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EX-31.1 - CEO CERTIFICATION - TRANSCEND SERVICES INCtrcr-93011xex311.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_____________________________________________
FORM 10-Q
_____________________________________________
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number 000-18217
_____________________________________________
TRANSCEND SERVICES, INC.
(Exact name of registrant as specified in its charter)
_____________________________________________
Delaware
 
33-0378756
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S Employer
Identification No.)

One Glenlake Parkway, Suite 1325, Atlanta, GA 30328
(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (678) 808-0600


_____________________________________________

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   x     No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
 
Accelerated filer
x
 
 
 
 
 
Non-accelerated filer
o
 
Smaller reporting company
o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x

Indicate the number of shares outstanding of the registrant’s common stock, as of the latest practicable date.
Class
 
Outstanding at October 31, 2011
Common Stock, $0.05 par value
 
10,687,223
 
 
 

INDEX

 
 
Page
Number
 
 
 
PART I.
 
 
 
Item 1.
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
PART II.
 
 
 
Item 1A.
 
 
 
Item 6.
 
 
 
 


2


PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
TRANSCEND SERVICES, INC.
CONSOLIDATED BALANCE SHEETS
(Rounded to the nearest thousand)
 
 
 
 
 
September 30, 2011
 
December 31, 2010
ASSETS
(unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
10,398,000

 
$
6,207,000

Short-term investments
1,901,000

 
20,454,000

Accounts receivable, net of allowance for doubtful accounts of $177,000 at September 30, 2011 and $124,000 at December 31, 2010
17,462,000

 
12,037,000

Deferred income tax, net
1,481,000

 
482,000

Prepaid expenses and other current assets
925,000

 
688,000

Total current assets
32,167,000

 
39,868,000

Property and equipment:
 
 
 
Computer equipment
4,638,000

 
4,113,000

Software
5,172,000

 
4,263,000

Furniture and fixtures
704,000

 
652,000

Total property and equipment
10,514,000

 
9,028,000

Accumulated depreciation and amortization
(7,423,000
)
 
(6,052,000
)
Property and equipment, net
3,091,000

 
2,976,000

Capitalized software development costs, net
6,063,000

 
3,188,000

Goodwill and intangible assets:
 
 
 
Goodwill
46,509,000

 
28,246,000

Other intangible assets
15,269,000

 
8,789,000

Total intangible assets
61,778,000

 
37,035,000

Accumulated amortization
(2,690,000
)
 
(1,734,000
)
Intangible assets, net
59,088,000

 
35,301,000

Deferred income tax, net - non current
1,503,000

 
470,000

Other assets
337,000

 
414,000

Total assets
$
102,249,000

 
$
82,217,000

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
2,014,000

 
$
1,653,000

Accrued compensation and benefits
3,603,000

 
3,666,000

Promissory notes payable

 
67,000

Income tax payable
817,000

 
1,193,000

Other accrued liabilities
3,511,000

 
2,180,000

Total current liabilities
9,945,000

 
8,759,000

Long term liabilities:
 
 
 
Uncertain tax position
9,041,000

 
2,606,000

Other liabilities
573,000

 
689,000

Total long term liabilities
9,614,000

 
3,295,000

Commitments and contingencies (Note 10)
 
 
 
Stockholders’ equity:
 
 
 
Preferred stock, $0.01 par value; 2,000,000 shares authorized and no shares outstanding at September 30, 2011 and December 31, 2010

 


3


 
 
 
 
Common stock, $0.05 par value; 30,000,000 shares authorized at September 30, 2011 and December 31, 2010; 10,685,000 and 10,566,000 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively
534,000

 
528,000

Additional paid-in capital
65,157,000

 
63,368,000

Retained earnings
16,999,000

 
6,267,000

Total stockholders’ equity
82,690,000

 
70,163,000

Total liabilities and stockholders’ equity
$
102,249,000

 
$
82,217,000


The accompanying notes are an integral part of these consolidated financial statements.


4


TRANSCEND SERVICES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and rounded to the nearest thousand,
except earnings per share)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2011
 
2010
 
2011
 
2010
Revenue
$
32,202,000

 
$
22,916,000

 
$
92,162,000

 
$
67,331,000

Direct costs (1)
19,747,000

 
14,245,000

 
55,230,000

 
43,149,000

Gross profit
12,455,000

 
8,671,000

 
36,932,000

 
24,182,000

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing (1)
774,000

 
483,000

 
1,826,000

 
1,421,000

Information Technology (1)
1,221,000

 
498,000

 
3,127,000

 
1,332,000

General and administrative (1)
4,059,000

 
2,935,000

 
11,931,000

 
10,630,000

Depreciation and amortization
965,000

 
485,000

 
2,393,000

 
1,393,000

Total operating expenses
7,019,000

 
4,401,000

 
19,277,000

 
14,776,000

Operating income
5,436,000

 
4,270,000

 
17,655,000

 
9,406,000

Interest and other income
(50,000
)
 
(7,000
)
 
(118,000
)
 
(38,000
)
Interest and other expense
2,000

 
36,000

 
113,000

 
117,000

Loss on foreign currency transactions
379,000

 

 
284,000

 

Net other expense
331,000

 
29,000

 
279,000

 
79,000

Income before income taxes
5,105,000

 
4,241,000

 
17,376,000

 
9,327,000

Income tax provision
1,758,000

 
1,626,000

 
6,644,000

 
3,665,000

Net income
$
3,347,000

 
$
2,615,000

 
$
10,732,000

 
$
5,662,000

Basic earnings per share:
 
 
 
 
 
 
 
Net earnings per share
$
0.31

 
$
0.25

 
$
1.01

 
$
0.54

Weighted average shares outstanding
10,676,000

 
10,487,000

 
10,642,000

 
10,486,000

Diluted earnings per share:
 
 
 
 
 
 
 
Net earnings per share
$
0.30

 
$
0.24

 
$
0.97

 
$
0.52

Weighted average shares outstanding
11,110,000

 
10,800,000

 
11,053,000

 
10,827,000

 
 
 
 
 
 
 
 
(1) Amounts shown exclusive of depreciation and amortization

The accompanying notes are an integral part of these consolidated financial statements.


5


TRANSCEND SERVICES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2011
(Unaudited and rounded to the nearest thousand)
 
 
Number of
Shares of
Series A
Preferred
Stock
 
Series A
Preferred
Stock
 
Number of
Shares of
Common
Stock
 
Common
Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Total
Stockholders’
Equity
Balance, December 31, 2010

 
$

 
10,566,000

 
$
528,000

 
$
63,368,000

 
$
6,267,000

 
$
70,163,000

Net income

 

 

 

 

 
10,732,000

 
10,732,000

Issuance of common stock from stock incentive plans

 

 
119,000

 
6,000

 
728,000

 

 
734,000

Share-based compensation expense

 

 

 

 
917,000

 

 
917,000

Tax benefit for share based payments

 

 

 

 
144,000

 

 
144,000

Balance, September 30, 2011

 
$

 
10,685,000

 
$
534,000

 
$
65,157,000

 
$
16,999,000

 
$
82,690,000


The accompanying notes are an integral part of this consolidated financial statement.


6


TRANSCEND SERVICES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited and rounded to the nearest thousand)

 
Nine Months Ended September 30,
 
2011
 
2010
Cash flows from operating activities:
 
 
 
Net income
$
10,732,000

 
$
5,662,000

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Deferred income taxes
(921,000
)
 
(50,000
)
Depreciation and amortization
2,393,000

 
1,393,000

Share-based compensation
917,000

 
1,276,000

               Tax benefit for share based payments
(144,000
)
 
32,000

Changes in assets and liabilities:
 
 
 
Accounts receivable, net
(2,975,000
)
 
(21,000
)
Prepaid income taxes, excluding tax benefit for share-based payments
144,000

 
32,000

Prepaid expenses and other current assets
(196,000
)
 
(83,000
)
Other assets
93,000

 
77,000

Accounts payable
25,000

 
(12,000
)
Accrued and other liabilities
(1,225,000
)
 
828,000

Total adjustments
(1,889,000
)
 
3,472,000

Net cash provided by operating activities
8,843,000

 
9,134,000

Cash flows from investing activities:
 
 
 
Capital expenditures
(1,380,000
)
 
(1,571,000
)
Capitalized software development costs
(2,875,000
)
 
(2,569,000
)
Purchase of investments
(20,534,000
)
 
(55,716,000
)
Sale and maturity of investments
39,087,000

 
28,339,000

Purchase of business, net of cash acquired
(19,761,000
)
 

Net cash used in investing activities
(5,463,000
)
 
(31,517,000
)
Cash flows from financing activities:
 
 
 
Proceeds from stock options and other issuances of stock
734,000

 
75,000

Revision of estimate for capitalized expenses of stock offering

 
56,000

Tax benefit for share-based payments
144,000

 
(32,000
)
Repayment of promissory notes payable
(67,000
)
 
(832,000
)
Repayment of promissory note to related parties

 
(2,000,000
)
Net cash provided by (used in) financing activities
811,000

 
(2,733,000
)
Net change in cash and cash equivalents
4,191,000

 
(25,116,000
)
Cash and cash equivalents at beginning of period
6,207,000

 
25,732,000

Cash and cash equivalents at end of period
$
10,398,000

 
$
616,000

Supplemental cash flow information:
 
 
 
Cash paid for interest
$
1,000

 
$
20,000

Cash paid for interest to related party
$

 
$
100,000

Cash paid for income taxes
$
8,300,000

 
$
3,183,000


The accompanying notes are an integral part of these consolidated financial statements.


