GULF RESOURCES, INC. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a Nevada holding company which conducts operations through our wholly-owned China-based subsidiaries. Our business is conducted and reported in four segments, namely, bromine, crude salt, chemical products and natural gas. Through our wholly-owned subsidiary, SCHC, we produce and trade bromine and crude salt. We are one of the largest producers of bromine in China, as measured by production output. Elemental bromine is used to manufacture a wide variety of bromine compounds used in industry and agriculture. Bromine also is used to form intermediary chemical compounds such as Tetramethylbenzidine. Bromine is commonly used in brominated flame retardants, fumigants, water purification compounds, dyes, medicines and disinfectants. Crude salt is the principal material in alkali production as well as chlorine alkali production and is widely used in the chemical, food and beverage, and other industries. Through our wholly-owned subsidiary, SYCI, we manufacture and sell chemical products used in oil and gas field exploration, oil and gas distribution, oil field drilling, papermaking chemical agents, inorganic chemicals and materials that are used for human and animal antibiotics. Our wholly-owned subsidiary, DCHC, was established to explore and develop natural gas and brine resources (including bromine and crude salt) in Sichuan Province, China. As disclosed in the Company’s Current Report on Form 8-K filed on September 8, 2017, the Company received, on September 1, 2017, letters from the Yangkou County, Shouguang City government addressed to each of its subsidiaries, SCHC and SYCI, which stated that in an effort to improve the safety and environmental protection management level of chemical enterprises, the plants are requested to immediately stop production and perform rectification and improvements in accordance with the country’s new safety and environmental protection requirements. In the Company’s press release of August 11, 2017 and on its conference call of August 14, 2017, the Company addressed concerns that increased government enforcement of stringent environmental rules that were adopted in early 2017 to insure corporations bring their facilities up to necessary standards so that pollution and other negative environmental issues are limited and remediated, could have an impact on our business in both the short and long-term. The Company also expressed that although it believed its facilities were fully compliant at the time, the Company did not know how its facilities would fare under the new rules. Teams of inspectors from the government were sent to many provinces to inspect all mining and manufacturing facilities. The local government requested that facilities be closed, so that the facilities could undergo the inspection and analysis in the most efficient manner by inspectors’ team. As a result, our facilities were closed on September 1, 2017. The Company believes that this is another step by the government to improve the environment. It further believes the goal of the government is not to close all plants, but rather to codify the regulations related to project approval, land use, planning approval and environmental protection assessment approval so that illegal plants are not able to open in the future and so that plants close to population centers do not cause serious environmental damage. In addition, the Company believes that the Shandong provincial government wants to assure that each of its regional and county governments has applied the Notice in a consistent manner. The Shouguang City Bromine Association, on behalf of all the bromine plants in Shouguang, started discussions with the local government agencies. The local governmental agencies confirmed the facts that their initial requirements for the bromine industry did not include the project approval, the planning approval and the land use rights approval and that those three additional approvals were new requirements of the provincial government. The Company understood from the local government that it has been coordinating with several government agencies to solve these three outstanding approval issues in a timely manner and that all the affected bromine plants willnot be allowed to commence production prior to obtaining those approvals. In February 2019, the Company received a notification from the local government of Yangkou County that its Factory No. 1, No.4, No. 7 and No. 9 have passed inspection and ccould resume operations. In April 2019, Factory No. 1 and No. 7 resumed operations. On February 28, 2020, the Company announced that it received