QUEST DIAGNOSTICS INCORPORATED and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands Unless Otherwise Indicated)
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QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands unless otherwise indicated) 1. DESCRIPTION OF BUSINESS Quest Diagnostics Incorporated and its subsidiaries (“Quest Diagnostics” or the “Company”) is the largest provider of diagnostic testing, information and services in the United States, providing insights that enable physicians and other healthcare professionals to make decisions to improve health. Quest Diagnostics offers patients and physicians the broadest access to diagnostic laboratory services through the Company’s nationwide network of laboratories and owned patient service centers. The Company provides interpretive consultation through the largest medical and scientific staff in the industry, with approximately 900 M.D.s and Ph.D.s around the country. Quest Diagnostics is the leading provider of gene-based testing and other esoteric testing, the leading provider of anatomic pathology services, including dermatopathology, and the leading provider of testing for drugs-of-abuse. The Company is also a leading provider of testing for clinical trials, and risk assessment services for the life insurance industry. The Company’s diagnostics products business manufactures and markets diagnostic test kits and specialized point-of-care testing. Quest Diagnostics empowers healthcare organizations and clinicians with state-of-the-art information technology solutions that can improve patient care and medical practice. During 2007, Quest Diagnostics processed approximately 145 million requisitions through its extensive network of laboratories and patient service centers in virtually every major metropolitan area throughout the United States. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of all entities controlled by the Company through its direct or indirect ownership of a majority voting interest and the accounts of any variable interest entities, as defined in Financial Accounting Standards Board (“FASB”) Interpretation No. 46 “Consolidation of Variable Interest Entities”, where the Company is subject to a majority of the risk of loss from the variable interest entity’s activities, or entitled to receive a majority of the entity’s residual returns or both. The Company’s relationships with variable interest entities were not material at both December 31, 2007 and 2006. Investments in entities which the Company does not control, but in which it has a substantial ownership interest (generally between 20% and 49%) and can exercise significant influence, are accounted for using the equity method of accounting. As of December 31, 2007 and 2006, the Company’s investments in affiliates accounted for under the equity method of accounting totaled $37.5 million and $38.5 million, respectively. The Company’s share of equity earnings from investments in affiliates, accounted for under the equity method, totaled $27.0 million, $28.5 million and $26.2 million, respectively, for 2007, 2006 and 2005. All significant intercompany accounts and transactions are eliminated in consolidation. Basis of Presentation During the third quarter of 2006, the Company completed its wind-down of NID, a test kit manufacturing subsidiary, and classified the operations of NID as discontinued operations. The accompanying consolidated statements of operations and related disclosures have been prepared to report the results of NID as discontinued operations for all periods presented. See Note 16 for a further discussion of discontinued operations. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition The Company primarily recognizes revenue for services rendered upon completion of the testing process. Billings for services reimbursed by third-party payers, including Medicare and Medicaid, are recorded as revenues net of allowances for differences between amounts billed and the estimated receipts from such payers. Adjustments to the estimated receipts, based on final settlement with the third-party payers, are recorded upon F-6 QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (dollars in thousands unless otherwise indicated) settlement. In 2007, 2006 and 2005, approximately 17%, 17% and 18%, respectively, of net revenues were generated by Medicare and Medicaid programs. Under capitated arrangements with healthcare insurers, the Company recognizes revenue based on a predetermined monthly reimbursement rate for each member of an insurer’s health plan regardless of the number or cost of services provided by the Company. Taxes on Income The Company uses the asset and liability approach to account for income taxes. Under this method, deferred tax assets and liabilities are recognized for the expected future tax consequences of differences between the carrying amounts of assets and liabilities and their respective tax bases using tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period when the change is enacted. On January 1, 2007, the Company adopted FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109 “Accounting for Income Taxes.” FIN 48 provides guidance on recognizing, measuring, presenting and disclosing in the financial statements uncertain tax positions that a company has taken or expects to take on a tax return. See Note 5 for further information related to FIN 48. Earnings Per Share Basic earnings per common share is calculated by dividing net income by the weighted average common shares outstanding. Diluted earnings per common share is calculated by dividing net income, adjusted for the after-tax impact of the interest expense associated with the Company’s 13⁄4% contingent convertible debentures due 2021 (the “Debentures”), by the weighted average common shares outstanding after giving effect to all potentially dilutive common shares outstanding during the period. Potentially dilutive common shares include the dilutive effect of outstanding stock options, performance share units and restricted common shares granted under the Company’s Amended and Restated Employee Long-Term Incentive Plan and its Amended and Restated Director Long-Term Incentive Plan and the Debentures. The Debentures were called for redemption by the Company in December 2004 and redeemed as of January 18, 2005. The computation of basic and diluted earnings per common share (using the if-converted method) was as follows (in thousands, except per share data): 2007 2006 2005 Income from continuing operations – basic. ....................... $ 553,828 $625,692 $573,196 Loss from discontinued operations – basic . ....................... (213,889) (39,271) (26,919) Net income available to common stockholders – basic .............. 339,939 586,421 546,277 Add: Interest expense associated with the Debentures, net of related tax effects. ................................................... - - 82 Net income available to common stockholders – diluted ............ $ 339,939 $586,421 $546,359 Weighted average common shares outstanding – basic .............. 193,241 196,985 201,833 Effect of dilutive securities: Stock options . ................................................... 2,019 2,535 3,533 Restricted common shares and performance share units ............. 2 22 11 Debentures ....................................................... - - 153 Weighted average common shares outstanding – diluted ............ 195,262 199,542 205,530 Earnings per common share – basic: Income from continuing operations ................................ $ 2.87 $ 3.18 $ 2.84 Loss from discontinued operations . ................................ (1.11) (0.20) (0.13) Net income....................................................... $ 1.76 $ 2.98 $ 2.71 Earnings per common share – diluted: Income from continuing operations ................................ $ 2.84 $ 3.14 $ 2.79 Loss from discontinued operations . ................................ (1.10) (0.20) (0.13) Net income....................................................... $ 1.74 $ 2.94 $ 2.66 F-7 QUEST DIAGNOSTICS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (dollars in thousands unless otherwise indicated) The following securities were not included in the diluted earnings per share calculation due to their antidilutive effect (in thousands): 2007 2006 2005 Stock options........................................................ 3,114 2,443 337 Restricted common shares and performance share units . .............. 731 786 - Stock-Based Compensation SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”),