SHARE-BASED COMPENSATION

General

We have six stockholder-approved stock incentive plans (“Plans”), for our key employees, directors and key consultants. The Plans provide for the grant of incentive stock options, nonqualified stock options, restricted stock awards, and, in the case of the plans approved by the shareholders on May 10, 2007 and May 19, 2009, restricted stock units and stock appreciation rights. We intend to grant new awards under only the 2009 Stock Incentive Plan (“2009 Plan”). The 2009 Plan was amended on June 1, 2011 to increase the number of shares available for grant by 500,000 and to require shareholder approval to reprice awards under the 2009 Plan. No such repricing has ever been done nor is it anticipated to be done in the future. The options are granted at fair market value, as defined in the option agreement, on the date of grant. There were 656,344 shares available for issuance at September 30, 2011.

Our stock-based awards are accounted for under the provisions of FASB ASC Topic 718 – Stock Compensation. We measure and recognize stock-based compensation expense based on the fair value measurement for all stock-based payment awards made to our employees and directors over the service period for which the awards are expected to vest. We calculate the fair value of each restricted stock award based on our stock price on the date of grant and the fair value of each stock option award on the date of grant using the Black-Scholes-Merton option pricing model. The determination of fair value of stock option awards on the date of grant using an option-pricing model is affected by our stock price as well as a number of assumptions including expected life, expected volatility, risk-free interest rate and dividend yield. As a result, the future stock-based compensation expense may differ from our historical amounts.

In June 2010, we implemented an equity tracking software system. In the course of that implementation, it came to our attention that we had three issues with our historical expense calculations that we broke into two categories: (1) cumulative adjustments and (2) first quarter 2010 restricted stock vesting. We concluded that these adjustments should be considered “correction of errors” as opposed to “changes in estimates” based on the definitions set out in FASB ASC Topic 250 – Accounting Changes and Error Corrections. We performed an analysis under SAB108 – Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (SAB108), and used the materiality guidance of SAB99 – Materiality (SAB99) to determine whether or not the impact to any one period or the cumulative impact on a given period was material enough to require a restatement to previously filed financial statements.

The cumulative adjustment is the result of netting two offsetting issues. The first issue involved the use of estimated forfeiture rates and the required true-up to actual forfeiture rates for all awards issued between 2006 and 2010, and the second issue was a mathematical error in the calculation of the volatility rate used to establish the grant date fair value of awards issued from 2008 to 2010. Since both adjustments impact the same financial statement item, stock-based compensation expense, we determined that they could be combined into one net adjustment of additional expense of $445,000 ($308,000 of which related to periods prior to 2010). Based on our analysis and an evaluation of materiality, which required us to assess both qualitative and quantitative factors, it was determined that the adjustment was not material to any prior reporting periods or to the expected annual results for 2010; therefore, the entire adjustment was recorded in the second quarter of 2010.

The second category related to the vesting of certain restricted stock awards in the first quarter of 2010. At the time of vesting in the first quarter of 2010, only $124,000 of the total stock-based compensation expense of $355,000 had been recorded. The difference of $231,000 should have been recorded as additional compensation expense in the first quarter of 2010. Based on our analysis, it was determined that the adjustment was not material to the first quarter and did not require a restatement of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010. In accordance with SAB108, the entry was recorded as a first quarter of 2010 adjustment in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 and has been and will be reflected in any future filing of the financial information for the period ending March 31, 2010 and the year ended December 31, 2010.

The following table shows the impact of the adjustment and the revised financial information for the quarter ended March 31, 2010.



	Quarter ended March 31, 2010 as Reported		Adjustment		Quarter Ended March 31, 2010 as Revised
Revenue	$	22,206,000			$	22,206,000
Gross profit	7,480,000				7,480,000
General and administrative expense	3,528,000		231,000		3,759,000
Operating expense	4,805,000		231,000		5,036,000
Operating income	2,675,000		(231,000	)	2,444,000
Income tax provision	1,016,000		(78,000	)	938,000
Net income	1,632,000		(153,000	)	1,479,000
Earnings per share - basic	0.16		(0.02	)	0.14
Earnings per share - diluted	0.15		(0.01	)	0.14

The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton option pricing model that uses the assumptions or range of assumptions. The risk-free interest rate for the period matching the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The dividend yield is the calculated yield on our stock at the time of grant. The expected term of the options represents the period of time that options granted are expected to be outstanding and is derived by analyzing historic exercise behavior along with currently outstanding options. Expected volatilities are based on the historic volatility of our common stock. The expected forfeiture rates are based on historical forfeiture rates. There were 10,000 options granted in the quarter ended September 30, 2011. The weighted average grant date fair value of options granted in the quarter ended September 30, 2011 was $13.27, and the assumptions used were as follows:



Risk-free interest rate	1.06	%
Expected dividend yield	0	%
Expected term	5.52 years
Expected volatility	58.05	%
Expected forfeiture rate	19.15	%
Exercise price of options issued	$25.56

Transactions involving our stock options for the nine months ended September 30, 2011 were as follows:



	Number of Shares Subject to Stock Options		Weighted Average Exercise Price		Weighted Average Remaining Contract Life	Aggregate Intrinsic Value*
Outstanding at December 31, 2010	872,767		$	8.91	6.6 years
Granted	29,500		$	25.28
Forfeited	(54,750	)	$	17.54
Exercised	(72,711	)	$	9.98		$	913,000
Outstanding at September 30, 2011	774,806		$	8.83	5.8 years	$	10,623,000

*The aggregate intrinsic value is based on a closing stock price of $22.54 as of September 30, 2011.

In the first nine months of 2011, we issued 28,580 shares of restricted stock to certain participants under the 2009 Plan. Our directors were issued 9,580 of these shares which vest over three years. The remaining 19,000 shares were issued to employees, of which 15,000 shares are performance based vesting in quarterly increments each March in 2012 through 2015 and 4,000 shares are time based and vest over four years. We use the average of the grant date high and low stock price along with expected forfeiture rates of 0% to 25.55% to calculate fair value of restricted stock awards issued. During the first quarter of 2011, 18,000 shares of performance based restricted stock were forfeited due to the failure to meet 2010 performance measures required for the vesting of these shares.

Transactions involving our restricted stock for the nine months ended September 30, 2011 were as follows:



	Number of Shares		Weighted Average Grant Date Fair Value
Non-vested stock outstanding at December 31, 2010	99,500		$	16.25
Granted	28,580		$	25.30
Forfeited	(18,000	)	$	16.34
Vested	—
Non-vested stock outstanding at September 30, 2011	110,080		$	18.32

We recognized stock-based compensation expense under FASB ASC Topic 718 – Compensation-Stock Compensation of approximately $342,000 and $191,000 for the three months ended September 30, 2011 and 2010, and $917,000 and $1,276,000 for the nine months ended September 30, 2011 and 2010, respectively. These totals include the adjustment to stock-based compensation expense in the first quarter of 2010 discussed above. As of September 30, 2011, we had approximately $2,500,000 of future equity-based compensation expense which we expect to record in our statements of operations through 2015.