2. Restatement of the Condensed Consolidated Financial Statements

Background

In July 2013, the Audit Committee (the “Audit Committee”) of the Company’s Board of Directors (the “Board”) commenced an independent review with the assistance of outside professionals into whether the Company had properly recognized revenue under U.S. generally accepted accounting principles (“GAAP”) in connection with certain revenue that had been recorded in 2012 and 2011 (the “Independent Review”). In conjunction with the Independent Review, the Company concluded that material errors existed in the previously issued financial statements for the fiscal years ended December 31, 2012, 2011 and 2010 (as well as the interim quarterly periods within such years), as well as for the interim quarterly period ended March 31, 2013. In addition, the Company has identified and corrected errors occurring prior to January 1, 2010 by recognizing a cumulative adjustment to beginning retained earnings in the consolidated statements of changes in shareholders’ equity included in the consolidated financial statements filed with the 2012 Form 10-K/A.

In reaching these conclusions, the Company considered information obtained in the Independent Review, including emails, data and interviews with current and former employees that indicated (i) the existence of extra-contractual terms or arrangements at the onset of the sale and concessions agreed to subsequent to the initial sale, such as extended payment terms, and return and exchange rights for sales to distributors with respect to certain transactions, (ii) that at the time of some sales collection was not reasonably assured, and (iii) that certain amounts previously characterized as commissions were paid to related parties of the applicable customer.

The Company assessed the information derived from the Independent Review in making determinations with respect to accounting adjustments reflected in the restated consolidated financial statements contained in this Form 10-Q/A and in the 2012 Form 10-K/A, and such determinations are consistent with the findings of the Independent Review. In addition to the matters that were the subject of the Independent Review, certain other adjustments identified by management, including revisions to inventory reserves and royalties, were made to the consolidated financial statements in connection with the restatement.

The correction of these errors had the following impact for the three months ended March 31, 2013 and March 31, 2012: increased net sales by $3.1 million and decreased net sales by $7.1 million, respectively; and increased net income from continuing operations by $2.7 million and decreased net income from continuing operations by $3.6 million, respectively. The following include descriptions of the significant adjustments to the Company’s financial position and results of operations from the previously reported consolidated financial statements.

Distributor Revenue Recognition

The Company has determined that it previously recognized revenue with respect to certain distributor relationships before all revenue recognition criteria were met. Specifically, the Company has determined that a fixed or determinable sales price did not exist, and/or collection was not reasonably assured, with respect to certain transactions where revenue had previously been recognized at the time of shipment. Specifically, the Company’s review revealed arrangements, or extra-contractual terms, with certain of the Company’s distributors regarding extended payment terms, return or exchange rights, and contingent payment obligations for sales to such distributors with respect to certain transactions. There were also concessions being made subsequent to the shipment of inventory to the distributors and the related revenue recognition. Based on the results of this review, it was determined that these arrangements were not appropriately evaluated under the appropriate revenue recognition criteria applicable under GAAP.

The Company previously recognized distributor revenue as title and risk of loss passed at either shipment from the Company’s facilities or receipt at the distributor’s facility, assuming all other revenue recognition criteria had been achieved (the “sell-in method”). Based on review of all facts and circumstances related to the arrangements described above, the Company determined that in many instances the revenue recognition criteria under the sell-in method were not satisfied at the time of shipment or receipt; specifically, the existence of extra-contractual terms or arrangements caused the Company not to meet the fixed or determinable criteria for revenue recognition in some cases, and in others collectability had not been established. In situations where the Company is unable to reasonably estimate the effects of these extra-contractual terms, it is precluded from recognizing revenue relating to distributor arrangements until the product is delivered to the end customer. This method is commonly referred to as the “sell-through” revenue recognition method because the vendor does not recognize revenue until the transaction consideration is fixed or determinable, which coincides with the selling of the product through the distribution channel to the end customer. Because the Company does not have reliable information about when its distributors sell the product through to end customers, the Company will use cash collection from distributors as a basis for revenue recognition under the sell-through method. Although in many cases the Company is legally entitled to the accounts receivable at the time of shipment, since the revenue recognition criteria has not been met, the Company has not recognized accounts receivables or any corresponding deferred revenues associated with these transactions.