7


TRANSCEND SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying consolidated financial statements include the accounts of Transcend Services, Inc. and its subsidiary companies (the “Company” or “Transcend”). All intercompany accounts and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements are unaudited and have been prepared by our management in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for the fair presentation of the consolidated financial position, results of operations and cash flows, have been included. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010. Footnote disclosure that substantially duplicates the disclosure contained in that document has been omitted.

Recent Accounting Pronouncements

Recently Adopted Accounting Pronouncements

In December 2010, the FASB issued ASU 2010-28 to Topic 350— Intangibles—Goodwill and Other : When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. The amendments to the Codification in this update modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. Goodwill of a reporting unit is required to be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This update was effective starting in the first quarter of 2011 with early adoption not permitted. Adoption of this update did not have a material impact on our financial statements.

In December 2010, the FASB issued ASU 2010-29 to Topic 805—Business Combinations: Disclosure of Supplementary Pro Forma Information for Business Combinations. The amendments to the Codification in this ASU apply to any public entity that enters into business combinations that are material on an individual or aggregate basis and specify that the entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The update also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The update is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning in January 2011 with early adoption permitted. We have adopted this update for all acquisitions in 2011.

Recently Issued Accounting Pronouncements Not Yet Adopted

In May 2011, the Financial Accounting Standard Board ("FASB") issued Accounting Standards Update, ("ASU") 2011-04 to Topic 820 - Fair Value Measurements and Disclosures. The update, entitled Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, amends current fair value measurement and disclosure guidance to include increased transparency around valuation inputs and investment categorization.  The update results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. Generally Accepted Accounting Principles ("GAAP") and International Financial Reporting Standards ("IFRS") and also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The update is effective prospectively for interim and annual periods beginning after December 15, 2011. We do not expect that the adoption of this update will have a material impact on our financial statements.
In June 2011, the FASB issued ASU No. 2011-05 to Topic 220 - Comprehensive Income. The update, entitled Comprehensive Income (Topic 220): Presentation of Comprehensive Income requires comprehensive income to be reported in either a single statement or in two consecutive statements reporting net income and other comprehensive income. The amendment does not

8


change what items are reported in other comprehensive income or the U.S. GAAP requirement to report reclassification of items from other comprehensive income to net income. The update is effective for interim and annual periods beginning after December 15, 2011. This update affects the presentation of financial information only. Accordingly, we do not expect that the adoption of this update will have a material impact on our financial statements.
In September 2011, the FASB issued ASU No. 2011-08 to Topic 350 - Intangibles-Goodwill and Other. The update, entitled Testing Goodwill for Impairment, allows an entity to first assess qualitative factors in determining the necessity of performing the two-step quantitative goodwill impairment test. If, after assessing qualitative factors, an entity determines it is not likely that the fair value of a reporting unit is less than its carrying amount, performing the two-step impairment test is unnecessary. An entity also has the option to bypass the qualitative assessment and proceed directly to performing the first step of the two-step impairment test. The update will be effective for fiscal years beginning after December 15, 2011. We do not expect that the adoption of this update will have a material impact on our financial statements.

Net Earnings Per Share

We account for earnings per share in accordance with FASB ASC Topic 260 – Earnings per Share. Topic 260 requires the disclosure of basic net earnings per share and diluted net earnings per share. Basic net earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period and does not include any other potentially dilutive securities. Diluted net income per share gives effect to all potentially dilutive securities. Our stock options are potentially dilutive securities. Stock options with exercise prices that are
greater than the average market price are excluded from the calculation of diluted earnings per share because their effect would be anti-dilutive.

The reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations are presented below: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2011
 
2010
 
2011
 
2010
Numerator:
 
 
 
 
 
 
 
Net income
$
3,347,000

 
$
2,615,000

 
$
10,732,000

 
$
5,662,000

Denominator:
 
 
 
 
 
 
 
Weighted average shares outstanding
10,676,000

 
10,487,000

 
10,642,000

 
10,486,000

Effect of dilutive securities
 
 
 
 
 
 
 
Common stock options
434,000

 
313,000

 
411,000

 
341,000

Denominator for diluted calculation
11,110,000

 
10,800,000

 
11,053,000

 
10,827,000

 
 
 
 
 
 
 
 
Basic earnings per share
$
0.31

 
$
0.25

 
$
1.01

 
$
0.54

Diluted earnings per share
$
0.30

 
$
0.24

 
$
0.97

 
$
0.52

 
 
 
 
 
 
 
 
Weighted-average outstanding stock options not included in diluted net income per share calculation as they had an anti-dilutive effect
26,000

 
181,000

 
109,000

 
110,000


2. ACQUISITIONS
In the third quarter of 2011 we finalized our adjustments to the purchase price allocation of the October 2010 acquisition of Spryance, Inc. ("Heartland"). We identified three main adjustments:
1.
A possible uncertain tax position of approximately $6.8 million related to pre-acquisition tax returns filed by Heartland. In accordance with FASB ASC 740, we have established a liability of $6.8 million for this uncertain tax position which increases goodwill by $7.0 million and reduces the acquired deferred tax assets by $225,000. See Note 11 for further discussion.
2.
A $210,000 increase in goodwill and the tax contingent liability related to transfer-pricing with India.
3.
A $72,000 decrease in goodwill and a corresponding increase in the deferred tax asset related to completion of the limitation study of allowable net operating losses. See Note 11 for further discussion.


9


A reconciliation of the Heartland goodwill balance is as follows:
Balance December 31, 2010
 
 
$
4,580,000

Purchase price allocation adjustments
 
 
7,122,000

Balance September 30, 2011
 
 
$
11,702,000

On April 29, 2011, we entered into an Agreement and Plan of Merger with DTS America, Inc. ("DTS") and certain principal stockholders and acquired DTS America, Inc. through a merger of DTS Acquisition Corporation (a wholly-owned subsidiary of Transcend Services, Inc.) into DTS America, Inc. The aggregate consideration was $9,500,000, consisting of cash at closing of $8,900,000, $200,000 payable after receipt of financial statements and $400,000 payable one year after closing. As of September 30, 2011, none of the remaining $600,000 has been paid and is included in Other Accrued Liabilities on the Balance Sheet. There is no earn-out provision in the purchase agreement and no debt was assumed.
Founded in 1995, DTS was a medical transcription company that served approximately 30 hospitals plus a number of clinics and surgery centers in 13 states and generated approximately $12 million of annual revenue at the date of acquisition. We purchased DTS to capitalize on the potential for the acquired business to grow and leverage our fixed overhead costs across a larger revenue base.
We allocated the purchase price between goodwill, customer relationships and related deferred tax liability, covenant not to compete and net identifiable assets. We have included the results of DTS operations in our financial statements from the close date forward.
The following is a detailed list of the fair value of identifiable assets acquired and liabilities assumed in the DTS acquisition:
Cash
 
$
119,000

Accounts receivable
 
1,179,000

Fixed assets
 
147,000

Deferred tax asset
 
3,721,000

Other assets
 
22,000

    Total identifiable assets
 
5,188,000

Accounts payable
 
336,000

Benefits payable
 
377,000

Other liabilities
 
116,000

    Total identifiable liabilities
 
829,000

Net identifiable assets
 
$
4,359,000

The fair value of accounts receivable acquired approximated gross contractual amounts receivable. There were no assets arising from contingencies that were acquired in the transaction.
Goodwill of $3.2 million was recorded for the DTS acquisition. This consisted primarily of the synergies and economies of scale expected from combining the operations of Transcend and DTS and the value of the DTS assembled workforce. We have initially allocated the purchase price between goodwill, customer relationships and related deferred tax liability, and net identifiable assets. Since this transaction was a stock purchase, goodwill and intangibles will not be deductible for income tax purposes. As permitted, we expect to finalize the purchase price allocation within one year of the purchase date. We do not expect any changes to the purchase price allocation to materially increase or decrease amortization expenses, but there could be an impact on the allocation between goodwill and the deferred tax asset. As of September 30, 2011, the purchase price was allocated as follows:
Net identifiable assets
 
$
4,359,000

Customer relationships
 
3,000,000

Covenant not to compete
 
70,000

Goodwill
 
3,205,000

Deferred tax liability
 
(1,134,000
)
      Total purchase price
 
$
9,500,000

Intangible assets, except for goodwill, are amortized over their useful lives. The customer list is being amortized over ten years and the covenant not to compete over five years.

