Note 1–Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of PC Connection, Inc. and its subsidiaries (the “Company,” “we,” “us,” or “our”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting and in accordance with accounting principles generally accepted in the United States of America. Such principles were applied on a basis consistent with the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the Securities and Exchange Commission (the “SEC”), other than the adoption of Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers” (“ASC 606”) under the modified retrospective method as of January 1, 2018, as discussed below. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in our Annual Report on Form 10-K.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the results of operations for the interim periods reported and of the Company’s financial condition as of the date of the interim balance sheet. The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated through the date of issuance of these financial statements. The operating results for the three and nine months ended September 30, 2018 may not be indicative of the results expected for any succeeding quarter or the entire year ending December 31, 2018.

Revenue Recognition

On January 1, 2018, we adopted ASC 606, which replaced existing revenue recognition rules with a comprehensive revenue measurement and recognition standard and expanded disclosure requirements. See Adoption of Recently Issued Accounting Standards within this footnote for additional information.

Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. In most instances, when several performance obligations are aggregated into one single transaction, these performance obligations are fulfilled at the same point in time. We account for an arrangement when it has approval and commitment from both parties, the rights are identified, the contract has commercial substance, and collectability of consideration is probable. We generally obtain oral or written purchase authorizations from our customers for a specified amount of product at a specified price, which constitutes an arrangement. Revenue is recognized at the amount expected to be collected, net of any taxes collected from customers, which are subsequently remitted to governmental authorities. We generally invoice for our products at the time of shipping, and accordingly there is not a significant financing component included in our arrangements.

Nature of Products and Services

Information technology (“IT”) products typically represent a distinct performance obligation, and revenue is recognized at the point in time when control is transferred to the customer which is generally upon delivery to the customer. We recognize revenue as the principal in the transaction with the customer (i.e., on a gross basis), as we control the product prior to delivery to the customer and derive the economic benefits from the sales transaction given our control over customer pricing.

We do not recognize revenue for goods that remain in our physical possession before the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from the products, the goods are ready for physical transfer to and identified as belonging to the customer, and when we have no ability to use the product or to direct it to another customer.

Licenses for on-premise software provide the customer with a right to take possession of the software. Customers may purchase perpetual licenses or enter into subscriptions to the licensed software. We are the principal in these transactions and recognize revenue for the on-premise license at the point in time when the software is made available to the customer and the commencement of the term of the software license or when the renewal term begins, as applicable.

For certain on-premise licenses for security software, the customer derives substantially all of the benefit from these arrangements through the third-party delivered software maintenance, which provides software updates and other support services. We do not have control over the delivery of these performance obligations, and accordingly we are the agent in these transactions. We recognize revenue for security software net of the related costs of sales at the point in time when our vendor and customer accept the terms and conditions in the sales arrangement. Cloud products allow customers to use hosted software over the contractual period without taking possession of the software and are provided on a subscription basis. We do not exercise control over these products or services and therefore are an agent in these transactions. We recognize revenue for cloud products net of the related costs of sales at the point in time when our vendor and customer accept the terms and conditions in the sales arrangements.

Certain software sales include on-premise licenses that are combined with software maintenance. Software maintenance conveys rights to updates, bug fixes and help desk support, and other support services transferred over the underlying contract period. On-premise licenses are considered distinct performance obligations when sold with the software maintenance, as we sell these items separately. We recognize revenue related to the software maintenance as the agent in these transactions because we do not have control over the on-going software maintenance service. Revenue allocated to software maintenance is recognized at the point in time when our vendor and customer accept the terms and conditions in the sales arrangements.

Certain of our larger customers are offered the opportunity by vendors to purchase software licenses and maintenance under enterprise agreements (“EAs”). Under EAs, customers are considered to be compliant with applicable license requirements for the ensuing year, regardless of changes to their employee base. Customers are charged an annual true-up fee for changes in the number of users over the year. With most EAs, our vendors will transfer the license and bill the customer directly, paying resellers, such as us, an agency fee or commission on these sales. We record these agency fees as a component of net sales as earned and there is no corresponding cost of sales amount. In certain instances, we invoice the customer directly under an EA and account for the individual items sold based on the nature of each item. Our vendors typically dictate how the EA will be sold to the customer.

