OPERATIONS

Management's Discussion and Analysis of Financial Condition and Results of Operations (or, "MD&A") should be read in conjunction with Note 2 ("Segment Reporting") of Notes to Consolidated Financial Statements.

Critical Accounting Estimates

The preparation of financial statements and related disclosures in accordance with GAAP requires us to make judgments, assumptions, and estimates that affect the amounts reported in our Consolidated Financial Statements and accompanying notes. Actual results may ultimately differ from our original estimates, as future events and circumstances sometimes do not develop as expected. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of our Consolidated Financial Statements. In addition, we believe that the following are our most critical accounting estimates, which are not ranked in any particular order, that may affect our reported financial condition and/or results of operations.

In estimating the realizable value of art held in inventory and art pledged as collateral for SFS loans, we consider the following complex array of factors: (i) whether the property is expected to be offered at auction or sold privately, and the timing of any such sale; (ii) the supply and demand for the property, taking into account current art market conditions, as well as changing trends as to which collecting categories and artists are most sought after; (iii) recent sale prices achieved for comparable items within a particular collecting category and/or by a particular artist; (iv) the state of the global economy and financial markets; and (v) our intent and ability to hold the property in order to maximize its realizable value.

Due to the inherent subjectivity involved in estimating the realizable value of art held in inventory and art pledged as collateral for SFS loans, our estimates of realizable value may prove, with the benefit of hindsight, to be different than the amount ultimately realized upon sale.

See Note 1 of Notes to Consolidated Financial Statements for information related to inventory. See Note 4 of Notes to Consolidated Financial Statements for information related to SFS loans.

(2) Accounts Receivable— Accounts receivable principally includes amounts due from buyers as a result of auction and private sale transactions. The recorded amount reflects the purchase price of the property (including any commissions, as well as any applicable taxes and royalties). Under the standard terms and conditions of our auction and private sales, we are not obligated to pay the consignor for property that has not been paid for by the buyer. If a buyer defaults on payment, the sale is cancelled and the property is returned to the consignor. We continually evaluate the collectability of amounts due from individual buyers and, if we determine that it is probable that a buyer will default, a cancelled sale is recorded in the period in which that determination is made and the associated accounts receivable balance, including our auction commission, is reversed. Historically, cancelled sales have not been material in relation to the aggregate hammer price of property sold at auction.

In certain instances and subject to management approval under our internal corporate governance policy, we may pay the consignor the net sale proceeds before payment is collected from the buyer while we retain possession of the property. In these situations, if the buyer does not make payment, Sotheby's takes title to the property, but could be exposed to losses if the value of the property subsequently declines. In certain other situations and subject to management approval under our internal corporate governance policy, we allow the buyer to take possession of purchased property before making payment. In these situations, we are liable to the seller for the net sale proceeds whether or not the buyer makes payment and would incur a loss in the event of buyer default. We maintain an allowance for doubtful accounts that principally includes estimated losses associated with situations when we have paid the net sale proceeds to the seller, and it is probable that payment will not be collected from the buyer. The allowance for doubtful accounts also includes an estimate of probable losses inherent in the remainder of the accounts receivable balance.

Our judgments regarding the collectability of accounts receivable and the amount of any required allowance for doubtful accounts are based on the facts available to management, including an assessment of the buyer's payment history, discussions with the buyer, and the value of any property held as security against the buyer's payment obligation. Our judgments with respect to the collectability of amounts due from buyers for auction and private sale purchases are reevaluated and adjusted as additional facts become known, but may ultimately prove, with the benefit of hindsight, to be incorrect. See Note 4 of Notes to Consolidated Financial Statements for information related to accounts receivable.

On December 22, 2017, the U.S. Tax Cuts and Jobs Act was enacted into law. Among other things, the Act reduces the U.S. corporate income tax rate from 35% to 21%, and makes changes to certain other business-related exclusions, deductions and credits. The SEC soon thereafter issued Staff Accounting Bulletin No. 118 ("SAB 118"), which allows companies to record the income tax effects of the Act as a provisional amount based upon reasonable estimates. As of December 31, 2017, we have not completed our accounting for the income tax effects of the Act. However, in accordance with SAB 118, we recorded a provisional net income tax expense of approximately $1.2 million in the fourth quarter of 2017 based on reasonable estimates for those tax effects. This provisional net income tax expense is subject to adjustment as we complete our analysis of the Act, collect and prepare the necessary data, and interpret any additional guidance issued by the U.S. Treasury Department, the IRS, the Financial Accounting Standards Board (the "FASB"), and other standard-setting and regulatory bodies. Adjustments may impact our provision for income taxes and effective tax rate in the period in which the adjustments are determined. Our accounting for the income tax effects of the Act will be completed during the measurement period, which should not extend beyond one year from the enactment date. The impact of the provisional accounting effects of the Act are described in greater detail in Note 16 of Notes to Consolidated Financial Statements.

