fl ffl Oh 11006690 gv CORPORATE PROFILE Psychemedics Corporation The Companys multi patented is the worlds largest provider of hair testing for the detection of drugs of abuse process has been utilized by thousands of clients including over 10% of the Fortune 500 companies for pre-employment and random drug testing Major police departments Federal Reserve Banks schools and other public entities also secure the safety and reliability of their activities from drug abusers internet ECommerce website wwwdrugfreeteenagers.com by using our unique process Our personal drug testing service PDT-90 is available via our The Companys drug test provides for the detection of cocaine marijuana opiates including and PCP We strongly believe our drug oxycontin and vicodin amphetamines including Ecstasy testing method to be superior to any other product currently in use including traditional urine testing and other hair testing methods LYNCH BREWER HOFFMAN FINKLLP .i-ittorneys at Law ________________________________________________ 75 FEDERAL STREET 7TH FLOOR BOSTON MASSACHuSETrS 02110 TEL 617 951-0800 FAX 617 951-0811 WWW.LYNCHBREWER.COM OWEN LYNCH EDWARDS BREWER JR HOFFMAN ALAN DALE KERESTER JENNIFER PLAIT WHITMANt CHRISTINE THOMAS SONIAJ EWONt CLEMENS JR LISA CASEY ALSO ADMI1TED ADMITTED ALSO tALSO ADMITTED IN CT IN FL IN ME ALSO ADMI1TED IN NH PETERW FINKt JOHN DENNISt PATRICKJ ANNE HOFFMAN KINNEY April 201 OVERNIGHT DELIVERY Securities and Exchange Commission Street NE 100 Washington DC 20549 Re Corporation Psychemedics Commission File No 1-13738 CIK No 0000806517 Dear Sir/Madam Pursuant to Rule 4a-3 of the Securities Exchange Act of 1934 on behalf of Psychemedics as supplemental Corporation Corporations 2010 Annual Report Except for the Companys Form 10-K am enclosing information seven copies of Psychemedics included therein which was filed with the Commission on March 25 2011 pursuant to be considered to be treated as soliciting material and is not this report is not to Rule 13a- to be filed under the Securities Exchange Act of 1934 Please acknowledge receipt of copy of this cover letter and returning it the foregoing materials by date stamping the enclosed to the undersigned in the self-addressed metered envelope provided enclosures cc Nell Lemer Psychemedics Corporation via email without end Nicole Cunneen BDO USA LLP with copy of end regular U.S Mail 312843.1 Dear Fellow Shareholders In 2010 sales and profits were back on the growth track Revenues advanced 19% and our EPS increased 72% over last year While we are very proud of been profitable every year since 1993 including the severe 2009 recession continues that we have focus to be sales and earnings growth While some of our growth in 2010 can be the fact our attributed to the economic recovery the primary increase has come from new customers and introducing new programs to existing customers As reported to you last year in 2009 we made major investments in sales and marketing at salary cuts In 2010 while we continued the same time we had to make major reductions tight cost controls we again made major including across-the-board investments in sales and marketing to grow our business In April we brought on Jim Dyke to be our Corporate Vice President of Sales This is Marketing and general manager experience He is charged with accelerating given his extremely new position for us Jim has extensive professional he is focused strong background on profitable our sales growth and sales growth sales experience In July we announced the UK an international of that we had signed science-based and diagnostic services and reference standards company and market to market sales and marketing agreement with LGC forensic leader in analytical the patented Psychemedics hair analysis drug test whose forensic science capabilities to the UK We are very proud to be working with LGC company sets the highest quality standards in the UK Since we the highest quality and most cost effective provide match With this agreement we hope to capitalize in the UK and Europe and help companies place drug test available this is on the developing perfect growth opportunities drug free work there establish and maintain We also continued to add to our internal sales team and undertook and completed of our website www.Psychemedics.com total overhaul well as to expand our e-commerce platform We strongly believe in sales and marketing position us well investments for future growth to improve our internet presence as that these continued In addition Neil Lerner joined us as our new Vice President and Controller Neils background with extensive added strength He has come in and restructured the finance department in the Company with the key data required to drive our business as well as handle our external number of major large as well as small companies to better gives us serve all reporting In September 2010 for the fourth year in row DeMarche Associates Inc leading research and financial consulting firm included investment companies with the Best CEOs in the nation This is awarded American firms with CEOs who had generated the most shareholder compensation over effort at Psychemedics We are all pleased with this award as we strive to accomplish our goal of generating maximum return for shareholders while delivering the highest quality most cost effective three years We mention this because it is truly small group of value the previous per unit of CEO in their listing of Psychemedics team to drug test available With our strong track record of profitability and the major investments in sales and marketing that we have made over future growth and come into 2011 with great confidence largest provider of drug testing using hair analysis We have the most sensitive available which results rate This higher detection higher detection in the last two years we believe we are well positioned for in our future We are the worlds rate serves as drug test powerful upfront deterrent is our proprietary process allows to drug use What makes our test the most sensitive and effective us to get virtually 100% of the drug out of the hair if you cant get test in this case radioimmunoassay the drug out you cant measure it and all our we have the most sensitive tests are cleared by the FDA screening we have been and continue have the most extensive legal track record supporting to be the leader in mass-spectrometry confirmation testing we our proprietary testing method We industries including over 10% of the and wide base of have thousands Fortune 500 along with schools and major law enforcement agencies We believe we have of customers across very strong technology platform and customer base to build on and are excited about the years ahead In addition the Companys balance million in cash and short-term investments our confidence the financial success of in the future and remain committed to rewarding shareholders and no long term debt Our directors share and sharing the company with them as they grow We are very pleased now to sheet remains strong with approximately $5.7 have had 58 consecutive quarters of paying dividend would like to thank all our clients deterring drug abuse our directors for the major contribution they are making for their counsel and guidance and all my teammates in at for their continued commitment and dedication to excellence in serving our want to thank you our shareholders for your continued support Psychemedics customers And Sincerely Raymond Kubacki Chairman President and Chief Executive Officer SECURITIES AND EXCHANGE COMMISSION UNITED STATES Washington D.C 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31 2010 TRANSITION REPORT PURSUANT OF THE SECURITIES EXCHANGE ACT OF 1934 TO SECTION 13 OR 15d Commission File Number 1-13738 PSYCHEMEDICS CORPORATION Exact Name of Registrant as Specified in Its Charter Delaware State or Other Jurisdiction of Incorporation or Organization 125 Nagog Park Acton Massachusetts Address of Principal Executive Offices 58-1701987 I.R.S Employer No Identification 01720 Zip Code Registrants Telephone Number Including Area Code 978 206-8220 Securities registered pursuant to Section 12b of the Act Common Stock $0.005 par value Title of Class Securities registered pursuant to Section 12g of the Act None Indicate by 1934 YesE No check mark if the registrant is well-known seasoned issuer as defined in Rule 405 of the Securities Exchange Act of Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15d of the Securities Exchange Act of 1934 Yes No Indicate by check mark whether the registrant has filed all reports required to be filed by Section 13 or 15d 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 has been subject to such filing requirements for the past 90 days Yes No 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 during the preceding 12 months or for such shorter period that the registrant was required to submit and post such files Yes No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 229.405 of this chapter is not contained herein and will not be contained to the best of registrants knowledge in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K Indicate by check mark whether the registrant is large accelerated filer an accelerated filer or non-accelerated filer See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Securities Exchange Act of 1934 Large Accelerated Do not check if Filer Accelerated Filer Non-Accelerated Filer Smaller Reporting Company smaller reporting company Indicate by check mark whether the registrant is shell company as defined in Rule 12b-2 of the Securities and Exchange Act of 1934 Yes No As of June 30 2010 there were 5212835 shares of Conmion Stock of the Registrant outstanding The aggregate market value of the Common Stock of the Registrant held by non-affiliates and 5% shareholders are affiliates of the Registrant price of $7.98 per share on June 30 2010 assuming for these purposes but not conceding that all executive officers directors as of June 30 2010 was approximately $18 million computed based upon the closing As of March 22 2011 there were of Common Stock of the Registrant outstanding shares 5212013 DOCUMENTS INCORPORATED BY REFERENCE Part III of this Annual Report on Form 10-K incorporates by reference portions of the Registrants definitive proxy statement to be filed with the Securities and Exchange Commission no later than 120 days after the close of its fiscal year provided that if such proxy statement is not filed with the Commission in such 120-day period an amendment to this Form 10-K shall be filed no later than the end of the 120-day period SPECIAL NOTE REGARDiNG FORWARD-LOOKING STATEMENTS Some of the statements Registrants Common Stock under Business Risk Factors Legal Proceedings Market and Related Matters and Management Discussion Stockholder for and Analysis of Financial Condition Form 10-K constitute forward-looking amended and Section and Results of Operations and elsewhere in this Annual Report on Form 10-K this statements under Section 27A of the Securities Act of 1933 as 21E of the Securities Exchange Act of 1934 as amended including statements made with respect to future earnings per share future revenues future operating income future cash flows competitive and strategic initiatives potential stock repurchases and future liquidity needs These statements involve known and unknown risks uncertainties and other factors that may cause results levels of activity growth performance earnings per share or achievements to be materially different from any future results levels of activity growth performance earnings per share or achievements expressed or implied by such forward-looking statements The forward-looking statements included in this Form 10-K and referred to elsewhere are related to future events or our strategies or future financial forward-looking statements by terminology such performance as may should believe anticipate In some cases you can identify future potential plan expand focus through strategy provide offer allow commitment opportunity growth leader could expect estimate encourage intend implement result include or the negative increase establish perform make continue terms or comparable terminology All of such can ongoing forward-looking statements included in this Form 10-K are based on information available to us as of the filing date of this report and the Company assumes no obligation to update any such forward-looking statements Our actual results could differ materially from the forward-looking statements Important factors that could cause actual results to differ materially from expectations reflected in our forward-looking statements include those described in Item 1A Risk Factors PSYCHEMEDICS CORPORATION FORM 10-K ANNUAL REPORT For the Year Ended December 31 2010 TABLE OF CONTENTS Item Business Item 1A Item lB Risk Factors Unresolved Staff Comments Properties Legal Proceedings Reserved PART PART II Item Item Item Item Item Item Item 7A Item Item Market for Registrants Common Equity Related Stockholder Matters and Issuer Purchases of Equity Securities Selected Financial Data Managements Discussion and Analysis of Financial Condition and Results of Operations Quantitative and Qualitative Disclosures About Market Risk Financial Statements and Supplementary Data in and Disagreements With Accountants on Accounting and Financial Changes Disclosure Item 9A.T Controls and Procedures Item 9B Other Information Item 10 Directors Executive Officers and Corporate Governance Item 11 Executive Compensation PART III Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13 Item 14 Certain Relationships and Related Transactions and Director Independence Principal Accounting Fees and Services Item 15 Exhibits Financial Statement Schedules PART IV OTHER ITEMS Signatures Power of Attorney 11 Page 12 12 12 12 13 15 15 21 22 39 39 40 41 42 42 42 42 43 44 44 Available Information Background Psychemedics Corporation the Company or Psychemedics maintains executive offices located at PART 125 Nagog Park Acton MA 01720 Our NASDAQ Stock Exchange Market under The Company makes available telephone the symbol PMD Our number is 978 206-8220 Our stock is traded on the Internet address is wwwpsychemedics.com free of charge on the Investor Information section of its website its Annual Report on Form 10-K Quarterly Reports on Form 10-Q Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission the SEC Copies Corporation Attn Investor Relations SEC may be viewed or obtained Internet site at www.sec.gov We do not Annual Report on Form 10-K are also available without charge from Psychemedics 125 Nagog Park Acton MA 01720 Alternatively reports filed with the at the SEC Public Reference Room in Washington D.C or the SECs intend for information contained in our website to be part of this Item Business General Psychemedics Corporation is Delaware corporation organized on September 24 1986 to provide testing services for the detection of abused substances through the analysis of hair samples The Companys testing methods utilize patented technology to enzymatically dissolve hair samples and then perform radioimmunoyassays on the hair sampled with confirmation testing by mass spectrometry The Companys primary application of its patented technology is as testing service that analyzes hair samples for the presence of certain drugs of abuse Employing radioimmunoassay procedures to drug test hair samples differs from the more commonly used approach in which immunoassay procedures are employed to test urine samples The Companys tests provide quantitative information that can indicate the approximate amount of drug ingested as well as historical data which can show pattern of individual drug use over longer period of time providing superior detection compared to other types of drug testing This information is useful to employers for both applicant and employee testing as well as to physicians treatment professionals law enforcement agencies school administrators parents concerned about their childrens drug use and other individuals or entities engaged in any business where drug use or potential drug use is an issue The Company provides commercial testing and confirmation by mass spectrometry using industry-accepted practices for cocaine marijuana PCP methamphetamine sporadic use patterns and rapid clearance hydromorphone and oxycodone including Ecstasy which is difficult to detect in urine due to from the body and opiates including heroin hydrocodone Testing services are currently performed at the Companys laboratory at 5832 Uplander Way Culver City California The Companys services are marketed under registered service mark the name RIAH Radioimmunoassay of Hair Development of Radioimmunoassay of Hair The application of unique radioimmunoassay procedures to the analysis of hair was initially developed in 1978 by the founders of the Company Annette Baumgartner and Werner Baumgartner Ph.D The Baumgartners demonstrated that when certain chemical substances enter the bloodstream the blood carries these substances to the hair where they become entrapped in the protein matrix in amounts approximately proportional to the amount ingested The Companys patented drugs of abuse testing procedure involves direct analysis of liquefied hair samples by radioimmunoassay procedures utilizing effective reagents and antibodies The antibodies detect the presence of specific drug or drug metabolite in the liquefied hair sample by reacting with the drug present in the sample solution as well as an added radioactive analog of the drug The resulting antibody-drug complex is precipitated and analyzed The amount of drug present in the sample is inversely proportional to the amount of radioactive analog in the precipitate RIA positive results are then confirmed by Mass Spectrometry Depending upon the length of head hair the Company is able to provide historical information on drug use by the person from whom the sample was obtained Since head hair grows approximately 1.3 centimeters per month 3.9 centimeter head hair sample can reflect drug ingestion over the approximate several months prior to the collection of the sample Another testing option involves sectional analysis of the