We also offer extended service plans (“ESP”) on IT products, both as part of the initial arrangement and separately from the IT products. We recognize revenue related to ESP as the agent in the transaction because we do not have control over the on-going ESP service and do not provide any service after the sale. Revenue allocated to ESP is recognized at the point in time when our vendor and customer accept the terms and conditions in the sales arrangement.

We use our own engineering personnel in projects involving the design and installation of systems and networks, and we also engage third-party service providers to perform warranty maintenance, implementations, asset disposal, and other services. Service revenue is recognized in general over time as we perform the underlying services and satisfy our performance obligations. We evaluate such engagements to determine whether we are the principal or the agent in each transaction. For those transactions in which we do not control the service, we act as an agent and recognize the transaction revenue on a net basis at a point in time when the vendor and customer accept the terms and conditions in the sales arrangement.

All amounts billed to a customer in a sales transaction related to shipping and handling, if any, represent revenues earned for the goods provided, and these amounts have been included in net sales. Costs related to shipping and handling billing are classified as cost of sales. Sales are reported net of sales, use, or other transaction taxes that are collected from customers and remitted to taxing authorities.

Significant Judgments

Our contracts with customers often include promises to transfer multiple products or services to a customer. Determining whether we are the agent or the principal and whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.

We estimate the standalone selling price (“SSP”) for each distinct performance obligation when a single arrangement contains multiple performance obligations and the fulfillment occurs at different points of times. We maximize the use of observable inputs in the determination of the estimate for SSP for the items that we do not sell separately, including on-premise licenses sold with software maintenance, and IT products sold with ESP. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs.

We provide our customers with a limited thirty-day right of return which is generally limited to defective merchandise. Revenue is recognized at delivery and a reserve for sales returns is recorded. We make estimates of product returns based on significant historical experience and record our sales return reserves as a reduction of revenues and either as reduction of accounts receivable or, for customers who have already paid, as accrued expenses.

Description of Revenue

We disaggregate revenue from our arrangements with customers by type of products and services, as we believe this method best depicts how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors.

The following table represents a disaggregation of revenue from arrangements with customers for the three months ended September 30, 2018 and 2017, along with the reportable segment for each category.


	Three Months Ended September 30, 2018
	Business Solutions		Enterprise Solutions		Public Sector Solutions		Total
Notebooks/Mobility	$	68,822	$	63,926	$	50,079	$	182,827
Software (1)		31,578		25,718		15,541		72,837
Desktops		25,828		30,075		13,112		69,015
Servers/Storage		26,386		21,424		13,115		60,925
Net/Com products		27,380		16,601		12,745		56,726
Other hardware/services		64,878		107,733		43,563		216,174
Total net sales	$	244,872	$	265,477	$	148,155	$	658,504

(1) Certain software sales are reported on a net basis for the three months ended September 30, 2018 as a result of the adoption of ASC 606, but in the prior year would have been reported on a gross basis under the previous revenue recognition guidance – see the information below under the caption “Adoption of Recently Issued Accounting Standards”.


	Three Months Ended September 30, 2017
	Business Solutions		Enterprise Solutions		Public Sector Solutions		Total
Notebooks/Mobility	$	77,374	$	50,835	$	39,369	$	167,578
Software		66,094		67,623		39,579		173,296
Desktops		29,849		25,873		16,869		72,591
Servers/Storage		29,142		19,090		14,110		62,342
Net/Com products		24,085		14,645		11,855		50,585
Other hardware/services		64,025		89,956		48,857		202,838
Total net sales	$	290,569	$	268,022	$	170,639	$	729,230

The following table represents a disaggregation of revenue from arrangements with customers for the nine months ended September 30, 2018 and 2017, along with the reportable segment for each category.


	Nine Months Ended September 30, 2018
	Business Solutions		Enterprise Solutions		Public Sector Solutions		Total
Notebooks/Mobility	$	222,550	$	195,909	$	109,238	$	527,697
Software (1)		104,377		91,522		33,447		229,346
Desktops		82,518		91,307		41,948		215,773
Servers/Storage		85,190		70,262		46,753		202,205
Net/Com products		83,546		49,093		36,618		169,257
Other hardware/services		200,011		325,693		119,987		645,691
Total net sales	$	778,192	$	823,786	$	387,991	$	1,989,969

(1) Certain software sales are reported on a net basis for the nine months ended September 30, 2018 as a result of the adoption of ASC 606, but in the prior year would have been reported on a gross basis under the previous revenue recognition guidance – see the information below under the caption “Adoption of Recently Issued Accounting Standards”.


	Nine Months Ended September 30, 2017
	Business Solutions		Enterprise Solutions		Public Sector Solutions		Total
Notebooks/Mobility	$	226,152	$	150,799	$	99,999	$	476,950
Software		195,972		203,320		76,384		475,676
Desktops		85,994		76,015		78,045		240,054
Servers/Storage		85,949		59,864		40,290		186,103
Net/Com products		71,831		51,115		45,565		168,511
Other hardware/services		194,724		281,904		125,694		602,322
Total net sales	$	860,622	$	823,017	$	465,977	$	2,149,616

Contract Balances

The following table provides information about contract liability from arrangements with customers as of September 30, 2018 and January 1, 2018:


	September 30, 2018		January 1, 2018
Contract liability, which are included in "Accrued expenses and other liabilities"	$	2,629	$	2,914

Significant changes in the contract liability balances during the three and nine months ended September 30, 2018 are as follows (in thousands):


	Three Months Ended
	September 30,
Balances at July 1,2018	$	8,433
Cash received in advance and not recognized as revenue		1,024
Amounts recognized as revenue as performance obligations satisfied		(6,828)
Balances at September 30, 2018	$	2,629

	Nine Months Ended
	September 30,
Balances at January 1, 2018	$	2,914
Cash received in advance and not recognized as revenue		9,520
Amounts recognized as revenue as performance obligations satisfied		(9,805)
Balances at September 30, 2018	$	2,629

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the amounts reported in the accompanying condensed consolidated financial statements. Actual results could differ from those estimates.

Comprehensive Income

We had no items of comprehensive income, other than our net income for each of the periods presented.

Adoption of Recently Issued Accounting Standards

On May 28, 2014, the Financial Accounting Standards Board, or the FASB, issued ASC 606, which amended the accounting standards for revenue recognition and expanded our disclosure requirements. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

On January 1, 2018 we adopted ASC 606 using the modified retrospective transition method, which resulted in an adjustment at January 1, 2018, to retained earnings for the cumulative effect of applying the standard to all contracts not completed as of the adoption date. Upon adoption we recorded $1,197 as an increase to retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods.

The adoption resulted in an acceleration of the timing of revenue recognized for certain transactions where product that remained in our possession has been recognized as of the transaction date when all revenue recognition criteria have been met.

The following table presents the effect of the adoption of ASC 606 on our condensed consolidated balance sheet as of January 1, 2018:


				Adjustments
		Balance at		Due to ASU		Balance at
		December 31, 2017		2014-09		January 1, 2018
Balance Sheet
Assets
Accounts receivable, net	$	449,682	$	14,568	$	464,250
Inventories		106,753		(10,869)		95,884
Prepaid expenses and other current assets		5,737		(132)		5,605
Long-term accounts receivable		—		1,890		1,890
Other assets		5,638		(3,914)		1,724

Liabilities
Accounts payable		194,257		(62)		194,195
Accrued expenses and other liabilities		31,096		(312)		30,784
Accrued payroll		22,662		291		22,953
Deferred income taxes		15,696		429		16,125