10


DTS revenue of $2,938,000 and $4,984,000 are included in our Consolidated Statement of Operations for the three and nine months ended September 30, 2011, respectively. Since we have fully integrated the DTS operations, it is impossible to segregate net income related to the DTS operations for the three and nine months ended September 30, 2011.
On July 29, 2011, we entered into an Agreement and Plan of Merger with Salar, Inc. ("Salar") and certain principal stockholders and acquired Salar through a merger of Salar Acquisition Corporation (a wholly-owned subsidiary of Transcend Services, Inc.) into Salar. The aggregate consideration was $11,000,000, consisting of cash at closing of $11,000,000, $1,000,000 of which is being held in escrow for a period of one year. There is no earn-out provision in the purchase agreement and no debt was assumed.
Founded in 1999, Salar is a software development and services company whose solutions are used by leading academic and community hospitals. Salar generated approximately $4 million of annual revenue at the date of acquisition. Salar's product solutions provide a highly customizable and physician-friendly interface that integrates easily with existing electronic medical record systems. We purchased Salar for their expertise in clinical documentation and their technology, which we plan to integrate with our speech recognition products to give our customers added functionality and greater flexibility.
We allocated the purchase price between goodwill, customer relationships and related deferred tax liability, covenant not to compete, technology, trademarks and net identifiable assets. We have included the results of Salar operations in our financial statements from the close date forward.
The following is a detailed list of the fair value of identifiable assets acquired and liabilities assumed in the Salar acquisition:
Cash
 
$
19,000

Accounts receivable
 
885,000

Unbilled revenue
 
386,000

Fixed assets
 
25,000

Other assets
 
35,000

    Total identifiable assets
 
1,350,000

Benefits payable
 
80,000

Other liabilities
 
294,000

    Total identifiable liabilities
 
374,000

Net identifiable assets
 
$
976,000

The fair value of accounts receivable acquired approximated gross contractual amounts receivable. There were no assets arising from contingencies that were acquired in the transaction.
Goodwill of $7.9 million was recorded for the Salar acquisition. This consisted primarily of the value of the Salar workforce. We have initially allocated the purchase price between goodwill, customer relationships and related deferred tax liability, covenant not to compete, technology, trademarks and net identifiable assets. Since this transaction was a stock purchase, goodwill and intangibles will not be deductible for income tax purposes. As permitted, we expect to finalize the purchase price allocation within one year of the purchase date. We do not expect any changes to the purchase price allocation to materially increase or decrease amortization expenses, but there could be an impact on the allocation between goodwill and other intangible assets. As of September 30, 2011, the purchase price was allocated as follows:
Net identifiable assets
 
$
976,000

Customer relationships
 
1,800,000

Covenant not to compete
 
190,000

Technology
 
1,340,000

Trademarks
 
80,000

Goodwill
 
7,936,000

Deferred tax liability
 
(1,322,000
)
      Total purchase price
 
$
11,000,000

Intangible assets, except for goodwill, are amortized over their useful lives. The customer list is being amortized over eight years, the covenant not to compete over four years, the technology over five years and the trademarks over two years.
Salar revenue and net income of $577,000 and $93,000 respectively, are included in our Consolidated Statement of Operations for the three and nine months ended September 30, 2011. The net income excludes $103,000 of our transaction costs incurred.


11


Unaudited pro forma revenue and net income of the combined entity had the DTS and Salar acquisitions been completed on January 1, 2010 are as follows:
 
 
SUPPLEMENTAL PRO FORMA INFORMATION
 
 
Three Months Ended September 30,
Nine Months Ended September 30,
 
 
2011
2010
2011
2010
Revenue
 
$
32,381,000

$
26,952,000

$
99,710,000

$
80,754,000

Net Income
 
$
3,332,000

$
2,488,000

$
11,403,000

$
6,068,000

Adjustments have been made to move transaction costs to January 1, 2010 and to recognize the amortization of intangible assets and the related income tax impact in the periods presented. The pro forma information presented does not purport to be indicative of the results that would have been achieved had the acquisitions been made as of January 1, 2010.
3.
MAJOR CUSTOMERS

In September 2009, we announced that we had entered into a five-year single-source contract to provide medical transcription services to hospitals that are members of Health Management Associates (“HMA”) effective October 1, 2009. The agreement expanded our existing relationship with HMA to include the HMA hospitals which were using other transcription service providers. As of September 30, 2011, we have transitioned all of the existing HMA hospitals. In addition, pursuant to the terms of the agreement, any future hospitals acquired or managed by HMA will transition to us as soon as practicable.

Revenue attributable to our contract with HMA comprised 13.0% and 16.7% of our total revenue for the three months ended September 30, 2011 and 2010, respectively, and 14.1% and 17.4% for the nine months ended September 30, 2011 and 2010. The decrease in the percentages is due to our growth in non-HMA revenue, particularly from acquisitions.

Our top 10 customers (a customer is an individual hospital) accounted for approximately 14.5 % and 14.2% of our transcription revenue for the three and nine months ended September 30, 2011, respectively, and 15.6% and 16.2% of revenue for the three and nine months ended September 30, 2010, respectively. These customers averaged $1.8 million of annualized revenue each in 2011 and $1.4 million in 2010. Our average annual revenue per customer was approximately $324,000 for the first nine months of 2011 and $354,000 for the first nine months of 2010.

4.
INVESTMENTS

Short-term investments consist of government notes in the United States and uninsured fixed rate bank deposits in India. These investments, which have a contractual maturity of less than one year, are carried at fair value based on quoted market prices (level 1 inputs). 
Description
September 30, 2011
 
December 31, 2010
Available-for-sale
 
 
 
Fixed rate bank deposits in India
$
1,901,000

 
$
848,000

U.S. Treasury Securities

 
19,606,000

Total short-term investments
$
1,901,000

 
$
20,454,000


5.
GOODWILL AND OTHER INTANGIBLE ASSETS

We account for goodwill and other intangible assets in accordance with the provisions of FASB ASC Topic 350 – Intangibles-Goodwill and Other. Under this Topic, goodwill and intangible assets that have indefinite useful lives are tested at least annually for impairment rather than being amortized like intangible assets with finite useful lives, which are amortized over their useful lives. A portion of the respective purchase prices of the acquisitions of Medical Dictation, Inc. ("MDI") and PracticeXpert in 2005, OTP Technologies, Inc. ("OTP") in 2007, DeVenture Global Partners, Inc. ("DeVenture"), Transcription Relief Services, Inc. ("TRS") and Medical Dictation Services, Inc. ("MDSI") in 2009, Heartland in 2010 and DTS and Salar in 2011 were attributed to goodwill and other intangible assets.

12


Goodwill and Other Intangible Assets
(Rounded to the nearest thousand)

 
 
 
September 30, 2011
 
December 31, 2010
 
Useful Life
in Years
 
Gross
Assets
 
Accumulated
Amortization
 
Net
Assets
 
Gross
Assets
 
Accumulated
Amortization
 
Net
Assets
Goodwill
 
 
$
46,509,000

 
$

 
$
46,509,000

 
$
28,246,000

 
$

 
$
28,246,000

Amortized intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
Covenants not to compete
4 - 5
 
478,000

 
140,000

 
338,000

 
218,000

 
101,000

 
117,000

Trademarks
2
 
80,000

 
7,000

 
73,000

 

 

 

Technology
2 - 5
 
1,530,000

 
135,000

 
1,395,000

 
190,000

 
19,000

 
171,000

Customer relationships
5-10
 
13,181,000

 
2,408,000

 
10,773,000

 
8,381,000

 
1,614,000

 
6,767,000

Total goodwill and intangible assets
 
 
$
61,778,000

 
$
2,690,000

 
$
59,088,000

 
$
37,035,000

 
$
1,734,000

 
$
35,301,000


Amortization expense was $425,000 and $164,000 for the quarters ended September 30, 2011 and 2010, respectively, and $956,000 and $501,000 for the nine months ended September 30, 2011 and 2010, respectively. Estimated amortization expense for the next five fiscal years is as follows:

Fiscal Year
 
Amount
Remainder of 2011
 
$
478,000

2012
 
1,846,000

2013
 
1,750,000

2014
 
1,712,000

2015
 
1,674,000

2016
 
1,527,000


6.
FAIR VALUE OF FINANCIAL INSTRUMENTS

FASB ASC Topic 820 – Fair Value Measurements and Disclosures, establishes a framework for measuring fair value and expands financial statement disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This Topic requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1: Quoted market prices in active markets for identical assets or liabilities
Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data
Level 3: Unobservable inputs that are not corroborated by market data

In accordance with FASB ASC Topic 825 – Financial Instruments, the carrying value of short-term debt, which totaled $0 as of September 30, 2011 and $67,000 at December 31, 2010, was estimated to approximate its fair value. The fair value of debt is estimated based on approximate market interest rates for similar issues. Our other financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, approximate fair value due to the short-term nature of those assets and liabilities.

Investments are classified as available-for-sale and valued using Level 1 inputs (quoted prices in active markets) and carrying value approximates fair value.






13




The following table summarizes the carrying amounts and fair values of short-term investments at September 30, 2011:
Description
September 30, 2011
 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Available-for-sale
 
 
 
 
 
 
 
Fixed rate bank deposits in India
$
1,901,000

 
$
1,901,000

 
$

 
$

Total short-term investments
$
1,901,000

 
$
1,901,000

 
$

 
$


The following table summarizes the carrying amounts and fair values of short-term investments at December 31, 2010:
Description
December 31, 2010
 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Available-for-sale
 
 
 
 
 
 
 
Fixed rate bank deposits in India
$
848,000

 
$
848,000

 
$

 
$

U.S. Treasury Securities
19,606,000

 
19,606,000

 

 

Total short-term investments
$
20,454,000

 
$
20,454,000

 
$

 
$


7.
BORROWING ARRANGEMENTS

Credit Facility

On August 31, 2009, Transcend and MDSI entered into a loan and security agreement with Regions Bank. Transcend and MDSI are both “borrowers” under the loan and security agreement, which replaced our previous credit facility. The loan and security agreement includes a one-time, four-year term loan of $7.0 million for the costs and expenses of, and, to the extent necessary, a portion of the purchase price for MDSI. The loan and security agreement also provides for up to $5.0 million in a revolving loan commitment based on eligible accounts receivable. We may use proceeds of the revolving loan only for working capital, general corporate purposes, and for specified acquisitions. We used $4.0 million of the proceeds from the follow-on offering of our common stock completed in the fourth quarter of 2009 to pay down the term loan. The original revolving loan commitment expired in August, 2010 and has been renewed annually since then, with the current expiration in August 2012. When it was renewed in August, 2011, the revolving loan commitment was increased to $10.0 million. Borrowings bear interest at a rate based on the current LIBOR (3.75% as of December 31, 2010), and are secured by substantially all of our assets. The outstanding balance on the term loan of $67,000 was paid off in June, 2011 and the balance at September 30, 2011 was $0. The balance on the revolver was $0 as of September 30, 2011 and December 31, 2010. We utilized the revolving loan infrequently and for no more than one day in duration of each loan during the nine months ended September 30, 2011.

The loan and security agreement contains representations and warranties, as well as affirmative, reporting and negative covenants customary for financings of this type. Among other things, the loan and security agreement restricts us from incurring certain additional debt, prohibits us from creating, permitting or allowing certain liens on our property, restricts the payment of dividends, distributions and other specified equity related transactions, and prohibits certain borrowings and specified transactions with affiliates. The loan and security agreement also requires the maintenance of a specified minimum fixed charge coverage ratio, tangible net worth, and cash flow leverage, as defined in the agreement. As of September 30, 2011, we were in compliance with all covenants of the agreement except one covenant related to tangible net worth. Regions Bank issued a waiver of this covenant as of September 30, 2011.

On April 8, 2010, Transcend and MDSI entered into a commitment letter for a senior secured credit facility in an aggregate principal amount of up to $65,000,000 with Regions Business Capital, Regions Capital Markets and Regions Bank (collectively, “Regions”). We intended to use part of the proceeds from the credit facility to fund our bid for substantially all of the assets of Spheris, Inc. (“Spheris”) and the stock of its subsidiary, Spheris India Private Limited (“Spheris India”). Spheris declared bankruptcy under Chapter 11 and an auction under Section 363 of the United States Bankruptcy Code was held for substantially all of the assets of Spheris and the stock of Spheris India, subject to the terms of a stock and asset purchase agreement. The United States Bankruptcy Court for the District of Delaware established a bid process whereby interested parties, including us, submitted qualified bids on April 8, 2010. Qualified bidders participated in the auction held on April 13, 2010. We were not the successful bidder in the auction and did not enter into the new credit facility. In accordance with the commitment letter, the commitment terminated on May 28, 2010 because the definitive credit agreement and other legal

14


documents related to the senior credit facility were not executed by that date. We expensed approximately $300,000 and $61,000 of costs related to the credit facility in the first quarter and second quarter of 2010, respectively, that would have been capitalized if the credit facility had closed.

OTP Promissory Note

On January 16, 2007, we entered into a three-year $330,000 unsecured promissory note in conjunction with the purchase of OTP. The note bore interest at 5.0% and the principal was repaid as follows: $110,000 on January 16, 2008; $55,000 on July 16, 2008; $55,000 on January 16, 2009; $55,000 on July 16, 2009 and $55,000 on January 16, 2010. This note was paid in full in January 2010.

MDSI Promissory Note

On August 31, 2009, we entered into a one-year $2,000,000 unsecured promissory note at 5% interest, payable to Dorothy Fitzgerald, in conjunction with the purchase of MDSI. All principal and interest was due and paid at maturity on August 31, 2010.

8.
TRANSACTIONS WITH RELATED PARTIES

On August 31, 2009, we acquired all issued and outstanding shares of MDSI common stock from Dorothy Fitzgerald for an estimated purchase price of $15,487,000. Payment of the purchase price included a $2,000,000 payment due at the delivery of audited financial statements and a $2,000,000 promissory note payable to Ms. Fitzgerald, the terms of which are described in Note 7 “Borrowing Arrangements.” In addition, we entered into a registration rights agreement, dated August 31, 2009, providing Ms. Fitzgerald with “piggyback” registration rights. Ms. Fitzgerald was employed by us until the third quarter of 2011.


9.
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

15


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











16




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.

10.
CONTINGENCIES

From time to time in the normal course of business, we are involved in legal proceedings. We evaluate the need for loss accruals under the requirements of FASB ASC 450 – Contingencies. We record an estimated loss for any claim, lawsuit, investigation or proceeding when it is probable that a liability has been incurred and the amount of the loss can reasonably be estimated. If the reasonable estimate of a probable loss is a range, and no amount within the range is a better estimate, then we record the minimum amount in the range as our loss accrual. If a loss is not probable or a probable loss cannot be reasonably estimated, no liability is recorded.

On June 10, 2005, we entered into a master equipment lease agreement with Farnam Street Financial, Inc. (“Farnam Street”). On April 22, 2009, we filed a complaint in the United States District Court for the District of Minnesota against Farnam Street, alleging breach of contract, fraud and violation of the Deceptive Trade Practices Act, among other things. Farnam Street answered the complaint and filed a counter-claim against us, alleging breach of contract, among other things. The dispute centered on lease renewal, lease termination and lease buy-out provisions. On May 12, 2010, we finalized a settlement with Farnam Street and paid $720,000 to buy out the equipment leases. The settlement was allocated as $540,000 against amounts previously expensed and $180,000 was set up as fixed assets with a useful life of one year. These assets were fully depreciated in the second quarter of 2011.

17




The TRS asset purchase agreement provided for a contingent consideration payment of up to $3.0 million based on TRS fourth quarter 2009 revenue and TRS December 31, 2009 backlog. We calculated a fourth quarter 2009 revenue contingent consideration payment of $1,123,000, which was paid in February 2010. On February 26, 2010, we received notice that TRS disputed our calculation and claimed an additional payment of $1,877,000. We responded on March 10, 2010, stating that TRS’s objections were without merit and asking that the dispute be postponed pending delivery of the backlog contingent payment calculation. TRS agreed to the postponement. On March 30, 2010, we delivered the backlog contingent payment calculation to TRS showing an amount payable of $0. TRS objected to our backlog contingent payment calculation. On May 6, 2010, TRS filed a civil action against us in the United States District Court for the Middle District of North Carolina. TRS generally alleges that we frustrated their ability to maximize the contingent payment. TRS seeks compensatory damages of approximately $1,877,000, unspecified damages, attorneys’ fees, interest and costs. The lawsuit is in the early procedural stages and the ultimate outcome cannot be determined at this time. We have evaluated this claim and the civil action and believe that no additional payments are due under the calculations outlined in the asset purchase agreement.

11.
INCOME TAXES

We determine our periodic income tax provision based upon the current period taxable income and our annual estimated tax rate adjusted for any change to prior period estimates. The estimated tax rate is revised, if necessary, as of the end of each successive interim period during the fiscal year to our current annual estimated tax rate.

Since our October 21, 2010 acquisition of Heartland, we have been conducting business operations in India. The Indian operations are conducted through both flow-through entities and foreign corporations. We have included the Indian results from operations conducted through the flow-through entities in our U.S. current and deferred income tax provision calculation. We have undistributed foreign earnings in the foreign corporations, which we intend to permanently reinvest overseas. We also intend to reinvest future foreign earnings overseas. Therefore, no U.S. corporate income taxes have been provided on undistributed foreign earnings of the foreign corporations.

A valuation allowance is required to be recorded against deferred tax assets if, based on the available evidence, it is more likely than not that such assets will not be realized. When assessing the need for a valuation allowance, appropriate consideration should be given to all positive and negative evidence related to the realization of the deferred tax assets. This evidence includes, among other things, the existence of current and cumulative losses, forecasts of future profitability, the length of statutory carry-forward periods, our experience with loss carry-forwards expiring unused, and available tax planning strategies. At September 30, 2011 and December 31, 2010, we have recorded a valuation allowance of $310,000 related to expected future utilization of state net operating loss carry-forwards resulting from recent acquisitions. The conclusion to record the valuation allowance is based on the inability to predict, with any degree of certainty, whether we will generate apportionable income to the states in which it has these net operating loss carry-forwards.

With the 2010 acquisition of Heartland and the 2011 acquisition of DTS, we acquired net operating loss carry-forwards of approximately $17.3 million for Heartland and $23.4 million for DTS, which relate to losses incurred prior to their acquisition by Transcend. These net operating loss carry-forwards will begin to expire in 2025. As a result of the acquisitions, future utilization of these net operating loss carry-forwards is subject to the provisions of Section 382 of the Internal Revenue Code of 1986, as amended. As a result of the preliminary Section 382 analysis we expect $10.6 million and $14.1 million, for Heartland and DTS respectively, to expire unused. We have not established a deferred tax asset for those net operating loss carry-forwards which are expected to expire unused. Based on historical earnings and expected future taxable income, we have established a deferred tax asset in the amount of $2.1 million for Heartland and $3.2 million for DTS, representing the tax benefits related to the available net operating loss carry-forwards. We believe all of the net operating loss carry-forwards recorded as a deferred tax asset will be fully utilized before expiration, thus no valuation allowance has been recorded with respect to these federal operating loss carry-forwards. During the third quarter, 2011, we finalized the Section 382 analysis for the Heartland acquisition and have recorded an increase of $72,000 to goodwill. We plan to complete the same analysis for the DTS net operating loss carry-forward by the second quarter of 2012.
We account for all potentially uncertain tax positions in accordance with the provisions in FASB ASC Topic 740-Income Taxes which prescribes a recognition threshold of more-likely-than-not to be sustained upon examination. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax rules and the potential for future adjustment of our uncertain tax positions by the United States Internal Revenue Service or other taxing jurisdictions.

