NOTE B — SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in the accompanying financial statements.

Revision of Previously Reported Consolidated Financial Information

During the third quarter 2013, the Company corrected an error in the classification of certain components of bad debt expense (the “2013 Revision”). Hanger previously classified the reserves related to the write-off of older accounts receivable balances due from commercial and government payors as bad debt expense, which was reported as Other Operating Expense in its financial statements, instead of as a reduction of sales. Management has assessed the materiality of the errors on previously reported periods and concluded the impact was not material to any of the prior annual or quarterly consolidated financial statements. The errors had no impact on previously reported net income, balance sheet totals or the operating cash flows for any of the periods. The impact of the adjustment lowers sales and reduces Other Operating Expenses by equal and offsetting amounts in the Consolidated Statements of Income and Comprehensive Income and the Provision for doubtful accounts and Change in accounts receivable by equal and offsetting amounts in the Consolidated Statements of Cash Flows. Further, the Company has historically included the reserve for contra revenue in its presentation of the Allowance for doubtful accounts on the Consolidated Balance Sheets and the net change in the reserve for contra revenue in the Provision for doubtful accounts on the Consolidated Statements of Cash Flows and the Schedule II Valuation and Qualifying Accounts included in the Company’s Annual Report on Form 10-K. The Company has revised that presentation to only include the reserve for doubtful accounts and the related activity in the reserve for doubtful accounts in those respective balances. The impacts of the revisions on net sales are included in the results of the Patient Care Services segment in Note K.

During the fourth quarter of 2012, the Company identified adjustments necessary to correct prior periods for the overstatement of the value of work-in-process inventory at December 31, 2011 and 2010. The Company assessed the materiality of the errors on previously reported periods and concluded the impact was not material to any prior annual consolidated financial statements. Management, however, deemed the impact of this error on the consolidated financial statements for the three months ended March 31, 2012 and 2011 to be material and restated the first quarter 2012 and 2011 financial results (“2012 Restatement”) in the restated Quarterly Report on Form 10-Q/A, filed with the SEC on March 22, 2013 (the “Amended Filing”) and revised the consolidated financial statements for the three and six month periods ended June 30, 2012 in the Second Quarter 2013 Report on Form 10Q. These errors had no impact on operating cash flows for any of the periods. The impact of the errors is included in the results of the Patient Care Services segment in Note K. The 2012 Restatement did not have an impact on the Consolidated Balance Sheets as of September 30, 2012 or the Consolidated Statement of Income and Comprehensive Income or the Consolidated Statement of Cash Flows for the three month period ended September 30, 2012.

The impact of the 2013 Revision on the Consolidated Statements of Income and Comprehensive Income and the Consolidated Statements of Cash Flows for the three months ended March 31, 2013, the three and six months ended June 30, 2013, the three months ended March 31, 2012, the three and six months ended June 30, 2012, the three and nine months ended September 30, 2012, the annual periods ended 2010, 2011 and 2012, and Schedule II Valuation and Qualifying Accounts for the annual periods 2010, 2011 and 2012 are shown below. The impact of the 2012 Restatement resulted in a revision to the Consolidated Statements of Income and Comprehensive Income and the Consolidated Statement of Cash Flows for the nine month period ended September 30, 2012 which is included within the respective table below.

Impact of 2013 Revision to previously reported 2013 consolidated interim results

	Three Months Ended March 31, 2013				Three Months Ended June 30, 2013				Six Months Ended June 30, 2013
	As Previously				As Previously				As Previously
(in thousands)	Reported		As Revised		Reported		As Revised		Reported			As Revised

Consolidated Statements of Income and Comprehensive Income
Net sales	$	233,535	$	229,350	$	273,735	$	267,798	$	507,270		$	497,148
Other operating expenses*	$	43,843	$	39,658	$	54,959	$	49,022	$	98,802		$	88,680

Consolidated Statements of Cash Flows
Provision for doubtful accounts	$	5,229	$	1,657					$	14,905		$	4,591
Change in accounts receivable	$	3,644	$	7,216					$	(18,026	)	$	(7,712	)

* The other operating expense balance for the three months ended March 31, 2013 includes $0.1 million of acquisition expenses previously reported as a separate caption in the presentation of the Consolidated Statements of Income and Comprehensive Income.

