(1)

Summary of Significant Accounting Policies

Description of Business and Basis of Presentation

National Research Corporation

, doing business as NRC Health (“NRC Health,” the “Company,” “we,” “our,” “us” or similar terms), is a leading provider of analytics and insights that facilitate measurement and improvement of the patient and employee experience while also increasing patient engagement and customer loyalty for healthcare providers, payers and other healthcare organizations in the United States and Canada. The Company’s solutions enable its clients to understand the voice of the customer with greater clarity, immediacy and depth. The Company’s

ten

largest clients accounted for

17%,

15%,

and

16%

of the Company’s total revenue in

2016,

2015,

and

2014,

respectively.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company

and its wholly-owned subsidiary, National Research Corporation Canada. Prior to becoming a wholly-owned subsidiary in

March

2016,

the accounts of Customer-Connect LLC (“Connect”), then a variable interest entity for which NRC Health was deemed the primary beneficiary, were included in the consolidated financial statements of the Company. On

June

30,

2016,

Customer-Connect LLC was dissolved. All significant intercompany transactions and balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Translation of Foreign Currencies

The Company

’s Canadian subsidiary uses as its functional currency the local currency of the country in which it operates. It translates its assets and liabilities into U.S. dollars at the exchange rate in effect at the balance sheet date. It translates its revenue and expenses at the average exchange rate during the period. The Company includes translation gains and losses in accumulated other comprehensive income (loss), a component of shareholders’ equity. Gains and losses related to transactions denominated in a currency other than the functional currency of the country in which the Company operates and short-term intercompany accounts are included in other income (expense) in the consolidated statements of income. Since the undistributed earnings of the Company’s foreign subsidiary are considered to be indefinitely reinvested, the components of accumulated other comprehensive income (loss) have not been tax effected.

Revenue Recognition

The Company derives a majority of its operating revenue from its annually renewable services, which include performance measurement and improvement services, healthcare analytics and governance education services. The Company provides these services to its clients under annual client service contracts, although such contracts are generally cancelable

on short or no notice without penalty. Services are provided under subscription-based service agreements. The Company recognizes subscription-based service revenue over the period of time the service is provided. Generally, the subscription periods are for

twelve

months and revenue is recognized equally over the subscription period.

Certain contracts are fixed-fee arrangements with a portion of the project fee billed in advance and the remainder billed periodically over the duration of the project. Revenue for services provided under these contracts are recognized under the proportional performance method. Under the proportional performance method, the Company recognizes revenue based on output measures or key milestones such as survey set-up, survey mailings, survey returns and reporting. The Company measures its progress based on the level of completion of these output measures and recognizes revenue accordingly. Management judgments and estimates must be made and used in connection with revenue recognized using the proportional performance method. If management made different judgments and estimates, then the amount and timing of revenue for any period could differ materially from the reported revenue.

The Company

’s revenue arrangements with a client

may

include combinations of NRC Health’s Experience, Transparency, Governance, and Market Insights solutions which

may

be executed at the same time, or within close proximity of

one

another (referred to as a multiple-element arrangement). Each element of a multiple-element arrangement is accounted for as a separate unit of accounting provided each delivered element is sold separately by the Company or another vendor; and for an arrangement that includes a general right of return relative to the undelivered elements, delivery or performance of the undelivered services are considered probable and substantially in the control of the Company. The Company’s arrangements generally do not include a general right of return related to the delivered services. If these criteria are not met, the arrangement is accounted for as a single unit of accounting with revenue generally recognized equally over the subscription period or recognized under the proportional performance method.

Revenue is allocated to each separate unit of accounting based on relative selling price using a selling price hierarchy: vendor-specific objective evidence (“VSOE”), if available,

third

-party evidence (“TPE”) if VSOE is not available, or estimated selling price if VSOE nor TPE is available. VSOE is established based on the services normal selling price and discounts for the specific services when sold separately. TPE is established by evaluating similar competitor services in standalone arrangements. If neither exists for a deliverable, the best estimate of the selling price (“ESP”) is used for that deliverable based on list price, representing a component of management’s market strategy, and an analysis of historical prices for bundled and standalone arrangements. Revenue allocated to an element is limited to revenue that is not subject to refund or otherwise represents contingent revenue. VSOE, TPE and ESP are periodically adjusted to reflect current market conditions. These adjustments are not expected to differ significantly from historical results.

Business Combinations

The Company uses the acquisition method of accounting for acquired businesses. Under the acquisition method, the financial statements reflect the operations of an acquired business starting from the completion of the acquisition. The assets acquired and liabilities assumed are recorded at their respective estimated fair values at the date of the acquisition. Any excess of the purchase price over the

estimated fair values of the identifiable net assets acquired is recorded as goodwill. Significant judgment is required in estimating the fair value of assets acquired, especially intangible assets. As a result, in the case of significant acquisitions we typically engage

third

-party valuation specialists in estimating fair values of tangible and intangible assets. The fair value estimates are based on available historical information and on expectations and assumptions about the future, considering the perspective of marketplace participants.

Segment Information

2016,

the Company had

six

operating segments comprised of Experience, The Governance Institute, Market Insights,

Transparency, National Research Corporation Canada and Connect, which offer a portfolio of solutions that address specific needs around market insight, experience, transparency and governance for healthcare providers, payers and other healthcare organizations. The Company’s

six

operating segments are aggregated into

one

reporting segment because they have similar economic characteristics and meet the other aggregation criteria from the Financial Accounting Standards Board (“FASB”) guidance on segment disclosure. As discussed in Note

December

21,

2015,

selected assets and liabilities were sold from the former Predictive Analytics operating segment, reducing the number of operating segments from

seven

six

December

2015.

Trade Accounts Receivable

Trade accounts receivable are recorded at the invoiced amount. The allowance for doubtful accounts is the Company

’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on the Company’s historical write-off experience and current economic conditions. The Company reviews the allowance for doubtful accounts monthly. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

Property and Equipment

Property and equipment is stated at cost. Major expenditures to purchase property or to substantially increase useful lives of property are capitalized. Maintenance, repairs and minor renewals are expensed as incurred. When assets are retired or otherwise disposed of, their costs and related accumulated depreciation are removed from the accounts and resulting gains or losses are included in income.

For costs of software developed for internal use, the Company expenses computer software costs

as incurred in the preliminary project stage, which involves the conceptual formulation, evaluation and selection of technology alternatives. Costs incurred related to the design, coding, installation and testing of software during the application project stage are capitalized. Costs for training and application maintenance are expensed as incurred. The Company has capitalized approximately

$2.5

million and

$2.0

million of internal and external costs incurred for the development of internal-use software for the years ended

December

31,

2016

and

2015,

respectively, with such costs classified as property and equipment.

he Company provides for depreciation and amortization of property and equipment using annual rates which are sufficient to amortize the cost of depreciable assets over their estimated useful lives. The Company uses the straight-line method of depreciation and amortization over estimated useful lives of

three

ten

years for furniture and equipment,

three

five

years for computer equipment,

one

five

years for capitalized software, and

seven

forty

years for the Company’s office building and related improvements.

Leases are categorized as operating or capital at the inception of the lease. Assets under capital lease obligations are reported at the lower of fair value or the present value of the aggregate future minimum lease payments at the beginning of the lease term. The Company depreciates capital lease assets

without transfer-of-ownership or bargain-purchase-options using the straight-line method over the lease terms, excluding any lease renewals, unless the lease renewals are reasonably assured. Capital lease assets with transfer-of-ownership or bargain-purchase-options are depreciated using the straight-line method over the assets’ estimated useful lives.

Impairment of Long-L

ived Assets and Amortizing Intangible Assets

Long-lived

assets, such as property and equipment and purchased intangible assets subject to depreciation or amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset

may

not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, the Company

first

compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and

third

-party independent appraisals, as considered necessary.

impairments were recorded during the years ended

December

31,

2016,

2015,

2014.

Among others, m

anagement believes the following circumstances are important indicators of potential impairment of such assets and as a result

may

trigger an impairment review:

●

Significant underperformance in comparison to historical or projected operating results;

●

Significant changes in the manner or use of acquired assets or the Company

’s overall strategy;

●

Significant negative trends in the Company

’s industry or the overall economy;

●

A significant decline in the market price for the Company

’s common stock for a sustained period; and

●

The Company

’s market capitalization falling below the book value of the Company’s net assets.

Goodwill and

Intangible Assets

Intangible assets include customer relationships, trade names,

technology, non-compete agreements and goodwill. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets

may

not be recoverable. The Company reviews intangible assets with indefinite lives for impairment annually as of

October

and whenever events or changes in circumstances indicate that the carrying value of an asset

may

not be recoverable.

