2. Summary of Significant Accounting Policies

(a) Principles of Consolidation

The consolidated financial statements include the Company’s accounts and transactions and those of the Company’s wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

(b) Use of Estimates

The preparation of the consolidated financial statements in conformity with United States generally accepted accounting principles (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Certain reclassifications were made to prior year amounts to conform to the current period presentation.

(d) Cash and Cash Equivalents

The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Cash equivalents consist of deposits that are readily convertible into cash.

(e) Concentration of Credit Risk

Financial instruments (principally cash and cash equivalents, accounts receivable, accounts payable and accrued expenses) are carried at cost, which approximates fair value due to the short-term maturity of these instruments. The Company’s long-term debt or revolving credit facility is carried at cost. Due to the variable interest rate associated with the revolving credit facility and the variable interest margin based upon the Company’s consolidated leverage ratio, the fair value of the credit facility approximates its carrying value.

The Company’s policy is to limit credit exposure by placing cash in accounts which are exposed to minimal interest rate and credit risk. HMS maintains cash in cash depository accounts, U.S. Treasuries, and money market mutual funds with large financial institutions with a minimum credit rating of A1/P1 or better, as defined by Standard and Poor’s. The balance at these institutions generally exceeds the maximum balance insured by the Federal Deposit Insurance Corporation of up to $250,000 per entity. HMS has not experienced any losses on the bank deposits and believes these deposits do not expose the Company to any significant credit risk.

The Company is subject to potential credit risk related to changes in economic conditions within the healthcare market. However, HMS believes that the billing and collection policies are adequate to minimize the potential credit risk. The Company performs ongoing credit evaluations of customers and generally does not require collateral. HMS has no history of significant losses from uncollectible accounts.

(f) Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation is provided over the estimated useful lives of the assets utilizing the straight-line method. HMS amortizes leasehold improvements on a straight-line basis over the term of the related lease, including any anticipated renewal periods, or the life of the leasehold improvement, whichever is shorter. Equipment leased under capital leases is depreciated over the shorter of (i) the term of the lease and (ii) the estimated useful life of the equipment. The depreciation expense on assets acquired under capital leases is in selling, general and administrative expense (“SG&A”). Estimated useful lives are as follows:

Equipment (in years)	2	—	3
Leasehold improvements (in years)	3	—	10
Furniture and fixtures (in years)	3	—	5
Building and building improvements (in years)		up to 39.5

(g) Software and Software Development Cost

Software development costs related to software that is acquired or developed for internal use while in the application development stage are capitalized. All other costs to develop software for internal use, either in the preliminary project stage or post-implementation stage, are expensed as incurred. Amortization of software and software development costs is calculated on a straight-line basis over the expected economic life, generally estimated to be 5 to 10 years.

(h) Goodwill

Goodwill is the excess of acquisition costs over the fair value of assets and liabilities of acquired businesses, is subject to a periodic assessment for impairment in accordance with Accounting Standards Codification (“ASC”) 350—

Intangibles, Goodwill and Other

. HMS assesses goodwill for impairment on an annual basis as of June 30th of each year or more frequently if an event occurs or changes in circumstances would more likely than not reduce the fair value of a reporting unit below its carrying amount. Assessment of goodwill impairment is at the HMS Holdings Corp. entity level as the Company operates as a single reporting unit.

The Company has the option to perform a qualitative assessment to determine if impairment is more likely than not to have occurred. If the Company can support the conclusion that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then HMS would not need to perform the two-step impairment test for that reporting unit. If the Company cannot support such a conclusion, or the Company does not elect to perform the qualitative assessment, then the first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill.

HMS completed the annual impairment test as of June 30, 2015 and determined no impairment existed. The result of the annual impairment test indicated that the fair value of the reporting unit is significantly in excess of its carrying value.

There were no impairment charges related to goodwill during the fiscal years ended December 31, 2015, 2014 or 2013.

(i) Long-Lived Assets

Long-lived assets, which include property and equipment and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying value of its asset group to the estimated undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying value of the asset group exceeds the fair value of the assets, which amount is charged to earnings. Fair value is based on a projection of the estimated discounted future net cash flows expected to result from the asset group, using a discount rate reflective of the Company’s cost of funds.

The Company did not recognize any impairment charges related to the long-lived assets, property and equipment intangible assets, during the years ended December 31, 2015, 2014 or 2013, as management believes that carrying amounts were not impaired.

(j) Acquisition Accounting

The Company assign values to assets acquired and liabilities assumed based upon their fair value. In most instances there is not a readily defined or listed market price for individual assets and liabilities acquired in connection with a business, including intangible assets. The determination of fair value for individual assets and liabilities in many instances requires a high degree of estimation. The valuation of intangible assets, in particular, is very subjective. The use of different valuation techniques and assumptions could change the amounts and useful lives assigned to the assets and liabilities acquired, including goodwill and other intangible assets and related amortization expense.

(k) Income Taxes

Income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. This method also requires the recognition of future tax benefits for net operating loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. A valuation allowance is provided against deferred tax assets to the extent their realization is not more likely than not.

