Electromed, Inc. 10-K

Item 8. Financial Statements and Supplementary Data. Index to Financial Statements Report of Independent Registered Public Accounting Firm F-2 Balance Sheets F-3 Statements of Operations F-4 Statements of Shareholders’ Equity F-5 Statements of Cash Flows F-6 Notes to Financial Statements F-7 F- 1 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Electromed, Inc. Opinion on the Financial Statements We have audited the accompanying balance sheets of Electromed, Inc. (the Company) as of June 30, 2020 and 2019, the related statements of operations, shareholders’ equity and cash flows for the years then ended, and the related notes to the financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2020 and 2019, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 1 to the financial statements, the Company has changed the manner in which it accounts for leases in fiscal year 2020, due to the adoption of Accounting Standards Codification Topic 842, Leases . Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ RSM US LLP We have served as the Company’s auditor since 2010. Duluth, Minnesota August 25, 2020 F- 2 Electromed, Inc. Balance Sheets June 30, 2020 and 2019 June 30, 2020 2019 Assets Current Assets Cash $ 10,479,150 $ 7,807,928 Accounts receivable (net of allowances for doubtful accounts of $45,000) 12,940,677 12,760,042 Contract assets 902,619 995,847 Inventories 3,084,620 2,622,000 Prepaid expenses and other current assets 353,318 353,214 Income tax receivable 262,155 — Total current assets 28,022,539 24,539,031 Property and equipment, net 3,788,469 3,604,744 Finite-life intangible assets, net 598,389 581,413 Other assets 80,166 45,044 Deferred income taxes 755,000 629,000 Total assets $ 33,244,563 $ 29,399,232 Liabilities and Shareholders’ Equity Current Liabilities Current maturities of other long-term liabilities $ 72,328 $ 30,320 Accounts payable 555,510 586,575 Accrued compensation 1,404,497 1,404,662 Income tax payable — 288,511 Warranty reserve 740,000 810,000 Other accrued liabilities 214,045 530,453 Total current liabilities 2,986,380 3,650,521 Other long-term liabilities 8,868 14,737 Total liabilities 2,995,248 3,665,258 Commitments and Contingencies Shareholders’ Equity Common stock, $0.01 par value; authorized: 13,000,000 shares; 8,567,834 and 8,408,351 issued and outstanding at June 30, 2020 and June 30, 2019, respectively 85,678 84,084 Additional paid-in capital 16,480,134 16,127,826 Retained earnings 13,683,503 9,522,064 Total shareholders’ equity 30,249,315 25,733,974 Total liabilities and shareholders’ equity $ 33,244,563 $ 29,399,232 See Notes to Financial Statements. F- 3 Electromed, Inc. Statements of Operations Years Ended June 30, 2020 and 2019 Years Ended June 30, 2020 2019 Net revenues $ 32,470,688 $ 31,299,750 Cost of revenues 7,270,642 7,451,806 Gross profit 25,200,046 23,847,944 Operating expenses (income) Selling, general and administrative 19,944,851 20,435,010 Research and development 1,049,612 583,311 Government stimulus income (913,108 ) — Total operating expenses 20,081,355 21,018,321 Operating income 5,118,691 2,829,623 Interest income, net 120,748 90,707 Net income before income taxes 5,239,438 2,920,330 Income tax expense 1,078,000 940,000 Net income $ 4,161,439 $ 1,980,330 Income per share: Basic $ 0.50 $ 0.24 Diluted $ 0.47 $ 0.23 Weighted-average common shares outstanding: Basic 8,403,220 8,306,338 Diluted 8,826,418 8,631,469 See Notes to Financial Statements. F- 4 Electromed, Inc. Statements of Shareholders’ Equity Years Ended June 30, 2020 and 2019 Common Stock Additional Paid- in Capital Retained Earnings Total Shareholders’ Equity Shares Amount Balance at June 30, 2018 8,288,659 $ 82,887 $ 14,953,103 $ 7,541,734 $ 22,577,724 Net income — — — 1,980,330 1,980,330 Issuance of restricted stock 40,000 400 (400 ) — — Issuance of common stock upon exercise of options 79,692 797 251,052 — 251,849 Share-based compensation expense — — 924,071 — 924,071 Balance at June 30, 2019 8,408,351 84,084 16,127,826 9,522,064 25,733,974 Net income — — — 4,161,439 4,161,439 Issuance of restricted stock 50,000 500 (500 ) — — Issuance of common stock upon exercise of options 109,483 1,094 79,275 — 80,369 Taxes paid on stock option exercised on a net basis — — (628,399 ) — (628,399 ) Share-based compensation expense — — 901,932 — 901,932 Balance at June 30, 2020 8,567,834 $ 85,678 $ 16,480,134 $ 13,683,503 $ 30,249,315 See Notes to Financial Statements. F- 5 Electromed, Inc. Statements of Cash Flows Years Ended June 30, 2020 and 2019 Years Ended June 30, 2020 2019 Cash Flows From Operating Activities Net income $ 4,161,439 $ 1,980,330 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 616,468 804,587 Amortization of finite-life intangible assets 121,762 120,640 Amortization of debt issuance costs — 1,958 Share-based compensation expense 901,932 924,071 Deferred income taxes (126,000 ) (265,000 ) Loss on disposal of property and equipment 2,622 11,186 Loss on disposal of intangible assets — 4,840 Changes in operating assets and liabilities: Accounts receivable (180,635 ) (948,734 ) Contract assets 93,228 (219,509 ) Inventories (449,335 ) (106,174 ) Prepaid expenses and other assets 78,222 591,457 Income tax receivable (262,155 ) — Income tax payable (288,511 ) (108,879 ) Accounts payable and accrued liabilities (472,589 ) (200,899 ) Net cash provided by operating activities 4,196,448 2,589,874 Cash Flows From Investing Activities Expenditures for property and equipment (844,226 ) (1,330,598 ) Proceeds of sales of equipment — 1,750 Expenditures for finite-life intangible assets (132,970 ) (57,790 ) Net cash used in investing activities (977,196 ) (1,386,638 ) Cash Flows From Financing Activities Principal payments on long-term debt including capital lease obligations — (1,103,001 ) Issuance of common stock upon exercise of options 80,369 251,849 Taxes paid on stock options exercised on a net basis (628,399 ) — Net cash used in financing activities (548,030 ) (851,152 ) Net increase in cash 2,671,222 352,084 Cash Beginning of period 7,807,928 7,455,844 End of period $ 10,479,150 $ 7,807,928 Supplemental Disclosures of Cash Flow Information Cash paid for interest $ 3,133 $ 22,991 Cash paid for income taxes 1,754,666 1,313,878 Supplemental Disclosures of Noncash Investing and Financing Activities Property and equipment acquisitions in accounts payable $ 1,278 $ 29,405 Intangible asset acquisitions in accounts payable $ 5,768 $ — See Notes to Financial Statements. F- 6 Electromed, Inc. Notes to Financial Statements Note 1. Nature of Business and Summary of Significant Accounting Policies Nature of business: Electromed, Inc. (the “Company”) develops, manufactures and markets innovative airway clearance products that apply High Frequency Chest Wall Oscillation (“HFCWO”) therapy in pulmonary care for patients of all ages. The Company markets