When performing the impairment assessment, the Company will

first

assess qualitative factors to determine whether it is necessary to recalculate the fair value of the intangible assets with indefinite lives. If the Company believes, as a result of the qualitative assessment, that it is more likely than not that the fair value of the indefinite

-lived intangibles is less than their carrying amount, the Company calculates the fair value using a market approach. If the carrying value of intangible assets with indefinite lives exceeds their fair value, then the intangible assets are written-down to their fair values. The Company did

not

recognize any impairments related to indefinite-lived intangibles during

2016,

2015

2014.

Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. All of the Company

’s goodwill is allocated to its reporting units, which are the same as its operating segments. Goodwill is reviewed for impairment at least annually, as of

October

and whenever events or changes in circumstances indicate that the carrying value of goodwill

may

not be recoverable.

The Company reviews for

goodwill impairment by

first

assessing qualitative factors to determine whether any impairment

may

exist. If the Company believes, as a result of the qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, a quantitative

two

-step test is required; otherwise, no further testing is required. Under the

first

step of the quantitative test, the fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit exceeds its carrying value, step

two

is not performed. If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the Company performs step

two

of the impairment test (measurement). Under step

two,

an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the fair value of that goodwill. The fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation and the residual fair value after this allocation is the fair value of the reporting unit goodwill.

In instances when a step

two

is required, the f

air value of the reporting unit is determined using an income approach and comparable market multiples. Under the income approach, there are a number of inputs used to calculate the fair value using a discounted cash flow model, including operating results, business plans, projected cash flows and a discount rate. Discount rates, growth rates and cash flow projections are the most sensitive and susceptible to change as they require significant management judgment. Discount rates are determined by using a weighted average cost of capital, which considers market and industry data. Management develops growth rates and cash flow projections for each reporting unit considering industry and Company-specific historical and projected information. Terminal value rate determination follows common methodology of capturing the present value of perpetual cash flow estimates beyond the last projected period assuming a constant weighted average cost of capital and low long-term growth rates. Under the market approach, the Company considers its market capitalization, comparisons to other public companies’ data, and recent transactions of similar businesses within the Company’s industry.

The Company performed a qualitativ

e analysis as of

October

2016

which did not indicate that it was more likely than not that the carrying values of the reporting units exceeded fair value.

impairments were recorded during the years ended

December

31,

2016,

2015

2014.

Income Taxes

The Company uses the asset and liability method of accounting for income taxes. Under that method, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bas

is using enacted tax rates. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances, if any, are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company uses the deferral method of accounting for its investment tax credits related to state tax incentives. During the years ended

December

31,

2016,

2015

and

2014,

the Company recorded income tax benefits relating to these tax credits of

$77,000,

$156,000,

and

$224,000,

respectively.

he Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than

50%

likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.

Share-Based Compensation

The compensation expense

on share-based payments is recognized based on the grant-date fair value of those awards. All of the Company’s existing stock option awards and non-vested stock awards have been determined to be equity-classified awards.

Amounts recognized in the financial statements with respect to these plans:

	20 16			20 15			20 14
	(In thousands)
Amounts charged against income, before income tax benefit	$	1,929		$	1,383		$	742
Amount of related income tax benefit		(704	)		(505	)		(269	)
Total impact to net income	$	1,225		$	878		$	473

Cash and Cash Equivalents

he Company considers all highly liquid investments with original maturities of

three

months or less to be cash equivalents. Cash equivalents were

$32.7

million and

$39.8

million as of

December

31,

2016,

and

2015,

respectively, consisting primarily of money market accounts and funds invested in commercial paper. At certain times, cash equivalent balances

may

exceed federally insured limits.

Fair Value

Measurements

The Company

’s valuation techniques are based on maximizing observable inputs and minimizing the use of unobservable inputs when measuring fair value. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. The inputs are then classified into the following hierarchy:

(1)

Level

Inputs—quoted prices in active markets for identical assets and liabilities;

(2)

Level

Inputs—observable market-based inputs other than Level

inputs, such as quoted prices for similar assets or liabilities in active markets, quoted prices for similar or identical assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data;

(3)

Level

Inputs—unobservable inputs.

Commercial paper included in cash equivalents

is valued at amortized cost, which approximates fair value due to its short-term nature. These are included as a Level

measurement in the table below.

The following details the Company’s financial assets within the fair value hierarchy at

December

31,

2015

and

2014:

	Level 1		Level 2		Level 3		Total
	(In thousands)
As of December 31, 2016
Money Market Funds	$	11,200	$	--	$	--	$	11,200
Commercial Paper		--		21,450		--		21,450
Total Cash Equivalents	$	11,200	$	21,450	$	--	$	32,650
As of December 31, 2015
Money Market Funds	$	8,954	$	--	$	--	$	8,954
Commercial Paper		--		30,872		--		30,872
Total Cash Equivalents	$	8,954	$	30,872	$	--	$	39,826

There were no transfers between levels during the years ended

December

31,

201

and

2015.

The Company's long-term

debt described in Note

is recorded at historical cost. The fair value of long-term debt is classified in Level

of the fair value hierarchy and was estimated based primarily on estimated current rates available for debt of the same remaining duration and adjusted for nonperformance and credit.

The following are the carrying a

mount and estimated fair values of long-term debt:

	December 31, 2016		December 31, 201 5
	(In thousands)
Total carrying amount of long-term debt	$	3,540	$	5,739
Estimated fair value of long-term debt	$	3,533	$	5,708

The carrying amounts of accounts receivable, accounts payable, and accrued expenses approximate their fair value. All non-financial assets that are not recognized or disclosed at fair value in the financial statements on a recurring basis, which includes goodwill and non-financial long-lived assets, are measured at fair value in certain circumstances (for example, when there is evidence of impairment). As of Decembe

31,

2016

and

2015,

there was no impairment related to property and equipment, goodwill and other intangible assets.

ontingencies

From time to time, the Company is involved in certain claims and litigation arising in the normal course of business. Management assesses the probability of loss for such contingencies and recognizes a liability when a loss is probable and estimable. At

December

31,

2016,

the Company was not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material effect on the Company.

Earnings Per Share

Net income per share of class A common stock and class B common stock is computed using the

two

-class method. Basic net income per share is computed by allocating undistributed earnings to common shares and using the weighted-average number of common shares outstanding during the period.

Diluted net income per share is computed using the weighted-average number of common shares and, if dilutive, the potential common shares outstanding during the period. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options and vesting of restricted stock. The dilutive effect of outstanding stock options is reflected in diluted earnings per share by application of the treasury stock method.

The liquidation rights and the rights upon the consummation of an extraordinary transaction are the same for the holders of class A common stock and class B common stock. Other than share distributions and liquidation rights, the amount of any dividend or other distribution payable on each share of class A common stock will be equal to

one

sixth

(1/6

) of the amount of any such dividend or other distribution payable on each share of class B common stock. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the class A and class B common stock as if the earnings for the year had been distributed.

December

31,

2016,

2015,

and

2014,

the Company had

156,610,

487,639

and

162,391

options of class A shares and

49,262,

58,429,

and

19,561

options of class B shares, respectively, which have been excluded from the diluted net income per share computation because the exercise price exceeds the fair market value. At

December

31,

2016,

2015,

and

2014

an additional

390,299,

68,779,

and

185,461

options of class A shares and

34,178,

1,101,

and

1,687

options of class B shares, respectively were excluded as their inclusion would be anti-dilutive.

	201 6						201 5						201 4
	Class A			Class B			Class A			Class B			Class A		Class B
	(In thousands, except per share data)

Numerator for net income per share - basic:
Net income	$	10,178		$	10,341		$	8,759		$	8,851		$	9,062	$	9,094
Allocation of distributed and undistributed income to unvested restricted stock shareholders		(88	)		(88	)		(76	)		(77	)		--		--
Net income attributa ble to common shareholders	$	10,090		$	10,253		$	8,683		$	8,774		$	9,062	$	9,094
Denominator for net income per share - basic:
Weighted average common shares outstanding - basic		20,713			3,505			20,741			3,478			20,764		3,473
Net income per share - basic	$	0.49		$	2.93		$	0.42		$	2.52		$	0.44	$	2.62
Numerator for net income per share - diluted:
Net inco me attributable to common shareholders for basic computation	$	10,090		$	10,253		$	8,683		$	8,774		$	9,062	$	9,094
Denominator for net income per share - diluted:
Weighted average common s hares outstanding - basic		20,713			3,505			20,741			3,478			20,764		3,473
Weighted average effect of dilutive securities – stock options:		324			55			240			44			312		63
Denomi nator for diluted earnings per share – adjusted weighted average shares		21,037			3,560			20,981			3,522			21,076		3,536
Net income per share - diluted	$	0.48		$	2.88		$	0.41		$	2.49		$	0.43	$	2.57