Uncertain income tax positions are accounted for by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements.

(l) Revenue Recognition and Estimated Liability for Appeals

The Company provides services under contracts that contain various fee structures, including contingency fee and fixed fee arrangements. Revenue is recognized when a contract exists, services have been provided to the customer, the fee is fixed and determinable, and collectability is reasonably assured. In addition, the Company has contracts with the federal government which are generally cost-plus or time and material based. Revenue on cost-plus contracts is recognized based on costs incurred plus the negotiated fee earned. Revenue on time and materials contracts is recognized based on hours worked and expenses incurred.

Under the Company’s Medicare Recovery Audit Contractor (“RAC”) contract with the Centers for Medicare & Medicaid Services (“CMS”), the Medicaid RAC contracts with various states, and similar contracts for private health plan customers, HMS recognizes revenue when claims are sent to the customer for offset against future claims payments. Providers have the right to appeal a claim and may pursue additional appeals if the initial appeal is found in favor of the customer. HMS accrues an estimated liability for appeals based on the amount of revenue that is subject to appeals, closures or other adjustments and which HMS estimate are probable of being returned to providers following a successful appeal. This estimated liability for appeals is an offset to revenue in the Company’s Consolidated Statements of Income. The Company’s estimates are based on the Company’s historical experience with appeals. The estimated liability for appeals of $33.1 million and $36.8 million as of December 31, 2015 and 2014, respectively, represents the Company’s estimate of the potential amount of repayments related to appeals of claims, closures and other adjustments for which revenue was previously collected. This is reflected as a separate line item in the current liabilities section of the balance sheet titled “Estimated liability for appeals.” To the extent the amount to be returned to providers following a successful appeal, closure or other adjustment exceeds the amount accrued, revenue in the applicable period would be reduced by the amount of the excess.

As of December 31, 2015, HMS has an estimated liability for appeals and estimated allowance for appeals (which is an offset to accounts receivable) based on the Company’s historical experience with this activity under the Company’s customers’ contracts. Any future changes to any of the Company’s customer contracts, including further modifications to the transition plan for incumbent Medicare RACs may require the Company to apply different assumptions that could affect HMS’ estimated liability for future periods. The Company similarly accrues an allowance against accounts receivable related to revenue yet to be collected, based on the same estimates used to establish the estimated liability for appeals of revenue received.

In addition, some of the Company’s contracts may include customer acceptance provisions. Formal customer sign-off is not always necessary to recognize revenue, provided HMS objectively demonstrates that the criteria specified in the acceptance provision are satisfied. Due to the range of products and services that HMS provides and the differing fee structures associated with each type of contract, revenue may be recognized in irregular increments.

(m) Stock-Based Compensation

The Company estimates the fair value of all stock awards granted using the Black-Scholes option pricing model for “non-performance-based” grants and Monte Carlo simulation is used for performance-based grants with certain market conditions.

The determination of the fair value of the stock based awards on the grant date using the applicable option pricing model is affected by the Company’s stock price, as well as assumptions regarding a number of complex and subjective variables. These variables include the Company’s expected stock price volatility over the expected term of the awards, actual and projected option exercise experience, a risk-free interest rate and any expected dividends. The Company estimates the expected term of the options granted by calculated the average term from the Company’s historical option exercise experience and volatility of the common stock using historical volatility. The assumed risk-free interest rate is based on the yield on the measurement date of a zero-coupon U.S. Treasury bond with a maturity period equal to the option’s expected term. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option valuation models.

The Company estimates forfeitures at the time of grant and revises the forfeiture rate in subsequent periods if actual forfeitures differ from estimates. If actual forfeitures vary from estimates, a difference in compensation expense will be recognized in the period the actual forfeitures occur or at the time of vesting.

The fair value of each award is determined and the compensation expense is recognized over the service period. Compensation expense reflects an estimate of the number of awards expected to vest after taking into consideration an estimate of award forfeitures based on actual experience. Upon the exercise of stock options or the vesting of restricted stock units and restricted stock awards, the resulting excess tax benefits, if any, are credited to additional paid-in capital. Any resulting tax deficiencies will first be offset against those cumulative credits to additional paid-in capital. If the cumulative credits to additional paid-in capital are exhausted, tax deficiencies will be recorded to the provision for income taxes. Excess tax benefits are required to be reflected as financing cash inflows in the accompanying Consolidated Statements of Cash Flows.

(n) Fair Value of Financial Instruments

The Company had no financial assets or liabilities measured at fair value was of December 31, 2015 and 2014. However, if HMS opted to measure financial assets and liabilities at fair value in the future, the policy is to measure fair value based on valuation techniques using the best information available, which may include quoted market prices, market comparables and discounted cash flow projections. In general, and where applicable, quoted prices in active markets are used for identical assets to determine fair value. If quoted prices in active markets for identical assets are not available to determine fair value, then the Company uses quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly. If quoted prices for identical or similar assets are not available, the Company uses internally developed valuation models, whose inputs include bid prices, and third party valuations utilizing underlying asset assumptions.

The fair values of the Company’s financial instruments reflect the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). In addition, the Financial Accounting Standards Board (the “FASB”), authoritative guidance requires disclosure of the fair value of financial instruments, both assets and liabilities recognized and not recognized in the statement of financial position, for which it is practicable to estimate fair value.

The Company’s financial instruments are categorized into a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument. In the event the fair value is not readily available or determinable, the financial instrument is carried at cost and referred to as a cost method investment. The evaluation of whether an investment’s fair value is less than cost is determined by using a disclosed fair value estimate, if one is available, otherwise, it is determined by evaluating whether an event or change in circumstances has occurred that may have a significant adverse effect on the fair value of the investment (an impairment indicator). HMS is not aware of any identified events or change in circumstances that would have a significant adverse effect on the carrying value of the cost method investments. Financial instruments recorded at fair value on the consolidated balance sheets are categorized as follows:

Level 1: Observable inputs such as quoted prices in active markets;

Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and

Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The carrying amounts of cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value due to the short-term nature of their maturities. Due to the variable interest rate associated with the revolving credit facility and the variable interest margin based upon the Company’s consolidated leverage ratio, the fair value of the credit facility approximates its carrying value.

(o) Leases

HMS accounts for the lease agreements as either operating or capital leases, depending on certain defined criteria. Lease costs are amortized on a straight-line basis without regard to deferred payment terms, such as rent holidays, that defer the commencement date of required payments. Additionally, incentives such as tenant improvement allowances, are capitalized and are treated as a reduction of rental expense over the term of the lease agreement.

(p) Recently Issued Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09,

Revenue from Contracts with Customers (Topic 606

) (“ASU 2014-09”), which is the new comprehensive revenue recognition standard that will supersede all existing revenue recognition guidance under U.S. GAAP. The standard's core principle is that a company will recognize revenue when it transfers promised goods or services to a customer in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. ASU 2015-14,

Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date

, which was issued in August 2015, revised the effective date for this ASU to annual and interim periods beginning on or after December 15, 2017, with early adoption permitted, but not earlier than the original effective date of annual and interim periods beginning on or after December 15, 2016, for public entities. Entities will have the option of using either a full retrospective approach or a modified approach to adopt the guidance in ASU 2014-09. The Company is currently evaluating the impact of adopting this guidance.

In June 2014, the FASB issued ASU 2014-12,

Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period

(“ASU 2014-12”). ASU 2014-12 brings consistency to the accounting for share-based payment awards that require a specific performance target to be achieved in order for employees to become eligible to vest in the awards. Effective January 1, 2015, HMS adopted the provisions of ASU 2014-12. The adoption of this guidance did not have a material effect on the Company’s consolidated financial statements.

In April 2015, the FASB issued ASU 2015-03,

Simplifying the Presentation of Debt Issuance Costs

(“ASU 2015-03”). ASU 2015-03 simplifies the presentation of debt issuance costs by requiring that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by ASU 2015-03. In August 2015, FASB issued ASU 2015-15,

Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements

(“ASU 2015-15”). ASU 2015-15 clarifies the presentation and measuring of debt issuance costs incurred in connection with line-of-credit arrangements given the lack of guidance on this topic in ASU 2015-03. For line-of-credit arrangements, an entity can continue to present debt issuance costs as an asset and amortize the deferred debt issuance costs ratably over the term of the line-of-credit arrangement. ASU 2015-03, as amended, is effective for annual reporting periods beginning after December 15, 2015, including interim periods within such annual reporting periods with early adoption permitted. ASU 2015-03 is to be retrospectively adopted to each prior reporting period presented. HMS does not expect the adoption of this guidance to have a material effect on the Company’s consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05,

Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement

(“ASU 2015-05”). ASU 2015-05 provides explicit guidance to help companies evaluate the accounting for fees paid by a customer in a cloud computing arrangement and clarifies that if a cloud computing arrangement includes a software license, the customer should account for the license consistent with its accounting for other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 is effective for annual reporting periods beginning after December 15, 2015, including interim periods within such annual reporting periods with early adoption permitted. HMS does not expect the adoption of this guidance to have a material effect on the Company’s consolidated financial statements.

In November 2015, the ASB issued ASU 2015-17,

Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes

(“ASU 2015-17”). ASU 2015-17 simplifies the current presentation of separately classifying deferred tax assets and deferred tax liabilities as current and noncurrent in a classified balance sheet by requiring companies to present them as noncurrent. ASU 2015-17, as amended, is effective for annual reporting periods beginning after December 15, 2016, including interim periods within such annual reporting periods with early adoption permitted. HMS has not early adopted this guidance and is currently evaluating the effect on the Company’s consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02,

Leases (Topic 842)

(“ASU 2016-02”). ASU 2016-02 will require most lessees to recognize a majority of the Company’s leases on the balance sheet, which will increase reported assets and liabilities. ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2018. Early adoption is permitted. HMS has not early adopted this guidance and is currently evaluating the effect on the Company’s consolidated financial statements.

Other new pronouncements issued but not effective until after December 31, 2015 are not expected to have a material impact on our financial position, results of operations or liquidity.