ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Except for the historical information contained herein, the matters discussed in this management’s discussion and analysis of financial condition and results of operations (“MD&A”), including discussions of our trend analyses, product development plans, business and growth strategies, future operations, financial condition and prospects, share repurchases, developments in and the impacts of government regulation and legislation, and market factors influencing our results, may include forward-looking statements that involve certain risks and uncertainties, all of which are based on current expectations, estimates, and forecasts, and the beliefs and assumptions of our management. Actual results may differ from those anticipated by us as a result of various factors, both foreseen and unforeseen, including, but not limited to, our ability to continue to develop and sell new products and services in markets characterized by rapid technological evolution, consolidation and competition from larger, better-capitalized competitors, our ability to finalize a settlement with the DOJ, cybersecurity and data protection risk and related liabilities, current or potential legal proceedings involving us, shits in our revenue mix that may impact gross margins, and the effect of developments in and the impacts of government regulation and legislation. Many other economic, competitive, governmental and technological factors could affect our ability to achieve our goals, and interested persons are urged to review the risk factors discussed in “Item 1A. Risk Factors” as set forth herein, as well as in our other public disclosures and filings with the Securities and Exchange Commission ("SEC").
This MD&A is provided as a supplement to the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K ("Report") in order to enhance your understanding of our results of operations and financial condition and should be read in conjunction with, and is qualified in its entirety by, Item 1A Risk factors and the consolidated financial statements and related notes thereto included elsewhere in this Report. Historical results of operations, percentage margin fluctuations and any trends that may be inferred from the discussion below are not necessarily indicative of the operating results for any future period. For information regarding the year ended March 31, 2021, including a year-to-year comparison of our financial condition and results of operations for the years ended March 31, 2022 and March 31, 2021, refer to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the year ended March 31, 2022, filed with the SEC on May 18, 2022.
Company Overview
NextGen Healthcare is a leading provider of innovative, cloud-based, healthcare technology solutions that empower ambulatory healthcare providers to manage the risk and complexity of delivering care in the United States healthcare system. Our combination of technological breadth, depth, and domain expertise positions us as a preferred solution provider and trusted advisor for our clients. In addition to highly configurable core clinical and financial capabilities, our portfolio includes tightly integrated solutions that deliver on ambulatory healthcare imperatives, including consumerism, digitization, risk allocation, regulatory influence, and integrated care and health equity.
We serve clients across all 50 states. Over 100,000 providers use NextGen Healthcare solutions to deliver care in nearly every medical specialty in a wide variety of practice models including accountable care organizations (“ACOs”), independent physician associations (“IPAs”), managed service organizations (“MSOs”), veterans service organizations (“VSOs”), and dental service organizations (“DSOs”). Our clients range from some of the largest and most progressive multi-specialty groups in the country to sole practitioners with a wide variety of business models. With the addition of behavioral health to our medical and oral health capabilities, we continue to extend our share not only in federally qualified health centers (“FQHCs”) but also in the growing integrated care market.
Our company was incorporated in California in 1974. Previously named Quality Systems, Inc., we changed our corporate name to NextGen Healthcare, Inc. in September 2018, and in 2021, we changed our state of incorporation to Delaware. As a remote-first company, we no longer maintain a principal executive office. Our principal website is www.nextgen.com. We operate on a fiscal year ending on March 31.
Our Vision, Mission and Strategy
NextGen Healthcare’s vision is better healthcare outcomes for all. We strive to achieve this vision by delivering innovative solutions and insights aimed at creating healthier communities. We focus on improving care delivered in ambulatory settings but do so recognizing that the entire healthcare ecosystem needs to work in concert to achieve the quadruple aim
“to improved patient experience, improved provider experience, improve the health of a population, and reduce per capita health care costs.”
Our long-term strategy is to position NextGen Healthcare as both the essential, integrated, delivery platform and the most trusted advisor for the ambulatory practices of the future. To that end, we primarily serve organizations that provide or orchestrate care in ambulatory settings and do so across diverse practice sizes, specialties, care modalities, and business models. These customers include conventional practices as well as new market entrants.
We plan to invest in our current capabilities as well as build and/or acquire new capabilities. In October 2019, we acquired Topaz Information Systems, LLC for its behavioral health solutions. In December 2019, we acquired Medfusion, Inc. for its Patient Experience Platform capabilities (i.e., patient portal, self-scheduling, and patient pay) and OTTO Health, LLC for its virtual care solutions, notably telemedicine. In August 2022, we divested our commercial dental assets, further emphasizing
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the company’s focus on serving ambulatory care In November 2022, we acquired TSI Healthcare, LLC ("TSI") for its purpose-built clinical content and differentiated service offerings, which expands the addressable market served by our Enterprise domain, including new specialties, such as rheumatology, pulmonology, and cardiology. The integration of these acquired technologies has made NextGen Healthcare’s solutions among the most comprehensive in the market. Further, we are also actively innovating our business models and exploring new high-growth market domains.
Market Opportunity, and Trends
The scale and scope of the healthcare industry continues to expand. Annual United States healthcare spend today represents nearly $4.1 trillion and ~20% of GDP. A significant portion of this spend is directed towards the treatment of chronic conditions and administrative solutions that service an increasingly complex system with diverse stakeholders. While there are several convergent market forces reshaping the healthcare industry landscape, we are focused on six trends we believe will materially impact the markets we participate in and our customer value proposition:
Regulatory Drivers – Medicare and Medicaid continue to expand and represent approximately a third of covered lives. Further, the 21st Century Cures Act (“Cures Act”) certification requirements and impending changes by Centers for Medicare & Medicaid Services (“CMS”) to Medicare reimbursement and shared savings programs parameters (i.e., MIPS, MSSP and telehealth programs) represent continued and escalating regulatory requirements in the healthcare industry broadly and the shape of primary healthcare. Considering these regulatory and market-based changes, many ambulatory practices have come to place a very high value on partnering with vendors that demonstrate the expertise and consistency to stay ahead of these regulatory and industry changes.
Risk Reallocation – As healthcare shifts away from defined benefit models towards defined contribution, employers, payors, providers, and consumers are increasingly evaluating models to share and reallocate risk. In 2020, nearly 40% of all healthcare payments representing over 75% of all covered lives flowed through an alternative payment model. While Medicare Advantage related payments led the charge with over 55% of payments tied to alternative models, a plurality of commercial payors are also leveraging value-based provider arrangements to incent care quality standards and reduce health disparities. For providers, effective participation in these models requires a full view of the patient population’s clinical and cost data and robust financial management solutions and services to navigate multiple contract types.
Consumerism – Consumers increasingly direct their own healthcare and require greater levels of access, convenience, and experience personalization. Beyond tailoring healthcare interactions to their needs and preferences, they also expect greater transparency about the costs for visits, medications, and procedures. Accompanied by a significant shift of care from inpatient to lower cost outpatient settings and virtual modes, healthcare is poised to become increasingly ‘retail-like’ and will place unique demands on practices and care providers who need comprehensive engagement platforms to attract, retain and engage patients through their complete health journey
New Modalities and Coordinated Team Based Care – Untethered from physical clinics and desktops, care is now being delivered in “boundless” venues by multiple, coordinated care providers.
Meaningful Interoperability & Digitization – Greater levels of data exchange, automation, Artificial Intelligence (AI) and speech enabled workflows.
Integrated Care and Health Equity – Integrated, whole-person health continues to trend strongly as evidenced by FQHCs/CHCs receiving Health Resources and Services Administration (“HRSA”) funding to drive integrated medical, behavioral, and oral health. Public sector and private investment in understanding and addressing social determinants of health and improving community health are growing.
NextGen Healthcare is well positioned to play a key role in guiding our clients through short-term and long-term changes that impact healthcare in the United States and is committed to helping them deliver better outcomes.
Our Value Proposition
NextGen Healthcare’s value proposition to our clients can be summarized by the four “I’s” as follows:
Integration – Delivering a broad and highly integrated set of solutions and end-user experiences. NextGen Healthcare, a top ranked platform solution provider, is driving greater levels of efficiency and engagement for practices. Our clients value the full breadth of our solution offering and seamless integration into their clinical workflows. This integration is an important determinant of our success.
Interoperability – Building seamlessly connected data and human networks across ambulatory healthcare. NextGen Healthcare’s Interoperability solutions help create a frictionless environment where those that need important healthcare data can rapidly find and utilize it. For example, NextGen Healthcare powers over a third of all United States state-based Health Information Exchanges (“HIE’s”), with over 170 million patient records passing over our network of almost 2.8 million directory addresses.
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Insights – Providing intelligence at the point of care to enable better health and financial decision-making. We are helping our clients move from being data rich to insight rich. By providing intelligence, through innovative solutions that take data out of electronic health records (“EHRs”), normalize, cleanse, and present it back as usable data pipelines, NextGen Healthcare can help optimize prescription guidance, care gap reviews, billing quality, practice variance, etc. and insert it directly into clinician’s workflows in order to facilitate sound clinical and financial decisions when serving patients.
Impact – Delivering and shaping outcomes in all aspects of our solutions and service. NextGen Healthcare is pivoting towards becoming a true performance partner for our clients and is evidenced by proactively helping manage performance and outcomes for our clients.
NextGen Healthcare delivers value to our clients in several ways. Our solutions enable our clients to address current needs while preparing for the needs of the future including expanding access to health services, enhancing the coordination and management of care, and optimizing patient outcomes while also ensuring the sustainability of their practices. Specifically, we offer a range of solutions to allow clinicians to practice anywhere and work in new and innovative collaboration models.
NextGen Healthcare provides integrated cloud-based solutions and services that align with our client’s strategic imperatives. Ultimately, this value is reflected in the overall insights and impact delivered to the client. The foundation for our integrated ambulatory care platform is a core of our industry-leading EHR and practice management (“PM”) systems that support clinical, financial and patient engagement activities.
We optimize the core with an automation and workflow layer that gives our clients control over how platform capabilities are implemented to drive their desired outcomes. The workflow layer includes mobile and voice-enabled capabilities proven to reduce physician burden. Recognizing that engaged patients are key to positive outcomes, our patient experience platform enables our clients to create personalized care experiences that enhance trust and drive patient loyalty. Further, we support the advances in integrated care that focus on the whole person with solutions supporting behavioral and oral health. Our cloud-based population health and analytics engine allows our clients to improve results in both fee-for-service and fee-for-value environments.
In support of extensibility, we surround the core with open, web-based application programming interfaces (“APIs”) to drive the secure exchange of health and patient data with connected health solutions. Our commitment to interoperability, defragmenting care and our experience powering many of the nation’s HIE’s places us in a unique position to enable our clients to leverage this technology to lower the cost of care and improve the patient and provider experience by providing an integrated community patient record.
Finally, to ensure our clients get maximum value from our solutions, we have augmented our technology with key services aligned with their needs, helping to ensure they reach their organizational goals. We partner with our clients to optimize their information technology (“IT”) operations, enhance revenue cycle processes across fee-for-service and fee-for-value models, service line expansion and operations, as well as advise on long-term strategy.
Positioning NextGen Healthcare for Growth. As NextGen Healthcare applies this value proposition framework across the ambulatory care market, we incorporate some or all our current solution offerings within three broad domains illustrated in Figure 1 below:
Enterprise – The Enterprise domain is both the largest and encompasses our broadest portfolio of solutions (e.g., clinical, financial, and patient engagement solution portfolios) provided to ambulatory care practices that incorporate 10 or more healthcare providers.
Office – The Office domain reflects almost all solutions (software solutions and adjacent services) provided to an ambulatory care practice that incorporates fewer than 10 healthcare providers. Our main offering in this group is a cloud-based, multi-tenant SaaS EHR and PM solution, called NextGen ® Office.
Insights – The Insights domain incorporates solutions that address interoperability, data and analytics, and value-based care. Previously described as population health and connected health, the Insights solutions portfolio is offered to clients across both our Enterprise and Office domains as well as additional ambulatory healthcare stakeholders addressing connectivity or value-based care needs. NextGen is highlighting this domain as a reflection of its overall importance and high future growth potential.