head hair sample In this procedure the hair is sectioned lengthwise to approximately correspond to certain time periods Each section corresponds to time period which allows the Company to provide information on patterns of drug use Validation of the Companys Proprietary Testing Method The process of analyzing human hair been the subject of numerous peer-reviewed for the presence of drugs using the Companys patented method has scientific field studies Results from the studies that have been published or accepted technology Some of these studies were performed with the following journals are generally in scientific for publication favorable to the Companys organizations Boston University School of Public Health Citizens for Better Community Court Columbia University Connecticut Department of Mental Health and Addictive Services Koba Associates-DC Initiative Harvard Cocaine Recovery Project Hutzel Hospital ISA Associates Interscience America-NIDA Workplace Study University of California-Sleep State Organization Maternal/Child Substance Abuse Project Matrix Center National Public Services Research Institute Narcotic and Drug Research Institute San Diego State University-Chemical Dependency Center Spectrum Inc Stapleford Centre London Task Force on Violent Crime Cleveland Ohio University of Miami-Department of Psychiatry University of Miami-Division of Neonatology University of South Florida- Par Inc University Operation Ana and Wayne State University of Washington VA Medical Center-Georgia U.S Probation Parole-Santa The above studies include research in the following areas effects of prenatal drug use treatment evaluation workplace drug use the criminal justice system and epidemiology Many of the studies have been funded by the National NIDA Several supporting the general validity hundred research and usefulness of hair analysis Institute of Justice or the National Institute on Drug Abuse articles written by independent researchers have been published Some of the Companys customers have also completed their own testing to validate the Companys proprietary hair testing method as prelude to utilizing the Companys services These studies have consistently confirmed the Companys superior detection rate compared to urinalysis testing When results based on the Companys patented hair testing method were compared to urine results in side-by-side evaluations to 10 times as many drug abusers were accurately identified by the Companys proprietary method offers In addition to these studies the Companys proprietary method is validated through for whom it has performed testing of clients to the thousands the services it In 1998 the National Institute of Justice utilizing Psychemedics hair testing completed Pennsylvania Prison study where hair analysis revealed an average prison drug use level of approximately 7.9% in 1996 Comparatively urinalysis revealed virtually no positives After measures to curtail drug use were instituted drug-sniffing dogs searches and scanners the use level fell to approximately hair analysis in 1998 Again the urine tests showed virtually no positives of hair analysis to monitor populations and the weakness of urinalysis 2% according The study illustrates to the results of the usefulness The Company FDA on all has received 510k clearance from the United States Food and Drug Administration five of its assays used to test human hair for drugs of abuse As of the date of this report Psychemedics has received FDA clearance for five-drug panel test that is not restricted to head hair samples for drugs of abuse Advantages of Using the Companys Patented Method The Company asserts that hair testing using its patented method confers substantive advantages relative to existing means of drug detection through urinalysis Although urinalysis testing can provide accurate drug use information the scope of the information is short-term and is generally limited to the type of drug ingested within few days of the test Studies published in many scientific publications have indicated that most drugs disappear from urine within few days In contrast to urinalysis testing hair testing historical drug use information resulting in using the Companys patented method can provide long-term This window may wider window of detection significantly be several months or longer depending on the length of the hair sample The Companys standard test offering however uses 3.9 centimeter length head hair sample cut close to the scalp which measures use for approximately the previous several months This wider window enhances the detection efficiency of hair analysis making it particularly useful in pre-employment and random testing Hair testing not only identifies more drug users but it may also uncover patterns and severity of drug use information most helpful in determining the scope of an individuals involvement with drugs while serving as deterrent against the use of drugs Hair testing employing the Companys patented method greatly reduces the incidence of false negatives associated with evasive measures typically encountered with urinalysis testing For example urinalysis test results are adversely impacted by excessive fluid intake prior to testing and by adulteration or substitution of the urine sample Moreover drug user who abstains from use for few days prior to urinalysis testing can usually escape detection Hair testing is effectively free of these problems as it cannot be thwarted by evasive measures typically encountered with urinalysis testing Hair testing is also attractive to customers since sample collection is typically performed under close supervision yet is less intrusive and less embarrassing for test subjects Hair testing using the Companys patented method with mass spectrometry confirmation further reduces the prospects of error in conducting drug detection tests Urinalysis testing is more susceptible to problems such as evidentiary false positives resulting from passive drug exposure or poppy seeds To combat this problem in federally mandated testing the opiate cutoff levels for urine testing were raised 667% from 300 to 2000 ng/ml on December 1998 and testing for the presence of heroin metabolite 6-AM was These requirements required 6-AM in urine down to several hours post drug use In contrast be detected for months effectively however reduced the detection time frame for confirmed heroin with the metabolite 6-AM is stable in hair and can In the event positive urinalysis test result is challenged test on newly collected urine sample is not viable remedy Unless the forewarned individual continues to use drugs prior to the date of the newly collected sample re-test may yield negative result when using urinalysis testing because of temporary abstinence In contrast when the Companys hair testing method is offered on repeat hair sample the individual suspected of drug use cannot as easily affect the results because historical drug use data remains locked in the hair fiber When compared to other hair testing methods not only are the Companys assays cleared by the FDA they also employ unique patented method of enzyme digestion that the Company believes allows for the most efficient release of drugs from the hair without destroying the drugs The Companys method of releasing drugs from hair is key advantage and results in superior detection rates Disadvantages of Hair Testing There are some disadvantages of hair testing as compared to drug detection through urinalysis Because hair starts growing below the skin surface drug ingestion evidence does not appear in hair above the scalp until approximately five to seven days after use Thus hair testing is not suitable for determining drug presence in for cause testing as is done in connection with an accident It does however provide drug history which can complement urinalysis information investigation in for cause testing Currently radioimmunoassay testing using hair samples under the Companys patented method is only practiced by Psychemedics Corporation The Companys prices for its tests are generally somewhat higher than prices for tests using urinalysis but the Company believes that its superior detection rates provide more value to the customer This pricing policy could however adversely impact the growth of the Companys sales volume Intellectual Property Certain aspects of the Companys hair analysis method are covered by six US patents and number of foreign patents and trade secrets owned by the Company One U.S patent expires in 2011 see risk factors and two additional patent applications have been filed The Company believes that its superior technology is protected by this combination of US and foreign patents and trade secrets The Companys ability to protect the confidentiality of these trade secrets is dependent upon the Companys internal safeguards and upon the laws protecting trade secrets and unfair competition Target Markets Workplace The Company focuses applicant and employee testing its primary marketing efforts on the private sector with particular emphasis on job Most businesses use drug testing to screen job applicants and employees The Hazeldon Foundation survey from 2007 indicated that 85 percent of human resource professionals believe that drug testing is an effective way to diagnose substance abuse The prevalence of drug screening programs reflects concern that use contributes drug HR professionals believe that absenteeism to employee health problems and costs as the same study found that 62 percent of is the most significant problem caused by substance abuse and addiction followed at 49 percent by reduced productivity lack of trustworthiness at 39 percent negative impact on the companys external image at 32 percent and missed deadlines at 31 percent and in certain industries safety hazards It has been estimated that the cost to American businesses is more than $100 billion annually The principal criticism of employee drug testing programs centers on the effectiveness of the testing program Most private sector testing programs use urinalysis Such programs are susceptible to evasive maneuvers and the inability An industry has developed dilutants clean urine and devices over to obtain confirmation through repeat samples in the event of challenged result the Internet and through direct mail marketing wide variety of adulterants to assist drug users in falsifying urine test results Moreover scheduled tests such as pre-employment testing and some random testing programs provide an opportunity for many drug users to simply abstain for few days in order to escape detection by urinalysis The Company presents its patented hair analysis method to potential clients as better technology well suited to employer needs Field studies and actual client results support the accuracy and effectiveness of the Companys patented technology and its ability to detect varying levels of drug use This information provides an employer with greater flexibility in assessing the scope of an applicants or an employees drug problem The Company performs confirmation test of all presumptive positive results through mass spectrometry The use of mass spectrometry is an industry accepted practice used to confirm positive drug test results of an initial screen In an employment setting mass spectrometry confirmation is typically used prior to the taking of any disciplinary action against an employee The Company offers its clients five-drug screen with mass spectrometry confirmation of cocaine PCP marijuana amphetamines including Ecstasy and opiates including heroin and oxycodone Schools The Company currently serves hundreds of schools throughout the United States and in several foreign countries The Company offers its school clients the same five-drug screen with mass spectrometry confirmation that is used with the Companys workplace testing service Parents The Company also offers personal drug testing service known as PDT90 for parents concerned about drug use by their children It allows parents to collect small sample from their child in the privacy of it to the Companys laboratory service uses the same patented method that and have it tested for drugs of abuse by the Company The is used with the Companys workplace testing the home send PDT-90 service testing Research The Company is involved in ongoing studies involving use of drugs of abuse in various populations including North Carolina Chapel Hill Johns Hopkins Bloomberg School Of Public Health Mclean Hospital Wayne Boston Medical Center Boston University School of Public Health University the following of State University and Chemistry and Drug Metabolism Section NIDA Sales and Marketing The Company markets its corporate drug testing services primarily through its own sales force Sales offices are located in several major cities in the United States in order to facilitate communications with corporate employers The Company markets its home drug testing service PDT-90 through the Internet and retail distributors Competition The Company competes directly with numerous commercial laboratories that test for drugs primarily through urinalysis testing Most of these laboratories such as Laboratory Corporation of America and Quest Diagnostics have substantially greater financial resources market identity marketing organizations facilities and numbers of personnel than the Company The Company has been steadily increasing its base of corporate customers and believes that future success with new customers is dependent on the Companys ability to communicate the advantages of implementing drug program utilizing the Companys patented hair analysis method The Companys ability to compete is also function of pricing The Companys prices for its tests are generally somewhat higher than prices for tests using urinalysis However the Company believes that its superior detection rates coupled with the customers ability to test less frequently due to hair testings wider window of detection several months versus approximately three days with urinalysis provide more value to the customer This pricing policy could however lead to slower sales growth for the Company Although other laboratories also offer hair testing for drugs of abuse Psychemedics is the only laboratory with FDA clearance for five-drug panel test that is not limited to head hair samples date no other laboratory engaged in hair testing has received approval or clearance its assays for the testing of both head and body hair samples two other laboratories for drugs of abuse To from the FDA on all of have either partial FDA clearance or clearance specific to head hair samples only Additionally several of these laboratories that purport to test hair samples use method that the Company presumes includes the use of form of immunoassay procedures The Company however does not believe that immunoassay testing of hair samples is as effective on commercial basis without using the Companys unique patented method which allows for the efficient release of drugs from the hair through enzyme digestion without destroying the drugs Government Regulation The Company is licensed as clinical laboratory by the State of California as well as certain other states All tests are performed according to the laboratory Human Services through the Clinical Laboratories licensing statutes standards established by the Department of Health Improvement Amendments CLIA and various and state substantial number of states regulate drug testing The scope and nature of such regulations varies greatly from state to state and is subject to change from time to time The Company addresses state law issues on an ongoing basis In 2000 the FDA issued regulations under the Federal Food Drug and Cosmetic Act as amended the FDC Act with respect the regulations not previously recognized to companies that market drugs of abuse test sample collection systems Under companies engaged in the business by the FDA are required to submit testing of for drugs of abuse using test screening assay their assay to the FDA for recognition prior to marketing In addition the laboratory performing the tests is required to be certified by recognized agency The regulations included transitional period in order for companies not immediately in compliance with the proposed requirements to obtain the necessary data they needed for submission to the FDA By May 2002 the Company had received 510k clearance to market all five of its assays In June 2008 Psychemedics also received the first CAP College of American Pathologists certification specifically including hair testing Research and Development The Company is continuously engaged in research and development activities During the years ended December 31 2010 2009 and 2008 $481433 $467435 and $474622 respectively were expended for research and development The Company continues to perform research activities to develop new products and services and to improve existing products and services utilizing the Companys proprietary technology The Company also continues to evaluate methodologies to enhance its drug screening capabilities Additional research using the Companys proprietary technology is being conducted by outside research organizations through government-funded studies Research has continued on the interactions of different types of hair with drugs in the environment and from actual drug usage This work has concentrated on assessments of various published methods for removal of externally deposited drug from hair surfaces and on methods of extraction of metabolically deposited drugs from the solid hair matrix Some of the work has been presented at meetings of the Society of Forensic Toxicologists and the European Society of Hair Testing Sources and Availability of Raw Materials Since its inception the Company has purchased raw materials for its laboratory services from outside suppliers The most critical of these raw materials are the radio-labeled drugs which the Company purchases from single supplier although other suppliers of radio-labeled drugs exist The Company has entered into an agreement with its principal supplier to purchase certain proprietary information regarding the manufacture of such radio-labeled drugs owned by the supplier in the event that the supplier ceases to be able to supply such radio-labeled drugs to the Company Employees As of December 31 2010 the Company had 91 full-time equivalent employees of whom full-time employees were in research and development None of the Companys employees are subject to collective bargaining agreement Item 1A Risk Factors In addition to other information contained in this Form 10-K the following risk factors should be carefully considered in evaluating Psychemedics Corporation and its business because such factors could have significant impact on our business operating results and financial condition These risk factors could cause actual results to materially differ from those projected in any forward-looking statements Companies may develop products that compete with our products and some of these companies may be larger and better capitalized than we are Many of our competitors and potential competitors are larger and have greater financial resources than we do and offer range of products broader than our products Some of the companies with which we now compete or may compete in the future may develop more extensive research and marketing capabilities and greater technical and personnel resources than we do and may become better positioned to compete in an evolving industry Failure to compete successfully could harm our business and prospects Increased competition including price competition could have material impact on the Company net revenues and profitability Our business is intensely competitive both in terms of price and service Pricing of drug testing services is significant factor often considered by customers in selecting drug testing laboratory As result of the clinical laboratory industry undergoing significant consolidation larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing This consolidation results in greater price competition The Company may be unable to increase cost efficiencies sufficiently if at all and as result its net earnings and cash flows could be negatively impacted by such price competition The Company may also face increased competition from companies that do not comply with existing laws or regulations or otherwise disregard compliance standards in the industry Additionally the Company may also face changes in fee schedules competitive bidding for laboratory services or other actions or pressures reducing payment schedules as result of increased or additional competition Additional competition including price competition could have material adverse impact on the Companys net revenues and profitability Our results of operations are subject in part to variation in our customers hiring practices and other factors beyond our control Our results of operations have been and may continue to be subject to variation in our customers hiring practices which in turn is dependent to large extent on the general condition of the economy Results for particular quarter may vary due to number of factors including economic conditions in our markets in general economic conditions affecting our customers and their particular industries the introduction of new products and product enhancements by us or our competitors and pricing and other competitive conditions failure to obtain and retain new customers or loss of existing customers or reduction in tests ordered could impact the Company ability to successfully grow its business The Company needs to obtain and retain new customers In addition reduction in tests ordered without offsetting growth in its customer base could impact the Companys ability and could have material adverse impact on the Companys net revenues to successfully grow its business and profitability We compete primarily on the basis of the quality of testing reputation in the industry the pricing of services and ability to employ qualified personnel The Companys failure to successfully compete on any of these factors could result in the loss of customers and reduction in the Companys ability to expand its customer base Our business could be harmed if we are unable to protect our proprietay technology We rely primarily on combination of trade secrets patents and trademark laws and confidentiality procedures to protect our technology Despite these precautions unauthorized third parties may infringe or copy portions of our technology In addition because patent applications in the United States are not publicly disclosed until either 18 months after the application filing date or the publication date of an issued patent wherein applicants seek only US patent protection which relate to our there is technology Moreover risk that applications not yet disclosed may have been filed foreign intellectual property laws will not protect our intellectual property rights to the same extent as United States intellectual property laws One of our patents is due to expire in 2011 be vulnerable to competitors who attempt In the absence of protections afforded by patents or by trade secrets we may to copy our products processes or technology Our business could be affected by computer or other IT System failure computer or IT system failure could affect our ability to perform tests report test results or properly bill customers Failures could conversions telecommunications occur as result of the standardization and other system failures malicious human acts such as electronic break-ins or computer IT systems of our viruses or natural disasters Sustained system failures or interruption of the Companys systems in one or more of its operations could disrupt the Companys ability to process and provide test results in timely manner and/or bill the appropriate party Failure of the Companys information systems could adversely affect the Companys business profitability and financial condition Failure to maintain confidential information could result in signficant financial impact The Company maintains confidential information regarding the results of drug tests and other information including credit card and payment information from our customers The failure to protect this information could result in lawsuits fines or penalties Any loss of data or breach of confidentiality such as through computer security breach could expose the Company to financial liability Our future success will depend on the continued services of our key personnel The loss of any of our key personnel could harm our business and prospects We may not be able to attract and retain personnel under contract other than necessary officers who have for the development of our business We do not have key personnel agreements providing for severance and non compete covenants in the event of termination of employment following change of control Further we do not have any key man life insurance for any of our officers or other key personnel We may become and attestation process mandated on certain exposed to potential risks and related costs as result of the internal control assessment issuers by Section 404 of the Sarbanes-Oxley Act of 2002 We evaluated tested and implemented internal controls over financial reporting to enable management to report on such we cease qualifying as internal controls as required by Section the Sarbanes-Oxley smaller reporting company under SEC rules under 404 of Act of 2002 At such time $75 million market cap we will be required to provide an auditor attestation on internal controls The auditor attestation could cause us to incur significant costs including increased accounting fees and staffing levels While we believe that we are compliant with the management evaluation requirements of Section 404 if our independent registered public accounting firm were unable to attest in timely manner to our evaluation we could be subject to regulatory scrutiny and loss of public confidence in our internal controls In addition new or improved controls or difficulties encountered in their or cause us to fail to meet our reporting obligations implementation could any failure to implement required harm our operating results Our reliance on one supplier for certain raw materials used in our testing procedures could harm our business and prospects Since its inception the Company has purchased raw materials for its laboratory services from outside suppliers The most critical of these raw materials are the radio-labeled drugs which the Company purchases from single supplier although other suppliers of radio-labeled drugs exist The Company has entered into an agreement with its principal supplier to purchase certain proprietary information regarding the manufacture of such radio-labeled drugs owned by the supplier in the event that the supplier ceases to be able to supply such radio-labeled drugs to the Company Obtaining alternative sources of supply of the radio-labeled drugs could involve delays and other costs however the Company maintains surplus supply The failure of the Companys primary or any alternative supplier of radio-labeled drugs to provide such radio-labeled drugs at an acceptable price or an interruption of supplies from such supplier and the exhaustion of the Companys current supply on hand could result in lost or deferred sales There is risk that our insurance will not be sufficient to protect us from errors and omissions liability or other claims or that in the future errors and omissions insurance will not be available to us at reasonable cost if at all Our business involves the risk of claims of errors and omissions and other claims inherent to our business We maintain errors and omissions and general liability insurance subject to deductibles and exclusions There is risk that our insurance will not be sufficient to protect us from all such possible claims An under-insured or uninsured claim could harm our operating results or financial condition Our research and development capabilities may not produce viable new services or products We are attempting to develop further capabilities in the drug testing arena It is uncertain whether we will be able to develop services that are more efficient effective or that are suitable for our customers Our ability to create viable products or services depends on many factors including the implementation of appropriate technologies the development of effective new research tools the complexity of the chemistry and biology the lack of predictability in the scientific process and the performance and decision-making capabilities of our scientists Further some of our existing patents are due to expire within the next years including one in 2011 Our research and development teams are working to develop improved processes with the aim of gaining additional patent protection There is no guarantee that they will be successful in developing these improvements or gaining such additional patent protection If any or all of our patents expire there may be increased competition in the marketplace for our service or we might be required to rely to greater extent on trade secret protection Improved testing technologies or the Companys customers using new technologies to perform their own tests could adversely affect the Companys business Advances in technology may lead to the development of more cost-effective technologies such as point- of-care testing equipment that can be operated by third parties or customers themselves in their own offices without requiring the services of freestanding laboratory Development of such technology and its use by the Companys customers could reduce the demand for its testing services and negatively impact our revenues We may not be able to recruit and retain the experienced scientists and management we need to compete in our industry Our future success depends upon our ability to attract retain and motivate highly skilled scientists and management Our ability caliber scientists to achieve our business and other qualified experts We compete with other strategies depends on our ability to hire and retain high testing companies research companies and academic and research institutions to recruit personnel personnel We may incur greater costs than anticipated and face significant or may not be successful competition for qualified in attracting new scientists or management or in retaining or motivating our existing personnel Our future success also depends on the personal efforts and abilities of the principal members of our senior management and scientific staff to provide strategic direction to manage our operations and maintain cohesive and stable environment Our facilities and practices may fail to comply with government regulations Our testing facilities and processes must be operated in conformity with current government regulations These requirements include records and documentation among other things quality control quality assurance If we fail to comply with these requirements and the maintenance of we may not be able to continue our services to certain customers or we could be subject to fines and penalties suspension of production or withdrawal of our certifications We operate facility that we believe conforms to all applicable requirements This facility and our testing practices are subject to periodic regulatory inspections to ensure compliance Our business could be harmed from the loss or suspension of any licenses The forensic laboratory testing industry is subject to significant regulation and many of these statutes and regulations are subject to change The Company cannot assure that applicable statutes and regulations will not be interpreted or applied by regulatory authority in manner that would adversely affect its business Potential sanctions for violation of these regulations could include the suspension or loss of various licenses certificates and authorizations which could have material adverse effect on the Companys business If our use of chemical and hazardous materials injury we may be liable for damages violates applicable laws or regulations or causes personal Our drug testing activities including the analysis and synthesis of chemicals involve the controlled use of chemicals including flammable combustible toxic and radioactive materials that are potentially hazardous Our use storage handling and disposal of these materials is subject to federal state and local laws and regulations including the Resource Conservation and Recovery Act the Occupational Safety and Health Act and local fire codes and regulations promulgated by the Department of Transportation Agency the Department of Energy and the California Department of Public Health the Drug Enforcement and Environment We may incur significant costs to comply with these laws and regulations in the future In addition we cannot completely eliminate the risk of accidental contamination or injury from these materials which could result in material unanticipated expenses such as substantial fines or penalties remediation costs or damages or the loss of permit or other authorization to operate or engage in our business Those expenses could exceed our net worth and limit our ability to raise additional capital Our operations could be interrupted by damage to our specialized laboratory facilities Our operations are dependent upon the continued use of our highly specialized laboratories and equipment in Culver City California Catastrophic events including earthquakes fires or explosions could damage our laboratories equipment scientific data work in progress or inventories of chemicals and may materially interrupt our business We employ safety precautions in our laboratory activities in order to reduce the likelihood of the occurrence of certain catastrophic events however we cannot eliminate the chance that such events will occur The availability of laboratory space in these locations is limited and rebuilding our facilities could be time consuming and result in substantial delays in fulfilling our agreements with our customers We maintain business interruption insurance to cover continuing expenses and lost revenue caused by such occurrences However this insurance does not compensate us for the loss of opportunity and potential harm to customer relations that our inability to meet our customers needs in timely manner could create Agreements we have with our employees our trade secrets confidential information consultants and customers may not afford adequate protection for and other proprietary information In addition to patent protection we also rely on copyright and trademark protection trade secrets know- how continuing technological innovation and licensing opportunities In an effort to maintain the confidentiality and ownership of our trade secrets and proprietary information we require our employees consultants and advisors to execute confidentiality and proprietary information agreements However these agreements may not provide us with adequate protection against improper use or disclosure of confidential information and there may not be adequate Furthermore we may from time to time hire scientific remedies in the event of unauthorized use or disclosure personnel formerly employed by other companies involved in one or more areas similar to the activities we conduct In some situations our confidentiality and proprietary information agreements may conflict with or be subject to the rights of third parties with whom 10 our employees consultants or advisors have prior employment or consulting relationships Although we require our employees and consultants to maintain the confidentiality of all proprietary information of their previous employers these individuals or we may be subject to allegations of trade secret misappropriation or other similar claims as result of their prior affiliations Finally others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets Our failure or inability to protect our proprietary information and techniques may inhibit or limit our ability to compete effectively or exclude certain competitors from the market Risks Related to Our Stock Our quarterly operating results could fluctuate significantly which could cause our stock price to decline Our quarterly operating results have fluctuated in the past and are likely to fluctuate in the future Our results are impacted by