most cases, deferred charges are recovered over the life of the underlying asset. Deferred Liabilities Deferred liabilities, at December 31 consisted of the following: (9) Patronage Capital Chugach has a Board-approved capital credit retirement policy, which is contained in Chugach’s Financial Forecast. This establishes, in general, a plan to return the capital credits of wholesale and retail customers based on the members’ proportionate contribution to Chugach’s assignable margins. At December 31, 2016, Chugach had $169,996,436 of patronage capital (net of capital credits retired in 2016), which included $164,182,580 of patronage capital that had been assigned and $5,813,856 of patronage capital to be assigned to its members. At December 31, 2015, Chugach had $167,447,781 of patronage capital (net of capital credits retired in 2015), which included $160,944,929 of patronage capital that had been assigned and $6,502,852 of patronage capital to be assigned to its members. Approval of actual capital credit retirements is at the discretion of the Chugach Board. Chugach records a liability when the retirements are approved by the Board. In December of 2013, the Board resumed its capital credit retirement program. Chugach entered into an agreement with HEA to return all of its patronage capital within five years after expiration of its power sales agreement, which was December 31, 2013. This patronage capital retirement was related to a settlement agreement associated with the 2005 Test Year General Rate Case (Docket U-06-134). The RCA accepted the parties’ settlement agreement on August 9, 2007. HEA’s patronage capital payable was $7.9 million at December 31, 2016 and 2015, respectively. In an agreement reached in May of 2014 with MEA, capital credits retired to MEA are classified as patronage capital payable on Chugach’s Balance Sheet. MEA’s patronage capital payable was $4.1 million and $3.2 million at December 31, 2016 and 2015, respectively. Chugach Electric Association, Inc. December 31, 2016 and 2015 The Second Amended and Restated Indenture of Trust (Indenture) and the CoBank Second Amended and Restated Master Loan Agreement prohibit Chugach from making any distribution of patronage capital to Chugach’s customers if an event of default under the Indenture or debt agreements exists. Otherwise, Chugach may make distributions to Chugach’s members in each year equal to the lesser of 5% of Chugach’s patronage capital or 50% of assignable margins for the prior fiscal year. This restriction does not apply if, after the distribution, Chugach’s aggregate equities and margins as of the end of the immediately preceding fiscal quarter are equal to at least 30% of Chugach’s total liabilities and equities and margins. Capital credits retired, net of HEA’s allocations, were $3,265,201, $3,190,124, and $5,130,381 for the years ended December 31, 2016, 2015, and 2014, respectively. With the exception of MEA’s and HEA’s patronage capital payable, the outstanding liability for capital credits authorized but not paid at December 31, 2016, 2015, and 2014 was $2,014,080, $2,105,440 and $1,042,064, respectively. (10) Other Equities A summary of other equities at December 31 follows: 1Represents unclaimed capital credits that have met all requirements of Alaska Statute section 34.45.200 regarding Alaska’s unclaimed property law and has therefore reverted to Chugach. Chugach Electric Association, Inc. December 31, 2016 and 2015 (11) Debt Covenants Chugach is required to comply with all covenants set forth in the Indenture that secures the 2011 Series A Bonds, the 2012 Series A Bonds and the 2016 CoBank Note. The CoBank Note is governed by the Second Amended and Restated Master Loan Agreement, which is secured by the Indenture dated January 20, 2011. Chugach Electric Association, Inc. December 31, 2016 and 2015 Chugach is also required to comply with the 2016 Credit Agreement, between Chugach and NRUCFC, KeyBank National Association, Bank of America, N.A., CoBank, and ACB dated June 13, 2016, governing loans and extensions of credit associated with Chugach’s commercial paper program, in an aggregate principal amount not exceeding $150.0 million at any one time outstanding. Chugach is also required to comply with other covenants set forth in the Revolving Line of Credit Agreement with NRUCFC. Security The Indenture, which became effective on January 20, 2011, imposes a lien on substantially all of Chugach’s assets to secure Chugach’s long-term debt obligations. Assets that are generally not subject to the lien of the Indenture include cash (other than cash deposited with the indenture trustee); instruments and securities; patents, trademarks, licenses and other intellectual property; vehicles and other movable equipment; inventory and consumable materials and supplies; office furniture, equipment and supplies; computer equipment and software; office leases; other leasehold interests for an original term of less than five years; contracts (other than power sales agreements with members having an original term exceeding three years, certain contracts specifically identified in the indenture, and other contracts relating to the ownership, operation or maintenance of generation, transmission or distribution facilities); non-assignable permits, licenses and other contract rights; timber and minerals separated from land; electricity, gas, steam, water and other products generated, produced or purchased; other property in which a security interest cannot legally be perfected by the filing of a Uniform Commercial Code financing statement, and certain parcels of real property specifically excepted from the lien of the Indenture. The lien of the Indenture may be subject to various permitted encumbrances that include matters existing on the date of the Indenture or the date on which property is later acquired; reservations in United States patents; non-delinquent or contested taxes, assessments and contractors’ liens; and various leases, rights-of-way, easements, covenants, conditions, restrictions, reservations, licenses and permits that do not materially impair Chugach’s use of the mortgaged property in the conduct of Chugach’s business. Rates The Indenture also requires Chugach, subject to any necessary regulatory approval, to establish and collect rates reasonably expected to yield margins for interest equal to at least 1.10 times total interest expense. If there occurs any material change in the circumstances contemplated at the time rates were most recently reviewed, the Indenture requires Chugach to seek appropriate adjustment to those rates so that they would generate revenues reasonably expected to yield margins for interest equal to at least 1.10 times interest charges, provided, however, upon review of rates based on a material change in circumstances, rates are required to be revised in order to comply and there are less than six calendar months remaining in the current fiscal year, Chugach can revise its rates so as to reasonably expect to meet the covenant for the next succeeding 12-month period after the date of any such revision. Chugach Electric Association, Inc. December 31, 2016 and 2015 The CoBank Master Loan Agreement also required Chugach to establish and collect rates reasonably expected to yield margins for interest equal to at least 1.10 times interest expense. The Second Amended and Restated Master Loan Agreement with CoBank, which became effective on June 30, 2016, did not change this requirement. The 2016 Credit Agreement governing the unsecured facility providing liquidity for Chugach’s Commercial Paper Program requires Chugach to maintain minimum margins for interest of at least 1.10 times interest charges for each fiscal year. Margins for interest generally consist of Chugach’s assignable margins plus total interest expense. Distributions to Members Under the Indenture and debt agreements, Chugach is prohibited from making any distribution of patronage capital to Chugach’s customers if an event of default under the Indenture or debt agreements exists. Otherwise, Chugach may make distributions to Chugach’s members in each year equal to the lesser of 5% of Chugach’s patronage capital or 50% of assignable margins for the prior fiscal year. This restriction does not apply if, after the distribution, Chugach’s aggregate equities and margins as of the end of the immediately preceding fiscal quarter are equal to at least 30% of Chugach’s total liabilities and equities and margins. Maturities of Long-term Obligations Long-term obligations at December 31, 2016, mature as follows: Lines of credit Chugach maintains a $50.0 million line of credit with NRUCFC. Chugach did not utilize this line of credit in 2016 or 2015, and therefore had no outstanding balance at December 31, 2016 and 2015. The borrowing rate is calculated using the total rate per annum and may be fixed by NRUCFC. The borrowing rate was 2.90% at December 31, 2016 and 2015. The NRUCFC Revolving Line Of Credit Agreement requires that Chugach, for each 12-month period, for a period of at least five consecutive days, pay down the entire outstanding principal balance. The NRUCFC line of credit expires October 12, 2017, and is immediately available for unconditional borrowing. Chugach Electric Association, Inc. December 31, 2016 and 2015 Commercial Paper On November 17, 2010, Chugach entered into a $300.0 million Unsecured Credit Agreement, which is used to back Chugach’s Commercial Paper Program. The participating banks were NRUCFC, Bank of America, N.A., KeyBank National Association, JPMorgan Chase Bank, N.A., Bank of Montreal, CoBank, ACB, Goldman Sachs Bank USA, Bank of Taiwan, Los Angeles Branch and Chang Hwa Commercial Bank, Ltd., Los Angeles Branch. Effective May 4, 2012, Chugach reduced the commitment amount to $100.0 million and on June 29, 2012, amended and extended the Credit Agreement to update the pricing and extend the term. This pricing included an all-in drawn spread of one month London Interbank Offered Rate (LIBOR) plus 107.5 basis points, along with a 17.5 basis points facility fee (based on an A- unsecured debt rating). The Amended Unsecured Credit Agreement was set to expire on November 17, 2016. On June 13, 2016, Chugach entered into a $150.0 million senior unsecured credit facility, the Credit Agreement, which is used to back Chugach’s commercial paper program. The new pricing includes an all-in drawn spread of one month LIBOR plus 90.0 basis points, along with a 10.0 basis points facility fee (based on an A/A2/A unsecured debt rating). The new Credit Agreement will expire on June 13, 2021. The participating banks include NRUCFC, KeyBank National Association, Bank of America, N.A., and CoBank, ACB. Our commercial paper can be repriced between one day and 270 days. Chugach is expected to continue to issue commercial paper in 2017, as needed. Chugach had $68.2 million and $20.0 million of commercial paper outstanding at December 31, 2016 and 2015, respectively. The following table provides information regarding 2016 monthly average commercial paper balances outstanding (dollars in millions), as well as corresponding weighted average interest rates: Chugach Electric Association, Inc. December 31, 2016 and 2015 Financing On January 21, 2011, Chugach issued $275.0 million of First Mortgage Bonds, 2011 Series A, in two tranches, Tranche A and Tranche B, for the purpose of refinancing the 2001 and 2002 Series A Bonds in 2011 and 2012, and for general corporate purposes. Interest is paid semi-annually on March 15 and September 15 commencing on September 15, 2011. Principal on the 2011 Series A Bonds is paid in equal annual installments beginning March 15, 2012. On January 11, 2012, Chugach issued $250.0 million of First Mortgage Bonds, 2012 Series A, in three tranches, Tranche A, Tranche B and Tranche C, for the purpose of repaying outstanding commercial paper used to finance SPP construction and for general corporate purposes. Interest is paid semi-annually March 15 and September 15 commencing on September 15, 2012. The 2012 Series A Bonds, Tranche A and Tranche C, pay principal in equal installments on an annual basis beginning March 15, 2013, and 2023, respectively. The 2012 Series A Bonds, Tranche B, pay principal beginning March 15, 2013, through 2020, and on March 15, 2032, through 2042. The bonds and all other long-term debt obligations are secured by a lien on substantially all of Chugach’s assets, pursuant to the Indenture, which became effective on January 20, 2011. Chugach had a term loan facility with CoBank, evidenced by the 2011 CoBank Note, which was governed by the Amended and Restated Master Loan Agreement dated January 19, 2011, and secured by the Indenture. On July 13, 2016, Chugach used commercial paper to pay off the $22.2 million balance and therefore had no outstanding balance at December 31, 2016. Chugach had $24.9 million outstanding on this facility at December 31, 2015. On June 30, 2016, Chugach entered into another term loan facility with CoBank, evidenced by the 2016 CoBank Note, which is governed by the Second Amended and Restated Master Loan Agreement dated June 30, 2016, and secured by the Indenture. Chugach had $43.8 million outstanding on this facility at December 31, 2016. The following table provides additional information regarding the 2011 Series A and 2012 Series A bonds and the 2016 CoBank Note at December 31, 2016 (dollars in thousands): Chugach Electric Association, Inc. December 31, 2016 and 2015 (12) Employee Benefit Plans Pension Plans Pension benefits for substantially all union employees are provided through the Alaska Electrical Pension Trust Fund and the UNITE HERE National Retirement Fund, multi-employer plans. Chugach pays an hourly amount per eligible union employee pursuant to the collective bargaining unit agreements. In these master, multi-employer plans, the accumulated benefits and plan assets are not determined or allocated separately to the individual employer. Pension benefits for non-union employees are provided by the National Rural Electric Cooperative Association (NRECA) Retirement and Security Plan (RS Plan). The RS Plan is a defined benefit pension plan qualified under Section 401 and tax-exempt under Section 501(a) of the Internal Revenue Code. Under ASC 960, “Topic 960 - Plan Accounting - Defined Benefit Pension Plans,” the RS Plan is a multi-employer plan, in which the accumulated benefits and plan assets are not determined or allocated separately to individual employers. Chugach makes annual contributions to the RS Plan equal to the amounts accrued for pension expense. Chugach made contributions to all significant pension plans for the years ended December 31, 2016, 2015 and 2014 of $6.7 million, $6.7 million and $6.8 million, respectively. The rate and number of employees in all significant pension plans did not materially change for the years ended December 31, 2016, 2015 and 2014. In December 2012, a committee of the NRECA Board of Directors approved an option to allow participating cooperatives in the Retirement Security (RS) Plan (a defined benefit multiemployer pension plan) to make a prepayment and reduce future required contributions. The prepayment amount is a cooperative’s share, as of January 1, 2013, of future contributions required to fund the RS Plan’s unfunded value of benefits earned to date using Plan actuarial valuation assumptions. The prepayment amount will typically equal approximately 2.5 times a cooperative’s annual RS Plan required contribution as of January 1, 2013. After making the prepayment, for most cooperatives the billing rate is reduced by approximately 25%, retroactive to January 1, 2013. The 25% differential in billing rates is expected to continue for approximately 15 years. However changes in interest rates, asset returns and other plan experience different from that expected, plan assumption changes, and other factors may have an impact on the differential in billing rates and the 15 year period. On December 29, 2106, Chugach made a prepayment of $7.9 million to the NRECA RS Plan. See Note 2n - “Deferred Charges and Liabilities.” Chugach Electric Association, Inc. December 31, 2016 and 2015 The following table provides information regarding pension plans which Chugach considers individually significant: 1A “zone status” determination is not required, and therefore not determined under the Pension Protection Act (PPA) of 2006. 2The CEO is the only participant in the NRECA RS Plan who is subject to an employment agreement, which is effective through April 30, 2020. 3The Alaska Electrical Pension Plan financial statements are publicly available. The NRECA RS Plan financial statements are available on Chugach’s website at www.chugachelectric.com. 4The provisions of the PPA do not apply to the RS Plan, therefore, funding improvement plans and surcharges are not applicable. Future contribution requirements are determined each year as part of the actuarial valuation of the RS Plan and may change as a result of plan experience. Health and Welfare Plans Health and welfare benefits for union employees are provided through the Alaska Electrical Health and Welfare Trust and the Alaska Hotel, Restaurant and Camp Employees Health and Welfare and Pension Trust Fund. Chugach participates in multi-employer plans that provide substantially all union workers with health care and other welfare benefits during their employment with Chugach. Chugach pays a defined amount per union employee pursuant to collective bargaining unit agreements. Amounts charged to benefit costs and contributed to the health and welfare plans for these benefits for the years ending December 31, 2016, 2015, and 2014 were $4.5 million, $4.5 million, and $4.5 million, respectively. Chugach participates in a multi-employer plan through the Group Benefits Program of NRECA for non-union employees. Amounts charged to benefit cost and contributed to this plan for those benefits for the years ended December 31, 2016, 2015, and 2014 totaled $2.8 million, $2.6 million, and $2.9 million respectively. Chugach Electric Association, Inc. December 31, 2016 and 2015 Money Purchase Pension Plan Chugach participates in a multi-employer defined contribution money purchase pension plan covering some employees who are covered by a collective bargaining agreement. Contributions to the Plan are made based on a percentage of each employee’s compensation. Contributions to the money purchase pension plan for the years ending December 31, 2016, 2015 and 2014 were $132.3 thousand, $133.6 thousand and $149.2 thousand, respectively. 401(k) Plan Chugach has a defined contribution 401(k) retirement plan which covers substantially all employees who, effective January 1, 2008, can participate immediately. Employees who elect to participate may contribute up to the Internal Revenue Service’s maximum of $18,000 in 2016 and 2015 and $17,500 in 2014, and allowed catch-up contributions for those over 50 years of age of $6,000 in 2016 and 2015 and $5,500 in 2014. Chugach does not make contributions to the plan. Deferred Compensation Effective January 1, 2011, Chugach participates in Vanguard’s unfunded Deferred Compensation Program (the Program) to allow highly compensated employees who elect to participate in the Program to defer a portion of their current compensation and avoid paying tax on the deferrals until received. The program is a non-qualified plan under Internal Revenue Code 457(b). Deferred compensation accounts are established for the individual employees, however, they are considered to be owned by Chugach until a distribution is made. The amounts credited to the deferred compensation account, including gains or losses, are retained by Chugach until the entire amount credited to the account has been distributed to the participant or to the participant’s beneficiary. The balance of the Program for the years ending December 31, 2016, and 2015 was $907,836 and $763,913, respectively. Potential Termination Payments Pursuant to a Chugach Operating Policy, non-represented employees, including the executive officers except the Chief Executive Officer, who are terminated by Chugach for reasons unrelated to employee performance are entitled to severance pay for each year or partial year of service as follows: two weeks for each year of service to a maximum of 26 weeks for 13 years or more of service. Chugach Electric Association, Inc. December 31, 2016 and 2015 (13) Bradley Lake Hydroelectric Project Chugach is a participant in the Bradley Lake Hydroelectric Project (Bradley Lake). Bradley Lake was built and financed by the Alaska Energy Authority (AEA) through State of Alaska grants and $166.0 million of revenue bonds. Chugach and other participating utilities have entered into take-or-pay power sales agreements under which shares of the project capacity have been purchased and the participants have agreed to pay a like percentage of annual costs of the project (including ownership, operation and maintenance costs, debt service costs and amounts required to maintain established reserves). Under these take-or-pay power sales agreements, the participants have agreed to pay all project costs from the date of commercial operation even if no energy is produced. Chugach has a 30.4% share, or 27.4 megawatts (MW) as currently operated, of the project’s capacity. The share of Bradley Lake indebtedness for which we are responsible is approximately $19.0 million. Upon the default of a Bradley Lake participant, and subject to certain other conditions, AEA is entitled to increase each participant’s share of costs pro rata, to the extent necessary to compensate for the failure of another participant to pay its share, provided that no participant’s percentage share is increased by more than 25%. Upon default, Chugach could be faced with annual expenditures of approximately $6.0 million as a result of Chugach’s Bradley Lake take-or-pay obligations. Management believes that such expenditures, if any, would be recoverable through the fuel recovery process. The State of Alaska provided an initial grant for work on a project to divert water from Battle Creek into Bradley Lake. The project is being managed by the Alaska Energy Authority. Based on stream flow measurements from 1991 through 1993, diverting a portion of Battle Creek into Bradley Lake has the potential to increase annual energy output up to 40,000 megawatt-hours (MWh). Chugach would be entitled to 30.4% of the additional energy produced. The following represents information with respect to Bradley Lake at June 30, 2016 (the most recent date for which information is available). Chugach's share of expenses was $5,662,522 in 2016, $5,663,304 in 2015, and $5,228,907 in 2014 and is included in purchased power in the accompanying financial statements. Chugach's share of a Bradley Lake transmission line financed internally is included in Intangible Electric Plant. Chugach Electric Association, Inc. December 31, 2016 and 2015 (14) Eklutna Hydroelectric Project Along with two other utilities, Chugach purchased the Eklutna Hydroelectric Project from the Federal Government in 1997. Ownership was transferred from the United States Department of Energy’s Alaska Power Administration jointly to Chugach (30%), MEA (17%) and ML&P (53%). Plant in service in 2016 included $4,229,167, net of accumulated depreciation of $2,442,175, which represents Chugach’s share of the Eklutna Hydroelectric Project. In 2015, plant in service included $4,401,440, net of accumulated depreciation of $2,203,659. The facility is operated by Chugach and maintained jointly by Chugach and ML&P. Each participant contributes their proportionate share for operation, maintenance and capital improvement costs to the plant, as well as to the transmission line between Anchorage and the plant. Under net billing arrangements, Chugach then reimburses MEA for their share of the costs. Chugach’s share of expenses was $532,678, $689,501, and $761,613 in 2016, 2015, and 2014, respectively, and is included in purchased power, power production and depreciation expense in the accompanying financial statements. ML&P performs major maintenance at the plant. Chugach performs the daily operation and maintenance of the power plant, providing personnel who perform daily plant inspections, meter reading, monthly report preparation, and other activities as required. (15) Beluga River Unit On February 4, 2016, Chugach entered into an agreement entitled, “Purchase and Sale Agreement between ConocoPhillips Alaska, Inc. and Municipality of Anchorage d/b/a Municipal Light & Power and Chugach Electric Association, Inc.” The Purchase and Sale Agreement transfers CPAI’s working interest in the BRU to Chugach and ML&P. The total purchase price was $148.0 million, with Chugach’s portion totaling $44.4 million. Chugach’s interest in the BRU is to reduce the cost of electric service to its retail and wholesale members by securing an additional long-term supply of natural gas to meet on-going generation requirements. The acquisition complements existing gas supplies and is expected to provide greater fuel diversity. Under the joint bid arrangement, Chugach’s ownership of CPAI’s working interest is 30% and ML&P’s ownership is 70%. The ownership shares include the attendant rights and privileges of all gas and oil resources, including 15,500 lease acres (8,200 in Unit / Participating Area and 7,300 held by Unit), Sterling and Beluga producing zones, and CPAI’s 67% working interest in deep oil resources. On April 21, 2016, the acquisition was approved by the RCA (see “Note 5 - Regulatory Matters - Beluga River Unit”) and the transaction closed on April 22, 2016. Chugach had a firm gas supply contract with CPAI as previously discussed in “Note 16 - Commitments and Contingencies - Fuel Supply Contracts”. In addition to Chugach, CPAI had contractual gas sales obligations to ENSTAR through 2017. These contracts were assumed by ML&P and Chugach on the basis of ownership share. Chugach Electric Association, Inc. December 31, 2016 and 2015 The BRU is located on the western side of Cook Inlet, approximately 35 miles from Anchorage, and is an established natural gas field that was originally discovered in 1962. The BRU was jointly owned (one-third) by CPAI, Hilcorp, and ML&P. Following the acquisition, ML&P’s ownership of the BRU increased to approximately 56.7%, Hilcorp’s ownership remained unchanged at 33.3%, and Chugach’s ownership is 10.0%. Chugach’s interest in the BRU is insignificant to the BRU as a whole and compared to Chugach’s operations prior to the acquisition. As such, Chugach has not provided supplemental pro forma financial information. Since the BRU activities are limited to the extraction of natural gas, Chugach is following the guidance provided in ASC 932-810-45-1 (Extractive Activities-Oil and Gas - Consolidation - Other Presentation Matters) and will record its pro rata share of the assets, liabilities, revenues and expenses of the BRU. Chugach recorded the acquisition at fair value on the acquisition date. The fair value estimate used the discounted cash flow method assuming an estimated useful life of 18 years with 27 Bcf of proven developed producing reserves and using Chugach’s BRU financing rate as the credit adjusted risk free rate. The table below outlines the acquisition allocation recorded at December 31, 2016. Acquisition costs are recorded as deferred charges on Chugach’s balance sheet because Chugach believes it is probable the RCA will allow them to be collected through rates, and totaled $1.5 million at December 31, 2016. Chugach has requested that these costs be amortized based on units of production of the BRU and recognized as depreciation and amortization on Chugach’s statement of operations. Each of the BRU participants has a right to take their interest of the gas produced. Parties that take less than their interest of the field’s output may either accept a cash settlement for their underlift or take their underlifted gas in future years. As part of the BRU acquisition, Chugach acquired 30% of CPAI’s underlift, which was 69,099 Mcf at acquisition and was in an overlift position of 84 Mcf at December 31, 2016. Chugach has opted to take any cumulative underlift in gas in the future and will record the gas as fuel expense on the statement of operations when received. The revenue generated by Chugach’s interest in the BRU operations is primarily associated with the gas sold to ENSTAR, pursuant to the aforementioned contract due to expire December 31, 2017. Chugach recognized revenue from the BRU in the amount of $2.8 million through December 31, 2016. Chugach Electric Association, Inc. December 31, 2016 and 2015 Chugach records depreciation, depletion and amortization on BRU assets based on units of production. As of December 31, 2016, Chugach lifted 1.9 Bcf resulting in approximately 25.1 Bcf remaining in Chugach’s proven developed reserves. Prior to the acquisition, CPAI was the contracted operator of the BRU. Following the acquisition, Hilcorp temporarily assumed operations under an agreement similar to that previously held by CPAI. A final operator agreement is expected during the second quarter of 2017. In addition to the operator fees to Hilcorp, other BRU expenses include royalty expense and interest on long-term debt. All expenses other than depreciation, depletion and amortization and interest on long-term debt are included as fuel expense on Chugach’s statement of operations. Chugach has applied and qualified for a small producer tax credit, provided by the State of Alaska, resulting in an estimate of no liability for production taxes. The revenue in excess of expenses less the allowed TIER from BRU operations is adjusted through Chugach’s fuel and purchased power adjustment process. (16) Commitments and Contingencies Contingencies Chugach is a participant in various legal actions, rate disputes, personnel matters and claims both for and against Chugach’s interests. Management believes the outcome of any such matters will not materially impact Chugach’s financial condition, results of operations or liquidity. Chugach establishes reserves when a particular contingency is probable and calculable. Chugach has not accrued for any contingency at December 31, 2016, as it does not consider any contingency to be probable nor calculable. Chugach faces contingencies that are reasonably possible to occur; however, they cannot currently be estimated. Concentrations Approximately 70% of our employees are members of the International Brotherhood of Electrical Workers (IBEW). Chugach has three Collective Bargaining Unit Agreements (CBA) with the IBEW. We also have an agreement with the Hotel Employees and Restaurant Employees (HERE). All three IBEW CBA’s have been renewed through June 30, 2021. The HERE contract was renewed through June 30, 2021. We believe our relationship with our employees is good. Chugach Electric Association, Inc. December 31, 2016 and 2015 Fuel Supply Contracts Chugach has fuel supply contracts from various producers at market terms. A gas supply contract between Chugach and ConocoPhillips Alaska, Inc. and ConocoPhillips, Inc. (collectively “ConocoPhillips”), approved effective by the RCA on August 21, 2009, began providing gas in 2010 and expired December 31, 2016. The total amount of gas under the contract was 62 Bcf. This contract was assumed by Chugach and ML&P as part of the BRU acquisition, on the basis of ownership share. As such, Chugach pays ML&P for 70% of gas purchased under this contract. Chugach entered into a gas contract with Hilcorp effective January 1, 2015, to provide gas through March 31, 2018. On September 15, 2014, the RCA approved an amendment to the Hilcorp gas purchase agreement extending gas delivery and subsequently filling 100 percent of Chugach’s needs through March 31, 2019. On September 8, 2015, the RCA approved another amendment to the Hilcorp gas purchase agreement extending the term of the agreement, thus filling up to 100 percent of Chugach’s needs through March 31, 2023. The total amount of gas under this contract is estimated to be 60 Bcf. All of the production is expected to come from Cook Inlet, Alaska. The terms of the ML&P (previously under ConocoPhillips) and Hilcorp agreements require Chugach to manage the natural gas transportation over the connecting pipeline systems. Chugach has gas transportation agreements with ENSTAR Natural Gas Company (ENSTAR) and Hilcorp. The RCA approved a natural gas supply contract with Marathon Alaska Production, LLC (MAP) effective May 17, 2010. This contract includes two contract extensions that were exercised in 2011. Effective February 1, 2013, this gas purchase agreement was assigned to Hilcorp, who purchased MAP’s assets in Cook Inlet. This contract began providing gas April 1, 2011, and will expire March 31, 2023. The total amount of gas under contract is currently estimated up to 49 Bcf. These contracts fill 100% of Chugach’s needs through March 31, 2023. All of the production is expected to come from Cook Inlet, Alaska. In 2016, 77% of our power was generated from gas, with 9% generated at the Beluga Power Plant and 88% generated at SPP. In 2015, 86% of our power was generated from gas, with 30% generated at Beluga and 61% generated at SPP. The terms of the ConocoPhillips and Hilcorp agreements require Chugach to handle the natural gas transportation over the connecting pipeline systems. We have gas transportation agreements with ENSTAR and Hilcorp. The following represents the cost of fuel purchased and or transported from various vendors as a percentage of total fuel costs for the years ended December 31: Chugach Electric Association, Inc. December 31, 2016 and 2015 Patronage Capital Payable Pursuant to agreements reached with HEA and MEA, and discussed in Note (9) - “Patronage Capital,” patronage capital allocated or retired to HEA or MEA is classified as patronage capital payable on Chugach’s balance sheet. HEA’s patronage capital payable was $7.9 million at December 31, 2016 and 2015. MEA’s patronage capital payable was $4.1 million and $3.2 million at December 31, 2016 and 2015, respectively. Regulatory Cost Charge In 1992, the State of Alaska Legislature passed legislation authorizing the Department of Revenue to collect a Regulatory Cost Charge from utilities to fund the governing regulatory commission, which is currently the RCA. The tax is assessed on all retail consumers and is based on kilowatt-hour (kWh) consumption. The tax is collected monthly and remitted to the State of Alaska quarterly. The Regulatory Cost Charge has changed since its inception (November of 1992) from an initial rate of $0.000626 per kWh to the current rate of $0.000675, effective July 1, 2016. The tax is reported on a net basis and the tax is not included in revenue or expense. Sales Tax Chugach collects sales tax on retail electricity sold to Kenai and Whittier consumers. The tax is collected monthly and remitted to the Kenai Peninsula Borough quarterly. Sales tax is reported on a net basis and the tax is not included in revenue or expense. Gross Revenue Tax Chugach pays to the State of Alaska a gross revenue tax in lieu of state and local ad valorem, income and excise taxes on electricity sold in the retail market. The tax is collected monthly and remitted annually. Production Taxes Production taxes on Chugach fuel purchases are paid directly to our gas producers and are recorded under “Fuel” in Chugach’s financial statements. Underground Compliance Charge In 2005, the Anchorage Municipal Assembly adopted an ordinance to require utilities to convert overhead distribution lines to underground. To comply with the ordinance, Chugach must expend two percent of a three-year average of gross retail revenue within the Municipality of Anchorage annually in moving existing distribution overhead lines underground. Consistent with Alaska Statutes regarding undergrounding programs, Chugach is permitted to amend its rates by adding a two percent charge to its retail members’ bills to recover the actual costs of the program. The rate amendments are not subject to RCA review or approval. Chugach’s liability was $2,507,482 and $5,184,551 for this charge at December 31, 2016 and 2015, respectively, and is included in other current liabilities. These funds are used to offset the costs of the undergrounding program. Chugach Electric Association, Inc. December 31, 2016 and 2015 Environmental Matters Since January 1, 2007, transformer manufacturers have been required to meet the US Department of Energy (DOE) efficiency levels as defined by the Energy Act of 2005 (Energy Act) for all “Distribution Transformers.” As of January 1, 2016, the specific efficiency levels are increasing from the original “TP1” levels to the new “DOE-2016” levels. All new transformers are DOE-2016 compliant. At this time a small increase in capital costs is anticipated along with a reduction in energy losses. The Clean Air Act and Environmental Protection Agency (EPA) regulations under the Clean Air Act establish ambient air quality standards and limit the emission of many air pollutants. New Clean Air Act regulations impacting electric utilities may result from future events or new regulatory programs. On August 3, 2015, the EPA released the final 111(d) regulation language aimed at reducing emissions of carbon dioxide (CO2) from existing power plants that provide electricity for utility customers. In the final rule, the EPA took the approach of making individual states responsible for the development and implementation of plans to reduce the rate of CO2 emissions from the power sector. The EPA initially applied the final rule to 47 of the contiguous states. At this time, Alaska, Hawaii, Vermont, Washington D.C. and two U.S. territories are not bound by the regulation. Alaska may be required to comply at some future date. On February 9, 2016 the U.S. Supreme Court issued a stay on the proposed EPA 111(d) regulations until the DC Circuit decides the case, or until the disposition of a petition to the Supreme Court on the issue. On September 27, 2016, the US Court of Appeals for the District of Columbia Circuit heard oral arguments challenging the legality of the Clean Power Plan. The court is expected to issue a decision in the near future. The EPA 111(d) regulation, in its current form, is not expected to have a material effect on Chugach’s financial condition, results of operations, or cash flows. While Chugach cannot predict the implementation of any additional new law or regulation, or the limitations thereof, it is possible that new laws or regulations could increase capital and operating costs. Chugach has obtained or applied for all Clean Air Act permits currently required for the operation of generating facilities. Chugach is subject to numerous other environmental statutes including the Clean Water Act, the Resource Conservation and Recovery Act, the Toxic Substances Control Act, the Endangered Species Act, and the Comprehensive Environmental Response, Compensation and Liability Act and to the regulations implementing these statutes. Chugach does not believe that compliance with these statutes and regulations to date has had a material impact on its financial condition, results of operation or cash flows. However, the implementation of any additional new law or regulation, or the limitations thereof, or changes in or new interpretations of laws or regulations could result in significant additional capital or operating expenses. Chugach monitors proposed new regulations and existing regulation changes through industry associations and professional organizations. Chugach Electric Association, Inc. December 31, 2016 and 2015 (17) Subsequent Events On March 17, 2017, Chugach issued $40,000,000 of First Mortgage Bonds, 2017 Series A, due March 15, 2037 for general corporate purposes. The 2017 Series A Bonds will mature on March 15, 2037, and will bear interest at 3.43%. Interest will be paid each March 15 and September 15, commencing on September 15, 2017. The 2017 Series A Bonds will pay principal in equal installments on an annual basis beginning March 15, 2018, resulting in an average life of approximately 10.0 years. The bonds are secured, ranking equally with all other long-term obligations, by a first lien on substantially all of Chugach’s assets, pursuant to the Sixth Supplemental Indenture to the Second Amended and Restated Indenture of Trust, which initially became effective on January 20, 2011, as previously amended and supplemented. (18) Quarterly Results of Operations (unaudited) 2016 Quarter Ended 2015 Quarter Ended Item 9
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Based on the provided financial statement excerpt, here's a summary:
Revenue:
- Revenues recognized upon electricity delivery
- Rates authorized by the Regulatory Commission of Alaska (RCA)
- Unbilled revenue accrued at $10,940,274
- Calculated monthly to ensure full calendar year revenue recognition
Accounts Receivable:
- Recorded at invoiced amount
- Allowance for doubtful accounts based on historical write-off experience
- Reviewed monthly
- Considers current economic conditions
Expenses and Accounting:
- Uses estimates for various financial aspects like:
* Doubtful accounts
* Workers' compensation liability
* Deferred charges
* Unbilled revenue
* Utility plant useful life
* Asset retirement obligations
Assets and Liabilities:
- Includes consolidated financial statements for Chugach and Beluga River Unit (BR
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Claude
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Tropic International Inc. Consolidated Financial Statements Year Ended August 31, 2016 (Expressed in Canadian dollars) ACCOUNTING FIRM The Board of Directors and Stockholders of Tropic International Inc.: We have audited the accompanying consolidated balance sheets of Tropic International Inc. (the “Company”) as of August 31, 2016 and 2015, and the related consolidated statements of loss and comprehensive loss, stockholders’ equity, and cash flows for each of the years in the three-year period ended August 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Tropic International Inc. as of August 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended August 31, 2016, in conformity with U.S. generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has a deficit of $5,900,974 since inception, a working capital deficiency of $934,525, and stockholders’ equity of $3,016,652 as of August 31, 2016. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Vancouver, Canada December 13, 2016 See accompanying notes to the consolidated financial statements. TROPIC INTERNATIONAL INC. CONSOLIDATED BALANCE SHEETS (EXPRESSED IN CANADIAN DOLLARS) Contingent liability (Note 18) Subsequent events (Note 19) See accompanying notes to the consolidated financial statements. TROPIC INTERNATIONAL INC. CONSOLIDATED STATEMENTS OF LOSS AND COMPREHENSIVE LOSS (EXPRESSED IN CANADIAN DOLLARS) See accompanying notes to the consolidated financial statements. TROPIC INTERNATIONAL INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (EXPRESSED IN CANADIAN DOLLARS) On June 13, 2016, the Company issued 50,000,000 shares of common stock in exchange for all of the outstanding common shares of Notox. The Company also incurred $19,519 in professional fees relating to this transaction. See Note 3. See accompanying notes to the consolidated financial statements. TROPIC INTERNATIONAL INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (EXPRESSED IN CANADIAN DOLLARS) *The above presentation reflects the issued share capital of Tropic Spa Inc. until the completion of the June 28, 2013 reverse takeover, at which point it is adjusted to reflect the share capital of the Company. The above presentation also reflects a 1:2 reverse split of the Company’s common stock on August 25, 2016. See Note 14. See accompanying notes to the consolidated financial statements. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 1. Company Overview and Basis of Presentation Nature and History of Operations Tropic International Inc. (formerly Rockford Minerals, Inc.) (the “Company”) was incorporated under the laws of the state of Nevada on October 29, 2007. The Company was a natural resource exploration company with an objective of acquiring, exploring and, if warranted and feasible, developing natural resource properties. Activities during the exploration stage included developing the business plan and raising capital. On June 28, 2013, the Company completed a reverse takeover transaction (see Note 2) with Tropic Spa Inc. (“TSI”), a company that manufactures and sells Home Mist Tanning units that deliver a full-body application. As a result of this transaction, the Company became a holding company operating through TSI. Upon the closing of the share exchange agreement described below, the Company changed its fiscal year end from October 31 to August 31 to coincide with the fiscal year end of TSI. On December 6, 2013, the Company changed its name to Tropic International Inc. as a result of a merger with a wholly-owned subsidiary incorporated solely to effect the name change. On September 3, 2014, the Company’s shares became eligible for quotation on the OTCQB under the symbol TRPO. On June 13, 2016, the Company completed an asset acquisition transaction (see Note 3) with Notox Bioscience Inc. (“Notox”), a private Nevada corporation incorporated on May 31, 2016 for the purpose of acquiring 100% of the right, title and interest in and to an exclusive license agreement (the “License Agreement”) with The Cleveland Clinic Foundation (the "Clinic"), an Ohio not-for-profit corporation. As a result of this transaction, the Company is a holding company operating through both TSI and Notox. The accompanying consolidated financial statements include the results of operations of the Company and TSI for the years ended August 31, 2016 and 2015 and of Notox for the period from June 13, 2016 to August 31, 2016. On November 19, 2007, TSI entered into Share Subscription Agreements (the “Agreements”) with MCM Consulting Ltd., Nandoor Enterprises Ltd., Sierra Tan Ltd., Sunshower Incorporated, Sunshower International Corporation and Tropic Spa Group Inc. (the “Originating Companies”). Pursuant to the terms of the Agreements, the Originating Companies subscribed for, in aggregate, 18,202,503 common shares of TSI valued at $3,657,175. This assigned value was the cost to the Originating Companies, as of that date, of developing a Home Mist Tanning system and the application for and acquisition of a United States Patent “Apparatus for Spray Application of a Sunless Tanning Product” (the “US Patent”). The Agreements included a triggering event (a “Triggering Event”) which was defined to mean the occurrence of any of the following events: ● Ninety days after TSI has been listed as a public company on a stock exchange; ● Ninety days after TSI either purchases or is purchased by a company that is trading on a stock exchange; or ● Notwithstanding the above, ninety days after TSI has notified the Originating Companies in writing that a Triggering Event has occurred. The Originating Companies entered into agreements with their shareholders allowing the shareholders, upon the Triggering Event, to exchange their class A shares in the Originating Companies, by exercising the option under their common share exchange warrant, for common shares in TSI. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 1. Company Overview and Basis of Presentation (cont’d) On April 9, 2009, the Board of Directors of TSI (the “Board”) resolved that the Triggering Event had occurred and approved and issued a Notification of Triggering Event to the shareholders of the Originating Companies. The decision to exercise the Triggering Event was driven by three factors: ● The approval of the US Patent; ● Delivery of the final production model on or before April 21, 2009; and ● Implementation of an aggressive marketing strategy. After November 19, 2007, and subsequent to the execution of the Agreements, Tropic Spa Group Inc. (“TSGI”) incurred an additional $2,685,104 on the continued development of the Home Mist Tanning system and the application for and acquisition of the US Patent. On March 11, 2013, TSI executed a second Share Subscription Agreement (the “Second Agreement”) with TSGI to cover the common shares of TSI issued to the shareholders of TSGI in respect of the additional costs incurred. Pursuant to the terms of the Second Agreement, TSGI subscribed for 26,034,520 common shares valued at $3,155,462 covering the period from November 20, 2007 to June 2010. Of these amounts, 3,880,745 common shares were for $470,358 received directly by TSI. The value assigned to the carrying value of the US Patent, during the year ended August 31, 2010, was $2,685,104 ($3,155,462 less $470,358). The total value assigned to the carrying value of the US Patent pursuant to the Agreements and the Second Agreement, collectively, was $6,342,279. On October 16, 2014, the Company, through TSI, obtained an Australian patent (the “Australian Patent”), incurring application costs of $4,976. On June 21, 2016, the Company, through TSI, obtained a Canadian patent (the “Canadian Patent”), incurring application costs of $17,406. The Company, through TSI, has a patent pending which is in the process of being completed for China. Costs incurred are recorded as intangible assets (see Note 8). As reflected in the accompanying consolidated financial statements, the Company has a deficit of $5,900,974 (August 31, 2015 - $4,870,681) since inception, a working capital deficiency of $934,525 (August 31, 2015 - $571,546) and stockholders’ equity of $3,016,652 (August 31, 2015 - $3,603,659). This raises substantial doubt about its ability to continue as a going concern. The ability of the Company to continue as a going concern is dependent on its ability to raise additional capital and to implement its business plan. The accompanying consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. Management believes that actions presently being taken to obtain additional funding and implement its strategic plans provide the opportunity for the Company to continue as a going concern. 2. Reverse Takeover On June 28, 2013 (the “Closing Date”), the Company, its wholly-owned subsidiary 1894632 Ontario Inc. (“Subco”) and TSI entered into a share exchange agreement (the “Exchange Agreement”) with certain of the shareholders of TSI (the “Selling Shareholders”) pursuant to which the Company acquired 39,015,439 common shares, or approximately 78% of the issued and outstanding shares, of TSI in exchange for the issuance of 39,015,439 preferred shares of Subco to the Selling Shareholders on a one-for-one basis. Each one preferred share of Subco is exchangeable into one share of the Company’s common stock at the option of the holder subject to the following restrictions: ● The Selling Shareholders required the written consent of Subco to exchange, sell or otherwise dispose of, directly or indirectly, any of their preferred shares of Subco until the six month anniversary of the Closing Date; ● Within 30 days of that time, and provided TSI generated at least $1,000,000 in gross revenue during the preceding six month period, Subco permitted the Selling Shareholders to require Subco to redeem an aggregate of 1% of its then-outstanding preferred shares on a pro-rata basis; and TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 2. Reverse Takeover (cont’d) ●Within 30 days of each six month anniversary of the Closing Date until June 30, 2015, on which date all restrictions on the preferred shares automatically expired unless extended by the Selling Shareholders, Subco granted the holders of its preferred shares a permission identical to the one above. Upon the closing of the Exchange Agreement, the sole officer and director of TSI became the sole officer and a director of the Company and the Company adopted the business plan of TSI. As a result of the share exchange, the Selling Shareholders controlled approximately 87% of the issued and outstanding common shares of the Company on a fully-exchanged basis as of the Closing Date. The Exchange Agreement represented a reverse takeover and was therefore accounted for under the acquisition method with TSI as the accounting acquirer and continuing entity for accounting and financial reporting purposes and the Company as the legal parent being the acquiree. There was no active market to reliably determine fair value of the consideration other than the value of the identifiable assets acquired. Therefore, the purchase price allocation of the acquisition was based on the fair value of the net liabilities acquired which was charged to additional paid-in-capital. The fair values of assets acquired and liabilities assumed were as follows: On February 17, 2015, the Company, Subco, TSI and the Selling Shareholders entered into an amendment to the Exchange Agreement in order to correct certain administrative errors in the Exchange Agreement and provide for the post-closing execution of the Exchange Agreement by those shareholders of TSI who were not original signatories thereto. In addition, the Selling Shareholders approved certain changes to the rights, privileges, restrictions and conditions attached to the preferred shares of Subco by consent in writing. This included extending the automatic expiration date in respect of the preferred shares of Subco from June 30, 2015 to June 30, 2017. 3. Asset Acquisition and License Agreement On June 13, 2016 (the “Second Closing Date”), the Company, Notox and the shareholders of Notox (the “Notox Shareholders”) entered into a share exchange agreement (the “Share Exchange Agreement”) pursuant to which the Company acquired 100% of the issued and outstanding common stock of Notox from the Notox Shareholders in exchange for the issuance of 50,000,000 shares of the Company’s common stock. See Notes 14 and 19. On the Second Closing Date, Notox and Zoran Holding Corporation ("ZHC"), a private Ontario corporation, entered into an assignment agreement (the "Assignment Agreement") pursuant to which ZHC irrevocably assigned 100% of its right, title and interest in and to the License Agreement, as amended, to Notox. See Note 19. Also on the Second Closing Date, the sole officer and director of Notox and ZHC became a director of the Company. On December 1, 2012, ZHC and the Clinic entered into the License Agreement whereby the Clinic granted ZHC an exclusive worldwide license and a non-exclusive worldwide license in the field of aesthetics and pain to make, use, offer to sell, sell and import certain products throughout the term of the License Agreement. The term continues until the expiration of the last to expire of the certain patents. The License Agreement was amended on July 30, 2013. Pursuant to the License Agreement, as amended, TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 3. Asset Acquisition and License Agreement (cont’d) the Clinic will receive a royalty based on the sale of certain products, a milestone payment upon first commercial sale of the first such product and a percentage of any sublicensing revenues. In the month in which cumulative gross revenues reach a specified amount, the Clinic will be reimbursed for all incurred and to be incurred patent expenses to a specified amount. Royalties and other payments are payable quarterly. ZHC is required to achieve a commercial milestone on or before November 30, 2017, and failure to achieve this milestone, without satisfactory justification, constitutes a material breach of the License Agreement giving the Clinic the right, but not the obligation, to terminate the License Agreement. The Clinic has the right to verify ZHC’s compliance with the License Agreement. As a result of the share exchange and on the Second Closing Date, the Notox Shareholders controlled approximately 89% of the issued and outstanding common stock of the Company (52.5% on a fully-exchanged basis) and Notox became a wholly-owned subsidiary of the Company. Notox does not meet the definition (inputs, processes and outputs criteria) of a business. The Share Exchange Agreement represents an asset acquisition and therefore has been accounted for under the asset acquisition method. Acquired intangible assets are recognized and initially measured based on their fair value plus transaction costs incurred as part of the acquisition. There was no active market to reliably determine the fair value of the License Agreement acquired. Therefore the fair value of the License Agreement was based on the par value of the common stock exchanged by the Company. The fair value and carrying value of the License Agreement is as follows: 4. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the financial statements of the Company, TSI, Notox, Subco and 1894631 Ontario Inc., the Company’s wholly-owned subsidiaries. All significant inter-company balances and transactions have been eliminated. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, the Company evaluates its estimates, including those related to equipment, fair values of intangible assets, and useful lives of intangible assets and the likelihood of realization of its deferred tax assets. The Company bases its estimates on assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 4. Summary of Significant Accounting Policies (cont’d) Concentration of Risk The financial instrument which potentially subjects the Company to a concentration of credit risk is cash. The Company places its cash in an account with a high credit quality financial institution. Significant Accounting Policies The accompanying consolidated financial statements reflect the application of certain significant accounting policies. There have been no material changes to the Company’s significant accounting policies that are disclosed in the consolidated financial statements and notes thereto during the year ended August 31, 2016. Inventory Inventory is stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of inventory exceeds its market value, a provision is made currently for the difference between the cost and market value. The Company’s inventory consists of finished goods, components and supplies. Equipment, Net Equipment is stated at cost, net of accumulated depreciation. Equipment is depreciated over the estimated useful life of the asset. Mould equipment is depreciated at 20% on a declining-balance basis. The website was depreciated on a straight-line basis over five years. One-half of these rates are used in the year of acquisition. Replacements and major improvements are capitalized, while maintenance and repairs are charged to expense as incurred. Upon retirement or sale, the cost of assets disposed of and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is credited or charged to operations. Intangible Assets Patents The US Patent is recorded at the value attributed to the shares issued to the Originating Companies and shareholders of TGSI less accumulated amortization. The US Patent was issued on September 29, 2009 and is effective until September 29, 2026. The Australian and Canadian Patents are recorded at the application costs incurred less accumulated amortization. The Australian Patent was issued on October 16, 2014 and is effective until April 5, 2027. The Canadian Patent was issued on June 21, 2016 and is effective until April 5, 2027. Upon expiration, the patents can be extended subject to certain changes required to secure the extension. Although the effects of obsolescence, demand, competition and other economic factors (such as stability of the industry, technological advances and legislative action that results in an uncertain or changing regulatory environment) can have an adverse effect on the industry and the Company’s product, management is not currently aware of any known adverse factors that will affect the Company in the future. Costs incurred for patents which are in the process of being completed will be amortized over the life of the patent when the patent is issued. The Company does not believe that there are any limits to how long its Home Mist Tanning units can sell in the market place. While it expects to be able to secure extensions for its patents prior to expiry, this cannot be predicted with certainty at this time. Accordingly, management has determined that the best estimates of useful lives of the US, Australian, and Canadian Patents are 17, 13, and 11 years, respectively. At this time, the Company does not believe that the patents will have a residual value at the end of their useful lives. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 4. Summary of Significant Accounting Policies (cont’d) License Agreement The License Agreement is recorded at estimated fair value plus acquisition costs less accumulated amortization. The term of the License Agreement continues until the expiration of the last to expire of the Licensed Patents (as defined in the License Agreement). Management is in the process of determining the best estimate of the useful life of the License Agreement. Amortization and Impairment Definite-lived intangible assets are required to be amortized using a method that reflects the pattern in which the economic benefits of the intangible assets are consumed or utilized. At this time, management is not able to determine with any amount of certainty the number of Home Mist Tanning units that will be sold over the useful lives of the patents. Accordingly, the patents are being amortized on a straight-line basis over the period of their useful lives. Management is in the process of determining the most appropriate method for amortizing the License Agreement. Intangible assets subject to amortization are required to be reviewed for impairment. An impairment loss must be recognized if the intangible asset’s carrying amount is not recoverable and the carrying amount exceeds fair value. The Company applies the following three-step process to identify, recognize and measure impairment of intangible assets: ● Consider whether indicators of impairment are present indicating that the intangible assets’ carrying amount might not be recoverable; ● If indicators are present, perform a recoverability test by comparing the sum of the estimated undiscounted future cash flows attributable to the intangible assets to their carrying amounts; and ● If the undiscounted cash flows used in the recoverability test are less than the intangible assets’ carrying amount, determine the intangible assets’ fair value and recognize an impairment loss if the carrying amount exceeds fair value. Because of the unique nature of a patent and a license agreement, income-producing definite-lived intangible assets, the calculation of cash flows can be very difficult to estimate. In this case, the estimated cash flows reflect the direct revenue expected to be generated by the patents and the License Agreement as well as an allocation of expenses. Leases The Company currently rents premises pursuant to an operating lease. Impairment of Long-Lived Assets Long-lived assets, including equipment and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be evaluated. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the asset to the estimated undiscounted future cash flows expected to be generated by it. If the carrying amount of the asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds its fair value. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 4. Summary of Significant Accounting Policies (cont’d) Sales and Other Revenue The Company sells Home Mist Tanning units and related supplies primarily on line via its website. The Company recognizes revenue when the units and supplies have been shipped to the customer, the amount to be paid by the customer is fixed or determinable and collectability is reasonably assured. Revenue is recorded net of applicable sales taxes. Warranty The Company is committed to supplying products of superior quality and design. Because of this commitment, it provides a limited one year warranty effective from the date of purchase. The Company warranties its Home Mist Tanning units to be free of defects. If a unit stops operating due to defects in materials or workmanship, the Company either repairs or replaces it for free. Production Costs Production costs consist of patent amortization, production consulting fees, equipment depreciation, materials and supplies. Advertising Costs The Company charges all advertising and marketing costs to expense in the period incurred. Income Taxes Deferred income tax is accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income and expense items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax bases of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversals of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At this time, the Company is not able to project future taxable income over the periods in which the deferred tax assets are deductible and, accordingly, management is not able to determine if it is more likely than not that the Company will realize the benefits of these deductible differences. Derivative Financial Instruments The Company does not have any derivative financial assets or liabilities. Fair Value of Financial Instruments Fair values of cash, accounts payable and accrued liabilities, and advances from shareholders approximate fair value because of the short-term nature of these items. Amounts receivable consists primarily of Harmonized Sales Tax (“HST”) receivable from the Government of Canada. HST is not a financial instrument. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 4. Summary of Significant Accounting Policies (cont’d) Foreign Currency The functional currency of the Company and its subsidiaries is the Canadian dollar. The accompanying consolidated financial statements are presented in Canadian dollars. Foreign currency transactions are translated into functional currency using the exchange rates prevailing at the date of the transaction. Foreign currency monetary items are translated at the period-end exchange rate. Non-monetary items measured at historical cost continue to be carried at the exchange rate at the date of the transaction. Exchange differences arising on the translation of monetary items or on settlement of monetary items are recognized in the loss in the period in which they arise. 5. Loss Per Share The following table sets forth the computation of loss per share: 6. Fair Value Measurements Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: Level 1 - Observable inputs such as quoted prices in active markets for identical assets or liabilities; Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and Level 3 - Unobservable inputs that are supported by little or no market activity, which require management judgment or estimation. The Company measures its financial instruments at fair value. The carrying value of cash deposits is a reasonable estimate of its fair value due to the short maturity of the financial instrument. The Company does not have assets and liabilities that are measured at fair value on a recurring basis. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 7. Equipment, Net Equipment, at cost, consisted of: Depreciation was $10,687, $19,132 and $22,473 for the years ended August 31, 2016, 2015 and 2014 respectively. 8. Patents, Net The following tables provide information regarding the patents and patents pending: Also see Note 1 Company Overview and Basis of Presentation. During the year ended August 31, 2016, management identified the following indicators of impairment indicating that the patents’ carrying amounts might not be recoverable: ● The inability to raise equity financing to implement its strategic plan; and ● Operating and cash flow losses since the Company completed the development of the US, Australian, and Canadian patents. Management performed a recoverability test and determined that the estimated undiscounted future cash flows are greater than the patents’ carrying amounts and that, accordingly, there is no impairment. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 8. Patents, Net (cont’d) As of August 31, 2016, amortization expense on intangible assets for the next five years was expected to be as follows: 9. License Agreement, Net Also see Note 3 Asset Acquisition and License Agreement. 10. Accounts Payable and Accrued Liabilities Accounts payable and accrued liabilities consisted of: 11. Related Party Transactions The President of the Company advanced $5,000 during the year ended August 31, 2016 (2015 - $7,500). Advances payable to the President totaled $257,500 at August 31, 2016 (2015 - $252,500). These advances are unsecured and bear interest at 3% per annum. Of this amount, $245,000 is due on demand and $12,500 has no repayment terms. Interest expense of $7,696 was accrued on these advances during the year ended August 31, 2016 (2015 - $7,572). Accrued interest payable to the President totaled $18,578 at August 31, 2016 (2015 - $10,882). Consulting fees paid or accrued as payable to a company controlled by the President of the Company were $136,665 ($102,870 and US$26,040), $88,400 and $88,400 for the years ended August 31, 2016, 2015 and 2014, respectively. Consulting fees paid or accrued as payable to a company controlled by the CEO of the Company were $67,509 (US$56,040), $nil and $nil for the years ended August 31, 2016, 2015 and 2014, respectively. See Note 3. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 11. Related Party Transactions (cont’d) Consulting fees accrued as payable to a company controlled by a major shareholder of the Company were $136,665 ($102,870 and US$26,040), $88,400 and $88,400 for the years ended August 31, 2016, 2015 and 2014, respectively. See Note 3. Prior to June 13, 2016, this company was not a related party. Consulting fees accrued as payable to a company controlled by the former CFO of the Company were $75,000, $nil and $nil for the years ended August 31, 2016, 2015 and 2014, respectively. See Note 19. At August 31, 2016, the Company owed $286,555 (2015 - $265,630) to its President, including the above advances and accrued interest, and $10,477 (2015 - $2,248) for reimbursable expenses incurred on the Company’s behalf. At August 31, 2016, the Company owed $215,224 ($181,070 and US$26,040) (2015 - $78,200) in consulting fees to a company controlled by the President of the Company. At August 31, 2016, the Company owed $34,154 (US$26,040) (2015 - $nil) in consulting fees to a company controlled by the CEO of the Company. At August 31, 2016, the Company owed $215,224 ($181,070 and US$26,040) (2015 - $78,200) in consulting fees to a company controlled by a major shareholder. Prior to June 13, 2016, this company was not a related party. At August 31, 2016, the Company owed $12,500 (2015 - $12,500) in shareholder advances and $761 (2015 - $385) in accrued interest on these advances to the same major shareholder. Prior to June 13, 2016, this shareholder was not a related party. At August 31, 2016, the Company owed $75,000 (2015 - $nil) in consulting fees to a company controlled by the former CFO of the Company. See Note 19. All transactions with related parties occurred in the normal course of business and were measured at the exchange amount, which was the amount of consideration agreed upon between management and the related parties. Also see Notes 3 and 14. 12. Advances from Shareholders Shareholders of the Company advanced $nil to the Company during the year ended August 31, 2016 (2015 - $95,000). Advances payable to shareholders totaled $157,500 at August 31, 2016 (2015 - $157,500). These advances are unsecured and bear interest at 3% per annum. Of this amount, $12,500 is due on demand and $145,000 has no repayment terms. Interest expense of $4,738 was accrued on these advances during the year ended August 31, 2016 (2015 - $4,065). Accrued interest payable to shareholders totaled $9,031 at August 31, 2016 (2015 - $4,293). 13. Commitments On November 16, 2015, the Company entered into a consulting agreement (the “ECC Agreement”) with Edgewater Consulting Corp., a private Ontario corporation (“ECC”). Pursuant to the ECC Agreement, ECC, through its principal, acted in the capacity of CFO of the Company. The ECC Agreement was terminated effective November 10, 2016 (see Note 19). A signing bonus of 750,000 exchangeable preferred shares of Subco was issued on August 24, 2016. As at August 31, 2016, ECC is entitled to $75,000 in accrued remuneration. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 13. Commitments (cont’d) On December 1, 2015, the Company entered into consulting agreements with 1040614 Ontario Ltd., a private Ontario corporation (the “Old 1040614 Agreement”) and MCM Consulting, an Ontario sole proprietorship (the “Old MCM Agreement”, and together with the Old 1040614 Agreement, the “Old Agreements”). Pursuant to the Old 1040614 Agreement, the company, through its principal, performed various services related to business development, strategic planning and capital-raising for the Company. Pursuant to the Old MCM Agreement, the sole proprietor acted in the capacity of CEO of the Company. On June 13, 2016, the Old 1040614 and MCM Agreements were terminated and replaced by the 1040614 and MCM Agreements (see below). As at August 31, 2016, in addition to previously accrued amounts, 1040614 and MCM are each entitled to $80,770 in accrued remuneration in respect of the Old Agreements. On February 4, 2016, the Company entered into a consulting agreement (the “Old ZKC Agreement”) with Zoran K Corporation, a private Ontario corporation (“ZKC”). Pursuant to the Old ZKC Agreement, ZKC, through its principal, acted in the capacity of the Company’s exclusive sales, marketing and product development agent. On June 13, 2016, the Old ZKC Agreement was terminated and replaced by the ZKC Agreement (see below). As at August 31, 2016, there is no remuneration payable by the Company under the Old ZKC Agreement. On February 10, 2016, the Company renewed its premises lease dated November 11, 2011 for one additional year from February 1, 2016 to January 31, 2017 for a rental of $13,200 per year plus HST. On June 13, 2016, the Company entered into consulting agreements with 1040614 Ontario Ltd. (the “1040614 Agreement”), MCM Consulting (the “MCM Agreement”) and ZKC (the “ZKC Agreement”). Pursuant to the 1040614 Agreement, the company, through its principal, performs general consulting services on behalf of the Company. Pursuant to the MCM Agreement, the sole proprietor acts in the capacity of President of the Company. Pursuant to the ZKC Agreement, ZKC, through its principal, acts in the capacity of CEO of the Company. Each consulting agreement is for a period of 10 years, with successive automatic renewal periods of two years until terminated. Pursuant to these consulting agreements, each consultant is entitled to receive the following compensation: ● Remuneration - an aggregate of US$125,000 per annum plus HST on a bi-monthly basis; ● EPS Bonus - when the Company generates earnings per share of $0.05, plus any multiple thereof, the Company shall issue the consultant 1,000,000 shares of the Company’s common stock and pay the consultant US$250,000 plus HST; ● Change of Control Bonus - immediately prior to the completion of a change of control (as defined in these consulting agreements) the Company shall issue the consultant an aggregate of 20,000,000 shares of the Company’s common stock; and ● Additional Bonus - the company may from time to time pay the consultant one or more bonuses as determined by the Board of Directors at its sole discretion. 14. Stockholders' Equity The Company is authorized to issue 300,000,000 shares of common stock at a par value of $US0.001. On August 25, 2016, the Company completed a reverse split of the Company's common stock at the ratio of one new share for every two existing shares. All share and per share amounts have been adjusted to reflect this reverse split. At August 31, 2016, the Company had 56,132,073 shares of common stock legally issued and outstanding (2015 - 6,132,073 shares). TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 14. Stockholders' Equity (cont’d) On June 28, 2013, pursuant to the Exchange Agreement, RMI acquired 39,015,439 common shares of TSI in exchange for the issuance of 39,015,439 preferred shares of Subco to the Selling Shareholders on a one-for-one basis. As a result of the Exchange Agreement, TSI became the Company’s majority-owned subsidiary. Each preferred share of Subco is exchangeable into one share of the Company’s common stock at the option of the holder subject to certain restrictions. As at August 31, 2016 and 2015, none of the preferred shares had been exchanged. As a condition of the closing of the Exchange Agreement, the Company also entered into a Support Agreement and a Voting and Exchange Trust Agreement on the closing date. The Support Agreement ensures that the obligations of Subco remain effective until all of the preferred shares have been exchanged. The Voting and Exchange Trust Agreement provides and establishes a procedure whereby the voting rights attached to shares of the Company’s common stock are exercisable by the registered holders (the Selling Shareholders) of the preferred shares. The Trustee holds legal title to a Special Voting Share to which voting rights are attached for the benefit of the Selling Shareholders. The Trustee holds the Special Voting Share solely for the use and benefit of the Selling Shareholders. Common Stock Issuances During the year ended August 31, 2016, the Company completed the following common stock transactions: ● 50,000,000 shares of common stock were issued on June 13, 2016 at a par value of US$0.002 ($127,920; US$100,000). See Note 3. Pursuant to a stock restriction agreement entered into on June 13, 2016, these shares cannot be sold or otherwise disposed of until June 30, 2017. During the year ended August 31, 2015, the Company had no common stock transactions. Stock Subscribed During the year ended August 31, 2016, $315,366 in stock subscriptions was received pursuant to 12 individual private placements. These subscriptions are for a total of: ● 80,000 units of the Company at a price of $0.50 per unit. Each unit consists of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of $0.80 per share for two years. ● 220,770 units of the Company at a price of US$0.50 per unit. Each unit consists of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of US$0.80 per share for two years. ● 100,000 units of the Company at a price of US$1.00 per unit. Each unit consists of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of US$1.40 per share for two years. During the year ended August 31, 2015, $30,000 in stock subscriptions was received pursuant to three individual private placements. These subscriptions were for a total of 60,000 units of the Company at a price of $0.50 per unit. Each unit consists of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of $0.80 per share for two years. See Note 19. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 15. Taxes Income tax expense differs from the amounts computed by applying the statutory income tax rate to net loss before income taxes as follows: (1)Canada - 26.50%; United States - 34% Deferred Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes. Significant components of the Company’s deferred tax assets are as follows: Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. A valuation allowance was established based upon management’s inability to determine whether sufficient future profits will be generated. The Company has approximately $4,069,000 of United States and Canadian net operating loss carryforwards expiring from 2024 to 2036. 16. Risks and Uncertainties The Company’s future results of operations involve a number of risks and uncertainties. Factors that could affect its future operating results and cause actual results to vary materially from expectations include, but are not limited to: current economic conditions, uncertainty in the potential markets for its Home Mist Tanning units, increasing competition, and dependence on its existing management and key personnel. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 17. Accounting Pronouncements During the year ended August 31, 2016, the Financial Accounting Standards Board (“FASB”) issued the following Accounting Standard Updates (“ASUs”) that may be of relevance to the Company. The Company is currently assessing the impact that the adoption of these ASUs will have on its financial statements and related disclosures. ● August 2014 - ASU No. 2014-15, “Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” (“ASU 2014-15”) is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, with early adoption permitted. The Company is currently assessing the impact the adoption of ASU 2014-15 will have on its financial statements and related disclosures. ● July 2015 - ASU No. 2015-11, which amended Accounting Standards Codification (“ASC”) Topic 330 Inventory simplifies the measurement of inventory, applying to inventories for which cost is determined by methods other than last-in first-out (LIFO) and the retail inventory method (RIM), specifying that an entity should measure inventory at the lower of cost and net realizable value instead of at the lower of cost or market. The amendments in this ASU are effective for fiscal years beginning after December 15, 2016, and interim periods therein. ● January 2016 - ASU No. 2016-01 “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” enhances the reporting model for financial instruments, including certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The amendments in this ASU are effective for reporting periods beginning after December 15, 2017, with early adoption permitted. ● February 2016 - ASU No. 2016-02 “Leases (Topic 842)” provides guidance establishing the principles to report transparent and economically neutral information about the assets and liabilities that arise from leases. The amendments in this ASU are effective for fiscal years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020. ● April 2016 - ASU 2016-10 “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing” clarifies the process of identifying performance obligations and provide licensing implementation guidance. The amendments in this ASU are effective for reporting periods beginning after December 15, 2017, with early adoption permitted for annual periods beginning after December 15, 2016. ● May 2016 - ASU No. 2016-12 “Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients” provides guidance regarding how an entity should recognize revenue for the transfer of goods and services to customers to reflect the consideration to which the entity expects to be entitled in exchange for those goods or services. The amendments in this ASU are effective for reporting periods beginning after December 15, 2017, with early adoption permitted for annual periods beginning after December 15, 2016. ● August 2016 - ASU No. 2016-15 “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” provides guidance concerning how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments in this ASU are effective for reporting periods beginning after December 15, 2017, to be applied retrospectively, with early adoption permitted. TROPIC INTERNATIONAL INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (EXPRESSED IN CANADIAN DOLLARS) 18. Contingent Liability Pursuant to the Exchange Agreement, as amended, the Company may be required to acquire up to 296,500 common shares of TSI, being those TSI shares still outstanding, in exchange for 148,250 preferred shares of Subco on a one-for-two basis. Such preferred shares would then be exchangeable on the same basis as the approximately 50 million Subco preferred shares currently outstanding (see Notes 2 and 14). On August 24, 2016, 21,672,623 common shares of TSI were exchanged for 10,836,312 preferred shares of Subco. 19. Subsequent Events On September 21, 2016, the Company received US$300,000 ($395,580) in stock subscriptions pursuant to two individual private placements. These subscriptions are for 300,000 units of the Company at a price of US$1.00 per unit. Each unit consists of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of US$1.40 for a period of two years from the closing date of the financing. US$15,020 ($19,805) in finder’s fees were paid in respect of these private placements. On October 27, 2016, the Company elected to terminate the ECC Agreement and provided ECC with 14 days written notice in accordance with the terms of the ECC Agreement. See Note 13. The Company’s President was named interim CFO. On October 31, 2016, the Company closed a concurrent Canadian and US dollar financing as follows: ● Canadian financing - the Company issued 140,000 units, with each unit consisting of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of $0.80 per share until October 31, 2018. ● US financing - the Company issued 220,770 units, with each unit consisting of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of US$0.80 per share until October 31, 2018. See Note 14. On November 2, 2016, the Company closed a US dollar financing pursuant to which the Company issued 400,000 units, with each unit consisting of one share of the Company’s common stock and one warrant to purchase one share of common stock exercisable at a price of US$1.40 per share until November 2, 2018. See Note 14. On November 23, 2016, the Company, Notox and the Notox Shareholders entered into an amendment to the Share Exchange Agreement in order to clarify certain sections in the Share Exchange Agreement, to provide for an assignment fee and to describe how the Company will use the proceeds of any equity financing completed after the Second Closing Date. In consideration for inducing ZHC to enter into the Assignment Agreement, the Company will pay an aggregate of US$1,000,000 to ZKC in the form of a one-time assignment fee. This fee is payable as follows: ● US$50,000 per calendar month beginning on October 1, 2016; and ● Upon completion of any equity financing pursuant to which the Company raises gross proceeds of at least US$1,000,000, the balance of the fee, less any amounts already paid. The required payments were made on October 1, 2016 and November 1, 2016. See Note 3. Subsequent to the year end, the Company, Notox and the Clinic are in the process of negotiating a second amendment to the License Agreement. See Note 3.
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I apologize, but the text you've provided appears to be an incomplete or fragmented financial statement excerpt. It seems to be cut off mid-sentence and lacks sufficient context to provide a meaningful summary. To help you summarize a financial statement, I would need the complete document with full details about revenues, expenses, assets, liabilities, and other financial metrics.
If you could provide the full financial statement or clarify which specific parts you'd like summarized, I'd be happy to assist you.
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Claude
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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page | 32 ACCOUNTING FIRM Board of Directors and Stockholders Handy & Harman Ltd. New York, New York We have audited the accompanying consolidated balance sheets of Handy & Harman Ltd. and subsidiaries (the "Company") as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive (loss) income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Handy & Harman Ltd. and subsidiaries at December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Handy & Harman Ltd.'s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2017 expressed an unqualified opinion thereon. /s/ BDO USA, LLP New York, New York February 28, 2017 Page | 33 ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING Board of Directors and Stockholders Handy & Harman Ltd. New York, New York We have audited Handy & Harman Ltd. and subsidiaries' (the "Company") internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Handy & Harman Ltd.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Item 9A, "Management's Report on Internal Control Over Financial Reporting." Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. As indicated in the accompanying Item 9A, "Management's Report on Internal Control Over Financial Reporting," management's assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of SL Industries, Inc. ("SLI"), which was acquired on June 1, 2016, and the Electromagnetic Enterprise division ("EME") of Hamilton Sundstrand Corporation, which was acquired on September 30, 2016, both which are included on the consolidated balance sheet of Handy & Harman Ltd. as of December 31, 2016, and the related consolidated statements of operations, comprehensive (loss) income, changes in stockholders' equity and cash flows for the year then ended. These businesses constituted 35.3% of total assets as of December 31, 2016 and 15.5% of net sales for the year then ended. Management did not assess the effectiveness of internal control over financial reporting of SLI and EME because of the timing of the acquisitions, which were completed on June 1, 2016 and September 30, 2016, respectively. Our audit of internal control over financial reporting of Handy & Harman Ltd. also did not include an evaluation of the internal control over financial reporting of SLI and EME. In our opinion, Handy & Harman Ltd. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Handy & Harman Ltd. as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive (loss) income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2016, and our report dated February 28, 2017 expressed an unqualified opinion thereon. /s/ BDO USA, LLP New York, New York February 28, 2017 Page | 34 HANDY & HARMAN LTD. Consolidated Balance Sheets SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Page | 35 HANDY & HARMAN LTD. Consolidated Statements of Operations SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Page | 36 HANDY & HARMAN LTD. Consolidated Statements of Comprehensive (Loss) Income SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Page | 37 HANDY & HARMAN LTD. Consolidated Statements of Changes in Stockholders' Equity SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Page | 38 HANDY & HARMAN LTD. Consolidated Statements of Cash Flows Page | 39 SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Page | 40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - The Company and Nature of Operations Handy & Harman Ltd. ("HNH") is a diversified manufacturer of engineered niche industrial products. HNH's diverse product offerings are marketed throughout the United States and internationally. HNH owns Handy & Harman Group Ltd. ("H&H Group"), which owns Handy & Harman ("H&H") and Bairnco, LLC ("Bairnco"), formerly Bairnco Corporation. HNH manages its group of businesses on a decentralized basis with operations principally in North America. HNH's business units encompass the following segments: Joining Materials, Tubing, Building Materials, Performance Materials, Electrical Products, and Kasco Blades and Route Repair Services ("Kasco"). The Electrical Products segment is currently comprised of the operations of SL Industries, Inc. ("SLI") and the Electromagnetic Enterprise division ("EME") of Hamilton Sundstrand Corporation ("Hamilton"), which were acquired on June 1, 2016 and September 30, 2016, respectively, as discussed in Note 4 - "Acquisitions." All references herein to "we," "our" or the "Company" refer to HNH together with all its subsidiaries. Note 2 - Summary of Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of HNH and its subsidiaries. All material intercompany transactions and balances have been eliminated. Discontinued Operations The results of operations for businesses that have been disposed of or classified as held-for-sale are segregated from the results of the Company's continuing operations and classified as discontinued operations for each period presented in the Company's consolidated statements of operations. Similarly, the assets and liabilities of such businesses are reclassified from continuing operations and presented as discontinued operations for each period presented on the Company's consolidated balance sheets. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to bad debts, inventories, long-lived assets, intangibles, accrued liabilities, income taxes, pension and other post-retirement benefit obligations, and contingencies and litigation. Estimates are based on historical experience, expected future cash flows and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Revenue Recognition Revenues are recognized when title and risk of loss has passed to the customer. This condition is normally met when product has been shipped or the service performed. An allowance is provided for estimated returns and discounts based on experience. Cash received by the Company from customers prior to shipment of goods, or otherwise not yet earned, is recorded as deferred revenue. Rental revenues are derived from the rental of certain equipment to the food industry where customers prepay for the rental period, usually three to six month periods. For prepaid rental contracts, sales revenue is recognized on a straight-line basis over the term of the contract. Service revenues consist of repair and maintenance work performed on equipment used at mass merchants, supermarkets and restaurants. The Company experiences a certain degree of sales returns that varies over time, but is able to make a reasonable estimation of expected sales returns based upon history. The Company records all shipping and handling fees billed to customers as revenue, and related costs are charged principally to cost of goods sold when incurred. The Company has also entered into agreements with certain customers under which the Company has agreed to pay rebates to such customers. These programs are typically structured to incentivize the customers to increase their annual purchases from the Company. The rebates are usually calculated as a percentage of the purchase amount, and such percentages may increase as the customer's level of purchases rise. Rebates are recorded as a reduction of net sales in the consolidated statements of operations and are accounted for on an accrual basis. As of December 31, 2016 and 2015, accrued rebates payable totaled $7.4 million and $7.6 million, respectively, and are included in accrued liabilities on the consolidated balance sheets. In limited circumstances, the Company is required to collect and remit sales tax on certain of Page | 41 its sales. The Company accounts for sales taxes on a net basis, and such sales taxes are not included in net sales in the consolidated statements of operations. Cash and Cash Equivalents Cash and cash equivalents include cash on hand and on deposit and highly liquid debt instruments with original maturities of three months or less. As of December 31, 2016 and 2015, the Company had cash held in foreign banks of $10.9 million and $4.5 million, respectively. The Company's credit risk arising from cash deposits held in U.S. banks in excess of insured amounts is reduced given that cash balances in U.S. banks are generally utilized to pay down the Company's revolving credit loans (see Note 11 - "Credit Facilities"). At December 31, 2016, the Company held cash and cash equivalents which exceeded federally-insured limits by approximately $17.6 million. Trade Receivables and Allowance for Doubtful Accounts The Company extends credit to customers based on its evaluation of the customer's financial condition. The Company does not typically require that any collateral be provided by its customers. The Company has established an allowance for accounts that are expected to be uncollectible in the future. This estimated allowance is based primarily on management's evaluation of the financial condition of the customer and historical experience. The Company monitors its trade receivables and charges to expense an amount equal to its estimate of expected credit losses. Accounts that are outstanding longer than contractual payment terms are considered past due. The Company considers a number of factors in determining its estimates, including the length of time its trade receivables are past due, the Company's previous loss history and the customer's current ability to pay its obligation. Trade receivable balances are charged off against the allowance when it is determined that the receivables will not be recovered, and payments subsequently received on such receivables are credited to recovery of accounts written-off. The Company does not typically charge interest on past due receivables. The Company believes that the credit risk with respect to trade receivables is limited due to the Company's credit evaluation process, the allowance for doubtful accounts that has been established and the diversified nature of its customer base. There were no customers which accounted for more than 10% of consolidated net sales in 2016, 2015 or 2014. In 2016, 2015 and 2014, the 15 largest customers accounted for approximately 29%, 33% and 31% of consolidated net sales, respectively. Inventories Inventories are generally stated at the lower of cost (determined by the first-in, first-out method or average cost method) or market. Cost is determined by the last-in, first-out ("LIFO") method for certain precious metal inventory held in the U.S., and remaining precious metal inventory is primarily carried at fair value. For precious metal inventory, no segregation among raw materials, work in process and finished products is practicable. Non-precious metal inventories are evaluated for estimated excess and obsolescence based upon assumptions about future demand and market conditions, and are adjusted accordingly. If actual market conditions are less favorable than those projected, future write-downs may be required. Derivatives and Risks Precious Metal and Commodity Risk HNH's precious metal and commodity inventories are subject to market price fluctuations. HNH enters into commodity futures and forward contracts to mitigate the impact of price fluctuations on its precious and certain non-precious metal inventories that are not subject to fixed price contracts. The Company's hedging strategy is designed to protect it against normal volatility; therefore, abnormal price changes in these commodities or markets could negatively impact HNH's earnings. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. HNH accounts for these contracts as either fair value hedges or economic hedges under the guidance in Accounting Standards Codification ("ASC") 815, Derivatives and Hedging. Fair Value Hedges. The fair values of these derivatives are recognized as derivative assets and liabilities on the consolidated balance sheets. The net change in fair value of the derivative assets and liabilities, and the change in the fair value of the underlying hedged inventory, are recognized in the consolidated statements of operations, and such amounts principally offset each other due to the effectiveness of the hedges. The fair value hedges are associated primarily with the Company's precious metal inventory carried at fair value. Page | 42 Economic Hedges. As these derivatives are not designated as accounting hedges under ASC 815, they are accounted for as derivatives with no hedge designation. The derivatives are marked to market, and both realized and unrealized gains and losses are recorded in current period earnings in the consolidated statements of operations. The economic hedges are associated primarily with the Company's precious metal inventory valued using the LIFO method. Interest Rate Risk HNH has entered into interest rate swap agreements in the past in order to economically hedge a portion of its debt, which was subject to variable interest rates. As these derivatives were not designated as accounting hedges under U.S. GAAP, they were accounted for as derivatives with no hedge designation. The Company recorded the gains and losses both from the mark-to-market adjustments and net settlements in interest expense in the consolidated statements of operations as the hedges were intended to offset interest rate movements. Foreign Currency Exchange Rate Risk The Company is subject to the risk of price fluctuations related to anticipated revenues and operating costs, firm commitments for capital expenditures and existing assets and liabilities denominated in currencies other than the U.S. dollar. The Company has not generally used derivative instruments to manage this risk. Property, Plant and Equipment Property, plant and equipment is recorded at historical cost. Depreciation of property, plant and equipment is provided principally on the straight line method over the estimated useful lives of the assets, which range as follows: machinery and equipment 3 - 15 years and buildings and improvements 10 - 30 years. Interest cost is capitalized for qualifying assets during the asset's acquisition period. Maintenance and repairs are charged to expense, and renewals and betterments are capitalized. Gain or loss on dispositions is recorded in operating income. Goodwill, Other Intangibles and Long-Lived Assets Goodwill represents the difference between the purchase price and the fair value of net assets acquired in a business combination. Goodwill is reviewed annually for impairment in accordance with U.S. GAAP as of the end of the fourth quarter. The Company uses judgment in assessing whether assets may have become impaired between annual impairment tests. Circumstances that could trigger an interim impairment test include, but are not limited to: the occurrence of a significant change in circumstances, such as continuing adverse business conditions or legal factors; an adverse action or assessment by a regulator; unanticipated competition; loss of key personnel; the likelihood that a reporting unit or significant portion of a reporting unit will be sold or otherwise disposed; or results of testing for recoverability of a significant asset group within a reporting unit. The testing of goodwill for impairment is performed at a level referred to as a reporting unit. Goodwill is allocated to each reporting unit based on the goodwill valued in connection with each business combination consummated within each reporting unit. Five reporting units of the Company have goodwill assigned to them. Goodwill impairment testing consists of a two-step process. Step 1 of the goodwill impairment test involves comparing the fair values of the applicable reporting units with their carrying values, including goodwill. If the carrying amount of a reporting unit exceeds the reporting unit's fair value, Step 2 of the goodwill impairment test is performed to determine the amount of impairment loss. Step 2 of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit's goodwill against the carrying value of that goodwill. An entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the two-step quantitative impairment test discussed above; otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the two-step quantitative impairment test. The Company utilized a qualitative approach to assess its goodwill as of its most recent assessment date, except for the Performance Materials segment, for which the Company performed a Step 1 and a Step 2 process. Intangible assets with finite lives are amortized over their estimated useful lives. The Company also reviews long-lived assets for impairment whenever events, or changes in circumstances, indicate the carrying amount of such assets may not be Page | 43 recoverable. Long-lived assets consisting of land and buildings used in previously operating businesses are carried at the lower of cost or fair value less cost to sell and are included primarily in other non-current assets on the consolidated balance sheets. A reduction in the carrying value of such long-lived assets used in previously operating businesses is recorded as an asset impairment charge in the consolidated statements of operations. Investment In Associated Company The Company accounts for its investment in ModusLink Global Solutions, Inc. ("ModusLink") using the equity method of accounting because the Company has the ability to exercise significant influence over the investee's operating and financial policies. Stock-Based Compensation The Company accounts for stock options and restricted stock granted to employees, directors and service providers as compensation expense, which is recognized in exchange for the services received. The compensation expense is based on the fair value of the equity instruments on the grant-date and is recognized as an expense over the service period of the recipients. Income Taxes Income taxes currently payable or tax refunds receivable are recorded on a net basis and included in accrued liabilities on the consolidated balance sheets. Deferred income taxes reflect the tax effect of net operating loss carryforwards ("NOLs"), capital loss or tax credit carryforwards, and the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting and income tax purposes, as determined under enacted tax laws and rates. Valuation allowances are established if, based on the weight of available evidence, it is more likely than not that some portion or the entire deferred income tax asset will not be realized. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. Earnings Per Share Basic earnings per share is calculated based on the weighted-average number of shares of common stock outstanding during each year. Diluted earnings per share gives effect to dilutive potential common shares outstanding during each year. Foreign Currency Translation Assets and liabilities of foreign subsidiaries are translated at current exchange rates and related revenues and expenses are translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments are recorded as a separate component of other comprehensive income (loss). Legal Contingencies The Company provides for legal contingencies when the liability is probable and the amount of the associated costs is reasonably estimable. The Company regularly monitors the progress of legal contingencies and revises the amounts recorded in the period in which a change in estimate occurs. Environmental Liabilities The Company accrues for losses associated with environmental remediation obligations when such losses are probable and reasonably estimable. Accruals for estimated losses from environmental remediation obligations generally are recognized no later than completion of the remedial feasibility study. Such accruals are adjusted as further information develops or circumstances change. Costs of future expenditures for environmental remediation obligations are not discounted to their present value. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. Note 3 - New or Recently Adopted Accounting Pronouncements In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services, and the guidance defines a five step process to achieve this core principle. In August 2015, the FASB issued ASU No. 2015-14, which deferred the effective date of ASU No. 2014-09 by one year. The ASU, as amended, is effective for the Company's 2018 fiscal year and may be applied either (i) retrospectively Page | 44 to each prior reporting period presented with an election for certain specified practical expedients, or (ii) retrospectively with the cumulative effect of initially applying the ASU recognized at the date of initial application, with additional disclosure requirements. The Company is continuing to evaluate the impact of this guidance and the transition alternatives on its consolidated financial statements and, therefore, cannot reasonably estimate the impact that adoption will have on its financial condition, results of operations or cash flows. In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, which requires an entity to measure inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The amendments do not apply to inventory that is measured using the LIFO method. On January 1, 2017, the Company began applying the inventory measurement provisions of the new ASU and such provisions did not have and are not expected to have a material impact on the Company's consolidated financial statements. In September 2015, the FASB issued ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments, which eliminates the requirement to restate prior-period financial statements for measurement-period adjustments following a business combination. The new guidance requires that the cumulative impact of a measurement-period adjustment (including the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. The prior-period impact of the adjustment should either be presented separately on the face of the statement of operations or disclosed in the notes. This new guidance was effective for the Company's 2016 fiscal year. The amendments in this ASU will be applied prospectively to adjustments to provisional amounts that occur after the effective date of this ASU. The adoption of ASU No. 2015-16 did not have any impact on the Company's 2016 financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The new standard establishes a right-of-use ("ROU") model that requires a lessee to record a ROU asset and a lease liability, measured on a discounted basis, on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the statement of operations. A modified retrospective transition approach is required for capital and operating leases existing at the date of adoption, with certain practical expedients available. The Company is currently evaluating the potential impact of this new guidance, which is effective for the Company's 2019 fiscal year. In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This new standard simplifies the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows, among other things. The new standard is effective for the Company's 2017 fiscal year, and the Company has adopted its provisions as of January 1, 2017. The impacts of certain amendments in ASU No. 2016-09, such as those related to the treatment of tax windfalls from stock based compensation that are included in NOLs and elections made for accounting for forfeitures, are required to be adopted on a modified retrospective basis through a cumulative-effect adjustment to retained earnings. However, since the Company has utilized the majority of its NOLs at December 31, 2016 (see Note 16 - "Income Taxes"), and has elected to continue to estimate forfeitures under its current policy, there were no modified retrospective adjustments recorded upon adoption. The other provisions of ASU No. 2016-09, such as classification of certain items in the statement of cash flows, will be applied in 2017, with reclassification of prior period amounts where applicable. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The new standard changes the impairment model for most financial assets that are measured at amortized cost and certain other instruments, including trade receivables, from an incurred loss model to an expected loss model and adds certain new required disclosures. Under the expected loss model, entities will recognize estimated credit losses to be incurred over the entire contractual term of the instrument rather than delaying recognition of credit losses until it is probable the loss has been incurred. The new standard is effective for the Company's 2020 fiscal year with early adoption permitted for all entities in fiscal years beginning after December 15, 2018. The Company is currently evaluating the potential impact of this new guidance. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This new standard provides guidance to help decrease diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. The amendments in ASU No. 2016-15 provide guidance on eight specific cash flow issues. The new standard is effective for the Company's 2018 fiscal year. The Company is currently evaluating the potential impact of this new guidance. In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash. This new standard provides guidance on the classification of restricted cash in the statement of cash flows. The amendments in ASU No. Page | 45 2016-18 are effective for the Company's 2018 fiscal year. The Company is currently evaluating the potential impact of this new guidance. In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This new standard provides guidance to help determine more clearly what is a business acquisition, as opposed to an asset acquisition. The amendments provide a screen to help determine when a set of components is a business, by reducing the number of transactions in an acquisition that need to be evaluated. The new standard states that to classify the acquisition of assets as a business, there must be an input and a substantive process that jointly contribute to the ability to create outputs, with outputs being defined as the key elements of the business. If all of the fair value of the assets acquired are concentrated in a single asset group, this would not qualify as a business. The amendments in ASU No. 2017-01 are effective for the Company's 2018 fiscal year. The Company is currently evaluating the potential impact of this new guidance. In January 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This new standard simplifies subsequent measurements of goodwill by eliminating Step 2 from the goodwill impairment test. Instead, entities will perform their interim or annual goodwill impairment testing by comparing the fair value of a reporting unit with its carrying amount, and recognizing an impairment charge based on the amount that the carrying amount exceeds the reporting unit's fair value. The loss recognized should not exceed the total goodwill allocated to the reporting unit. The amendments in ASU No. 2017-04 are effective for the Company's 2020 fiscal year. The Company is currently evaluating the potential impact of this new guidance. Note 4 - Acquisitions ITW On March 31, 2015, the Company, through its indirect subsidiary, OMG, Inc. ("OMG"), acquired certain assets and assumed certain liabilities of ITW Polymers Sealants North America Inc. ("ITW"), which are used in the business of manufacturing two-component polyurethane adhesive for the roofing industry, for a cash purchase price of $27.4 million, reflecting a final working capital adjustment of $0.4 million. The assets acquired and liabilities assumed primarily included net working capital of inventories and accrued liabilities; property, plant and equipment; and intangible assets, primarily developed technology, valued at $1.7 million, $0.1 million and $4.4 million, respectively. ITW was the exclusive supplier of certain adhesive products to OMG, and this acquisition will provide OMG with greater control of its supply chain and allow OMG to expand its product development initiatives. The results of operations of the acquired business are reported within the Company's Building Materials segment. In connection with the ITW acquisition, the Company has recorded goodwill totaling approximately $21.3 million, which is expected to be deductible for income tax purposes. JPS Effective July 2, 2015, H&H Group completed the acquisition of JPS Industries, Inc. ("JPS") pursuant to an agreement and plan of merger, dated as of May 31, 2015, by and among the Company, H&H Group, HNH Group Acquisition LLC, a Delaware limited liability company and a subsidiary of H&H Group ("H&H Acquisition Sub"), HNH Group Acquisition Sub LLC, a Delaware limited liability company and a wholly owned subsidiary of H&H Acquisition Sub ("Sub"), and JPS. JPS is a manufacturer of mechanically formed glass, quartz and aramid substrate materials for specialty applications in a wide expanse of markets requiring highly engineered components. At the effective time of the Merger (as defined below), Sub was merged with and into JPS ("Merger"), with JPS being the surviving corporation in the Merger, and each outstanding share of JPS common stock (other than shares held by the Company and its affiliates, including SPH Group Holdings LLC ("SPH Group Holdings"), a subsidiary of Steel Partners Holdings L.P. ("SPLP"), the parent company of the Company, and a significant stockholder of JPS), was converted into the right to receive $11.00 in cash. The aggregate merger consideration of $70.3 million was funded by H&H Group and SPH Group Holdings. H&H Group's funding of the aggregate merger consideration totaled approximately $65.7 million, which was financed through additional borrowings under the Company's senior secured revolving credit facility. As a result of the closing of the Merger, JPS was indirectly owned by both H&H Group and SPH Group Holdings. Following the expiration of the 20-day period provided in Section 262(d)(2) of the Delaware General Corporation Law for JPS stockholders to exercise appraisal rights in connection with the Merger, and in accordance with an exchange agreement, dated as of May 31, 2015, by and between H&H Group and SPH Group Holdings, on July 31, 2015, the Company issued ("Issuance") to H&H Group 1,429,407 shares of the Company's common stock with a value of $48.7 million and, following the Issuance, H&H Group exchanged ("Exchange") those shares of Company common stock for all shares of JPS common stock held by SPH Group Holdings. As a result of the Exchange, H&H Group owned 100% of JPS and merged JPS with and into its wholly-owned subsidiary, HNH Acquisition LLC, a Delaware limited liability company, which was the surviving entity in the merger and was renamed JPS Industries Holdings LLC. Page | 46 The following table summarizes the amounts of the assets acquired and liabilities assumed at the acquisition date (in thousands): The goodwill of $32.2 million arising from the acquisition was assigned to the Company's Performance Materials segment, of which $24.1 million was not expected to be deductible for income tax purposes. Other intangibles consist primarily of acquired trade names of $4.3 million, customer relationships of $3.1 million and developed technology of $1.7 million. These intangible assets have been assigned useful lives ranging from 10 to 15 years based on the long operating history, broad market recognition and continued demand for the associated brands, and the limited turnover and long-standing relationships JPS has with its existing customer base. The valuations of acquired trade names and developed technology were performed utilizing a relief from royalty method, and significant assumptions used in the valuation included the royalty rate assumed and the expected level of future sales, as well as the rate of technical obsolescence for the developed technology. The acquired customer relationships were valued using an excess earnings approach, and significant assumptions used in the valuation included the customer attrition rate assumed and the expected level of future sales. The amount of net sales and operating loss of the acquired business included in the consolidated statement of operations for the year ended December 31, 2016 were approximately $101.6 million and $32.1 million, respectively. The operating loss reflects a goodwill impairment charge of $24.3 million (see Note 9 - "Goodwill and Other Intangibles"). The amount of net sales and operating loss of the acquired business included in the consolidated statement of operations for the year ended December 31, 2015 were approximately $59.5 million and $2.2 million, which included $3.4 million of nonrecurring expense related to the fair value adjustment to acquisition-date inventories. The results of operations of the acquired business are reported within the Company's Performance Materials segment, which is currently comprised solely of the operations of JPS. SLI On April 6, 2016, the Company entered into a definitive merger agreement with SLI, pursuant to which it commenced a cash tender offer to purchase all the outstanding shares of SLI's common stock, at a purchase price of $40.00 per share in cash ("Offer"). SLI designs, manufactures and markets power electronics, motion control, power protection, power quality electromagnetic equipment, and custom gears and gearboxes used in a variety of medical, commercial and military aerospace, computer, datacom, industrial, architectural and entertainment lighting, and telecom applications. Consummation of the Offer was subject to certain conditions, including the tender of a number of shares that constituted at least (1) a majority of SLI's outstanding shares and (2) 60% of SLI's outstanding shares not owned by HNH or any of its affiliates, as well as other customary conditions. SPLP beneficially owned approximately 25.1% of SLI's outstanding shares at the time of the Offer. On June 1, 2016, the conditions noted above, as well as all other conditions to the Offer were satisfied, and the Company successfully completed its tender offer through a wholly owned subsidiary. Pursuant to the terms of the merger agreement, the wholly-owned subsidiary merged with and into SLI, with SLI being the surviving corporation ("SLI Merger"). Upon completion of the SLI Merger, SLI became a wholly owned subsidiary of the Company. Page | 47 The aggregate consideration paid by the Company in the Offer and SLI Merger was approximately $162.0 million, excluding related transaction fees and expenses. The funds necessary to consummate the Offer, the Merger and to pay related fees and expenses were financed with additional borrowings under the Company's senior secured revolving credit facility. The following table summarizes the amounts of the assets acquired and liabilities assumed at the acquisition date on a preliminary basis (in thousands): The preliminary purchase price allocation is subject to finalization of valuations of certain acquired assets and liabilities. The goodwill of $54.2 million arising from the acquisition consists largely of the synergies expected from combining the operations of HNH and SLI. The goodwill is assigned to the Company's Electrical Products segment and is not expected to be deductible for income tax purposes. Other intangibles consist primarily of acquired trade names of $14.7 million, customer relationships of $59.9 million, developed technology and patents of $10.7 million, and customer order backlog of $6.9 million. The customer order backlog is being amortized based on the expected period over which the orders will be fulfilled, ranging from two to eight months. The remaining intangible assets have been assigned useful lives ranging from 10 to 15 years based on the long operating history, broad market recognition and continued demand for the associated brands, and the limited turnover and long-standing relationships SLI has with its existing customer base. The valuations of acquired trade names, developed technology and patents were performed utilizing a relief from royalty method, and significant assumptions used in the valuation included the royalty rate assumed and the expected level of future sales, as well as the rate of technical obsolescence for the developed technology and patents. The acquired customer relationships were valued using an excess earnings approach, and significant assumptions used in the valuation included the customer attrition rate assumed and the expected level of future sales. Included in accrued liabilities and other non-current liabilities above is a total of $8.1 million for existing and contingent liabilities relating to SLI's environmental matters, which are further discussed in Note 19 - "Commitments and Contingencies." The amount of net sales and operating loss of the acquired business included in the consolidated statement of operations for the year ended December 31, 2016 were approximately $112.7 million and $1.8 million, respectively, which includes $1.9 million of expenses associated with the amortization of the fair value adjustment to acquisition-date inventories and also $1.9 million of expenses associated with the acceleration of SLI's previously outstanding stock-based compensation awards, which became fully vested on the date of acquisition pursuant to the terms of the merger agreement, and which are included in selling, general and administrative expenses in the 2016 consolidated statement of operations. SLI's results of operations are reported within the Company's Electrical Products segment. EME On September 30, 2016, SL Montevideo Technology, Inc. ("SMTI"), a subsidiary of SLI, entered into an asset purchase agreement ("Purchase Agreement") with Hamilton. Pursuant to the Purchase Agreement, SMTI acquired from Hamilton certain assets of EME used or useful in the design, development, manufacture, marketing, service, distribution, repair and sale of electric motors, starters and generators for certain commercial applications, including for use in commercial hybrid electric vehicles and refrigeration and in the aerospace and defense sectors. The acquisition of EME expands SLI's product portfolio and diversifies its Page | 48 customer base. SMTI purchased the acquired net assets for $62.6 million in cash and assumption of certain ordinary-course business liabilities, subject to adjustments related to working capital at closing and quality of earnings of the acquired business for the period of January 1, 2016 to June 30, 2016, each as provided in the Purchase Agreement. The Purchase Agreement includes a guarantee by Hamilton of a minimum level of product purchases from SMTI by an affiliate of Hamilton for calendar years 2017, 2018 and 2019, in exchange for compliance by SMTI with certain operating covenants. The transaction was financed with additional borrowings under the Company's senior secured revolving credit facility. The following table summarizes the amounts of the assets acquired and liabilities assumed at the acquisition date on a preliminary basis (in thousands): The preliminary purchase price allocation is subject to finalization of valuations of certain acquired assets and liabilities. The goodwill of $30.6 million arising from the acquisition consists largely of the synergies expected from combining the operations of SLI and EME. The goodwill is assigned to the Company's Electrical Products segment and is expected to be deductible for income tax purposes. Other intangibles consist of customer relationships of $27.2 million and customer order backlog of $1.2 million. The customer order backlog is being amortized based on the expected period over which the orders will be fulfilled of four months. The customer relationships have been assigned a useful life of 15 years based on the limited turnover and long-standing relationships EME has with its existing customer base. The acquired customer relationships were valued using an excess earnings approach, and significant assumptions used in the valuation included the customer attrition rate assumed and the expected level of future sales. The amount of net sales and operating loss of the acquired business included in the consolidated statement of operations for the year ended December 31, 2016 were approximately $15.9 million and $0.1 million, respectively. EME's results of operations are reported within the Company's Electrical Products segment. Pro Forma Disclosures Unaudited pro forma net sales and income from continuing operations, net of tax, of the combined entities is presented below as if JPS had been acquired January 1, 2014, and SLI and EME had both been acquired January 1, 2015. This unaudited pro forma data is presented for informational purposes only and does not purport to be indicative of the results of future operations or of the results that would have occurred had the JPS acquisition taken place on January 1, 2014 and both the SLI and EME acquisitions taken place on January 1, 2015. The information for the years ended December 31, 2016, 2015 and 2014 is based on historical financial information with respect to the acquisitions and does not include operational or other changes which might have been effected by the Company. The unaudited pro forma earnings for all periods reflect incremental depreciation and amortization expense based on the fair value adjustments for the acquired property, plant and equipment and intangible assets, which are amortized using the double-declining balance method for customer relationships and the straight line method for other intangibles, over periods principally ranging from 10 to 15 years, except for the customer order backlog, which Page | 49 is amortized over periods ranging from two to eight months. The unaudited pro forma earnings were also adjusted to reflect incremental interest expense on the borrowings made to finance the acquisitions. The 2016 unaudited pro forma earnings exclude a total of $9.2 million of acquisition-related costs incurred by both the Company and the acquired entities during the year ended December 31, 2016. Of these costs that were excluded from 2016 pro forma expenses, an expense of $1.9 million from the amortization of the fair value adjustment to acquisition-date inventories and an expense of $1.9 million associated with the acceleration of SLI's previously outstanding stock-based compensation awards were reflected in 2015 and reduced the 2015 unaudited pro forma earnings. The 2015 unaudited pro forma earnings also reflect adjustments to exclude a total of $7.5 million of acquisition-related costs incurred by both the Company and the acquired entities during the year ended December 31, 2015 and $3.4 million of nonrecurring expense related to JPS's amortization of the fair value adjustment to acquisition-date inventories. The 2014 unaudited pro forma earnings were adjusted to include the fair value adjustment to acquisition-date inventories for JPS. Note 5 - Divestitures On December 18, 2014, H&H Group and Bairnco entered into a stock purchase agreement to sell all the issued and outstanding equity interests of Arlon, LLC, a Delaware limited liability company and a wholly-owned subsidiary of Bairnco, and its subsidiaries (other than Arlon India (Pvt) Limited) for $157.0 million in cash, less transaction fees, subject to a final working capital adjustment and certain potential reductions as provided in the stock purchase agreement, which are reflected in proceeds from sale of discontinued operations in the consolidated statements of cash flows. The closing of the sale occurred in January 2015. The operations of Arlon, LLC comprised substantially all of the Company's former Arlon Electronic Materials segment, which manufactured high performance materials for the printed circuit board industry and silicone rubber-based materials. The net income from discontinued operations includes the following: Based on a tax reorganization completed in anticipation of the sale of Arlon, LLC, as well as the release of Arlon, LLC's net deferred tax liabilities totaling $7.6 million, the effective tax rate on the gain on disposal of Arlon, LLC in 2015 was 5.4%. In October 2016, JPS sold the equipment and certain customer information, as well as related inventories, of its Slater, South Carolina facility for $3.5 million. The operations of this facility were not significant to the consolidated financial statements of the Company. Note 6 - Asset Impairment Charges In connection with its continued integration of JPS, the Company approved the closure of JPS' Slater, South Carolina operating facility during the second quarter of 2016 and recorded asset impairment charges totaling $7.9 million associated with the planned closure, including write-downs of $6.6 million to property, plant and equipment, and $0.4 million to intangible assets, as well as a $0.9 million inventory write-down, which was recorded in cost of goods sold in the consolidated statements of operations. In the Joining Materials segment, due to improved operational productivity and available capacity at other Lucas-Milhaupt facilities, the Company approved the closure of its Lucas-Milhaupt Gliwice, Poland operating facility as part of its continual focus to optimize infrastructure costs. During the third quarter of 2016, the Company recorded asset impairment charges totaling $2.5 Page | 50 million, primarily due to write-downs of $1.5 million to property, plant and equipment, and $0.5 million to inventories, associated with the planned closure. The inventory write-down was recorded in cost of goods sold in the consolidated statements of operations. In the fourth quarter of 2015, a non-cash asset impairment charge of $1.4 million was recorded related to certain unused, real property located in Norristown, Pennsylvania to reflect its current market value. In the fourth quarter of 2014, a non-cash asset impairment charge of $0.6 million was recorded related to certain equipment owned by the Company's Joining Materials segment located in Toronto, Canada to be sold or scrapped as part of the Company's integration activities associated with a 2013 acquisition. In addition, the Company recorded a $0.6 million non-cash asset impairment charge associated with certain unused, real property owned by the Company's Kasco segment located in Atlanta, Georgia in the fourth quarter of 2014. Note 7 - Inventories Inventories, net at December 31, 2016 and 2015 were comprised of: In order to produce certain of its products, HNH purchases, maintains and utilizes precious metal inventory. HNH records certain of its precious metal inventory at the lower of LIFO cost or market, with any adjustments recorded through cost of goods sold. Remaining precious metal inventory is accounted for primarily at fair value. Certain customers and suppliers of HNH choose to do business on a "pool" basis and furnish precious metal to HNH for return in fabricated form or for purchase from or return to the supplier. When the customer's precious metal is returned in fabricated form, the customer is charged a fabrication charge. The value of this customer metal is not included on the Company's consolidated balance sheets. To the extent HNH is able to utilize customer precious metal in its production processes, such customer metal replaces the need for HNH to purchase its own inventory. As of December 31, 2016, customer metal in HNH's custody consisted of 126,427 ounces of silver, 520 ounces of gold and 1,391 ounces of palladium. Note 8 - Property, Plant and Equipment Property, plant and equipment, net at December 31, 2016 and 2015 was comprised of: Page | 51 Depreciation expense for the years ended 2016, 2015 and 2014 was $21.2 million, $14.4 million and $9.9 million, respectively. Note 9 - Goodwill and Other Intangibles The changes in the net carrying amount of goodwill by reportable segment for the years ended December 31, 2016 and 2015 were as follows (in thousands): The $84.8 million addition to goodwill within the Electrical Products segment during the year ended December 31, 2016 was due to the Company's SLI and EME acquisitions discussed in Note 4 - "Acquisitions." Other intangible assets at cost as of December 31, 2016 include $120.7 million in intangible assets, primarily trade names, customer relationships, developed technology, patents and customer order backlog, associated with the SLI and EME acquisitions. The goodwill and intangible asset balances associated with the SLI and EME acquisitions are subject to adjustment during the finalization of the purchase price allocations for these acquisitions. In the fourth quarter of 2016, the Company recorded a goodwill impairment charge of $24.3 million in its Performance Materials segment, resulting from a decline in market conditions and lower demand for certain of JPS' product lines. The fair value of the Performance Materials segment used in determining the goodwill impairment charge was based on valuations using a combination of the income and market approaches. See Note 18 - "Fair Value Measurements" for further discussion of these valuation methodologies. Other intangible assets as of December 31, 2016 and 2015 consisted of: Page | 52 Amortization expense totaled $18.9 million, $4.0 million and $3.2 million for the years ended December 31, 2016, 2015 and 2014, respectively. The increase in amortization expense during 2016 was principally due to the Company's recent acquisitions. The estimated amortization expense for each of the five succeeding years and thereafter is as follows: Note 10 - Investment The Company holds an investment in the common stock of a public company, ModusLink, which is classified as an investment in associated company on the consolidated balance sheets. The Company carries its ModusLink investment on the consolidated balance sheets at fair value, calculated based on the closing market price for ModusLink common stock, with unrealized gains and losses on the investment reported in net income or loss. HNH owned 8,436,715 shares of common stock of ModusLink at both December 31, 2016 and December 31, 2015, and the value of this investment decreased from $20.9 million at December 31, 2015 to $12.3 million at December 31, 2016 entirely due to a decrease in the share price of ModusLink's common stock. As of December 31, 2016, SPLP and its associated companies, which include the Company, owned a combined total of 18,182,705 ModusLink common shares, which represented approximately 32.9% of ModusLink's outstanding shares. SPLP is a majority shareholder of HNH, owning directly or indirectly through its subsidiaries in excess of 50% of HNH's common shares. The power to vote and dispose of the securities held by SPLP is controlled by Steel Partners Holdings GP Inc. ("SPH GP"). SPLP also holds warrants to purchase 2,000,000 additional shares of ModusLink common stock at an exercise price of $5.00 per share. These warrants will expire in March 2018. ModusLink's fiscal year ends on July 31. Summarized unaudited information as to assets, liabilities and results of operations of ModusLink appears in the table below. This information is presented for the quarter ended October 31, 2016, ModusLink's most recently completed fiscal quarter, as compared to the same quarter of 2015, as well as for the twelve-month periods ended October 31, 2016, 2015 and 2014, the nearest practicable twelve-month periods corresponding to the Company's fiscal years. Page | 53 Note 11 - Credit Facilities Debt at December 31, 2016 and 2015 was as follows: Long-term debt at December 31, 2016 matures in each of the next five years as follows: (a) Assumes repayment of the Company's senior secured revolving credit facility on its contractual maturity date. Senior Credit Facilities On August 29, 2014, H&H Group entered into an amended and restated senior credit agreement ("Senior Credit Facility"), which provided for an up to $365.0 million senior secured revolving credit facility, including a $20.0 million sublimit for the issuance of letters of credit and a $20.0 million sublimit for the issuance of swing loans. On January 22, 2015, H&H Group, and certain subsidiaries of H&H Group, entered into an amendment to its Senior Credit Facility to, among other things, provide for the consent of the administrative agent and the lenders, subject to compliance with certain conditions, for the tender offer by H&H Acquisition Sub for the shares of JPS, including the use of up to $71.0 million under the Senior Credit Facility to purchase such shares, and certain transactions related thereto. In addition, H&H Acquisition Sub and HNH Acquisition LLC became guarantors under the Senior Credit Facility pursuant to the amendment. See further discussion regarding the JPS transaction in Note 4 - "Acquisitions." On March 23, 2016, H&H Group entered into an amendment to its Senior Credit Facility to increase the size of Page | 54 the credit facility by $35.0 million to an aggregate amount of $400.0 million. On December 21, 2016, H&H Group, and certain subsidiaries of H&H Group, entered into an additional amendment to its Senior Credit Facility to, among other things, allow Lucas Milhaupt, Inc., a wholly-owned subsidiary of H&H Group, to enter into a precious metal consignment arrangement with Bank of Nova Scotia, as consignor, and permit the loan parties under the Senior Credit Facility to enter into certain additional factoring arrangements on the same conditions upon which such arrangements are already permitted under the Senior Credit Facility. On February 24, 2017, H&H Group entered into an amendment to its Senior Credit Facility, which permits H&H Group to fund the minimum annual pension requirements of the WHX Pension Plan II. Borrowings under the Senior Credit Facility bear interest, at H&H Group's option, at either LIBOR or the Base Rate, as defined, plus an applicable margin as set forth in the loan agreement (2.50% and 1.50%, respectively, for LIBOR and Base Rate borrowings at December 31, 2016), and the revolving facility provides for a commitment fee to be paid on unused borrowings. The weighted-average interest rate on the revolving facility was 3.24% at December 31, 2016. At December 31, 2016, letters of credit totaling $6.7 million had been issued under the Senior Credit Facility, including $3.2 million of the letters of credit guaranteeing various insurance activities, and $3.5 million for environmental and other matters. H&H Group's availability under the Senior Credit Facility was $70.1 million as of December 31, 2016. The Senior Credit Facility will expire, with all amounts outstanding due and payable, on August 29, 2019. The Senior Credit Facility is guaranteed by substantially all existing and thereafter acquired or created domestic wholly-owned subsidiaries and certain foreign wholly-owned subsidiaries of H&H Group, and obligations under the Senior Credit Facility are collateralized by first priority security interests in and liens upon all present and future assets of H&H Group and these subsidiaries. The Senior Credit Facility restricts H&H Group's ability to transfer cash or other assets to HNH, subject to certain exceptions, including required pension payments to the WHX Corporation Pension Plan ("WHX Pension Plan") and the WHX Pension Plan II. The Senior Credit Facility is subject to certain mandatory prepayment provisions and restrictive and financial covenants, which include a maximum ratio limit on Total Leverage and a minimum ratio limit on Fixed Charge Coverage, as defined, as well as a minimum liquidity level. The Company was in compliance with all debt covenants at December 31, 2016. The increase in the amount outstanding under the Senior Credit Facility during the year ended December 31, 2016 was principally attributable to the SLI and EME acquisitions discussed in Note 4 - "Acquisitions." The Company's prior senior credit facility, as amended, consisted of a revolving credit facility in an aggregate principal amount not to exceed $110.0 million and a senior term loan. On August 5, 2014, this agreement was further amended to, among other things, permit a new $40.0 million term loan and permit H&H Group to make a distribution to HNH of up to $80.0 million. The revolving facility provided for a commitment fee to be paid on unused borrowings. Borrowings under the prior senior credit facility bore interest, at H&H Group's option, at a rate based on LIBOR or the Base Rate, as defined, plus an applicable margin as set forth in the loan agreement. On August 29, 2014, all amounts outstanding under this agreement were repaid. Interest Rate Swap Agreements H&H Group entered into an interest rate swap agreement in February 2013 to reduce its exposure to interest rate fluctuations. Under the interest rate swap, the Company received one-month LIBOR in exchange for a fixed interest rate of 0.569% over the life of the agreement on an initial $56.4 million notional amount of debt, with the notional amount decreasing by $1.1 million, $1.8 million and $2.2 million per quarter in 2013, 2014 and 2015, respectively. H&H Group entered into a second interest rate swap agreement in June 2013, also to reduce its exposure to interest rate fluctuations. Under the interest rate swap, the Company received one-month LIBOR in exchange for a fixed interest rate of 0.598% over the life of the agreement on an initial $5.0 million notional amount of debt, with the notional amount decreasing by $0.1 million, $0.2 million and $0.2 million per quarter in 2013, 2014 and 2015, respectively. Both agreements expired in February 2016. Master Lease Agreement During the year ended December 31, 2016, the Company entered into a master lease agreement with TD Equipment Finance, Inc. ("TD Equipment"), which establishes the general terms and conditions for a $10.0 million credit facility under which the Company may lease equipment and other property from TD Equipment pursuant to the terms of individual lease schedules. As of December 31, 2016, no leases had been entered into under the master lease agreement. WHX CS Loan On June 3, 2014, WHX CS Corp., a wholly-owned subsidiary of the Company, entered into a credit agreement ("WHX CS Loan"), which provided for a term loan facility with borrowing availability of up to a maximum aggregate principal amount Page | 55 of $15.0 million. The amounts outstanding under the WHX CS Loan bore interest at LIBOR plus 1.25%. On August 29, 2014, the WHX CS Loan was terminated and all outstanding amounts thereunder were repaid. Other Debt A subsidiary of H&H has two mortgage agreements, each collateralized by real property. On October 5, 2015, this subsidiary refinanced one of its outstanding mortgage notes, which had an original maturity in October 2015. Under the terms of the revised agreement, the subsidiary paid down $0.7 million of the original outstanding principal balance. The remaining outstanding principal balance of $5.4 million was refinanced and will be repaid in equal monthly installments totaling $0.4 million per year over the next 5 years, with a final principal payment of $3.6 million due at maturity of the loan in October 2020. The mortgage bears interest at LIBOR plus a margin of 2.00%, or 2.65% at December 31, 2016. The mortgage on the second facility was approximately $1.5 million and $1.6 million at December 31, 2016 and 2015, respectively. This mortgage bears interest at LIBOR plus a margin of 2.70%, or 3.46% at December 31, 2016, and matures in 2017. Note 12 - Derivative Instruments Precious Metal and Commodity Inventories As of December 31, 2016, the Company had the following outstanding forward contracts with settlement dates through January 2017. There were no futures contracts outstanding at December 31, 2016. Fair Value Hedges. Of the total forward contracts outstanding, 452,684 ounces of silver and substantially all the copper contracts are designated and accounted for as fair value hedges. Economic Hedges. The remaining outstanding forward contracts for silver, and all the contracts for gold and tin, are accounted for as economic hedges. The forward contracts were made with a counterparty rated A+ by Standard & Poors. Accordingly, the Company has determined that there is minimal credit risk of default. The Company estimates the fair value of its derivative contracts through the use of market quotes or with the assistance of brokers when market information is not available. The Company maintains collateral on account with the third-party broker. Such collateral consists of both cash that varies in amount depending on the value of open contracts, as well as ounces of precious metal held on account by the broker. Debt Agreements H&H Group entered into two interest rate swap agreements to reduce its exposure to interest rate fluctuations. Both agreements expired in February 2016. See Note 11 - "Credit Facilities" for further discussion of the terms of these arrangements. Effect of Derivative Instruments in the Consolidated Statements of Operations - Income/(Expense) Page | 56 Fair Value of Derivative Instruments on the Consolidated Balance Sheets - Asset/(Liability) Note 13 - Pension and Other Post-Retirement Benefits The Company maintains several qualified and non-qualified pension and other post-retirement benefit plans. The Company's significant pension, post-retirement health care benefit and defined contribution plans are discussed below. The Company's other pension and post-retirement benefit plans are not significant individually or in the aggregate. Qualified Plans HNH sponsors a defined benefit pension plan, the WHX Pension Plan, covering many of H&H's employees and certain employees of H&H's former subsidiary, Wheeling-Pittsburgh Corporation ("WPC"). The WHX Pension Plan was established in May 1998 as a result of the merger of the former H&H plans, which covered substantially all H&H employees, and the WPC plan. The WPC plan, covering most United Steel Workers of America-represented employees of WPC, was created pursuant to a collective bargaining agreement ratified on August 12, 1997. Prior to that date, benefits were provided through a defined contribution plan, the Wheeling-Pittsburgh Steel Corporation Retirement Security Plan ("RSP Plan"). The assets of the RSP Plan were merged into the WPC plan as of December 1, 1997. Under the terms of the WHX Pension Plan, the benefit formula and provisions for the WPC and H&H participants continued as they were designed under each of the respective plans prior to the merger. The qualified pension benefits under the WHX Pension Plan were frozen as of December 31, 2005 and April 30, 2006 for hourly and salaried non-bargaining participants, respectively, with the exception of a single operating unit. In 2011, the benefits were frozen for the remainder of the participants. WPC employees ceased to be active participants in the WHX Pension Plan effective July 31, 2003, and as a result, such employees no longer accrue benefits under the WHX Pension Plan. JPS sponsors a defined benefit pension plan ("JPS Pension Plan"), which was assumed in connection with the JPS acquisition. Under the JPS Pension Plan, substantially all JPS employees who were employed prior to April 1, 2005 have benefits. The JPS Pension Plan was frozen effective December 31, 2005. Employees no longer earned additional benefits after that date. Benefits earned prior to December 31, 2005 will be paid out to eligible participants following retirement. The JPS Pension Plan was "unfrozen" for employees who were active employees on or after June 1, 2012. This new benefit, calculated based on years of service and a capped average salary, will be added to the amount of any pre-2005 benefit. The JPS Pension Plan was again frozen for all future accruals effective December 31, 2015, although unvested participants may still vest in accrued but unvested benefits. Page | 57 Bairnco had several pension plans, which covered substantially all its employees. In 2006, Bairnco froze the Bairnco Corporation Retirement Plan and initiated employer contributions to its 401(k) plan. On June 2, 2008, two Bairnco plans (Salaried and Kasco) were merged into the WHX Pension Plan. Some of the Company's foreign subsidiaries provide retirement benefits for their employees through defined contribution plans or otherwise provide retirement benefits for employees consistent with local practices. The foreign plans are not significant in the aggregate and, therefore, are not included in the following disclosures. Pension benefits under the WHX Pension Plan are based on years of service and the amount of compensation earned during the participants' employment. However, as noted above, the qualified pension benefits have been frozen for all participants. Pension benefits for the WPC bargained participants include both defined benefit and defined contribution features, since the plan includes the account balances from the RSP Plan. The gross benefit, before offsets, is calculated based on years of service and the benefit multiplier under the plan. The net defined benefit pension plan benefit is the gross amount offset for the benefits payable from the RSP Plan and benefits payable by the Pension Benefit Guaranty Corporation from previously terminated plans. Individual employee accounts established under the RSP Plan are maintained until retirement. Upon retirement, participants who are eligible for the WHX Pension Plan and maintain RSP Plan account balances will normally receive benefits from the WHX Pension Plan. When these participants become eligible for benefits under the WHX Pension Plan, their vested balances in the RSP Plan become assets of the WHX Pension Plan. Although these RSP Plan assets cannot be used to fund any of the net benefit that is the basis for determining the defined benefit plan's net benefit obligation at the end of the year, the Company has included the amount of the RSP Plan accounts of $13.1 million and $13.3 million on a gross-basis as both assets and liabilities of the plan as of December 31, 2016 and December 31, 2015, respectively. On December 30, 2016, the WHX Pension Plan was split into two plans by spinning off certain plan participants with smaller benefit obligations (which in the aggregate were equal to approximately 3.0% of the assets of the WHX Pension Plan), and assets equal thereto, to a new separate plan, the WHX Pension Plan II. The benefits of participants under the WHX Pension Plan II are equal to their accrued benefits under the benefit formula that was applicable to each participant under the WHX Pension Plan at the time of the plan spin-off. The total benefit liabilities of the two plans after the spin-off were equal to the benefit liabilities of the WHX Pension Plan immediately before the spin-off, and under the applicable spin-off rules, the WHX Pension Plan II is considered fully funded. Certain current and retired employees of H&H are covered by post-retirement medical benefit plans, which provide benefits for medical expenses and prescription drugs. Contributions from a majority of the participants are required, and for those retirees and spouses, the Company's payments are capped. Actuarial losses for the WHX Pension Plan are being amortized over the average future lifetime of the participants, which is expected to be approximately 20 years. The Company believes that use of the future lifetime of the participants is appropriate because the WHX Pension Plan is completely inactive. The components of pension expense and other post-retirement benefit (income) expense for the Company's benefit plans included the following: Actuarial assumptions used to develop the components of pension expense and other post-retirement benefit (income) expense were as follows: Page | 58 Pension expense in 2016 was favorably impacted by a change in the manner by which the interest cost component of net periodic pension expense was determined; specifically, by utilizing the "spot rate approach," which provides a more precise measurement of interest cost. The impact of this change was to reduce annual pension expense in 2016 by approximately $4.8 million. The measurement date for plan obligations is December 31. The discount rate is the rate at which the plans' obligations could be effectively settled and is based on high quality bond yields as of the measurement date. Summarized below is a reconciliation of the funded status for the Company's qualified defined benefit pension plans and other post-retirement benefit plan: Page | 59 The weighted-average assumptions used in the valuations at December 31 were as follows: Page | 60 The effect of a 1% increase (decrease) in health care cost trend rates on benefit expense and on other post-retirement benefit obligations is not significant. Pretax amounts included in accumulated other comprehensive loss (income) at December 31, 2016 and 2015 were as follows: The pretax amount of actuarial losses and prior service credit included in accumulated other comprehensive loss (income) at December 31, 2016 that is expected to be recognized in net periodic benefit cost (income) in 2017 is $13.7 million and $0.0 million, respectively, for the defined benefit pension plans, and $0.0 million and $(0.1) million, respectively, for the other post-retirement benefit plan. Other changes in plan assets and benefit obligations recognized in comprehensive (loss) income are as follows: The actuarial loss in 2016 occurred principally because the investment returns on the assets of the WHX Pension Plan and the JPS Pension Plan were lower than actuarial assumptions. Benefit obligations were in excess of plan assets for each of the pension plans and the other post-retirement benefit plan at both December 31, 2016 and 2015. Additional information for the plans with accumulated benefit obligations in excess of plan assets: In determining the expected long-term rate of return on plan assets, the Company evaluated input from various investment professionals. In addition, the Company considered its historical compound returns, as well as the Company's forward-looking expectations. The Company determines its actuarial assumptions for its pension and other post-retirement benefit plans on December 31 of each year to calculate liability information as of that date and pension and other post-retirement benefit expense or income for the following year. The discount rate assumption is derived from the rate of return on high-quality bonds as of December 31 of each year. The Company's investment policy is to maximize the total rate of return with a view to long-term funding objectives of the pension plans to ensure that funds are available to meet benefit obligations when due. Pension plan assets are diversified to the extent necessary to minimize risk and to achieve an optimal balance between risk and return. There are no target allocations. The pension plans' assets are diversified as to type of assets, investment strategies employed and number of investment managers used. Investments may include equities, fixed income, cash equivalents, convertible securities and private investment funds. Derivatives may be used as part of the investment strategy. The Company may direct the transfer of assets between investment managers in order to rebalance the portfolio in accordance with asset allocation guidelines established by the Company. Page | 61 The fair value of pension investments is defined by reference to one of three categories (Level 1, Level 2 or Level 3) based on the reliability of inputs, as such terms are defined in Note 18 - "Fair Value Measurements." The pension plan assets at December 31, 2016 and 2015, by asset category, are as follows (in thousands): Page | 62 Page | 63 (1) Certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy. (2) Hedge funds and common trust funds are comprised of shares or units in commingled funds that may not be publicly traded. The underlying assets in these funds are primarily publicly traded equity securities and fixed income securities. (3) The limited partnership operates as a fund of funds. The underlying assets in this fund are generally expected to be illiquid. The limited partnership's investment strategy is to seek above-average rates of return and long-term capital growth by investing in a broad range of investments, including, but not limited to, global distressed corporate securities, activist equities, value equities, post-reorganizational equities, municipal bonds, high yield bonds, leveraged loans, unsecured debt, collateralized debt obligations, mortgage-backed securities, commercial mortgage-backed securities, direct lending and sovereign debt. (4) The JPS Pension Plan holds a deposit administration group annuity contract with an immediate participation guarantee from Transamerica Life Insurance Company ("TFLIC"). The TFLIC contract unconditionally guarantees benefits to certain salaried JPS Pension Plan participants earned through June 30, 1984 in the plan of a predecessor employer. The assets deposited under the contract are held in a separate custodial account ("TFLIC Assets"). If the TFLIC Assets decrease to the level of the trigger point (as defined in the contract), which represents the guaranteed benefit obligation representing the accumulated plan benefits as of June 30, 1984, TFLIC has the right to cause annuities to be purchased for the individuals covered by these contract agreements. Since the TFLIC Assets have remained in excess of the trigger point, no annuities have been purchased for the individuals covered by these contract arrangements. (5) Fund of funds consist of fund-of-fund LLC or commingled fund structures. The underlying assets in these funds are primarily publicly traded equity securities, fixed income securities and commodity-related securities. The LLCs are valued based on net asset values calculated by the fund and are not publicly available. There were no assets for which fair value was determined using significant unobservable inputs (Level 3) during 2015. During 2016 and 2014, changes in Level 3 assets were as follows (in thousands): Page | 64 The Company's policy is to recognize transfers in and transfers out of Level 3 as of the date of the event or change in circumstances that caused the transfer. The following tables present the category, fair value, unfunded commitments, redemption frequency and redemption notice period for those assets whose fair value was estimated using the net asset value per share (or its equivalents), as well as plan assets which have redemption notice periods, as of December 31, 2016 and December 31, 2015 (in thousands): December 31, 2016: (1) 5 year staggered lockup period. One-third of the investment on each of December 31, 2020, 2021 and 2022. (2) Each capital commitment is subject to a commitment period of three years during which capital may be drawn-down, subject to two, one-year extensions. During the commitment period, no withdrawals are permitted. Once permitted, withdrawals of available liquidity in underlying investment vehicles is permitted quarterly. The fund-of-funds will not invest in any fund or investment vehicle that has an initial lock-up period of more than five years. Upon complete redemption, a holdback of up to 10% is withheld and paid after the fund's financial statement audit. (3) Redeemable annually subject to three year rolling, staggered lock up period. Upon complete redemption, a holdback of up to 10% is withheld and paid after the fund's financial statement audit. (4) Except for benefit payments to participants and beneficiaries and related expenses, withdrawals are restricted for substantially all of the assets in the account, as defined in the contract. However, a suspension or transfer can be requested with 30 days' notice. When funds are exhausted either by benefit payments, purchase of annuity contracts or transfer, the related contract terminates. (5) Entered into an agreement effective December 15, 2016 with a commitment of $10.0 million. Capital has not been called as of December 31, 2016. The agreement contains a commitment period of three years, subject to an extension of up to one additional year. Voluntary withdrawals are not permitted. Complete distributions will be made after eight years, subject to an extension of an additional two years. (6) Entered into an agreement effective September 8, 2016 with a commitment of $12.5 million. Capital has not been called as of December 31, 2016. Voluntary withdrawals are not permitted. Complete distributions will be made after ten years, subject to an extension of an additional one year. Page | 65 In addition to those on the table above, the Company has an additional unfunded commitment at December 31, 2016 totaling $20.0 million for a separately managed investment account, which will have a U.S. mid/large-cap equity strategy. December 31, 2015: (1) Request for redemption had been submitted as of December 31, 2015. Investment was redeemed in 2016. (2) Except for benefit payments to participants and beneficiaries and related expenses, withdrawals are restricted for substantially all of the assets in the account, as defined in the contract. However, a suspension or transfer can be requested with 30 days' notice. When funds are exhausted either by benefit payments, purchase of annuity contracts or transfer, the related contract terminates. Contributions Employer contributions consist of funds paid from employer assets into a qualified pension trust account. The Company's funding policy is to contribute annually an amount that satisfies the minimum funding standards of the Employee Retirement Income Security Act. The Company expects to have required minimum pension contributions for 2017, 2018, 2019, 2020, 2021 and for the five years thereafter of $34.2 million, $31.1 million, $39.9 million, $36.0 million, $32.7 million and $80.6 million, respectively. Required future pension contributions are estimated based upon assumptions such as discount rates on future obligations, assumed rates of return on plan assets and legislative changes. Actual future pension costs and required funding obligations will be affected by changes in the factors and assumptions described in the previous sentence, as well as other changes such as any plan termination or other acceleration events. Benefit Payments Estimated future benefit payments for the benefit plans over the next ten years are as follows (in thousands): 401(k) Plans Certain employees participate in a Company sponsored savings plan, which qualifies under Section 401(k) of the Internal Revenue Code. This savings plan allows eligible employees to contribute from 1% to 75% of their income on a pretax basis. The Company presently makes a contribution to match 50% of the first 6% of the employee's contribution. The charge to expense for the Company's matching contributions amounted to $2.2 million, $1.9 million and $2.0 million in 2016, 2015 and 2014, respectively. Note 14 - Stockholders' Equity Page | 66 The Company's authorized capital stock is a total of 185,000,000 shares, consisting of 180,000,000 shares of common stock and 5,000,000 shares of preferred stock. Of the authorized shares, no shares of preferred stock have been issued. As of December 31, 2016 and 2015, 12,240,735 and 12,208,016 shares of common stock were outstanding, respectively. Although the Board of Directors of HNH is expressly authorized to fix the designations, preferences and rights, limitations or restrictions of the preferred stock by adoption of a Preferred Stock Designation resolution, the Board of Directors has not yet done so. The common stock of HNH has voting power, is entitled to receive dividends when and if declared by the Board of Directors and is subject to any preferential dividend rights of any then-outstanding preferred stock, and in liquidation, after distribution of the preferential amount, if any, due to preferred stockholders, the common stockholders are entitled to receive all the remaining assets of the corporation. JPS Acquisition As discussed in Note 4 - "Acquisitions," the Company issued 1,429,407 shares of common stock during the year ended December 31, 2015 in connection with the JPS acquisition. Common Stock Repurchase Programs On March 24, 2014, the Company's Board of Directors approved the repurchase of up to an aggregate of $10.0 million of the Company's common stock. On June 6, 2014, the Board of Directors further approved the repurchase of up to an aggregate of $3.0 million of the Company's common stock, which was in addition to the previously approved repurchase of up to an aggregate of $10.0 million of common stock. Such repurchases were made from time to time on the open market at prevailing market prices or in negotiated transactions off the market, in compliance with applicable laws and regulations. The Company repurchased 242,383 shares for a total purchase price of approximately $5.8 million under the repurchase program, which concluded at the end of 2014. On April 28, 2016, the Company's Board of Directors approved the repurchase of up to an aggregate of 500,000 shares of the Company's common stock. Any such repurchases will be made from time to time on the open market at prevailing market prices or in negotiated transactions off the market, in compliance with applicable laws and regulations. The repurchase program is expected to continue unless and until revoked by the Board of Directors. As of December 31, 2016, the Company has repurchased 15,019 shares for a total purchase price of approximately $0.4 million under the 2016 repurchase program. Tender Offer On August 7, 2014, the Company commenced a tender offer to purchase for cash up to $60.0 million in value of shares of its common stock. The tender offer expired on September 5, 2014, and a total of 2,099,843 shares were properly tendered and repurchased by the Company at a price of $26.00 per share, for a total cost of approximately $54.7 million, including related fees and expenses. Accumulated Other Comprehensive Loss Changes, net of tax, in accumulated other comprehensive loss and its components follow: Income tax benefits of $3.0 million, $13.8 million and $31.9 million were recorded in accumulated other comprehensive loss for 2016, 2015 and 2014, respectively. Note 15 - Stock-Based Compensation On May 26, 2016, the Company's stockholders approved the adoption of the Company's 2016 Equity Incentive Award Plan ("2016 Plan"). The 2016 Plan provides equity-based compensation through the grant of cash-based awards, nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, Page | 67 performance units and other stock-based awards. The 2016 Plan replaces the Company's 2007 Incentive Stock Plan ("2007 Plan"), and no further awards will be granted under the 2007 Plan. The 2016 Plan allows for issuance of up to 1,626,855 shares of common stock. No shares have been issued under the 2016 Plan as of December 31, 2016. Restricted Stock Restricted stock grants made to employees are in lieu of a long-term incentive plan component in the Company's bonus plan for those individuals who receive shares of restricted stock. Compensation expense is measured based on the fair value of the stock-based awards on the grant date, as measured by the NASDAQ closing price for the Company's common stock. Compensation expense is recognized in the consolidated statements of operations on a straight-line basis over the requisite service period, which is the vesting period. Restricted stock grants made to employees and service providers vest in approximately equal annual installments over a three-year period from the grant date. Restricted stock grants to the Company's non-employee directors vest one year from the grant date. The Company allows certain grantees to forego the issuance of shares to meet applicable income tax withholding due as a result of the vesting of restricted stock. Such shares are returned to the unissued shares of the Company's common stock. Restricted stock activity was as follows for the year end December 31, 2016: The Company recognized compensation expense related to restricted shares of $1.5 million, $3.4 million and $5.1 million for the years ended December 31, 2016, 2015 and 2014, respectively. Unearned compensation expense related to restricted shares at December 31, 2016 is $1.0 million, which is net of an estimated 5% forfeiture rate for employees and service providers. This amount will be recognized over the remaining vesting period of the restricted shares. Stock Options In July 2007, stock options were granted to certain employees and directors under the 2007 Plan. The 2007 Plan permitted options to be granted up to a maximum contractual term of 10 years. The Company recorded no compensation expense related to its stock options in 2016, 2015 or 2014 since the options were fully vested, and no options were exercised during those periods. As of December 31, 2015, 13,000 stock options to purchase HNH shares at an exercise price of $90.00 per share were outstanding under the 2007 Plan. No stock options remain outstanding at December 31, 2016. Note 16 - Income Taxes Income from continuing operations before tax and equity investment for the three years ended December 31 is as follows: The provision for (benefit from) income taxes for the three years ended December 31 is as follows: Page | 68 Deferred income taxes result from temporary differences in the financial basis and tax basis of assets and liabilities. The amounts shown on the following table represent the tax effect of temporary differences between the Company's consolidated tax return basis of assets and liabilities and the corresponding basis for financial reporting, as well as tax credit and net operating loss carryforwards. Page | 69 The Company's 2016 tax provision reflects the utilization of approximately $26.0 million of U.S. federal NOLs. The Company's remaining U.S. federal NOLs as of December 31, 2016 total $37.8 million and expire between 2020 and 2031. Such amounts were acquired by the Company as a result of the JPS acquisition in 2015. The utilization of the JPS NOLs is subject to certain annual limitations under the ownership change rules of Section 382 of the Internal Revenue Code. Included in deferred income tax assets as of December 31, 2016 is a $13.2 million tax effect of the Company's U.S. federal NOLs, as well as certain state NOLs. The Company provides for income taxes on the undistributed earnings of non-U.S. corporate subsidiaries, except to the extent that such earnings are permanently invested outside the U.S. As of December 31, 2016, $7.6 million of accumulated undistributed earnings of non-U.S. corporate subsidiaries were permanently invested. At existing U.S. and state statutory income tax rates, additional taxes of approximately $2.7 million would need to be provided if such earnings were remitted. The provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pretax income as follows: Page | 70 U.S. GAAP provides that the tax effects from an uncertain tax position can be recognized in the financial statements only if the position is more likely than not of being sustained on audit, based on the technical merits of the position. At December 31, 2016 and 2015, the Company had approximately $2.6 million and $1.8 million of unrecognized tax benefits recorded, respectively, all of which, net of federal benefit for state taxes, would affect the Company's effective tax rate if recognized. Of this amount, the Company has offset approximately $0.3 million and $0.0 million against certain related deferred tax assets in the same jurisdiction as of December 31, 2016 and December 31, 2015, respectively. The changes in the amount of unrecognized tax benefits during 2016 and 2015 were as follows: The Company recognizes interest and penalties related to uncertain tax positions in its income tax provision. At December 31, 2016 and 2015, approximately $0.3 million and $0.1 million of interest related to uncertain tax positions was accrued. No penalties were accrued. It is reasonably possible that the total amount of unrecognized tax benefits will decrease by as much as $0.6 million during the next year as a result of the lapse of the applicable statutes of limitations in certain taxing jurisdictions. The Company is generally no longer subject to federal, state or local income tax examinations by tax authorities for any year prior to 2013, except as noted below. However, NOLs generated in prior years are subject to examination and potential adjustment by the Internal Revenue Service ("IRS") upon their utilization in future years' tax returns. The Company is not currently under examination by the IRS, but has received a notice of examination for tax year 2014, which has not commenced. The Company is currently under examination by the State of New York for 2012-2013, which is on-going. The Company has not been notified of any material adjustments to be made as a result of this examination. The Company underwent an examination by the State of New York for 2009 to 2011, which resulted in an assessment of $0.1 million paid in January 2016. Note 17 - Earnings Per Share Page | 71 The computation of basic earnings per share of common stock is calculated by dividing net (loss) income by the weighted-average number of shares of the Company's common stock outstanding, as follows: Diluted earnings per share gives effect to dilutive potential common shares outstanding during the reporting period. The Company had potentially dilutive common share equivalents, in the form of outstanding stock options (see Note 15 - "Stock-Based Compensation"), during the years ended December 31, 2016, 2015 and 2014, although none were dilutive because the exercise price of these equivalents exceeded the market value of the Company's common stock during those periods. During the year ended December 31, 2016, all remaining stock options expired unexercised. Note 18 - Fair Value Measurements Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e. the "exit price") in an orderly transaction between market participants at the measurement date. Fair value measurements are broken down into three levels based on the reliability of inputs as follows: Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. The valuation under this approach does not entail a significant degree of judgment ("Level 1"). Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, inputs other than quoted prices that are observable for the asset or liability (e.g. interest rates and yield curves observable at commonly quoted intervals or current market) and contractual prices for the underlying financial instrument, as well as other relevant economic measures ("Level 2"). Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date ("Level 3"). The fair value of the Company's financial instruments, such as cash and cash equivalents, trade and other receivables, and trade payables, approximate carrying value due to the short-term maturities of these assets and liabilities. Carrying cost approximates fair value for the Company's long-term debt which has variable interest rates. The fair value of the Company's investment in associated company is a Level 1 measurement because the underlying security is listed on a national securities exchange. The precious metal and commodity inventories associated with the Company's fair value hedges (see Note 12 - "Derivative Instruments") are reported at fair value. Fair values of these inventories are based on quoted market prices on commodity exchanges and are considered Level 1 measurements. The derivative instruments that the Company purchases in connection with its precious metal and commodity inventories, specifically commodity futures and forward contracts, are also valued at fair value. The futures contracts are Level 1 measurements since they are traded on a commodity exchange. The forward contracts are entered into with a counterparty and are considered Level 2 measurements. Page | 72 The Company's interest rate swap agreements were considered Level 2 measurements as the inputs were observable at commonly quoted intervals. These agreements expired in February 2016. The following tables summarize the Company's assets and liabilities that are measured at fair value on a recurring basis as of December 31, 2016 and 2015: The Company's non-financial assets and liabilities measured at fair value on a non-recurring basis include goodwill and other intangible assets, any assets and liabilities acquired in a business combination, or its long-lived assets written down to fair value. To measure fair value for such assets and liabilities, the Company uses techniques including an income approach, a market approach and/or appraisals (Level 3 inputs). The income approach is based on a discounted cash flow analysis and calculates the fair value by estimating the after-tax cash flows attributable to an asset or liability and then discounting the after-tax cash flows to a present value using a risk-adjusted discount rate. Assumptions used in the discounted cash flow analysis ("DCF") require the exercise of significant judgment, including judgment about appropriate discount rates and terminal values, growth rates and the amount and timing of expected future cash flows. The discount rates, which are intended to reflect the risks inherent in future cash flow projections, used in the DCF are based on estimates of the weighted-average cost of capital of a market participant. Such estimates are derived from analysis of peer companies and consider the industry weighted-average return on debt and equity from a market participant perspective. A market approach values a business by considering the prices at which shares of capital stock, or related underlying assets, of reasonably comparable companies are trading in the public market or the transaction price at which similar companies have been acquired. If comparable companies are not available, the market approach is not used. In 2016, the Company recorded a goodwill impairment charge of $24.3 million in the fourth quarter of 2016, related to the Performance Materials segment. The impairment resulted from a decline in market conditions and lower demand for certain of JPS' product lines. Long-lived assets consisting of land and buildings used in previously operating businesses and currently unused, which total $6.3 million as of December 31, 2016, are carried at the lower of cost or fair value less cost to sell and are included in other non-current assets on the consolidated balance sheets. A reduction in the carrying value of such long-lived assets is recorded as an asset impairment charge in the consolidated statements of operations. Note 19 - Commitments and Contingencies Operating Lease Commitments The Company leases certain facilities under non-cancelable operating lease arrangements. Rent expense for the Company in 2016, 2015 and 2014 was $5.7 million, $4.7 million and $4.4 million, respectively. Future minimum operating lease and rental commitments under non-cancelable operating leases are as follows (in thousands): Page | 73 Environmental Matters Certain H&H Group subsidiaries, including its newly acquired subsidiary SLI, have existing and contingent liabilities relating to environmental matters, including costs of remediation, capital expenditures, and potential fines and penalties relating to possible violations of national and state environmental laws. Those subsidiaries have remediation expenses on an ongoing basis, although such costs are continually being readjusted based upon the emergence of new techniques and alternative methods. The Company recorded liabilities of approximately $9.6 million related to estimated environmental remediation costs as of December 31, 2016. The Company also has insurance coverage available for several of these matters and believes that excess insurance coverage may be available as well. During the years ended December 31, 2015 and 2014, the Company recorded insurance reimbursements totaling $2.9 million and $3.1 million, respectively, for previously incurred remediation costs. No similar reimbursements were recorded during the year ended December 31, 2016. Included among these liabilities, certain H&H Group subsidiaries have been identified as potentially responsible parties ("PRPs") under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") or similar state statutes at sites and are parties to administrative consent orders in connection with certain properties. Those subsidiaries may be subject to joint and several liabilities imposed by CERCLA on PRPs. Due to the technical and regulatory complexity of remedial activities and the difficulties attendant in identifying PRPs and allocating or determining liability among them, the subsidiaries are unable to reasonably estimate the ultimate cost of compliance with such laws. Based upon information currently available, the H&H Group subsidiaries do not expect that their respective environmental costs, including the incurrence of additional fines and penalties, if any, will have a material adverse effect on them or that the resolution of these environmental matters will have a material adverse effect on the financial position, results of operations or cash flows of such subsidiaries or the Company, but there can be no such assurances. The Company anticipates that the H&H Group subsidiaries will pay any such amounts out of their respective working capital, although there is no assurance that they will have sufficient funds to pay them. In the event that the H&H Group subsidiaries are unable to fund their liabilities, claims could be made against their respective parent companies, including H&H Group and/or HNH, for payment of such liabilities. The sites where certain H&H Group subsidiaries have environmental liabilities include the following: H&H has been working with the Connecticut Department of Energy and Environmental Protection ("CTDEEP") with respect to its obligations under a 1989 consent order that applies to a property in Connecticut that H&H sold in 2003 ("Sold Parcel") and an adjacent parcel ("Adjacent Parcel") that together comprise the site of a former H&H manufacturing facility. The remaining remediation, monitoring and regulatory administrative costs for the Sold Parcel are expected to approximate $0.1 million. With respect to the Adjacent Parcel, an ecological risk assessment has been completed and the results, along with proposed clean up goals, were submitted in the second quarter of 2016 to the CTDEEP for their review and approval. The next phase will be a physical investigation of the upland portion of the parcel. A work plan was submitted in the third quarter of 2016 to the CTDEEP for review and approval. The CTDEEP has not completed their review and approval, but the work is expected to start in the first half of 2017 and is estimated to cost $0.2 million. Investigation of the wetlands portion is not expected to start until the later part of 2017, pending regulatory approvals and setting goals for the entire parcel. The total remediation costs for the Adjacent Parcel cannot be reasonably estimated at this time. Accordingly, there can be no assurance that the resolution of this matter will not be material to the financial position, results of operations or cash flows of H&H or the Company. In 1986, Handy & Harman Electronic Materials Corporation ("HHEM"), a subsidiary of H&H, entered into an administrative consent order ("ACO") with the New Jersey Department of Environmental Protection ("NJDEP") with regard to certain property that it purchased in 1984 in New Jersey. The ACO involves investigation and remediation activities to be performed with regard to soil and groundwater contamination. HHEM is actively remediating the property and continuing to investigate effective methods for achieving compliance with the ACO. HHEM anticipates entering into discussions with the NJDEP to address that agency's potential natural resource damage claims, the ultimate scope and cost of which cannot be estimated at this time. Page | 74 Pursuant to a settlement agreement with the former owner/operator of the site, the responsibility for site investigation and remediation costs, as well as any other costs, as defined in the settlement agreement, related to or arising from environmental contamination on the property (collectively, "Costs") are contractually allocated 75% to the former owner/operator and 25% jointly to HHEM and H&H, all after having the first $1.0 million paid by the former owner/operator. As of December 31, 2016, total investigation and remediation costs of approximately $5.7 million and $1.8 million have been expended by the former owner/operator and HHEM, respectively, in accordance with the settlement agreement. Additionally, HHEM is currently being reimbursed indirectly through insurance coverage for a portion of the Costs for which HHEM is responsible. HHEM believes that there is additional excess insurance coverage, which it intends to pursue as necessary. HHEM anticipates that there will be additional remediation expenses to be incurred once a final remediation plan is agreed upon. There is no assurance that the former owner/operator or guarantors will continue to timely reimburse HHEM for expenditures and/or will be financially capable of fulfilling their obligations under the settlement agreement and the guaranties. The final Costs cannot be reasonably estimated at this time, and accordingly, there can be no assurance that the resolution of this matter will not be material to the financial position, results of operations or cash flows of HHEM or the Company. HHEM has been complying with a 1987 ACO from the Massachusetts Department of Environmental Protection ("MADEP") to investigate and remediate the soil and groundwater conditions at a commercial/industrial property in Massachusetts. On June 30, 2010, HHEM filed a Response Action Outcome ("RAO") report to close the site since HHEM's licensed site professional concluded that groundwater monitoring demonstrated that the groundwater conditions have stabilized or continue to improve at the site. In June 2013, the MADEP issued a Notice of Audit Findings and Notice of Noncompliance that the site had not been fully delineated. As a result of meetings and subsequent discussions with the MADEP, HHEM conducted additional work that was completed in 2015. Based on the additional work and regulatory changes, and pursuant to a new ACO issued in October 2016, HHEM issued a revised partial RAO report in December 2016. The partial RAO excluded three adjacent properties on which deed restrictions could not be resolved with the property owners, but it does demonstrate that the other portions of the site have met all regulatory requirements for "closure." The next phase is the submission of a "Temporary Solution Statement" in the first half of 2017, which will demonstrate that no active response actions are warranted for the three excluded properties. The cost of the next phase, well decommissioning and any additional costs that could result from the final review of the closure report by the MADEP are not anticipated to be material. SLI may incur environmental costs in the future as a result of past activities of its former subsidiary, SurfTech, at sites located in Pennsauken, New Jersey ("Pennsauken Site") and in Camden, New Jersey ("Camden Site"). At the Pennsauken Site, SLI reached an agreement with both the U.S. Department of Justice and the Environmental Protection Agency ("EPA") related to its liability and entered into a Consent Decree which governs the agreement. SLI agreed to perform remediation, which is substantially complete, and to pay a fixed sum for the EPA's past costs. The fixed sum is to be paid in installments, and the final payment of $2.1 million is due to be made in the second quarter of 2017. In December 2012, the NJDEP served SLI with a settlement demand of $1.8 million for alleged past and future costs, as well as alleged natural resource damages related to the Pennsauken Site. Although SLI believes that it has meritorious defenses to any claim for costs and natural resource damages, to avoid the time and expense of litigating the matter, on February 13, 2013, SLI offered to pay the State of New Jersey $0.3 million to fully resolve the claim. On June 29, 2015, the State of New Jersey rejected SLI's counteroffer. No subsequent discussions have been had. The final scope and cost of this claim cannot be estimated at this time. With respect to the Camden Site, SLI has reported soil contamination and a groundwater contamination plume emanating from the site. A Remedial Action Workplan ("RAWP") for soils is being developed and is expected to be submitted to the NJDEP in the first quarter of 2017, by the Licensed Site Remediation Professional ("LSRP") for the site. The RAWP for treatment of unsaturated soils is scheduled to be initiated during the first quarter of 2017 with post-remediation rebound testing and slab removal to be conducted in the fourth quarter of 2017. SLI's environmental consultants also implemented an interim remedial action pilot study to treat on-site contaminated groundwater, which consisted of injecting food-grade product into the groundwater at the down gradient property boundary to create a "bio-barrier." Post-injection groundwater monitoring to assess the bio-barrier's effectiveness was completed. Consistent decreases in target contaminants concentrations in groundwater were observed. In December 2014, a report was submitted to the NJDEP stating sufficient information was obtained from the pilot study to complete the full-scale groundwater remedy design. A full-scale groundwater bioremediation will be implemented during the fourth quarter of 2017 following the soil remediation mentioned above. A reserve of $1.4 million has been established for anticipated costs at this site, but there can be no assurance that there will not be potential additional costs associated with the site, which cannot be reasonably estimated at this time. Accordingly, there can be no assurance that the resolution of this matter will not be material to the financial position, results of operations or cash flows of SLI or the Company. SLI is currently participating in environmental assessment and cleanup at a commercial facility located in Wayne, New Jersey. Contaminated soil and groundwater has undergone remediation with the NJDEP and LSRP oversight, but contaminants of concern ("COCs") in groundwater and surface water, which extend off-site, remain above applicable NJDEP remediation standards. A soil remedial action plan has been developed to remove the new soil source contamination that continues to impact groundwater. Page | 75 SLI's LSRP completed a supplemental groundwater remedial action, pursuant to a RAWP filed with, and permit approved by, the NJDEP, and a report was filed with the NJDEP in March 2015. SLI's consultants have developed cost estimates for supplemental remedial injections, soil excavation, and additional tests and remedial activities. The LSRP has prepared a Remedial Investigation Report, which was sent to the NJDEP in May 2016. Off-site access to the adjacent property has been negotiated and monitoring wells have been installed. Results of the initial samples detected COCs above NJDEP standards. There can be no assurance that there will not be potential additional costs associated with the site, which cannot be reasonably estimated at this time. Accordingly, there can be no assurance that the resolution of this matter will not be material to the financial position, results of operations or cash flows of SLI or the Company. Other Litigation In the ordinary course of our business, we are subject to other periodic lawsuits, investigations, claims and proceedings, including, but not limited to, contractual disputes, employment, environmental, health and safety matters, as well as claims associated with our historical acquisitions and divestitures. There is insurance coverage available for many of the foregoing actions. Although we cannot predict with certainty the ultimate resolution of lawsuits, investigations, claims and proceedings asserted against us, we do not believe any currently pending legal proceeding to which we are a party will have a material adverse effect on our business, prospects, financial condition, cash flows, results of operations or liquidity. Note 20 - Related Party Transactions As of December 31, 2016 and 2015, SPLP owned directly or indirectly through its subsidiaries 8,560,592 shares of the Company's common stock, representing approximately 69.9% and 70.1% of outstanding shares, respectively. The power to vote and dispose of the securities held by SPLP is controlled by SPH GP. Warren G. Lichtenstein, our Chairman of the Board of Directors, is also the Executive Chairman of SPH GP. Certain other affiliates of SPH GP hold positions with the Company, including Jack L. Howard, as Vice Chairman and Principal Executive Officer, John H. McNamara, Jr., as Director, Douglas B. Woodworth, as Chief Financial Officer, Leonard J. McGill, as Chief Legal Officer, and William T. Fejes, Jr., as President and Chief Executive Officer of H&H Group. The Company entered into a management services agreement, as amended ("Management Services Agreement"), with SP Corporate Services LLC ("SP Corporate"). SP Corporate is an affiliate of SPLP. Pursuant to the Management Services Agreement, SP Corporate provided the Company with certain executive and corporate services, including, without limitation, legal, tax, accounting, treasury, consulting, auditing, administrative, compliance, environmental health and safety, human resources, marketing, investor relations, and other similar services rendered for the Company or its subsidiaries. The Management Services Agreement provided that the Company pay SP Corporate a fixed annual fee of approximately $8.9 million. On May 3, 2015, the Company and SP Corporate entered into an amendment to the Management Services Agreement to add operating group management services to the scope of services to be provided pursuant to the Management Services Agreement and to adjust the fee for services provided under the Management Services Agreement from $8.9 million to $10.6 million. In connection with the amendment, the Company also entered into a transfer agreement, dated May 3, 2015, with Steel Partners LLC ("Steel Partners"), pursuant to which three employees of the Company and its subsidiaries were transferred to Steel Partners, which assumed the cost of compensating those employees and providing applicable benefits. Effective February 23, 2016, SP Corporate assigned its rights and responsibilities under the Management Services Agreement to its parent company, Steel Services Ltd ("SPH Services"), and the Company and SPH Services entered into an Amended and Restated Management Services Agreement ("Amended and Restated Management Services Agreement") to have SPH Services furnish the services to be provided pursuant to the Management Services Agreement and to make certain other changes. During the years ended December 31, 2016, 2015 and 2014, the Company reimbursed SPH Services and its affiliates approximately $1.6 million, $0.7 million and $0.4 million, respectively, for business expenses incurred on its behalf pursuant to the management services agreements. The fees payable under the Amended and Restated Management Services Agreement are subject to review and such adjustments as may be agreed upon by SPH Services and the Company. The Amended and Restated Management Services Agreement had a term through December 31, 2016 and automatically renews for successive one-year periods unless and until terminated in accordance with the terms set forth therein. Upon any such termination, a reserve fund will be established by the Company for the payment of expenses incurred by or due to SPH Services that are attributable to the services provided to the Company. Page | 76 In connection with its acquisition of JPS, on July 31, 2015, HNH issued to H&H Group 1,429,407 shares of HNH common stock, and H&H Group then exchanged those shares of HNH common stock for all shares of JPS common stock held by SPH Group Holdings, a subsidiary of SPLP. See Note 4 - "Acquisitions" for further discussion. Mutual Securities, Inc. is the custodian for the majority of the Company's holdings in ModusLink common stock. Jack L. Howard is a registered principal of Mutual Securities, Inc. Note 21 - Reportable Segments HNH is a diversified holding company whose strategic business units encompass the following segments: Joining Materials, Tubing, Building Materials, Performance Materials, Electrical Products and Kasco. For a more complete description of the Company's segments, see "Item 1 - Business - Products and Product Mix." Management has determined that certain operating companies should be aggregated and presented within a single segment on the basis that such segments have similar economic characteristics and share other qualitative characteristics. Management reviews net sales, gross profit and operating income (loss) to evaluate segment performance. Operating income (loss) for the segments generally includes costs directly attributable to the segment and excludes other unallocated general corporate expenses. Interest expense, other income and expense, and income taxes are not presented by segment since they are excluded from the measures of segment profitability reviewed by the Company's management. The following tables present information about the Company's reportable segments for the years ended December 31, 2016, 2015 and 2014: Page | 77 (a) The results of the Joining Materials segment in 2016 include non-cash asset impairment charges totaling $2.5 million, primarily due to write-downs of $1.5 million to property, plant and equipment, and $0.5 million to inventories, associated with the planned closure of its Lucas-Milhaupt Gliwice, Poland operating facility as part of its continual focus to optimize infrastructure costs. The results of the Joining Materials segment in 2014 include a non-cash asset impairment charge of $0.6 million related to certain equipment located in Toronto, Canada to be sold or scrapped as part of the Company's integration activities associated with a 2013 acquisition. (b) The results of the Performance Materials segment in 2016 include a non-cash goodwill impairment charge of $24.3 million, as well as non-cash asset impairment charges totaling $7.9 million associated with its Slater, South Carolina operating facility, including write-downs of $6.6 million to property, plant and equipment, and $0.4 million to intangible assets, as well as a $0.9 million inventory write-down. (c) The results of the Kasco segment in 2014 include a non-cash asset impairment charge of $0.6 million associated with certain unused, real property located in Atlanta, Georgia. (d) Unallocated corporate expenses and non-operating units in 2015 includes a non-cash asset impairment charge of $1.4 million related to certain unused, real property located in Norristown, Pennsylvania. Page | 78 The following table presents revenue and long-lived asset information by geographic area as of and for the years ended December 31. Foreign revenue is based on the country in which the legal subsidiary generating the revenue is domiciled. Long-lived assets in 2016 and 2015 consist of property, plant and equipment, plus approximately $6.3 million and $7.3 million, respectively, of land and buildings from previously operating businesses and other non-operating assets that are carried at the lower of cost or fair value less cost to sell and are included in other non-current assets on the consolidated balance sheets. Neither net sales nor long-lived assets from any single foreign country was material to the consolidated financial statements of the Company. Note 22 - Parent Company Condensed Financial Information As discussed in Note 11 - "Credit Facilities," certain of the Company's subsidiaries have long-term debt outstanding which place restrictions on distributions of funds to HNH, subject to certain exceptions including required pension payments to the WHX Pension Plan and the WHX Pension Plan II. As these subsidiaries' restricted net assets, which totaled approximately $684 million at December 31, 2016, represent a significant portion of the Company's consolidated total assets, the Company is presenting the following parent company condensed financial information. The HNH parent company condensed financial information is prepared on the same basis of accounting as the HNH consolidated financial statements, except that the HNH subsidiaries are accounted for under the equity method of accounting. HNH is a holding company with minimal assets or operations, and all its subsidiaries are 100% owned. We may offer debt securities in a registered offering in the future. If we do, and if we offer guarantees of these securities, then we expect the guarantees will be full and unconditional and joint and several. We expect that any subsidiaries of HNH that do not guarantee the securities would be minor. Page | 79 HANDY & HARMAN LTD. (PARENT ONLY) Balance Sheets (in thousands, except par value) Page | 80 HANDY & HARMAN LTD. (PARENT ONLY) Statements of Operations and Comprehensive (Loss) Income (in thousands) Page | 81 HANDY & HARMAN LTD. (PARENT ONLY) Statements of Cash Flows (in thousands) Page | 82 Note 23 - Unaudited Quarterly Results Unaudited quarterly financial results during the years ended December 31, 2016 and 2015 were as follows: (a) A goodwill impairment charge of $24.3 million was recorded in the fourth quarter of 2016. See Note 9 - "Goodwill and Other Intangibles." (b) Other comprehensive loss of $7.4 million and $23.9 million, net of tax, were recorded in the fourth quarter of 2016 and 2015, respectively, primarily from unrealized actuarial losses associated with the Company's defined benefit pension plans. Note 24 - Subsequent Events In January 2017, the Company sold its Micro-Tube Fabricators, Inc. business ("MTF") for approximately $2.5 million. MTF specialized in the production of precision fabricated tubular components produced for medical device, aerospace, aircraft, automotive and electronic applications. The operations of this business and expected gain on sale are not significant to the consolidated financial statements of the Company. MTF was part of the Tubing segment. Page | 83
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This appears to be more of an accounting policy disclosure rather than a complete financial statement, but I'll summarize the key financial points mentioned:
Key Financial Elements:
1. Revenue Recognition:
- Revenue is recognized when title and risk of loss passes to customer
- Typically occurs when products are shipped or services performed
- Includes allowances for returns and discounts
- Rental revenue is recognized on a straight-line basis for prepaid contracts
- Service revenue comes from equipment repair and maintenance
2. Revenue Adjustments:
- Customer rebates are deducted from net sales
- Shipping and handling fees are included in revenue
- Related costs go to cost of goods sold
3. Key Liabilities include:
- Bad debts
- Inventory obligations
- Long-lived asset obligations
- Tax liabilities
- Pension and post-retirement benefits
- Contingent liabilities
- Litigation obligations
Note: The excerpt doesn't provide specific financial figures or balances, as it focuses on accounting policies and procedures rather than actual financial results.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HEIDRICK & STRUGGLES INTERNATIONAL, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Heidrick & Struggles International, Inc.: We have audited the accompanying consolidated balance sheets of Heidrick & Struggles International, Inc. and subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. We also have audited the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heidrick & Struggles International, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) . /s/ KPMG LLP Chicago, Illinois March 23, 2017 HEIDRICK & STRUGGLES INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts) The accompanying notes to Consolidated Financial Statements are an integral part of these statements. HEIDRICK & STRUGGLES INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands, except per share amounts) The accompanying notes to Consolidated Financial Statements are an integral part of these statements. HEIDRICK & STRUGGLES INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (In thousands) The accompanying notes to Consolidated Financial Statements are an integral part of these statements. HEIDRICK & STRUGGLES INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) The accompanying notes to Consolidated Financial Statements are an integral part of these statements. HEIDRICK & STRUGGLES INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (All tables in thousands, except share and per share figures) 1. Basis of Presentation Heidrick & Struggles International, Inc. and Subsidiaries (the “Company”) is engaged in providing executive search, culture shaping and leadership consulting services to clients on a retained basis. The Company operates in the Americas, Europe and Asia Pacific regions. The consolidated financial statements include Heidrick & Struggles International, Inc. and its wholly-owned subsidiaries and have been prepared using accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant items subject to estimates and assumptions include revenue recognition, allowances for deferred tax assets and liabilities, and assessment of goodwill and other intangible assets for impairment. Estimates are subject to a degree of uncertainty and actual results could differ from these estimates. 2. Summary of Significant Accounting Policies Cash and Cash Equivalents The Company considers all highly liquid instruments with an original maturity of three months or less to be cash equivalents. Concentration of Risk The Company is potentially exposed to concentrations of risk associated with its accounts receivable. However, this risk is limited due to the Company’s large number of clients and their dispersion across many different industries and geographies. At December 31, 2016, the Company had no significant concentrations of risk. Accounts Receivable The Company’s accounts receivable consist of trade receivables. The allowance for doubtful accounts is developed based upon several factors including the age of the Company’s accounts receivable, historical write-off experience and specific account analysis. These factors may change over time, impacting the allowance level. Fair Value of Financial Instruments Cash equivalents are stated at cost, which approximates fair market value. The carrying value for receivables from clients, accounts payable, deferred revenue and other accrued liabilities reasonably approximate fair market value due to the nature of the financial instruments and the short term nature of the items. Property and Equipment Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful life of the asset or, for leasehold improvements, the shorter of the lease term or the estimated useful life of the asset, as follows: Depreciation is calculated for tax purposes using accelerated methods, where applicable. Long-lived Assets The Company reviews its long-lived assets, including property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge, equal to the amount by which the carrying amount of the asset exceeds the fair value of the asset, is recognized. Investments The Company’s investments consist primarily of available-for-sale investments within the U.S. non-qualified deferred compensation plan (the “Plan”). Available-for-sale investments are reported at fair value with changes in unrealized gains (losses) recorded as a separate component of Accumulated other comprehensive income in the Consolidated Balance Sheets until realized. Realized gains (losses) resulting from an employee’s termination from the Plan are recorded as a non-operating expense in the Consolidated Statements of Comprehensive Income. Goodwill and Other Intangible Assets Goodwill represents the difference between the purchase price of acquired companies and the related fair value of the net assets acquired, which is accounted for by the acquisition method of accounting. Other intangible assets include client relationships, trade name, software, employee non-compete agreements and technology. The Company performs assessments of the carrying value of goodwill at least annually and of its goodwill and other intangible assets whenever events occur or circumstances indicate that a carrying amount of these assets may not be recoverable. These circumstances include a significant change in business climate, attrition of key personnel, changes in financial condition or results of operations, a prolonged decline in the Company’s stock price and market capitalization, competition, and other factors. The goodwill impairment test compares the fair value of a reporting unit to its carrying amount, including goodwill. The Company has historically operated four reporting units: the Americas; Europe, which includes Africa; Asia Pacific, which includes the Middle East; and Culture Shaping. During the fourth quarter of 2016, the Company revised its reporting unit structure based on the manner in which the Company's chief operating decision maker allocates resources and assesses performance. Under the revised reporting unit structure, the Company operates five reporting units: Americas Executive Search; Europe Executive Search, which includes Africa; Asia Pacific Executive Search, which includes the Middle East; Leadership Consulting; and Culture Shaping. If the carrying amount of a reporting unit exceeds its fair value, goodwill of the reporting unit would be considered impaired. To measure the amount of the impairment loss, the implied fair value of a reporting unit’s goodwill is compared to the carrying amount of that goodwill. If the carrying amount of a reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination is determined. The fair value of each of the Company’s reporting units is determined using a discounted cash flow methodology. In connection with the reporting unit structure change, the Company revised its historical methodology for allocating corporate costs to the reporting units for goodwill impairment purposes to more closely align with the Company's allocation methodology for financial reporting purposes and reflect estimated consumption. The Company also reallocated its goodwill to the new reporting unit structure utilizing the relative fair value method. The other intangible asset impairment review compares the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge, equal to the amount by which the carrying amount of the asset exceeds the fair value, is recognized. Other intangible assets acquired are amortized either using the straight-line method over their estimated useful lives or based on the projected cash flow associated with the respective intangible assets. Revenue Recognition Revenue before reimbursements of out-of-pocket expenses (“net revenue”) consists of retainers and indirect expenses billed to clients. For each assignment, the Company and its client enter into a contract that outlines the general terms and conditions of the assignment. Typically, the Company is paid a retainer for its executive search services equal to approximately one-third of the estimated first year compensation for the position to be filled. In addition, generally, if the actual compensation of a placed candidate exceeds the estimated compensation, the Company often is authorized to bill the client for one-third of the excess. Indirect expenses are calculated as a percentage of the retainer with certain dollar limits per search. The Company generally bills its clients for its retainer and indirect expenses in one-third increments over a three-month period commencing in the month of a client’s acceptance of the contract. Net revenue is recognized when earned and realizable and therefore when the following criteria have been met: (a) persuasive evidence of an arrangement exists, (b) services have been rendered, (c) the fee to our client is fixed or determinable, and (d) collectability is reasonably assured. Taxes collected from clients and remitted to governmental authorities are presented on a net basis. Typically, net revenue from standard executive search engagements is recognized over the expected average period of performance, in proportion to the estimated personnel time incurred to fulfill our obligations under the arrangements. Net revenue in excess of the retainer, resulting from actual compensation of the placed candidate exceeding the estimated compensation, is recognized upon completion of the executive search when the amount of the additional fee is known. Net revenue associated with culture shaping consulting is recognized proportionally as services are performed. Net revenue associated with licenses to use our culture shaping proprietary materials is typically recognized over the term of the arrangement. Depending on the terms of that agreement, net revenue from certain leadership consulting and non-standard executive search engagements is either recognized proportionally as services are performed or in accordance with the completion of the engagement deliverables. Reimbursements The Company incurs certain out-of-pocket expenses that are reimbursed by its clients, which are accounted for as revenue and expense in its Consolidated Statements of Comprehensive Income. Salaries and Employee Benefits Salaries and employee benefits consist of compensation and benefits paid to consultants, executive officers, and administrative and support personnel, of which the most significant elements are salaries and annual performance-related bonuses. Other items in this category are expenses related to sign-on bonuses, forgivable employee loans and minimum guaranteed bonuses (often incurred in connection with the hiring of new consultants), restricted stock unit and performance share unit amortization, payroll taxes, profit sharing and retirement benefits, and employee insurance benefits. Salaries and employee benefits are recognized on an accrual basis. Certain sign-on bonuses, retention awards, and minimum guaranteed compensation are capitalized and amortized in accordance with the terms of the respective agreements. A portion of the Company’s consultants’ and management cash bonuses are deferred and paid over a three-year vesting period. The portion of the bonus is approximately 15% depending on the employee’s level or position. The compensation expense related to the amounts being deferred is recognized on a graded vesting attribution method over the requisite service period. This service period begins on January 1 of the respective fiscal year and continues through the deferral date, which coincides with the Company’s bonus payments in the first quarter of the following year, and for an additional three year vesting period. The deferrals are recorded in Accrued salaries and employee benefits within both Current liabilities and Non-current liabilities in the Consolidated Balance Sheets. Income Taxes Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities, applying enacted statutory tax rates in effect for the year in which the tax differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Earnings per Common Share Basic earnings per common share is computed by dividing net income by weighted average common shares outstanding for the year. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted. Common equivalent shares are excluded from the determination of diluted earnings per share in periods in which they have an anti-dilutive effect. The following table sets forth the computation of basic and diluted earnings per share: Translation of Foreign Currencies The Company generally designates the local currency for all its subsidiaries as the functional currency. The Company translates the assets and liabilities of its subsidiaries into U.S. dollars at the current rate of exchange prevailing at the balance sheet date. Revenue and expenses are translated at a monthly average exchange rate for the period. Translation adjustments are reported as a component of Accumulated other comprehensive income. Restricted Cash The Company has lease agreements and business licenses with terms that require the Company to restrict cash through the termination dates of the agreements, which extend through 2018. During 2016, the Company paid certain key executives of Senn Delaney a $6.5 million retention bonus out of restricted cash for remaining with the Company for three years subsequent to the acquisition (See Note 7, Acquisitions). As of December 31, 2016 and 2015, the total restricted cash was $0.6 million and $7.8 million, respectively. Current and non-current restricted cash is included in Other current assets and Other non-current assets, respectively, on the Consolidated Balance Sheet. Reclassifications Certain prior year amounts have been recast as a result of the change in the Company's operating segments. The reclassifications had no impact on net income, net cash flows or stockholders' equity. Recently Issued Financial Accounting Standards In November 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-18, Statement of Cash Flows: Restricted Cash, which requires that the statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore amounts generally described as restricted cash should be included with cash and cash equivalents when recording the beginning of period and end of period total amounts shown on the statement of cash flows. The Company currently does not include restricted cash amounts in the beginning and ending cash amounts and will change the presentation of the cash flow statement to include restricted cash in the beginning and ending cash totals. The standard is effective for annual reporting periods beginning after December 15, 2017 with early adoption permitted.The Company has not yet determined when it will adopt this guidance. The impact of this change is not expected to be significant to the classification of these activities on the Consolidated Statement of Cash Flows. In August 2016, the Financial Accounting Standards Board ("FASB") issued accounting Standards Update ("ASU") No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments, which is intended to reduce diversity in practice as to how certain cash receipts and cash payments should be presented and classified. The standard is effective for interim and annual reporting periods beginning after December 15, 2017 with early adoption permitted. The Company has evaluated the standard and noted the guidance for contingent consideration payments made after a business combination are applicable to the Condensed Consolidated Statements of Cash Flows. The Company currently classifies all contingent consideration payments as financing activities. The impact of this change is not expected to be significant to the classification of these activities on the Consolidated Statements of Cash Flows. In February 2016, the FASB issued ASU No. 2016-02, Leases, intended to improve financial reporting about leasing transactions. The new guidance will require entities that lease assets to recognize on their balance sheets the assets and liabilities for the rights and obligations created by those leases and to disclose key information about the leasing arrangements. ASU 2016-02 is effective for interim and annual periods beginning after December 15, 2018 with early adoption permitted. The guidance requires lessees and lessors to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Company is currently evaluating the impact of this accounting guidance. The effect is not known or reasonably estimable at this time. In January 2016, the FASB issued ASU 2016-01, Financial Instruments: Recognition and Measurement of Financial Assets and Financial Liabilities, which addresses certain aspects of recognition, measurement, presentation and disclosure of financial instruments including the recognition of unrealized changes in fair value within net income. The standard is effective for annual reporting periods beginning after December 15, 2017. The Company is currently evaluating the impact of this accounting guidance. The effect is not known or reasonably estimable at this time. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. The ASU requires that an entity recognizes revenue to depict the transfer of promised goods or services to customer in an amount that reflects the consideration to which the Company expects to be entitled in exchange for these goods or services. The effective date has been deferred for one year to the interim and annual reporting periods beginning after December 15, 2017. The guidance permits the use of either of the following transition methods: (i) a full retrospective method reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients or (ii) a retrospective method with the cumulative effect upon initial adoption recognized at the date of initial application (modified retrospective). The Company will adopt the guidance on January 1, 2018 and will apply the modified retrospective method. The Company is performing its evaluation of ASU No. 2014-09. The Company is paid a retainer for its executive search services equal to approximately one-third of the estimated first year compensation for the position to be filled. If the actual compensation of a placed candidate exceeds the estimated compensation, the Company is often authorized to bill the client for one-third of the excess. The Company currently recognizes revenue associated with the difference between the estimated compensation and actual compensation at the time this amount is considered fixed and determinable. Under ASU 2014-09, the difference between estimated compensation and actual compensation is considered variable consideration. The Company will be required to estimate the amount of variable consideration for its executive search services at contract inception. The Company is still evaluating the financial impact of this change. The Company is continuing to evaluate the impacts of adoption of this guidance and its preliminary assessments are subject to change. Recently Adopted Financial Accounting Standards In March 2016, the FASB issued ASU No. 2016-09, Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which is intended to simplify several aspects of the accounting for share-based payment transactions including the income tax accounting, classification of awards as either equity or liabilities, the accounting for forfeitures and classification on the statement of cash flows. The standard is effective for annual reporting periods beginning after December 15, 2016 with early adoption permitted. The Company early adopted this standard during the fourth quarter of 2016. The adoption of this standard reduced tax expense by approximately $0.7 million for the year ended December 31, 2016. 3. Allowance for Doubtful Accounts The activity of the allowance for doubtful accounts for the years ended: 4. Property and Equipment, net The components of the Company’s property and equipment are as follows: Depreciation expense for the years ended December 31, 2016, 2015, and 2014 was $9.4 million, $8.8 million, and $9.8 million, respectively. 5. Investments The Company has a U.S. non-qualified deferred compensation plan that consists primarily of U.S. marketable securities and mutual funds, all of which are valued using Level 1 inputs (See Note 6, Fair Value Measurements). The fair value for these investments was $17.3 million and $14.1 million as of December 31, 2016 and 2015, respectively. The aggregate cost basis for these investments was $13.3 million and $11.1 million as of December 31, 2016 and 2015, respectively. 6. Fair Value Measurements Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A three-level fair value hierarchy prioritizes the inputs used to measure fair value. The hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows: •Level 1 - Quoted prices in active markets for identical assets and liabilities. •Level 2 - Quoted prices in active markets for similar assets and liabilities, or other inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. •Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets and liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs. The following table provides a reconciliation of the beginning and ending balance of Level 3 assets and liabilities for the year ended December 31, 2016. The Level 2 assets above are reinsurance contracts fair valued in accordance with BaFin - German Federal Financial Supervisory Authority guidelines, which utilize observable inputs including mortality tables and discount rates. The Level 3 liabilities are accruals for future earnout payments related to current year and prior acquisitions, the values of which are determined based on discounted cash flow models. The Company considers the recorded value of its financial assets and liabilities, which consist primarily of cash and cash equivalents, accounts receivable, and accounts payable, to approximate the fair value of the respective assets and liabilities at December 31, 2016 and December 31, 2015 based upon the short-term nature of the assets and liabilities. 7. Acquisitions Philosophy IB, LLP On September 1, 2016, the Company acquired substantially all of the assets of Philosophy IB, LLP ("Philosophy IB"), a New Jersey-based leadership, organization development and management consulting firm for $6.0 million, which was funded from existing cash. The former owners of Philosophy IB are eligible to receive an additional cash consideration based on two components: achieving revenue milestones generated from its software products from September 2016 through August 2019 and percentage of consulting revenue achieved over the period September 2016 to August 2019, subject to a profitability test. When estimating the value of future cash consideration, the Company has accrued $1.1 million as of December 31, 2016. The Company recognized $0.1 million of accretion expense included in General and administrative expenses during the twelve months ended December 31, 2016. The Company recorded $2.9 million of intangible assets and $2.4 million of goodwill. The goodwill is primarily related to the acquired workforce and strategic fit. As of the acquisition date, the Company expects that approximately $1.3 million of goodwill will be deductible for tax purposes. JCA Group Limited On August 4, 2016, the Company acquired JCA Group Limited ("JCA Group"), a UK-based provider of executive search, succession planning and coaching services, and, from the partners thereof, the entire partnership interest in JCA Partners LLP for £11.2 million (equivalent to $14.9 million at the acquisition date and $13.8 million at December 31, 2016) of initial consideration, which was funded from existing cash. The former owners of JCA Group are eligible to receive additional cash consideration upon the realization of specific revenue milestones achieved over the period August 2016 through August 2018. When estimating the value of future cash consideration, the Company has accrued £2.7 million (equivalent to $3.3 million) as of December 31, 2016. The Company recognized less than $0.1 million of accretion expense included in General and administrative expenses during the twelve months ended December 31, 2016. The Company recorded $3.9 million of intangible assets and $15.8 million of goodwill. The goodwill is primarily related to the acquired workforce and strategic fit. The Company will not be able to deduct the recorded goodwill for tax purposes. Decision Strategies International, Inc. On February 29, 2016, the Company acquired substantially all of the assets of Decision Strategies International, Inc. ("DSI"), a Pennsylvania-based business consulting firm and its wholly owned subsidiary, Decision Strategies International (UK) Limited. DSI specializes in advising organizations and institutions on strategic planning and decision making in uncertain operating environments, leadership development and talent strategy. Total consideration for the acquisition of DSI's assets was approximately $9.0 million and was funded from existing cash. The former owners of DSI are eligible to receive an additional cash consideration payment in 2019 based on revenue targets to be achieved in 2017 and 2018. When estimating the value of future cash consideration, the Company has accrued $1.7 million as of December 31, 2016. The Company recognized $0.3 million of accretion expense included in General and administrative expenses during the twelve months ended December 31, 2016. The Company recorded $3.2 million of intangible assets related to customer relationships and $5.7 million of goodwill. The goodwill is primarily related to the acquired workforce and strategic fit. As of the acquisition date, the Company expects that approximately $4.2 million of goodwill will be deductible for tax purposes. Co Company Limited On October 1, 2015, the Company acquired Co Company, a UK-based management consulting firm that specializes in Organizational Development for £7.1 million (equivalent to $10.8 million at the acquisition date and $8.8 million at December 31, 2016) of initial consideration, pursuant to a stock purchase, which was funded from existing cash. The former owners of Co Company are eligible to receive additional cash consideration upon the realization of specific revenue and EBITDA Margin milestones achieved over the period October 1, 2015 through December 2018. On August 25, 2016, the Company and the former owners of Co Company entered into a Deed of Amendment (the "Amendment") to the Share Purchase Agreement dated October 1, 2015. The Amendment adjusts the target fee revenue and targeted EBITDA margin for each remaining earn out period taking into consideration the unanticipated acquisitions completed subsequent to the Share Purchase Agreement. The new targets include subsequent acquisitions and take effect retrospectively from January 1, 2016. When estimating the fair value of future cash consideration, the Company has accrued £3.2 million and £2.8 million (equivalent to $3.9 million and $4.2 million) as of December 31, 2016 and December 31, 2015, respectively, of which $0.2 million was paid during 2016. As a result of the Amendment and related adjustment of the earnout liability, the Company recognized $0.1 million of income in General and administrative expenses during the year ended December 31, 2016. The Company recognized $0.1 million of expense in General and administrative expenses during the year ended December 31, 2015. The Company recorded $2.9 million of intangible assets and $10.7 million of goodwill. The goodwill is primarily related to the acquired workforce and strategic fit. The Company will not be able to deduct the recorded goodwill for tax purposes. Scambler MacGregor Executive Search Pty Limited In November 2013, the Company acquired Scambler MacGregor, an Australian-based retained Executive Search boutique in the financial services industry for 1.1 million Australian dollars (equivalent to $1.0 million at the acquisition date and $0.8 million at December 31, 2016) of initial consideration, pursuant to a stock purchase, which was funded from existing cash. In December 2013, the Company paid an additional $0.1 million related to the final working capital settlement. The former owners of Scambler MacGregor are eligible to receive earnout payments of up to 2.8 million Australian dollars (equivalent to $2.1 million as of December 31, 2016) based on the achievement of certain revenue metrics over the period November 2013 through December 2018, of which $0.4 million and $0.7 million were paid during the first quarters of 2016 and 2015 respectively. When estimating the fair value of future earnout payments, the Company has accrued 1.1 million Australian dollars and 1.6 million Australian dollars, equivalent to $0.8 million and $1.2 million as of December 31, 2016 and 2015, respectively. The Company also recorded $0.4 million of intangible assets and $2.7 million of goodwill. The goodwill is primarily related to the acquired workforce and strategic fit. The Company will not be able to deduct the recorded goodwill for tax purposes. Senn-Delaney Leadership Consulting Group, LLC In December 2012, the Company acquired Senn-Delaney Leadership Consulting Group, LLC, a global leader of corporate culture shaping. Under the terms of the purchase agreement, the Company paid $53.5 million at closing for 100 percent of the equity of Senn Delaney. The agreement also included additional cash consideration up to $15.0 million based on the realization of specific earnings milestones achieved over the period December 2012 through December 2015, of which $6.8 million, $4.8 million and $3.4 million was paid in 2016, 2015 and 2014, respectively. The Company had accrued $6.6 million at December 31, 2015 for the remaining cash consideration, which was paid during the year ended December 31, 2016. The Company has recognized $0.2 million and $1.1 million of accretion expense included in General and administrative expenses for the years ended December 31, 2016 and 2015, respectively. The Company recognized $2.1 million of compensation expense included in Salaries and employee benefits for the year ended December 31, 2015 related to the retention awards. As of the acquisition date, the Company expects that approximately $19.1 million of goodwill will be deductible for tax purposes. 8. Goodwill and Other Intangible Assets Goodwill Changes in the carrying amount of goodwill by segment for the years ended December 31, 2016, 2015 and 2014 were as follows: (1) Due to the Company's change in segment reporting, goodwill amounts included in the Company's Americas, Europe and Asia Pacific segments in the prior year have been reallocated to the Leadership Consulting segment utilizing the relative fair value method. During the 2016 fourth quarter, the Company conducted its annual goodwill impairment evaluation as of October 31, 2016. The goodwill impairment evaluation is performed using a two-step, fair value based test. The first step compares the fair value of a reporting unit with its carrying amount, including goodwill. The second step measures the impairment charge and is performed only if the carrying amount of a reporting unit exceeds its fair value as determined in step one. To measure the amount of the impairment loss, the implied fair value of a reporting unit’s goodwill is compared to the carrying amount of that goodwill. If the carrying amount of a reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. The impairment test is considered for each of the Company’s reporting units that have goodwill as defined in the accounting standard for goodwill and intangible assets. The Company has historically operated four reporting units: the Americas; Europe, which includes Africa; Asia Pacific, which includes the Middle East; and Culture Shaping. During the fourth quarter of 2016, the Company revised its reporting unit structure based on the manner in which the Company's chief operating decision maker allocates resources and assesses performance. Under the revised reporting unit structure, the Company operates five reporting units: Americas Executive Search; Europe Executive Search, which includes Africa; Asia Pacific Executive Search, which includes the Middle East; Leadership Consulting; and Culture Shaping. As a result of the change in reporting units, the Company conducted it's annual impairment evaluation for both the former and revised reporting unit structures as required by the accounting standard for goodwill and intangible assets. During the impairment evaluation process, the Company used a discounted cash flow methodology to estimate the fair value of its reporting units. The discounted cash flow approach is dependent on a number of factors, including estimates of future market growth and trends, forecasted revenue and costs, capital investments, appropriate discount rates, certain assumptions to allocate shared costs, assets and liabilities, historical and projected performance of the Company’s reporting units, the outlook for the executive search industry, and the macroeconomic conditions affecting each of the Company’s reporting units. The assumptions used in the determination of fair value were (1) a forecast of growth in the near term; (2) the discount rate; (3) working capital investments; and (4) other factors. As a result of the reporting unit structure change, the Company revised its historical methodology for allocating corporate costs to the reporting units for goodwill impairment purposes to more closely align with the Company's allocation methodology for financial reporting purposes and reflect estimated consumption. Based on the result of the first step of this goodwill impairment analysis, the fair values of the Americas, Europe, Asia Pacific, and Culture Shaping reporting units under the old reporting unit structure exceeded their carrying values by118%, 68%, 38%, and 5%, respectively. Under the new reporting unit structure, the result of the first step of this goodwill impairment analysis indicated the fair values of the Americas Executive Search, Europe Executive Search, Asia Pacific Executive Search, Leadership Consulting and Culture Shaping reporting units exceeded their carrying values by 124%, 69%, 34%,46% and 5%, respectively. The fair value of a reporting unit may deteriorate and could result in the need to record an impairment charge in future periods. The Company continues to monitor potential triggering events including changes in the business climate in which it operates, the Company’s market capitalization compared to its book value, and the Company’s recent operating performance. Any changes in these factors could result in an impairment charge. Since the fair value of the reporting units exceeded their carrying values, the second step of the goodwill impairment test was not necessary. Other Intangible Assets, net The Company’s other intangible assets, net by segment, are as follows: (1) Due to the Company's change in segment reporting, intangible assets included in the Company's Europe Executive Search and Leadership Consulting segment in the prior year have been reallocated to the Leadership Consulting segment. The carrying amount of amortizable intangible assets and the related accumulated amortization were as follows: Intangible asset amortization expense for the years ended December 31, 2016, 2015 and 2014 was $7.1 million , $4.9 million and $5.5 million respectively. The Company's estimated future amortization expense related to intangible assets as of December 31, 2016 for the years ended December 31st is as follows: 9. Other Non-Current Liabilities The components of other non-current liabilities are as follows: 10. Line of Credit On June 30, 2015, the Company entered into a Second Amended and Restated Credit Agreement (the “Restated Credit Agreement”). The Restated Credit agreement amended and restated the Credit Agreement executed on June 22, 2011 (the “Credit Agreement”). Pursuant to the Restated Credit Agreement, the Company replaced its Revolving Facility and Term Facility (“Existing Facility”) with a single senior unsecured revolving line of credit with an aggregate commitment of up to $100 million, which includes a sublimit of $25 million for letters of credit, and a $50 million expansion feature (the “Replacement Facility”). The Replacement Facility will mature on June 30, 2020. Borrowings under the Restated Credit Agreement bear interest at the Company’s election at the existing Alternate Base Rate (as defined in the Credit Agreement) or Adjusted LIBOR Rate (as defined in the Credit Agreement) plus a spread as determined by the Company’s leverage ratio. Borrowings under the Replacement Facility may be used for working capital, capital expenditures, Permitted Acquisition (as defined in the Credit Agreement) and for other general purposes of the Company and its subsidiaries. The obligations under the Replacement Facility are guaranteed by certain of the Company's subsidiaries. As of December 31, 2016 and 2015, the Company had no outstanding borrowings under the Restated Credit Agreement and the Company was in compliance with the financial and other covenants under the Restated Credit Agreement and no event of default existed. On March 8, 2017, the Company borrowed $40.0 million under the Restated Credit Agreement and elected the Adjusted LIBOR Rate. 11. Employee Benefit Plans Qualified Retirement Plan The Company has a defined contribution retirement plan (the “Plan”) for all eligible employees in the United States. Eligible employees may begin participating in the Plan upon their hire date. The Plan contains a 401(k) provision, which provides for employee pre-tax and/or after-tax contributions, from 1% to 50% of their eligible compensation up to a combined maximum permitted by law. The Company matched employee contributions on a dollar for dollar basis per participant up to the greater of $6,000, or 6.0%, of eligible compensation for the year ended December 31, 2016. The Company matched employee contributions up to the greater of $5,500, or 5.5%, of eligible compensation for the year ended December 31, 2015, and up to the greater of $5,000, or 5.0%, of eligible compensation for the year ended December 31, 2014. Beginning in 2016, employees are eligible for the Company match immediately provided that they are working on the last day of the Plan year in which the match is made. Previously, employees were eligible for the Company match after satisfying a one year service requirement provided that they were working on the last day of the Plan year in which the match was made. The Plan also provides for employees who retire, die or become disabled during the Plan year to receive the Company match for that Plan year. The Plan provides that forfeitures will be used to reduce the Company’s contributions. Forfeitures are created annually by participants who terminate employment before becoming entitled to the Company’s matching contribution under the Plan. The Company also has the option of making discretionary contributions. There were no discretionary contributions made for the years ended December 31, 2016, 2015 and 2014. The expense that the Company incurred for matching employee contributions for the years ended December 31, 2016, 2015 and 2014 was $4.8 million, $3.3 million and $2.8 million, respectively. The Company maintains additional retirement plans in the Americas, Europe and Asia Pacific regions which the Company does not consider as material, and, therefore additional disclosure has not been presented. The balances associated with these plans have been reported in the Consolidated Statements of Comprehensive Income for the years ended December 31, 2016, 2015 and 2014 and in the Consolidated Balance Sheets as of December 31, 2016 and 2015. Deferred Compensation Plans The Company has a deferred compensation plan for certain U.S. employees (the “U.S. Plan”) that became effective on January 1, 2006. The U.S. Plan allows participants to defer up to 25% of their base compensation and up to the lesser of $500,000 or 25% of their eligible bonus compensation into several different investment vehicles. These deferrals are immediately vested and are not subject to a risk of forfeiture. In 2016 and 2015, all deferrals in the U.S. Plan were funded. The compensation deferred in the U.S. Plan was $14.9 million and $12.0 million, at December 31, 2016 and 2015, respectively. The assets of the U.S. Plan are included in Investments and the liabilities of the U.S. Plan are included in Retirement and pension plans in the Consolidated Balance Sheets as of December 31, 2016 and 2015. The Company has a Non-Employee Directors Voluntary Deferred Compensation Plan whereby non-employee members of the Company’s Board of Directors may elect to defer up to 100% of the cash component of their directors’ fees into several different investment vehicles. As of December 31, 2016 and 2015, the total amounts deferred under the plan were $2.4 million and $2.1 million, respectively, all of which was funded. The assets of the plan are included in Investments and the liabilities of the plan are included in Retirement and pension plans in the Consolidated Balance Sheets at December 31, 2016 and 2015. The U.S. and Non-Employee Directors Voluntary Deferred Compensation Plans consist primarily of marketable securities and mutual funds, all of which are valued using Level 1 inputs (See Note 6, Fair Value Measurements). 12. Pension Plan and Life Insurance Contract The Company maintains a pension plan for certain current and former employees in Germany. The pensions are individually fixed Euro amounts that vary depending on the function and the eligible years of service of the employee. The benefit obligation amounts recognized in the Consolidated Balance Sheets are as follows: The accumulated benefit obligation amounts at December 31, 2016 and 2015 are $22.1 million million and $22.4 million million, respectively. The components of and assumptions used to determine the net periodic benefit cost are as follows: Assumptions to determine the Company’s benefit obligation are as follows: (1) The discount rates are based on long-term bond indices adjusted to reflect the longer duration of the benefit obligation. The amounts in Accumulated other comprehensive income as of December 31, 2016 and 2015 that had not yet been recognized as components of net periodic benefit cost were $3.6 million and $2.5 million, respectively. As of December 31, 2016, an insignificant amount of the accumulated other comprehensive income is expected to be recognized as a component of net periodic benefit cost in 2017. The Company’s investment strategy is to support its pension obligations through reinsurance contracts. The BaFin-German Federal Financial Supervisory Authority-supervises the insurance companies and the reinsurance contracts. The BaFin requires each reinsurance contract to guarantee a fixed minimum return. The Company’s pension benefits are fully reinsured by group insurance contracts with ERGO Lebensversicherung AG, and the group insurance contracts are measured in accordance with BaFin guidelines (including mortality tables and discount rates) which are considered Level 2 inputs (See Note 6, Fair Value Measurements). The fair value at December 31, 2016 and 2015 was $17.0 million million and $18.2 million, respectively. The expected contribution to be paid into the plan in 2017 is $1.3 million. Since the pension assets are not segregated in trust from the Company’s other assets, the pension assets are not shown as an offset against the pension liabilities in the Consolidated Balance Sheets. These assets are included in the Consolidated Balance Sheets at December 31, 2016 and 2015, as a component of Other current assets and Assets designated for retirement and pension plans. The benefits expected to be paid in each of the next five years, and in the aggregate for the five years thereafter are as follows: 13. Stock-Based Compensation GlobalShare Program The Company’s 2007 Heidrick & Struggles GlobalShare Program (the “Prior Program”) provided for grants of stock options, stock appreciation rights, and other stock-based awards to directors, selected employees, and independent contractors. The Prior Program expired on May 24, 2012. Outstanding awards granted under the Prior Program remain outstanding and subject to the terms of the Prior Program and award agreements until such awards vest, are exercised, terminate or expire pursuant to their terms. As of December 31, 2016, there were 43,338 awards outstanding under the Prior Program, consisting of 8,877 stock options and 34,461 restricted stock units. On May 24, 2012, the stockholders of the Company approved the 2012 Heidrick & Struggles GlobalShare Program (the “2012 Program”) at the Company’s Annual Meeting of Stockholders. The 2012 Program provides for grants of stock options, stock appreciation rights, and other stock-based awards that are valued based upon the grant date fair value of shares. These awards may be granted to directors, selected employees and independent contractors. The total number of shares authorized or reserved for issuance under the 2012 Program is 1,300,000 shares (consisting of a number of shares not previously authorized for issuance under any plan, and the number of shares not subject to awards and remaining available for issuance under the Prior Program, as amended on April 2, 2012), plus any shares subject to the 671,528 outstanding awards as of April 2, 2012 under the Prior Program that on or after the effective date cease for any reason to be subject to such awards. Stock awards forfeited or canceled under the Prior Program and the 2012 Program are eligible for reissuance under the 2012 Program. On May 22, 2014, the stockholders of the Company approved an amendment to the 2012 Program to increase the number of shares of Common Stock reserved for issuance under the 2012 Program by 700,000 shares. As of December 31, 2016, 1,397,410 awards have been issued under the 2012 Program and 1,003,228 shares remain available for future awards, which includes 400,638 forfeited awards. The 2012 Program provides that no awards can be granted after May 24, 2022. The Company measures its stock-based compensation costs based on the grant date fair value of the awards and recognizes these costs in the financial statements over the requisite service period. A summary of information with respect to stock-based compensation is as follows: Restricted Stock Units Restricted stock units are generally subject to ratable vesting over a three year period. Compensation expense related to service-based restricted stock units is recognized on a straight-line basis over the vesting period. For awards requiring satisfaction of service and performance conditions, compensation expense is recognized using a graded vesting attribution method. Restricted stock unit activity as of December 31, 2016, 2015 and 2014: As of December 31, 2016, there was $3.4 million of pre-tax unrecognized compensation expense related to unvested restricted stock units, which is expected to be recognized over a weighted average of 1.8 years. Performance Stock Units The Company grants performance stock units to certain of its senior executives. The performance stock units are generally subject to a cliff vesting at the end of a three year period. The vesting will vary between 0% - 200% based on the attainment of operating income goals over the three year vesting period. The performance stock units are expensed on a straight-line basis over the three year vesting period. In 2014, the Company granted market-based performance stock units to the Chief Executive Officer as part of his initial compensation package. The market-based awards vest after a two-year service period and if the price of the Company’s common stock exceeds specified targets. The fair value of the market-based awards was determined using the Monte-Carlo simulation model. A Monte Carlo simulation model uses stock price volatility and other variables to estimate the probability of satisfying the market conditions and the resulting fair value of the award. Compensation costs related to the market-based awards are recognized regardless of whether the market condition is satisfied, as long as the requisite service has been provided. All of the market-based performance conditions were satisfied such that all 125,000 performance stock units granted to the Chief Executive Officer vested upon the completion of the two year service period in February 2016. Performance share unit activity as of December 31, 2016, 2015 and 2014: As of December 31, 2016, there was $2.4 million of pre-tax unrecognized compensation expense related to unvested performance stock units, which is expected to be recognized over a weighted average of 1.9 years. 14. Changes in Accumulated Other Comprehensive Income The changes in Accumulated other comprehensive income (“AOCI”) by component for the year ended December 31, 2016 is summarized below: (1) Available-for-Sale Securities and Pension reclassifications from AOCI are included in Interest, net, Other, net and Salaries and employee benefits, respectively, in the Consolidated Statement of Comprehensive Income. 15. Income Taxes The sources of income before income taxes are as follows: The provision for (benefit from) income taxes are as follows: A reconciliation of the provision for income taxes to income taxes at the statutory U.S. federal income tax rate of 35% is as follows: The deferred tax assets and liabilities are attributable to the following components: The recognition of deferred tax assets is based on management’s belief that it is more likely than not that the tax benefits associated with temporary differences, net operating loss carryforwards and tax credits will be utilized. The Company assesses the recoverability of the deferred tax assets on an ongoing basis. In making this assessment, the Company considers all positive and negative evidence, and all potential sources of taxable income including scheduled reversals of deferred tax liabilities, tax-planning strategies, projected future taxable income and recent financial performance. The valuation allowance decreased from $25.2 million at December 31, 2015 to $25.0 million at December 31, 2016. The valuation allowance at December 31, 2016 was related to foreign net operating loss carryforwards and certain foreign deferred tax assets. The Company intends to maintain these valuation allowances until sufficient evidence exists to support their reversal. At December 31, 2016, the Company had a net operating loss carryforward of $101.7 million related to its foreign filings and $0.5 million related to its U.S. state tax filings. Of the $101.7 million net operating loss carryforward, $79.9 million is subject to a valuation allowance. Depending on the tax rules of the tax jurisdictions, the losses can be carried forward indefinitely or for periods ranging from five to twenty years. The Company also has a foreign tax credit carryforward of $12.1 million, expiring in 2017 through 2025. At December 31, 2015, the Company had a net operating loss carryforward of $97.0 million related to its foreign filings and $1.1 million related to its U.S. state tax filings. Of the $97.0 million net operating loss carryforward, $75.6 million is subject to a valuation allowance. Depending on the tax rules of the tax jurisdictions, the losses can be carried forward indefinitely or for periods ranging from five to twenty years. The Company also had a foreign tax credit carryforward of $16.3 million, expiring in 2017 through 2025. As of December 31, 2016, the Company had unremitted earnings held in its foreign subsidiaries of approximately $72.7 million, of which the company has provided $3.3 million of tax on $15.6 million of earnings that are intended to be remitted. In 2016, the Company repatriated dividends from foreign operations to the United States. This resulted in additional book tax expense which will be offset by utilizing foreign tax credits. The Company did not recognize a deferred tax liability for U.S. income taxes and foreign withholding taxes related to the unremitted earnings of its foreign operations because the Company intends to reinvest those earnings indefinitely. If a distribution of these earnings were to be made, the Company might be subject to both foreign withholding taxes and U.S. income taxes, net of any allowable foreign tax credits or deductions. An estimate of these taxes; however, is not practicable. A deferred tax liability will be recognized if and when the Company is no longer able to demonstrate that it plans to permanently reinvest unremitted earnings. As of December 31, 2015, the Company had certain unremitted earnings held in its foreign subsidiaries of approximately $72.9 million, of which the company has provided $4.4 million of tax on $18.2 million of earnings that are intended to be remitted. The Company did not recognize a deferred tax liability for U.S. income taxes and foreign withholding taxes related to the unremitted earnings of its foreign operations because the Company intends to reinvest those earnings indefinitely. If a distribution of these earnings were to be made, the Company might be subject to both foreign withholding taxes and U.S. income taxes, net of any allowable foreign tax credits or deductions. An estimate of these taxes; however, is not practicable. A deferred tax liability will be recognized if and when the Company is no longer able to demonstrate that it plans to permanently reinvest unremitted earnings. As of January 1, 2016, the Company had $0.1 million of unrecognized tax benefits. As of December 31, 2016 the Company had $1.0 million of unrecognized tax benefits of which, if recognized, approximately $0.9 million, net of federal tax benefits, would be recorded as a component of income tax expense. A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows: In many cases the Company’s uncertain tax positions are related to tax years that remain subject to examination by the relevant taxable authorities. Years 2012 through 2015 are subject to examination by the state taxing authorities. The years 2013 to 2015 are subject to examination by the federal taxing authority. There are certain foreign jurisdictions that are subject to examination for years prior to 2012. The Company is currently under audit by some jurisdictions. It is likely that the examination phase of several of these audits will conclude in the next twelve months. No significant increases or decreases in unrecognized tax benefits are expected to occur by December 31, 2017. Estimated interest and penalties related to the underpayment of income taxes are classified as a component of the provision for income taxes in the Consolidated Statements of Comprehensive Income. Accrued interest and penalties are $0.1 million as of December 31, 2016. 16. Segment Information In the fourth quarter of 2016, the Company restructured its operating segments. Given the significant growth of the Company's Leadership Consulting service line, the Company's chief operating decision maker began to regularly assess performance and make resource allocation decisions separately for Executive Search and Leadership Consulting. Therefore, the Company now reports Executive Search and Leadership Consulting as separate operating segments. Previously reported operating segment results for the years ended December 31, 2015 and 2014 have been recast to conform to the new operating segment structure. The Company currently operates its executive search business in the Americas; Europe (which includes Africa); and Asia Pacific (which includes the Middle East) and operates its leadership consulting and culture shaping businesses as separate segments. For segment purposes, reimbursements of out-of-pocket expenses classified as revenue and other operating income are reported separately and, therefore, are not included in the results of each segment. The Company believes that analyzing trends in revenue before reimbursements (net revenue), analyzing operating expenses as a percentage of net revenue, and analyzing operating income (loss) more appropriately reflects its core operations. The revenue, operating income, depreciation and amortization, and capital expenditures, by segment, are as follows: Identifiable assets, and goodwill and other intangible assets, net, by segment, are as follows: (1) The December 31, 2015 goodwill and other intangible assets, net balances do not reflect the relative fair value allocation of goodwill to the Leadership Consulting segment that occurred in the fourth quarter of 2016 as a result of the Company restructuring its reporting units. Refer to Note 8, Goodwill and Other Intangible Assets, for additional information regarding the allocation of goodwill to the Leadership Consulting segment. 17. Guarantees The Company has issued cash collateralized bank guarantees and letter of credit backed bank guarantees supporting certain obligations, primarily the payment of office lease obligations and business license requirements for certain of its subsidiaries in Europe and Asia Pacific. The bank guarantees were made to secure the respective agreements and are for the terms of the agreements, which extend through 2018. For each bank guarantee issued, the Company would have to perform under the guarantee if the subsidiary defaults on a lease payment. The maximum amount of undiscounted payments the Company would be required to make in the event of default on all outstanding bank guarantees is approximately $2.3 million as of December 31, 2016. The Company has not accrued for these arrangements as no event of default exists or is expected to exist. 18. Commitments and Contingencies Operating Leases The Company leases office space in 47 cities in 25 countries. The terms of these office-related leases provide that the Company pay base rent and a share of operating expenses and real estate taxes in excess of defined amounts. These leases expire at various dates through 2026. The Company also leases certain computer equipment and cars, the terms of which are accounted for as operating leases. Rent expense, which includes the base rent, maintenance costs, operating expenses and real estate taxes, and the costs of equipment leases for the years ended December 31, 2016, 2015 and 2014 was $30.8 million, $29.6 million, and $32.3 million, respectively. Minimum future operating lease payments due in each of the next five years and thereafter are as follows: The aggregate minimum future payments on office leases are $164.2 million. The Company has contractual arrangements to receive aggregate sublease income of $1.0 million related to certain leases that expire at various dates through 2019. This sublease income primarily relates to properties that were part of prior office consolidations and closings. Certain leases provide for renewal options and payments of real estate taxes and other occupancy costs. In addition, certain leases contain rent escalation clauses that require additional rental amounts in later years of the term. Rent expense for leases with rent escalation clauses is recognized on a straight-line basis over the minimum lease term. The Company has an obligation at the end of the lease term to return the office to the landlord in its original condition, which is recorded at fair value at the time the liability is incurred. The Company had $2.6 million and $2.3 million of asset retirement obligations as of December 31, 2016 and 2015, respectively. Litigation The Company has contingent liabilities from various pending claims and litigation matters arising in the ordinary course of the Company’s business, some of which involve claims for damages that are substantial in amount. Some of these matters are covered by insurance. Based upon information currently available, the Company believes the ultimate resolution of such claims and litigation, including the “UK Employee Benefits Trust” matter discussed below, will not have a material adverse effect on its financial condition, results of operations or liquidity. UK Employee Benefits Trust On January 27, 2010, HM Revenue & Customs (“HMRC”) in the United Kingdom notified the Company that it was challenging the tax treatment of certain of the Company’s contributions in the United Kingdom to an Employee Benefits Trust between 2002 and 2008. HMRC alleges that these contributions should have been subject to Pay As You Earn tax and Class 1 National Insurance Contributions in the United Kingdom; and HMRC is proposing an adjustment to the Company’s payroll tax liability for the affected years. The aggregate amount of HMRC’s proposed adjustment is approximately £3.9 million million (equivalent to $4.8 million at December 31, 2016). The Company has appealed the proposed adjustment. At this time, the Company believes that the likelihood of an unfavorable outcome with respect to the proposed adjustment is not probable and the potential amount of any loss cannot be reasonably estimated. The Company also believes that the amount of any final adjustment would not be material to the Company’s financial condition. PART II (continued)
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Here's a summary of the financial statement:
Key Components:
1. Revenue Structure:
- Based on retainer payments (approximately 1/3 of estimated first-year compensation for positions)
- Additional billing if actual compensation exceeds estimates
- Indirect expenses calculated as percentage of retainer
- Billing occurs in three installments over three months
- Revenue recognition requires:
* Proof of arrangement
* Services rendered
* Fixed/determinable fees
* Reasonable assurance of collection
2. Expenses:
- Main component is salaries and employee benefits, including:
* Base salaries
* Performance bonuses
* Sign-on bonuses
* Employee insurance benefits
* Payroll taxes
* Profit sharing
- Approximately 15% of bonuses are deferred over three years
3. Assets & Liabilities:
- Includes goodwill and intangible assets
- Regular assessment of asset values
- Deferred tax assets and liabilities based on differences between financial statement and tax basis
- Foreign currency translation for international subsidiaries
- Restricted cash for lease agreements and business licenses
4. Accounting Practices:
- Uses accrual basis accounting
- Implements various estimates and assumptions for:
* Revenue recognition
* Tax allowances
* Goodwill assessment
- Earnings calculated on both basic and diluted per-share basis
The statement reflects a complex international business with significant emphasis on employee compensation and careful revenue recognition practices.
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Claude
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FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - 16 - Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders Repro Med Systems, Inc. Chester, New York We have audited the accompanying balance sheets of Repro Med Systems, Inc. as of February 29, 2016 and February 28, 2015, and the related statements of operations, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Repro Med Systems, Inc. as of February 29, 2016 and February 28, 2015, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. /s/ McGrail, Merkel, Quinn & Associates, P.C. Scranton, Pennsylvania May 13, 2016 - 17 - REPRO MED SYSTEMS, INC. BALANCE SHEETS The accompanying notes are an integral part of these Financial Statements. - 18 - REPRO MED SYSTEMS, INC. STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these financial statements. - 19 - REPRO MED SYSTEMS, INC. STATEMENT OF STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 The accompanying notes are an integral part of these Financial Statements. - 20 - REPRO MED SYSTEMS, INC. STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these Financial Statements. - 21 - REPRO MED SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 NOTE 1 NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NATURE OF OPERATIONS REPRO MED SYSTEMS, INC. (the “Company”) designs, manufactures and markets proprietary medical devices primarily for the ambulatory infusion market and emergency medical applications. The Food and Drug Administration (the “FDA”) regulates these products. The Company operates as one segment. CASH AND CASH EQUIVALENTS For purposes of the statement of cash flows, the Company considers all short-term investments with an original maturity of three months or less to be cash equivalents. The Company holds cash in excess of $250,000 at multiple depositories, which exceeds the FDIC insurance limits and is, therefore, uninsured. CERTIFICATES OF DEPOSIT The certificates of deposit are recorded at cost plus accrued interest. The certificates of deposit earn interest at a rate of 0.35% to 0.55% and mature in June 2016 and February 2017. INVENTORY Inventories of raw materials are stated at the lower of standard cost, which approximates average cost, or market value including allocable overhead. Work-in-process and finished goods are stated at the lower of standard cost or market value and include direct labor and allocable overhead. PATENTS Costs incurred in obtaining patents have been capitalized and are being amortized over the legal life of the patents. INCOME TAXES Deferred income taxes are provided using the liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry forwards and deferred tax liabilities are recognized for taxable temporary differences. The Company believes that it has no uncertain tax positions requiring disclosure or adjustment. Generally, tax years starting with 2012 are subject to examination by income tax authorities. PROPERTY, EQUIPMENT, AND DEPRECIATION Property and equipment is stated at cost and is depreciated using the straight-line method over the estimated useful lives of the respective assets. STOCK-BASED COMPENSATION The Company maintains various long-term incentive stock benefit plans under which it grants stock options and restricted stock awards to certain directors and key employees. The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model. All options are charged against income at their fair value. The entire compensation expense of the award is recognized over the vesting period. Shares of stock granted are recorded at the fair value of the shares at the grant date, over the vesting period. - 22 - NET INCOME PER COMMON SHARE Basic earnings per share are computed on the weighted average of common shares outstanding during each year. Diluted earnings per share include only an increase in the weighted average shares by the common shares issuable upon exercise of employee and director stock options (Note 6). USE OF ESTIMATES IN THE FINANCIAL STATEMENTS The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Important estimates include but are not limited to, asset lives, valuation allowances, inventory, and accruals. REVENUE RECOGNITION Sales of manufactured products are recorded when shipment occurs. The Company’s revenue stream is derived from the sale of an assembled product. Other service revenues are recorded as the service is performed. Shipping and handling costs generally are billed to customers and are included in sales. The Company generally does not accept return of goods shipped unless it is a Company error. The only credits provided to customers are for defective merchandise. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In March 2016, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2016-09 - Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The ASU was issued as part of the FASB’s simplification initiative and under the ASU, the areas of simplification in the update involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classifications of awards as either equity or liabilities, and classification on the statement of cash flows. Some of the areas for simplification apply only to nonpublic entities. The amendment eliminates the guidance in Topic 718 that was indefinitely deferred shortly after the issuance of FASB Statement No. 123 (revised 2004), Share-Based Payment. This should not result in a change in practice because the guidance that is being superseded was never effective. The amendment in this ASU is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted for any entity in any interim or annual period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. An entity that elects early adoption must adopt all of the amendments in the same period. - 23 - In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The main difference between the current requirement under GAAP and this ASU is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases. This ASU requires that a lessee recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term (other than leases that meet the definition of a short-term lease). The liability will be equal to the present value of lease payments. The asset will be based on the liability, subject to adjustment, such as for initial direct costs. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. Operating leases will result in straight-line expense (similar to current operating leases) while finance leases will result in a front-loaded expense pattern (similar to current capital leases). Classification will be based on criteria that are largely similar to those applied in current lease accounting. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. This is effective for annual and interim periods beginning after December 15, 2018 and early adoption is permitted. This ASU must be adopted using a modified retrospective transition, and provides for certain practical expedients. Transition will require application of the new guidance at the beginning of the earliest comparative period presented. We are currently assessing the potential impact of this ASU and expect it will have a material impact on our consolidated financial condition and results of operations upon adoption. In November 2015, the FASB issued ASU No. 2015-17 - Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. Prior this ASU, GAAP required an entity to separate deferred income tax asset and liabilities into current and noncurrent amounts on the balance sheet. This ASU requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. This ASU is effective for annual and interim periods beginning after December 15, 2016 and early adoption is permitted. This ASU may be applied either prospectively to all deferred tax assets and liabilities or retrospectively to all periods presented. The requirement that deferred tax liabilities and assets be offset and presented as a single amount was not affected by this amendment. The Company has adopted this ASU retrospectively. In July 2015, the FASB issued Accounting Standards Update (“ASU”) No. 2015-11-Simplifying the Measurement of Inventory. The ASU was issued as part of the FASB’s simplification initiative and under the ASU, inventory is measured at the lower of cost and net realizable value, which would eliminate the other two options that currently exist for the market: (1) replacement cost and (2) net realizable value less an approximately normal profit margin. This ASU is effective for interim and annual periods beginning after December 15, 2016. Early application is permitted and should be applied prospectively. The Company does not expect the adoption of the ASU to have any impact on its financial statements. In May 2014, FASB issued ASU No. 2014-09-Revenue from Contracts with Customers. The ASU clarifies the principles for recognizing revenue and develops a common revenue standard for U.S. GAAP and International Financial Reporting Standards (“IFRS”) that removes inconsistencies and weaknesses in revenue requirements, provides a more robust framework for addressing revenue issues, improves comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets, provides more useful information to users of the financial statements through improved disclosure requirements and simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer. The amendments in this update are effective for the annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Full or modified retrospective adoption is required and early application is not permitted. On July 9, 2015, the FASB issued ASU No. 2015-14 Revenue from Contracts with Customers (Topic 606); Deferral of the Effective Date, which (a) delays the effective date of ASU 2014-09, Revenue from Contracts with Customers (Topic 606), by one year to annual periods beginning after December 15, 2017 and (b) allows early adoption of the ASU by all entities as of the original effective date for public entities. In March 2016, the FASB issued ASU No. 2016-08 Revenue from Contracts with Customers (Topic 606); Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which is intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations and the effective date is the same as the requirements in ASU 2014-09. In April 2016, the FASB issued ASU No. 2016-10 Revenue from Contracts with Customers (Topic 606); Identifying Performance Obligations and Licensing, which is intended to clarify identifying performance obligations and the licensing implementation guidance, while retaining the related principles for those areas and the effective date is the same as the requirements in ASU 2014-09. The Company is assessing the impact of the adoption of the ASU on its financial statements, disclosure requirements and methods of adoption. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts reported in the balance sheet for cash, trade receivables, accounts payable and accrued expenses approximate fair value based on the short-term maturity of these instruments. - 24 - ACCOUNTING FOR LONG-LIVED ASSETS The Company reviews its long-lived assets for impairment at least annually or whenever the circumstances and situations change such that there is an indication that the carrying amounts may not be recoverable. As of February 29, 2016, the Company does not believe that any of its assets are impaired. NOTE 2 INVENTORY Inventory consists of: NOTE 3 PROPERTY AND EQUIPMENT Property and equipment consists of the following at: Depreciation expense was $258,738 and $268,759 for the years ended February 29, 2016, and February 28, 2015, respectively. NOTE 4 RELATED PARTY TRANSACTIONS On December 20, 2013, we executed an agreement effective March 1, 2014, with a Company director, Dr. Mark Baker, to provide clinical research and support services related to new and enhanced applications for the FREEDOM60® Syringe Infusion System. Authorized by the Board of Directors, the agreement provides for payment of 420,000 shares of common stock valued at $0.20 per share over a three-year period. Amortization amounted to $28,000 for the each of the fiscal years ended February 29, 2016 and February 28, 2015. In August, 2014, Dr. Baker was paid a previously approved bonus of $25,000 to assist him in covering taxes due on the grant of common stock. On October 21, 2015, Cyril Narishkin was appointed to the Board of Directors and Interim Chief Operating Officer of the Company. Also effective October 21, 2015, we entered into a consulting agreement with Mr. Narishkin, to support our expanded management team and accelerate our growth opportunities under his role of Interim Chief Operating Officer. The agreement provides for payment of $16,000 per month, of which half is to be paid in cash and half is to be paid in shares of common stock. Effective January 1, 2016, the agreement provides for the same payment of $16,000 per month, of which seventy-five percent is to be paid in cash and twenty-five percent is to be paid in shares of common stock. On April 26, 2016, Cyril Narishkin was appointed President of the Company. - 25 - LEASED AIRCRAFT The Company leases an aircraft from a company controlled by the Chief Executive Officer. The lease payments were $21,500 for each of the years ended February 29, 2016, and February 28, 2015. The original lease agreement has expired and the Company is currently on a month-to-month basis for rental payments. BUILDING LEASE Mr. Mark Pastreich, a director, is a principal in the entity that owns the building leased by Company. The Company is in year seventeen of a twenty-year lease. There have been no changes to lease terms since his directorship and none are expected through the life of the current lease. NOTE 5 STOCKHOLDERS’ EQUITY On August 8, 2014, we executed an agreement with Horton Capital Partners Fund, an institutional investor based in Philadelphia, PA, to sell one million shares of our common stock and warrants to purchase an additional one million shares of common stock at an exercise price of $0.45 per share. The aggregate purchase price was $0.3 million. On September 30, 2015, RMS’s Board of Directors authorized a stock repurchase program pursuant to which the Company will make open market purchases of up to 1,000,000 shares of the Company’s Outstanding Common Stock. The purchases will be made through a broker to be designated by the Company with price, timing and volume restrictions based on average daily trading volume, consistent with the safe harbor rules of the Securities and Exchange Commission for such repurchases. As of February 29, 2016, the Company had repurchased 180,406 shares at an average price of $0.45 under the program. NOTE 6 STOCK-BASED COMPENSATION In July 2012, 1,465,000 shares were authorized to issue to employees as share compensation valued at $0.18 per share, the market value on the date of the board authorization. The value of these shares will be amortized into operations over the one to two year restriction on the shares. Amortization amounted to zero and $51,750 for the years ended February 28, 2016, and February 28, 2015, respectively. On September 30, 2015, the Board of Directors approved the 2015 Stock Option Plan authorizing the Company to grant awards to certain employees under the plan at fair market value, subject to shareholder approval at the Annual Meeting to be held on July 27, 2016. The total number of shares of common stock of the Company, par value $.01 per share (“Common Stock”), with respect to which awards may be granted pursuant to the Plan shall not exceed 2,000,000 shares. As of February 29, 2016, the Company awarded 1,060,000 options to certain executives and key employees under the plan. On October 21, 2015, the Board of Directors of the Company approved director compensation of $25,000 each annually, to be paid quarterly half in cash and half in common stock, effective September 1, 2015. Directors include Dr. Mark Baker, Mr. Mark Pastreich, Mr. Arthur Radin and Mr. Cyril Narishkin. For purposes of director compensation, Mr. Narishkin will receive $25,000 annually in addition to his payments under his consulting agreement. As of February 29, 2016, each director was paid $12,500 of which half was paid in cash and half in common stock of which each director received 14,566 in common shares. Beginning March 1, 2016, all Directors, excluding Mr. Andrew Sealfon, the Company’s Chief Executive Officer, will receive director compensation. The per share weighted average fair value of stock options granted during the fiscal year ended February 29, 2016 and February 28, 2015 was $0.19 and zero, respectively. The fair value of each award is estimated on the grant date using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in the fiscal year ended February 29, 2016. Historical information was the primary basis for the selection of the expected volatility, expected dividend yield and the expected lives of the options. The risk-free interest rate was selected based upon yields of the U.S. Treasury issues with a term equal to the expected life of the option being valued: - 26 - The following table summarizes the status of the Company’s stock option plan: Total stock-based compensation expense for stock option awards totaled $50,413 and zero for the fiscal year ended February 29, 2016 and February 28, 2015, respectively. The weighted-average grant-date fair value of options granted during fiscal years ended February 29, 2016 and February 28, 2015 was $201,890 and zero, respectively. The total intrinsic value of options exercised during fiscal years ended February 29, 2016 and February 28, 2015, was zero for both periods. The following table presents information pertaining to options outstanding at February 29, 2016: As of February 29, 2016, there was $0.2 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 17 months. The total fair value of shares vested during the fiscal years ended February 29, 2016 and February 28, 2015, was zero for both periods. NOTE 7 CONTINGENT LIABILITY On March 25, 2016, the Company’s legal counsel, who had represented the Company in its patent litigation withdrew as legal counsel, after discussions regarding whether they were the most suited to be our representative in this action and verbally waived payment on any remaining open invoices which totaled $0.5 million. The Company does not believe it is liable for these fees nor does it believe that the law firm will take action to collect these fees. The unpaid legal fees have been reversed. - 27 - NOTE 8 SALE-LEASEBACK TRANSACTION - OPERATING LEASE On February 25, 1999, the Company entered into a sale-leaseback arrangement whereby the Company sold its land and building at 24 Carpenter Road in Chester, New York and leased it back for a period of twenty years. The leaseback is accounted for as an operating lease. The gain of $0.5 million realized in this transaction has been deferred and is amortized to income in proportion to rental expense over the term of the related lease. At February 29, 2016, minimum future rental payments are: Rent expense for both the years ended February 29, 2016, and February 28, 2015 were $132,504. NOTE 9 FEDERAL AND STATE INCOME TAXES The provision for income taxes consisted of at February 29, 2016, and February 28, 2015: The reconciliation of income taxes shown in the financial statements and amounts computed by applying the Federal expected tax rate of 34% is as follows: The components of deferred tax liabilities at February 29, 2016, and February 28, 2015, respectively, are as follows: - 28 - NOTE 10 MAJOR CUSTOMERS For the years ended February 29, 2016, and February 28, 2015, approximately, 55.3% and 52.9%, respectively, of the Company’s gross product revenues were derived from one major customer. At February 29, 2016, and February 28, 2015, accounts receivable due from this customer were $0.5 million and $1.0 million, respectively. The largest customer in both years is a domestic medical products and supplies distributor. Although a number of larger infusion customers have elected to consolidate their purchases through one or more distributors in recent years, we continue to maintain a strong direct relationship with them. We do not believe that their continued purchases of FREEDOM60 pumps, tubing, needle sets and related supplies is contingent upon the distributor. NOTE 11 LEGAL PROCEEDINGS In 2013, the Company commenced in the United States District Court for the Eastern District of California a declaratory judgment action against competitor, EMED Technologies Corp. (“EMED”) to establish the invalidity of one of EMED’s patents and non-infringement of the Company’s needle sets. EMED answered the complaint and asserted patent infringement and unfair business practice counterclaims. The Company responded by asserting its own unfair business practice claims against EMED. On June 16, 2015, the Court issued what it termed a “narrow” preliminary injunction against the Company from making certain statements regarding some of EMED’s products. The Company is complying with that order. On March 24, 2016, EMED filed a motion for a second preliminary injunction regarding sales of RMS products in California. The Company is opposing that motion and briefing for this motion, as well as case discovery is ongoing. On June 25, 2015, EMED filed a claim of patent infringement for the second of its patents, also directed to the Company’s needle sets, in the United States District Court for the Eastern District of Texas. This second patent is related to the one concerning the Company’s declaratory judgment action. Given the close relationship between the two patents, the Company has requested that the Texas suit be transferred to California. The Court has not yet ruled on the Company’s transfer request. Discovery in the Texas suit is ongoing. On September 11, 2015, the Company requested an ex parte reexamination of the patent in the first filed case, and on September 17, 2015 the Company requested an inter partes review (IPR) of the patent in the second filed case. On November 20, 2015, the U.S. Patent and Trademark Office (USPTO) instituted the ex parte reexamination request having found a substantial new question of patentability concerning EMED’s patent in the first filed case. A decision to institute the IPR for EMED’s patent in the second filed case was ordered by the USPTO on February 19, 2016 having determined a reasonable likelihood all claims of the patent may be found to be unpatentable. Based on the grant of the IPR, the Company intends to request the Court stay proceedings of the second filed case until conclusion of the IPR. Although the Company believes it has meritorious claims and defenses in these litigations and proceedings, their outcomes cannot be predicted with any certainty. - 29 -
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Based on the provided text, which appears to be an incomplete or fragmented financial statement excerpt, here's a summary:
The statement discusses tax-related financial aspects:
- The company has loss and tax credit carry forwards
- Deferred tax liabilities are recognized for taxable temporary differences
- The company claims to have no uncertain tax positions requiring disclosure
- Tax years starting from 2012 are generally referenced
However, the text seems incomplete or repetitive, making a comprehensive analysis difficult. A full financial statement would typically provide more detailed information about the company's financial performance, income, expenses, and tax situation.
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Claude
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