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Figure 1: NextGen Healthcare Solutions Domains
Results of Operations
The following table sets forth the percentage of revenue represented by each item in our consolidated statements of net income and comprehensive income for the years ended March 31, 2023 and 2022 (certain percentages below may not sum due to rounding):
Fiscal Year Ended March 31,
Revenues:
Recurring
Software, hardware, and other non-recurring
Total revenues
Cost of revenue:
Recurring
Software, hardware, and other non-recurring
Amortization of capitalized software costs and acquired intangible assets
Total cost of revenue
Gross profit
Operating expenses:
Selling, general and administrative
Research and development costs, net
Amortization of acquired intangible assets
Impairment of assets
Restructuring costs
Total operating expenses
Income from operations
Interest income
Interest expense
Other income (expense), net
Income before provision for income taxes
Provision for income taxes
Net income (loss)
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Revenues
The following table presents our consolidated revenues for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Recurring revenues:
Subscription services
Support and maintenance
Managed services
Transactional and data services
Total recurring revenues
Software, hardware, and other non-recurring revenues:
Software license and hardware
Other non-recurring services
Total software, hardware and other non-recurring revenues
Total revenues
Recurring revenues as a percentage of total revenues
We generate revenue from sales of licensing rights and subscriptions to our software solutions, hardware and third-party software products, support and maintenance, managed services, transactional and data services, and other non-recurring services, including implementation, training, and consulting services performed for clients who use our products.
Consolidated revenue for the year ended March 31, 2023 increased $56.8 million compared to the prior year, comprised of a $54.2 million increase in recurring revenues and a $2.6 million increase in software, hardware and other non-recurring revenues. The increase in recurring revenues was driven by $21.4 million higher subscription services, $17.7 million higher managed services revenue, and a $17.2 million increase in transactional and data services, partially offset by a $2.1 million decrease in support and maintenance. The increase in subscription services reflect the incremental revenues associated with the acquisition of TSI and higher subscriptions of our NextGen Office and Insights solutions, including interoperability, virtual visits, mobile, financial analytics, and NextGen Enterprise solutions, due to higher recent bookings. The increase in managed services revenue was primarily due to increases in revenue cycle management ("RCM") services and hosting services associated with higher recent bookings. The increase in transactional and data services revenue was primarily driven by higher bookings and transaction volumes associated with our patient pay solutions, partially offset by a decrease in electronic data interchange (“EDI”) and data services revenue due to lower transaction volume. Support and maintenance decreased primarily due to net client attrition, our continued shift to subscription-based solutions, the negative impact to revenues associated with the acquisition of TSI, which was one of our value-added resellers, and the disposition of our Commercial Dental assets, as described in Note 8, "Business Combinations and Disposals" of our notes to the consolidated financial statements included elsewhere in this Report. The increase in software, hardware, and other non-recurring revenues was primarily due to higher professional services revenue from more hours incurred and projects completed in the current year period, partially offset by a decrease in software license revenue due to lower software bookings.
Bookings reflect the estimated annual value of our executed contracts, adjusted to include the effect of pre-acquisition bookings if applicable, and are believed to provide a broad indicator of the general direction and progress of the business. Total bookings were $166.5 million for the year ended March 31, 2023 compared to $152.5 million in the prior year, primarily reflecting higher bookings of patient pay services, NextGen Enterprise subscriptions, and EDI, partially offset by lower bookings of software and maintenance.
We continue to see overall practice volumes at healthy, pre-pandemic levels. This reflects in our volume- and transaction-based solutions, as noted above, and reflects an ongoing industry trend of procedure volumes migrating out of higher cost settings, like hospitals, favoring lower cost care settings and independent healthcare providers. We also continue to see healthy activity levels in our current pipeline. Sales development activities, such as lead generation and demos, indicate a positive demand environment. We have not been significantly impacted by the current economic concerns and general market conditions, and we continue to constructively engage prospects and our clients to find ways to achieve better outcomes for all.
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Cost of Revenue and Gross Profit
The following table presents our consolidated cost of revenue and gross profit for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Cost of revenue:
Recurring
Software, hardware, and other non-recurring
Amortization of capitalized software costs and acquired intangible assets
Total cost of revenue
Gross profit
Gross margin %
Cost of revenue consists primarily of compensation expense, including share-based compensation, for personnel that deliver our products and services. Cost of revenue also includes amortization of capitalized software costs and acquired technology, third party consultant and outsourcing costs, costs associated with our EDI business partners and clearinghouses, patient pay processing and support costs, hosting service costs, third party software costs and royalties, and other costs directly associated with delivering our products and services. Refer to Note 10, "Intangible Assets" and Note 11, "Capitalized Software Costs" of our notes to consolidated financial statements included elsewhere in this Report for additional information on current period amortization of capitalized software costs and acquired technology and an estimate of future expected amortization.
Share-based compensation expense included in cost of revenue was $3.1 million and $2.2 million for the years ended March 31, 2023 and 2022, respectively.
Gross profit for the year ended March 31, 2023 increased $10.2 million compared to the prior year while our gross margin percentage decreased to 47.6% for the year ended March 31, 2023 compared to 50.5% in the prior year period.
The increase in cost of revenue for the year ended March 31, 2023 compared to the prior year period was primarily due to higher transactional and data costs directly associated with higher recent revenues and bookings of our patient pay services. Recurring cost of revenue, including costs of subscription services and managed services, also increased driven by higher hosting costs, third party costs, and higher salaries and benefits from increased employee headcount related to delivering our software solutions and services, directly associated with higher revenues and bookings. Software, hardware, and other non-recurring services revenue costs increased compared to the prior periods primarily due to higher salaries and benefits from increased employee headcount and an increase in consulting costs associated with the delivery of our professional services as we accelerate Spring’21 migration. These increases in cost of revenue were partially offset by lower amortization of capitalized software costs and acquired intangible assets.
Our gross margin for the year ended March 31, 2023 compared to the prior year period decreased primarily due to increased investments in professional services as we accelerate Spring’21 migration and a shift in product mix to lower margin transactional and data services, including patient pay services, and managed services, as noted above.
Selling, General and Administrative Expense
The following table presents our consolidated selling, general and administrative expense for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Selling, general and administrative
Selling, general and administrative, as a percentage of revenue
Selling, general and administrative expense consists of compensation expense, including share-based compensation, for management and administrative personnel, selling and marketing expense, facilities costs, depreciation, professional service fees, including legal and accounting services, legal settlements, acquisition and transaction-related costs, and other general corporate and administrative expenses.
Share-based compensation expense included in selling, general and administrative expenses was $26.1 million and $19.9 million for the years ended March 31, 2023 and 2022, respectively. The increase in share-based compensation expense is due to increased utilization of share-based awards to incentivize our executives and employees. Refer to Note 16, "Stockholders’ Equity" of our notes to consolidated financial statements included elsewhere in this Report for additional information on our share-based awards and related incentive plans.