As part of the review, the Company also considered the accounting treatment for the related cost of sales when distributor revenue is recognized on a sell-through basis. Previously, cost of sales were recognized upon shipment; however, the Company believes the matching of the recognition of costs of sales with revenue is preferred and therefore considered if such costs should be deferred until revenue is recognized on a sell-through basis. In making this assessment, the Company considered the financial viability of its distributors based on their creditworthiness to determine if collectability of amounts sufficient to realize the costs of the products shipped was reasonably assured at the time of shipment to these distributors. In instances where the distributor was determined to be financially viable, the Company determined that costs of sales should be deferred until the revenue is recognized. For those distributors where the Company has concluded that collectability was not reasonably assured, the Company has expensed the related cost of sales upon shipment.

Based on the results of the Independent Review, the Company determined that all distributor transactions should be transitioned to the sell-through method of accounting as of the dates described below:

•

For distributor transactions within the Company’s Orthopedics division, the Company has determined that sell-through accounting should be applied within the Brazil subsidiary for all prior periods given the frequency with which the Company conducted business under extra-contractual and undocumented terms, as well as the Company’s inability to fully access underlying transactional and other information that would be necessary to evaluate transactions under a sell-in basis. For distributor transactions within the division outside the Brazil subsidiary, there were also sales to four distributors that did not meet the fixed or determinable or collectability revenue recognition criteria and therefore, such sales were adjusted to sell-through accounting in the restatement.

•

For distributor transactions within the Company’s U.S. Spine division, the Company has determined that sell-through accounting should be applied beginning January 1, 2011. Following its consideration of the information provided from the Independent Review, the Company believes that January 1, 2011 is the date extra-contractual terms became pervasive in the Company’s U.S. business, and it is unaware of circumstances existing prior to that date that would require it to broadly apply sell-through accounting to all distributor transactions within the U.S. Spine division. Additionally, there were sales in 2012 and 2011 for which revenue was previously recognized that did not meet the fixed or determinable criteria and the product associated with such sales was subsequently returned in 2013 (i) under the terms of negotiated agreements whereby the Company terminated its relationships with two distributors and (ii) by an additional distributor who returned certain product sold pursuant to a contingent sales arrangement. Such sales represented approximately $3.3 million for the year ended December 31, 2012. Due to the return of the product, no revenue will be recognized for these transactions.

•

The Company has determined that stimulation products sold to distributors within the Company’s U.S. Spine division during 2012 did not meet the fixed or determinable (and in some cases, collectability) revenue recognition criterion at the time of shipment. Therefore, the Company has determined that sell-through accounting should be applied for these sales. Management also determined that many of these distributors (or affiliates thereof) received commission payments as part of the sales transactions, which the Company previously recorded as sales and marketing expense. The Company has recorded adjustments in the restatement to net these commission expenses against revenue, as they represented product discounts.

•

The Company has determined that it will prospectively apply sell-through accounting for all remaining distributor arrangements (which entails arrangements within the Company’s Orthopedics division outside the Brazil subsidiary) beginning April 1, 2013, the earliest date for which financial statements have not previously been issued by the Company. Although the Independent Review did not provide information to indicate extra-contractual terms or that historical revenue recognition was inappropriate in these remaining instances, the Company believes the information from the Independent Review indicating that the Company has a history of extra-contractual arrangements for distributor transactions, as described above, provides additional information which should be considered in reassessing the application of sell-through accounting on a prospective basis, particularly given that the Company believes that there is a higher risk associated with distributor arrangements generally.

The effect of adjustments made to the Company’s previously filed consolidated statements of operations as a result of these matters are shown in the tables below. These adjustments also had the following effects on the Company’s previously filed consolidated balance sheets:

•

Accounts receivable decreased as of March 31, 2013 and December 31, 2012 by $34.3 million and $41.3 million, respectively, related to the de-recognition of receivables for which revenue has been deferred and will now be recognized on a sell-through basis, based on cash collections.

•

Inventory increased as of March 31, 2013 and December 31, 2012 by $8.8 million and $11.0 million, respectively, to recognize the costs of inventory shipments to distributors determined to be financially viable as discussed previously.

Inventory Reserves

The Company also identified material errors in inventory reserves. One error related to the Company recording an increase of $1.2 million to the Company’s excess and obsolete reserve in the second quarter of 2012 related to a product within the Spine business that was subsequently reversed by the Company in the fourth quarter of 2012. During the Company’s review, it was determined that removing the reserve in the fourth quarter of 2012 was not correct; therefore the reserve has been reinstated.

The Company has also determined that certain inconsistencies existed with respect to how the Company previously computed and recorded inventory reserves. As a result, the Company has reviewed the methodologies used to compute and record inventory reserves and determined that errors in the application of GAAP existed in prior periods, which required adjustment in these financial statements. Based on this review, the Company has determined that it previously made reductions to previously recorded reserves based on changes in forecasted demand, which it believes was contrary to guidance set forth in ASC Topic 330, Inventory (specifically ASC 330-10-35-14), which states that a write-down of inventory to the lower-of-cost-or-market value at the close of a fiscal year creates a new cost basis that subsequently should not be marked up based on changes in underlying circumstances. The restated consolidated financial statements contain several adjustments to reflect recomputed inventory reserves in each of the relevant periods.

These adjustments resulted in a decrease to inventory (due to an increase in reserves) as of March 31, 2013 and December 31, 2012 of $14.8 million and $14.8 million, respectively.

Royalties

The Company also reviewed the accounting for royalties and determined there were royalties classified as sales and marketing expense; however, such royalties were based on sales of products and were paid to doctors who consulted on development of those products. Given these amounts are attributable to the cost of producing our products, we determined they are correctly classified as cost of goods sold.

Other Adjustments

In addition to the adjustments recorded to address the Company’s errors in accounting for distributor revenue recognition, inventory reserves, and royalties, the Company has identified other errors that are generally not material, individually or in the aggregate, but have been recorded in connection with the restatement.

There were no material impacts to the statements of cash flows for the items above. The results of the adjustments to the Company’s previously filed consolidated statements of operations detailed above are summarized in the tables below. The tax effect of the adjustments is estimated based on the Company’s effective tax rate.


	Three Months Ended March 31, 2013
				Adjustments by Category
	Previously			Distributor			Inventory									Total
(U.S. Dollars, in thousands)	Reported			Revenue			Reserves			Royalties			Other			Adjustments			Restated
Net sales	$	100,254		$	2,963		$	—		$	—		$	156		$	3,119		$	103,373
Cost of sales		22,699			471			86			2,030			331			2,918			25,617

Gross profit		77,555			2,492			(86	)		(2,030	)		(175	)		201			77,756
Operating expenses
Sales and marketing		48,839			(2,073	)		—			(2,030	)		318			(3,785	)		45,054
General and administrative		18,788			—			—			—			(458	)		(458	)		18,330
Research and development		5,400			—			—			—			341			341			5,741
Amortization of intangibles assets		504			—			—			—			40			40			544
Charges related to U.S. Government resolutions		—			—			—			—			—			—			—

		73,531			(2,073	)		—			(2,030	)		241			(3,862	)		69,669

Operating income		4,024			4,565			(86	)		—			(416	)		4,063			8,087
Other income and (expense)		4,204			—			—			—			—			—			4,204

Income before income taxes		8,228			4,565			(86	)		—			(416	)		4,063			12,291
Income tax expense		(3,320	)		(1,529	)		29			—			139			(1,361	)		(4,681	)

Net income from continuing operations, net of tax	$	4,908		$	3,036		$	(57	)	$	—		$	(277	)	$	2,702		$	7,610


	Three Months Ended March 31, 2012
				Adjustments by Category
	Previously			Distributor			Inventory									Total
(U.S. Dollars, in thousands)	Reported			Revenue			Reserves			Royalties			Other			Adjustments			Restated
Net sales	$	116,042		$	(7,394	)	$	—		$	—		$	288		$	(7,106	)	$	108,936
Cost of sales		21,940			(1,471	)		(1,212	)		2,126			(5	)		(562	)		21,378

Gross profit		94,102			(5,923	)		1,212			(2,126	)		293			(6,544	)		87,558
Operating expenses
Sales and marketing		49,521			(417	)		—			(2,126	)		150			(2,393	)		47,128
General and administrative		14,570			—			—			—			—			—			14,570
Research and development		7,050			—			—			—			—			—			7,050
Amortization of intangibles assets		530			—			—			—			50			50			580
Charges related to U.S. Government resolutions		—			—			—			—			310			310			310

		71,671			(417	)		—			(2,126	)		510			(2,033	)		69,638

Operating income		22,431			(5,506	)		1,212			—			(217	)		(4,511	)		17,920
Other income and (expense)		(2,852	)		—			—			—			—			—			(2,852	)

Income before income taxes		19,579			(5,506	)		1,212			—			(217	)		(4,511	)		15,068
Income tax expense		(7,363	)		1,089			(240	)		—			43			892			(6,471	)

Net income from continuing operations, net of tax	$	12,216		$	(4,417	)	$	972		$	—		$	(174	)	$	(3,619	)	$	8,597

The effects of the restatement on the Company’s condensed consolidated balance sheet as of March 31, 2013 are as follows:


(Unaudited, U.S. Dollars, in thousands, except share data)	As of March 31, 2013
	Previously Reported			Adjustments			Restated
Assets
Current assets:
Cash and cash equivalents	$	33,675		$	—		$	33,675
Restricted cash		29,446			—			29,446
Trade accounts receivable, less allowances of $11,731		132,425			(35,919	)		96,506
Inventories		92,133			(7,442	)		84,691
Deferred income taxes		17,363			16,552			33,915
Prepaid expenses and other current assets		32,211			2,179			34,390

Total current assets		337,253			(24,630	)		312,623
Property, plant and equipment, net		52,402			1,717			54,119
Patents and other intangible assets, net		6,765			170			6,935
Goodwill		72,607			—			72,607
Deferred income taxes		20,200			(1,024	)		19,176
Other long-term assets		14,153			(3,855	)		10,298

Total assets	$	503,380		$	(27,622	)	$	475,758

Liabilities and shareholders’ equity
Current liabilities:
Trade accounts payable	$	14,230		$	757		$	14,987
Other current liabilities		51,295			(6,566	)		44,729

Total current liabilities		65,525			(5,809	)		59,716
Long-term debt		20,000			—			20,000
Deferred income taxes		11,460			765			12,225
Other long-term liabilities		4,227			6,198			10,425

Total liabilities		101,212			1,154			102,366
Contingencies (Note 17)
Shareholders’ equity:
Common shares $0.10 par value; 50,000,000 shares authorized; 19,453,294 issued and outstanding		1,945			—			1,945
Additional paid-in capital		250,186			195			250,381
Retained earnings		150,665			(31,318	)		119,347
Accumulated other comprehensive income		(628	)		2,347			1,719

Total shareholders’ equity		402,168			(28,776	)		373,392

Total liabilities and shareholders’ equity	$	503,380		$	(27,622	)	$	475,758

The effects of the restatement on the Company’s condensed consolidated balance sheet as of December 31, 2012 are as follows:


(Unaudited, U.S. Dollars, in thousands, except share data)	As of December 31, 2012
	Previously Reported		Adjustments			Restated
Assets
Current assets:
Cash and cash equivalents	$	31,055	$	—		$	31,055
Restricted cash		21,314		—			21,314
Trade accounts receivable, less allowances of $13,543		150,316		(43,004	)		107,312
Inventories		88,744		(5,371	)		83,373
Deferred income taxes		16,959		16,491			33,450
Prepaid expenses and other current assets		32,056		2,023			34,079

Total current assets		340,444		(29,861	)		310,583
Property, plant and equipment, net		51,362		2,473			53,835
Patents and other intangible assets, net		6,880		410			7,290
Goodwill		74,388		—			74,388
Deferred income taxes		19,904		(1,023	)		18,881
Other long-term assets		11,303		(3,383	)		7,920

Total assets	$	504,281	$	(31,384	)	$	472,897

Liabilities and shareholders’ equity
Current liabilities:
Trade accounts payable	$	21,812	$	763		$	22,575
Other current liabilities		46,985		(7,375	)		39,610

Total current liabilities		68,797		(6,612	)		62,185
Long-term debt		20,000		—			20,000
Deferred income taxes		11,456		—			11,456
Other long-term liabilities		4,930		6,494			11,424

Total liabilities		105,183		(118	)		105,065
Contingencies (Note 17)
Shareholders’ equity:
Common shares $0.10 par value; 50,000,000 shares authorized; 19,339,329 issued and outstanding		1,934		—			1,934
Additional paid-in capital		246,111		195			246,306
Retained earnings		148,549		(33,702	)		114,847
Accumulated other comprehensive income		2,504		2,241			4,745

Total shareholders’ equity		399,098		(31,266	)		367,832

Total liabilities and shareholders’ equity	$	504,281	$	(31,384	)	$	472,897

The effects of the restatements on the Company’s condensed consolidated statement of operations and comprehensive income (loss) for the three months ended March 31, 2013 are as follows:


(Unaudited, U.S. Dollars, in thousands, except share and per share data)	Three Months Ended March 31, 2013
	Previously Reported			Adjustments			Restated
Product sales	$	88,358		$	2,978		$	91,336
Marketing service fees		11,896			141			12,037

Net sales		100,254			3,119			103,373
Cost of sales		22,699			2,918			25,617

Gross profit		77,555			201			77,756
Operating expenses
Sales and marketing		48,839			(3,785	)		45,054
General and administrative		18,788			(458	)		18,330
Research and development		5,400			341			5,741
Amortization of intangible assets		504			40			544

		73,531			(3,862	)		69,669

Operating income		4,024			4,063			8,087
Other income and expense
Interest expense, net		(560	)		—			(560	)
Other income		4,764			—			4,764

		4,204			—			4,204

Income before income taxes		8,228			4,063			12,291
Income tax expense		(3,320	)		(1,361	)		(4,681	)

Net income from continuing operations, net of tax		4,908			2,702			7,610

Discontinued operations (Note 16)
Loss from discontinued operations		(4,432	)		(2	)		(4,434	)
Income tax benefit		1,640			(316	)		1,324

Net loss from discontinued operations, net of tax		(2,792	)		(318	)		(3,110	)

Net income	$	2,116		$	2,384		$	4,500

Net income (loss) per common share- basic:
Net income from continuing operations, net of tax	$	0.25		$	0.14		$	0.39
Net loss from discontinued operations, net of tax		(0.14	)		(0.02	)		(0.16	)

Net income per common share- basic	$	0.11		$	0.12		$	0.23

Net income (loss) per common share- diluted:
Net income from continuing operations, net of tax	$	0.25		$	0.14		$	0.39
Net loss from discontinued operations, net of tax		(0.14	)		(0.02	)		(0.16	)

Net income per common share- diluted	$	0.11		$	0.12		$	0.23

Weighted average number of common shares:
Basic		19,431,093			—			19,431,093
Diluted		19,691,141			—			19,691,141
Comprehensive (loss) income	$	(1,016	)	$	2,490		$	1,474

The effects of the restatements on the Company’s condensed consolidated statement of operations and comprehensive income for the three months ended March 31, 2012 are as follows:


(Unaudited, U.S. Dollars, in thousands, except share and per share data)	Three Months Ended March 31, 2012
	Previously Reported			Adjustments			Restated
Product sales	$	104,820		$	(7,212	)	$	97,608
Marketing service fees		11,222			106			11,328

Net sales		116,042			(7,106	)		108,936
Cost of sales		21,940			(562	)		21,378

Gross profit		94,102			(6,544	)		87,558
Operating expenses
Sales and marketing		49,521			(2,393	)		47,128
General and administrative		14,570			—			14,570
Research and development		7,050			—			7,050
Amortization of intangible assets		530			50			580
Charges related to US Government Resolutions		—			310			310

		71,671			(2,033	)		69,638

Operating income		22,431			(4,511	)		17,920
Other income and expense
Interest expense, net		(2,221	)		—			(2,221	)
Other expense, net		(631	)		—			(631	)

		(2,852	)		—			(2,852	)

Income before income taxes		19,579			(4,511	)		15,068
Income tax expense		(7,363	)		892			(6,471	)

Net income from continuing operations, net of tax		12,216			(3,619	)		8,597

Discontinued operations (Note 16)
(Loss) income from discontinued operations		(506	)		1,033			527
Income tax benefit		306			(23	)		283

Net (loss) income from discontinued operations, net of tax		(200	)		1,010			810

Net income	$	12,016		$	(2,609	)	$	9,407

Net income (loss) per common share- basic:
Net income from continuing operations, net of tax	$	0.65		$	(0.19	)	$	0.46
Net (loss) income from discontinued operations, net of tax		(0.01	)		0.05			0.04

Net income per common share- basic	$	0.64		$	(0.14	)	$	0.50

Net income (loss) per common share- diluted:
Net income from continuing operations, net of tax	$	0.64		$	(0.19	)	$	0.45
Net (loss) income from discontinued operations, net of tax		(0.01	)		0.05			0.04

Net income per common share- diluted	$	0.63		$	(0.14	)	$	0.49

Weighted average number of common shares:
Basic		18,675,694			—			18,675,694
Diluted		19,116,195			—			19,116,195
Comprehensive income	$	14,726		$	(2,918	)	$	11,808