its products in the U.S. to the home health care and institutional markets for use by patients in personal residences, hospitals and clinics. The Company also sells internationally both directly and through distributors. International sales were approximately $718,000 and $747,000 for the fiscal years ended June 30, 2020 (“fiscal 2020”) and 2019 (“fiscal 2019”), respectively. Since its inception, the Company has operated in a single industry segment: developing, manufacturing and marketing medical equipment. A summary of the Company’s significant accounting policies follows: Use of estimates: Management uses estimates and assumptions in preparing the financial statements in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could vary from the estimates that were used. The Company believes the critical accounting policies that require the most significant assumptions and judgments in the preparation of its financial statements include revenue recognition and the related estimation of variable consideration, allowance for doubtful accounts, the potential impairment of intangible and long-lived assets, inventory obsolescence, share-based compensation and the warranty reserve. COVID-19 Pandemic and CARES Act Funding In March 2020, the World Health Organization designated COVID-19 as a global pandemic. The impact of the COVID-19 pandemic on the Company’s business remains uncertain and its effects on operational and financial performance will depend in part on future developments, which cannot be reasonably estimated at this time. Such future developments include, but are not limited to, the duration, scope and severity of the COVID-19 pandemic in geographic areas in which the Company operates or in which its patients live, actions taken to contain or mitigate its impact, the impact on governmental healthcare programs and budgets, the development of treatments or vaccines, and the resumption of widespread economic activity. Due to the inherent uncertainty of the unprecedented and evolving situation, the Company is unable to predict with confidence the likely impact of the COVID-19 pandemic on its future operations. The COVID-19 pandemic has created significant volatility, uncertainty and economic disruption and has negatively impacted business in the Company’s industry starting in March 2020. In particular, certain healthcare facilities and clinics restricted access to their clinicians, reducing patient consultations and treatments, or closed temporarily due to the COVID-19 pandemic, which reduced homecare referrals and resulted in institutional orders being postponed. The Company believes that these and other responses by healthcare systems had a negative impact on the Company’s operating results and cash flows during the fourth quarter of fiscal 2020. In response to the negative impacts of the COVID-19 pandemic on the Company’s business, in April 2020 the Company initiated cost-containment measures, which included reducing discretionary and variable spend, such as travel, and the use of contractors, consultants, temporary help and employee furloughs in its manufacturing and general and administrative functions due to lower near-term demand for its products. The Company has also taken measures to ensure the safety of its employees and to comply with applicable governmental orders. The Company considers its business to be essential under applicable orders due primarily to its role in manufacturing and supplying needed medical devices to patients with respiratory related issues. In response to the COVID-19 pandemic and the U.S. federal government’s declaration of a public health emergency, the CMS implemented a number of temporary rule changes and waivers to allow prescribers to best treat patients during the period of the public health emergency. These waivers are retroactively effective to March 1, 2020. Clinical indications and documentation typically required will not be enforced for respiratory related products including the SmartVest System (solely with respect to Medicare patients). The minimum documentation now requires a valid order and documentation of a respiratory related diagnosis. Face-to-face and in-person requirements for respiratory devices are being waived during such period, which is currently scheduled to expire in October 2020. F- 7 On April 10, 2020, the Company received a stimulus payment in the amount of approximately $913,000 under the Provider Relief Fund established pursuant to the Coronavirus Aid Relief, and Economic Security Act (“CARES Act”), which is intended to offset losses in revenue and expenses Medicare fee-for-service providers incurred due to the impacts of the COVID-19 pandemic. The Company, a Medicare fee-for-service provider, incurred revenue losses subsequent to receipt of the funds in excess of the amount of the stimulus payment, and recognized the full amount as income during fiscal 2020. Revenue recognition: Revenue is measured based on consideration specified in the contract with a customer, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, including noncash consideration, consideration paid or payable to customers and significant financing components. Revenue from all customers is recognized when a performance obligation is satisfied by transferring control of a distinct good or service to a customer. See Note 2 for information on revenue. Shipping and handling expense: Shipping and handling charges incurred by the Company are included in cost of revenues and were $515,000 and $454,000 for fiscal 2020 and 2019, respectively. Cash: The Company maintains its cash in bank deposit accounts that, at times, may exceed federally insured limits. The Company has not experienced any losses in these accounts. Accounts receivable: The Company’s accounts receivable balance is comprised of amounts due from individuals, institutions and distributors. Balances due from individuals are typically remitted to the Company by third-party reimbursement agencies such as Medicare, Medicaid and private insurance companies. Accounts receivable are carried at amounts estimated to be received from patients under reimbursement arrangements with third-party payers. Accounts receivable are also net of an allowance for doubtful accounts. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition and credit history. Receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded when received. The allowance for doubtful accounts was approximately $45,000 as of June 30, 2020 and 2019. Contract assets: Contract assets include amounts recognized as revenue that are estimates of variable consideration for Medicare appeals where the final determination of the insurance coverage amount is dependent on future approval of an appeal, or when the consideration due to the Company is dependent on a future event such as the patient meeting a deductible prior to the Company’s claim being processed by the payer. Contract assets are classified as current as amounts will turn into accounts receivable and be collected during the Company’s normal business operating cycle. Contract assets are reclassified to accounts receivable when the right to receive payment is unconditional. Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Work in process and finished goods are carried at standard cost, which approximates actual cost, and includes materials, labor and allocated overhead. Standard costs are reviewed at least quarterly by management, or more often in the event circumstances indicate a change in cost has occurred. The reserve for obsolescence is determined by analyzing the inventory on hand and comparing it to expected future sales. Estimated inventory to be returned is based on how many devices that have shipped that are expected to be returned prior to completion of the insurance reimbursement process. Property and equipment: Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are depreciated over the shorter of their estimated useful lives or the remaining lease term. The Company retains ownership of demonstration equipment in the possession of both inside and outside sales representatives, who use the equipment in the sales process. Finite-life intangible assets: Finite-life intangible assets include patents and trademarks. These intangible assets are amortized on a straight-line basis over their estimated useful lives, as described in Note 5. Long-lived assets: Long-lived assets, primarily property and equipment and finite-life intangible assets, are evaluated for impairment whenever events or changes in circumstances indicate the carrying value of an asset or asset group may not be recoverable. In evaluating recoverability, the following factors, among others, are considered: a significant change in the circumstances used to determine the amortization period, an adverse change in legal factors or in the business climate, a transition to a new product or service strategy, a significant change in customer base, and a realization of failed marketing efforts. The recoverability of an asset or asset group is measured by a comparison of the carrying value of the asset to future undiscounted cash flows. F- 8 If the Company believes the carrying value is unrecoverable, then it recognizes an impairment charge necessary to reduce the unamortized balance to the estimated fair value of the asset or asset group. The amount of such impairment is charged to operations in the current period. Warranty liability: The Company provides a lifetime warranty on its products to the prescribed patient for sales within the U.S. and Canada, and a three-year warranty for all institutional sales and sales to individuals outside the U.S. (except for Canadian home care). The Company estimates the costs that may be incurred under its warranty and records a liability in the amount of such costs at the time the product is shipped. Factors that affect the Company’s warranty liability include the number of units shipped, historical and anticipated rates of warranty claims, the product’s useful life, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amounts as necessary. Changes in the Company’s warranty liability were approximately as follows: Years Ended June 30, 2020 2019 Beginning warranty reserve $ 810,000 $ 760,000 Accrual for products sold 79,000 201,000 Expenditures and costs incurred for warranty claims (149,000 ) (151,000 ) Ending warranty reserve $ 740,000 $ 810,000 Income taxes: Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company reverses a valuation allowance if it determines, based on the weight of all available evidence, including when cumulative losses become positive income, that it is more likely than not that some or all of the deferred tax assets will be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company recognizes tax liabilities when the Company believes that certain positions may not be fully sustained upon review by tax authorities. Benefits from tax positions are measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences impact income tax expense in the period in which such determination is made. Interest and penalties, if any, related to accrued liabilities for potential tax assessments are included in income tax expense. Research and development: Research and development costs include costs of research activities as well as engineering and technical efforts required to develop new products or make improvements to existing products. Research and development costs are expensed as incurred. Advertising costs: Advertising costs are charged to expense when incurred. Advertising, marketing and trade show costs for the fiscal years 2020 and 2019, were approximately $781,000 and $576,000, respectively. Share-based payments: Share-based payment awards consist of options and restricted stock issued to employees for services, and to non-employees in lieu of payment for services. Expense for options is estimated using the Black-Scholes pricing model at the date of grant and expense for restricted stock is determined by the closing price on the day the grant is made. Expense is recognized on a straight-line basis over the requisite service or vesting period of the award, or at the time services are provided for non-employee awards. Fair value of financial instruments: The carrying values of cash, accounts receivable, accounts payable and accrued expenses approximate their fair value due to the short-term nature of these instruments. The carrying value of long-term debt is the remaining amount due to debtors under borrowing arrangements. To estimate the fair value of debt, the Company estimates the interest rate necessary to secure financing to replace its debt. F- 9 Basic and diluted earnings per share: Net income is presented on a per share basis for both basic and diluted common shares. Basic net income per common share is computed using the weighted-average number of common shares outstanding during the period, excluding any restricted stock awards which have not vested. The diluted net income per common share calculation includes outstanding restricted stock grants and assumes that all stock options were exercised and converted into common stock at the beginning of the period, unless their effect is anti-dilutive. Common stock equivalents of zero shares and 318,000 shares were excluded from the calculation of diluted earnings per share for fiscal 2020 and 2019, respectively, as their impact was antidilutive. See Note 8 for information on stock options. New accounting pronouncements: In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842)” (“ASU 2016-02”). This standard requires the recognition of all lease transactions on the balance sheet as a lease liability and a right-of-use asset (as defined in ASU 2016-02). ASU 2016-02 to Topic 842 – Leases (“ASC 842”) became effective on July 1, 2019 and was applied retrospectively to all periods presented. The Company applied the practical expedient to calculate the present value of the fixed payments without having to perform an allocation to lease and non-lease components. Additional information and required disclosures are included in Note 10. Impact on Previously Reported Results: The following table presents a recast of selected unaudited statement of operations line items after giving effect to the adoption of ASC 842: For the twelve months ended June 30, 2019 As Previously Reported Effect of Adoption As Adjusted Net revenues $ 31,299,750 $ — $ 31,299,750 Cost of revenues 7,451,806 — 7,451,806 Gross profit 23,847,944 — 23,847,944 Operating expenses Selling, general and administrative 20,446,122 (11,112 ) 20,435,010 Research and development 583,311 — 583,311 Total operating expenses 21,029,433 (11,112 ) 21,018,321 Operating income 2,818,511 11,112 2,829,623 Interest income, net 90,707 — 90,707 Net income before income taxes 2,909,218 11,112 2,920,330 Income tax expense 940,000 — 940,000 Net income $ 1,969,218 $ 11,112 $ 1,980,330 Income per share: Basic $ 0.24 $ 0.00 $ 0.24 Diluted $ 0.23 $ 0.00 $ 0.23 F- 10 The following table presents a recast of selected unaudited balance sheet line items after giving effect to the adoption of ASC 842: June 30, 2019 As Previously Reported Effect of Adoption As Adjusted Assets Other assets $ — $ 45,044 $ 45,044 Liabilities and Shareholder’s Equity Current maturities of other long-term liabilities — 30,320 30,320 Other long-term liabilities — 14,737 14,737 Retained earnings 9,522,076 (12 ) 9,522,064 The following table presents a recast of selected unaudited statement of cash flow line items after giving effect to the adoption of ASC 842: For the Twelve months ended June 30, 2019 As Previously Reported Effect of Adoption As Adjusted Cash Flow from Operating Activities Net income $ 1,969,218 $ 11,112 $ 1,980,330 Changes in operating assets and liabilities: Prepaid expenses and other assets 404,234 187,223 591,457 Accounts payable and accrued liabilities (2,564 ) (198,335 ) (200,899 ) Note 2. Revenues Revenue is measured based on consideration specified in the contract with a customer, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, including non-cash consideration, consideration paid or payable to customers and significant financing components. Revenue from all customers is recognized when a performance obligation is satisfied by transferring control of a distinct good or service to a customer, as further described below under Performance obligations and transaction price . Individual promised goods and services in a contract are considered a performance obligation and accounted for separately if the individual good or service is distinct (i.e., the customer can benefit from the good or service on its own or with other resources that are readily available to the customer and the good or service is separately identifiable from other promises in the arrangement). If an arrangement includes multiple performance obligations, the consideration is allocated between the performance obligations in proportion to their estimated standalone selling price, unless discounts or variable consideration is attributable to one or more but not all the performance obligations. Costs related to products delivered are recognized in the period incurred, unless criteria for capitalization of costs under FASB Accounting Standards Codification (“ASC”) 340-40, “Other Assets and Deferred Costs” (“ASC 340”), or other applicable guidance are met. The Company includes shipping and handling fees in net revenues. Shipping and handling costs associated with the shipment of the Company’s SmartVest® Airway Clearance System (“SmartVest System”) after control has transferred to a customer are accounted for as a fulfillment cost and are included in cost of revenues. The timing of revenue recognition, billings and cash collections results in accounts receivable on the balance sheets as further described below under Accounts receivable and Contract assets . F- 11 Disaggregation of revenues. In the following table, revenue is disaggregated by market: For the twelve months ended June 30, 2020 2019 Home Care $ 29,322,649 $ 28,948,861 Institutional 1,999,784 1,603,522 Home Care Distributor 430,363 — International 717,892 747,367 Total $ 32,470,688 $ 31,299,750 In the following table, home care revenue is disaggregated by payer type: For the twelve months ended June 30, 2020 2019 Commercial $ 11,728,179 $ 13,106,919 Medicare 14,863,032 13,787,059 Medicaid 1,696,380 1,230,766 Other 1,035,058 824,117 Total $ 29,322,649 $ 28,948,861 Revenues in the Company’s home care, home care distributor and international markets are recognized at a point in time when control passes to the customer upon product shipment or delivery. Revenues in the Company’s institutional market include sales recognized at a point in time upon shipment or delivery as well as revenues recognized over time under operating leases. Performance obligations and transaction price. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account under ASC 606, “Revenue From Contracts With Customers” (“ASC 606”). A contract’s transaction price is allocated to each distinct performance obligation in proportion to the standalone selling price for each and recognized as revenue when, or as, the performance obligation is satisfied. The Company’s performance obligations and the timing or method of revenue recognition in each of the Company’s markets are discussed below: Home care market . In the Company’s home care market, its customers are patients who use the SmartVest System. The various models of the SmartVest System are comprised of three main components - a generator, a vest and a connecting hose - that are sold together as an integrated unit. Accordingly, in contracts within the home care market, the Company regards the SmartVest System to be a single performance obligation. The Company makes available to its home care patients limited post-sale services that are not material in the context of the contracts, either individually or taken together, and therefore does not consider them to be performance obligations. The costs associated with the services are accrued and expensed when the related revenues are recognized. As such, transactions in the home care market consist of a single performance obligation: the SmartVest System. Home care patients generally will rely on third-party payers, including commercial payers and governmental payers such as Medicare, Medicaid and the U.S. Department of Veterans Affairs to cover and reimburse all or part of the cost of the SmartVest System. The third-party payers’ reimbursement programs fall into three types, distinguished by the differences in the timing of payments from the payer, consisting of either (i) outright sale, in which payment is received from the payer based on standard terms, (ii) capped installment sale, under which the SmartVest System is sold for a series of payments that are capped not to exceed a prescribed or negotiated amount over a period of time or (iii) installment sale, under which the SmartVest System is paid for over a period of several months as long as the patient continues to use the SmartVest System. Regardless of the type of transaction, provided criteria for an enforceable contract are met, it is the Company’s long-standing business practice to regard all home care agreements as transferring control to the patient upon shipment or delivery, in spite of possible payment cancellation under government or commercial programs where the payer is controlling the payment over specified time periods. For home care sales that feature installment payments, the ultimate amount of consideration received from Medicare, Medicaid or commercial payers can be significantly less than expected if the contract is terminated due to changes in the patient’s status, including insurance coverage, hospitalization, death or otherwise becoming unable to use the SmartVest System. However, once delivered to a patient who needs the SmartVest System, the patient is under no obligation to return the SmartVest System should payments be terminated as a result of the described contingencies. As a result, the Company’s product sales qualify for point in time revenue recognition. Control transfers to the patient, and revenue is recognized, upon shipment of the SmartVest System. At this point, physical possession and the significant risks and rewards of ownership are transferred to the patient and either a current or future right to payment is triggered, as further discussed under Accounts receivable and Contract assets below. F- 12 The Company’s contractually stated transaction prices in the home care market are generally set by the terms of the contracts negotiated with insurance companies or by government programs. The transaction price for the Company’s products may be further impacted by variable consideration. ASC 606 requires the Company to adjust the transaction price at contract inception and throughout the contract duration for the estimated value of payments to be received from insurance payers based on historical experience and other available information, subject to the constraint on estimates of variable consideration. Transactions requiring estimates of variable consideration primarily include (i) capped installment payments, which are subject to the third-party payer’s termination due to changes in insurance coverage, death or the patient’s discontinued use of the SmartVest System, (ii) contracts under appeal and (iii) patient responsibility amounts for deductibles, coinsurance, copays and other similar payments. Although estimates may be made on a contract-by-contract basis, whenever possible, the Company uses all available information including historical collection patterns to estimate variable consideration for portfolios of contracts. The Company’s estimates of variable consideration consist of amounts it may receive from insurance providers in excess of its initial revenue estimate due to patients meeting deductibles or coinsurance during the payment duration, changes to a patient’s insurance status, changes in an insurance allowable, claims in appeals with Medicare and amounts received directly from patients for their allowable or coinsurance. The Company believes it has representative historical information to estimate the amount of variable consideration in relevant portfolios considering the significant experience it has with each portfolio and the similarity of patient accounts within a portfolio. The analysis includes steps to ensure that revenue recognized on a portfolio basis does not result in a material difference when compared with an individual contract approach. The Company also leverages its historical experience and all available relevant information for each portfolio of contracts to minimize the risk its estimates used to arrive at the transaction price will result in a significant reversal in the amount of cumulative revenue recognized when the uncertainty associated with the variable consideration is subsequently resolved. Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. For example, for contracts in which the Company believes the criteria for reimbursement under government or commercial payer contracts have been met but for which coverage is unconfirmed or payments are under appeal, the Company has significant observable evidence of relatively consistent claims recovery experience over the prior three to five years. The Company believes the low volatility in historical claims approval rates for populations of patients whose demographics are similar to those of current patients provides reliable predictive value in arriving at estimates of variable consideration in such contracts. Similarly, historical payment trends for recovery of claims subject to payer installments and payments from patients have remained relatively consistent over the past five years. No significant changes in patient demographics or other relevant factors have occurred that would limit the predictive value of such payment trends in estimating variable consideration for current contracts. As a result, the Company believes its estimates of variable consideration are generally not subject to the risk of significant revenue reversal. For each type of variable consideration discussed above, there are a large number of contracts with similar characteristics with a wide range of possible transaction prices. For that reason, the Company uses the probability-weighted expected value method provided under ASC 606 to estimate variable consideration. The Company often receives payment from third-party payers for the SmartVest System sales over a period of time that may exceed one year. Despite these extended payment terms, no significant financing component is deemed to exist because the purpose of such terms is not to provide financing to the patient, the payer or the Company. Rather, the extended payment terms are mandated by the government or commercial insurance programs; the fundamental purpose of which is to avoid paying the full purchase price of equipment that may potentially be used by the patient for only a short period of time. Home Care Distributors. Sales to distributors, who sell direct to patients, are made at fixed contract prices and may include tiered pricing structures or volume-based rebates which offer more favorable pricing once certain volumes are achieved per the negotiated contract. The distributor’s purchases accumulate to give the distributor a right to a higher discount on purchases in excess of the specified level within the contract period. As a result, to the extent the Company expects the distributor to exceed the specified volume of purchases in the annual period, it recognizes revenue at a blended rate based on estimated total annual volume and sales revenue. This effectively defers a portion of the transaction price on initial purchases below the specified volumes for recognition when the higher discount is earned on purchases in excess of specified volumes. Transfer of control of the products occurs upon shipment or delivery to the distributor as applicable. F- 13 Institutional market. The Company’s institutional sales are made to hospitals and home health care centers, pulmonary rehabilitation centers and other clinics. Sales to these institutions are negotiated with the individual institution or with group purchasing organizations, with payments received directly from the institution. No insurance reimbursement is involved. Generators are either sold or leased to the institutions and associated hoses and wraps (used in institutional settings rather than vests) are sold separately. Accordingly, each product is distinct and considered a separate performance obligation in sales to institutional customers. The agreements with institutions fall into two main types, distinguished by differences in the timing of transfer of control and timing of payments: ● Outright sale – Under these transactions, the Company sells its products for a prescribed or negotiated price. Transfer of control of the product, and associated revenue recognition, occurs at the time of shipment and payment is made within normal credit terms, usually within 30 days. ● Rentals – Under these transactions, the customer obtains a right to use the product for a period of time in exchange for consideration as usage occurs. These transactions are treated as operating leases and revenue is recognized ratably over the applicable rental period. Lease revenue recognized during fiscal 2020 and 2019 was approximately $6,000 and $38,000, respectively. International market. Sales to international markets are made directly to a number of independent distributors at fixed contract prices that are not subject to further adjustments for variable consideration. Transfer of control of the products occurs upon shipment or delivery to the distributor as applicable. Product Warranty. The Company offers warranties on its products. These warranties are assurance type warranties not sold on a standalone basis or are otherwise considered immaterial in the context of the contract, and therefore are not considered distinct performance obligations under ASC 606. The Company estimates the costs that may be incurred under its warranties and records a liability in the amount of such costs at the time the product is sold. Accounts receivable. Accounts receivable include amounts billed to customers and third-party payers, for which only the passage of time is required before payment of consideration is due. Amounts due are stated at their net estimated realizable value. Contract assets. Contract assets include amounts recognized as revenue that are estimates of variable consideration for Medicare appeals where the final determination of the insurance coverage amount is dependent on future approval of an appeal, or when the consideration due to the Company is dependent on a future event such as the patient meeting a deductible prior to the Company’s claim being processed by the payer. Contract assets are classified as current as amounts will turn into accounts receivable and be collected during the Company’s normal business operating cycle. Contract assets are reclassified to accounts receivable when the right to receive payment is unconditional. Incremental costs to obtain a contract. Sales incentives paid to sales representatives are eligible for capitalization as they are incremental costs that would not have been incurred without entering into a specific sales arrangement and are recoverable through the expected margin on the transaction . However, the recovery period is less than one year as the performance obligation is satisfied upon shipment or delivery. Consequently, the Company applies the practical expedient provided by ASC 340 and expense sales incentives as incurred. These costs are included in selling, general and administrative expenses in the Company’s statements of operations. Contract balances. The following table provides information about accounts receivable and contracts assets from contracts with customers: June 30, 2020 June 30, 2019 Receivables, included in “Accounts receivable, net of allowance for doubtful accounts” $ 12,940,677 $ 12,760,042 Contract assets $ 902,619 $ 995,847 F- 14 Significant changes in contract assets during the period are as follows: Twelve Months Ended Fiscal Year Ended June 30, 2020 June 30, 2019 Increase (decrease) Increase (decrease) Contract assets, beginning $ 995,847 $ 776,338 Reclassification of contract assets to accounts receivable (1,857,818 ) (2,012,619 ) Contract assets recognized 1,733,835 2,169,835 Increase as a result of changes in the estimate of amounts to be realized from payers, excluding amounts transferred to receivables during the period 30,755 62,293 Contract assets, ending $ 902,619 $ 995,847 Note 3. Inventories The components of inventories at June 30, 2020 and 2019 were approximately as follows: June 30, 2020 2019 Parts inventory $ 2,271,000 $ 1,783,000 Work in process 127,000 444,000 Finished goods 827,000 521,000 Estimated inventory to be returned 150,000 184,000 Less: Reserve for obsolescence (290,000 ) (310,000 ) Total $ 3,085,000 $ 2,622,000 Note 4. Property and Equipment Property and equipment were approximately as follows: Estimated Useful Lives (Years) June 30, 2020 2019 Building and building improvements 15-39 $ 3,437,000 $ 1,977,000 Land N/A 200,000 200,000 Land improvements 15 166,000 166,000 Equipment 3-7 3,311,000 3,082,000 Demonstration and rental equipment 3 1,075,000 1,018,000 Construction in progress 15-39 16,000 1,090,000 8,205,000 7,533,000 Less: Accumulated depreciation (4,417,000 ) (3,928,000 ) Net property and equipment $ 3,788,000 $ 3,605,000 During fiscal 2020 and 2019, the Company impaired or disposed of certain property and equipment, no longer in use, with a net value of approximately $3,000 and $11,000, respectively, which was included as an expense in cost of revenues or selling, general and administrative expense on the statements of operations. Note 5. Finite-life Intangible Assets The carrying value of patents and trademarks includes the original cost of obtaining the patents, periodic renewal fees, and other costs associated with maintaining and defending patent and trademark rights. Patents and trademarks are amortized over their estimated useful lives, generally 15 and 12 years, respectively. During fiscal 2019, the Company abandoned certain domestic and foreign patents with a net value of approximately $5,000 which was included as an expense in selling, general and administrative expense on the statements of operations. Accumulated amortization was approximately $1,119,000 and $1,010,000 at June 30, 2020 and 2019, respectively. F- 15 The activity and net balances of finite-life intangible assets were approximately as follows: Years Ended June 30, 2020 2019 Balance, beginning $ 581,000 $ 649,000 Additions 139,000 58,000 Abandonments — (5,000 ) Amortization expense (122,000 ) (121,000 ) Balance, ending $ 598,000 $ 581,000 Based on the carrying value as of June 30, 2020, future amortization is expected to be approximately as follows: Fiscal years ending June 30: 2021 $ 125,000 2022 91,000 2023 29,000 2024 25,000 2025 23,000 Thereafter 305,000 Total $ 598,000 Note 6. Financing Arrangements The Company has a credit facility that provides for a revolving line of credit and a term loan. Effective December 18, 2019, the Company renewed its $2,500,000 revolving line of credit. There was no outstanding principal balance on the line of credit as of June 30, 2020 or June 30, 2019. Interest on borrowings under the line of credit, if any, accrues at the prime rate (3.25% at June 30, 2020) less 1.00% and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable and the line of credit expires on December 18, 2020, if not renewed. At June 30, 2020, the maximum $2,500,000 was eligible for borrowing. The line of credit is secured by a security interest in substantially all the tangible and intangible assets of the Company. The documents governing the line of credit contain certain financial and nonfinancial covenants that include a minimum tangible net worth covenant of not less than $10,125,000 and restrictions on the Company’s ability to incur certain additional indebtedness or pay dividends. Note 7. Common Stock Authorized shares: The Company’s Articles of Incorporation, as amended, have established 15,000,000 authorized shares of capital stock consisting of 13,000,000 shares of common stock, par value $0.01 per share, and 2,000,000 shares of undesignated stock. Note 8. Share-Based Payments Share-based compensation expense for fiscal 2020 and 2019 was approximately $902,000 and $924,000, respectively, related to employee options and restricted stock awards. At June 30, 2020, the Company had approximately $409,000 of unrecognized compensation expense related to non-vested equity awards, which is expected to be recognized over a weighted-average period of 0.8 years. F- 16 Employee options: The Company has historically granted stock options to employees as long-term incentive compensation. Options expire ten years from the grant date and vest over a period of up to five years. In November 2017, the Company’s shareholders approved the 2017 Omnibus Incentive Plan (the “2017 Plan”) which supersedes the 2014 Equity Incentive Plan (the “2014 Plan”). The 2017 Plan allows the Company’s Board of Directors to grant stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards, as well as cash incentive awards to all employees, non-employee directors, and advisors or consultants of the Company. The vesting schedule and term for each award are determined by the Board upon each grant. The maximum number of shares of common stock available for issuance under the 2017 Plan is 900,000. There were 316,249 options granted under the 2014 Plan and prior plans outstanding as of June 30, 2020. There were 274,531 options issued under the 2017 Plan outstanding and 505,800 shares available for grant under the 2017 Plan as of June 30, 2020. The Company recognizes compensation expense related to share-based payment transactions in the financial statements based on the estimated fair value of the award issued. The fair value of each option is estimated using the Black-Scholes pricing model at the time of award grant. The Company estimates the expected life of options based on the expected holding period by the option holder. The risk-free interest rate is based upon observed U.S. Treasury interest rates for the expected term of the options. The Company makes assumptions with respect to expected stock price volatility based upon the volatility of its stock price. Forfeitures are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from initial estimates. Forfeitures are estimated based on the percentage of awards expected to vest, taking into consideration the seniority level of the award recipient. The following assumptions were used to estimate the fair value of options granted: Years Ended June 30, 2020 2019 Risk-free interest rate 1.85 % 2.36-2.77 % Expected term (years) 6 6 Expected volatility 190.1 % 182.4-192.0 % The following table presents employee option activity for fiscal 2020 and 2019: Number of Shares Weighted- Average Grant Date Fair Value Weighted- Average Exercise Price Weighted- Average Remaining Contractual Life (in Years) Options outstanding at June 30, 2018 902,059 $ 2.63 $ 3.47 5.31 Granted 193,750 5.28 5.41 — Exercised (79,692 ) 2.15 3.16 — Canceled or Forfeited (333,117 ) 2.81 3.92 — Options outstanding at June 30, 2019 683,000 3.35 3.84 6.96 Granted 149,300 5.19 5.29 — Exercised (194,670 ) 2.47 3.08 — Canceled or Forfeited (46,850 ) 5.16 5.34 — Options outstanding at June 30, 2020 590,780 3.96 4.34 6.87 Options exercisable at June 30, 2020 445,655 3.54 3.99 6.31 The aggregate intrinsic value of options outstanding was $6,529,000 and options exercisable were $5,079,000 at June 30, 2020. There were 194,670 and 79,692 options exercised during the fiscal years ended June 30, 2020 and June 30, 2019, respectively. Restricted stock: The 2014 Plan permitted, and the 2017 Plan permits the Personnel and Compensation Committee of the Board to grant other stock-based awards, including restricted stock. The Company makes restricted stock grants to key employees and non-employee directors that vest over six months to three years following the applicable grant date. F- 17 The Company issued restricted stock awards to employees totaling 35,000 and 30,000 during fiscal 2020 and 2019, respectively, with a vesting term of one to three years and a fair value of $5.84 and $5.42 per share, respectively. During fiscal 2020 and 2019, the Company issued restricted stock awards to directors totaling 18,000 and 10,000, respectively, with a vesting term of six months and a fair value of $9.74 and $5.70 per share, respectively. Restricted stock transactions during the years ended June 30, 2020 and 2019 are summarized as follows: Shares of Restricted Stock Weighted-Average Grant Date Fair Value per Share Outstanding at June 30, 2018 29,998 $ 4.96 Granted 40,000 $ 5.49 Vested (40,000 ) $ 5.12 Outstanding at June 30, 2019 29,998 $ 5.46 Granted 53,000 $ 7.17 Vested (45,833 ) $ 6.83 Forfeited (14,666 ) $ 6.23 Outstanding at June 30, 2020 22,499 $ 6.19 Note 9. Income Taxes Components of the provision for income taxes for fiscal 2020 and 2019 were as follows: Years Ended June 30, 2020 2019 Current: Current Federal $ 922,000 $ 945,000 Current State 282,000 260,000 Total Current 1,204,000 1,205,000 Deferred: Deferred Federal (70,000 ) (190,000 ) Deferred State (56,000 ) (75,000 ) Total Deferred (126,000 ) (265,000 ) Total Income Tax Expense $ 1,078,000 $ 940,000 The total income tax expense differed from the expected tax expense, computed by applying the federal statutory rate to the Company’s pretax income, as follows: Years Ended June 30, 2020 2019 Tax expense at statutory federal rate $ 1,100,000 $ 611,000 State income tax expense, net of federal tax effect 151,000 155,000 Change in valuation allowance on deferred tax assets 91,000 — Change in uncertain tax positions — 8,000 Other permanent items (264,000 ) 166,000 Income tax expense $ 1,078,000 $ 940,000 The effective tax rates for fiscal 2020 and 2019 were 20.6% and 32.3%, respectively. F- 18 The significant components of deferred income taxes were as follows: June 30, 2020 2019 Deferred tax assets (liabilities): Revenue recognition and accounts receivable reserves $ 468,000 $ 468,000 Accrued liabilities 253,000 246,000 Property and equipment (202,000 ) (201,000 ) Finite-life intangible assets (6,000 ) (6,000 ) Stock options 458,000 421,000 Tax credits and net operating loss carryforwards 92,000 82,000 Accounting method change (282,000 ) (420,000 ) Valuation allowance on deferred taxes (91,000 ) — Other 65,000 39,000 Net deferred tax assets $ 755,000 $ 629,000 The Company has state tax credit carryforwards of $91,000, net of federal taxes, which if unused, will begin to expire in years 2026 and 2034. The Company has taken a full valuation allowance against these credits which relate to R&D tax credits in Minnesota, a state in which the Company has a low state apportionment factor. The Company applies the accounting standard for uncertain tax positions pursuant to which a more-likely-than-not threshold is utilized to determine the recognition and derecognition of uncertain tax positions. Once the more-likely-than-not threshold is met, the amount of benefit to be recognized is the largest amount of tax benefit that is greater than 50 percent likely of being ultimately realized upon settlement. It further requires that a change in judgment related to the expected ultimate resolution of uncertain tax positions be recognized in earnings in the period of such a change. The Company does not believe there will be significant changes to the estimates in the next 12-month period. Due to the complexity of some of these uncertainties, the ultimate settlement may result in payments that are different from the Company’s current estimate of tax liabilities, resulting in the recognition of additional charges or benefits to income tax expense. Changes in the Company’s unrecognized tax expense were approximately as follows: Years Ended June 30, 2020 2019 Beginning balance of unrecognized tax benefits $ 11,000 $ — Increase (decrease) in unrecognized tax expense (11,000 ) 11,000 Lapse of statute of limitations — — Ending balance of unrecognized tax benefits $ — $ 11,000 The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. During fiscal 2020 and 2019 the amount of recognized interest expense, net of tax benefit, and accrued interest on a gross basis was insignificant. The Company is subject to U.S. federal income tax as well as income tax of multiple state jurisdictions. With limited exceptions, tax years prior to the Company’s fiscal year ended June 30, 2017 are no longer open to federal, state and local examination by taxing authorities. F- 19 Note 10. Leases The Company has four leases for office and warehouse space that require monthly payments. These leases have escalating payments ranging from approximately $400 to $4,400 per month which expire through July 2022 and are recognized on a straight-line basis over the life of the lease. The Company has a lease for office equipment that requires payments of approximately $1,600 per month through August 2022. All leases are classified as operating leases which do not include renewal options. The Company currently does not have any short-term or variable lease costs. The Company applied the practical expedient to calculate the present value of the fixed payments without having to perform an allocation to lease and non-lease components. The Company has recognized right of use assets associated with its operating leases of approximately $80,000 and $45,000 as of June 30, 2020 and June 30, 2019, respectively, which is included in other assets on the Company’s balance sheet. Operating lease liabilities were $81,000 and $45,000 as of June 30, 2020 and June 30, 2019, respectively, which are included in current maturities of long-term liabilities and other long-term liabilities on the Company’s balance sheet. As of June 30, 2020, the Company has a weighted-average lease term of 0.5 years for its operating leases, which have a weighted-average discount rate of 4.0%. Operating lease payments of $73,000 are included in operating cash flows in Fiscal 2020. Maturities of lease liabilities, which are included in current maturities of long-term liabilities and other long-term liabilities on the Company’s balance sheet, are as follows: Fiscal years ending June 30: 2021 $ 73,000 2022 9,000 2023 1,000 Total lease payments 83,000 Less: Interest (2,000 ) Present value of lease liabilities $ 81,000 Note 11. Commitments and Contingencies Litigation: The Company may occasionally be party to actions, proceedings, claims or disputes arising in the ordinary course of business. The Company insures certain business risks where possible to mitigate the financial impact of individual claims and establishes reserves for an estimate of any probable cost of settlement or other disposition. 401(k) Profit Sharing Plan: The Company has an employee benefit plan under Section 401(k) of the Internal Revenue Code covering all employees who are 21 years of age or older and have at least 1,000 hours of service with the Company. The Company matches each employee’s salary reduction contribution, not to exceed four percent of annual compensation. Total employer contributions to this plan for fiscal 2020 and 2019, were approximately $329,000 and $336,000, respectively. Employment Agreements: The Company has entered into formal employment agreements with its President and Chief Executive Officer and its Chief Financial Officer, as amended from time to time. These agreements provide these officers with, among other things, twelve to eighteen months of base salary upon a termination without “Cause” or in the event the employee resigns for “Good Reason” or within twelve months of a “Change in Control,” as such terms are defined in the respective employment agreements. F- 20 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None.