3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Financial Statement Presentation

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”) and the applicable rules and regulations of the Securities and Exchange Commission (“SEC”).

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported therein. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be based upon amounts that differ from these estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of Diplomat Pharmacy, Inc., its wholly owned subsidiaries, and a 51 percent owned subsidiary, formed in August 2014, which the Company controlled until it was dissolved during the fourth quarter of 2017. The Company also owns a 22 percent interest in a non-consolidated entity which is accounted for under the equity method of accounting since the Company does not control the entity but has the ability to exercise significant influence over its operating and financial policies. This equity method investment was fully impaired during the fourth quarter of 2014 (Note 9). An investment in an entity in which the Company owned less than 20 percent and did not have the ability to exercise significant influence was accounted for under the cost method. This cost method investment was impaired during the fourth quarter of 2016 and dissolved in 2018 (Note 9).

Noncontrolling interest in a consolidated subsidiary in the consolidated balance sheets represented the minority shareholders’ proportionate share of the equity in such subsidiary. Consolidated net income (loss) was allocated to the Company and noncontrolling interests (i.e., minority shareholders) in proportion to their percentage ownership.

All intercompany transactions and balances have been eliminated in consolidation.

Reclassifications

During the second quarter of 2018, the Company changed its accounting policy to classify shipping and handling costs incurred at its dispensing pharmacies in “Cost of sales” which were previously reported in “Selling, general and administrative expenses” (“SG&A”) in its consolidated statements of operations. The amounts of the reclassifications from SG&A to Cost of sales were $55,426 and $45,795 for the years ended December 31, 2017 and 2016, respectively.

The Company has historically classified the cost of its nursing support services within SG&A as these amounts were not considered significant in relation to total cost of sales. During the second quarter of 2018, the Company reclassified these nursing support service costs from SG&A to cost of sales. The amounts reclassified were $19,108 and $13,447 for the years ended December 31, 2017 and 2016, respectively.

In addition, certain prior year amounts have been reclassified to conform with the current year presentation.

These reclassifications, discussed above, had no impact on “(Loss) income from operations,” “Net (loss) income,” or “(Loss) income per common share, basic and diluted,” for any of the periods presented.

Concentrations of Risk

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash on deposit with banks or other financial institutions and trade accounts receivable.

A federal program provides noninterest-bearing cash balances insurance coverage up to $250 per depositor at each financial institution. The Company’s cash balances often exceed federally insured limits.

Concentration of credit risk with respect to trade accounts receivable is limited by the large number of patients comprising the Company’s customer base and their dispersion across multiple payers and multiple geographic areas. No single payer customer accounted for more than 10 percent of net sales for any period presented or trade accounts receivable at December 31, 2018 and 2017.

The Company purchases prescription drug inventory from AmerisourceBergen, a prescription drug wholesaler. Such purchases from AmerisourceBergen accounted for approximately 28 percent, 41 percent and 49 percent of drug purchases for the years ended December 31, 2018, 2017 and 2016, respectively. The Company has alternative vendors available, if necessary. See Note 16 for a discussion of the terms of the Company’s distribution agreement and minimum purchase obligation under the agreement.

Also, the Company purchases certain prescription drugs from the drug manufacturers, Celgene Corporation (“Celgene”) and Pharmacyclics, Inc. (“Pharmacyclics”). Purchases from Celgene and Pharmacyclics accounted for approximately 17 percent and 17 percent, 17 percent and 14 percent, and 13 percent and 10 percent of total drug purchases for the years ended December 31, 2018, 2017 and 2016, respectively, with no minimum purchase obligation. The specialty drugs that the Company purchases from Celgene and Pharmacyclics are not available from any other source.

Cash Equivalents

The Company considers all highly liquid investments with maturities of three months or less from the date of purchase to be cash equivalents.

Receivables, net

Receivables, net consisted of the following:


	December 31,
	2018		2017
Trade receivables, net of allowances of $(25,342) and $(22,050), respectively	$	299,407	$	317,004
Rebate receivables		22,375		12,847
Other receivables		4,820		2,240
	$	326,602	$	332,091

Trade receivables are stated at the invoiced amount. Trade receivables primarily include amounts due from clients,third-party pharmacy benefit managers and insurance providers and are based on contracted prices. Trade receivables are unsecured and require no collateral. Trade receivable terms vary by payer, but generally are due within 30 days after the sale of the product or performance of the service.

