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’sCompany’s solutions enable its clients to understand the voice of the customer with greater clarity, immediacy and depth.

The Company’s 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. The six operating segments are Experience, The Governance Institute, Market Insights, Transparency, NRC Health Canada and Transitions (formerly 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 condensed consolidated balance sheet of the Company at December 31, 2016, 2017, was derived from the Company’sCompany’s audited consolidated balance sheet as of that date. All other financial statements contained herein are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) the Company considers necessary for a fair presentation of financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States.

Information and footnote disclosures included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto that are included in the Company’sCompany’s Form 10-K10-K for the year ended December 31, 2016, 2017, filed with the Securities and Exchange Commission (the “SEC”) on March 3, 2017.14, 2018.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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.

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, National Research Corporation Canada, doing business as NRC Health Canada. The condensed consolidated statement of income for the three and six months ended June 30, 2016 also included Customer-Connect LLC.  Customer-Connect LLC became a wholly-owned subsidiary in March 2016 and was previously a variable interest entity for which NRC Health was deemed the primary beneficiary. On June 30, 2016, Customer-Connect LLC was dissolved. All significant intercompany transactions and balances have been eliminated.

The Company’s Canadian subsidiary uses as its functional currency the local currency of the Company’s foreign subsidiary, National Research Corporation Canada, doing business as NRC Health Canada, is the subsidiary’s local currency. The Companycountry in which it operates. It translates theits assets and liabilities of its foreign subsidiaryinto U.S. dollars at the period-endexchange rate of exchangein effect at the balance sheet date. It translates its revenue and its foreign subsidiary’s income statement balancesexpenses at the average exchange rate prevailing during the period. The Company records the resultingincludes translation adjustmentgains and losses in accumulated other comprehensive loss,income (loss), a component of shareholders’ equity. Since the undistributed earnings of the Company’s foreign subsidiary are considered to be indefinitely reinvested, no taxes were provided for on currency translation adjustments arising from converting the investment denominated in a foreign currency to U.S. dollars. Gains and losses related to transactions denominated in a currency other than the subsidiary’s localfunctional currency of the country in which the Company operates and short-term intercompany accounts are included in other income (expense) in the condensed consolidated statements of income.

Revenue Recognition

Reclassifications

Reclassifications have been madeOn January 1, 2018, the Company adopted Accounting Standards Update ("ASU") 2014-09,Revenue- Revenue from noncurrent deferred income taxesContracts with Customers and all related amendments (“ASC 606” or “new revenue standard”) using the modified retrospective method for all incomplete contracts as of the date of adoption. The Company applied the practical expedient to other noncurrent liabilities reflect the total of all contract modifications occurring before January 1, 2018 in the 2016 condensed consolidated balance sheettransaction price and performance obligations at transition rather than accounting for each modification separately. Results for reporting periods beginning on or after January 1, 2018 are presented under ASC 606, while prior period amounts are not adjusted and continue to presentbe reported under the unrecognized tax benefitsaccounting standards in effect for the prior period. As discussed in more detail below and under “Deferred Contract Costs”, the largest impact of implementing the new revenue standard was the deferral and amortization of direct and incremental costs of obtaining contracts. In addition, there were other revisions to the revenue recognition primarily related to state taxes grossperformance obligation determinations and estimating variable consideration. The Company recorded a transition adjustment of federalapproximately $2.7 million, net of $814,000 of tax, benefits, consistent withto the 2017 financial statement presentation. There was no impact on the previously reported net income and earnings per share.opening balance of retained earnings.

Fair Value MeasurementsThe Company derives a majority of its revenues from its annually renewable subscription-based service agreements with its customers, which include performance measurement and improvement services, healthcare analytics and governance education services. Such agreements are generally cancelable on short or no notice without penalty. See Note 2 for further information about the Company's contracts with customers. Under ASC 606, the Company accounts for revenue using the following steps:

