ITEM 1. Financial Statements

See accompanying notes to consolidated financial statements.

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See accompanying notes to consolidated financial statements.

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See accompanying notes to consolidated financial statements.

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NATIONAL RESEARCH CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

National Research Corporation (the “Company”) is a provider of ongoing survey-based performance measurement, analysis, tracking, improvement services and governance education to the healthcare industry in the United States and Canada. The Company develops tools that enable healthcare organizations to obtain performance measurement information necessary to comply with industry and regulatory standards, and to improve their business practices.

The consolidated balance sheet of the Company at December 31, 2006, was derived from the Company’s audited consolidated balance sheet as of that date. All other financial statements contained herein are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) the Company considers necessary for a fair presentation of financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States of America.

Information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These consolidated financial statements should be read in conjunction with the financial statements and notes thereto that are included in the Company’s Form 10-K for the fiscal year ended December 31, 2006, filed with the Securities and Exchange Commission in April 2007.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The consolidated financial statements include the accounts of National Research Corporation and its wholly-owned subsidiary, National Research Corporation Canada. All significant intercompany transactions and balances have been eliminated.

The functional currency of the Company’s foreign subsidiary is the subsidiary’s local currency. The Company translates the assets and liabilities of foreign subsidiaries at the period end rate of exchange, and income statement items at the average rate prevailing during the period. The Company records the resulting translation adjustment in accumulated other comprehensive income, a component of shareholders’ equity. Gains and losses related to transactions denominated in a currency other than the subsidiary’s local currency and short-term intercompany accounts are included in other income (expense) in the income statement.

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The components of accumulated other comprehensive incomes were as follows (in thousands):

On May 30, 2006, the Company acquired substantially all of the assets of TGI Group, LLC, operating as The Governance Institute (“TGI”). TGI provides board members, executive management and physician leaders of hospitals and health systems with knowledge and solutions to successfully confront a wide array of strategic issues. TGI operations have been included in the Company’s consolidated financial statements since the date of acquisition. The purchase price for TGI was $19.8 million in cash, plus the assumption of certain liabilities. The Company recorded direct acquisition costs of $305,000.

The following unaudited pro forma information for the Company has been prepared as if the acquisition of TGI had occurred on January 1, 2006. The information is based on the historical results of the separate companies and may not necessarily be indicative of the results that could have been achieved or of results that may occur in the future. The pro forma information includes adjustments for depreciation, amortization, interest, and income taxes.

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On March 17, 2003, the Company acquired 100% of the outstanding common shares of Smaller World Communications Inc. (“Smaller World”) based in Toronto, Canada. The purchase price included two additional scheduled payments in 2006 and 2008. The first payment of $536,200 was made in March 2006. The second aggregate payment has a minimum of $0 and a maximum of $706,000 based on meeting certain revenue goals. As of September 30, 2007, the second aggregate payment of $706,000 was included in other long-term liabilities.

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109. The Company had no liability for unrecognized tax benefits, or related interest and penalties, as of the adoption date. For the nine-month period ended September 30, 2007, there were no changes to the total amount of unrecognized tax benefits or to the amount of accrued interest and penalties. The Company does not have any unrecognized tax benefits that would impact the effective tax rate if recognized. The Company does not expect any changes in the amount of unrecognized tax benefits within the 12 months following adoption.

The Company’s policy is to recognize potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company files a federal income tax return as well as returns in various state and foreign jurisdictions. With few exceptions, the Company is no longer subject to tax examinations for years prior to 2006.