As of December 31, 2017 , we had net deferred tax assets of $20.5 million, which include the provisional effects of the Act recorded in the fourth quarter of 2017. This amount includes gross deferred tax assets of $47.5 million, primarily resulting from deductible temporary differences which will reduce taxable income in future periods. To a lesser extent, we also have deferred tax assets relating to net operating loss carryforwards, which are partially offset by a valuation allowance of $3.2 million to reduce the deferred tax assets to the amount that we have determined is more likely than not to be realized. In assessing the need for a valuation allowance, we consider, among other things, projections of future taxable income and ongoing prudent and feasible tax planning strategies. If we determine that sufficient negative evidence exists (for example, if we experience cumulative three-year losses in a certain jurisdiction), then we will consider recording a valuation allowance against a portion or all of the deferred tax assets in that jurisdiction. If, after recording a valuation allowance, our projections of future taxable income and other positive evidence considered in evaluating the need for a valuation allowance prove, with the benefit of hindsight, to be inaccurate, it could prove more difficult to support the realization of these deferred tax assets. As a result, an additional valuation allowance could be required, which would have an adverse impact on our effective income tax rate and results. Conversely, if, after recording a valuation allowance, we determine that sufficient positive evidence exists in the jurisdiction in which a valuation allowance is recorded (for example, if we are no longer in a three-year cumulative loss position in the jurisdiction, and we expect to have future taxable income in that jurisdiction based upon our forecasts and the expected timing of deferred tax asset reversals), we may reverse a portion or all of the valuation allowance in that jurisdiction. In such situations, the adjustment made to the deferred tax asset would have a favorable impact on our effective income tax rate and results in the period such determination was made.

Due to the global complexity of tax regulation, we record liabilities to address potential exposures involving uncertain tax positions that we have taken, or expect to take, on income tax returns that could be challenged by taxing authorities. These potential exposures result from the varying applications and interpretations of income tax related statutes, rules, and regulations. As of December 31, 2017, our liability for unrecognized tax benefits, excluding interest and penalties, was $13.2 million. We believe that our recorded tax liabilities are adequate to cover all open years based on an assessment of the relevant facts and circumstances. This assessment involves assumptions and significant judgments about future events and potential actions by taxing authorities, as well as an evaluation of past experiences. The cost of the ultimate resolution of these matters may be greater or less than the liability that we have recorded. To the extent that our opinion as to the outcome of these matters changes, income tax expense will be adjusted accordingly in the period in which such a determination is made.

See "Income Tax Expense" below, as well as Note 16 and Note 17 of Notes to Consolidated Financial Statements.

In 2015, we granted a share-based payment award to Thomas S. Smith, Jr., our President and CEO, with a single vesting opportunity after a five-year service period contingent upon the achievement of pre-determined levels of price appreciation in our stock. The compensation expense recognized for this share-based payment is based on our estimate of the grant date fair value of the award. In developing this estimate, we considered then-current market conditions, historical data, and other relevant data. See Note 21 of Notes to Consolidated Financial Statements for additional information related to our share-based payment programs.

Seasonality

The global art auction market has two principal selling seasons, which generally occur in the second and fourth quarters of the year. In the aggregate, second and fourth quarter Net Auction Sales ¹ represented 80% and 82% of our total annual Net Auction Sales in 2017 and 2016 , respectively, with auction commission revenues comprising approximately 66% and 75% of our total revenues, respectively. Accordingly, our financial results are seasonal, with peak revenues and operating income generally occurring in the second and fourth quarters. Consequently, first and third quarter results have historically reflected lower revenues when compared to the second and fourth quarters and, typically, a net loss due to the fixed nature of many of our operating expenses.