Selling, general and administrative expenses increased $13.8 million for the year ended March 31, 2023 compared to the prior year period is primarily due to $35.2 million of estimated legal settlement and related costs associated with the DOJ investigation regulatory matter (refer to Note 17, "Commitments, Guarantees and Contingencies" of our notes to consolidated
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financial statements included elsewhere in this Report for additional information), increased share-based compensation expense, as noted above, higher travel, conferences, and conventions costs, and incremental acquisition costs associated with the acquisition of TSI in November 2022. These increases were partially offset by higher legal and related costs for our shareholder litigation matter incurred in the prior year period, including an $11.4 million payment related to the indemnification of certain expenses related to the Hussein matter, approximately $9.3 million of incremental proxy contest expenses associated with our prior year annual shareholders’ meeting, and lower facilities and infrastructure costs as we transition to a remote-first company.
Research and Development Costs, net
The following table presents our consolidated net research and development costs, capitalized software costs, and gross expenditures prior to capitalization, for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Gross expenditures
Capitalized software costs
Research and development costs, net
Research and development costs, as a percentage of revenue
Capitalized software costs as a percentage of gross expenditures
Gross research and development expenditures, including costs expensed and costs capitalized, consist of compensation expense, including share-based compensation for research and development personnel, certain third-party consultant fees, software maintenance costs, and other costs related to new product development and enhancement to our existing products.
The healthcare information systems and services industry is characterized by rapid technological change, requiring us to engage in continuing investments in our research and development to update, enhance and improve our systems. This includes expansion of our software and service offerings that support pay-for-performance initiatives around accountable care organizations, bringing greater ease of use and intuitiveness to our software products, enhancing our managed cloud and hosting services to lower our clients' total cost of ownership, expanding our interoperability and enterprise analytics capabilities, and furthering development and enhancements of our portfolio of specialty-focused templates within our electronic health records software.
The capitalization of software development costs results in a reduction to our reported net research and development costs. Our software capitalization rate, or capitalized software costs as a percentage of gross expenditures, has varied historically and may continue to vary based on the nature and status of specific projects and initiatives in progress. Although changes in software capitalization rates have no impact on our overall cash flows, it results in fluctuations in the amount of software development costs that may be capitalized or expensed up front and the amount of net research and development costs reported in our consolidated statements of net income and comprehensive income, and ultimately also affects the future amortization of our previously capitalized software development costs. Refer to Note 11, "Capitalized Software Costs" of our notes to financial statements included elsewhere in this Report for additional information on current period amortization of capitalized software costs and an estimate of future expected amortization.
Share-based compensation expense included in research and development costs was $4.2 million and $4.5 million for the years ended March 31, 2023 and 2022, respectively.
Net research and development costs for the year ended March 31, 2023 increased $5.6 million compared to the prior year due to $15.1 million increase in our gross expenditures net of $9.5 million higher capitalization of software costs. Our software capitalization rate fluctuates due to differences in the nature and status of our projects and initiatives during a given year, which affects the amount of development costs that may be capitalized. The increase in gross expenditures was primarily driven by an increase in consulting costs and higher personnel costs from increased headcount associated with the timing and status of research and development projects. Our software capitalization rate fluctuates due to differences in the nature and status of our projects and initiatives during a given year, which affects the amount of development costs that may be capitalized.
Amortization of Acquired Intangible Assets
The following table presents our amortization of acquired intangible assets for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Amortization of acquired intangible assets
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Amortization of acquired intangible assets included in operating expense consists of the amortization related to our customer relationships, re-acquired rights and trade names intangible assets acquired as part of our business combinations. Refer to Note 10, "Intangible Assets" of our notes to consolidated financial statements included elsewhere in this Report for an estimate of future expected amortization.
Amortization of acquired intangible assets for the year ended March 31, 2023 increased $0.1 million, compared to the prior year period due to the amortization of customer relationships and re-acquired rights assets associated with our acquisition of TSI in November 2022 (refer to Note 8, "Business Combinations and Disposals" of our notes to consolidated financial statements included elsewhere in this Report for additional information). This increase was partially offset by the declining amortization of the customer relationships intangible assets associated with Medfusion and HealthFusion, which are amortized under an accelerated method of amortization.
Restructuring Costs and Impairment of Assets
During the year ended March 31, 2023, we implemented a business restructuring plan as part of our continued efforts to preserve and grow the value of the Company through client-focused innovations while reducing our cost structure. We recorded restructuring costs of $2.5 million, consisting of payroll-related costs, such as severance, outplacement costs, and continuing healthcare coverage, associated with the involuntary separation of employees pursuant to a one-time benefit arrangement, within operating expenses in our consolidated statements of net income and comprehensive income. As of March 31, 2023, the remaining restructuring liability associated with payroll-related costs was $2.0 million.
During the year ended March 31, 2022, we recorded $0.5 million of restructuring costs, consisting of payroll-related costs, such as severance, outplacement costs, and continuing healthcare coverage, associated with the involuntary separation of employees pursuant to a one-time benefit arrangement, within operating expenses in our consolidated statements of net income and comprehensive income.
During the year ended March 31, 2023, we vacated portions of certain leased locations and recorded impairments of $3.2 million to our right-of-use assets and certain related fixed assets associated with the vacated locations, or portions thereof, in St. Louis, Atlanta, Horsham, Hunt Valley, Chapel Hill, Irvine and Bangalore based on projected sublease rental income and estimated sublease commencement dates and the remeasurement of our operating lease liabilities associated with the modification and early termination of certain leases.
During the year ended March 31, 2022, we vacated portions of certain leased locations and recorded impairments of $3.9 million to our right-of-use assets and certain related fixed assets associated with the vacated locations, or portions thereof, in Irvine, Horsham, Atlanta, Fairport, Hunt Valley, Bangalore, and St. Louis based on projected sublease rental income and estimated sublease commencement dates.
The impairment analyses noted above were performed by operating right-of-use asset and the impairment charges were estimated by comparing the fair value of each operating right-of-use asset based on the expected cash flows to its respective book value. We determined the discount rate for each lease based on the approximate interest rate on a collateralized basis with similar remaining terms and payments as of the impairment date. Significant judgment was required to estimate the fair value of each operating right-of-use asset and actual results could vary from the estimates, resulting in potential future adjustments to amounts previously recorded.
Interest and Other Income and Expense
The following table presents our interest expense for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Interest income
Interest expense
Other income (expense), net
Interest expense relates to our convertible senior notes and revolving credit agreement, as well as the related amortization of deferred debt issuance costs. The increase in interest expense for the year ended March 31, 2023 compared to the prior year period is primarily related to the $275.0 million aggregate principal amount of 3.75% Convertible Senior Notes due 2027 that we issued on November 1, 2022, as described in more detail in Note 12, “Debt” of our notes to consolidated financial statements included elsewhere in this Report. Interest expense changes are also caused by fluctuations in outstanding balances under our revolving credit agreement and the related amortization of debt issuance costs. As of March 31, 2023, we had no outstanding balances under the revolving credit agreement.
Interest income is earned from funds in our money market and marketable securities accounts. The increase in interest income compared to the prior year period is primarily due to interest income on our marketable securities in the current period.
Other income (expense), net for the year ended March 31, 2023 primarily represents the $10.3 million gain from our disposition of our Commercial Dental assets (refer to Note 8, "Business Combinations and Disposals" of our notes to
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consolidated financial statements included elsewhere in this Report for additional information), net accretion income on our marketable securities, and fluctuations in the India foreign exchange rates.
Provision for Income Taxes
The following table presents our provision for income taxes for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Provision for income taxes
Effective tax rate
The change in the effective tax rate for the year ended March 31, 2023 compared to the prior year was driven primarily by a net increase of the foreign and state impact, and higher nondeductible expenses for legal, executive and stock compensation, partially offset with an increase of the research and development credit and other adjustments to the deferred and valuation allowance and uncertain tax positions.
Liquidity and Capital Resources
The following table presents selected financial statistics and information for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Cash and cash equivalents
Marketable securities
Unused portion of revolving credit agreement (1)
Total liquidity
Net income (loss)
Net cash provided by operating activities
We had no outstanding borrowings under our $300.0 million revolving credit agreement as of March 31, 2023 and 2022.
Our principal sources of liquidity are our cash generated from operations, driven mostly by our net income and working capital management, our cash and cash equivalents, marketable securities, and our debt arrangements.
We believe that our cash and cash equivalents on hand at March 31, 2023, together with our cash flows from operating activities and liquidity provided by our marketable securities and debt arrangements, will be sufficient to meet our working capital and capital expenditure requirements for the next twelve months. We intend to expend some of our available funds for the development and/or acquisition of products complementary to our existing product line as well as new versions of certain of our products. These developments are intended to take advantage of more powerful technologies and to increase the integration of our products. Our investment policy is determined by our Board of Directors. Excess cash, if any, may be invested in very liquid short term assets including tax exempt and taxable money market funds, certificates of deposit and short-term municipal bonds with weighted-average maturities of 365 days or less at the time of purchase. Our Board of Directors continues to review alternate uses for our cash including an expansion of our investment policy and other items. Any or all of these programs could significantly impact our investment income in future periods.
For the period beyond the next twelve months, we believe that we will be able to meet our working capital and capital expenditure needs from our existing cash and cash equivalents, marketable securities, cash flows generated from our operating activities, and, if necessary, proceeds from our debt arrangements. Our cash, cash equivalents, and marketable securities consist of bank deposits, United States treasury securities, money market funds, corporate notes and bonds, agency securities, and commercial paper. Our assessments of the period of time through which our existing liquidity and capital resources will be adequate to support our ongoing operations and our expected sources of capital for the future operations of our business after such period of time are forward-looking statements and involve risks and uncertainties. Our actual results could vary as a result of, and our near- and long-term future capital requirements will depend on, many factors, including our growth rate, the timing and extent of spending to support our infrastructure and research and development efforts, the expansion of sales and marketing activities, the timing of new product development and enhancements, and other general market and economic factors.
We may, from time to time, enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights, and such acquisitions and investments could increase our need for additional capital. We may be required to seek additional financing from time to time in the future. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all.
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Cash Flows from Operating Activities
The following table summarizes our consolidated statements of cash flows for the years ended March 31, 2023 and 2022 (in thousands):
Fiscal Year Ended March 31,
Net income (loss)
Non-cash expenses
Cash from net income, as adjusted
Change in contract assets and liabilities, net
Change in accounts receivable
Change in all other assets and liabilities
Net cash provided by operating activities
For the year ended March 31, 2023, cash provided by operating activities decreased $9.9 million compared to the prior year due to a $26.1 million decrease from lower net income, as adjusted for non-cash expenses, $11.9 million decrease from net changes in accounts receivable and $3.6 million decrease from net changes in contract balances, partially offset by a $31.8 million increase from net changes in other assets and liabilities. Non-cash expenses decreased $21.8 million primarily due to a $10.3 million gain from the disposition of our Commercial Dental assets reflected in the current year period, changes in our deferred income taxes, lower amortization of operating lease assets, and lower amortization of intangible assets, partially offset by higher share-based compensation expense. The decrease in cash from changes in accounts receivable is primarily related to growth in subscriptions and milestone invoicing from higher recent bookings, as well as incremental invoicing from our acquisition of TSI, partially offset by continued efforts to resolve aged balances and improve collections. The decrease in cash associated with net changes in contract assets and liabilities is primarily due to an increase in contract liabilities associated with our acquisition of TSI and higher subscriptions invoicing due to higher recent bookings, partially offset by lower contract assets from lower software bookings and RCM contract terminations in the current year period. The increase in cash from net changes in other assets and liabilities is primarily due to $34.0 million in accrued estimated legal settlement and related costs associated with the DOJ regulatory matter in the current period and changes in our income tax assets and liabilities, including our uncertain tax positions tax liability, partially offset by a decrease in cash related to higher payments of prior year incentive bonuses paid in the current year period compared to the prior year due to a higher rate of bonus for the prior fiscal year.
Cash Flows from Investing Activities
Net cash used in investing activities for the years ended March 31, 2023 and 2022 was $216.9 million and $28.1 million, respectively. The $188.8 million net increase in cash used in investing activities compared to the prior year is primarily due to $140.0 million in purchases of marketable securities in the current year period, $51.3 million of cash paid, net of cash acquired, for the acquisition of TSI, and $9.5 million higher additions to capitalized software in the current year period, partially offset by $11.3 million in cash proceeds from the disposition of our Commercial Dental assets.
Cash Flows from Financing Activities
Net cash provided by financing activities in the year ended March 31, 2023 was $212.6 million compared to net cash used for financing activities of $37.3 million in the prior year. The increase in cash provided by financing activities is primarily due to $275.0 million in proceeds from our convertible senior notes, net of $8.5 million in debt issuance costs, partially offset by a $14.0 million increase in share repurchases in the current year period.
