The amount of cash potentially advanced upon the sale of a new membership, prior to the recoupment of any charge-backs (described below), represents an amount approximately equal to three years overall commission earnings. Although the average number of marketing associates receiving an advance commission payment on a new membership is ten, the overall initial advance may be paid to as many as nineteen different individuals, each at a different level within the overall commission structure. This commission advance immediately increase an associate's account with the Company and represents prepaid commissions on active memberships. These advance commission payments ("advances") are recovered at different rates depending on the amount of commission earnings ("earnings") attributable to each level with in the commission structure and are determined by the relationship between the advance amount and the earnings amount attributable to each commission level. These recovery periods range from a period of 12 months to 64 months.
Accounting Standards to be Adopted In March 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121 ("FAS 121"), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." Effective for fiscal years beginning after December 15, 1995, FAS 121 establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles and goodwill related to such assets. The Company will adopt FAS 121 in 1996. Management has not evaluated the effect of this pronouncement on the Company's consolidated financial statements.
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 ("FAS 123"), "Accounting for Stock - -Based Compensation." FAS 123 establishes a fair value method and disclosure standards for stock-based employee compensation arrangements, such as stock purchase plans and stock options. It also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees, requiring that such transactions be accounted for based on fair value. As allowed by FAS 123, the Company will continue to follow the provisions of Accounting Principles Board Opinion No. 25 for its stock-based employee compensation arrangements, and disclose the pro forma effects of applying FAS 123 for 1995 and 1996 in its 1996 financial statements. Pursuant to its 1995 Stock Option Plan for Associates, the Company will record compensation expense based on the fair value of the options issued under such Plan.
Contract premiums totaled $31.2 million during 1995 compared to $22.9 million for 1994, an increase of 37%. The increase in Contract premiums was primarily the result of increased new Contract sales resulting in a higher number of active Contracts in force. New Contract sales during 1995 were 109,922 compared to 45,893 during 1994. At December 31, 1995, there were 203,535 active Contracts in force compared to 144,438 at December 31, 1994. Additionally, the average annual premium per Contract has increased from $229 for those Contracts written in 1994 to $239 for Contracts written during 1995, a 4.0% increase, as a result of a higher portion of Contracts written during 1995 including the additional pre-trial hours benefits at an additional cost to the member.
Primarily as a result of the increase in Contract premiums, total revenues increased to $37.4 million for 1995 from $25.1 million during 1994, an increase of 49%.
Contract benefits totaled $10.6 million for 1995 compared to $8.0 million for 1994, an increase of 33%. However, the loss ratio for 1995 decreased to 34% from 35% for 1994.
General and administrative expenses during 1995 and 1994 were $4.9 million and $4.4 million, respectively, and represented 16% and 19% of Contract premiums for such years. Although the total amount of general and administrative expenses increased approximately $500,000 during 1995, these expenses, as a percent of Contract premiums, decreased 3%. This trend of gradual increases in the total dollar amount of these expenses but decreases when expressed as a percentage of Contract premiums should continue as a result of certain economies of scale pertaining to the Company's operating leverage.
Direct marketing costs increased to $1.0 million for 1995 from $644,000 for 1994 but were fairly consistent as a percent of Contract premiums and include those costs other than commissions, which are directly associated with new Contract sales.
Comparison of 1994 to 1993 The Company reported net income of $3.7 million and net income applicable to common shares of $3.3 million, or $.26 per common share, for 1994 compared to net income of $108,000 and net income applicable to common shares of $93,000, or $.01 per common share, for 1993. The increase in the net income for 1994 is primarily the result of increases in every revenue category for 1994 as compared to 1993 and non-recurring contingency reserves established during 1993.
Associate services revenue increased from $462,000 for 1993 to $912,000 during 1994 as a result of higher new associate enrollments. New associates enrolled during 1994 were 14,129 compared to 8,386 for 1993, an increase of 68%. Associate services revenue also increased as a result of increases in sales of marketing materials used by the associates in sales presentations of the Company's Contracts. Associate services revenue for 1994 was comprised of $686,000 in enrollment fees and $226,000 in sales of marketing materials. Future revenues from associate services will depend primarily on the number of new associates enrolled, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of providing associate services.
During the fourth quarter of 1993 the Company implemented a charge to associates on advance commissions which have not yet been earned. Primarily as a result of this charge, interest income for 1994 increased to $466,000 compared to $195,000 for 1993. Interest income also increased as a result of increases in the average investments outstanding and higher interest rates on investments. At December 31, 1994 the Company reported $11.7 million in cash and investments compared to $5.4 million at December 31, 1993. Future interest income attributable to the charge to associates for commission advances will depend upon the number of new Contracts sold and will be impacted by the reduced monthly rate of .5% compared to the prior 1.5%, offset by the expected higher levels of associate commission advances.
Primarily as a result of the increase in Contract premiums, total revenues increased to $25.1 million for 1994 from $20.5 million during 1993, an increase of 22%.
The provision for current income taxes in both 1994 and 1993 was insignificant because the Company in each period had unused tax benefits which substantially offset any current tax liabilities. A deferred tax benefit was recorded in 1994 related to recognition of the Company's alternative minimum tax carryforward.
Dividends paid on outstanding preferred stock during 1994 increased to $465,000 from $15,000 during 1993. This $450,000 increase is attributable to dividends paid on outstanding shares of $2.40 Cumulative Convertible Preferred Stock issued during June and July, 1994 in conjunction with a public unit offering. This series of preferred stock automatically converted to common stock pursuant to its terms on February 27, 1995, as described below.
General Consolidated net cash provided by operating activities was $548,000, $3.0 million and $1.1 million for 1995, 1994 and 1993, respectively. The decrease of $2.5 million from 1995 to 1994 was primarily the result of increases in commission advances of $9.2 million which was partially offset by an increase in net income of $3.6 million and an increase in provision for deferred income taxes of $4.3 million. The increase of $1.9 million from 1993 to 1994 in cash provided by operating activities resulted primarily from an increase in net income of $3.6 million and was only partially reduced by the decrease in accounts payable and accrued expenses and contingency reserves of $518,000 and the decreases in accrued Contract benefit costs of $955,000.
In our opinion, the consolidated statements of operations, of cash flows and of changes in stockholders' equity for the year ended December 31, 1993 present fairly, in all material respects, the results of operations and cash flows of Pre-Paid Legal Services, Inc. and its subsidiaries for the year ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. We have not audited the consolidated financial statements of Pre-Paid Legal Services, Inc. for any period subsequent to December 31, 1993.
Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, as well as those of PPL Agency, Inc. See Note 8 for additional information regarding PPL Agency, Inc. Significant subsidiaries of the Company include Pre-Paid Legal Casualty, Inc. (PPLCI) and Pre-Paid Legal Services, Inc. of Florida (PPLSIF). All significant intercompany accounts and transactions have been eliminated.
All investment securities are adjusted for amortization of premiums and accretion of discounts. Amortization of premiums and accretion of discounts are recorded to income over the contractual maturity or estimated life of the individual investment on the level yield method. The Company has the ability and intent to hold to maturity its investment securities classified as held to maturity; accordingly, no adjustment has been made for the excess, if any of amortized cost over market. In determining the investment category classifications, management considers its asset/liability strategy, changes in interest rates and prepayment risk, the need to increase capital and other factors. Under certain circumstances (including the deterioration of the issuer's creditworthiness, a change in tax law, or statutory or regulatory requirements), the Company may change the investment security classification. Gain or loss on sale of investments is based upon the specific identification method. Income earned on the Company's investments in state and political subdivisions is not taxable.
Revenue Recognition Contract premiums are recognized in income when due in accordance with Contract terms which generally require the holder of the Contract to remit premiums on a monthly basis. Contracts are canceled for nonpayment of premium after ninety days. Premiums due but not collected at the end of an accounting period are recorded as accrued contract income; a provision for uncollectible premiums, if any, is recorded currently. Sales of marketing kits to Associates are recognized as revenue when cash is received.
Contract Benefit Costs Contract benefit costs represent claims reported but not paid and actuarially estimated claims incurred but not reported. The Company calculates Contract benefit costs based on completion factors which consider historical claims experience based on the dates that claims are incurred, reported to the Company and subsequently paid. Processing costs related to these claims are accrued based on an estimate of expenses to process such claims.
Income Taxes Deferred taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The Company records deferred tax assets related to the recognition of future tax benefits of temporary differences and net operating loss and tax credit carryforwards. To the extent that realization of such benefits is not considered more likely than not, the Company establishes a valuation allowance to reduce such assets to estimated realizable value.
Earnings per common share - assuming full dilution are determined on the assumptions described above except that the purchases assumed to have been made upon the exercise of warrants and options are assumed to have been made at the market price at the close of the respective periods if that market price is higher than the average market price for such periods. Additionally, the $2.40 Cumulative Convertible Preferred Stock and certain convertible subordinated Debentures are assumed to have been converted and the respective dividends and interest are included in determining net income applicable to common shares. Weighted average number of shares used in computing earnings per common share-assuming full dilution are 21,778,000, 15,772,000, and 12,643,000 for 1995, 1994 and 1993, respectively.
December 31, 1994 Amortized Gross Unrealized Cost Gains Losses Fair Value U.S. Government $ 5,989 $ - $ 37 $ 5,952 obligations Obligations of 410 7 24 393 state and political subdivisions Total =========== ========= ========= ======== $ 6,399 $ 7 $ 61 $ 6,345
A comparison of the amortized cost and fair value of the Company's held to maturity investment securities at December 31, 1995 by maturity date follows:
Amortized Cost Fair Value One year or less $ 500 $ 500 Two years through five years 1,055 1,046 Total $ 1,555 $ 1,546
December 31, 1995 1994 Held-to-maturity short-term investments $ - $ 5,989 Held-to-maturity investments-current portion 500 - Held-to-maturity investments 112 110 Investments pledged 943 300 Total $ 1,555 $ 6,399
Estimated December 31, Useful Life 1995 1994 Equipment, furniture and fixtures .......... 3-10 years $ 4,338 $ 4,020 Computer software .......................... 5 years 1,822 1,651 Building and improvements .................. 20 years 1,621 1,618 Automotive ................................. 3 years 163 89 Land ....................................... 110 110 8,054 7,488
The Company accounts for income taxes in accordance with SFAS 109, which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that are recognized in different periods in the Company's financial statements and tax returns. In estimating future tax consequences, SFAS 109 generally considers all future events other than enactments of changes in the tax law or rates. The cumulative effect of adopting SFAS 109 as of January 1, 1993 was immaterial.
Deferred tax liabilities and assets at December 31, 1995 and 1994 are comprised of the following: December 31, 1995 1994 Deferred tax liabilities: Commissions advanced ................................. $ 4,408 $ 914 Depreciation ......................................... 179 207 Total deferred tax liabilities .................... 4,587 1,121
Deferred tax assets: Litigation accruals .................................. 135 340 Contract benefit reserve ............................. 226 302 Receivables allowance ................................ 201 333 Net operating loss carryforward ...................... 3,188 3,429 Capital loss carryforward ............................ 653 704 General Business Credit carryforward ................. 325 325 AMT Credit carryforward .............................. 366 362 Total deferred tax assets ........................ 5,094 5,795 Valuation allowance for deferred tax assets .......... (4,073) (4,312) Total net deferred tax assets .................... 1,021 1,483 Net deferred (liability) tax asset .................. $(3,566) $ 362
At December 31, 1995, the Company has net operating loss carryforwards (NOLs) for regular tax and alternative minimum tax purposes of approximately $9.1 million and $8.7 million, respectively, expiring in 2001 and 2002. In addition, the Company has general business and rehabilitation tax credit carryforwards of approximately $325,000, expiring primarily in 1998 to 2001, and an alternative minimum tax credit carryforward of $366,000 which does not expire. The Company also has a capital loss carryforward of $1,800,000 which expires in 1997.
On February 27, 1995, all of the Company's remaining outstanding $2.40 Cumulative Convertible Preferred Stock automatically converted into common stock pursuant to its terms which provided for such automatic mandatory conversion if its closing price exceeded $33.60 per share for ten (10) consecutive trading days. The closing price of this Preferred Stock exceeded such price level for the 10 consecutive trading days resulting in the conversion. Approximately 3.9 million shares of common stock were issued as a result of this conversion.
The Company's ability to pay dividends is dependent in part on its ability to derive dividends from its subsidiaries. The payment of dividends by PPLCI is restricted under the Oklahoma Insurance Code to available surplus funds derived from realized net profits. At December 31, 1995, PPLCI did not have funds available for payment of dividends without the approval of the Oklahoma Insurance Commissioner. The Company's ability to pay dividends is also restricted under a line of credit agreement which precludes payments of dividends on Common Stock as long as any amounts are outstanding pursuant to such credit agreement. To date, the Company has not borrowed under the bank credit agreement.
Agency's financial position and results of operations are included in the Company's financial statements on a combined basis. Agency earned commissions during 1995, 1994 and 1993 of $413,000, $401,000 and $416,000, respectively, through its sales of insurance products of an unaffiliated company. Agency had net income for the year ended December 31, 1995 of $599 and net losses for the years ended December 31, 1994 and 1993 of $170,000 and $3,000, respectively, after incurring commissions earned by the Chairman of $45,000, $229,000 and $44,000, respectively, and annual management fees of $72,000 paid to the Company.
A former executive officer and director of the Company has a loan from the Company which was made prior to the time he became a director. The largest balance of this loan during the year ended December 31, 1995 was $68,000. The outstanding balance of this loan as of December 31, 1995 was $59,000. The loan bears annual interest at the rate of 3% in excess of the prime rate, adjusted on January 1 of each year, and is secured by commissions due from the Company.
The former executive officer and director owns interests ranging from 10% to 67% in corporations or partnerships not affiliated with the Company but engaged in the marketing of the Company's Contracts and which earn commissions from sales of Contracts. These entities earned commissions, net of amounts passed through as commissions to their sales agents, during 1995, 1994 and 1993 of $55,000, $71,000 and $121,000, respectively.
In accordance with Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation", the Company recorded compensation expense related to the issuance of stock options to Marketing associates of $76,000 during 1995.
During 1988, the Company adopted an employee stock ownership plan. Under the plan, employees may elect to defer a portion of their compensation by making contributions to the plan. Up to seventy-five percent of the contributions made by employees may be used to purchase Company Common Stock. The Company, at its option, may make matching contributions to the plan, and recorded expense during 1995, 1994 and 1993 of $39,150, $34,027 and $22,591 based on contributions of Company stock of 20,000 shares, 20,000 shares, and 18,000 shares, respectively.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE