Summary of Significant Accounting Policies

12 Months Ended

Dec. 31, 2011

Summary of Significant Accounting Policies

Summary of Significant Accounting Policies

1.Summary of Significant Accounting Policies

Basis of Presentation and Description of Business

The consolidated financial statements include the accounts of Res-Care, Inc. and its subsidiaries. All references in these financial statements to “ResCare”, “Company”, “our company”, “we”, “us”, or “our” mean Res-Care, Inc. and, unless the context otherwise requires, its consolidated subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation.

On November 16, 2010, an affiliate of Onex Partners III LP (Purchaser) completed a tender offer to acquire all outstanding shares of ResCare common stock, as further described in Note 2. The acquisition resulted in a new basis of accounting under the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805, Business Combinations. This change creates many differences between reporting for ResCare post-acquisition, as successor, and ResCare pre-acquisition, as predecessor. The accompanying consolidated financial statements and the notes to consolidated financial statements reflect separate reporting periods. The separate reporting periods are for successor and predecessor where applicable. Periods prior to November 16, 2010 are related to the predecessor.

We receive revenues primarily from the delivery of residential, therapeutic, job training and educational support services to various populations with special needs.

Fiscal Year

Operating results of acquired businesses are included in the Consolidated Statements of Income from the date of acquisition. During 2009, we eliminated the one-month lag between the reporting periods of our international operations and the rest of the company. Therefore, our international results include one additional month for the year ended December 31, 2009. This adjustment, a $0.5 million loss, did not have a material effect on our 2009 results of operations.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires us to make estimates and assumptions that affect the reported amounts and related disclosures of commitments and contingencies. We rely on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.

Reclassification

During the third quarter of 2011, the Company finalized the purchase price allocation on the Onex transaction. As a result, we have adjusted our December 31, 2010 balance sheet. See Note 2 for further discussion.

During 2011, we ceased providing international services within the Workforce Services operating segment. In accordance with Accounting Standards Codification (ASC) 205-20, Discontinued Operations, the closure and sale of the international operations have been accounted for as discontinued operations. Accordingly, the results of our international Workforce Services operations, loss on sale of the business and all exit costs have been classified as discontinued operations, net of taxes, for all periods presented, in the accompanying consolidated statements of income. Additional information regarding discontinued operations can be found in Note 3.

Certain prior year amounts have been reclassified to conform to the current year presentation due to the change in reporting segments discussed in Note 10 and for the presentation of gross profit. We have changed the presentation in our consolidated statements of income by reclassifying operational general and administrative expenses, previously classified as facility and program expenses, to Operating expenses. Costs related to the provision of services are now deducted from revenues to arrive at gross profit. This reclassification had no impact to the Operating income line item. All prior period amounts were reclassified to conform to this new presentation. Such reclassifications had no material effect on the Company’s previously reported consolidated financial position, results of operations or cash flows.

Segments

Effective January 1, 2011, we changed our reportable operating segments to: (i) Residential Services, (ii) ResCare HomeCare, (iii) Youth Services and (iv) Workforce Services. Residential Services primarily includes services for individuals with intellectual, cognitive or other developmental disabilities in our community home settings. ResCare HomeCare primarily includes periodic in-home care services to the elderly, as well as persons with disabilities. Youth Services consists of our Job Corps centers, a variety of youth programs including foster care, alternative education programs and charter schools. Workforce Services is comprised of job training and placement programs that assist welfare recipients and disadvantaged job seekers in finding employment and improving their career prospects. We have presented prior periods to reflect the change in our segments. Further information regarding our segments is included in Note 10.

Revenue Recognition

Overview: We recognize revenues as they are realizable and earned in accordance with the Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). SAB 104 requires that revenue can only be recognized when persuasive evidence of an arrangement exists, services have been rendered, the price is fixed or determinable and collectibility is reasonably assured.

Residential Services: Revenues are derived primarily from 35 different state Medicaid programs and from management contracts with private operators, generally not-for-profit providers, who contract with state government agencies and are also reimbursed under the Medicaid programs. Revenues from the state Medicaid programs are recorded at rates established at or before the time services are rendered. Revenue is recognized in the period services are rendered.

ResCare HomeCare: Revenues are derived from State Medicaid programs, other government agencies, commercial insurance companies, long-term care insurance policies, as well as private pay customers. Revenues are recorded at rates established at or before the time services are rendered. Revenue is recognized in the period services are rendered.

Youth Services: Revenues include amounts reimbursable under cost reimbursement contracts with the Department of Labor (DOL) for operating Job Corps centers for education and training programs. The contracts provide reimbursement for direct facility and program costs related to operations, allowable indirect costs for general and administrative costs, plus a predetermined management fee, normally a combination of fixed and performance-based. Final determination of amounts due under the contracts is subject to audit and review by the applicable government agencies. Additional revenues are reimbursed from various state government agencies including Medicaid programs as we operate our foster care programs, residential youth programs and school programs in multiple states. Revenue is recognized in the period associated costs are incurred and services are rendered.

Workforce Services: Revenues are derived primarily through contracts with local and state governments funded by federal agencies. Revenue is generated from contracts which contain various pricing arrangements, including: (1) cost reimbursable, (2) performance-based, (3) hybrid, and (4) fixed price.

With cost reimbursable contracts, revenue is recognized for the direct costs associated with functions that are specific to the contract, plus an indirect cost percentage that is applied to the direct costs, plus a profit. Revenue is recognized in the period the associated costs are incurred and services are rendered.

Under a performance-based contract, revenue is generally recognized as earned based upon the attainment of a unit performance measure times the fixed unit price for that specific performance measure. Typically, there are many different performance measures that are stipulated in the contract that must be tracked to support the billing and revenue recognition. Revenues may be recognized prior to achieving a benchmark as long as reliable measurements of progress-to-date activity can be obtained, indicating that it is probable that the benchmark will be achieved. This requires judgment in determining what is considered to be a reliable measurement.

Revenues for hybrid contracts are recognized based on the specific contract language. The most common type of hybrid contract is “cost-plus,” which provide for the reimbursement of direct and indirect costs with profit tied to meeting certain performance measures. Revenues for cost-plus contracts are generally recognized in the period the associated costs are incurred with an estimate made for the performance-based portion, as long as reliable measurements of progress-to-date activity can be obtained, indicating that it is probable that the benchmark will be achieved. This requires judgment in determining what is considered to be a reliable measurement.

Revenues for fixed price contracts are generally recognized in the period services are rendered. Some fixed priced contracts may contain performance-based measures that may increase or decrease our revenue. Those adjustments are made to revenue when the performance indicators have been achieved or an estimate can be made as long as reliable measurements of progress to date activity can be obtained, indicating that it is probable that the benchmarks will be achieved. This requires judgment in determining what is considered to be a reliable measurement.

Laws and regulations governing the government programs and contracts are complex and subject to interpretation. As a result, there is at least a reasonable possibility that recorded estimates will change by a material amount in the near term. For each operating segment, expenses are subject to examination by agencies administering the contracts and services. We believe that adequate provisions have been made for potential adjustments arising from such examinations.

We are substantially dependent on revenues received under contracts with federal, state and local government agencies. Operating funding sources for 2011 and 2010 in both the successor and predecessor were approximately 65% through Medicaid reimbursement, 8% from the DOL and 27% from other payors. There was no single customer whose revenue was 10% or more of our consolidated revenue for any reporting period presented. Generally, these contracts are subject to termination at the election of governmental agencies and in certain other circumstances such as failure to comply with applicable regulations or quality of service issues.

Cost of Services

We classify expenses directly related to providing services, along with depreciation and amortization attributable to our operating segments, as cost of services. Direct costs and expenses principally include salaries and benefits for direct care professionals, contracted labor costs, insurance costs, transportation costs for clients requiring services, certain client expenses such as food, supplies and medicine, residential occupancy expenses, which primarily comprise rent and utilities, and other miscellaneous direct service-related expenses.

Cash Equivalents

We consider all highly liquid instruments purchased with an original maturity of three months or less to be cash equivalents and are treated as such for reporting cash flows. Cash equivalents are stated at cost, which approximates market value.

Valuation of Accounts Receivable

Accounts receivable consist primarily of amounts due from Medicaid programs, other government agencies and commercial insurance companies. An estimated allowance for doubtful accounts receivable is recorded to the extent it is probable that a portion or all of a particular account will not be collected. In evaluating the collectibility of accounts receivable, we consider a number of factors, including historical loss rates, age of the accounts, changes in collection patterns, the status of ongoing disputes with third-party payors, general economic conditions and the status of state budgets. Complex rules and regulations regarding billing and timely filing requirements in various states are also a factor in our assessment of the collectibility of accounts receivable. Actual collections of accounts receivable in subsequent periods may require changes in the estimated allowance for doubtful accounts. Changes in these estimates are charged or credited to the results of operations in the period of the change of estimate.

Valuation of Long-Lived Assets

We regularly review the carrying value of long-lived assets with respect to any events or circumstances that indicate a possible inability to recover their carrying amount. Indicators of impairment include, but are not limited to, loss of contracts, significant census declines, reductions in reimbursement levels, significant litigation and impact of economic conditions on service demands and levels. Our evaluation is based on undiscounted cash flows, profitability and projections that incorporate current or projected operating results, as well as significant events or changes in the reimbursement or regulatory environment. If circumstances suggest the recorded amounts cannot be recovered, the carrying values of such assets are reduced to fair value based upon various techniques to estimate fair value.

Goodwill and Other Indefinite-lived Intangible Assets

Goodwill is calculated as the excess of the cost of purchased businesses over the fair value of their underlying net assets. Goodwill was recorded for the Onex transaction (see Note 2) to reflect the amount of purchase price in excess of the fair value of the Company’s net assets. Other indefinite-lived intangible assets include licenses that are essential for ResCare to operate its businesses in various states and other jurisdictions. Goodwill and other indefinite-lived intangible assets are not amortized. We test goodwill and other indefinite-lived intangible assets for impairment annually, unless changes in circumstances indicate impairment may have occurred sooner. We test goodwill on a reporting unit basis, in which a reporting unit is generally defined as the operating segment, but can be a component of an operating segment. We use a fair value approach to test goodwill for impairment and recognize an impairment charge for the amount, if any, by which the carrying amount of reporting unit goodwill exceeds its implied fair value. Fair values for goodwill are typically determined using an income approach (using discounted cash flow analysis method) or a market approach (using the guideline company method or the guideline transactions method), or it can be based on a weighted average of all or a combination of these methods. Due to limited comparability to our reporting units of the comparable guideline companies and limited financial information available surrounding the transactions for companies sold, we utilized the discounted cash flow analysis to establish fair values in our 2011 annual impairment test. The goodwill impairment test is a two-part test. Step One of the impairment test compares the fair values of each of our reporting units to their carrying value. If the fair value is less than the carrying value for any of our reporting units, Step Two must be completed. Fair values for indefinite-lived intangible assets are measured using the cost approach.

For our October 1, 2011 annual impairment test, all reporting units passed Step One. The Youth Services-Residential Youth and Workforce Services reporting units only passed Step One with a fair value that exceeded its carrying value by a 13 and 12 percent margin, respectively. The Youth Services-Residential Youth and Workforce Services reporting units had allocated goodwill balances of $9.6 million and $32.7 million, respectively, as of October 1, 2011. A 100 basis point increase in the discount rate for these two reporting units would decrease the fair value in excess of carrying value to a 5 percent margin for each reporting unit. A 100 basis point decrease in the long-term growth rate for these two reporting units would decrease the fair value in excess of carrying value to a 9 percent margin for each reporting unit.

In February 2012, we were informed by the New York City Human Resources Administration that the Wellness, Comprehensive Assessment, Rehabilitation and Employment (WeCARE) contract had been awarded to another operator through the competitive bid process. We anticipate that our performance will continue under a contract extension until December 2012. Annual revenues for this contract are $28 million. We have filed a formal protest and are exploring all available options to challenge the contract award and the bid process. We believe it is at least reasonably possible that we will be unsuccessful in our efforts to retain this contract, which would indicate the potential for an impairment of the Workforce Services goodwill exists and require us to perform an impairment assessment in the near term. We estimate that this could result in an impairment charge up to $5 million for the Workforce Services reporting unit in 2012.

During the predecessor period ended November 15, 2010, we recorded a goodwill impairment charge of $263.2 million, of which $13.0 million is included in our loss from discontinued operations. In 2009, we recorded a goodwill impairment charge of $70.1 million, of which $8.9 million is included in our loss from discontinued operations. See Note 5 for the details of the impairment charges.

Intangible Assets – Defined Lives

Our intangible assets consist primarily of trade names, customer contracts and relationships and non-competition agreements, which are amortized over two to twenty years, based on their estimated useful lives.

Debt Issuance Costs

Debt issuance costs are capitalized and amortized as interest expense over the terms of the related debt using an effective interest method.

Income Taxes

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. 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 of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. A valuation allowance is provided for deferred assets if it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

The Company recognizes tax benefits that are considered more-likely-than-not. Recognized income tax positions are measured at the largest amount that is more likely than not of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.

Our policy is to recognize interest related to unrecognized tax benefits as interest expense and penalties as corporate general and administrative expense.

Deferred Gains on Sale and Leaseback of Assets

Gains from the sale and leaseback of assets are deferred and amortized over the term of the operating lease as a reduction of rental expense.

Legal Contingencies

We are a party to numerous claims and lawsuits with respect to various matters. We provide for costs, including legal costs, related to contingencies when a loss is probable and the amount is reasonably determinable. We confer with outside counsel in estimating our potential liability for certain legal contingencies. While we believe our provision for legal contingencies is adequate, the outcome of legal proceedings is difficult to predict and we may settle legal claims or be subject to judgments for amounts that exceed our estimates.

Insurance Losses

We self-insure a substantial portion of our professional, general and automobile liability, workers’ compensation and health benefit risks. These liabilities are necessarily based on estimates and, while we believe that the provision for loss is adequate, the ultimate liability may be more or less than the amounts recorded. Provisions for losses for workers’ compensation risks are based upon actuarially determined estimates and include an amount determined from reported claims and an amount based on past experiences for losses incurred but not reported. Estimates of workers’ compensation claims reserves have been discounted using a discount rate of 3% at December 31, 2011 and 2010. The liabilities are evaluated quarterly and any adjustments are reflected in earnings in the period known. We have excess general and professional liability insurance coverages.

Operating Leases

We lease certain operating facilities, office space, vehicles and equipment under operating leases. Our operating lease terms generally range from one to fifteen years with renewal options. Facility lease agreements may include rent holidays and rent escalation clauses. We recognize rent holiday periods and scheduled rent increases on a straight-line basis over the lease term beginning with the date we take possession of the leased space.

Property and Equipment

At November 16, 2010, all property and equipment was stated at fair value as discussed in Note 2. All additions of property and equipment since November 16, 2010 are stated at cost. At December 31, 2011 all property and equipment was stated at fair value or cost, less accumulated depreciation and amortization. Depreciation and amortization are provided by the straight-line method over the estimated useful lives of the assets. Estimated useful lives for buildings are 20 years. Assets under capital lease and leasehold improvements are amortized over the term of the respective lease or the useful life of the asset, if shorter, which varies from one to fifteen years. The useful lives of furniture and equipment vary from three to seven years. Depreciation expense includes amortization of assets under capital lease.

We act as custodian of assets where we have contracts to operate facilities or programs owned or leased by the DOL, various states and private providers.

Foreign Currency Translation

A foreign subsidiary designates its local currency as its functional currency. Operating results are translated into U.S. dollars using monthly average exchange rates, while balance sheet accounts are translated using year-end exchange rates. The resulting translation adjustments are included as a component of accumulated other comprehensive income (loss) in shareholders’ equity.

Share-based Compensation

Effective January 1, 2006, the Company adopted the provisions of ASC 718, Stock Compensation, (ASC 718) using the modified prospective transition method. Under this transition method, compensation expense recognized during the period ended November 15, 2010 and years ended December 31, 2011 and 2009 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of, December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of ASC 718, and (b) compensation expense for all share-based awards granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of ASC 718. No share-based compensation expense was recorded in the period November 16, 2010 to December 31, 2010. Pursuant to ASC 718, the income tax benefits exceeding the recorded deferred income tax benefit from share-based compensation awards (the excess tax benefits) are required to be reported in cash provided by financing activities. Our share-based compensation plans and share-based payments are described more fully in Note 12, Share-based Compensation.

Financial Instruments

We used various methods and assumptions in estimating the fair value disclosures for significant financial instruments. Fair values of cash and cash equivalents, accounts receivable and accounts payable approximate their carrying amount because of the short maturity of those investments. The fair value of long-term debt is determined using market quotes and calculations based on current market rates available to us.

Impact of Recently Issued Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (FASB) issued new guidance intended to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with accounting principles generally accepted in the United States of America and those prepared in accordance with international financial reporting standards. While the new guidance is largely consistent with existing fair value measurement principles, it expands existing disclosure requirements for fair value measurements and makes other amendments which could change how existing fair value measurement guidance is applied. The new guidance will be effective for us beginning with the filing of our Form 10-Q for the three months ending March 31, 2012. We do not expect this new guidance will have a material impact on our financial position, results of operations or cash flows, as it expands existing disclosure requirements.

In June 2011, the FASB issued Accounting Standard Update (ASU) 2011-05, Comprehensive Income (Topic 220), which provides new guidance on the presentation of comprehensive income. ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in stockholders’ equity and instead requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement or in two separate but consecutive statements. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, with early adoption permitted. We do not expect the adoption of this ASU will have a material impact on our financial position, results of operations or cash flows, as it only requires a change in the format of the current presentation.

In September 2011, the FASB issued authoritative guidance in ASC 350, Intangibles - Goodwill and Other, intended to simplify goodwill impairment testing. Entities will be allowed to perform a qualitative assessment on goodwill impairment to determine whether it is more likely than not (defined as having a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. This guidance is effective for goodwill impairment tests performed in interim and annual periods for fiscal years beginning after December 15, 2011. We do not expect this new guidance will have a material impact on our financial position, results of operations or cash flows.