On May 26, 2006, the Company entered into a credit facility pursuant to which it borrowed $9.0 million under a term note and $3.5 million under a revolving credit note in order to partially finance the acquisition of TGI. The term note is payable pursuant to the credit facility in 83 equal installments of $106,000, with the balance of principal and interest payable on May 31, 2013. Borrowings under the term note bear interest at a rate of 7.21% per year. The revolving credit note provided a revolving credit facility that was to have matured on July 31, 2007, but has been renewed to July 31, 2008. The maximum aggregate amount available under the revolving credit facility is $3.5 million, subject to a borrowing base equal to 75% of the Company’s eligible accounts receivable. The Company may borrow, repay and reborrow amounts under the revolving credit facility from time to time until its maturity on July 31, 2008. Borrowings under the revolving credit facility bear interest at a variable rate equal to (a) prime (as defined in the credit facility) less 0.50% or (b) one-, two-, three-, six- or twelve-month LIBOR. As of September 30, 2007, the Company had no borrowings outstanding under the revolving credit note. Monthly installment payments were made on the term note in accordance with the credit facility. Also, additional pay downs on the loan were made with no prepayment penalties. The credit facility is secured by certain of the Company’s assets, including the Company’s land, building, accounts receivable and intangibles.

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Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”) under the modified version of the prospective transition method. Under the modified prospective transition method, compensation cost is recognized on or after the required effective date for the portion of the outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS No. 123R for either recognition or pro forma disclosures. All of the Company’s existing stock option awards and non-vested stock awards have been determined to be equity awards in accordance with SFAS No. 123R. There was no cumulative effect of initially adopting SFAS No. 123R.

The Company currently intends that shares of common stock issued upon the exercise of options will be newly-issued shares. Amounts recognized in the financial statements with respect to these plans under SFAS No. 123R are as follows:

The share-based compensation plans are described below. As shares are issued in connection with any of these plans, they will be issued using newly registered shares.

The National Research Corporation 2001 Equity Incentive Plan (“2001 Equity Incentive Plan”) is a nonqualified plan that provides for the granting of stock options, stock appreciation rights, restricted stock, performance shares and other share-based awards and benefits up to an aggregate of 600,000 shares of the Company’s common stock. Options granted may be either nonqualified or incentive stock options. Options vest over one to five years following the date of grant and option terms are generally five to ten years following the date of grant. At September 30, 2007, there were 20,812 shares available for issuance pursuant to future grants under the 2001 Equity Incentive Plan. The Company has accounted for grants of 579,188 options under the 2001 Equity Incentive Plan using the date of grant as the measurement date for financial accounting purposes.

The National Research Corporation 2004 Director Plan (the “2004 Director Plan”) is a nonqualified plan that provides for the granting of options with respect to 250,000 shares of the Company’s common stock. The 2004 Director Plan provides for grants of nonqualified options to each director of the Company who is not employed by the Company. On the date of each Annual Meeting of Shareholders of the Company, options to purchase 12,000 shares of the Company’s common stock are granted to directors that are re-elected or retained as a director at such meeting. Options vest one year following the date of grant and option terms are generally ten years following the date of grant, or three years in the case of termination of the outside director’s service. At September 30, 2007, there were 73,000 shares available for issuance pursuant to future grants under the 2004 Director Plan. The Company has accounted for grants of 177,000 options under the 2004 Director Plan using the date of grant as the measurement date for financial accounting purposes.

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The National Research Corporation 2006 Equity Incentive Plan (the “2006 Equity Incentive Plan”) is a nonqualified plan that provides for the granting of stock options, stock appreciation rights, restricted stock, performance shares and other share-based awards and benefits up to an aggregate of 600,000 shares of the Company’s common stock. Options granted may be either incentive stock options or nonqualified stock options. Options vest over one to five years following the date of grant and option terms are generally five to ten years following the date of grant. At September 30, 2007, there were 527,311 shares available for issuance pursuant to future grants under the 2006 Equity Incentive Plan. The Company has accounted for grants of 72,689 options under the 2006 Equity Incentive Plan using the date of grant as the measurement date for financial accounting purposes.

The Company did not grant stock options during either of the three-month periods ended September 30, 2007 and 2006, and granted 131,382 and 128,862 during the nine-month periods ending September 30, 2007 and 2006, respectively. Options to purchase shares of common stock were granted with exercise prices equal to the fair market value of the common stock on the date of grant. The fair value of stock options granted was estimated using a Black-Scholes valuation model with the following assumptions:

The risk-free interest rate assumptions were based on the U.S. Treasury yield curve in effect at the time of the grant. The expected volatility was based on historical monthly price changes of the Company’s stock based on the expected life of the option at the date of grant. The expected life of options is the average number of years the Company estimates that options will be outstanding. The Company considers groups of associates (employees) that have similar historical exercise behavior separately for valuation purposes.

