Nutrisystem 2005 Annual Report Download - page 27

Impairment of Fixed Assets and Intangibles. We continually assess the impairment of long-lived assets
whenever events or changes in circumstances indicate that the carrying value of the assets may not be
recoverable. Judgments regarding the existence of impairment indicators are based on legal factors, market
conditions and our operating performance. Future events could cause us to conclude that impairment indicators
exist and the carrying values of fixed and intangible assets may be impaired. Any resulting impairment loss
would be limited to the value of net fixed and intangible assets.
Income Taxes. As a result of a change of control transaction which occurred in December 2002,
approximately $2.0 million of the net operating loss carryforwards are subject to usage limitations pursuant to the
rules of Internal Revenue Code section 382.
During 2005, the tax deduction from the exercise of certain stock options eliminated taxable income. As a
result, we had federal net operating loss carryforwards of $12.9 million and state net operating loss carryforwards
of $22.5 million at December 31, 2005. Net operating losses will begin to expire in 2014.
Through March 2003, a valuation allowance had been maintained for the deferred tax asset based on
management’s assessment that the deferred tax asset would not be realized given the historical taxable levels of
income (loss), the uncertainty of future operating results, tax planning strategies, and the expiration date of net
operating loss carryforwards. In the second quarter of 2003, management determined based on an analysis of the
cumulative level of pretax profits over the prior three years, projected levels of profits, schedule of reversal of
deferred taxes and tax strategies that recognition of the benefits related to deferred tax assets was more likely
than not. As a result, the valuation allowance was reduced, a deferred tax asset was recorded on the consolidated
balance sheet and an income tax benefit was recorded. A portion of the deferred tax asset recognized arose prior
to a 1999 merger transaction; in order to reflect the recognition of the deferred tax asset on the previously
recorded merger transaction we eliminated $290,000 of goodwill and credited equity by $790,000. Management
continues to believe that the deferred tax assets are realizable at December 31, 2005 based on our projected levels
of profits, schedule of reversal of deferred taxes and tax strategies.
Currently, we are recording income taxes at a rate equal to the combined federal and state statutory rates.
For the year ended December 31, 2005, we recorded $13.1 million of income taxes, which was recorded at an
estimated annual effective tax rate of 38.5%. For the year ended December 31, 2004, we recorded income tax
expense of $680,000, which reflected an estimated annual effective tax rate of 40.0%.
Results of Operations
Revenue and expenses consist of the following components:
Revenue. Revenue consists primarily of food sales. Food sales include sales of food, supplements,
shipping and handling charges billed to customers and sales credits and adjustments, including product returns.
No revenue is recorded for food products provided at no charge as part of promotions. Revenue for Slim and
Tone consists primarily of franchise fees and royalties. Revenue for franchise fees is recognized when a franchise
center opens for business. Royalties are paid monthly and recognized in the month the royalty is earned.
Cost of Revenue. Cost of revenue consists primarily of the cost of the products sold, including
compensation related to fulfillment, the costs of outside fulfillment, incoming and outgoing shipping costs,
charge card discounts, packing material and the write-off of obsolete packaging and product. Cost of products
sold includes products provided at no charge as part of promotions and the non-food materials provided with
customer orders. Cost of revenue also includes the fees paid to independent distributors and sales commissions.
Cost of revenue for Slim and Tone consists of the costs incurred associated with the opening of a franchise
center.
Marketing Expense. Marketing expense includes advertising, marketing and promotional expenses and
payroll related expenses for personnel engaged in these activities. We follow the American Institute of Certified
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