In quarterly reporting periods, the comparison of our results between reporting periods can be significantly influenced by a number of factors, such as changes in the timing of when certain auctions occur, the level of non-recurring single-owner auction sale events, the level and timing of individually negotiated private sale transactions, and changes in certain accounting estimates that rely upon forecasted results such as variable incentive and share-based compensation expense and our estimated annual effective income tax rate. Accordingly, when evaluating our performance, we believe that investors should also consider results for rolling six and twelve month periods, which better reflect the business cycle of the global art auction market. See Note 28 of Notes to Consolidated Financial Statements for our quarterly results for the years ended December 31, 2017 and 2016 .

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Business and Industry Trends

Following a period of expansion that began in late-2009 and lasted until the fourth quarter of 2015, the global art market entered a period of lower sales, particularly in the Impressionist, Modern and Contemporary Art collecting categories, which resulted in a 27% decrease in Consolidated Sales ¹ in 2016, when compared to 2015. However, even during this period of lower sales, collectors continued to purchase top quality works of art for strong prices and our auction sell-through rates remained encouraging. In 2017, the art market strengthened, and we achieved a 12% increase in Consolidated Sales when compared to 2016, which led to an 10% increase in agency commissions and fees.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2017 AND 2016

Consolidated Results of Operations

Overview —In 2017, our net income was $118.8 million , or $2.20 per diluted share, representing a $44.7 million ( 60% ) improvement when compared to the prior year when we reported net income of $74.1 million , or $1.27 per diluted share. After excluding certain unusual items, including $1.2 million of net income tax expense associated with the U.S. Tax Cuts and Jobs Act, Adjusted Net Income* improved $22.1 million ( 22% ), from $99.6 million to $121.7 million , and Adjusted Diluted EPS* improved from $1.71 to $2.25 . The improvement in Adjusted Net Income* is principally due to a stronger art market, which resulted in a 12% increase in Consolidated Sales ¹ and a 10% increase in agency commissions and fees when compared to the prior year, as well as a significant improvement in our inventory activities. These factors are partially offset by a higher level of indirect expenses largely due to investments in growth initiatives and a higher level of incentive compensation reflecting improved performance against plan targets. (See "Income Tax Expense" below for a more detailed discussion of the impact of the U.S. Tax Cuts and Jobs Act on our Consolidated Financial Statements.)

Outlook —As a result of the strengthening of the art market in 2017 and sales results to date in 2018, we are encouraged by the direction of the art market and our prospects for the upcoming year. In 2018, we expect that the stronger art market will result in a higher level of agency commissions and fees. We also expect to continue investing in technology and marketing programs to drive our future growth and reduce our cost structure over the long-term.

The comparison of our results for the first quarter of 2018 to the prior year will be materially influenced by a change in the timing of the spring Modern and Contemporary Art sales in Hong Kong, which will be held in the first quarter of 2018 after occurring in the second quarter of 2017. Accordingly, first quarter revenue in 2018 will likely be higher than the prior year.

Taking into account the effects of the U.S. Tax Cuts and Jobs Act and our projected jurisdictional mix of earnings, we estimate that our effective income tax rate for 2018, excluding discrete items, will be in the range of 25% to 27%. However, we are still evaluating the effects of certain provisions of the Act, which could have an impact on our effective income tax rate in the future. Accordingly, this estimate is subject to change.

(See statement on Forward Looking Statements.)

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¹ See the definition of Consolidated Sales in the Consolidated Financial Data Table below.

Consolidated Financial Data Table —The table below presents a summary of our consolidated results of operations and related statistical metrics for the years ended December 31, 2017 and 2016 , as well as a comparison between the two years (in thousands of dollars, except per share data):

Agency Segment

Agency Segment Overview —In 2017, Agency segment income before taxes increased $36.6 million ( 57% ), from $64.6 million to $101.2 million . After excluding certain items in the current and prior year, Adjusted Agency Segment Income Before Taxes* improved $9 million ( 10% ), from $94.9 million to $104 million . The improvement in Adjusted Agency Segment Income Before Taxes* is principally due to a stronger art market, which resulted in a 12% increase in Consolidated Sales and associated increases in auction commissions ( 8% ) and private sale commissions ( 26% ), as well as a significant improvement in our inventory activities and better results from our portfolio of auction guarantees. These factors are partially offset by a higher level of indirect expenses largely due to investments in growth initiatives and a higher level of incentive compensation reflecting improved performance against plan targets.

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Agency Segment Financial Data Table —The table below presents a summary of Agency segment income before taxes and related statistical metrics for the years ended December 31, 2017 and 2016 , as well as a comparison between the two years (in thousands of dollars):