The following table summarizes stock option activity under the Company’s 2001 and 2006 Equity Incentive Plans, and the 1997 (under which no additional options will be granted) and the 2004 Director Plans for the nine months ended September 30, 2007.

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The weighted-average grant date fair value of stock options granted during the nine months ended September 30, 2007 and 2006, was $6.39 and $6.02, respectively. The total intrinsic value of stock options exercised during the nine months ended September 30, 2007 and 2006, was $107,000 and $883,000, respectively. As of September 30, 2007, the total unrecognized compensation cost related to non-vested stock option awards was approximately $1.3 million, which was expected to be recognized over a weighted average period of 2.69 years.

Cash received from stock options exercised for the nine-month periods ended September 30, 2007 and 2006, was $184,000 and $713,000, respectively. The actual tax benefit realized for the tax deduction from stock options exercised was $41,000 and $343,000 for the nine months ended September 30, 2007 and 2006, respectively.

During the nine months ended September 30, 2007, the Company granted 32,115 non-vested shares of common stock under the 2006 Equity Incentive Plan. As of September 30, 2007, the Company had 72,757 non-vested shares of common stock outstanding under the plan. These shares vest over one to five years following the date of grant and holders thereof are entitled to receive dividends from the date of grant, whether or not vested. The fair value of the awards is calculated as the fair market value of the shares on the date of grant.

The following table summarizes information regarding non-vested stock granted to associates under the Company’s 2001 and 2006 Equity Incentive Plans for the nine months ended September 30, 2007.

The weighted-average grant date fair value of non-vested stock granted during the nine months ended September 30, 2007 and 2006, was $23.54 and $19.61, respectively. As of September 30, 2007, the total unrecognized compensation cost related to non-vested stock option awards was approximately $797,000 and is expected to be recognized over a weighted average period of 2.26 years.

The change in the carrying amount of goodwill and customer relationships included the impact of foreign currency translation and the contingent purchase price incurred for the Smaller World acquisition.

Net income per share has been calculated and presented for “basic” and “diluted” data. “Basic” net income per share was computed by dividing net income by the weighted average number of common shares outstanding, whereas “diluted” net income per share was computed by dividing net income by the weighted average number of common shares outstanding adjusted for the dilutive effects of options and restricted stock. As of September 30, 2007 and 2006, the Company excluded 48,000 and -0- options, respectively, from the diluted net income per share computation because their exercise price exceeded the fair market value of the common stock on such date.

The following table shows the amounts used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements . SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective as of the beginning of a company’s first fiscal year that begins after November 15, 2007. Management believes that SFAS No. 157 will not have a material effect on the consolidated financial statements.

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In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115 . This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The provisions of SFAS No. 159 are effective as of the beginning of a company’s first fiscal year that begins after November 15, 2007. Management believes that SFAS No. 159 will not have a material effect on the consolidated financial statements.

In June 2007, the FASB ratified the consensus reached by the Emerging Issues Task Force (EITF) in EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (EITF 07-3) , which requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and amortized over the period that the goods are delivered or the related services are performed, subject to an assessment of recoverability. EITF 07-3 are effective as of the beginning of a company’s first fiscal year that begins after December 15, 2007. Management believes that EITF 07-3 will not have a material effect on the consolidated financial statements.

A member of the Company’s Board of Directors also serves as a director of the Picker Institute. The Company advanced $300,000 in each of 2004 and 2003 to the Picker Institute to fund designated research projects. During the nine-month period ended September 30, 2007, the Picker Institute used $208,000 of these deposited amounts for research, and as a result the Company recognized expense equal to that amount. In addition, the Company is a party to a support services agreement with the Picker Institute under which the Company conducts the annual NRC+Picker Symposium. Under the support services agreement, the Picker Institute receives a portion of the gross receipts of each Symposium. For the nine months ended September 30, 2007 and 2006, the Picker Institute received $15,000 and $12,000, respectively.