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Restatement of the Consolidated Financial Statements
 12 Months Ended
Dec. 31, 2018
Accounting Changes and Error Corrections [Abstract]  
Restatement of the Consolidated Financial Statements
Restatement of the Consolidated Financial Statements
In February 2018, the Audit Committee (the “Audit Committee”) of the Board retained King & Spalding LLP (“King & Spalding”) as counsel to the Audit Committee to assist in conducting an independent investigation into current and prior-period matters relating to allegations regarding certain sales and distribution practices at the Company and certain other matters (the “Investigation” or the “Audit Committee Investigation”). Following its engagement by the Audit Committee, King & Spalding retained KPMG LLP (“KPMG”) to assist with the Investigation.
As a result of the Investigation, the Company determined that the financial statements as of period ended December 31, 2016, 2015, 2014, 2013, and 2012 should no longer be relied upon and accordingly would need to be restated. A summary of the impact of the Restatement on the Company’s consolidated statement of operations includes, but is not limited to, the following:
•
the timing of revenue recognition for sales through all distributors and direct sales to all customers, as discussed above;
•
the impact of bad debt expense as a result of the timing of revenue recognition;
•
the presentation of net revenue instead of gross revenue for administrative fees paid to GPOs;
•
the impact of changes in revenue recognition on cost of goods sold;
•
the timing of recognizing certain general and administrative expenses;
•
the impact on losses associated with contingency exposures;
•
the impact of other miscellaneous adjustments, such as patent cost and share-based compensation, and
•
the impact of the above on income tax.
The impact of the Restatement on the Company’s consolidated balance sheet includes, but is not limited to, the following:
•
changes in the amount of reported cash, due to the timing of certain cash collections;
•
changes to reported accounts receivable and other current assets and the related reserves on each, due to the restatement of revenue recognition;
•
accrual balances that are impacted by the expense and contingency determinations discussed above; and
•
the related income tax effects of the above.
The effect of adjustments made to the Company’s previously filed consolidated statements of operations as a result of these matters are shown in the table below. The tax effect of the adjustments is estimated based on the Company’s effective tax rate of 28.46%.
 
Year Ended December 31, 2016
 
(in thousands, except share and per share data)
 
Previously Reported
 
Adjustments
 
Restated
Net sales
$
245,015

 
$
(23,303
)
 
$
221,712

Cost of sales
32,407

 
(1,469
)
 
30,938

Gross profit
212,608

 
(21,834
)
 
190,774

 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
Selling, general and administrative
179,997

 
(6,585
)
 
173,412

Research and development
12,038

 
2,303

 
14,341

Amortization of intangible assets
2,127

 
10

 
2,137

Operating income
18,446

 
(17,562
)
 
884

 
 
 
 
 
 
Other expense, net
(339
)
 
—

 
(339
)
 
 
 
 
 
 
Income before income tax provision
18,107

 
(17,562
)
 
545

Income tax provision (expense)
(6,133
)
 
5,978

 
(155
)
 
 
 
 
 
 
Net income (loss)
$
11,974

 
$
(11,584
)
 
$
390

 
 
 
 
 
 
Net income (loss) per common share - basic
$
0.11

 
$
—

 
$
—

 
 
 
 
 
 
Net income (loss) per common share - diluted
$
0.11

 
$
—

 
$
—

 
 
 
 
 
 
Weighted average shares outstanding - basic
105,928,348

 
—

 
105,928,348

 
 
 
 
 
 
Weighted average shares outstanding - diluted
112,441,709

 
—

 
112,645,640






The effects of the restatements on the Company’s consolidated statement of operations by category for the year ended December 31, 2016 are shown in the table below. The tax effect of the adjustments is estimated based on the Company’s effective tax rate of 28.46%.
 
Year Ended December 31, 2016
 
Adjustments by Category
(in thousands)
Previously
 
Cash
 
 
 
Revenue
 
 
 
Total
 
 
 
Reported
 
Revenue
 
GPO Fees
 
Related
 
Other
 
Adjustments
 
Restated
Net sales
$
245,015

 
$
(14,725
)
 
$
(4,487
)
 
$
(4,091
)
 
$
—

 
$
(23,303
)
 
$
221,712

Cost of sales
32,407

 
—

 
—

 
(1,469
)
 
—

 
(1,469
)
 
30,938

Gross profit
212,608

 
(14,725
)
 
(4,487
)
 
(2,622
)
 
—

 
(21,834
)
 