Stockholders' Equity
Retained earnings	$	383,673	$	1,197	$	384,870

In addition to the timing of revenue recognition impacted by the above described transactions, upon adoption of ASC 606, the amount of revenue to be recognized prospectively was affected by the presentation of revenue transactions as an agent instead of principal in the following transactions:

Revenue related to the sale of cloud products as well as certain security software is now being recognized net of costs of sales as we determined that we act as an agent in these transactions. These sales are recorded on a net basis at a point in time when our vendor and the customer accept the terms and conditions in the sales arrangement. In addition, we sell third-party software maintenance that is delivered over time either separately or bundled with the software license. We have determined that software maintenance is a distinct performance obligation that we do not control, and accordingly, we act as an agent in these transactions and recognize the related revenue on a net basis under ASC 606. We previously recognized revenue for cloud products, security software, and software maintenance on a gross basis (i.e., acting as a principal). This change reduced both net sales and cost of sales with no impact on reported gross profit as compared to our prior accounting policies.

The following tables present the effect of the adoption of ASC 606 on our condensed consolidated income statement and balance sheet for the three and nine months ended September 30, 2018 and as of September 30, 2018, respectively:


		Three Months Ended September 30, 2018						Nine Months Ended September 30, 2018
						Balances without						Balances without
		As				Adoption of		As				Adoption of
		Reported		Adjustments		ASC 606		Reported		Adjustments		ASC 606
Income statement
Revenues
Net sales	$	658,504	$	107,826	$	766,330	$	1,989,969	$	296,583	$	2,286,552

Costs and expenses
Cost of sales		558,060		107,575		665,635		1,685,685		295,540		1,981,225

Income from operations		18,950		224		19,174		59,369		808		60,177
Income before taxes		19,064		224		19,288		59,781		808		60,589
Net income		13,766		162		13,928		43,292		584		43,876


		September 30, 2018
						Balances without
		As				Adoption of
		Reported		Adjustments		ASC 606
Balance Sheet
Assets
Accounts receivable, net	$	400,831	$	(4,463)	$	396,368
Inventories		105,283		6,059		111,342
Prepaid expenses and other current assets		6,068		129		6,197
Other assets		1,442		3,914		5,356

Liabilities
Accrued expenses and other liabilities	$	23,475	$	4,670	$	28,145
Accrued payroll		20,359		(103)		20,256
Deferred income taxes		16,125		(205)		15,920

Stockholders' Equity
Retained earnings	$	428,162	$	(613)	$	427,549

We have elected the use of certain practical expedients in our adoption of the new standard, which includes continuing to record revenue reported net of applicable taxes imposed on the related transaction and the application of the new standard to all arrangements not completed as of the adoption date. We have also elected to use the practical expedient to not account for the shipping and handling as separate performance obligations. Adoptions of the standard related to revenue recognition had no net impact on our condensed consolidated statement of cash flows.

Recently Issued Financial Accounting Standards

In February 2016, the FASB issued ASU 2016-02, Leases. The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than twelve months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, or by not adjusting the comparative periods and recording a cumulative effect adjustment as of the adoption date, with certain practical expedients available. The Company has reviewed the requirements of the new standard and has formulated a plan for implementation. The Company is currently accumulating details on the population of leases and lease assets and has selected a software repository to track all of its lease agreements and to assist in the reporting and disclosures required by the new standard. The Company will continue to assess and disclose the impact that the new standard will have on its consolidated financial statements, disclosures, and related controls, when known.

In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment, which simplifies the accounting for goodwill impairments by eliminating step two from the goodwill impairment test. Instead, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. ASU 2017-04 also clarifies the requirements for excluding and allocating foreign currency translation adjustments to reporting units related to an entity's testing of reporting units for goodwill impairment and clarifies that an entity should consider income tax effects from any tax-deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The new standard is effective for fiscal years beginning January 1, 2020 for both interim and annual reporting periods. The Company is currently assessing the potential impact of the adoption of ASC 2017-04 on its consolidated financial statements.