The initial evaluation of uncertain tax positions resulting from the 2010 acquisition of Heartland was related to intercompany transfer pricing, a liability was established at acquisition and had a balance of $4,681,000 at December 31, 2010. In the second

18


quarter of 2011, we received a final order from the India taxation authority for the year 2006 resulting in a $212,000 (includes $82,000 of accrued interest) reduction in the liability and this was recognized as a reduction of current tax expense. In the third quarter of 2011, we received two final orders from the India taxation authority for the year 2008 resulting in a $411,000 (includes $70,000 of accrued interest) reduction in the liability that was recognized as a reduction of current tax expense. We also made a $209,000 (includes $68,000 of accrued interest) adjustment to increase the original purchase accounting balance in the third quarter of 2011. In addition to these adjustments, we have been adding to the liability for additional taxes on current operations. At September 30, 2011, the tax liability balance is $3,727,000.
During the second quarter of 2011, we identified an uncertain tax position pursuant to ASC 740 that resulted in recording a liability of approximately $5,300,000. Further analysis was done in the third quarter, and the liability was adjusted to $6,759,000. This uncertain tax position relates to prior tax returns filed by Heartland prior to the 2010 acquisition. We believe there is currently an uncertain tax position with respect to the deduction of certain dual consolidated losses generated from Heartland's India operations. We are currently in the process of pursuing administrative relief from the Internal Revenue Service which, based on our understanding of the relevant facts, although there can be no assurance of relief, we believe such relief will likely be granted no later than the first quarter of 2012. Based on the standards under ASC 740, however, we are required to estimate the potential impact of this uncertain tax position since such administrative relief is not a widely understood administrative practice. It is important to note that the purchase agreement contains indemnification provisions that we believe would potentially entitle us to reimbursement of actual tax and interest expense incurred if administrative relief is not obtained.

As of September 30, 2011 and December 31, 2010, the total amount of unrecognized tax benefits was $10,527,000 and $4,681,000, respectively, all of which would affect the effective tax rate if recognized.

Our effective income tax rate was approximately 34.4% and 38.3% for the three months ended September 30, 2011 and 2010, respectively, and 38.2% and 39.3% for the nine months ended September 30, 2011and 2010, respectively. The lower effective tax rate in 2011 was due primarily to the favorable resolution of transfer-pricing related income tax contingencies in India.

12.
SUBSEQUENT EVENT

In accordance with FASB ASC Topic 855—Subsequent Events, we evaluated all events or transactions that occurred after September 30, 2011 up through the date these financial statements were issued. During this period, no material recognizable subsequent events occurred.

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that represent our expectations, anticipations or beliefs about future events, including our operating results, financial condition, liquidity, expenditures, and compliance with legal and regulatory requirements. For this purpose, any statements that are not statements of historical fact may be deemed to be forward-looking statements made under the provisions of the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties that could cause actual results to differ materially depending on a variety of important factors. Factors that might cause or contribute to such differences include, but are not limited to, competitive pressures, loss of significant customers, the mix of revenue, changes in pricing policies, delays in revenue recognition, lower-than-expected demand for the Company’s products and services, business conditions in the integrated health care delivery network market, general economic conditions, and the risks and uncertainties described in greater detail under the caption “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2010, in subsequently filed Quarterly Reports on Form 10-Q and in other filings that we make with the Securities Exchange Commission (“SEC”). Our SEC filings are available from us and are also available at the SEC’s website at http://www.sec.gov. In addition, factors that we are not currently aware of could harm our future operating results. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to make any revisions to the forward-looking statements or to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q, except as required by applicable law.

Overview

We believe we are the second largest medical transcription services company in the United States based on revenue. We serve approximately 390 hospital customers nationwide plus a number of clinics and physician's offices. We estimate that our primary target market is approximately $2.5 billion, comprised primarily of approximately 5,000 community-based hospitals

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(hospitals accessible by the general public) in the United States. Our mission is to provide accurate and timely documentation of the patient/medical provider encounter at a competitive price. Customer service is crucial to our success, and we have consistently been ranked among the top medical transcription service organizations in the industry. Our approximately 2,800 medical language specialists, including 800 based in India, supplemented by our offshore partners, provide high quality medical documents and fast turnaround times, resulting in high customer retention rates, which have averaged more than 95% (measured by revenue) over the last four years. We develop and utilize an array of technology solutions to support the transcription process, including robust voice capture systems, state-of-the-art speech recognition technology, our proprietary transcription platforms and various customer-specific systems. We believe we are well-positioned to benefit from the increasing adoption and use of electronic medical records (or "EMRs") because the data and narrative content we create comprise key portions of EMRs.

Hospitals have the flexibility to choose from four alternatives for creating clinical documentation:
1.
Outsourced transcription
2.
Encore transcription workflow platform for in-house transcription departments
3.
Physician dictation and self-editing solutions
4.
Physician template-based solutions (as a result of our acquisition of Salar)

Our revenue is substantially recurring in nature, which we believe results from our customers’ ongoing, mission-critical need to document each patient/medical provider encounter and our consistently high service levels, resulting in high customer retention rates. Since we are paid directly by hospitals and other providers, we have no direct insurance-related reimbursement risk.

Outlook

The U.S. economy deteriorated significantly in 2008 and 2009, stemming primarily from disruption in the global credit markets. Although there was arguably a degree of recovery in 2010 and 2011, if the economy were to further deteriorate, we could see deterioration in the financial condition of our customers and collection of our accounts receivable. The decrease in availability of consumer credit as well as general unfavorable economic conditions, has caused consumers to reduce their discretionary spending, including spending for medical care. Job losses and the resulting losses of healthcare benefits could further reduce demand for healthcare services. We have not experienced any noticeable deterioration in accounts receivable or transcription volume to date related to the financial condition of our customers. It is also uncertain what effect the credit crisis may have on the security of the U.S. banking system, and specifically the bank where our cash and cash equivalents are deposited. This could impact our access to and cost of capital. In addition, Federal Deposit Insurance Corporation ("FDIC") insurance does not fully insure our deposits. At September 30, 2011, approximately $838,000 of our cash balances exceeded the current FDIC or Securities Investor Protection Corporation ("SIPC") insurance limits, all of these balances were held in overseas banks for our India operations. In addition to the impact of the overall economic environment, the following trends and uncertainties could have a material future impact on our financial results:

The aging of the “baby boomers” will create increased demand for healthcare services, which should in turn create increased demand for medical transcription services. Over the next 20 years, the U.S. population over the age of 65 is expected to increase from roughly 40 million to 70 million, according to the U.S. Census Bureau.

Increased adoption of EMR solutions could result in greater demand for electronic documentation, including transcription of reports that are currently hand-written. Alternatively, EMR solutions could reduce the demand for traditional transcription since physicians could be required to “point and click” to complete a template rather than dictate to document portions of their patient encounters. Management believes that dictation is more efficient and can produce a more robust record than using templates alone, and we anticipate that in the future, hybrid solutions will become more common. This is one of the reasons that we acquired Salar, which specializes in template-based clinical documentation. We believe that the pace of change in the healthcare industry has increased, particularly as it relates to adoption of the EMR, and we expect this trend to continue. We are addressing this opportunity and risk by exploring opportunities to make the data in our reports more useful to hospitals and by exploring the opportunity to partner with firms to more deeply integrate our service offering into total documentation solutions for hospitals.

Increased use of speech recognition technology and offshore resources in the future could result in higher profitability for us. At the same time, competition within the medical transcription industry, combined with use of offshore resources and speech recognition technology by our competitors, could create downward pricing pressure in the industry. The potential net impact of these two trends is difficult to predict with certainty.

In March 2010, U.S. federal legislation was enacted which is likely to have a significant impact on, among other things, access to and the cost of healthcare in the United States. The legislation provides for extensive health insurance

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reforms and expands coverage to approximately 32 million Americans which will result in expanded access to healthcare. We believe these changes will benefit our industry by leading to increased utilization of our services. These benefits are expected to be partially offset by provisions of the legislation aimed at reducing the overall cost of healthcare. It is uncertain at this time what additional healthcare reform initiatives, if any, will be implemented, or whether there will be other changes in the administration of governmental healthcare programs or interpretations of governmental policies or other changes affecting the healthcare system. The ultimate content or timing of any future legislation, and its impact on us, is impossible to predict. If significant reforms are made to the healthcare system in the United States, or in other jurisdictions, those reforms may have an adverse effect on our financial condition and results of operations.

Historically, our new customer sales have predominantly come from replacing incumbent medical transcription firms. A significant portion of medical transcription work in hospitals is still performed by hospital employees. Management sees a trend toward outsourcing medical transcription services that could have a positive impact on our financial results if the trend accelerates and we are able to successfully compete for the business.

We have not historically had difficulty in staffing to meet demand as we have grown. However, looking at the industry as a whole, we do not expect the domestic labor market for medical transcriptionists to grow fast enough to meet increased demand. We are addressing this challenge by increasing employee productivity through the use of speech recognition technology, utilizing offshore resources and by attempting to develop a reputation as one of the best places to work in the industry. It is possible that in the future a tightening labor market could result in upward pressure on wages, but to date we have not seen evidence of this and we do not anticipate this occurring in the short-term.

We completed three acquisitions in 2009, one in October 2010 and two thus far in 2011, which have had a material impact on our financial statements. Acquisitions involve significant risk, including integration risk, and it is possible that we will not realize the anticipated benefits of the acquisitions we have made.

We have experienced annual operating losses in prior years, the most recent occurring in 2005. While we have increased our level of net income in recent years, there can be no assurance that operating losses will not occur in the future. Over the short term, excluding the impact of acquisitions, the variability in our earnings and cash flow is mitigated by the fact that our revenue is recurring in nature and our largest expense, the cost of the transcriptionists, is variable in relation to revenue.

Our largest competitor, MedQuist, recently announced that it had acquired Multimodal Technologies (“M*Modal”). M*Modal provides speech recognition-related technology and services to us. While we have been assured that our business relationship will continue and have recently entered into a new contract with M*Modal, which is effective through December 31, 2016, there is a possibility that the new relationship could pose challenges to us in the future.

With our acquisition of Heartland in 2010, we now have significant operations in India. We have tried to manage our risk of changes in exchange rates through forward currency contracts, however unfavorable changes in exchange rates could materially impact our results of operations.