The Company’s revenue arrangements with a client may include combinations of more than one service offering which may be executed at the same time, or within close proximity of one another. The Company combines contracts with the same customer into a single contract for accounting purposes when the contract is entered into at or near the same time and the contracts are negotiated as a single performance obligation. For contracts that contain more than one separately identifiable performance obligation, the total transaction price is allocated to the identified performance obligations based upon the relative stand-alone selling prices of the performance obligations. The stand-alone selling prices are based on an observable price for services sold to other comparable customers, when available, or an estimated selling price using a cost plus margin or residual approach. The Company estimates the amount of total contract consideration it expects to receive for variable arrangements based on the most likely amount it expects to earn from the arrangement based on the expected quantities of services it expects to provide and the contractual pricing based on those quantities. The Company only includes some or a portion of variable consideration in the transaction price when it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. The Company considers the sensitivity of the estimate, its relationship and experience with the client and variable services being performed, the range of possible revenue amounts and the magnitude of the variable consideration to the overall arrangement.

Prior to 2018, total contract consideration was allocated to each separate unit of accounting that was separately sold by the Company or a competitor, based on relative selling price using a selling price hierarchy: vendor-specific objective evidence (“VSOE”), if available, third-party evidence (“TPE”) if VSOE was not available, or estimated selling price if VSOE nor TPE was available. VSOE was established based on the services normal selling prices and discounts for the specific services when sold separately. TPE was established by evaluating similar competitor services in standalone arrangements. If neither existed for a deliverable, the best estimate of the selling price (“ESP”) was 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 was limited to revenue that was not subject to refund or otherwise represented contingent revenue.

The Company’s arrangements with customers consist principally of four different types of arrangements: 1) subscription-based service agreements; 2) one-time specified services performed at a single point in time; 3) fixed, non-subscription service agreements; and 4) unit-priced service agreements.

Subscription-based services - Services that are provided under subscription-based service agreements are usually for a twelve month period and represent a single promise to stand ready to provide reporting, tools and services throughout the subscription period as requested by the customer. These agreements are renewable at the option of the customer at the completion of the initial contract term for an agreed upon price increase each year. These agreements represent a series of distinct monthly services that are substantially the same, with the same pattern of transfer to the customer as the customer receives and consumes the benefits throughout the contract period. Accordingly, subscription services are recognized ratably over the subscription period. Subscription services are typically billed annually in advance, but may also be billed on a quarterly and monthly basis.

One-time services – These agreements typically require the Company to perform a specific one-time service in a particular month. The Company is entitled to fixed payment upon completion of the service. Under these arrangements, the Company recognizes revenue at the point in time the service is completed by the Company and accepted by the customer.

Fixed, non-subscription services – These arrangements typically require the Company to perform an unspecified amount of services for a fixed price during a fixed period of time. Revenues are recognized over time based upon the costs incurred to date in relation to the total estimated contract costs. In determining cost estimates, management uses historical and forecasted cost information which is based on estimated volumes, external and internal costs and other factors necessary in estimating the total costs over the term of the contract. Changes in estimates are accounted for using a cumulative catch up adjustment which could impact the amount and timing of revenue for any period. Prior to 2018, these arrangements were recognized under the proportional performance method based on cost inputs, output measures or key milestones such as survey set-up, survey mailings, survey returns and reporting.

Unit-price services – These arrangements typically require the Company to perform certain services on a periodic basis as requested by the customer for a per-unit amount which is typically billed in the month following the performance of the service. Revenue under these arrangements is recognized over the time the services are performed at the per-unit amount.

The Company’s recognizes contract assets or unbilled receivables related to revenue recognized for services completed but not invoiced to the clients. Unbilled receivables are classified as receivables when the Company has an unconditional right to contract consideration. A contract liability is recognized as deferred revenue when we invoice clients in advance of performing the related services under the terms of a contract. Deferred revenue is recognized as revenue when we have satisfied the related performance obligation.