the extent to which we are able to gain new customers and on the hiring practices of our existing customers which are in turn impacted by general economic conditions Entering into new customer contracts can involve long lead time Accordingly negotiation can be lengthy and is subject to number of significant risks including customers budgetary constraints and internal reviews Due to these and other market factors our operating results could fluctuate significantly from quarter to quarter In addition we may experience industry-specific economic conditions significant fluctuations in quarterly operating results due to factors such as general and that may affect the budgets and the hiring practices of our customers Due to the possibility of fluctuations in our revenue and expenses we believe that quarter-to-quarter comparisons of our operating results are not necessarily good indication of our future performance Our operating results in some quarters may not meet the expectations of stock market analysts and investors If we do not meet analysts and/or investors expectations our stock price could decline Our stock price could experience substantid volatility The market price of our common stock has historically experienced and may continue to experience extensive volatility Our quarterly operating results the success or failure of future development efforts changes in general conditions in the economy or the financial markets and other developments affecting our customers our competitors or us could cause the market price of our common stock to fluctuate substantially This volatility may adversely affect the price of our common stock In the past securities class action litigation has often been instituted following periods of volatility in the market price of companys securities securities class action suit against us could result in potential liabilities substantial costs and the diversion of managements attention and resources regardless of whether we win or lose Payment of dividend could decline or cease Because we have historically paid dividends any cessation of our program or reduction in our quarterly dividend could affect our stock price We have paid dividends on our common stock for 58 consecutive quarters It is our intent to continue this practice as long as we are able However if we are forced to cease this practice or reduce the amount of the regular dividend due to operating or economic conditions our stock price could suffer In December 2008 the Company also paid special dividend Investors should not anticipate or expect any future or recurring special dividends Further if the Company ceases its future dividends return on investment in our common stock would depend entirely upon future appreciation There is no guarantee that our common stock will appreciate in value or even maintain the price at which stockholders have purchased their shares The general economic condition could continue to deteriorate Our business is dependent upon new hiring and the supply of new jobs created by overall economic conditions If the economy continues to deteriorate leading to high unemployment and the lack of new job creation our business and stock price could be adversely affected 11 Item lB Unresolved Staff Comments Not applicable Item Properties The Company maintains its corporate office and northeast sales office at 125 Nagog Park Acton Massachusetts the office consists of 3971 square feet and is leased through February 2015 The Company leases 18000 square feet of space in Culver City California for laboratory purposes This facility is leased through December 31 2012 with an option to renew for an additional three years The Company also leases an additional 5400 square feet of space and information purposes This office technology space in Culver City California for customer service is leased through December 31 2012 with an option to renew for an additional three years Item Legal Proceedings The Company is involved in various suits and claims in the ordinary course of business The Company does not believe that the disposition of any such suits or claims will have material adverse effect on the continuing operations or financial condition of the Company Item Reserved Not applicable 12 PART II Item Market for Registrants Common Equity Related Shareholder Matters and Issuer Purchases of Equity Securities The Companys common stock is traded on the NASDAQ Stock Market under the symbol PMD As of March 25 2011 there were 217 record holders of the Companys common stock The number of record owners was determined from the Companys stockholder records maintained by the companys transfer agent and does not include beneficial owners of the Companys common stock whose shares are held in the names of various security holders dealers and clearing agencies The Company believes that the number of beneficial owners of the Companys common stock held by others as or in nominee names exceeds 2000 The following table sets forth for the periods indicated the range of prices for the Companys common stock as reported by the NASDAQ Stock Exchange and dividends declared by the Company Fiscal 2009 First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal 2010 First Quarter Second Quarter Third Quarter Fourth Quarter High Low Dividends $7.32 $3.03 $0.170 6.99 7.05 7.70 5.51 6.00 5.10 0.170 0.120 0.120 $8.21 $7.17 $0.120 9.03 9.72 9.95 7.54 7.76 6.89 0.120 0.120 0.120 The Company has paid dividends over the past fourteen years It most recently declared dividend in March 2011 which was paid in March 2011 The Companys current intention is to continue to declare dividends to the extent funds are available and not required for operating purposes or capital requirements and only then upon approval by the Board of Directors Issuer Purchases of Equity Securities During the fourth quarter of 2010 the Company repurchased 822 common shares for treasury at weighted average price of $7.31 per share See Item for more detail 13 EQUITY COMPENSATION PLAN INFORMATION The following table provides information as of December 31 2010 with respect to shares of the Companys common stock Equity Incentive Plan that were issuable under the Companys 2006 Equity Incentive Plan the 2006 The table does not include information with respect to shares subject to outstanding options granted under other equity compensation plans that were no longer in effect on December 31 2010 Footnote to the table sets forth the total number of shares of common stock such expired or discontinued plans as of December issuable upon 31 2010 and the weighted the exercise of options under average exercise price of those options No additional options may be granted under such other expired or discontinued plans Number of Securities to Be Issued Upon Exercise of Outstanding Options Weighted Average Exercise Price of Outstanding Number of Securities That Options Warrants and Remained Available for Plan Category Equity compensation plans approved by security holders Equity compensation plans not approved by security holders Total Warrants and Rights Rights Future Issuance 94700 $0.00 84450 94700 $0.00 84450 Consists of the 2006 Equity Incentive Plan This table does not May 11 2006 As of December the exercise of outstanding options under include information 31 2010 for the Companys 2000 Stock Option Plan discontinued on total of 289371 the foregoing discontinued shares of common stock were issuable upon average exercise plan The weighted per share No additional options may be granted price of outstanding options under such plan is $13.96 under the 2000 Stock Option Plan Performance Graph COMPARE YEAR CUMULATIVE TOTAL RETURN AMONG PSCYCHEMEDICS CORPORATION NASDAQ COMPOSITE INDEX AND RUSSELL 2000 INDEX 200 150 100 50 Iii__ 2005 2006 2007 2008 2009 2010 PSYCHEMEDICS CORPORAF1ON RUSSELL 2000 INDEX NASDAQ COMPOSI FL INDEX Psychemedics Corporation 100.00 142.93 124.28 2005 2006 2007 Russell 2000 Index NASDAQ Composite Index 100.00 121.40 106.90 100.00 109.52 120.27 71.51 102.89 2008 61.67 7458 2009 74.49 88.03 2010 82.25 107.83 12029 Calculated by the Company using www.vahoo.com/finance historical prices aol sa endec Dccc nhcr 31 2010 ci Company Daa 20 11 ommon Stock the Russell 2000 Index oh and the \SDAQ Composite Index The prices all assume the reinvestment of dividends 14 The Russell 2000 Index is composed of the smallest 2000 companies in the Russell 3000 Index The Company has been unable to identify peer group of companies that engage in testing of drugs of abuse except for large pharmaceutical companies where such business is insignificant to such companies other lines of businesses The Company therefore uses in its proxy statements peer index based on market capitalization The NASDAQ Composite Index Exchange Market includes companies whose shares are traded on the NASDAQ Stock In September 2008 Psychemedics moved its listing to the NASDAQ Stock Exchange Market from the AMEX Stock Exchange Market Item Selected Financial Data The selected financial data presented below is derived from our financial statements and should be read in connection with those statements Revenue Gross profit Income from operations Net income Basic net income per share Diluted net income per share Total assets Working capital Shareholders equity Cash dividends declared per common share As of and for the Years Ended December 31 2010 2009 2008 2007 2006 In Thousands Except for per Share Data $20109 $16955 $22949 $24569 $23425 12042 4414 2614 0.50 0.50 11766 8566 9748 0.480 9610 2584 1527 0.29 0.29 10602 8471 9294 0.530 13350 14677 14056 4707 2969 0.57 0.57 12628 9516 10560 7139 4484 0.86 0.85 15561 12773 13878 1.160 0.575 7563 4902 0.95 0.94 13261 10534 11504 0.475 Item Managements Discussion and Analysis of Financial Condition and Results of Operations The Managements Discussion and Analysis of Financial Condition and Results of Operations should be read together with the more detailed business information and financial statements and related notes that appear elsewhere in this annual report on Form 10-K This annual report may contain certain forward-looking information within the meaning of the Private Securities Litigation Reform Act of 1995 This information involves risks and uncertainties Actual results may differ materially from the results discussed in the forward-looking statements Factors that might cause such difference include but are not limited to those discussed in Item 1A Risk Factors Overview Psychemedics Corporation is the worlds largest provider of hair testing for drugs of abuse utilizing patented hair analysis method involving radioimmunoassay technology and confirmation by mass spectrometry to analyze human hair to detect abused substances The Companys customers include Fortune 500 companies as well as small to mid-size corporations schools and governmental entities located primarily in the United States During the year ended December 31 2010 the Company generated $20.1 million in revenue while maintaining gross margin of 60% and pre-tax margins of 22% At December 31 2010 the Company had $5.7 million of cash cash equivalents and short-term investments During 2010 the Company had operating cash flow of $3.3 million and it distributed approximately $2.5 million or $0.48 per share of cash dividends to its shareholders To date the Company has paid fifty-eight consecutive quarterly cash dividends 15 The following table sets forth for the periods indicated the selected statements of operations data as percentage of total revenue Revenue Cost of revenue Gross profit Operating expenses General and administrative Marketing and selling Research and development Total operating expenses Operating income Other income Interest income Other income Total other income Income before taxes Provision for income taxes Net income Year Ended December 31 2010 2009 2008 100.0% 100.0% 100.0% 40.1% 43.3% 41.8% 59.9% 56.7% 58.2% 20.9% 21.2% 19.7% 14.6% 17.5% __ __ _1 15.9% 37.9% 41.5% 22.0% 15.2% 37.7% 20.5% 0.1% 0.3% 1.3% 0.1% 0.3% 1.3% 15.5% 21.8% 9.1% 6.5% 8.9% 22 _2 Results for the Year Ended DecembeE 31 2010 Compared to Results for the Year Ended December 31 2009 Revenue increased $3.2 million or 19% to $20.1 million in 2010 compared to $17.0 million in 2009 This increase was due to an increase in volume from new and existing clients Average revenue per sample increased 2% between 2010 and 2009 Gross profit increased $2.4 million to $12.0 million in 2010 compared to $9.6 million in 2009 Direct costs increased by 10% from 2009 to 2010 mainly associated with the direct cost of materials resulting from higher volumes The gross profit margin increased from 57% in 2009 to 60% in 2010 as revenue increased more than direct costs General and administrative GA expenses were $4.2 million for the year ended December 31 2010 compared to $3.6 million for the year ended December of revenue GA expenses were 20.9% and 21.2% for 31 2009 representing an increase of 17% As 31 2010 the years ended December and percentage 2009 respectively The increase in general and administrative expenses in 2010 was due to several factors an increase in salary expense due to the reinstatement of salaries in 2010 following salary cut in the second half of 2009 an increase in accounting and audit fees an increase in legal fees defending our technology on behalf of our customers and bonuses earned in 2010 and not in 2009 Marketing and selling expenses were $2.9 million for the year ended December 31 2010 compared to $3.0 million for the year ended December 31 2009 decrease of less than 1% Total marketing and selling expenses represented 14.6% and 17.5% of revenue for the years ended December 31 2010 and 2009 respectively Research and development RD expenses 2009 RD expenses represented 2.4% and 2.8% of revenue for the years ended December 31 2010 and for 2010 were $0.5 million compared to $0.5 million for 2009 respectively Interest income decreased approximately $22000 to approximately December 31 2010 compared to $45000 for the year ended December $23000 for the year ended 31 2009 Interest income in both periods represented interest and dividends earned on cash equivalents and short-term investments decrease in the yield on investment balances in 2010 as compared to 2009 caused the decrease in interest income 16 During the year ended December 31 2010 the Company recorded tax provision of $1.8 million representing an effective tax rate of 41.1% During the year ended December 31 2009 the Company recorded tax provision of $1.1 million representing an effective tax rate of 41.9% We do not expect significant change in our tax rate in the foreseeable future for the Year Ended December 31 2009 Compared to Results for the Year Ended December 31 Results 2008 Revenue decreased $6.0 million or 26% to $17.0 million in 2009 compared to $22.9 million in 2008 This decrease was due in part to decreased testing volume which fell 26% compared to 2008 Average revenue per sample was unchanged between 2009 and 2008 Revenue included the recognition of deferred revenue relating to the sale of PDT-90 products was $0.1 million for each of the years ended December 31 2009 and 2008 Gross profit decreased $3.7 million to $9.6 million in 2009 compared to $13.4 million in 2008 Direct costs decreased The gross profit margin fell from 58% in 2008 to 57% in 2009 as revenue by 23% from 2008 to 2009 mainly due to lower General and administrative GA expenses were $3.6 million for labor and associated direct cost of materials declined more than direct costs the year ended December 31 2009 compared to $4.5 million for the year ended December of revenue GA expenses were 21.2% and percentage 31 2008 representing 19.7% for the years ended December decrease of 20% As 31 2009 and 2008 respectively The decrease in general and administrative expenses in 2009 was due primarily to decrease in several categories lower legal fees defending our technology on behalf of our customers reduced salaries and stock compensation decreased bad debt expense and lower consulting fees Marketing and selling expenses were $3.0 million for the year ended December 31 2009 compared to $3.6 million for the year ended December 31 2008 decrease of 19% The variation in marketing and selling expenses was primarily due to lower staffing levels salary expense and reduced benefit expense of approximately $289000 Total marketing and selling expenses represented 17.5% and 15.9% of revenue for the years ended December 31 2009 and 2008 respectively Research and development RD expenses represented 2.8% and 2.1% of revenue for the years ended December 31 2009 and for 2009 were $0.5 million compared to $0.5 million for 2008 RD expenses 2008 respectively Interest income decreased approximately $263000 to approximately December 31 2009 compared to $308000 for the year ended December $45000 for the year ended 31 2008 Interest income in both periods represented interest and dividends earned on cash equivalents and short-term investments Lower average investment balances along with decrease in the yield on investment balances in 2009 as compared to 2008 caused the decrease in interest income During the year ended December 31 2009 the Company recorded tax provision of $1.1 million representing an effective tax rate of 41.9% During the year ended December tax rate of 40.8% of $2.0 million representing an effective tax provision 31 2008 the Company recorded Liquidity and Capital Resources At December 31 2010 the Company had $5.7 million of cash cash equivalents and short 31 2009 The Companys operating activities compared to $5.8 million at December term generated investments net cash of $3.3 million in 2010 $2.4 million in 2009 and $3.7 million in 2008 Investing activities used $1.9 million in 2010 used $1.1 million in 2009 and generated $3.5 million in 2008 Financing activities used $2.6 million in 2010 $3.1 million in 2009 and $6.7 million in 2008 Operating cash flow of $3.3 million in 2010 primarily reflected net income of $2.6 million adjusted for depreciation and amortization of $0.3 million stock compensation expense of $0.4 million an increase in prepaid expenses and accounts receivable of $0.9 million and an increase in accounts payable of $0.5 million and an increase in accrued expenses of $0.2 million Operating cash flow of $2.4 million in 2009 primarily reflected net income of $1.5 million adjusted for depreciation and amortization of $0.3 million stock compensation expense of $0.4 million decrease in prepaid expenses and accounts receivable of $0.8 million and accounts payable of $0.5 million and decrease in accrued expenses of $0.2 million Operating cash flow 17 of $3.7 million in 2008 primarily reflected net income of $3.0 million adjusted for depreciation and amortization of $0.3 million stock compensation expense of $0.6 million offset by an increase in accrued expenses of $0.4 million and an increase in prepaid expenses of $0.3 million We expect operating cash flow to increase as our projected sales increase Investing cash flow principally reflected the purchase of short-term investments and capital expenditures During 2010 the Company invested in short-term investments of $1.0 million During 2009 the Company invested in short-term investments of $1.0 million while in 2008 the Company redeemed at par investments of $3.9 million Capital expenditures were $0.8 million $0.04 million and $0.3 million in 2010 2009 and 2008 respectively equipment We expect The expenditures related principally to new equipment laboratory to increase from the current year as additional including and computer software and capital expenditures equipment is purchased primarily for our laboratory During 2010 the Company repurchased 17219 shares of common stock for 822 shares for In 2009 the Company repurchased treasury The Company has authorized 750000 shares for repurchase treasury since June of 1998 of which 250000 shares of common stock were authorized in March of 2009 for repurchase Since 1998 total of 547899 shares have been repurchased The Company also distributed $2.5 million $3.0 million and $6.1 million of which $2.6 million was special dividend of cash dividends to its shareholders in 2010 2009 and 2008 respectively At December 31 2010 the Companys principal sources of liquidity included approximately $5.7 million of cash cash equivalents and short-term investments Management currently believes that such funds together with future operating profits should be adequate to fund anticipated working capital requirements and capital expenditures in the near term Depending upon the Companys results of operations its future capital needs and available marketing opportunities the Company may use various financing sources to raise additional funds Such sources could include joint ventures issuance of common stock or debt financing although there is no assurance that such financings will be available to the Company on terms it deems acceptable if at all At December 31 2010 the Company had no long-term debt The Company has paid dividends over the past fifty-eight quarters It most recently declared dividend in March 2011 which was paid in March 2011 and amounted to $625442 The Companys current intention is to continue to declare dividends to the extent funds are available and not required for operating purposes or capital and only then upon approval in the future the Company will declare dividends requirements by the Board of Directors There can be no assurance that Contractual obligations as of December 31 2010 were as follows Contractual Obligation Operating leases Purchase commitment Total Purchase Commitment Payments Due by Period Less Than Year Years 35 Years Greater Than Years Amounts in Thousands $738 $54 546 569 $1155 $738 $54 Total $1338 569 $1907 The Company has supply agreement with vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier at prices based upon prior year purchase levels Purchases amounted to $432000 $584000 and $606000 in 2010 2009 and 2008 respectively The Company expects to purchase $569000 in 2011 In exchange for exclusivity the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions including the failure to meet the Companys purchase commitments This agreement does not include fixed termination date however it is cancelable upon mutual agreement by both parties or after six months termination notice by the Company of its intent to use different technology in connection with its drug testing procedures 18 Critical Accounting Policies The Companys significant accounting policies are described in Note to the financial statements included in Item of this Form 10-K Management believes the most critical accounting policies are as follows Revenue Recognition The Company is in the business of performing drug testing and reporting the results thereof The Companys drug testing services include training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples The revenues are recognized when the predominant deliverable drug testing is provided and reported to the customer The Company recognizes Revenue Recognition Standards Codification ASC 605 In accordance with ASC 605 the Company considers testing training and storage with Accounting in accordance revenue elements as one unit of accounting for revenue recognition minimis and do not have stand-alone value to the customer purposes The Company recognizes as the training and storage costs are de revenue as the service is performed and reported to the customer since the predominant deliverable in each arrangement is the testing of the units The Company also provides expert testimony when and if necessary to support the results of the tests which is generally billed separately and recognized as the services are provided Deferred revenue represents payments received in advance of the performance of drug testing procedures generally in relation to the personal drug testing kits PDT-90 Deferred revenue is recognized as revenue when the underlying test results are delivered With respect to portion of these transactions there may be instances where the customer ultimately does not require performance Revenue is then recognized when the Company can reasonably reliably and objectively determine that it is remote that performance will be required for an estimable portion of transactions The Company recorded approximately $24000 $128000 and $90000 of revenue in the results of operations for the years ended December 31 2010 2009 and 2008 respectively related to test kits that were sold for which the Companys obligations to provide service were deemed remote Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates including bad debts and income tax valuation and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period Actual results could differ from those estimates Allowance for Doubtful Accounts The allowance for doubtful accounts is based on managements assessment of the ability to collect amounts owed to it by its customers Management and uses based methodology on calculating the allowance reviews its accounts receivable aging for doubtful accounts using combination of factors including the age of the receivable along with managements judgment to identify accounts that may not be collectible The Company routinely assesses the financial strength of its customers and as consequence believes that its accounts receivable credit risk exposure is limited The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area Bad debt expense has been within managements expectations Income Taxes The Company accounts for income taxes using the liability method which requires the Company to recognize current tax liability or asset for current taxes payable or refundable and deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable Deferred tax expense benefit results from the net change in deferred tax assets and liabilities during the year deferred tax valuation allowance is required if it is more likely than not that all or portion of the recorded deferred tax assets will not be realized 19 The Company had net deferred tax assets in the amount of $240000 at December 31 2010 which the Company believes are fully realizable based upon expected future taxable income which the Companys believes is reasonably attainable in light of previous operating results during the past three years The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions These audits may involve complex resolve The Company has provided issues which may require an extended period of time to for its estimated taxes payable in the accompanying financial statements Interest and penalties related to income tax matters are recognized as general and administrative expense The Company did not have as of December any unrecognized 31 2010 or 2009 The Company does tax benefits and did not have any interest or penalties accrued not expect the unrecognized tax benefits to change significantly over the next twelve months The above listing is not intended to be comprehensive list of all of the Companys accounting policies In many cases the accounting treatment of particular transaction is specifically dictated by accounting principles generally accepted in the United States with no need for managements judgment in their application There are also areas in which managements judgment in selecting any available alternative would not produce materially different result Recent Accounting Pronouncements In April 2010 the FASB issued Accounting Standards Update or ASU No 2010-17 Revenue Recognition ASU 2010-17 allows the milestone method as Milestone Method Topic 605 Milestone Method an acceptable revenue of Revenue Recognition or ASU 2010-17 recognition methodology when an arrangement includes substantive milestones ASU 2010-17 provides definition of substantive milestone and should be applied regardless of whether the arrangement includes single or multiple deliverables or units of ASU 2010-17 is limited to transactions involving milestones relating to research and development accounting deliverables ASU 2010-17 also includes enhanced disclosure requirements about each arrangement individual milestones and related contingent consideration information about substantive milestones and factors considered in the determination ASU 2010-17 is effective on prospective basis for milestones achieved in fiscal years and interim periods within those years beginning on or after June 15 2010 with early adoption permitted The adoption of this standard is not expected to have material impact on the Companys financial position results of operations or cash flows In October 2009 the FASB issued ASU No 2009-14 Software Topic 985 Certain Revenue of the FASB EITF or ASU 2009-14 Arrangements ASU 2009-14 changes That Include Software Elements consensus the accounting model for revenue arrangements that software elements The amendments of this update provide additional guidance include tangible products on how to determine and which software if any relating to the tangible product also would be excluded from the scope of the software revenue recognition guidance The amendments in this update also provide guidance on how vendor should allocate arrangement consideration to deliverables in an arrangement that includes both tangible products and software as well as arrangements that have deliverables both included and excluded from the scope of software revenue recognition guidance This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15 2010 The adoption of this standard is not expected to have material impact on the Companys financial position results of operations or cash flows In October 2009 the FASB issued ASU No 2009-13 Revenue Recognition Topic 605 Multiple-Deliverable ASU 2009-13 will separate multiple-deliverable Revenue Arrangements consensus of the FASB EITF or ASU 2009-13 revenue arrangements This update establishes selling price hierarchy for determining the selling price of deliverable The amendments of this update will replace the term fair value in the revenue allocation guidance with selling price to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of marketplace participant The amendments of this update will eliminate the residual method of allocation and require that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method The amendments in this update will require that vendor determine its best estimated selling price in manner consistent with that used to determine the price to sell the deliverable on standalone basis This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal 20 years beginning on or after June 15 2010 The adoption of this standard is not expected to have material impact on the Companys financial position results of operations or cash flows Effective January Disclosures Topic 820 Improving 2010 the Company adopted ASU No 2010-06 Fair Value Measurements or ASU 20 10-06 about Fair Value Measurements Disclosures and reporting entity should provide additional disclosures about the different classes of assets and liabilities measured at fair value the valuation techniques and inputs used the activity in Level fair value measurements and the transfers between Levels and fair value measurements The adoption of the additional disclosures for Level and Level fair value measurements did not have an impact on our financial position results of operations or cash flows The disclosures regarding Level fair value measurements do not become effective until January 2011 and the adoption is not expected to have material impact on the Companys financial position results of operations or cash flows Item 7A Quantitative and Qualitative Disclosures About Market Risk Not Required 21 Item Financial Statements and Supplementary Data Financial Statements Report of Independent Registered Public Accounting Firm Balance Sheets as of December 31 2010 and 2009 Statements of Income for the Years Ended December 31 2010 2009 and 2008 Statements of Shareholders Equity for the Years Ended December 31 2010 2009 and 2008 Statements of Cash Flows for the Years Ended December 31 2010 2009 and 2008 Notes to Financial Statements Not Covered by Above Report Unaudited Supplementary Quarterly Financial Information Page 23 24 25 26 27 28 38 22 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Psychemedics Corporation Acton Massachusetts We have audited the accompanying balance sheets of Psychemedics Corporation the Company as of December 31 2010 and 2009 and the related statements of income shareholders equity and cash flows for each of the three years in the period ended December 31 2010 These financial statements are the responsibility of the Companys management Our responsibility is to express an opinion on these financial statements based on our audits We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board United States Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement The Company is not required to have nor were we engaged to perform an audit of its internal control over financial reporting Our audit includes consideration of internal control over financial reporting as basis for designing audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting Accordingly we express no such opinion An audit also includes examining on test basis evidence supporting the amounts and disclosures in the financial statements assessing the accounting principles used management as well as evaluating the overall financial statement and significant presentation We believe that our audits estimates made by provide reasonable basis for our opinion In our opinion the financial statements referred to above present fairly in all material respects the financial position of the Company at December 31 2010 and 2009 and the results of its operations and its cash flows for each of the three years in the period ended December 31 2010 in conformity with accounting principles generally accepted in the United States of America Is BDO USA LLP Boston Massachusetts March 25 2011 23 PSYCHEMEDICS CORPORATION BALANCE SHEETS ASSETS Current assets Cash and cash equivalents Short-term investments Accounts receivable net of allowance of $119295 in 2010 and $134282 in 2009 Prepaid expenses and other current assets Deferred tax assets Total current assets Property and equipment net Computer software Office furniture and equipment Laboratory equipment Leasehold improvements Less accumulated depreciation and amortization Deferred tax assets net of current portion Other assets Total assets LIABILITIES AND SHAREHOLDERS EQUITY Current liabilities Accounts payable Accrued expenses Deferred revenue Total current liabilities Commitments and contingencies Note 10 Shareholders equity December 31 2010 2009 3720488 2018452 4840367 1006436 3905821 3016084 700822 239831 663433 253221 10585414 9779541 1290255 2032406 7493190 1205840 1967701 6830750 915015 908615 11730866 10912906 10663996 10381599 1066870 114037 531307 204764 86814 11766321 10602426 699833 180784 1302370 1090898 16605 36360 2018808 1308042 Preferred stock $0.005 par value 872521 shares authorized no shares issued or outstanding Common stock $0.005 par value 50000000 shares authorized 5877358 shares issued in 2010 and 5861872 shares issued in 2009 29387 29309 Additional paid-in capital 27764992 27419359 Treasury stock at cost 665345 shares in 2010 and 664523 shares in 2009 Accumulated deficit Total shareholders equity Total liabilities and shareholders equity 10059398 10053364 7987468 9747513 8100920 9294384 11766321 10602426 The accompanying notes are an integral part of these financial statements 24 PSYCHEMEDICS CORPORATION STATEMENTS OF INCOME Revenues Cost of revenues Gross profit Operating expenses General and administrative Marketing and selling Research and development Total operating expenses Income from operations Interest income Income before taxes Provision for income taxes Net income Basic net income per share Diluted income per share Dividends declared per share Special dividends declared per share Year Ended December 31 2010 2009 2008 $20108862 $16954994 $22948604 8067229 7345016 9598515 12041633 9609978 13350089 4195998 2949739 3596774 2961477 481433 467435 7627170 7025686 4414463 2584292 4520074 3648584 474622 8643280 4706809 23091 4437554 1823834 2613720 0.50 0.50 0.48 0.00 45320 308034 2629612 1102317 1527295 5014843 2046054 2968789 0.29 0.29 0.53 0.00 0.57 0.57 0.66 0.50 Weighted average common shares outstanding basic 5207244 5193329 5219141 Weighted average common shares outstanding diluted 5226454 