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 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 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 and six months ended June 30, 2012: decreased net sales by $6.1 million and $13.2 million, respectively; and decreased net income from continuing operations by $4.1 million and $7.7 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 basis 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 other 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 had not previously been issued by the Company at the time of the determination. 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 for the three and six months ended June 30, 2012 are shown in the tables below. These adjustments also had the following effects on the Company’s previously filed December 31, 2012 consolidated balance sheet:

•

Accounts receivable decreased as of December 31, 2012 by $41.3 million 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 December 31, 2012 by $11.0 million 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 December 31, 2012 of $14.8 million.

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 for the three and six months ended June 30, 2012 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 June 30, 2012
				Adjustments by Category
(U.S. Dollars, in thousands)	Previously Reported			Distributor Revenue			Inventory Reserves			Royalties			Other			Total Adjustments			Restated
Net sales	$	119,492		$	(5,862	)	$	—		$	—		$	(207	)	$	(6,069	)	$	113,423
Cost of sales		23,676			(2,101	)		3,880			2,079			13			3,871			27,547

Gross profit		95,816			(3,761	)		(3,880	)		(2,079	)		(220	)		(9,940	)		85,876
Operating expenses
Sales and marketing		49,810			(527	)		—			(2,079	)		(129	)		(2,735	)		47,075
General and administrative		14,295			—			—			—			—			—			14,295
Research and development		9,252			—			—			—			—			—			9,252
Amortization of intangibles assets		530			—			—			—			50			50			580
Charges related to U.S. Government resolutions		1,364			—			—			—			(988	)		(988	)		376

		75,251			(527	)		—			(2,079	)		(1,067	)		(3,673	)		71,578

Operating income		20,565			(3,234	)		(3,880	)		—			847			(6,267	)		14,298
Other income and (expense)		(605	)		—			—			—			—			—			(605	)

Income before income taxes		19,960			(3,234	)		(3,880	)		—			847			(6,267	)		13,693
Income tax expense		(5,993	)		1,120			1,343			—			(293	)		2,170			(3,823	)

Net income from continuing operations, net of tax	$	13,967		$	(2,114	)	$	(2,537	)	$	—		$	554		$	(4,097	)	$	9,870


	Six Months Ended June 30, 2012
				Adjustments by Category
(U.S. Dollars, in thousands)	Previously Reported			Distributor Revenue			Inventory Reserves			Royalties			Other			Total Adjustments			Restated
Net sales	$	235,534		$	(13,256	)	$	—		$	—		$	81		$	(13,175	)	$	222,359
Cost of sales		45,616			(3,572	)		2,668			4,205			8			3,309			48,925

Gross profit		189,918			(9,684	)		(2,668	)		(4,205	)		73			(16,484	)		173,434
Operating expenses
Sales and marketing		99,331			(944	)		—			(4,205	)		21			(5,128	)		94,203
General and administrative		28,865			—			—			—			—			—			28,865
Research and development		16,302			—			—			—			—			—			16,302
Amortization of intangibles assets		1,060			—			—			—			100			100			1,160
Charges related to U.S. Government resolutions		1,364			—			—			—			(678	)		(678	)		686

		146,922			(944	)		—			(4,205	)		(557	)		(5,706	)		141,216

Operating income		42,996			(8,740	)		(2,668	)		—			630			(10,778	)		32,218
Other income and (expense)		(3,457	)		—			—			—			—			—			(3,457	)

Income before income taxes		39,539			(8,740	)		(2,668	)		—			630			(10,778	)		28,761
Income tax expense		(13,356	)		2,209			1,103			—			(250	)		3,062			(10,294	)

Net income from continuing operations, net of tax	$	26,183		$	(6,531	)	$	(1,565	)	$	—		$	380		$	(7,716	)	$	18,467

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


	As of December 31, 2012
(Unaudited, U.S. Dollars, in thousands, except share data)	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 16)
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 for the three months ended June 30, 2012 are as follows:


	Three Months Ended June 30, 2012
(Unaudited, U.S. Dollars, in thousands, except share and per share data)	Previously Reported			Adjustments			Restated
Product sales	$	107,906		$	(6,004	)	$	101,902
Marketing service fees		11,586			(65	)		11,521

Net sales		119,492			(6,069	)		113,423
Cost of sales		23,676			3,871			27,547

Gross profit		95,816			(9,940	)		85,876
Operating expenses
Sales and marketing		49,810			(2,735	)		47,075
General and administrative		14,295			—			14,295
Research and development		9,252			—			9,252
Amortization of intangible assets		530			50			580
Charges Related to US Government Resolutions		1,364			(988	)		376

		75,251			(3,673	)		71,578

Operating income		20,565			(6,267	)		14,298
Other income and expense
Interest expense, net		(1,265	)		—			(1,265	)
Other income		660			—			660

		(605	)		—			(605	)

Income before income taxes		19,960			(6,267	)		13,693
Income tax expense		(5,993	)		2,170			(3,823	)

Net income from continuing operations, net of tax		13,967			(4,097	)		9,870

Discontinued operations (Note 16)
Gain on sale of Breg, Inc. (net of tax)		1,040			—			1,040
Loss from discontinued operations		(5,846	)		(7	)		(5,853	)
Income tax benefit		2,044			153			2,197

Net loss from discontinued operations, net of tax		(2,762	)		146			(2,616	)

Net income	$	11,205		$	(3,951	)	$	7,254

Net income (loss) per common share- basic:
Net income from continuing operations, net of tax	$	0.74		$	(0.22	)	$	0.52
Net loss from discontinued operations, net of tax		(0.15	)		0.01			(0.14	)

Net income per common share- basic	$	0.59		$	(0.21	)	$	0.38

Net income (loss) per common share- diluted:
Net income from continuing operations, net of tax	$	0.73		$	(0.22	)	$	0.51
Net loss from discontinued operations, net of tax		(0.15	)		0.01			(0.14	)

Net income per common share- diluted	$	0.58		$	(0.21	)	$	0.37

Weighted average number of common shares:
Basic		18,827,452			—			18,827,452
Diluted		19,215,984			—			19,215,984
Comprehensive income	$	6,822		$	(3,112	)	$	3,710

The effects of the restatements on the Company’s condensed consolidated statement of operations and comprehensive income for the six months ended June 30, 2012 are as follows:


	Six Months Ended June 30, 2012
(Unaudited, U.S. Dollars, in thousands, except share and per share data)	Previously Reported			Adjustments			Restated
Product sales	$	212,726		$	(13,216	)	$	199,510
Marketing service fees		22,808			41			22,849

Net sales		235,534			(13,175	)		222,359
Cost of sales		45,616			3,309			48,925

Gross profit		189,918			(16,484	)		173,434
Operating expenses
Sales and marketing		99,331			(5,128	)		94,203
General and administrative		28,865			—			28,865
Research and development		16,302			—			16,302
Amortization of intangible assets		1,060			100			1,160
Charges Related to US Government Resolutions		1,364			(678	)		686

		146,922			(5,706	)		141,216

Operating income		42,996			(10,778	)		32,218
Other income and expense
Interest expense, net		(3,486	)		—			(3,486	)
Other income		29			—			29

		(3,457	)		—			(3,457	)

Income before income taxes		39,539			(10,778	)		28,761
Income tax expense		(13,356	)		3,062			(10,294	)

Net income from continuing operations, net of tax		26,183			(7,716	)		18,467

Discontinued operations (Note 16)
Gain on sale of Breg, Inc. (net of tax)		1,040			—			1,040
Loss from discontinued operations		(6,352	)		1,026			(5,326	)
Income tax benefit		2,350			130			2,480

Net loss from discontinued operations, net of tax		(2,962	)		1,156			(1,806	)

Net income	$	23,221		$	(6,560	)	$	16,661

Net income (loss) per common share- basic:
Net income from continuing operations, net of tax	$	1.40		$	(0.42	)	$	0.98
Net loss from discontinued operations, net of tax		(0.16	)		0.06			(0.10	)

Net income per common share- basic	$	1.24		$	(0.36	)	$	0.88

Net income (loss) per common share- diluted:
Net income from continuing operations, net of tax	$	1.37		$	(0.41	)	$	0.96
Net loss from discontinued operations, net of tax		(0.16	)		0.07			(0.09	)

Net income per common share- diluted	$	1.21		$	(0.34	)	$	0.87

Weighted average number of common shares:
Basic		18,751,573			—			18,751,573
Diluted		19,168,940			—			19,168,940
Comprehensive income	$	21,548		$	(6,030	)	$	15,518