The following tables summarize the impact the adoption of ASC 606 had on the Company’s consolidated financial statements (in thousands, except per share data):

Consolidated balance sheet:

Consolidated statement of income:

Consolidated statement of comprehensive income:

Consolidated statement of cash flows:

Deferred Contract Costs

Deferred contract costs, net is stated at gross deferred costs less accumulated amortization. Beginning January 1, 2018, with the adoption of the new revenue standard, the Company defers commissions and incentives, including payroll taxes, if they are incremental and recoverable costs of obtaining a renewable customer contract. Deferred contract costs are amortized over the estimated term of the contract, including renewals, which generally ranges from three to five years. The contract term was estimated by considering factors such as historical customer attrition rates and product life. The amortization period is adjusted for significant changes in the estimated remaining term of a contract.  An impairment of deferred contract costs is recognized when the unamortized balance of deferred contract costs exceeds the remaining amount of consideration the Company expects to receive less than the expected future costs directly related to providing those services.  The Company deferred incremental costs of obtaining a contract of $828,000 in the three months ended March 31, 2018. Total amortization was $628,000 for the three months ended March 31, 2018, of which $31,000 and $597,000 was included in direct expenses and selling, general and administrative expenses, respectively. Impairment losses, included in selling, general and administrative expenses, related to costs capitalized due to lost clients was $12,000 in 2018. The Company has elected the practical expedient to expense contract costs when incurred for any nonrenewable contracts with a term of one year or less. Prior to 2018, all commissions and incentives were expensed as incurred. The Company recorded a transition adjustment on January 1, 2018 as an increase to retained earnings of $2.6 million, net of $776,000 of tax, to reflect $3.4 million of commissions and incentives related to contracts that began prior to 2018, net of accumulated amortization.

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)(1) Level 1 Inputs—quoted prices in active markets for identical assets and liabilities; (2)(2) Level 2 Inputs—observable market-based inputs other than Level 1 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; and (3)(3) Level 3 Inputs—unobservable inputs.

Commercial paper and Eurodollar deposits are included in cash equivalents and are valued at amortized cost, which approximates fair value due to their short-term nature. Eurodollar deposits are United States dollars deposited in a foreign bank branch of a United States bank and have daily liquidity. Both of these are included as a Level 2 measurement in the table below.

The following details the Company’sCompany’s financial assets and liabilities within the fair value hierarchy at June 30, 2017 March 31, 2018 and December 31, 2016:2017: 

Fair Values Measured on a Recurring Basis

There were no transfers between levels during the three month period ended March 31, 2018.

The Company’sCompany's long-term debt is recorded at historical cost. The following arefair value of long-term debt is classified in Level 2 of the carrying amountsfair value hierarchy and was estimated fair values, using a Level 2 discounted cash flow analysis based primarily on estimated current rates available for debt of the same remaining duration and adjusted for nonperformance and credit risk:credit. The following are the carrying amount and estimated fair values of long-term debt:

The Company believes that the carrying amounts of trade accounts receivable, accounts payable and accrued expenses approximate their fair value due to the short maturity of those instruments. All non-financialLong-lived assets that are not recognized or disclosed at fair value in the financial statements on a recurring basis, which includes property and equipment, goodwill, intangibles, and non-financial long-lived assets,cost method investments are measured at fair value in certain circumstances (for example, when there is evidence of impairment). As of June 30, 2017, March 31, 2018, and December 31, 2016, 2017, there was no indication of impairment related to these assets.

Contingencies

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.

Since the September 2017 announcement of the original proposed recapitalization plan (“Original Transaction”) (see Note 10), three purported class action and/or derivative complaints have been filed in state or federal courts by three individuals claiming to be shareholders of the Company. All of the complaints name as defendants the Company and the individual directors of the Company. Two of these lawsuits were filed in the United States District Court for the District of Nebraska— a putative class action lawsuit captioned Gennaro v. National Research Corporation, et al., which was filed on November 15, 2017, and a putative class and derivative action lawsuit captioned Gerson v. Hays, et al., which was filed on November 16, 2017. These lawsuits were consolidated by order of the federal court under the caption In re National Research Corporation Shareholder Litigation. A third lawsuit was filed in the Circuit Court for Milwaukee County, Wisconsin—a putative class action lawsuit captioned Apfel v. Hays, et al., which was filed on December 1, 2017. The allegations in all of the lawsuits were very similar. The plaintiffs alleged, among other things, that the defendants breached their fiduciary duties in connection with the allegedly unfair proposed transaction, at an allegedly unfair price, conducted in an allegedly unfair and conflicted process and in alleged violation of Wisconsin law and the Company’s non-financial assets.Articles of Incorporation. The plaintiffs in these lawsuits sought, among other things, an injunction enjoining the defendants from consummating the Original Transaction, damages, equitable relief and an award of attorneys’ fees and costs of litigation. Since the December 2017 announcement of a revised proposed recapitalization plan (the “Proposed Recapitalization”), the plaintiffs have abandoned their efforts to enjoin the transaction. However, they have filed amended complaints. The plaintiffs in In re National Research Corporation Shareholder Litigation in Nebraska filed an Amended Complaint on March 23, 2018 seeking damages for alleged breach of fiduciary duties in connection with the Original Transaction and alleged omission of material facts in the proxy statement relating to the Proposed Recapitalization. The plaintiffs in the Apfel case in Wisconsin filed an amended complaint on April 4, 2018 seeking damages for alleged breach of fiduciary duties in connection with the Original Transaction and the Proposed Recapitalization. The Company and its directors will defend themselves against these lawsuits vigorously. As of March 31, 2018, no losses have been accrued as the Company does not believe the losses are probable or estimable.