5204767 5245713 The accompanying notes are an integral part of these financial statements 25 PSYCHEMEDICS CORPORATION STATEMENTS OF SHAREHOLDERS EQUITY Treasury Stock Common Stock Shares 5811982 17931 13155 $O.005 par Value $29060 90 66 BALANCE December 31 2007 Exercise of stock options Shares issued vested Stock compensation expense Acquisition of treasury stock Cash dividends declared $1.16 per share Net income Paid-In Capital Shares Cost Deficit Total Accumulated $26539764 586197 9163624 $3527269 $13877931 199114 66 379931 61107 810333 199204 379931 810333 6055634 6055634 2968789 6614114 2968789 10559888 BALANCE December 31 2008 5843068 29216 27118743 647304 9973957 Shares issued vested 18804 93 Tax withholding related to vested shares from employee stock pians Stock compensation expense Change in excess tax benefit on equity awards Acquisition of treasury stock Cash dividends declared $0.53 per share Net income 93 39381 394498 54408 17219 79407 ___________ 3014101 1527295 BALANCE December 31 2009 5861872 29309 27419359 664523 10053364 8100920 Shares issued vested 15486 78 Tax withholding related to vested shares from employee stock plans Stock compensation expense Acquisition of treasury stock Cash dividends declared $0.48 per share Net income 78 49261 394972 822 6034 2500268 2613720 BALANCE December 31 2010 5877358 $29387 $27764992 665345 $10059398 $7987468 39381 394498 54408 79407 3014101 1527295 9294384 49261 394972 6034 2500268 2613720 9747513 The accompanying notes are an integral part of these financial statements 26 PSYCHEMEDICS CORPORATION STATEMENTS OF CASH FLOWS Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization Deferred income taxes Change in excess tax benefit on equity awards Stock compensation expense Changes in operating assets and liabilities Accounts receivable Prepaid expenses and other current assets Accounts payable Accrued expenses Deferred revenue Net cash provided by operating activities Cash flows from investing activities Maturities of short-term investments Purchases of short-term investments Increase in other long-term assets Purchases of property and equipment Net cash provided by used in investing activities Cash flows from financing activities Dividends paid Proceeds from employee stock plans and stock option exercises net of tax withholding Acquisition of treasury stock Tax benefit associated with exercise of options Net cash used in financing activities Net increase decrease in cash and cash equivalents Cash and cash equivalents beginning of year Cash and cash equivalents end of year Supplemental disclosures of cash flow information Year Ended December 31 2010 2009 2008 2613720 1527295 2968789 284911 218154 394972 889737 37389 519049 211472 19755 336795 130434 54408 394498 382371 442453 464110 178026 117720 331393 72399 379931 156887 606967 156254 317682 88875 3295397 __________ 2399582 3687493 1012016 1006436 29737 817960 14582 35427 1859713 __________ 1056445 __________ 3875000 17811 344534 3512655 2500268 3014101 6055634 49261 6034 39381 79407 189891 810333 9313 2555563 3132889 6666763 1119879 1789752 4840367 _________ 3720488 6630119 _________ 4840367 533385 6096734 6630119 Cash paid for income taxes 2009694 112449 2553537 Non-cash investing and financing activities Issuance of restricted stock awards 78 93 66 The accompanying notes are an integral part of these financial statements 27 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Nature of Business and Basis of Presentation Psychemedics Corporation is the worlds largest provider of hair testing for drugs of abuse utilizing patented hair analysis method involving radioimmunoassay technology and confirmation by mass spectrometry to analyze human hair to detect abused substances The Companys customers include Fortune 500 companies as well as small to mid-size corporations schools and governmental entities located primarily in the United States Summary of Significant Accounting Policies Risks and Uncertainties The Company is subject to number of risks and uncertainties similar to those of other companies such as those associated with the continued expansion of the Companys sales and marketing network development of markets for new products and services offered by the Company the economic health of principal customers of the Company financial and operational risks associated with possible expansion of testing facilities used by the Company government regulation including but not limited to Food and Drug Administration regulations competition and general economic conditions Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates including those related to bad debts and income tax valuation and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period Actual results could differ from those estimates Changes in estimates are recorded in the period in which they become known Cash Equivalents and Short-Term Investments All highly liquid investments with original maturities of 90 days or less are considered cash equivalents These consist of cash savings U.S government Certificates of Deposit CDs at December 31 2010 U.S federal government $0.6 million was in U.S federal government-backed money-market issues the account backed itself reserve money market accounts and government and 2009 While the money market account is not federally insured As of December insured contains 31 2010 accounts and $2.0 million was in CDs with maturities under 90 days all of which are classified as cash and cash equivalents There was also $2.0 million of CDs with maturities within 14 weeks that are classified as short-term investments The Company accounts for investment securities in accordance with Accounting Standards Codification ASC 320 Under ASC 320 investments that the Company has positive intent and ability to hold are classified to maturity market value The Company intends to hold all CDs to maturity All short-term investments 31 2010 The Company does held-to-maturity at December not use derivative as held-to-maturity and are reported at amortized cost which approximates instruments financial fair for were classified as speculative or trading purposes 28 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Summary of Significant Accounting Policies continued During the first quarter of 2008 the Company adopted ASC 820 Fair Value Measurements and Disclosures which defines fair value establishes guidelines regarding fair value measurements Fair value and expands disclosures is defined under ASC 820 as the exchange price that would be for measuring fair value received for an asset or paid to transfer liability an exit price the asset or liability in an orderly transaction between market for in the principal or most advantageous market participants on the measurement date Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs The standard describes fair value hierarchy based on three levels of inputs of which the first two are considered observable and the last unobservable that may be used to measure fair value which are the following Level Level Quoted prices in active markets for identical assets or liabilities Inputs other than Level that are observable either directly or indirectly such as quoted prices for similar assets or liabilities quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities Level Unobservable inputs that are supported by little or no market activity and that are significant to the fair value financial instruments level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement In accordance with ASC 820 the Companys financial assets that are measured at fair value on recurring basis as of December 31 2010 are cash cash equivalents and short term investments The cash cash equivalents and short term investments are measured using level one inputs Inventory The Company expenses consumables such as chemicals and antibodies as purchased The Company has supply agreement with vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier in exchange for variable annual payments based upon prior year purchases Property and Equipment Property and equipment are stated at cost Depreciation and amortization are provided over the estimated useful lives of the assets using the straight-line method Repair and maintenance costs are expensed as incurred The estimated useful lives of the assets are as follows Computer software Office furniture and equipment Laboratory equipment Leasehold improvements to to to years years years Lesser of term of lease or estimated useful life The Company recorded depreciation and amortization related to property and equipment of $282397 $333844 and $331393 in 2010 2009 and 2008 respectively Other Assets Other assets primarily consist of capitalized legal costs relating to patent applications The Company amortizes these costs over 10 years from the date of grant of the applicable patent As of December 31 2010 and 2009 the Company had capitalized legal costs relating to an outstanding patent application of $26938 The amount of amortization related to patent applications is expected to remain and $13064 respectively below $10000 per year for the next years 29 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Summary of Significant Accounting Policies continued Revenue Recognition The Company is in the business of performing drug testing services and reporting the results thereof The Companys drug testing services include training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples The revenues are recognized when the predominant deliverable drug testing is provided and reported to the customer The Company recognizes revenue ASC 605 the Company considers testing training under ASC 605 Revenue Recognition and storage elements In accordance with as one unit of accounting for revenue recognition purposes as the training and storage costs are de minimis and do not have stand-alone value to the customer The Company recognizes revenue as the service is performed and reported to the customer since the predominant deliverable in each arrangement is the testing of the units The Company also provides expert testimony when and if necessary to support the results of the tests which is generally billed separately and recognized as the services are provided Deferred revenue represents payments received in advance of the performance of drug testing procedures generally in relation to the personal drug testing kits PDT-90 Deferred revenue is recognized as revenue when the underlying test results are delivered With respect to portion of these transactions where the customer ultimately does not require performance Revenue is then recognized there may be instances when the Company can reasonably reliably and objectively determine that it is remote that performance will be required for an estimable portion of transactions The Company recorded $24145 $127809 and $89714 of revenue in the results of operations for the years ended December 31 2010 2009 and 2008 related to test kits that were sold for which the At December 31 2010 and 2009 the Company had deferred revenue of approximately $17000 and $36000 respectively reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred and future obligations were not deemed remote Companys Research and Development Expenses The Company charges all research and development expenses to operations as incurred Income Taxes The Company accounts for income taxes using the liability method pursuant to FASB ASC 740 Income Taxes Under this method the Company recognizes deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year the differences are expected to reverse The Company evaluates uncertain tax positions annually and considers whether the amounts recorded for income taxes are adequate to address the Companys tax risk profile The Company analyzes the potential tax liabilities of specific transactions and tax positions based on managements judgment as to the expected outcome Concentration of Credit Risk and Off-Balance Sheet Risk The Company has no significant off-balance-sheet risk such as foreign exchange contracts option contracts or other foreign hedging arrangements Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash and cash equivalents short-term investments and accounts receivable institutions The Company places These include money market accounts its cash and cash equivalents and short-term investments in highly rated holding U.S federal government reserve securities While the underlying securities are federally issued the account itself is not insured Concentration of credit risk with respect to accounts receivable is limited to certain customers sales To reduce risk the Company routinely assesses the financial to whom the Company makes strength of its customers and as substantial consequence believes that its accounts receivable credit risk exposure is limited The Company maintains an 30 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Summary of Significant Accounting Policies continued allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area The Company does not require collateral Comprehensive Income The Companys comprehensive income is the same as its reported net income for the years ended December 31 2010 2009 and 2008 Stock-Based Compensation The Company accounts for equity awards in accordance with ASC 718 Compensation Stock FASB ASC 718 requires employee equity awards to be accounted Compensation method Accordingly share-based award It also requires the measurement of compensation cost at fair value is measured at compensation the grant date based for under the fair value on the fair value of the on the date of grant and recognition of compensation expense over the service period for awards expected to vest The Company uses the straight-line attribution method to recognize share-based compensation over the service period of the award which is generally equal to the vesting period Under ASC 718 the Company recorded $394972 $394498 and $379931 of stock compensation expense in the accompanying statements of income for the years ended December 31 2010 2009 and 2008 respectively See Note for additional information relating to the Companys stock plans Basic and Diluted Net Income per Share Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period Diluted net income per share is computed by dividing net income by the weighted average number of conmion shares and dilutive common stock equivalents outstanding during the period The number of dilutive common stock equivalents outstanding during the period has been determined in accordance with the treasury-stock method Common equivalent shares consist of common stock issuable upon the exercise of outstanding options and the unvested portion of stock unit awards SUAs Basic and diluted weighted average common shares outstanding are as follows Weighted average common shares outstanding 5207244 5193329 5219141 Dilutive common equivalent shares 19210 11438 26572 Weighted average common shares outstanding assuming dilution 5226454 5204767 5245713 2010 2009 2008 For the years ending December 31 2010 2009 and 2008 options to purchase 298390 361382 and 331292 common shares respectively were outstanding but not included in the dilutive common equivalent share calculation as their effect would have been anti-dilutive Financial Instruments Financial instruments include cash equivalents short-term investments and accounts receivable/payable Estimated fair values of these financial instruments approximate carrying values due to their short-term nature Segment Reporting The Company manages its operations as one segment drug testing services As result the financial information disclosed herein materially represents all of the financial information related to the Companys principal operating segment Substantially all of the Companys revenues and assets are in the United States 31 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Summary of Significant Accounting Policies continued Subsequent Events The Company evaluated all events time of filing with the SEC of the Companys annual the Company did not have 2010 During this period and transactions that occurred after December 31 2010 through report on Form 10-k for the year ended December any material recognizable subsequent events the 31 Recent Accounting Pronouncements In April 2010 the FASB issued Accounting Standards Update or ASU No 2010-17 Revenue Milestone Method Recognition ASU 2010-17 allows the milestone method as an acceptable revenue includes substantive milestones ASU 2010-17 provides Topic 605 Milestone Method arrangement of Revenue Recognition or ASU 2010-17 recognition methodology when an definition of substantive milestone and should be applied regardless of whether the arrangement includes single or multiple deliverables or units of ASU 2010-17 is limited to transactions involving milestones relating to research and development accounting deliverables ASU 2010-17 also includes enhanced disclosure requirements about each arrangement individual milestones and related contingent consideration information about substantive milestones and factors considered in the determination ASU 2010-17 is effective on prospective basis for milestones achieved in fiscal years and interim periods within those years beginning on or after June 15 2010 with early adoption permitted The adoption of this standard is not expected to have material impact on the Companys financial position results of operations or cash flows In October 2009 the FASB issued ASU No 2009-14 Software Topic 985 Certain Revenue of the FASB EITF or ASU 2009-14 Arrangements ASU 2009-14 changes That Include Software Elements consensus the accounting model for revenue arrangements that software elements The amendments of this update provide additional guidance include tangible products on how to determine and which software if any relating to the tangible product also would be excluded from the scope of the software revenue recognition guidance The amendments in this update also provide guidance on how vendor should allocate arrangement consideration to deliverables in an arrangement that includes both tangible products and software as well as arrangements that have deliverables both included and excluded from the scope of software revenue recognition guidance This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15 2010 The adoption of this standard is not expected to have material impact on the Companys financial position results of operations or cash flows In October 2009 the FASB issued ASU No 2009-13 Revenue Recognition Topic 605 Multiple-Deliverable ASU 2009-13 will separate multiple-deliverable Revenue Arrangements consensus of the FASB EITF or ASU 2009-13 revenue arrangements This update establishes selling price hierarchy for determining the selling price of deliverable The amendments of this update will replace the term fair value in the revenue allocation guidance with selling price to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of marketplace participant The amendments of this update will eliminate the residual method of allocation and require that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method The amendments in this update will require that vendor determine its best estimated selling price in manner consistent with that used to determine the price to sell the deliverable on standalone basis This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15 2010 The adoption of this standard is not expected to have material impact on the Companys financial position results of operations or cash flows Effective January Disclosures Topic 820 Improving 2010 the Company adopted ASU No 2010-06 Fair Value Measurements or ASU 2010-06 about Fair Value Measurements Disclosures and reporting entity should provide additional disclosures about the different classes of assets and liabilities measured at fair 32 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Summary of Significant Accounting Policies continued value the valuation techniques and inputs used the activity in Level fair value measurements and the transfers between Levels and fair value measurements The adoption of the additional disclosures for Level and Level fair value measurements did not have an impact on our financial position results of operations or cash flows The disclosures regarding Level fair value measurements do not become effective until January 2011 and the adoption is not expected to have material impact on the Companys financial position results of operations or cash flows Accounts Receivable The Company maintains an allowance for uncollectible accounts receivable based on managements assessment of the collectability of its customer accounts by reviewing customer payment patterns and other relevant factors The Company reviews the adequacy of the allowance for uncollectible accounts on quarterly basis and adjusts the balance as determined necessary The following is roliforward of the Companys allowance for doubtful accounts Balance beginning of period Provision for recoveries of doubtful accounts Write-offs Balance end of period Accrued Expenses Accrued expenses consist of the following Accrued payroll and employee benefits Accrued income taxes Accrued hair collection expense Accrued audit and tax consulting Other accrued expenses Income Taxes The income tax provision consists of the following Current Federal State Deferred Federal State 2010 2009 $134282 $246462 10302 25289 89378 22802 $119295 $134282 2010 607248 117727 151817 425578 2009 392558 331831 79480 98481 188548 $1302370 $1090898 2010 2009 2008 $1261670 344010 810538 215753 $1549593 424062 1605680 1026291 1973655 171848 46306 218154 71540 4486 76026 56819 15580 72399 $1823834 $1102317 $2046054 33 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Income Taxes continued reconciliation of the effective rate with the federal statutory rate is as follows Federal statutory rate State income taxes net of federal benefit Permanent differences Stock based compensation Effective tax rate 2010 2009 2008 34.0% 34.0% 34.0% 5.6 0.2 1.7 5.7 0.4 1.8 5.8 1.0 41.1% 41.9% 40.8% The components of the net deferred tax assets included in the accompanying balance sheets are as follows at December 31 Deferred tax assets Deferred revenue Stock-based compensation Allowance for doubtful accounts Excess of book over tax depreciation and amortization Accrued expenses Deferred tax liabilities Prepaid expenses Excess of tax over book depreciation and amortization 2010 2009 6566 146812 47171 133960 334509 17790 76888 94678 14382 136976 53114 204764 66719 475955 17970 17970 $239831 $457985 ASC 740 contains two-step approach to recognizing and measuring uncertain tax positions tax contingencies The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on an audit including resolution of related appeals or litigation processes if any The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement The Company considers many factors when evaluating and estimating the Companys tax positions and tax benefits which may require periodic adjustments and which may not accurately forecast actual outcomes The Company adopted these provisions effective January 2007 without material effect in the financial statements The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions These audits may involve complex issues which may require an extended period of time to resolve The Company has provided for its estimated taxes payable in the accompanying financial statements Interest and penalties related to income tax matters are recognized as general and administrative expense The Company did not have any unrecognized tax benefits and did not have any interest or penalties accrued as of December 31 2010 and 2009 The tax years ended December 31 2007 through December 31 2010 remain subject to examination by all major taxing authorities Preferred Stock The Board of Directors has the authority to designate authorized preferred shares in one or more series and to fix the relative rights and preferences without vote or action by the stockholders The Board of Directors has no present plans to designate or issue any shares of preferred stock 34 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Stock-Based Awards In 2006 the Company adopted new stock-based plan the 2006 Equity Incentive Plan for officers directors employees and consultants The 2006 Equity Incentive Plan provides for grants of options with terms of up to ten years grants of restricted stock or stock unit awards SUAs issuances of stock bonuses or grants other stock-based awards covering up to 250000 shares of common stock As of December 31 2010 84450 shares remained available for future grant under the 2006 Equity Incentive Plan The fair value of the SUAs was determined by the closing price on the date of grant The SUAs vest over period of two to four years and are convertible into an equivalent number of shares of the Companys common stock provided that the employee receiving the award remains continuously employed throughout the vesting period The Company records compensation the vesting term of the SUA Employees are issued shares upon vesting expense related net of tax withholdings to the SUAs on straight-line basis over The Company granted 34000 SUAs to certain members of management and its directors on May 10 2007 The fair value of the SUAs was $18.41 per share which was the closing price of the Companys stock on May 10 2007 The SUAs vest over number of shares of the Companys common stock provided that the awardee remains continuously employed period of two to four years and are convertible into an equivalent throughout the vesting periods Of these 34000 units 1500 were cancelled upon termination of an employee in 2010 In 2008 2009 and 2010 10000 10000 and 7000 units vested and were issued net of tax withholdings respectively In 2008 the Company granted 32600 SUAs on May 15 1000 SUAs on October 14 and 800 SUAs on November The fair values of the SUAs were $16.50 $10.67 and $9.30 per share respectively which was the closing price of the Companys stock on those dates The SUAs vest over period of two to four years and are convertible into an equivalent number of shares of the Companys common stock provided that the awardee remains continuously employed throughout the vesting period Of these 34400 units 1200 were cancelled upon termination of an employee in 2008 and 1850 were cancelled upon termination of three employees in 2010 In 2009 and 2010 9800 and 9350 of these units vested and were issued net of tax withholdings respectively In 2010 the Company granted 94000 SUAs on April which was the closing price of the Companys stock on that date The SUAs vest over years and are convertible into an equivalent number of shares of the awardee remains continuously employed throughout cancelled upon termination of three employees in 2010 The fair value of the SUAs was $7.75 per share period of two to four the Companys common stock provided the vesting period Of these 94000 units 17000 were that The Company also has stock option plans that have expired or been terminated but shares can be issued upon exercise of outstanding options that were granted prior to such expiration or termination No additional grants of options or other stock based for these plans is included in this footnote awards may be made under under Options granted such expired or terminated plans Activity the plans consisted of both non-qualified and incentive stock options and were granted in each case at price that was not less than the fair market value of the common stock at the date of grant These options generally have lives of ten years and vest either immediately or over periods up to four years 35 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Stock-Based Awards continued summary of stock option activity for the Companys stock option plans is as follows Outstanding December 31 2007 Granted Exercised Terminated Outstanding December 31 2008 Granted Exercised Terminated Outstanding December 31 2009 Granted Exercised Terminated Outstanding December 31 2010 Weighted Average Exercise Price per Share $15.63 Weighted Average Remaining Contractual Life Aggregate Intrinsic Va1ue 13.93 20.51 15.22 17.75 14.80 Number of Shares 450034 18139 39785 392110 55189 336921 47550 289371 19.93 $13.96 3.7 years The aggregate intrinsic value on this table was calculated based on the amount if any by which the closing market value of the Companys stock on December 31 2010 $8.20 exceeded the exercise price of the underlying options multiplied by the number of shares subject to each option The total intrinsic value of stock options exercised calculated based on the amount by which the market value of the Companys stock years 2010 2009 at the time of exercise exceeded the exercise price was $0 $0 and $65060 for and 2008 respectively the All SUAs were issued for $0 per share summary of activity for SUAs under the Companys 2006 Equity Incentive Plan is as follows Outstanding Granted Unvested December 31 2007 Converted to common stock Terminated Outstanding Granted Unvested December 31 2008 Converted to common stock Terminated Outstanding Granted Unvested December 31 2009 Converted to common stock Terminated Outstanding Unvested December 31 2010 Available for grant December 31 2010 Weighted Average Remaining Contractual Life Aggregate Intrinsic Value2 282975 156022 179801 3.0 years $776540 Number of Shares 51550 34400 17150 1200 67600 25000 42600 94000 21550 20350 94700 84450 The aggregate stock on December intrinsic value on this table was calculated based on the closing market price of the Companys 31 2010 $8.20 For value on the grants converted to common stock the price used is the price on the conversion date 36 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 Stock-Based Awards continued intrinsic The aggregate Companys stock on December price used is the price on the grant date value on this table was calculated based on the closing market price of the 31 2010 $8.20 For value on the grants converted to common stock the Total stock based compensation expense for 2010 was $394972 Figure includes 6064 shares in 2010 and 6196 shares in 2009 withheld to cover federal income taxes As of December 31 2010 total of 468521 shares of common stock were reserved for issuance under the various stock option and stock-based plans As of December 31 2010 the unamortized fair value of awards relating to SUAs was $638155 to be amortized over weighted average period of approximately years Employee Benefit Plan The Psychemedics Corporation 401k Savings and Retirement Plan the 40 1k Plan is qualified defined contribution plan in accordance with Section 40 1k of the Internal Revenue Code All employees over the age of 21 are eligible to make pre-tax contributions up to specified percentage of their compensation Under the 401k Plan the Company may but is not obligated to match portion of the employees contributions up to defined maximum Matching contributions of $0 $55018 and $127080 were made in the years ended December 31 2010 2009 and 2008 respectively The Company match was suspended on July 2009 and was reinstated as of January 2011 Royalty Agreements The Company has royalty-free license from its founder which was received in fair market value exchange in connection with the formation of the Company for the proprietary rights to certain patented hair analysis technology used by the Company in its drug testing services The Company has two agreements to sublicense its technology which have not generated significant royalties to date 10 Commitments and Contingencies Commitments The Company leases certain of its facilities and equipment under operating lease agreements expiring on various dates through February 2015 Total minimum lease payments including scheduled increases are charged to operations on the straight-line basis over the life of the respective lease Rent expense was approximately $558000 $534000 and $516000 in 2010 2009 and 2008 respectively At December 31 2010 minimum commitments remaining under lease agreements were approximately as follows Years Ending December 31 2011 2012 2013 2014 2015 Thereafter 37 Amount 546000 534000 101000 103000 45000 9000 $1338000 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31 2010 10 Commitments and Contingencies continued Purchase Commitment The Company has supply agreement with vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier in exchange for variable annual payments based upon prior year purchases Purchases amounted to $431897 $584109 and $606484 in 2010 2009 and 2008 respectively The Company expects to purchase approximately $569000 in 2011 In exchange for exclusivity the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions including the failure to meet the Companys purchase commitments This agreement does not include fixed termination date however it is cancelable upon mutual agreement by the parties or six months after termination notice by the Company of its intent to use different technology in connection with its drug testing procedures Contingencies The Company is subject to legal proceedings and claims which arise in the ordinary course of its business The Company believes that although there can be no assurance as to the disposition of these proceedings based upon information available to the Company at this time the expected outcome of these matters would not have material impact on the Companys results of operations or financial condition 11 Selected Quarterly Financial Data Unaudited The following are selected quarterly financial data for the years ended December 31 2010 and 2009 Revenues Gross profit Income from operations Net income Basic net income per share Diluted net income per share Revenues Gross profit Income from operations Net income Basic net income per share Diluted net income per share Quarter Ended 000s Except per Share Amounts March 31 2010 $4464 2554 836 506 0.09 0.09 June 30 2010 $5422 3380 1564 873 0.17 0.17 September 30 2010 December 31 2010 $5106 3026 1336 817 0.16 0.16 $5117 3082 678 418 0.08 0.08 Quarter Ended 000s Except per Share Amounts March 31 2009 $4078 2092 53 39 0.01 0.01 June 30 2009 $3934 2106 298 174 0.03 0.03 September 30 2009 $4670 2890 1273 768 0.15 0.15 December 31 2009 $4271 2522 960 546 0.11 0.10 38 Item Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None Item 9A Controls and Procedures Disclosure Controls and Procedures The Company maintains disclosure controls and procedures as defined in Exchange Act Rules 13a-15e and 15d-15e that are designed SEC are recorded processed and forms and that such to ensure that information required to be disclosed in reports filed with the summarized and reported within the time period specified by the SECs rules information is accumulated and communicated to our management including to our Chief Executive Office and Principal Financial Officer as appropriate to allow for timely decisions regarding required disclosure As required by Rule 13a-15 under the Exchange Act the Companys management with the participation of of the Companys Chief Executive Officer and its Principal Financial Officer has evaluated its disclosure controls and procedures 31 2010 Based as of December on this evaluation the effectiveness our Chief Executive Officer and Principal Financial Officer concluded that procedures were effective for ensuring that information the Companys disclosure controls and required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded processed summarized and reported within the time periods specified in the SECs rules and forms and that its disclosure controls and procedures were also effective to ensure that information required to be disclosed in the reports that it files or submits under the Exchange Act is accumulated and communicated to management including the Companys principal executive and financial officers to allow timely decisions regarding required disclosure Changes in Internal Control Over Financial Reporting There were no changes in the Companys internal control over financial reporting that occurred during the Companys last fiscal quarter that have materially affected or are reasonably likely to materially affect the Companys internal control over financial reporting Managements Report on Internal Control Over Financial Reporting The Companys management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 3a- 15f and 15d- 15f under the Exchange Act Under the supervision and with the participation of management including our Chief Executive Officer and Principal Financial Officer the Company conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission Based on the Companys evaluation under the framework in Internal Control Integrated Framework the Companys management concluded that our internal control over financial reporting was effective as of December 31 2010 This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting Managements report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only managements report in this annual report Inherent Limitations on Effectiveness of Controls The Companys management including its Chief Executive Officer and Principal Financial Officer does not expect that the Companys disclosure controls and procedures or the Companys internal controls will prevent all error and all fraud control system no matter how well conceived and operated can provide only reasonable not absolute assurance that the objectives for the control of control system must reflect the fact that there are resource constraints system are met Further and the benefits of controls must the design be considered relative to their costs Because of the inherent limitations in all control systems no evaluation of controls can provide absolute assurance that all control issues misstatements errors and instances of fraud if any within our company have been or will be prevented or detected Further internal controls may become inadequate as result of changes in conditions or through the deteriorations of the degree of compliance with policies or procedures 39 Item 9B Other Information On March 24 2011 the Compensation Committee of the Company approved the terms of cash performance Corporation the Board of Directors of Psychemedics bonus arrangements with certain executive officers including the Companys Chief Executive Officer its Vice President Laboratory Operations its Vice President and Controller and other employees for 2011 the cash bonus arrangements Bonus payments under the cash bonus arrangements are calculated and paid as follows Each participant has the opportunity to earn as bonus compensation up to an aggregate of an additional 25% of his or her Base Salary in 2011 based on achievement of Company and individual performance targets Each participants target percentages consist of the following Up to 10% of Base Salary based income goals for 2011 on the Companys achievement of pre-determined revenue and net Up to 10% of Base Salary based on the employees achievement of pre-determined individual goals for 2011 Up to 5% of Base Salary based on the Companys achievement of pre-determined customer service goals for 2011 The Compensation Committee reserves the right to withdraw amend add to and terminate the cash bonus arrangements or any portion of them in its discretion at any time including but not limited to changing or eliminating the threshold amounts giving rise to the payment of target percentages determining the calculation of such threshold amounts and adjusting threshold amounts to take into account special non recurring items in determining financial and individual performance At the end of fiscal year 2011 the Chief Executive Officer will review and assess the performance of each of the other participants with respect to achievement of his or her individual targets and provide his recommendations thereon to the Compensation Committee In addition the Compensation Committee will review and assess the Chief Executive Officers performance with respect to achievement of his individual targets The Compensation Committee will then determine the level of payout of the portion of the Chief Executive Officers bonus arrangement with respect to individual and Company targets and each of the other participants based on the Committees review and assessment of the performance of each individual toward his or her individual targets and Company targets 40 PART III Item 10 Directors and Executive Officers of the Registrant Following is list that sets forth as of March 25 2011 the names ages and positions within the Company of all of the Executive Officers of director has been nominated for reelection at the Company and the Directors of the Companys 2011 Annual Meeting the Company Each such to be held on May 24 2011 at 300 P.M at the Seaport Hotel 200 Seaport Boulevard Boston Massachusetts Name Raymond Neil Lerner Kubacki James Dyke Michael Schaffer Ph.D Harry Connick Walter Tomenson Jr Fred Weinert Age 66 43 46 66 85 64 63 Position Chairman Chief Executive Officer President Director Vice President Controller Corporate Vice President Sales Marketing Vice President Laboratory Operations Director Audit Committee member Compensation Committee Member Nominating Committee member Director Audit Committee member Compensation Committee Member Nominating Committee member Director Audit Committee member Compensation Committee Member Nominating Committee member All Directors hold office until the next annual meeting of stockholders or until their successors are elected Officers serve at the discretion of the Board of Directors Mr Kubacki has been the Companys President and Chief Executive Officer since 1991 He has also served as Chairman of the Board of the Company since 1993 He is director of Integrated Environmental Technologies LTD From 2007 until 2010 he served as director of Protection One Inc and from 2004 to 2007 he served as director of Integrated Alarm Services Group Inc He is also trustee of the Center for Excellence in Education based in Washington D.C and holds an Advanced Professional Director Certification from the American College of Directors As result of these and other professional experiences Mr Kubacki possesses collective particular and experience qualifications skills and experience Mr Kubacki has been knowledge in marketing and operations that strengthen the Boards director of the Company since 1991 Mr Lerner joined the Company as Vice President and Controller in October 2010 Prior to joining the Company Controller with Atlas TMS Divisional Controller with Mastec of Operational Accounting as Director he served at Beacon Roofing Supply Inc Corporate Inc and multiple roles with Johnson Johnson including plant controller in the Netherlands Mr Lerner is Certified Public Accountant Mr Dyke joined the Company as Corporate Vice President Sales and Marketing in April 2010 Prior to joining the Company he worked as Strategic Sales Consultant and held variety of Vice President of Sales/Sales Marketing and General Management positions with Pitney Bowes Inc in Canada the United Kingdom and United States Dr Schaffer has served as Vice President of Laboratory Operations since 1999 From 1990 to 1999 he served as Director of Toxicology Technical Manager and Responsible Person laboratory of SmithKline Beecham Clinical Laboratories From 1990 to 1999 for the Leesburg Florida he was also member of the Board of Directors of the American Board of Forensic Toxicologists Dr Schaffer has been an inspector for the Substance Abuse and Mental Health Services Administrations National Laboratory Certification Program since 1989 Mr Connick served as District Attorney for Orleans Parish New Orleans LA from 1974 to 2003 In 2002 Mr Connick received from Drug Czar John Walters the Directors Award for Distinguished Service in recognition of exemplary accomplishment result of these and other professional and distinguished experiences Mr Connick service in the fight against illegal drugs As possesses particular knowledge and experience in law enforcement and the effects of drugs of abuse and their effect on society that strengthen the Boards collective qualifications skills and experience Mr Connick has been director of the Company since 2003 41 Mr Tomenson is Senior Advisor to Integro Ltd Mr Tomenson was Managing Director and Chairman of Client Development of Marsh Inc from 1998 until 2004 From 1993 services division of Marsh Inc Mr Tomenson is to 1998 he was chairman of Director of the Trinity College FINPRO the financial School Fund Inc He also serves on the Executive Council of the Inner-City Scholarship Fund and holds Master Professional Director Certification from the American College of Directors As result of these and other professional experiences Mr Tomenson possesses particular knowledge and experience in marketing and distribution and human resources that strengthen the Boards collective qualifications skills and experience Mr Tomenson has been director of the Company since 1999 Mr Weinert is an entrepreneur whose current activities are concentrated in real estate and new business development He has served on the Business Advisory Council for the University of Dayton for over 20 years From 1973 until 1989 Mr Weinert held various executive positions in the Finance and Operations groups of Waste Management Inc and its subsidiaries including years as the President of Waste Management International Inc As result of these and other professional experiences Mr Weinert possesses particular knowledge and experience in accounting that strengthen the Boards collective the Company since 1991 finance capital structures qualifications skills and experience Mr Weinert distribution and international operations has been director of The information required by Item 405 of Regulation S-K will be set forth in the Proxy Statement of the Company relating to the 2011 Annual Meeting of Stockholders to be held on May 24 2011 and is incorporated herein by reference The Company has code of ethics that applies to all employees and non-employee directors This code satisfies the requirements set forth in Item 406 of Regulation S-K and applies to all relevant persons set forth therein The Company will mail and without charge Such to interested parties copy of the Code of Ethics upon written request request shall be made to our General Counsel 125 Nagog Park Acton Massachusetts 01720 Item 11 Executive Compensation The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2011 Annual Meeting of Stockholders to be held on May 24 2011 and is incorporated herein by reference Item 12 Security Ownership Matters of Certain Beneficial Owners and Management and Related Stockholder The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2011 Annual Meeting of Stockholders to be held on May 24 2011 and is incorporated herein by reference Item 13 Certain Relationships and Related Transactions and Director Independence The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2011 Annual Meeting of Stockholders to be held on May 24 2011 and is incorporated herein by reference Item 14 Principal Accounting Fees and Services The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2011 Annual Meeting of Stockholders to be held on May 24 2011 and is incorporated herein by reference 42 Item 15 Exhibits Financial Statement Schedules PART IV Financial Statements required by Item 15 are included and indexed in Part II Item Financial Statement Schedules included in Part IV of this report Schedule II is omitted because information is included in Notes to Financial Statements All other schedules under the accounting regulations of the SEC are not required under the related instructions and are inapplicable and thus have been omitted See Exhibit Index included elsewhere in this Report 43 Pursuant to the requirements of Section 13 or 15d 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 SIGNATURES Date March 25 2011 PSYCHEMEDICS CORPORATION By Is Raymond Kubacki Raymond Kubacki Chairman President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934 this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS that each person whose signature appears below appoints jointly and severally Raymond Kubacki and Neil Lemer and each one of them his attorneys-in- fact each with the power of substitution for him in any and all capacities to sign any and all amendments to this Annual Report on Form 10-K and to file the same with exhibits thereto and other documents in coimection therewith with the SEC hereby ratifying and confinning all that each attorneys-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof Is Raymond Kubacki Chairman President and Chief Executive Officer March 25 2011 Raymond Kubacki Director Principal Executive Officer Is Neil Lerner Neil Lemer Is Harry Connick Harry Connick Vice President Controller March 25 2011 Principal Financial and Accounting Officer Director March 25 2011 Is Walter Tomenson Jr Director March 25 2011 Walter Tomenson Jr Is Fred Weinert Director March 25 2011 Fred Weinert 44 Exhibit Number EXHIBIT INDEX Description 3.1 Amended and Restated Certificate of Incorporation by reference from the Registrants Quarterly Report filed on August on Form 10-Q for 2002 Incorporated the Quarter ended September 30 2002 3.2 By-Laws of the Company Incorporated by reference from the Registrants Annual Report on Form 10-K for the fiscal year ended December 31 2001 4.1 Specimen Stock Certificate Incorporated by reference from the Registrants Registration Statement on Form 8-A filed on July 31 2002 10.1 License Agreement with Werner Baumgartner Ph.D and Annette Baumgartner dated January 17 1987 Incorporated by reference from the Registrants Registration Statement 10.2.1 10.2.2 on Form S-18 File No 33-10186 LA Lease dated October 1992 with Mitchell Hersch et with respect to premises in Culver City California Incorporated by reference from the Registrants Annual Report on Form 10-KSB for the fiscal year ended December 31 1992 Security Agreement reference from the Registrants Annual Report on Form 10-KSB dated October 1992 with Mitchell Hersch et Incorporated by for the fiscal year ended December 31 1992 10.2.3 First Amendment to Lease dated with Mitchell Hersch et.al California Incorporated by reference from the Registrants Annual Report on Form 10-K for the fiscal year ended December 31 1997 10.2.4 Second Amendment to Lease dated with Mitchell Hersch et.al California Incorporated by reference from the Registrants Annual Report on Form 10-K for December 31 1997 the fiscal year ended 10.2.5 Third Amendment to Lease dated December 31 1997 with Mitchell Hersch et.al California Incorporated by reference from the Registrants Annual Report on Form 10-K for the fiscal year ended December 31 1997 10.2.6 Fourth Amendment to Lease dated May 24 2005 with Mitchell Hersch et.al California Incorporated by reference from the Registrants Annual Report on Form 10-K for the fiscal year ended December 31 2005 10.2.7 First Amendment to Lease dated December 10 1999 with Isabelle Greenspan et.al California 5840 Uplander Way 10.3 10.4 2000 Stock Option Plan on Form 10-Q for the Quarter ended September 30 2002 Amended and restated change Incorporated in Control Severance Agreement with Raymond Kubacki by reference from the Registrants Quarterly Report dated July 10 2008 Incorporated by reference from the Registrants current report on form 8-k filed on July 14 2008 10.5 2006 Equity Incentive Plan Incorporated by reference from the Registrants Current Report 10.6 10.7 on Form 8-K filed on May 17 2006 Form of Stock Unit Award used with employees and consultants under the 2006 Equity Incentive Plan Incorporated by reference from the Registrants Current Report on Form 8-K filed on May 17 2006 Form of Stock Unit Award used with non-employee directors under the 2006 Equity Incentive Plan Incorporated by reference from the Registrants Current Report on Form 8-K filed on May 17 2006 10.8 Change in control severance agreement with Michael Schaffer PhD dated July 10 2008 Incorporated by reference from the registrants current report on Form 8-k filed on July 14 10.9 2008 Amendment dated November 2008 to change in control severance agreement with Ray Kubacki Incorporated by reference from the Registrants Annual Report on Form 10-K for the fiscal year ended December 31 2008 45 Exhibit Number Description 10.10 Amendment dated November 2008 to change in control severance agreement with Michael Schaffer Incorporated by reference from the Registrants Annual Report on Form 10-K for the fiscal year ended December 31 2008 10.11 Employment offer letter dated April Registrants Quarterly Report 10.12 Change in Control Severance 2010 with James Dyke incorporated on Form 10-Q for the quarter ended June 30 2010 Agreement with James by reference from Dyke dated April 72010 Incorporated on Form 10-Q for the quarter ended June 30 by reference from Registrants Quarterly Report 2010 10.13 23.1 31.1 Employment Consent of BDO USA LLP Independent letter dated October offer 25 2010 with Neil Lerner Registered Public Accounting Firm Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Vice President and Controller Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Vice President and Controller Pursuant to 18 U.S.C Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Management compensation plan or arrangement 46 MANAGEMENT AND CORPORATE INFORMATION BOARD OF DIRECTORS Kubacki Raymond Chairman President and C.E.O Harry Connick Private Investor Walter Tomenson Jr Senior Advisor Integro Ltd Fred Weinert Private Investor CORPORATE OFFICERS Raymond Chairman President and C.E.O Kubacki Michael Schaffer Ph.D Vice President-Laboratory Operations Neil Lerner Vice President Finance James Dyke AUDITORS BDO USA LLP Boston Massachusetts CORPORATE OFFICES Corporate Headquarters 125 Nagog Park Acton Massachusetts 01720 Laboratory Facilities 5832 Uplander Way Culver City California 90230 FORM 10K copy of the Companys Form 10-K as filed with the Secunties and Exchange Commission may be obtained by any stockholder at our website www.psychernedics corn or by writing to Corporate Vice President Sales Marketing Investor Relations TRANSFER AGENT do Computershare Trust Company N.A P.O Box 43078 Providence RI 02940-3078 Investor Relations Telephone Number 1-800-426-5523 Internet Address http//www.computershare.com COUNSEL Lynch Brewer Hoffman Fink LLP Boston Massachusetts Psychemedics Corporation 125 Nagog Park Acton MA 01720 ANNUAL MEETING The 2011 Annual Meeting of Stockholders held on May 24 2011 at 300 p.m at will be The Seaport Hotel 200 Seaport Boulevard Boston Massachusetts NASDAQ Stock Exchange Symbol PMD PSYCHEMEDICS CORPORATION 125 NAGOG PARK ACTON MA 01720