190,774

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Selling, general and administrative expenses
179,997

 
—

 
(4,487
)
 
(1,744
)
 
(354
)
 
(6,585
)
 
173,412

Research and development expenses
12,038

 
—

 
—

 
—

 
2,303

 
2,303

 
14,341

Amortization of intangible assets
2,127

 
—

 
—

 
—

 
10

 
10

 
2,137

Operating income
18,446

 
(14,725
)
 
—

 
(878
)
 
(1,959
)
 
(17,562
)
 
884

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other expense, net
(339
)
 
—

 
—

 
—

 
—

 
—

 
(339
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income before income tax provision
18,107

 
(14,725
)
 
—

 
(878
)
 
(1,959
)
 
(17,562
)
 
545

Income tax provision (expense) benefit
(6,133
)
 
—

 
—

 
—

 
5,978

 
5,978

 
(155
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
$
11,974

 
$
(14,725
)
 
$
—

 
$
(878
)
 
$
4,019

 
$
(11,584
)
 
$
390

The effects of the restatements on the Company’s consolidated statement of stockholders’ equity for the year ended December 31, 2016 are as follows:
 
Year-ended December 31, 2016
 
(in thousands)
 
 
 
Adjustments by Category
 
 
 
 
 
Previously Reported
 
Cash Revenue
 
Revenue Related
 
Other
 
Total Adjustments
 
Restated
Total stockholders' equity, December 31, 2015
$
107,988

 
$
(60,064
)
 
$
6,669

 
$
(19,869
)
 
$
(73,264
)
 
$
34,724

Share-based compensation
17,818

 
—

 
—

 
(86
)
 
(86
)
 
17,732

Tax benefit of share-based compensation
(424
)
 
—

 
—

 
1

 
1

 
(423
)
Exercise of stock options
3,494

 
—

 
—

 
—

 
—

 
3,494

Issuance of restricted stock
1

 
—

 
—

 
(1
)
 
(1
)
 
—

Shares issued for services performed
346

 
—

 
—

 
—

 
—

 
346

Shares repurchased
(10,378
)
 
—

 
—

 
—

 
—

 
(10,378
)
Shares repurchased for tax withholding
(1,165
)
 
—

 
—

 
—

 
—

 
(1,165
)
Shares issued in conjunction with acquisition of Stability
3,346

 
—

 
—

 
1

 
1

 
3,347

Net income (loss)
11,974

 
(14,725
)
 
(878
)
 
4,019

 
(11,584
)
 
390

Total stockholders' equity, December 31, 2016
$
133,000

 
$
(74,789
)
 
$
5,791

 
$
(15,935
)
 
$
(84,933
)
 
$
48,067

The effects of the restatements on the Company’s consolidated statement of stockholders’ equity as of December 31, 2016 are as follows:
 
As of December 31, 2016
 
(in thousands)
 
 
 
Adjustments by Category
 
 
 
 

Previously Reported
 
Cash Revenue
 
Revenue Related
 
Other
 
Total Adjustments
 
Restated
Common stock
$
110

 
$
—

 
$
—

 
$
—

 
$
—

 
$
110

Additional paid-in capital
161,261

 
—

 
—

 
220

 
220

 
161,481

Treasury stock
(2,216
)
 
—

 
—

 
—

 
—

 
(2,216
)
Accumulated deficit
(26,155
)
 
(74,789
)
 
5,791

 
(16,155
)
 
(85,153
)
 
(111,308
)
Total stockholders' equity
$
133,000

 
$
(74,789
)
 
$
5,791

 
$
(15,935
)
 
$
(84,933
)
 
$
48,067

The effects of the restatements on the Company’s consolidated balance sheet as of December 31, 2016 are as follows:
 
Year Ended December 31, 2016
 
(in thousands)
 
Previously Reported
 
Adjustments
 
Restated
ASSETS
 
 
 
 
 
Current assets:
 
 
 
 
 
   Cash and cash equivalents
$
34,391

 
$
(4,070
)
 
$
30,321

   Accounts receivable, net
67,151

 
(65,224
)
 
1,927

   Inventory, net
17,814

 
(1,942
)
 
15,872

   Prepaid expenses
5,894

 
(4,056
)
 
1,838

   Other current assets
1,288

 
8,228

 
9,516

      Total current assets
126,538

 
(67,064
)
 
59,474

 
 
 
 
 
 
Property and equipment, net
13,786

 
199

 
13,985

Goodwill
20,203

 
—

 
20,203

Intangible assets, net
23,268

 
(10
)
 
23,258

Deferred tax asset, net
9,114

 
(9,114
)
 
—

Other assets
354

 
—

 
354

      Total assets
$
193,263

 
$
(75,989
)
 
$
117,274

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
Current liabilities:
 
 
 
 
 
   Accounts payable
$
11,436

 
$
976

 
$
12,412

   Accrued compensation
12,365

 
326

 
12,691

   Accrued expenses
10,941

 
8,266

 
19,207

   Current portion of earn out liability
8,740

 
(480
)
 
8,260

   Deferred tax liability, net
—

 
1,129

 
1,129

   Income taxes
5,768

 
(157
)
 
5,611

   Other current liabilities
1,482

 
—

 
1,482

      Total current liabilities
50,732

 
10,060

 
60,792

 
 
 
 
 
 
Earn out liability
8,710

 
(1,170
)
 
7,540

Other liabilities
821

 
54

 
875

      Total liabilities
60,263

 
8,944

 
69,207

 
 
 
 
 
 
Stockholders' equity:
 
 
 
 
 
Preferred stock; $.001 par value; 5,000,000 shares authorized and 0 shares issued and outstanding
—

 
—

 
—

Common stock; $0.001 par value; 150,000,000 shares authorized; 110,212,547 issued and 109,862,787 outstanding at December 31, 2016
110

 
—

 
110

Additional paid-in capital
161,261

 
220

 
161,481

Treasury stock at cost: 349,760 shares at December 31, 2016
(2,216
)
 
—

 
(2,216
)
Accumulated deficit
(26,155
)
 
(85,153
)
 
(111,308
)
      Total stockholders' equity
133,000

 
(84,933
)
 
48,067

      Total liabilities and stockholders' equity
$
193,263

 
$
(75,989
)
 
$
117,274


The effects of the restatements on the Company’s consolidated statement of cash flows for the year ended December 31, 2016 are as follows:
 
Year Ended December 31, 2016
 
(in thousands)
 
Previously Reported
 
Adjustments
 
Restated
Cash flows provided by operating activities:
 
 
 
 
 
Net (loss) income
$
11,974

 
$
(11,584
)
 
$
390

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 

 
 
Depreciation
3,333

 
—

 
3,333

Amortization of intangible assets
2,127

 
10

 
2,137

Amortization of inventory fair value step-up
1,485

 
—

 
1,485

Amortization of deferred financing costs
181

 
(30
)
 
151

Change in fair value of earn-out consideration
—

 
(1,650
)
 
(1,650
)
Share-based compensation
17,818

 
(86
)
 
17,732

Change in deferred income taxes
(594
)
 
(5,398
)
 
(5,992
)
Increase (decrease) in cash, net of effects of acquisition and divestiture, resulting from changes in:
 
 
 
 
 
Accounts receivable
(11,396
)
 
11,469

 
73

Inventory
(2,837
)
 
1,942

 
(895
)
Prepaid expenses
(2,400
)
 
1,607

 
(793
)
Other assets
(384
)
 
(1,183
)
 
(1,567
)
Accounts payable
(3,665
)
 
187

 
(3,478
)
Accrued compensation
(2,669
)
 
83

 
(2,586
)
Accrued expenses
6,297

 
3,233

 
9,530

Income taxes
5,835

 
(634
)
 
5,201

Other liabilities
723

 
55

 
778

Net cash flows provided by operating activities
25,828


(1,979
)
 
23,849

 
 
 
 
 
 
Cash flows used in investing activities:
 
 
 
 
 
Purchases of property and equipment
(6,269
)
 
64

 
(6,205
)
Stability acquisition
(7,631
)
 
—

 
(7,631
)
Fixed maturity securities redemption
3,000

 
—

 
3,000

Patent application costs
(842
)
 
—

 
(842
)
Net cash flows used in investing activities
(11,742
)
 
64

 
(11,678
)
 
 
 
 
 
 
Cash flows used in financing activities:
 
 
 
 
 
Proceeds from exercise of stock options
3,494

 
—

 
3,494

Shares repurchased under repurchase plan
(10,378
)
 
—

 
(10,378
)
Shares repurchased for tax withholdings on vesting of restricted stock
(1,165
)
 
—

 
(1,165
)
Deferred financing costs
(30
)
 
30

 
—

Payments under capital lease obligations
(102
)
 
—

 
(102
)
Net cash flows used in financing activities
(8,181
)
 
30

 
(8,151
)
 
 
 
 
 
 
Net change in cash
5,905

 
(1,885
)
 
4,020

 
 
 
 
 
 
Cash and cash equivalents, beginning of year
28,486

 
(2,185
)
 
26,301

Cash and cash equivalents, end of year
$
34,391

 
$
(4,070
)
 
$
30,321



The following include descriptions of the significant adjustments to the Company’s financial position and results of operations from the previously reported consolidated financial statements.
Revenue Recognition
Under the Company’s previous revenue recognition policy utilized in the preparation of the financial statements for each of the years ended December 31, 2016, 2015, 2014, 2013 and 2012 and each of the quarters ended March 31, 2017, June 30, 2017 and September 30, 2017, revenue was recorded as follows:
•
For sales to distributors, revenue was recorded upon shipment to the distributor;
•
Certain sales to direct customers were treated as consignment sales as the customer could return the product at any time and was not required to pay until the product was used, despite no formal consignment agreement being in place. Therefore, the Company did not record revenue until the product was sold to an end-user (i.e., the recipient of the product); and
•
For other sales to direct customers, revenue was recorded upon shipment to the customer.
Under ASC 605, revenue should not be recognized until it is realized or realizable and earned. SEC Staff Accounting Bulletin (“SAB”) Topic 13.A.1 (as codified in ASC 605-10-S99-1) outlines four criteria that generally indicate when revenue is realized or realizable and earned. If any of these criteria are not met, revenue recognition should be deferred until all criteria have been met. Therefore, the Company assessed these four criteria as follows:
1.
Persuasive evidence of an arrangement exists - The Company’s sales are driven either by contracts or purchase orders. These types of documents are typically used to establish persuasive evidence of an arrangement. The Company’s customary business practices, however, must be taken into account as a contract can be written, oral, or modified based on customary business practices. Throughout 2012-2017, although the Company may have created a legal contract upon the execution of a contract and/or fulfillment of a purchase order, the lack of clarity around the final terms of the arrangement due to the pervasive side agreements with customers preclude the Company’s sales transactions from meeting this criterion upon shipment of product. Therefore, even though there may have been a legal contract governing the arrangement (which typically would indicate persuasive evidence of an arrangement), the Company’s selling and collection practices amended the stated contract terms. After considering these factors, the Company concluded that persuasive evidence of an arrangement did not exist upon shipment of product.
2.
Delivery has occurred or services have been rendered - For sales to customers, physical possession and title transferred upon shipment to the customer. However, the Company concluded that it did not pass the risks of ownership to the customer upon shipment because customers were allowed to return product for multiple reasons, which included being unable to sell the product, damages which may have occurred subsequent to delivery, and dropped product. See below for additional discussion of the Company’s rationale for concluding that delivery had not yet occurred upon shipment to the customer.
3.
The seller’s price to the buyer is fixed or determinable - At certain quarter-ends, the Company was significantly increasing sales to customers without having visibility into the level of product remaining unsold at the customer’s location. This practice made it difficult to develop an appropriate estimate of future credits to be issued to customers at the time of sale, which, in turn, impacted whether the price at the time of transfer of physical possession to the customer was fixed or determinable. This previous practice in combination with the following actions of the Company preclude the price of the Company’s sales transactions from being fixed or determinable upon shipment of product:
a.
Offering customers an unconditional right of return with many items being returned over a year after the initial sale,
b.
Offering extended payment terms to customers with days sales outstanding averaging almost 3 months, and
c.
A history of exceeding established credit limits for customers.
4.
Collectability is reasonably assured - At the time of transfer of physical possession to the customer, collectability of the sales was questionable. As determined in the Investigation and described further below, the customers’ intention to pay amounts when due was uncertain in light of the conflicting messages customers received with respect to the payment
terms, rights of return and lack of adherence to credit limits. Although the Company did have a process in place to establish credit limits, the evidence indicates that those credit limits were overridden by certain sales personnel and members of management. Despite these overrides, the Company recovered the majority of its billings made between 2012 and 2017 with insignificant write-offs recorded; however, a significant amount of these billings were collected well after payment was due under the contractual terms. Furthermore, the quantitative and qualitative evidence gathered by the Company raised considerable doubt as to the collectability of its billings at the time of shipment, but this evidence was not persuasive enough for the Company to reach a conclusion as to whether collectability was reasonably assured.
In the Company’s evaluation of the point at which delivery occurred (the second criterion discussed above), the Company further considered the fact that there are instances under ASC 605 where the transfer of title of the product did not coincide with revenue recognition. Based on its review of all facts and circumstances, the Company determined that it did not meet all of the criteria to recognize revenue at the time of shipment of product to the customer. Specifically, the Company determined that the Company did not transfer the risks of ownership upon the transfer of physical possession because the Company’s customers were routinely granted an extended return period with very limited restrictions on the right of return and extended payment terms which raised doubt as to the intent or ability of customers to use and pay for the product delivered. Customers were allowed to return product for multiple reasons which included being unable to sell the product, damages which may have occurred subsequent to delivery, and dropped product (i.e., product that becomes contaminated and unusable). In other words, only upon use of the product in a surgical application (whether by the customer or by the ultimate end user in the case of distributors) would the customer no longer have the ability to return the product.
Accordingly, the Company concluded that, from 2012 to 2017, its previous decision to recognize revenue at the time of shipment of product to the customer was not appropriate. The Company determined that the aforementioned revenue recognition criteria were met only when both of the following events had occurred: (1) the Company fulfilled the customer's purchase order by delivering product ordered, and (2) the Company collected payment for the product delivered. Furthermore, the Company determined that the amount of revenue to be recognized should be limited to the amount of payment received in a given period less the amount expected to be refunded or credited to customers for sales returns made after payment.
GPO Fees (Net Revenue Presentation)
The Company sells its products to GPO members who transact directly with the Company at GPO agreed pricing. GPOs are funded by administrative fees that are paid by the Company. These fees are set as a percentage of the purchase volume, which is typically 3% of sales made to the GPO members. In prior years, Company concluded that these fees should be accounted for consistent with purchases of services from other suppliers within General and Administrative expenses and not as a reduction in transaction price. Based on analysis performed as part of the Restatement discussed above, the Company determined that the administrative fees paid to GPOs should be presented as a reduction of revenues, as the benefit received by the Company in exchange for the GPO fees was not sufficiently separable from the GPO member’s purchase of the Company’s products.
Revenue-Related Adjustments
As discussed above under “Revenue Recognition,” based on the results of the Audit Committee Investigation and subsequent management review, the Company determined that all distributor and customer transactions should be transitioned to the cash collection method of accounting as of January 1, 2012.
The Company considered the accounting treatment for the related cost of sales when distributor revenue is recognized on a cash collection basis. Previously, cost of sales were recognized upon shipment of the Company’s products, which was consistent with the previous revenue recognition policy. However, the Company believes the matching of the recognition of costs of sales with the recognition of revenue is preferred, and the Company’s product is such that upon return the Company could resell the product if it is not damaged. Therefore, the Company determined that such costs should be deferred until revenue is recognized. The capitalized costs associated with delivered products are classified as deferred costs and reported within current assets, separately from inventory. The adjustment to Cost of sales in the consolidated statement of operations and to Other current assets in the consolidated balance sheet reflects this change.
The Company also considers the financial viability of its customers based on their creditworthiness to determine if collectability of amounts sufficient to recover the costs of the products shipped is reasonably assured. In cases where the Company has concluded that collectability is not reasonably assured, the condition in paragraph ASC 450-20-25-2(a) is met and a loss contingency should be accrued. The Company therefore estimates this loss in each period and records a reserve against its deferred cost balance and charges income for the estimated loss. The adjustment to Selling, general and administrative expenses in the consolidated statement of operations and to Other current assets in the consolidated balance sheet reflects this change.
Deposits in Transit
The Company reduced the amount of reported cash and decreased revenue for incorrectly reflected deposits in transit, due to the timing of certain cash collections. The adjustments to net (loss) income and net change in cash in the consolidated statement of cash flows reflect this change.
Other Adjustments
In addition to the adjustments recorded to address the Company’s errors in accounting for revenue recognition, deposits in transit and gross versus net revenue presentation, the Company has identified other errors that have been recorded in connection with the Restatement, as follows:
•
timing adjustments for prepaid expenses and expense accruals for research and development expenses related to clinical trials, employee compensation and other employee-related costs, legal costs and other accruals;
•
adjustments to stock-based compensation, primarily to reflect share-based awards granted to consultants as non-employee instead of as employee awards; and
•
an adjustment for a change in fair value of $1.7 million for earn-out discussed further in Note 5. “Stability Biologics, L