Impact of 2013 Revision to previously reported 2012 consolidated interim results

	Three Months Ended March 31, 2012				Three Months Ended June 30, 2012				Six Months Ended June 30, 2012						Three Months Ended September 30, 2012
	As Previously				As Previously				As Previously						As Previously
(in thousands)	Reported		As Revised		Reported		As Revised		Reported			As Revised			Reported		As Revised

Consolidated Statements of Income and Comprehensive Income
Net sales	$	218,091	$	214,355	$	251,754	$	247,902	$	469,845		$	462,257		$	243,503	$	242,536
Other operating expenses*	$	40,219	$	36,483	$	51,256	$	47,404	$	91,475		$	83,887		$	42,177	$	41,210
Consolidated Statement of Cash Flows
Provision for doubtful accounts	$	4,723	$	907					$	12,925		$	4,462
Change in accounts receivable	$	851	$	4,667					$	(16,190	)	$	(7,727	)

* The other operating expense balance for the three months ended March 31, 2012 includes $0.1 million of acquisition expenses previously reported as a separate caption in the presentation of the Consolidated Statements of Income and Comprehensive Income.

Impact of 2013 Revision and 2012 Restatement to previously reported 2012 consolidated interim results

	Nine Months Ended September 30, 2012
(in thousands, except per share amounts)	As Previously Reported			As Revised

Consolidated Statements of Income and Comprehensive Income
Net sales	$	713,349		$	704,794
Material costs	$	210,107		$	212,706
Personnel costs	$	251,189		$	248,723
Other operating expenses	$	135,566		$	125,099
Income from operations	$	91,055		$	92,834
Income before taxes	$	67,843		$	69,622
Provision for income taxes	$	25,558		$	26,257
Net income	$	42,285		$	43,365
Basic earnings per share	$	1.24		$	1.27
Diluted earnings per share	$	1.21		$	1.25

Consolidated Statement of Cash Flows
Provision for doubtful accounts	$	15,926		$	6,580
Change in accounts receivable	$	(19,612	)	$	(10,266	)

Impact of 2013 Revision to previously reported consolidated annual results

	Year Ended December 31, 2010						Year Ended December 31, 2011						Year Ended December 31, 2012
(in thousands)	As Previously Reported			As Revised			As Previously Reported			As Revised			As Previously Reported			As Revised

Consolidated Statements of Income and Comprehensive Income
Net Sales	$	817,379		$	808,766		$	918,539		$	907,794		$	985,550		$	974,429
Other operating expenses	$	165,158		$	156,545		$	177,910		$	167,165		$	188,868		$	177,747

Consolidated Statements of Cash Flows
Provision for doubtful accounts	$	20,276		$	7,252		$	24,837		$	9,396		$	19,773		$	9,589
Change in accounts receivable	$	(31,041	)	$	(18,017	)	$	(42,024	)	$	(26,583	)	$	(40,443	)	$	(30,259	)

Impact of 2013 Revision to previously reported Schedule II Allowance for doubtful accounts table

Year (In thousands)	Classification	Balance at beginning of year		Additions Charged to Costs and Expenses		Write-offs		Balance at end of year
2012	Allowance for doubtful accounts
	Previously reported	$	22,028	$	19,773	$	20,422	$	21,379
	Revised	$	7,236	$	9,589	$	9,299	$	7,526

2011	Allowance for doubtful accounts
	Previously reported	$	16,686	$	22,101	$	16,759	$	22,028
	Revised	$	5,153	$	9,396	$	7,313	$	7,236

2010	Allowance for doubtful accounts
	Previously reported	$	10,526	$	20,276	$	14,116	$	16,686
	Revised	$	4,286	$	7,252	$	6,385	$	5,153

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, 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.

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less at the date of purchase to be cash equivalents. The Company maintains cash balances in excess of Federal Deposit Insurance Corporation limits at certain financial institutions.

Restricted Cash

Restricted cash has statutory or contractual restrictions that prevent it from being used in the Company’s operations. As of December 31, 2012, the Company agreed to restrict $3.1 million of cash to serve as collateral for its Workers’ Compensation program. In August of 2013, the Company substituted a letter of credit for the restricted cash to serve as collateral for its Worker’s Compensation program, and the cash balances used as collateral were transferred to the Company’s operating accounts.

Credit Risk

The Company primarily provides O&P (orthotics and prosthetics) devices and services and products throughout the United States of America and is reimbursed by the patients, third-party insurers, governmentally funded health insurance programs, and, for those products distributed through the Products & Services business, by independent O&P providers. The Company also provides advanced rehabilitation technology and clinical programs to skilled nursing facilities in the United States primarily through operating leases. The Company performs ongoing credit evaluations of its Products & Services segment customers. Accounts receivable are not collateralized. The ability of the Company’s debtors to meet their obligations is dependent upon their financial stability which could be affected by future legislation and regulatory actions. Additionally, the Company maintains reserves for potential losses from these receivables that historically have been within management’s expectations.

Inventories

Inventories in the Patient Care segment consisting principally of raw materials and work-in-process, which amounted to $113.7 million and $96.6 million as of September 30, 2013 and December 31, 2012, respectively, are valued based on the gross profit method, which approximates lower of cost or market using the first-in first-out method. The Company applies the gross profit method on a patient care clinic basis in this segment’s inventory to determine ending inventory at the end of each interim period. On October 31, which is the date of the Company’s annual physical inventory, the Company values the inventory at lower of cost or market using the first-in first-out method and includes work-in-process consisting of materials, labor and overhead which is valued based on established standards for the stage of completion of each custom order. Adjustments to reconcile the physical inventory to the Company’s books are treated as changes in accounting estimates and are recorded in the fourth quarter. The October 31 inventory is subsequently adjusted during interim periods to apply the gross profit method described above.

Inventories in the Products & Services segments consist principally of finished goods which are stated at the lower of cost or market using the first-in, first-out method for all reporting periods and are valued based on perpetual records.

Fair Value Measurements

The Company follows the authoritative guidance for financial assets and liabilities, which establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. The authoritative guidance requires disclosure about how fair value is determined for assets and liabilities and establishes a hierarchy by which these assets and liabilities must be categorized, based on significant levels of inputs as follows:

Level 1 unadjusted quoted prices for identical assets or liabilities in active markets accessible by the Company

Level 2 inputs that are observable in the marketplace other than those inputs classified as Level 1

Level 3 inputs that are unobservable in the marketplace and significant to the valuation

The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Financial Instruments

Assets measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012, are $2.5 million and $11.0 million, respectively, and are comprised of cash equivalent money market investments. The money market investments are based on Level 1 observable market prices and are equivalent to one dollar. The carrying value of the Company’s short-term financial instruments, such as receivables and payables, approximate their fair values based on the short-term maturities of these instruments. During the second quarter of 2013, the Company refinanced its credit facilities by replacing its $300.0 million Term Loan and $100.0 million Revolving Credit Facility with a $225.0 million Term Loan Facility and a $200.0 million Revolving Credit Facility. See Note F for further information.

· The carrying values of the Company’s outstanding Term Loans as of September 30, 2013 and December 31, 2012, were $223.6 million and $293.3 million, respectively. The Company has determined the carrying value on these loans approximates fair value for debt with similar terms and remaining maturities based on interest rates currently available and has therefore concluded these are Level 2 measurements.

· The carrying values of the Company’s outstanding Revolving Credit Facilities as of September 30, 2013 and December 31, 2012, were $26.0 million and $0 million, respectively. The Company has determined the carrying value on these loans approximates fair value for debt with similar terms and remaining maturities based on interest rates currently available and has therefore concluded these are Level 2 measurements.

· The carrying value of the Senior Notes was $200.0 million as of September 30, 2013 and December 31, 2012. The fair value of the Senior Notes, based on a Level 1 quoted market price, was $213.0 million and $211.5 million as of September 30, 2013 and December 31, 2012.

· Seller Notes are recorded at contractual carrying values of $21.5 million and $27.3 million as of September 30, 2013 and December 31, 2012, respectively, and carrying value approximates fair value for similar debt in all material respects. The Company estimates fair value of the seller notes with a discounted cash flow model using unobservable rates and has determined these represent Level 3 measurements.

Revenue Recognition

Revenues in the Company’s Patient Care segment are derived from the sale of O&P devices and the maintenance and repair of existing devices. Revenues are recorded based upon contracts with commercial insurance companies and government agencies, net of contractual adjustments and discounts. Individual patients are generally responsible for deductible and/or co-payments. Revenues are recorded when the patient has accepted and received the device. Revenues from maintenance and repairs are recognized when the service is provided.

The Company estimates an allowance for disallowed sales primarily for commercial & governmental contractual adjustments and discounts not identified at the time of sale. The allowance is estimated based upon historical experience. Additions to the allowance are reported as a reduction of Net sales.

The Company estimates an allowance for doubtful accounts to estimate uncollectible accounts due primarily from individual patients. The allowance is estimated based upon historical experience. Bad debt expense is reported within Other operating expenses.

Revenues in the Company’s Products & Services segment are derived from the distribution of O&P devices to customers and leasing rehabilitation technology combined with clinical therapy programs, education and training. Distribution revenues are recorded upon the shipment of products, in accordance with the terms of the invoice, net of merchandise returns received. Discounted sales are recorded at net realizable value. Leasing revenues are recognized based upon the contractual terms of the agreements, which contain negotiated pricing and service levels with terms ranging from one to five years, and are generally billed to the Company’s customers monthly.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost less accumulated depreciation, with the exception of assets acquired through acquisitions, which are initially recorded at fair value. Equipment acquired under capital leases is recorded at the lower of fair market value or the present value of the future minimum lease payments. The cost and related accumulated depreciation of assets sold, retired or otherwise disposed of are removed from the respective accounts, and any resulting gains or losses are included in the Consolidated Statements of Income and Comprehensive Income.

Goodwill and Other Intangible Assets

Goodwill represents the excess of purchase price over the fair value of net identifiable assets of purchased businesses. The Company assesses goodwill for impairment annually during the fourth quarter, or when events or circumstances indicate that the carrying value of the reporting units may not be recoverable. The Company has the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If the Company determines that a two-step goodwill impairment test is necessary or more efficient than a qualitative approach, it will measure the fair value of the Company’s reporting units using a combination of income, market and cost approaches. Any impairment would be recognized by a charge to operating results and a reduction in the carrying value of the intangible asset. There were no impairment indicators since the last annual impairment test on October 1, 2012.

Income Taxes

The Company recognizes deferred income tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred income tax liabilities and assets are determined based on the difference between the financial statements and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The Company recognizes a valuation allowance on the deferred tax assets if it is more likely than not that the assets will not be realized in future years. Significant accounting judgment is required in determining the provision for income taxes and related accruals, deferred tax assets and liabilities. The Company believes that its tax positions are consistent with applicable tax law, but certain positions may be challenged by taxing authorities. In the ordinary course of business, there are transactions and calculations where the ultimate tax outcome is uncertain. In addition, the Company is subject to periodic audits and examinations by the Internal Revenue Service and other state and local taxing authorities. Although the Company believes that its estimates are reasonable, actual results could differ from these estimates.

Segment Information

The Company applies a “management” approach to disclosure of segment information. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the basis of the Company’s operating segments. During the first quarter of 2013, the Company assessed and updated their operating segments to align with how the business is managed and determined their reportable segments are the same as their operating segments. The description of the Company’s segments and the disclosure of segment information are presented in Note K.

Recent Accounting Pronouncements

In July 2012, the FASB issued ASU 2012-02, “Testing Indefinite-Lived Intangibles for Impairment”. This ASU amended guidance that simplifies how entities test indefinite-lived intangible assets other than goodwill for impairment. After assessment of certain qualitative factors, if it is determined to be more likely than not that an indefinite-lived asset is impaired, entities must perform the quantitative impairment test. Otherwise, the quantitative test becomes optional. The amended guidance was effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. The Company adopted this new guidance in the first quarter of 2013, and the adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In February 2013, the FASB issued ASU 2013-2, “Other Comprehensive Income.” This ASU amends ASC 220, “Comprehensive Income,” and supersedes ASU 2011-05 “Presentation of Comprehensive Income” and ASU 2011-12 “Comprehensive Income,” to require reclassification adjustments from other comprehensive income to be presented either in the financial statements or in the notes to the financial statements. The standard does not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the guidance requires an entity to provide enhanced disclosures to present separately by component reclassifications out of accumulated other comprehensive income. The amendments in this ASU were effective prospectively for reporting periods beginning after December 15, 2012. The Company has adopted this guidance and its implementation did not have a material impact on its consolidated financial statements.

In July 2013, the FASB issued new accounting guidance that requires that unrecognized tax benefits be classified as an offset to deferred tax assets to the extent of any net operating loss carryforwards, similar tax loss carryforwards, or tax credit carryforwards available at the reporting date in the applicable tax jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position. An exception would apply if the tax law of the tax jurisdiction does not require the Company to use, and it does not intend to use, the deferred tax asset for such purpose. This guidance is effective for reporting periods beginning after December 15, 2013. The Company does not expect the adoption of these provisions to have a material effect on the consolidated financial statements.