For a more complete understanding of trends and uncertainties relevant to Transcend, please see Item 1 “Business” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, including the section titled “Industry Overview” and Item 1A “Risk Factors” to the Annual Report on Form 10-K and this Quarterly Report on Form 10-Q, as well as risk factors detailed in our other reports filed with the SEC.

Critical Accounting Estimates Which Are Material to Registrant

A critical accounting estimate meets two criteria: (1) it requires assumptions about highly uncertain matters; and (2) there would be a material effect on the financial statements from either using a different, also reasonable, amount within the range of the estimate in the current period or from reasonably likely period-to-period changes in the estimate. The preparation of consolidated financial statements requires that management make estimates and assumptions based on knowledge of current events and actions; however, actual results may ultimately differ from estimates and assumptions. Our critical accounting estimates are as follows:

Allowance for Doubtful Accounts. Accounts receivable are recorded net of an allowance for doubtful accounts established to provide for losses on uncollectible accounts based on management’s evaluation of each account and historical collection experience. We reserve specific accounts once collection appears unlikely and record a general reserve on remaining outstanding receivables. We evaluate the adequacy of the allowance for doubtful accounts quarterly. Accounts outstanding

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longer than contractual payment terms are considered past due and are reviewed individually for collectability. Management considers the age of the receivable, the financial health of the customer and payment history to evaluate the collectability of accounts receivable. Accounts receivable are written off once all collection efforts are exhausted.

Goodwill and Intangible Assets. We account for goodwill and other intangible assets in accordance with the provisions of FASB ASC Topic 350 – Intangibles-Goodwill and Other. Under the provisions of this Topic, goodwill and intangible assets that have indefinite useful lives are tested at least annually for impairment rather than being amortized like intangible assets with finite useful lives, which are amortized over their useful lives. We had goodwill of $46,509,000 at September 30, 2011 and $28,246,000 at December 31, 2010 and net intangible assets related to acquisitions of $12,579,000 and $7,055,000 at September 30, 2011 and December 31, 2010, respectively. Management reviews goodwill and other intangible assets for impairment annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. In testing for impairment, management calculates the fair value of the reporting units to which the goodwill and intangibles relate based on market capitalization of the company as a whole. We have concluded that we operate in one reporting unit—clinical documentation solutions—since all of our revenue is derived from clinical documentation solutions and since we have one organization dedicated to the delivery of our solutions.

In connection with certain of our acquisitions, we allocated a portion of the purchase price to acquired customer relationships, acquired technology, trademarks and covenants-not-to-compete using appraisals based on discounted cash flow analysis. The estimated fair values attributed to the relationships and covenants are being amortized over a period of four to ten years, which represented the estimated average remaining lives of the contracts and relationships. The estimated fair value attributed to acquired technology and trademarks is being amortized over a period of two to five years, which represented the estimated remaining life of the technology and trademarks. We account for long-lived assets such as purchased intangible assets with finite lives under The Impairment or Disposal of Long-Lived Assets Subsections of FASB ASC Topic 360 – Property, Plant and Equipment. This Subtopic requires that such long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets based on a discounted cash flow approach or, when available and appropriate, to comparable market values. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.

There were no impairments recognized to goodwill or intangible assets in the nine months ended September 30, 2011 or 2010.

Contingent Consideration Payable. A contingent consideration payment was part of the asset purchase agreement for our acquisition of TRS. We estimated the fair value of this payable as of the purchase date of the acquisition. FASB ASC Topic 805 –Business Combinations requires that this estimate is re-measured to fair value at each reporting date until the contingency is resolved. These interim changes in estimated fair value, along with any differences in the final settlement, are recognized in operating expense. The purchase date fair value of the TRS contingent consideration was $353,000. As of December 31, 2009, the value was calculated as $1,123,000. The $770,000 difference was recognized as operating expense in the fourth quarter of 2009 and the total amount of $1,123,000 was paid in February 2010.

Deferred Tax Assets and Liabilities. We account for our income taxes in accordance with FASB ASC Topic 740 – Income Taxes. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts for financial reporting purposes. As of September 30, 2011, we had net current deferred tax assets of $1,481,000 and net non-current deferred tax assets of $1,503,000. Deferred tax assets represent future tax benefits we expect to realize. Our ability to utilize the deferred tax benefits is dependent upon our ability to generate future taxable income. FASB ASC Topic 740 – Income Taxes requires us to record a valuation allowance against any deferred income tax benefits that we believe may not be realized. We estimate future taxable income to determine whether a valuation allowance is needed. Projecting our future taxable income requires us to use significant judgment regarding expected future revenues and expenses. In addition, we must assume that tax laws will not change sufficiently to materially impact the expected tax liability associated with our expected taxable income. We have valuation allowances against net operating loss carry-forwards in certain states in which future taxable income in those states may not be sufficient to utilize the net operating loss carry-forwards in those states prior to their expiration.

With the acquisition of Heartland, we are now subject to income taxes in India. Significant judgment is required in determining our consolidated provision for income taxes and recording the related assets and liabilities. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. Although we believe we have appropriate support for the positions taken on our tax returns, we have recorded a liability of $10,527,000 for our best estimate of the probable loss on certain of these positions. We believe that our accruals for tax liabilities are adequate for all

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open years, based on our assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter, which matters result from intercompany transfer pricing and the tax return treatment of certain dual consolidated losses generated from the India operations. Although we believe our recorded assets and liabilities are reasonable, tax regulations are subject to interpretation and tax litigation is inherently uncertain; therefore our assessments can involve both a series of complex judgments about future events and rely heavily on estimates and assumptions. The final determination of tax audits and any related litigation could be materially different than that which is reflected in historical income tax provisions and recorded assets and liabilities. Based on the results of an audit or litigation, a material effect on our income tax provision, net income, or cash flows in the period or periods for which that determination is made could result.

Self-funded Medical Insurance. In 2010, we moved to a self-funded medical insurance plan for our U.S. based employees. We contracted with a separate administrative service company to supervise and administer the program and act as our representative. We have reduced the risk under this self-funded plan by purchasing stop-loss insurance coverage for individual and aggregate claims in excess of prescribed limits. We record estimates for our claim liability based on information provided by the third-party plan administrators, historical claims experience, the life cycle of claims, expected costs of claims incurred but not paid, and expected costs to settle unpaid claims. We monitor our estimated insurance-related liabilities on a monthly basis. As facts change, it may become necessary to make adjustments that could be material to our results of operations and financial condition. This liability is subject to a total limitation that varies based on employee enrollment and factors that are established at each annual contract renewal. Actual claims experience may differ from our estimates. Costs related to the administration of the plan and related claims are expensed as incurred.

Stock-Based Compensation. 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, including stock options and restricted stock awards 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. We calculate 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 term, expected volatility, risk-free interest rate and dividend yield. As a result, the future stock-based compensation expense may differ from our historical amounts.

Legal Proceedings. From time to time in the normal course of business, we are involved in legal proceedings. We evaluate the need for loss accruals under the requirements of FASB ASC 450 – Contingencies. We record an estimated loss for any claim, lawsuit, investigation or proceeding when it is probable that a liability has been incurred and the amount of the loss can reasonably be estimated. If the reasonable estimate of a probable loss is a range, and no amount within the range is a better estimate, then we record the minimum amount in the range as our loss accrual. If a loss is not probable or a probable loss cannot be reasonably estimated, no liability is recorded.

Three Months Ended September 30, 2011 Compared to Three Months Ended September 30, 2010

Revenue increased $9,286,000, or 41%, to $32,202,000 in the quarter ended September 30, 2011 compared to revenue of $22,916,000 in the same period in 2010. The $9,286,000 increase in revenue was attributable to revenue contributed by the acquisition of Heartland of $4,168,000, revenue contributed by the acquisition of DTS of $2,938,000, revenue contributed by the acquisition of Salar of $577,000, revenue from new customers of $2,009,000, and increased revenue from existing customers of $54,000 offset by a decrease in revenue of $386,000 from customers who terminated their contracts since the third quarter of 2010. Revenue from the sale of hardware and professional services related to implementations also decreased by $74,000 .

Direct costs increased $5,502,000, or 39%, to $19,747,000 in the quarter ended September 30, 2011 compared to $14,245,000 in the same period in 2010. Direct costs include costs attributable to compensation for transcriptionists, fees paid for speech recognition processing, telephone expenses, recruiting, management, customer service, technical support for operations, and implementation of transcription services. Transcription compensation is a variable cost based on lines transcribed or edited multiplied by specified per-line pay rates that vary by individual as well as type of work. Speech recognition processing is a variable cost based on the minutes of dictation processed. All other direct costs referred to above are semi-variable operations infrastructure costs that periodically change in anticipation of or in response to the overall level of production activity.

As a percentage of revenue, direct costs were 61% for the quarter ended September 30, 2011 and 62% for the quarter ended September 30, 2010. The decrease in costs as a percentage of revenue was due primarily to increased utilization of speech recognition technology on our BeyondTXT platform, increased usage of offshore resources and the acquisition of Heartland. The percentage of BeyondTXT volume that was edited using speech recognition technology increased from 76% in the third

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quarter of 2010 to 83% in the third quarter of 2011. Work processed on BeyondTXT has lower costs due to the use of speech recognition technology to produce drafts of reports which are then edited by our medical language specialists. The percentage of work processed offshore increased from 19% in the third quarter of 2010 to 37% in the third quarter of 2011 due primarily to our acquisition of Heartland.

Gross profit increased $3,784,000, or 44%, to $12,455,000 in the quarter ended September 30, 2011 compared to $8,671,000 in the same period in 2010. Gross profit as a percentage of revenue increased to 39% in the quarter ended September 30, 2011 compared to 38% in the same period in 2010 (see direct costs discussion). Gross profit was negatively impacted by $110,000 of restructuring costs in India and $219,000 of non-recurring supplemental compensation expense to transfer over 50 hospital transcriptionists to Transcend as a result of a multi-hospital outsourcing contract.