Rebate receivables are amounts due from pharmaceutical manufacturers related to drug purchases by participants of the various pharmacy benefit plans that the Company manages, a portion of which, depending on contract terms, are paid back to the Company's customers. The Company estimates these rebates at period-end based on its contractual arrangements with its manufacturers and such rebates are recorded as a reduction of cost of sales.

The Company maintains an allowance for doubtful accounts that reduces receivables to amounts that are expected to be collected. In estimating the allowance, management considers factors such as current overall economic conditions, historical and anticipated customer performance, historical experience with write-offs and the level of past due accounts. The Company’s general policy for uncollectible accounts, if not reserved through specific examination procedures, is to reserve based upon the aging categories of accounts receivable. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

Activity in the allowance for doubtful accounts was as follows:


	Year Ended December 31,
	2018		2017		2016
Beginning balance	$	(22,050)	$	(15,257)	$	(8,123)
Charged to expense		(8,660)		(9,424)		(9,534)
Write-offs, net of recoveries		5,368		2,631		2,400
Ending balance	$	(25,342)	$	(22,050)	$	(15,257)

Inventories

Inventories consist of prescription and over-the-counter medications and are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out method. Prescription medications are returnable to the Company’s vendors and fully refundable before six months of expiration, and any remaining expired medication is relieved from inventory on a quarterly basis.

Property and Equipment, net

Property and equipment are stated at cost less accumulated depreciation. Depreciation is generally computed on a straight-line basis over the estimated useful lives of the assets. The costs of leasehold improvements are amortized either over the life of the improvement or the lease term, whichever is shorter. For income tax purposes, accelerated methods of depreciation are generally used. Significant improvements are capitalized, and disposed or replaced property is written off. Maintenance and repairs are charged to expense in the period they are incurred. When items of property or equipment are sold or retired, the related cost and accumulated depreciation are removed from the accounts, and any gain or loss is included in income.

Capitalized Software for Internal Use, net

The Company capitalizes certain development costs primarily related to custom-developed, proprietary, scalable patient care systems. The Company expenses the costs incurred during the preliminary project stage, and capitalizes the direct development costs, including the associated payroll and related costs for employees and outside contractors working on development, during the application development stage. The Company monitors development on an ongoing basis and capitalizes the costs of any major improvements or that result in significant additional functionality.

Capitalized internal use software costs are amortized on a straight-line basis over the estimated useful lives of the assets, generally three years. For income tax purposes, accelerated methods of amortization are generally used. Management evaluates the useful lives of these assets on an annual basis.

Definite-Lived Intangible Assets, net

Definite-lived intangible assets are amortized over their estimated useful lives using an accelerated method for the majority of customer, patient and physician relationships, and the straight-line method for the remaining intangible assets.

Long-Lived Assets

Long-lived assets, such as property and equipment, capitalized software for internal use and definite-lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group to be tested for possible impairment, the Company compares the undiscounted cash flows expected to be generated by that asset or asset group to its carrying amount. If the carrying amount of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment charge is recognized to the extent that the carrying amount exceeds fair value. Fair values of long-lived assets are determined through various techniques, such as applying probability weighted, expected present value calculations to the estimated future cash flows using assumptions a market participant would utilize, or through the use of a third-party independent appraiser or valuation specialist.

Goodwill

Goodwill represents the excess acquisition cost of an acquired entity over the estimated fair values of the net tangible assets and the identifiable intangible assets acquired. Goodwill is not amortized, but rather is reviewed for impairment annually during the fourth quarter, or more frequently if facts or circumstances indicate that the carrying value of the reporting unit’s goodwill may not be recoverable. The Company has three reporting units — Diplomat Specialty Pharmacy (“DSP”), Diplomat Specialty Infusion Group (“DSIG”) and PBM.

An entity has the option to perform a qualitative assessment to determine whether it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount prior to performing a quantitative impairment test. The qualitative assessment evaluates various events and circumstances, such as macro-economic conditions, industry and market conditions, cost factors, relevant events and financial trends that may impact a reporting unit’s fair value. If it is determined that the estimated fair value of the reporting unit is more-likely-than-not less than its carrying amount, including goodwill, a quantitative assessment is required. Otherwise, no further analysis is necessary.