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Contractual Obligations and Commitments
Convertible Senior Notes
On November 1, 2022, we issued $275.0 million in aggregate principal amount of 3.75% Convertible Senior Notes due 2027 (“Notes”). The Notes were issued pursuant to, and are governed by, an indenture, dated as of November 1, 2022, between the Company and U.S. Bank Trust Company, National Association, as trustee. Net proceeds from the issuance of the Notes were approximately $266.5 million, after deducting issuance costs totaling $8.5 million.
The Notes will accrue interest at a rate of 3.75% per annum, payable semi-annually in arrears on May 15 and November 15 of each year, beginning on May 15, 2023. The Notes will mature on November 15, 2027, unless earlier repurchased, redeemed or converted.
Approximately $10.7 million in interest payments are due within the next 12 months for our Notes. There are no required principal payments on the Notes prior to their maturity.
Refer to Note 12, “Debt” of our notes to consolidated financial statements included elsewhere in this Report for additional information.
Line of Credit
On March 12, 2021, we entered into a $300 million second amended and restated revolving credit agreement (the “Credit Agreement”). The Credit Agreement matures on March 12, 2026 and the full balance of the revolving loans and all other obligations under the Credit Agreement must be paid at that time. In addition, we are required to prepay the revolving loan balance if at any time the aggregate principal amount outstanding under the Credit Agreement exceeds the aggregate commitments thereunder.
On May 17, 2022, we entered into an amendment to the Credit Agreement, which, among other changes, provides more favorable terms and flexibility with regards to our ability to obtain additional revolving credit commitments and/or term loans thereunder, including amendments to the net leverage ratio and definition of restricted payments.
On October 27, 2022, the Company entered into that certain Amendment No. 2 to Credit Agreement (the “Second Amendment”) with the Administrative Agent and the lenders party thereto. The Second Amendment modifies the Credit Agreement to make certain updates to the conditions restricting the making of certain dividends, distributions, and other restricted payments by the Company so that the Company’s compliance with the net leverage ratio governor contained in such conditions is calculated net of the net cash proceeds of the Notes issued pursuant to the Indenture. On March 12, 2021, we entered into a $300 million second amended and restated revolving credit agreement (the “Credit Agreement”). The Credit Agreement matures on March 12, 2026 and the full balance of the revolving loans and all other obligations under the Credit Agreement must be paid at that time. In addition, we are required to prepay the revolving loan balance if at any time the aggregate principal amount outstanding under the Credit Agreement exceeds the aggregate commitments thereunder.
As of March 31, 2023, we had no outstanding borrowings under the Credit Agreement. Refer to Note 12, “Debt” of our notes to consolidated financial statements included elsewhere in this Report for additional information.
Non-cancelable Operating Leases
As of March 31, 2023, the total amount of future lease payments under operating leases was $8.3 million, of which $4.1 million is short-term. Our operating leases have a weighted average remaining lease term of 2.0 years. Included in our total future lease payments are $7.4 million of remaining lease obligations for vacated properties, of which $3.6 million is short-term. The preceding numbers do not include $0.7 million of future lease obligations, of which $0.1 million is short-term, for a lease that we have entered into that has not yet commenced. Remaining lease obligations for vacated properties relates to certain locations, including Cary, Brentwood, North Canton, Fairport, Atlanta, St. Louis, and portions of Irvine, Hunt Valley and Chapel Hill that we have vacated as part of our reorganization efforts and are actively marketing for sublease. Refer to Note 7, “Leases” and Note 18, "Restructuring Plan" of our notes to consolidated financial statements included elsewhere in this Report for additional information. The remaining obligations have not been reduced by projected sublease rentals or by minimum sublease rentals of $2.0 million due in future periods under non-cancelable subleases.
Purchase Obligations
As of March 31, 2023, we had minimum purchase commitments of $153.7 million related to payments due under certain non-cancelable agreements to purchase goods and services, of which $35.1 million is due within the next 12 months.
Share Repurchase Program
In October 2021, our Board of Directors ("Board") authorized a share repurchase program under which we may repurchase up to $60.0 million of our outstanding shares of common stock through March 2023. The timing and amount of any share repurchases under the share repurchase program will be determined by our management at its discretion based on ongoing assessments of the capital needs of the business, the market price of our common stock and general market conditions. The
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program does not obligate the Company to acquire any particular amount of our common stock, and the share repurchase program may be suspended or discontinued at any time at our discretion.
In October 2022, our Board authorized a new share repurchase program under which we may repurchase up to an additional $100.0 million of outstanding shares of our common stock through March 2025.
During the year ended March 31, 2023, we repurchased 2.7 million shares of common stock for a total of $49.9 million at a weighted-average share repurchase price of approximately $18.62. During the year ended March 31, 2022, we repurchased 2.2 million shares of common stock for a total of $35.9 million at a weighted-average share repurchase price of approximately $16.53.
As of March 31, 2023, $74.3 million remained available for share repurchases pursuant to the Company’s share repurchase programs.
Deferred Compensation
Deferred compensation liability was $8.0 million, for which timing of future benefit payments to employees is not determinable. To offset this liability, we have purchased life insurance policies on some of the participants. The Company is the owner and beneficiary of the policies and the cash values are intended to produce cash needed to help make the benefit payments to employees when they retire or otherwise leave the Company. The cash surrender value of the life insurance policies for deferred compensation was $8.1 million.
Income Taxes
We have an uncertain tax position liability of $5.9 million as of March 31, 2023, for which timing of expected payments is not determinable.
Off-Balance Sheet Arrangements
During the year ended March 31, 2023, we did not have any relationships with unconsolidated organizations, financial partnerships, or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes.
Recent Accounting Pronouncements
Refer to Note 2, “Summary of Significant Accounting Policies” of our notes to consolidated financial statements included elsewhere in this Report for a discussion of recently issued accounting pronouncements.
Critical Accounting Policies and Estimates
The discussion and analysis of our consolidated financial statements and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these consolidated financial statements requires us to make estimates and judgments that affect our reported amounts of assets, liabilities, revenue and expenses, and related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends, and other factors we believe to be reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. On a regular basis, we review the accounting policies and update our assumptions, estimates, and judgments, as needed, to ensure that our consolidated financial statements are presented fairly and in accordance with GAAP. Actual results could differ materially from our estimates under different assumptions or conditions. To the extent that there are material differences between our estimates and actual results, our financial condition or results of operations will be affected.
Our significant accounting policies, as described in Note 2, “Summary of Significant Accounting Policies” of our notes to consolidated financial statements included elsewhere in this Report, should be read in conjunction with management’s discussion and analysis of financial condition and results of operations. We believe that the following accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results because application of such policies require significant judgment regarding the effects of matters that are inherently uncertain and that affect our consolidated financial statements.
Revenue Recognition
Application of the revenue recognition guidance requires a significant amount of judgments and estimates, which may impact the amount and timing of revenue recognition and related disclosures. Refer to Note 3, "Revenue from Contracts with Customers" of our notes to consolidated financial statements included elsewhere in this Report for additional information regarding our revenue recognition policies, significant judgments, and estimates.
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Software Development Costs
Software development costs, consisting primarily of employee salaries and benefits and certain third party costs, incurred in the development of new software solutions and enhancements to existing software solutions for external sale are expensed as incurred, and reported as net research and development costs in the consolidated statements of net income and comprehensive income, until technological feasibility has been established. After technological feasibility is established, the incremental software development costs are capitalized until general release occurs. Amortization of capitalized software begins upon general release and is recorded on a straight-line basis over the estimated economic life of the related product, which is typically three years. The total of capitalized software costs incurred in the development of products for external sale are reported as capitalized software costs within our consolidated balance sheets.
We also incur costs related to the development of software applications for our internal-use and for the development of software-as-a-service ("SaaS") based solutions sold to our clients. The development costs of our SaaS-based solutions are considered internal-use for accounting purposes. Our internal-use capitalized development costs are stated at cost and amortized on a straight-line basis over the estimated useful lives of the assets, which is typically three years. Application development stage costs generally include costs associated with internal-use software configuration, coding, installation and testing. Costs related to the preliminary project stage and post-implementation activities are expensed as incurred. Costs of significant upgrades and enhancements that result in additional functionality are also capitalized, whereas costs incurred for maintenance and minor upgrades and enhancements are expensed as incurred. Capitalized software costs for the development of SaaS-based solutions are reported as capitalized software costs within our consolidated balance sheets and capitalized software costs for the development of our internal-use software applications are reported as equipment and improvements within our consolidated balance sheets.
We periodically reassess the estimated economic life and the recoverability of our capitalized software costs. If we determine that capitalized amounts are not recoverable based on the expected net cash flows to be generated from sales of the applicable software solutions, the amount by which the unamortized capitalized costs exceed the net realizable value is written off as a charge to earnings. The net realizable value is estimated as the expected future gross revenues from that product reduced by the estimated future costs of completing and disposing of that product, including the costs of performing maintenance and client support required to satisfy our responsibility at the time of sale. In addition to the assessment of net realizable value, we review and adjust the remaining estimated lives of our capitalized software costs, if necessary. We also perform a periodic review of our software solutions and dispose of fully amortized capitalized software costs after such products are determined to no longer be used by our clients.
Although we currently believe that our approach to estimates and judgments as described herein is reasonable, actual results could differ and we may be exposed to increases or decreases in revenue that could be material.
Business Combinations
In accordance with the accounting for business combinations, we allocate the purchase price of the acquired business to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The fair values of acquired assets and liabilities assumed represent our best estimate of fair value. The estimated fair value of the acquired tangible and intangible assets and liabilities assumed were determined using multiple valuation approaches depending on the type and nature of tangible or intangible asset acquired, including but not limited to the income approach, the excess earnings method and the relief from royalty method approach. The purchase price allocation methodology contains uncertainties as it requires us to make assumptions and to apply judgment to estimate the fair value of acquired assets and liabilities, including, but not limited to, intangible assets, goodwill, and contingent consideration liabilities. We estimate the fair value of the contingent consideration liabilities based on our projection of expected results, as needed. Unanticipated events or circumstances may occur which could affect the accuracy of our fair value estimates, including assumptions regarding industry economic factors and business strategies. We expect to finalize the purchase price allocation as soon as practicable within the measurement period, but not later than one year following the acquisition date. Any adjustments to fair value subsequent to the measurement period are reflected in the consolidated statements of net income and comprehensive income.
Goodwill
Goodwill acquired in a business combination is measured as the excess of the purchase price, or consideration transferred, over the net acquisition date fair values of the assets acquired and the liabilities assumed. Goodwill is not amortized as it has been determined to have an indefinite useful life.
We test goodwill for impairment annually during our first fiscal quarter, referred to as the annual test date. We will also test for impairment between annual test dates if an event occurs or circumstances change that would indicate the carrying amount may be impaired. Impairment testing for goodwill is performed at a reporting-unit level, which is defined as an operating segment or one level below an operating segment (referred to as a component). We operate as one segment and have a single reporting unit. The measures evaluated by our chief operating decision maker ("CODM"), consisting of our Chief Executive Officer, to assess company performance and make decisions about the allocation of resources include consolidated revenue and consolidated operating results.
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As part of our annual goodwill impairment test, we may elect to first assess qualitative factors to determine whether it is more likely than not that the fair value of our single reporting unit is less than its carrying amount. We assess events or changes in circumstances in totality, including macroeconomic and industry conditions, market and competitive environment, changes in customers or customer mix, cost factors, loss of key personnel, significant changes in legislative environment or other legal factors, changes in the use of our acquired assets, changes in our strategic direction, significant changes in projected future results of operations, changes in the composition or carrying amount of our net assets, and changes in our stock price. Based on our assessment, if we conclude that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, then additional impairment testing is not required. Otherwise, if we determine that a quantitative impairment test should be performed, we then evaluate goodwill for impairment by comparing the estimated fair value of the reporting unit with its book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the fair value of the reporting unit is less than book value, then an charge is recorded for the difference between the reporting unit’s fair value and carrying amount, not to exceed the carrying amount of the goodwill.
During the quarter ended June 30, 2022, we performed a qualitative assessment, which indicated that it was more likely than not that the fair value of goodwill exceeded its net carrying value and, therefore, additional impairment testing was not deemed necessary. We also did not identify any events or circumstances that would require an interim goodwill impairment test.
Application of the goodwill impairment test required significant judgment, including the identification of reporting units and determination of the fair value of the reporting unit. We determined the fair value of our reporting unit utilizing the average of two valuation methods, consisting of the income approach (based upon estimates of future discounted cash flows for the reporting unit) and a market comparable approach (based upon valuation multiples of companies that operate in similar industries with similar operating characteristics). The cash flows used to determine fair value under the income approach required significant judgments and represent Management's best estimates of projected operating results, terminal and long-term growth rates of our business, useful life over which cash flows will occur, and our weighted average cost of capital, that are dependent on a number of significant assumptions based on historical experience, expectations of future performance, and the expected macroeconomic environment, which are subject to change given the inherent uncertainty in predicting future results. We also considered our stock price and market capitalization as a corroborative step in assessing the reasonableness of the fair values estimated for the reporting unit as part of the goodwill impairment assessment.
The estimates used to calculate the fair value of a reporting unit changes from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for the reporting unit. We currently also do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we used to test for impairment losses on goodwill. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to future impairment charges that could be material.
Refer to Note 9, "Goodwill" of our notes to consolidated financial statements included elsewhere in this Report for additional information regarding our goodwill policies, significant judgments, and estimates.
Intangible Assets
Intangible assets consist of trade names, customer relationships, re-acquired rights, data health database, and software technology, all of which are associated with our business acquisitions.
The intangible assets are recorded at fair value and are reported net of accumulated amortization. We currently amortize the intangible assets over periods ranging from 3 to 11 years using a method that reflects the pattern in which the economic benefits of the intangible asset are consumed. We assess the recoverability of intangible assets at least annually or whenever adverse events or changes in circumstances indicate that impairment may have occurred. Impairment is deemed to have occurred if the future undiscounted cash flows expected to result from the use of the related assets are less than the carrying value of such assets, and a loss is recognized to reduce the carrying value of the intangible assets to fair value, which is determined by discounting estimated future cash flows. In addition to the impairment assessment, we routinely review the remaining estimated lives of our intangible assets and record adjustments, if deemed necessary.
Although currently we believe that our approach to estimates and judgments as described herein is reasonable, actual results could differ and we may be exposed to decreases in the fair value of our intangible assets, resulting in impairment charges that could be material. We test intangible assets for impairment if we believe indicators of impairment exist.
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Share-Based Compensation
We record share-based compensation related to share-based awards granted under equity incentive plans.
Share-based compensation expense associated with restricted stock awards is estimated using the closing share price of the common stock on the date of grant. Share-based compensation expense associated with performance stock awards that contain market conditions is based on the grant date fair value estimated using a Monte Carlo-based valuation model. Share-based compensation expense associated with performance stock awards that contain performance conditions are estimated using a probability-adjusted achievement rate combined with the closing share price of the common stock on the date of grant.
Share-based compensation expense is recognized as expense over the requisite service period in our consolidated statements of net income and comprehensive income.
We currently do not believe there is a reasonable likelihood there will be a material change in the future estimates or assumptions we use to determine share-based compensation expense. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to changes in share-based compensation expense that could be material.
See Note 16, “Stockholders' Equity,” of our notes to consolidated financial statements included elsewhere in this Report for a complete discussion of our stock-based compensation plans and our accounting policies, significant judgments, and estimates.
Reserves on Accounts Receivable
We maintain reserves for estimated potential sales returns and allowances for credit losses on our accounts receivable. Accounts receivable are reported net of an allowance for credit losses on our consolidated balance sheets.
Our standard contracts generally do not contain provisions for clients to return products or services. However, we historically have accepted sales returns under limited circumstances. We estimate expected sales returns and other forms of variable consideration considering our customary business practice and contract-specific facts and circumstances, and we consider such estimated potential returns as variable consideration when allocating the transaction price to the extent it is probable that there will not be a significant reversal of cumulative revenue recognized.
Allowance for credit losses are reserves related to estimated losses resulting from our clients’ inability to make required payments are established based on our assessment of the collectability of client accounts, including review of our historical experience of bad debt expense and the aging of our accounts receivable balances, net of specifically reserved accounts and amounts billed prior to revenue recognition. Specific reserves are based on our estimate of the probability of collection for certain accounts. As part of our assessment of the adequacy of the allowance for credit losses, we consider a number of factors including, but not limited to, historical credit loss experience and adjustments for certain asset-specific risk characteristics, such as bankruptcy filings, internal assessments of client credit quality, age of the client receivable balances, review of major third-party credit-rating agencies, and evaluation of external factors such as economic conditions, including the potential impacts of the COVID-19 pandemic, that may affect a client’s ability to pay, or other client-specific factors. Accounts are written off as uncollectible only after we have expended extensive collection efforts.
If a major client’s creditworthiness or financial condition were to deteriorate, if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional reserves or allowances could be required, which could have an adverse impact on our operating results. Although we currently believe that our approach to estimates and judgments as described herein is reasonable, actual results could differ and we may be exposed to increases or decreases in required reserves that could be material.
See Note 4, “Accounts Receivable,” of our notes to consolidated financial statements included elsewhere in this Report for additional information.
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Leases
Our leasing arrangements are reflected on the balance sheet as right-of-use assets and liabilities pertaining to the rights and obligations created by the leased assets. We determine whether an arrangement is a lease at inception and classify it as finance or operating. All of our existing material leases are classified as operating leases. Our leases do not contain any residual value guarantees.
Right-of-use lease assets and corresponding lease liabilities are recognized at commencement date based on the present value of lease payments over the expected lease term. Since the interest rate implicit in our lease arrangements is not readily determinable, we determine an incremental borrowing rate for each lease based on the approximate interest rate on a collateralized basis with similar remaining terms and payments as of the lease commencement date to determine the present value of future lease payments. Our lease terms may include options to extend or terminate the lease. Currently, it is not reasonably certain that we will exercise those options and therefore, we utilize the initial, noncancelable, lease term to calculate the lease assets and corresponding liabilities for all our leases. We have certain insignificant short-term leases with an initial term of twelve months or less that are not recorded in our consolidated balance sheets. Operating right-of-use lease assets are classified as operating lease assets on our consolidated balance sheets.
Our lease agreements generally contain lease and non-lease components. Non-lease components primarily include payments for maintenance and utilities. We have applied the practical expedient to combine fixed payments for non-lease components with our lease payments for all of our leases and account for them together as a single lease component, which increases the amount of our lease assets and corresponding liabilities. Payments under our lease arrangements are primarily fixed, however, certain lease agreements contain variable payments, which are expensed as incurred and not included in the operating lease assets and liabilities.
Operating lease costs are recognized on a straight-line basis over the lease term and included as a selling, general and administrative expense in the consolidated statements of net income and comprehensive income.
Refer to Note 7, "Leases" of our notes to consolidated financial statements included elsewhere in this Report for additional information.
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