an approval from the government to resume bromine production after winter temporary closure. Subsequently, it received another approval from the Shouguang Yangkou People’s Government dated on March 5, 2020 to resume production at its bromine factories No.1, No. 4, No.7 and No. 9 in order to meet the needs of bromide products for epidemic prevention and control. With these two approvals, the Company was allowed to resume production at all four bromine factories. On December 27, 2021, Gulf Resources announced that the government of Shouguang City had ordered the closing of all bromine facilities during the period from December 28, 2021 to February 21, 2022. And the company reopened its its four operating bromine and crude salt facilities as planned on February 21, 2022. 31 The Company is still waiting for governmental approval for factories No.2, No.8, and No.10. To its knowledge, the government is currently completing its planning process for all mining areas including that for prevention of flood. As a result, the Company may be required to make some modifications to our current wells and aqueducts prior to commencement of operations of these factories to satisfy the local government's requirements. On November 24, 2017, Gulf Resources received a letter from the People’s Government of Yangkou County, Shouguang City notifying the Company that due to the new standards and regulations relating to safety production and environmental pollution, from certain local governmental departments, such as the municipal environmental protection department, the security supervision department and the fire department, its chemical enterprises would have to be relocated to a new industrial park called Bohai Marine Fine Chemical Industry Park. Although our chemical companies were in compliance with regulations, they were also close to a residential area. As a result, the government determined we should relocate to the Bohai park. Chemical companies that are not being asked to move into the park are being permanently closed. Since our facrtories closed, the Company has secured from the government the land use rights for its chemical plant On January 6, 2020, the Company received the environmental protection approval by the government of Shouguang City, Shandong Province for the proposed Yuxin Chemical factory. The Company began the construction on its new chemical facilities located at Bohai Marine Fine Chemical Industrial Park in June 2020 due to the COVID-19 in China. The construction is expected to take approximately one year, and an additional six months to complete the equipment installation and testing, Which was delayed due to the supply chain issues as well as the electric restrictions impacted by the Word & Chinese Economy.On February 22, 2022, the Company announced that While the Company did not receive a formal notice from the government regarding the electricity needed for its Yuxin Chemical factory, discussions with the government have convinced management that the electricity restrictions are being eased. Accordingly, the Company has contacted its suppliers and will have the remainder of the equipment produced and delivered, so the Company can complete installation and begin testing and trial production. In January 2017, the Company completed the first brine water and natural gas well field construction in Daying located in Sichuan Province and commenced trial production in January 2019. On May 29, 2019, the Company received a verbal notice from the government of Tianbao Town ,Daying County, Sichuan Province, whereby the Company is required to obtain project approval for its well located in Daying, including the whole natural gas and brine water project, and approvals for safety production inspection, environmental protection assessment, and to solve the related land issue. Until these approvals have been received, the Company has to temporarily halt trial production at its natural gas well in Daying. In compliance with the Chinese government new policies, the Company is also required to obtain an exploration license and a mining license for bromine and natural gas, respectively. Pursuant to the Opinions of the Ministry of Natural Resources on Several Issues in Promoting the Reform of Mineral Resources Management (Trial) promulgated by the Ministry of Natural Resources of PRC on January 9, 2020, which came into effect on May 1, 2020, privately owned enterprises are allowed to participate in the natural gas production. The Company plans to proceed with its applications for the natural gas and brine project approvals with related government departments until after the governmental planning has been finalized the land and resource planning for Sichuan Province. As a result of our acquisitions of SCHC and SYCI, our historical consolidated financial statements and the information presented below reflects the accounts of SCHC, SYCI and DCHC, the consolidated financial statements and the information presented below as of and for the year ended December 31, 2021. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this report. On January 28, 2020 we completed a 1-for-5 reverse stock split of our common stock, such that for each five shares outstanding prior to the stock split there was one share outstanding after the reverse stock split. All shares of common stock referenced in this report have been adjusted to reflect the stock split figures. 32 RESULTS OF OPERATIONS. Year ended December 31, 2021 as compared to year ended December 31, 2020 Years ended December 31, 2021 December 31, 2020 Percent Change Increase/ (Decrease) Net Revenue $ 55,030,586 $ 28,207,024 95 % Cost of Net Revenue $ (27,132,372 ) $ (19,415,034 ) 40 % Gross Profit $ 27,898,214 $ 8,791,990 217 % Sales, Marketing and Other Operating Expense $ (62,964 ) $ (42,663 ) 48 % Direct labor and factory overheads incurred during plant shutdown $ (10,718,605 ) $ (8,170,390 ) 31 % General and Administrative Expenses $ (9,525,235 ) $ (10,239,943 ) (7 %) Other Operating Expense $ (2,380,540 ) $ (22,386 ) 10534 % Profit from Operations $ 5,210,870 $ (9,683,392 ) (154 %) Other Income, Net $ 162,230 $ 154,877 5 % Loss before Taxes $ 5,373,500 $ (9,528,515 ) (156 %) Income Tax Expense (Benefit) $ (6,298,218 ) $ 1,108,471 (668 %) Net loss $ (924,718) $ (8,420,044 ) (89 %) Net Loss of $924,718 was mainly due to:(1) the depreciation expense of $4,303,266 incurred for bromine factory No.2, No.8 and No.10 for year 2021;(2) the offset of $2,723,189 to deferred tax assets for SCHC and SYCI; and (3) the compensation costs $3,134,080 for shares issued to company employees, officers and consultant for year 2021. If we do not consider these unexpected nonrecurring and non-operational factors, and the impairments and write-offs for total $10,160,535, our net income would be adjusted back to $9,235,817 for fiscal year 2021. Net Revenue The table below shows the changes in net revenue in the respective segment of the Company for the fiscal year 2021 compared to the same period in 2020: Net Revenue by Segment Year Ended Year Ended Percent Increase (Decrease) December 31, 2021 December 31, 2020 of Net Revenue Segment % of total % of total Bromine $ 48,871,396 88.9 % $ 25,184,808 89 % 78 % Crude Salt 6,080,242 11 % 3,022,216 11 % 101 % Chemical Products — — — — — Natural Gas — — — — — Equipment Lease 78,948 0.1 % 100 % Total sales $ 55,030,586 100 % $ 28,207,024 100 % 95 % Years Ended December 31 Percent Change Bromine and crude salt segments product sold in tonnes 2021 2020 Increase Bromine (excluded volume sold to SYCI) 7,379 5,957 24 % Crude Salt 181,720 174,722 4 % 33 Year Ended Percentage Natural gas segments product sold in cubic metre December 31, 2021 December 31, 2020 Change Decrease Natural Gas — — — Bromine segment Net revenue from our bromine segment increased by 78% to $48,871,396 for the year ended December 31, 2021, compared to $25,184,808 for the year ended December 31, 2020. This increase was due to the 24% increase in tonnes sold and a 57% increase in average selling price. Crude salt segment Net revenue from our crude salt segment increased by 101% to $6,080,242 for the year ended December 31, 2021 compared $3,022,216 for the same period in 2020. This increase was due to increases in crude salt unit price. Chemical products segment For the years ended December 31, 2021 and December 31, 2020, the net revenue for the chemical products segment was $0 due to the closure of our chemical factories since September 1, 2017. 34 Natural gas segment For the years ended December 31, 2021, and December 31, 2020, the net revenue for the natural gas was $0. Equipment Lease For the year ended December 31, 2021, the net revenue for the equipment lease was $78,948. Cost of Net Revenue Cost of Net Revenue by Segment % Change Year Ended Year Ended of Cost of December 31, 2021 December 31, 2020 Net Revenue Segment % of total % of total Bromine $ 22,848,348 84 % $ 15,950,812 82 % 43 % Crude Salt 4,284,024 16 % 3,464,222 18 % 27 % Chemical Products — — — — — Natural Gas — — — — — Total $ 27,132,372 100 % $ 19,415,034 100 % 40 % Cost of net revenue reflects mainly the raw materials consumed and the direct salaries and benefits of staff engaged in the production process, electricity, depreciation and amortization of manufacturing plant and machinery and other manufacturing costs. Our cost of net revenue was $27,132,372 for the year ended December 31, 2021, an increase of $7,717,338(or 40%) as compared to the same period in 2020 due to the increase of net revenue by 95% for the year ended December 31, 2021 as compared to the same period in 2020 . Bromine production capacity and utilization of our factories The table below represents the annual capacity and utilization ratios for all of our bromine producing properties: Annual Production Capacity (in tonnes) Utilization Ratio (i) Fiscal year 2021 31,506 25 % Fiscal year 2020 31,506 24 % Variance of the fiscal year 2021 and 2020 0 (1 %) (i) Utilization ratio is calculated based on the annualized actual production volume in tonnes for the periods divided by the annual production capacity in tonnes. Bromine segment For the year ended December 31, 2021 the cost of net revenue for the bromine segment was $22,848,348. For the year ended December 31, 2020 the cost of net revenue for the bromine segment was $15,950,812. Crude salt segment For the year ended December 31, 2021 the cost of net revenue for the crude salt segment was $4,284,024.The cost of net revenue for our crude salt segment for the year ended December 31, 2020 was $3,464,222. Chemical products segment Cost of net revenue for our chemical products segment for the fiscal year 2021 and 2020 was $0. Natural gas segment Cost of net revenue for our natural gas segment for the year ended December 31, 2021 and 2020 was $0. 35 Gross Profit. Gross profit was $27,898,214, or 51%, of net revenue for the year ended December 31, 2021 compared to $8,791,990, or 31%, of net revenue for the same period in 2020. Gross Profit (Loss) by Segment % Point Change Year Ended Year Ended of Gross December 31, 2021 December 31, 2020 Profit Margin Segment Gross Profit (loss) Margin Gross Profit (loss) Margin Bromine $ 26,023,048 53 % $ 9,233,996 37 % 16 % Crude Salt 1,796,218 30 % (442,006 ) (15 %) 45 % Chemical Products — — — — — Natural Gas — — — — — Equipment Lease 78,948 100 % — — 100 % Total Gross Profit $ 27,898,214 51 % $ 8,791,990 31 % 20 % Bromine segment For the year ended December 31, 2021, the gross profit margin for our bromine segment was 53%, representing a 16% increase. This increase was primarily attributable to the higher average selling price of bromine of $6,623 per ton in the year ended December 31, 2021 compared to $4,228 per ton in the year ended December 31, 2020. For the year ended December 31, 2020, the gross profit margin for our bromine segment was 37%. Crude salt segment For the year ended December 31, 2021, the gross profit margin for our crude salt segment was 30%, compared to (15%) in the year ended December 31, 2020, representing a 45% increase. This increase was primarily attributable to the higher average selling price of crude salt of $34 per ton in the year ended December 31, 2021 compared to $17 per ton in the year ended December 31, 2020. Direct labor and factory overheads incurred during plant shutdown. On September 1, 2017, the Company received notification from the government of Yangkou County, Shouguang City of PRC stating that production at all its bromine and crude salt and chemical factories should be halted with immediate effect in order for the Company to perform rectification and improvement in accordance with the county’s new safety and environmental protection requirements. On November 24, 2017, the Company received a letter from the Government of Yangkou County, Shouguang City notifying the Company to relocate its two chemical production plants located in the second living area of the Qinghe Oil Extraction Plant to Bohai Park. As such, direct labor and factory overhead costs (including depreciation of plant and machinery) amounted $10,718,605 and $8,170,390 for fiscal years 2021 and 2020, which were presented as operating expenses instead of in cost of revenue. The increase in direct labor and factory overhead costs was primarily attributable to the factories operation status during the fiscal year 2021 and year 2020, respectively. These four factories ( including No.1,No.4,No.7 and No.9)were in production during the year 2021,;but Factory No. 4 and Factory No.9 resumed production in May 2020.The depreciation cost for Factories No.2, No.8, and No.10 in 2021 were $4,303,266 General and Administrative Expenses. General and administrative expenses were $9,525,235 for the year ended December 31, 2021, representing a decrease of $714,708 (or 7%) as compared to$10,239,943 for the same period in 2020. 36 Profit from Operations. Operating profits were $5,210,870 for the fiscal year 2021, compared to a loss of $9,683,392 in the same period in 2020. Income (loss) from Operations by Segment Year ended December 31, 2021 Year ended December 31, 2020 Segment: % of total % of total Bromine $ 13,364,649 140 % $ 1,616,542 (33 %) Crude Salt $ (1,078,320 ) (11 %) $ (3,589,494 ) 73 % Chemical Products $ (2,550,561 ) (27 %) $ (2,745,297 ) 56 % Natural Gas $ (167,139 ) (2 %) $ (204,514 ) 4 % Profit (Loss) from operations before corporate costs $ 9,568,629 100 % $ (4,922,763 ) 100 % Corporate costs $ (3,575,099 ) $ (2,928,603 ) Unrealized gain (loss) on translation of intercompany balance $ (782,660 ) $ (1,832,026 ) Profit (loss) from operations $ 5,210,870 $ (9,683,392 ) Bromine segment Income from operations from our bromine segment was $13,364,649 for the fiscal year 2021, compared to an income of $1,616,542 in the same period in 2020. Crude salt segment Loss from operations from our crude salt segment was $1,078,320 for fiscal year 2021, compared to a loss of $3,589,494 in the same period in 2020. Chemical products segment Loss from operations from our chemical products segment was $2,550,561 for the fiscal year 2021, compared to a loss of $2,745,297 in the same period in 2020. Natural gas segment Loss from operations from our natural gas segment was $167,139 for the fiscal year 2021, compared to a loss of $204,514 in the same period in 2020. Other Income, Net . Other income, net, which represent bank interest income, net of finance lease interest expense was $162,630 for the fiscal year 2021, an increase of $7,751 (or approximately 5%) as compared to the same period in 2020. Net Income (loss). Net loss was $924,718 for the fiscal year 2021, compared to net loss of $8,420,044 in the same period in 2020. This decrease in the net loss was mainlydue to the higher selling price for bromine in fiscal year 2021 compared to year 2020. . Effective Tax Rate. Our effective income tax (expense) benefit rate for the fiscal years 2021 and 2020 were a expense of 117% and a benefit of 12% respectively. The effective tax rate for the fiscal years 2021 was higher than the PRC statutory income tax rate of 25% mainly due to a non-deductible item in connection with the unrealized exchange loss and an increase in valuation allowance recorded for deferred tax assets arising from net operating losses of the parent company. 37 LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2021, cash and cash equivalents were $95,767,263 as compared to $94,222,538 as of December 31, 2020. The components of this increase of $1,544,725 are reflected below. Statement of Cash Flows Years Ended December 31 2021 2020 Net cash (used in) provided by operating activities $ 23,311,169 $ 9,305,627 Net cash used in investing activities $ (30,093,140 ) $ (21,719,369 ) Net cash used in financing activities $ (290,597 ) $ (264,976 ) Effects of exchange rate changes on cash and cash equivalents $ 8,617,293 $ 6,599,270 Net increase in cash and cash equipment $ 1,544,725 $ (6,079,448 ) For the fiscal years 2021 and 2020, we met our working capital and capital investment requirements by using cash flows from operations and cash on hand. Net Cash Provided by Operating Activities During the year ended December 31, 2021, cash flows provided by operating activities of approximately $23.3 million was mainly due to non-cash adjustments related to depreciation and amortization of property, plant and equipment of $21 million, unrealized translation loss of $0.8 million and stock-based compensation expense of $3.1 million reduced by net loss of $6.1 million. During the year ended December 31, 2020, cash flows provided by operating activities of approximately $8.3 million was mainly due to non-cash adjustments related to depreciation and amortization of property, plant and equipment of $16.0 million, unrealized translation loss of $1.8 million and stock-based compensation expense of $2.4 million reduced by net loss of $8.4 million. Accounts receivable Cash collections on our accounts receivable had a major impact on our overall liquidity. The following table presents the aging analysis of our accounts receivable as of December 31, 2021 and 2020. December 31, 2021 December 31, 2020 % of total % of total Aged 1-30 days $ 4,097,207 28 % $ 3,801,417 58 % Aged 31-60 days 5,164,840 36 % 2,720,381 42 % Aged 61-90 days 5,263,760 36 % — — Aged 91-120 days — — — — Aged 121-150 days — — — — Aged 151-180 days — — — — Aged 181-210 days — — — — Aged 211-240 days — — — — Total $ 14,525,807 100 % $ 6,521,798 100 % The overall accounts receivable balance as of December 31, 2021 increased by $8,004,009, as compared to those of December 31, 2020. We have policies in place to ensure that sales are made to customers with an appropriate credit history. We perform ongoing credit evaluation on the financial condition of our customers. All receivables were collected in the January through March in 2022. 38 Inventory Our inventory consists of the following: December 31, 2021 December 31, 2020 % of total % of total Raw materials $ 42,553 6 % $ 21,484 5 % Finished goods 648,558 94 % 398,125 95 % Total $ 691,111 100 % $ 419,609 100 % The net inventory level as of December 31, 2021 increased by $271,502, as compared to the net inventory level as of December 31, 2020. Raw materials increased by $21,069 as of December 31, 2021 as compared to December 31, 2020. Finished goods increased by $250,433 as of December 31, 2021 as compared to December 31, 2020. Net Cash Used In Investing Activities For the fiscal year 2021, we used approximately $30 million for investing activities. For the fiscal year 2020, we used approximately $22 million to acquire property, plant and equipment for the chemical factory. Net Cash Used In Financing Activities We have no major financing activities for the year ended December 31, 2021. We believe that our available funds and cash flows generated from operations will be sufficient to meet our anticipated ongoing operating needs for the next twelve months. We had available cash of approximately $96 million at December 31, 2021, all of which is in highly liquid current deposits which earn no or little interest. We do not anticipate paying cash dividends in the foreseeable future. We intend to continue to focus our efforts on the activities of SCHC, SYCI and DCHC as these segments continue to expand within the Chinese market. We may not be able to identify, successfully integrate or profitably manage any businesses or business segment we may acquire, or any expansion of our business. An expansion may involve a number of risks, including possible adverse effects on our operating results, diversion of management’s attention, inability to retain key personnel, risks associated with unanticipated events and the financial statement effect of potential impairment of acquired intangible assets, any of which could have a materially adverse effect on our condition and results of operations. In addition, if competition for acquisition candidates or operations were to increase, the cost of acquiring businesses could increase materially. We may effect an acquisition with a target business which may be financially unstable, under-managed, or in its early stages of development or growth. Our inability to implement and manage our expansion strategy successfully may have a material adverse effect on our business and future prospects. Contractual Obligations and Commitments We have no significant contractual obligations not fully recorded on our consolidated balance sheets or fully disclosed in the notes to our consolidated financial statements. Additional information regarding our contractual obligations and commitments at December 31, 2021 is provided in the notes to our consolidated financial statements. See “Notes to Consolidated Financial Statements, Note 19 - Capital Commitment and Other Service Contractual Obligations.” 39 Material Off-Balance Sheet Arrangements We do not currently have any off-balance sheet arrangements falling within the definition of Item 303(a) of Regulation S-K. Critical Accounting Policies and Estimates Our Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), which requires us to make judgments, estimates and assumptions. See “Note 1 – Nature of Business and Summary of Significant Accounting Policies,” in Notes to the Consolidated Financial Statements, which is included in “Item 8. Financial Statements and Supplementary Data,” which describes our significant accounting policies and methods used in the preparation of our Consolidated Financial Statements. The methods, estimates and judgments that we use in applying our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our most critical estimates include: · allowance for doubtful accounts, which impacts revenue; · the valuation of inventory, which impacts gross margins; · impairment of long-lived assets; · the valuation and recognition of share-based compensation, which impacts operating expenses; and · the recognition and measurement of deferred income taxes, which impact our provision for taxes. Allowance for Doubtful Accounts We make estimates of the uncollectibility of accounts receivable, especially analyzing accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms, when evaluating the adequacy of the allowance for doubtful accounts. Credit evaluations are undertaken for all major sale transactions before shipment is authorized. On a quarterly basis, we evaluate aged items in the accounts receivable aging report and provide an allowance in an amount we deem adequate for doubtful accounts. If management were to make different judgments or utilize different estimates, material differences in the amount of our reported operating expenses could result. Inventory Valuation Inventory is stated at the lower of cost or market, with cost determined on a first-in first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated market value based upon assumptions about future demand. We evaluate the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required in the future, which could have a material adverse effect on our results of operations. Depreciation of Property, Plant and Equipment Property, plant and equipment are stated at cost less accumulated depreciation and any impairment losses. Expenditures for new facilities or equipment, and major expenditures for betterment of existing facilities or equipment are capitalized and depreciated using the straight-line method at rates sufficient to depreciate such costs over the estimated productive lives. All other ordinary repair and maintenance costs are expensed as incurred. Mineral rights are recorded at cost less accumulated depreciation and any impairment losses. Mineral rights are amortized ratably over the term of the lease, or the equivalent term under the units of production method, whichever is shorter. In some situations, the life of the asset may be extended or shortened if circumstances arise that would lead us to believe that the estimated life of the asset has changed. The life of leasehold improvements may change based on the extension of lease contracts with our landlords. Changes in the estimated lives of assets will result in an increase or decrease in the amount of depreciation recognized in future periods. 40 Impairment of Long Lived Assets We periodically evaluate whether events or circumstances have occurred that indicate long-lived assets may not be recoverable or that the remaining useful life may warrant revision. When such events or circumstances are present, we assess the recoverability of long-lived assets by determining whether the carrying value will be recovered through the expected undiscounted future cash flows resulting from the use of the asset. In the event the sum of the expected undiscounted future cash flows is less than the carrying value of the asset, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded. Valuation Allowance on Deferred Tax Assets We evaluate our deferred income tax assets to determine if valuation allowances are required or should be adjusted. A valuation allowance is established against our deferred tax assets based on consideration of all available evidence, both positive and negative, using a “more likely than not” standard. This assessment considers, among other matters, the nature, frequency and severity of recent losses, forecasts of future profitability, the duration of statutory carry forward periods, our experience with expiring unused tax attributes and tax planning alternatives. In making such judgments, significant weight is given to evidence that can be objectively verified. Stock-based compensation We account for stock-based compensation in accordance with the fair value recognition provisions of U.S. GAAP. We use the Black-Scholes model which requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them, the estimated volatility of our common stock price over the expected term and the number of options that will ultimately not complete their vesting requirements. The assumptions for expected volatility and expected term are the two assumptions that significantly affect the grant date fair value. Changes in expected risk-free rate of return do not significantly impact the calculation of fair value, and determining this input is not highly subjective. We use annualized historical stock price volatility which is deemed to be appropriate to serve as the expected volatility of our stock price and is assumed to be constant and prevailing. The expected term represents the weighted-average period that our stock options are expected to be outstanding. The expected life is based on historical option exercise pattern. Recent Accounting Pronouncements See “Note 1 – Nature of Business and Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data for a full description of recent accounting pronouncements including the respective expected dates of adoption and effects on the consolidated financial statements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk. Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1).