Recent Accounting Pronouncements Not Yet Adopted

In January 2016, the FASB issued ASU 2016-01, Financial Instruments—Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 changes certain recognition, measurement, presentation and disclosure aspects related to financial instruments. ASU 2016-01 is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is not permitted. The Company believes its adoption will not significantly impact the Company’s results of operations and financial position. 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This ASU requires lessees to recognize a lease liability and a right-to-use asset for all leases, including operating leases, with a term greater than twelve months on its balance sheet. This ASU is effective in fiscal years beginning after December 15, 2018, with early adoption permitted, and requires a modified retrospective transition method. As of March 31, 2018, the Company had approximately $2.7 million of operating lease commitments which would be recorded on the balance sheet under the new guidance. However, the Company is currently in the process of further evaluating the impact that this new guidance will have on its consolidated financial statements and does not plan to elect early adoption.  

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326):  Measurement of Credit Losses on Financial Instruments.  This ASU will require the measurement of all expected credit losses for financial assets, including trade receivables, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The guidance is effective for annual reporting periods beginning after December 15, 2019 and interim periods within those fiscal years. The Company believes its adoption will not significantly impact the Company’s results of operations and financial position.  

The following table disaggregates revenue for the three month period ending March 31, 2018 based on timing of revenue recognition (In thousands):

The following table provides information about receivables, contract assets, and contract liabilities from contracts with customers (In thousands):

Significant changes in contract assets and contract liabilities during 2018 are as follows (in thousands):

The Company has elected to apply the practical expedient to not disclose the value of unsatisfied performance obligations for contracts with an original expected length of one year or less. Total remaining contract revenue for contracts with original duration of greater than one year expected to be recognized in the future related to performance obligations that are unsatisfied at March 31, 2018 approximated $402,000, of which $384,000 will be recognized during the remainder of 2018 and $18,000 will be recognized in 2019.

The effective tax rate for the three-monththree-month period ended June 30, 2017 March 31, 2018 decreased to 32.1%18.5% compared to 35.2%34.7% for the same period in 2016. The effective tax rate for the six-month period ended June 30, 2017 increased to 33.5% compared to 33.1% for the same period in 2016. The decrease in the effective tax rate for the three-month period ending June 30, 2017 was mainly due to a $323,000 increasethe reduction in the corporate tax rate from 35% to 21% due to the Tax Cut and Jobs Act (the “Tax Act”) that was enacted on December 22, 2017. In addition, the Company had increased tax benefits of $350,000 from the exercise of options and dividends paid to non-vested shareholders. The increase in the effective tax rate for the six-month period ended June 30, 2017 was due to increases in the estimated state tax rates as well as a greater proportion of United States income subject to higher tax rates than Canadian income,shareholders partially offset by increased tax benefits in 2017 from the exercise$67,000 of options and dividends paid to non-vested shareholders.  In addition, state tax incentives decreased by $38,000, and, in 2016, the United States federal tax examination adjustments decreasedadditional tax expense by $48,000.from non-deductible recapitalization expenses. 

The Company’sbalance on the Company’s term note is payablewas paid in monthly installments of $212,468. Borrowings under the term note bear interest at an annual rate of 3.12%. The outstanding balance of the term note at June 30, 2017 was $2.1 million.full in March 2018.