Sales and marketing expenses increased $291,000, or 60%, to $774,000 in the quarter ended September 30, 2011, compared to $483,000 in the same period in 2010. Sales and marketing expense as a percentage of revenue was 2% in both the quarters ended September 30, 2011 and September 30, 2010, respectively. The increase is primarily due to increased compensation, commission and travel expense related to the addition of the Heartland sales force, and increased advertising and marketing expenditures.

Information Technology ("IT") expenses increased $723,000, or 145%, to $1,221,000 in the quarter ended September 30, 2011, compared to $498,000 in the same period in 2010. IT expense as a percentage of revenue was 4% and 2 % in the quarters ended September 30, 2011 and September 30, 2010, respectively. The increase in expense was primarily due to an increase in compensation-related and infrastructure expenses (including new data centers) related to the acquisition of Heartland and DTS.

General and administrative expenses increased $1,124,000, or 38%, to $4,059,000 in the quarter ended September 30, 2011, compared to $2,935,000 in the same period in 2010. The increase was due primarily to increased compensation expense, share-based compensation expense, employee benefits, professional services and increased costs related to the acquisition of Heartland and DTS, partially offset by a decrease in bonus expense. We incurred $103,000 of transaction costs related to the Salar acquisition in the third quarter of 2011 compared to $58,000 in the third quarter of 2010 for the Heartland acquisition. General and administrative expenses were 13% of revenue in the quarters ended September 30, 2011 and 2010.

Depreciation and amortization expense was $965,000 in the quarter ended September 30, 2011, compared to $485,000 in the same period in 2010, an increase of $480,000 or 99%. Amortization of intangible assets resulting from the acquisition of Heartland, DTS and Salar contributed $262,000 of the increase. The remainder of the increase was due to higher capital expenditures resulting in increased depreciable assets.

Operating income increased $1,166,000, or 27%, to $5,436,000 in the quarter ended September 30, 2011, compared to $4,270,000 in the same period in 2010. Operating income decreased to 17% of revenue in the quarter ended September 30, 2011 from 19% in the same period in 2010 due primarily to the effects of the restructuring costs in India, non-recurring supplemental compensation expenses and the increased level of IT expenses, as discussed above.

Net other expense increased to $331,000 in the quarter ended September 30, 2011 compared to $29,000 in the same period in 2010. The increase was primarily due to net losses on foreign currency transactions due to a decrease in the value of the Indian Rupee, partially offset by a decrease in financing costs and increased interest income.

The income tax provision increased $132,000 to $1,758,000 for the three months ended September 30, 2011, compared to $1,626,000 for the same period in 2010. The provision increased primarily due to higher pretax income partially offset by a lower effective tax rate of 34.4% for the quarter ended September 30, 2011 compared to 38.3% for the quarter ended September 30, 2010. The lower effective tax rate was due primarily to the favorable resolution of transfer-pricing related income tax contingencies in India.

Net income increased $732,000, or 28%, to $3,347,000 in the quarter ended September 30, 2011, compared to $2,615,000 in the same period in 2010. Fully diluted earnings per share increased to $0.30 for the quarter ended September 30, 2011, compared to $0.24 for the same period in 2010.

Nine Months Ended September 30, 2011 Compared to Nine Months Ended September 30, 2010
Revenue increased $24,831,000, or 37%, to $92,162,000 in the nine months ended September 30, 2011 compared to revenue of $67,331,000 in the same period in 2010. The $24,831,000 increase in revenue was attributable to revenue contributed by the acquisition of Heartland of $13,795,000, increased revenue from new customers of $5,669,000, revenue from the acquisition of DTS of $4,984,000, revenue from the acquisition of Salar of $577,000, and increased revenue from existing customers of

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$829,000 offset by a decrease in revenue of $975,000 from customers who terminated their contracts since the third quarter of 2010 and a decrease in other revenue of $48,000.
Direct costs increased $12,081,000, or 28%, to $55,230,000 in the nine months ended September 30, 2011 compared to $43,149,000 in the same period in 2010. Direct costs include costs attributable to compensation for transcriptionists, fees paid for speech recognition processing, telephone expenses, recruiting, management, customer service, technical support for operations, and implementation of transcription services. Transcription compensation is a variable cost based on lines transcribed or edited multiplied by specified per-line pay rates that vary by individual as well as type of work. Speech recognition processing is a variable cost based on the minutes of dictation processed. All other direct costs referred to above are semi-variable operations infrastructure costs that periodically change in anticipation of or in response to the overall level of production activity.
As a percentage of revenue, direct costs were 60% for the nine months ended September 30, 2011 compared to 64% for the nine months ended September 30, 2010. The decrease in costs as a percentage of revenue was due primarily to increased utilization of speech recognition technology on our BeyondTXT platform, increased usage of offshore resources and the acquisition of Heartland. The percentage of BeyondTXT volume that was edited using speech recognition technology increased from 72% in the first nine months of 2010 to 84% in the first nine months of 2011. Work processed on BeyondTXT has lower costs due to the use of speech recognition technology to produce drafts of reports which are then edited by our medical language specialists. The percentage of work processed offshore increased from 17% in the first nine months of 2010 to 36% in the first nine months of 2011 primarily due to the acquisition of Heartland.
Gross profit increased $12,750,000, or 53%, to $36,932,000 in the nine months ended September 30, 2011 compared to $24,182,000 in the same period in 2010. Gross profit as a percentage of revenue increased to 40% in the nine months ended September 30, 2011 compared to 36% for the same period in 2010 (see direct costs discussion).
Sales and marketing expenses increased $405,000, or 29%, to $1,826,000 in the nine months ended September 30, 2011, compared to $1,421,000 in the same period of 2010. Sales and marketing expenses as a percentage of revenue were 2% in both the nine months ended September 30, 2011 and September 30, 2010, respectively. The increase is primarily due to increased compensation, commission and travel expense related to the addition of the Heartland sales force and increased advertising and marketing expenditures.
IT expense increased $1,795,000, or 135%, to $3,127,000 in the nine months ended September 30, 2011compared to $1,332,000 in the same period in 2010. IT expenses as a percentage of revenue were 3% in the nine month period ended September 30, 2011 and 2% in the nine month period ended September 30, 2010. The increase in expense was primarily due to an increase in compensation-related and infrastructure expenses (including new data centers) related to the acquisition of Heartland and DTS.
General and administrative expenses increased $1,301,000, or 12%, to $11,931,000 in the nine months ended September 30, 2011, compared to $10,630,000 in the same period in 2010. Included in 2011 and 2010 are acquisition-related costs of $324,000 and $1,337,000, respectively. The costs in 2010 were related to our unsuccessful bid to acquire Spheris and our acquisition of Heartland. Also included in 2010 is a $676,000 cumulative adjustment for share-based compensation expense. Excluding these items, general and administrative expenses increased $2,990,000, or 35% in the nine months ended September 30, 2011 compared to the same period in 2010. The balance of the increase was due primarily to increased costs related to the Heartland India operations and the acquisition of DTS, partially offset by decreases in contract services and employee benefits costs. Excluding one-time acquisition-related costs and the stock-based compensation adjustment, general and administrative expenses as a percentage of revenue were 13% in both the nine months ended September 30, 2011, and 2010.
Depreciation and amortization expense increased $1,000,000, or 72%, to $2,393,000 in the nine months ended September 30, 2011 compared to $1,393,000 in the same period in 2010. Amortization of intangible assets resulting from the acquisition of Heartland, DTS and Salar accounted for $454,000 of the increase. The remainder of the increase was due to higher capital expenditures resulting in increased depreciable assets.
Operating income increased $8,249,000, or 88%, to $17,655,000 in the nine months ended September 30, 2011, compared to $9,406,000 in the same period in 2010. Operating income as a percentage of revenue increased from 14% for the nine months ended September 30, 2010 to 19% for the nine months ended September 30, 2011 due primarily to the improved levels of gross profit and general and administrative expenses as percentages of revenue, as discussed above.
Net other expense increased $200,000 to $279,000 for the nine months ended September 30, 2011 compared to $79,000 in the same period in 2010. The increase was primarily due to net losses on foreign currency transactions due to a decrease in the value of the Indian Rupee in the third quarter of 2011 partially offset by increased interest income.
The income tax provision increased $2,979,000 to $6,644,000 for the nine months ended September 30, 2011 compared to $3,665,000 in the same period in 2010. The provision increased primarily due to higher pre-tax income partially offset by a

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lower effective tax rate of 38.2% for the nine months ended September 30, 2011 compared to 39.3% for the nine months ended September 30, 2010.
Net income increased $5,070,000, or 90%, to $10,732,000 in the nine months ended September 30, 2011, compared to $5,662,000 in the same period in 2010. Fully diluted earnings per share increased $0.45, to $0.97 for the nine months ended September 30, 2011, compared to $0.52 for the same period in 2010.
Liquidity and Capital Resources

As of September 30, 2011, we had cash, cash equivalents and short-term investments of $12,299,000, working capital of $22,222,000, and availability of approximately $10,000,000 on our revolving line of credit based on eligible accounts receivable (see Note 7 of the Notes to Consolidated Financial Statements). We had no debt outstanding as of September 30, 2011 and only utilized the revolving loan infrequently and for no more than one day duration of each loan during the nine months ended September 30, 2011.

Cash provided by operating activities was $8,843,000 for the nine months ended September 30, 2011, compared to $9,134,000 for the nine months ended September 30, 2010. The decrease was due primarily to increases in accounts receivable, deferred income taxes and other liabilities partially offset by higher net income (adjusted for non-cash depreciation, amortization and stock-based compensation).

Cash used by investing activities was $5,463,000 for the nine months ended September 30, 2011, compared to $31,517,000 for the nine months ended September 30, 2010. During the first nine months of 2011, we had net investment maturities of $18,553,000 offset by purchases of businesses of $19,761,000, purchases of $1,380,000 of equipment and software, and the capitalization of $2,875,000 in software development costs. We are investing significant resources in the next generation of our transcription platform and expect this level of capitalization will continue through the remainder of 2011. For the first nine months of 2010, investing activities were related primarily to the net purchase of $27,377,000 of investments with the proceeds from our 2009 stock offering, $1,571,000 of capital expenditures and $2,569,000 of capitalized software development costs.

Cash provided by financing activities was $811,000 for the nine months ended September 30, 2011, compared to cash used in financing activities of $2,733,000 in the same period in 2010. Cash provided by financing activities during the first nine months of 2011 was primarily from the proceeds from stock option exercises while cash used in financing activities in 2010 was due primarily the repayment of debt.

On August 31, 2009, Transcend and MDSI entered into a loan and security agreement with Regions Bank. Transcend and MDSI are both “borrowers” under the loan and security agreement, which replaced our previous credit facility. The loan and security agreement includes a one-time, four-year term loan of $7.0 million for the costs and expenses of, and, to the extent necessary, a portion of the purchase price for MDSI. The loan and security agreement also provides for up to $5.0 million in a revolving loan commitment based on eligible accounts receivable. We may use proceeds of the revolving loan only for working capital, general corporate purposes, and for specified acquisitions. We used $4.0 million of the proceeds from the follow-on offering of our common stock completed in the fourth quarter of 2009 to pay down the term loan. The original revolving loan commitment expired in August, 2010 and has been renewed annually since then, with the current expiration in August 2012. When the loan was renewed in August, 2011, the revolving loan commitment was increased to $10.0 million. Borrowings bear interest at a rate based on the current LIBOR (3.75% as of December 31, 2010), and are secured by substantially all of our assets. The outstanding balance on the term loan of $67,000 was paid off in June, 2011. The balance on the revolver was $0 as of September 30, 2011 and December 31, 2010. We utilized the revolving loan infrequently and for no more than one day in duration of each loan during the nine months ended September 30, 2011.

The loan and security agreement contains representations and warranties, as well as affirmative, reporting and negative covenants customary for financings of this type. Among other things, the loan and security agreement restricts us from incurring certain additional debt, prohibits us from creating, permitting or allowing certain liens on our property, restricts the payment of dividends, distributions and other specified equity related transactions, and prohibits certain borrowings and specified transactions with affiliates. The loan and security agreement also requires the maintenance of a specified minimum fixed charge coverage ratio, tangible net worth, and cash flow leverage, as defined in the agreement. As of September 30, 2011, we were in compliance with all covenants of the agreement except one covenant related to tangible net worth. Regions Bank issued a waiver of this covenant as of September 30, 2011.

We anticipate that cash on hand, availability under our revolving line of credit agreement, together with anticipated cash flows from operations, should be sufficient for at least the next twelve months to finance operations, make capital investments in the ordinary course of business and pay indebtedness when due.


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Part of our growth strategy is the completion of acquisitions. Management believes that available cash and our credit facility together with other acquisition options, such as seller financing, are only sufficient to complete small acquisitions. Additional financing would be required for larger acquisitions.

Item 3.
Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

We have a floating rate of interest on our credit facility. As of September 30, 2011, there was no balance on our term loan under our credit facility.

Foreign Currency Exchange Rate Risk

We are exposed to foreign currency exchange rate risk in the ordinary course of doing business as we transact or hold a portion of our funds in the Indian rupee. Accordingly, we periodically evaluate the need for hedging strategies, including the use of derivative financial instruments, to mitigate the effect of foreign currency exchange rate fluctuations and expect to continue to use such instruments in the future to reduce foreign currency exposure to appreciation or depreciation in the value of certain foreign currencies. All hedging transactions are authorized and executed pursuant to regularly reviewed policies and procedures.

We have entered into a series of foreign exchange forward contracts that are designated as cash flow hedges of expense payments in India. India converts U.S. dollar receipts from intercompany billings to Indian rupees to fund local expenses, including salaries. Our U.S. dollar / Indian rupee hedges are intended to partially offset the impact of movement of exchange rates on future operating costs. We limit the forward contracts operational period to 12 months or less, and we do not enter into foreign exchange forward contracts for trading purposes. As of September 30, 2011, the notional value of these contracts was $5,392,000. The outstanding contracts as of September 30, 2011 are scheduled to mature within one year. The fair value of our foreign exchange forward contracts is marked to market at each reporting period. As of September 30, 2011, the net unrealized loss on our outstanding foreign exchange forward contracts was $359,000, compared to $238,000 net unrealized gain as of December 31, 2010. The change in value of $597,000 is reflected as a decrease in pre-tax income in the first nine months of 2011 but was partially offset by realized gains of $243,000 in the nine months ended September 31, 2011. Based upon a sensitivity analysis of our foreign exchange forward contracts at September 30, 2011, which estimates the fair value of the contracts based upon market exchange rate fluctuations, a 10% change in the foreign currency exchange rate against the U.S. dollar with all other variables held constant would have resulted in a change in the fair value of approximately $500,000. Our hedges of our foreign currency exposure are not designed to, and, therefore, cannot entirely eliminate the effect of changes in foreign exchange rates on our consolidated financial position, results of operations and cash flows.

Item 4.
Controls and Procedures

a)
Evaluation of disclosure controls and procedures

As of the end of the period covered by this quarterly report, our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), has conducted an evaluation of the effectiveness of our disclosure controls and procedures in accordance with Rule 13a-15 under the Securities Exchange Act of 1934 (the "Exchange Act"). Based on this evaluation as of the end of the period covered by this quarterly report, our CEO and CFO concluded that, as of such date, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is (i) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Management believes, however, that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all controls are working as designed and that instances of fraud, if any, within a company have been detected.

b)
Changes in internal control over financial reporting

Internal control over financial reporting is a process designed by, or under the supervision of the principal executive officer and principal financial officers and effected by the board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external purposes in accordance with GAAP.

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To the extent that components of our internal control over financial reporting are included in our disclosure controls, they are included in the scope of the evaluation by our principal executive officer and principal financial officer referenced above.

No change in our internal control over financial reporting occurred during the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1A.
Risk Factors

In addition to the other information set forth in this report and in our other reports and statements that we file with the SEC, including our quarterly reports on Form 10-Q, careful consideration should be given to the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Item 6.
Exhibits

The exhibits listed in the accompanying exhibit index are filed as part of this quarterly report.


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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
TRANSCEND SERVICES, INC.
 
 
 
November 8, 2011
By:
/s/ Larry G. Gerdes
 
 
Larry G. Gerdes,
 
 
Chief Executive Officer
 
 
(Principal Executive Officer)
 
 
 
November 8, 2011
By:
/s/ Lance Cornell
 
 
Lance Cornell,
 
 
Chief Financial Officer
 
 
(Principal Financial Officer)


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EXHIBIT INDEX

Exhibit
Number
  
Exhibit Description
10.1
 
Waiver and Seventh Amendment to Loan and Security Agreement, by and between Transcend Services, Inc. and Regions Bank, dated November 2, 2011 (Incorporated by reference to Exhibit 10.1 to the Company's Form 8-K filed on November 3, 2011)

 
 
 
10.2
 
Sixth Amendment to Loan and Security Agreement, by and between Transcend Services, Inc. and Regions Bank, dated September 30, 2011 (Incorporated by reference to Exhibit 10.1 to the Company's Form 8-K filed on October 3, 2011)

 
 
 
10.3
 
Amended and Restated Revolving Note dated September 30, 2011 (Incorporated by reference to Exhibit 10.2 to the Company's Form 8-K filed on October 3, 2011)

 
 
 
10.4
 
Amended and Restated Clinical Document Solution Agreement dated August 10, 2011, between Multimodal Technologies, Inc. and Transcend Services (Incorporated by reference to Exhibit 10.1 to the Company's Form 8-K filed on September 30, 2011).x

 
 
 
31.1
  
Certification of Chief Executive Officer of the Registrant Pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
 
 
 
31.2
  
Certification of Chief Financial Officer of the Registrant Pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
 
 
 
*32.1
  
Certification of Chief Executive Officer of the Registrant Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
*32.2
  
Certification of Chief Financial Officer of the Registrant Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101.INS**
 
XBRL Instance Document
 
 
 
101.SCH**
 
XBRL Taxonomy Extension Schema Document
 
 
 
101.CAL**
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
101.LAB**
 
XBRL Taxonomy Extension Label Linkbase Docuement
 
 
 
101.PRE**
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
101.DEF**
 
XBRL Taxonomy Extension Definition Linkbase Document
____________________
X 
Portions of this exhibit have been omitted and filed separately with the Commission as part of an application for confidential treatment.

*
This certification is furnished to, but not filed with, the Commission. This certification shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933, as amended or the Securities Exchange Act of 1934, as amended, except to the extent that the Registrant specifically incorporates it by reference.

**
The following materials from our Quarterly Report on Form 10-Q for the quarter and nine months ended September 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010; (ii) the Condensed Consolidated Income Statements for the three and nine months ended September 30, 2011 and 2010; (iii) the Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010; and (iv) the Notes to the Condensed Consolidated Financial Statements, tagged as blocks of text. Pursuant to Rule 406T of Regulation S-T the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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