If a quantitative assessment is performed, a reporting unit’s fair value is compared to its carrying value. A reporting unit’s fair value is determined by the market approach, when available and appropriate, or the income approach, or combination of both. The income approach utilizes projected future cash flows discounted at rates commensurate with the risks involved, and multiples of current and future earnings. Management assesses the valuation methodology based upon the relevance and availability of the data at the time of the valuation is performed. If multiple valuation methodologies are used, the results are weighted appropriately. If the fair value of a reporting unit is less than its carrying amount, an impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized cannot exceed the total amount of goodwill allocated to that reporting unit.

Debt Issuance Costs

Costs incurred related to the issuance of the Company’s credit facility were deferred and are being amortized to interest expense using the effective interest method over the term of the agreement.

Revenue recognition (effective January 1, 2018)

The following table disaggregates net sales by therapeutic categories for the Specialty segment and by product and service distribution channels for the PBM segment:


	Year Ended December 31,
	2018		2017		2016
Specialty Segment:
Oncology	$	2,788,154	$	2,545,708	$	2,102,130
Specialty infusion		704,872		617,904		505,240
Immunology		555,115		561,730		644,173
Hepatitis		148,470		281,063		583,751
Other		594,226		466,452		575,094
Total Specialty segment		4,790,837		4,472,857		4,410,388
PBM Segment:
Retail networks		549,760		5,166		—
Specialty pharmacy		88,457		2,914		—
Mail order		68,158		2,261		—
Other		23,080		2,032		—
Total PBM segment		729,455		12,373		—
Inter-segment eliminations		(27,768)		—		—
Total net sales	$	5,492,524	$	4,485,230	$	4,410,388

Specialty Segment

The Company recognizes revenue from dispensing prescription drugs for home delivery at the time the drugs are physically delivered which is the point in time when control transfers to the customer. Revenue from dispensing prescription drugs that are picked up by patients at an open-door or retail pharmacy location are recorded at prescription adjudication, which approximates the fill date. Each prescription claim is considered an arrangement with the customer and is a separate performance obligation.

The Company accrues an estimate of fees, including direct and indirect remuneration fees (“DIR fees”), which are assessed or expected to be assessed by payers at some point after adjudication of a claim, as a reduction of revenue at the time revenue is recognized. Changes in the estimate of such fees are recorded as an adjustment to revenue when the change becomes known.

PBM Segment

The Company provides a pharmacy benefit management service, including mail order pharmacy and specialty pharmacy services, to its clients, which include Medicare Part D Plans, regional health Plans, self-insured clients and Medicaid Plans , which culminates in the dispensing of prescription drugs. The Company sells prescription drugs directly through its mail service dispensing pharmacy and indirectly through its contracted network of retail pharmacies. The Company recognizes revenue from the sale of prescription drugs by its mail order pharmacy service when the drugs are physically delivered when control transfers to the customer and by its retail pharmacy network when the claim is adjudicated. The Company’s pharmacy benefit management services are accounted for in a manner consistent with a master supply arrangement as there are no contractual minimum volumes and each prescription is considered a separate purchasing decision and distinct performance obligation transferred at a point in time. Pharmacy benefit management services performed in connection with each prescription claim are considered part of a single performance obligation which culminates in the dispensing of prescription drugs. The Company acts as the principal in the arrangement, exercises pricing latitude and independently has a contractual obligation to pay its network pharmacy providers for benefits provided to its clients’ members, and assumes primary responsibility for fulfilling the promise to provide prescription drugs to its client plan members while also performing the related pharmacy benefit management services and therefore recognizes revenue on a gross basis. The Company includes the total prescription price (drug ingredient cost plus dispensing fee) it has contracted with these clients as revenue, including member co-payments to pharmacies.

Net sales include (i) the portion of the price the client pays directly to the Company, net of any variable consideration including volume-related or other discounts paid back to the client, (ii) the price paid to the Company by client plan members for mail order prescriptions and the price paid to retail network pharmacies by client plan members for retail prescriptions and (iii) claims-based administrative fees. The Company records revenue, net of manufacturer’s rebates, which are earned by and paid to its clients based on their plan members’ utilization of brand-name formulary drugs. The Company estimates these rebates at period-end based on actual claims data and its estimates of manufacturers’ rebates earned by its clients based upon their claims volume and utilization of certain brand-name formulary drugs. The Company adjusts against revenues its estimated rebates payable to clients to the actual amounts paid when such adjustments become known. The Company also adjusts revenues for refunds owed to its clients resulting from pricing and performance guarantees against defined metrics which are estimated and accrued for based upon current performance to date against contractual performance guarantees.

Sales taxes are presented on a net basis, excluded from revenue and cost, for both reportable segments.

Cost of sales includes the cost of pharmaceuticals dispensed to customers either directly at its mail pharmacy locations, or indirectly through its nationwide network of participating pharmacies. Rebates attributable to clients are accrued as rebates receivable and a reduction of cost of sales with a corresponding payable for the amounts of the rebates to be remitted to those clients in accordance with their contracts which is recorded as a reduction of product revenue. Cost of sales also includes the cost of personnel to support the transaction processing services, system sales, maintenance and professional services.

Rebates retained, which represents the difference between the manufacturers’ rebates earned and rebates incurred to customers, approximated 17.9% and 0.4% of total gross profit for the years ended December 31, 2018 and 2017, respectively.

Advertising and Marketing Costs

Advertising and marketing costs are expensed as incurred as a component of SG&A and were $3,075, $2,251 and $3,868 for the years ended December 31, 2018, 2017 and 2016, respectively.

Defined Contribution Savings Plans

The Company maintains certain defined contribution savings plans for eligible employees. The total expenses attributable to the defined contribution savings plans are recorded as a component of SG&A and were $4,056, $2,908 and $2,665 for the years ended December 31, 2018, 2017 and 2016, respectively.

Share-Based Compensation

The Company grants stock options to key employees, which are accounted for as equity awards. The exercise price of a granted stock option is equal to the closing market stock price of the underlying common share on the date the option is granted. The grant date fair value of these awards is measured using the Black-Scholes-Merton option pricing model. Stock options generally become exercisable in installments of 25 percent per year, beginning on the first anniversary of the grant date and each of the three anniversaries thereafter or 33 percent per year, beginning on the first anniversary of the grant date and each of the two anniversaries thereafter, and have a maximum term of ten years. The Company expenses the grant date fair values of stock options over their respective vesting periods on a straight-line basis. Estimating grant date fair values for employee stock options requires management to make assumptions regarding expected volatility of the underlying shares, the risk-free rate over the expected life of the stock options and the length of time in years that the granted options are expected to be outstanding. Expected volatility is based on a weighted average of the Company’s historic volatility and an implied volatility for a group of industry-relevant healthcare companies as of the measurement date. Risk-free rate is determined based upon U.S. Treasury rates over the estimated expected option of lives. Expected dividend yield is zero as we do not anticipate declaring a dividend during the expected term of the options. Expected option life is calculated using the simplified method (the midpoint between the end of the vesting period and the end of the maximum term). Forfeitures are accounted for when they occur.

The Company also grants restricted stock units (“RSU” or “RSUs”) to key employees, which are accounted for as equity awards. Certain RSU grants have performance-based conditions, which require the satisfaction of certain revenue and/or adjusted EBITDA targets prior to vesting. The grant date fair value of a RSU is determined by the closing market price of the Company’s common stock as of the date of grant. The Company expenses the grant date fair values of RSUs on a straight-line basis over their respective vesting periods, which range from immediate vesting to three years from grant date.

The Company grants restricted stock awards (“RSA” or “RSAs”) to non-employee directors, which are accounted for as equity awards. RSAs generally fully vest on the first anniversary of the grant date. The grant date fair value of a RSA is determined by the closing market price of the Company’s common stock as of the date of grant. The Company expenses the grant date fair values of RSAs on a straight-line basis over their respective vesting periods.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income tax assets are evaluated quarterly to determine if valuation allowances are required or should be adjusted. The Company establishes valuation allowances for deferred tax assets based on a more likely than not standard. The ability to realize deferred tax assets depends on the ability to generate sufficient taxable income within the carryback or carryforward periods provided for in the tax law for each applicable tax jurisdiction. The assessment regarding whether a valuation allowance is required or should be adjusted also considers all available positive and negative evidence factors. It is difficult to conclude a valuation allowance is not required when there is significant objective and verifiable negative evidence, such as cumulative losses in recent years. We utilize a rolling three years of actual and current year results as the primary measure of cumulative losses in recent years. The Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized.

The Company records uncertain tax positions on the basis of a two-step process whereby it is determined whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position, and for those tax positions that meet the more likely than not criteria, the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority is recognized. The Company records interest and penalties on uncertain tax positions in Income tax benefit (expense).