TheAs of March 31, 2018, the Company also hashad a revolving credit note which was amended and extended effective June 30, 2017 with a maturity date of June 30, 2018. The maximum aggregate amount available under the revolving credit note is $12.0 million. Borrowings under the revolving credit note bear interest at a variable annual rate, with three rate options at the discretion of management as follows: (1) 2.1% plus the one-month London Interbank Offered Rate (“LIBOR”) or (2) 2.1% plus the one-, two- or three- month LIBOR rate, or (3) the bank’s one-, two, three, six, or twelve month Money Market Loan Rate. As of June 30, 2017 March 31, 2018, the revolving credit note did not have a balance and the Company had the capacity to borrow $12.0$12.0 million. The revolving credit note was terminated in April 2018 when the Company entered a new credit agreement, as described in Note 10.

The term note and revolving credit note arewere secured by certain of the Company’sCompany’s assets, including the Company’s land, building, trade accounts receivable and intangible assets. The term note and revolving credit note containcontained various restrictions and covenants applicable to the Company, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions on the ability of the Company to consolidate or merge, create liens, incur additional indebtedness or dispose of assets. As of June 30, 2017, March 31, 2018, the Company was in compliance with its financial covenants.

The Company measures and recognizes compensation expense for all share-based payments based on the grant-date fair value of those awards. All of the Company’sCompany’s existing stock option awards and unvested stock awards have been determined to be equity-classified awards.  As described in Note 10, the Company completed a recapitalization in April which settled all existing outstanding class B share-based awards, resulted in the elimination of the existing class B common stock and reclassified class A common stock to Common Stock.

The Company’s Company’s 2001 Equity Incentive Plan provided for the granting of stock options, stock appreciation rights, restricted stock, performance shares and other share-based awards and benefits up to an aggregate of 1,800,000 shares of the Company's former class A common stock and 300,000 shares of the Company's former class B common stock. Stock options granted could have been either nonqualified or incentive stock options. Stock options vest over one to five years following the date of grant and option terms are generally five to ten years following the date of grant.

The Company’s Company’s 2004 Non-Employee Director Stock Plan, as amended (the “2004“2004 Director Plan”), is a nonqualified plan that provides for the granting of options with respect to 3,000,000 shares of the Company's former class A common stock and 500,000 shares of the Company's former class B common stock. The 2004 Director Plan provides for grants of nonqualified stock options to each director of the Company who is not employed by the Company. On the date of each annual meeting of shareholders of the Company through 2017,options to purchase 36,000 shares of the Company's former class A common stock and 6,000 shares of the Company's former class B common stock arewere granted to directors that are elected or retained as a director at such meeting. Stock options vest one year following the date of grant and option terms are generally ten years following the date of grant, or three years in the case of termination of the outside director’s service.

The Company’s Company’s 2006 Equity Incentive Plan provides for the granting of stock options, stock appreciation rights, restricted stock, performance shares and other share-based awards and benefits up to an aggregate of 1,800,000 shares of former class A common stock and 300,000 shares of former class B common stock. Stock options granted may be either incentive stock options or nonqualified stock options. Vesting terms vary with each grant and option terms are generally five to ten years following the date of grant.

The Company granted options to purchase 299,91774,516 shares of the Company’s former class A common stock and 49,986 shares of the class B common stock during the six-monththree-month period ended June 30, 2017. March 31, 2018. Options to purchase shares of common stock were granted with exercise prices equal to the fair value of the common stock on the date of grant. The fair value of the stock options granted was estimated using a Black-Scholes valuation model with the following assumptions:

The risk-free interest rate assumptions were based on the U.S. Treasury yield curve in effect at the time of the grant. The expected volatility was based on historical monthly price changes of the Company’sCompany’s common stock based on the expected life of the options at the date of grant. The expected life of options is the average number of years the Company estimates that options will be outstanding. The Company considers groups of associates that have similar historical exercise behavior separately for valuation purposes.

The following table summarizes stock option activity under the Company’s Company’s 2001 and 2006 Equity Incentive Plans and the 2004 Director Plan for the three months ended June 30, 2017:March 31, 2018: