NORTECH SYSTEMS INC 10-K

Item 8. Financial Statements and Supplementary Data PAGE Report of Independent Registered Public Accounting Firm 25 Consolidated Financial Statements: Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2020 and 2019 26 Consolidated Balance Sheets as of December 31, 2020 and 2019 27 Consolidated Statements of Cash Flows for the years ended December 31, 2020 and 2019 28 Consolidated Statements of Shareholders' Equity for the years ended December 31, 2020 and 2019 29 Notes to Consolidated Financial Statements 30-50 (The remainder of this page was intentionally left blank.) 27 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the shareholders and the board of directors of Nortech Systems Incorporated: Opinion on the Consolidated Financial Statements We have audited the accompanying consolidated balance sheets of Nortech Systems Incorporated and subsidiaries (the "Company") as of December 31, 2020 and 2019, and the related consolidated statements of operations and comprehensive income (loss), shareholders' equity, and cash flows, for the years then ended, and the related notes (collectively referred to as the "consolidated financial statements"). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Basis for Opinion These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's consolidated 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 the 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 consolidated 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 consolidated 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 consolidated 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 consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of this critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. Critical Audit Matter Description Goodwill Impairment Evaluation – Refer to Notes 1 and 4 to the consolidated financial statements As discussed in Note 1 and Note 4 to the consolidated financial statements, goodwill is tested for impairment on the basis of the Company’s single reporting unit at least annually, or more frequently as events occur or circumstances change. On October 1, 2020, the Company performed its annual quantitative impairment test and recorded an impairment charge of $2,375,000. In connection with the quantitative impairment test, the Company reassessed its reporting units and concluded the Company, as a whole, is a single reporting unit. The Company views its operations and manages its business as one operating segment since the restructuring of Devicix in 2020. Prior to 2020, the Company had two reporting units, the Electronic Manufacturing Services and Devicix reporting units. In performing the impairment test, management’s third-party valuation specialist calculated the fair value of the reporting unit using a market approach and a discounted cash flow approach to determine the estimated fair value of the Company. The Company placed a 100% weighting on the discounted cash flow method, as they determined the results of the market approach were not representative of the Company, as there were no peer companies comparable to the Company in terms of size, profitability and product diversification. Management concluded goodwill was fully impaired as the difference between the carrying value and fair value of the reporting unit was more than the amount of goodwill recorded. Auditing management's goodwill impairment test was complex and highly judgmental due to the significant estimation required in the reassessment of the Company’s reporting unit and in the estimation of the fair value of the Company’s single reporting unit. In particular, the fair value estimate was sensitive to significant assumptions, such as changes in the Company's financial forecast, the discount rate, risk-free rate, weighted-average cost of capital, equity risk premium and terminal growth rate, which are affected by expectations about future market or economic conditions, including uncertainty resulting from the COVID-19 pandemic. How the Critical Audit Matter was Addressed in the Audit The primary procedures we performed to address this critical audit matter included: ● Obtained an understanding of the design and implementation of internal controls relating to the evaluation of the assumptions and inputs used to estimate the fair value of the Company's single reporting unit, including controls addressing: o Management’s review of the accuracy and reasonableness of the prospective financial information used in the discounted cash flow analysis. 28 o Management’s evaluation and controls over identifying the single reporting unit. o Management's evaluation of the key assumptions and inputs used by a third-party valuation specialist, including discount rate, risk-free rate, weighted-average cost of capital, equity risk premium and terminal growth rate used to determine fair value. o Management’s controls over the completeness and accuracy of the data and assumptions used. ● Substantively testing, with the assistance of firm personnel with experience in the application of fair value and valuation methodologies, the appropriateness of the judgments and assumptions used in management’s estimation process for determining the fair value of the Company's single reporting unit including: o Testing the mathematical accuracy of the calculations performed along with assessing the completeness of the information used in the calculation. o Evaluating the appropriateness of the valuation methodologies used, as well as the discount rate, risk-free rate, weighted-average cost of capital, equity risk premium, terminal growth rate, and overall reasonableness of the fair value calculation. o Comparing the significant assumptions used by management to current industry and economic trends, current and historical performance of the Company, and other relevant factors. o Compared the fair value of the reporting unit to the Company's enterprise value to coooborate a full impairment was appropriate. /s/ Baker Tilly US, LLP We have served as the Company's auditor since 2017. Minneapolis, Minnesota March 23, 2021 29 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE DATA) 2020 2019 Net Sales $ 104,106 $ 116,333 Cost of Goods Sold 95,651 103,757 Gross Profit 8,455 12,576 Operating Expenses: Selling Expenses 2,474 2,723 General and Administrative Expenses 8,043 9,629 Impairment of Goodwill 2,375 - Gain on Sale of Property and Equipment (3,821 ) - Total Operating Expenses 9,071 12,352 (Loss) Income From Operations (616 ) 224 Other Expense Interest Expense (620 ) (1,043 ) Loss Before Income Taxes (1,236 ) (819 ) Income Tax Expense 310 409 Net Loss $ (1,546 ) $ (1,228 ) Loss Per Common Share: Basic $ (0.58 ) $ (0.46 ) Weighted Average Number of Common Shares Outstanding - Basic 2,657,738 2,665,165 Diluted $ (0.58 ) $ (0.46 ) Weighted Average Number of Common Shares Outstanding - Dilutive 2,657,738 2,665,165 Other comprehensive income (loss) Foreign currency translation 220 (24 ) Comprehensive loss, net of tax $ (1,326 ) $ (1,252 ) See accompanying notes to consolidated financial statements 30 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET AS OF DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE DATA) ASSETS 2020 2019 Current Assets Cash $ 352 $ 351 Restricted Cash 3,212 309 Accounts Receivable, less allowances of $343 and $335 15,625 18,558 Inventories, net 13,917 14,279 Contract Assets 5,899 7,659 Prepaid Assets and Other Current Assets 2,032 2,128 Total Current Assets 41,037 43,284 Property and Equipment, Net 6,426 9,581 Operating Lease Assets 8,998 4,827 Goodwill - 2,375 Other Intangible Assets, Net 1,173 1,343 Total Assets $ 57,634 $ 61,410 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Current Portion of Long-Term Debt $ 1,204 $ 444 Current Portion of Finance Lease Obligations 660 557 Current Portion of Operating Leases 688 858 Accounts Payable 11,239 14,014 Accrued Payroll and Commissions 2,870 3,493 Other Accrued Liabilities 2,875 2,866 Total Current Liabilities 19,536 22,232 Long-Term Liabilities Long-term Line of Credit 3,328 10,088 Long-Term Debt, Net of Current Maturities 5,865 3,179 Long-Term Finance Lease Obligations, Net of Current Portion 1,152 1,451 Long-Tem Operating Lease Obligations, Net of current Portion 8,889 4,366 Other Long-Term Liabilities 146 118 Total Long-Term Liabilities 19,380 19,202 Total Liabilities 38,916 41,434 Shareholders' Equity Preferred Stock, $1 par value; 1,000,000 Shares Authorized; 250,000 Shares Issued and Outstanding 250 250 Common Stock - $0.01 par value; 9,000,000 Shares Authorized; 2,659,628 and 2,657,530 Shares Issued and Outstanding, respectively 27 27 Additional Paid-In Capital 15,816 15,748 Accumulated Other Comprehensive Loss (37 ) (257 ) Retained Earnings 2,662 4,208 Total Shareholders' Equity 18,718 19,976 Total Liabilities and Shareholders' Equity $ 57,634 $ 61,410 See accompanying notes to consolidated financial statements 31 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS) 2020 2019 CASH FLOWS FROM OPERATING ACTIVITIES Net Loss $ (1,546 ) $ (1,228 ) Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: Depreciation 2,002 1,926 Amortization 191 295 Compensation on Stock-Based Awards 68 261 Compensation on Equity Appreciation Rights 108 - Loss on Goodwill Impairment 2,375 - Deferred Taxes - 20 Change in Accounts Receivable Allowance 8 113 Change in Inventory Reserves 672 374 (Gain) loss on Disposal of Property and Equipment (3,821 ) 32 Changes in Current Operating Items Accounts Receivable 3,019 1,413 Inventories (216 ) 2,344 Contract Assets 1,760 (1,228 ) Prepaid Expenses and other Curent Assets 651 (1,015 ) Income Taxes (675 ) 401 Accounts Payable (2,950 ) (3,680 ) Accrued Payroll and Commissions (623 ) 746 Other Accrued Liabilities 340 223 Net Cash Provided by Operating Activities 1,363 997 CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from Sale of Property and Equipment 6,019 - Purchase of Intangible Asset (34 ) (39 ) Purchases of Property and Equipment (485 ) (719 ) Net Cash Provided by (Used in) Investing Activities 5,500 (758 ) CASH FLOWS FROM FINANCING ACTIVITIES Net Change in Line of Credit (6,760 ) 823 Proceeds from Long-Term Debt 6,077 - Principal Payments on Long-Term Debt (2,684 ) (856 ) Principal Payments on Financing Leases (592 ) (369 ) Stock Option Excercises - 7 Share Repurchases - (130 ) Net Cash Used in Financing Activities (3,959 ) (525 ) Effect of Exchange Rate Changes on Cash - (1 ) Net Change in Cash 2,904 (287 ) Cash - Beginning of Year 660 947 Cash - End of Year $ 3,564 $ 660 Reconciliation of cash and restricted cash reported within the consolidated balance sheets Cash $ 352 $ 351 Restricted Cash 3,212 309 Total Cash and restricted cash reported in the consolidated statements of cash flows $ 3,564 $ 660 Supplemental Disclosure of Cash Flow Information: Cash Paid for Interest $ 577 $ 980 Cash Paid for Income Taxes 855 194 Supplemental Noncash Investing and Financing Activities: Property and Equipment Purchases in Accounts Payable 175 4 Property Acquired under Operating Lease 4,999 - Equipment Acquired under Finance Lease $ 395 $ 1,089 See accompanying notes to consolidated financial statements 32 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS) Accumulated Additional Other Total Preferred Common Paid-In Comprehensive Retained Shareholders' Stock Stock Capital (Loss) Earnings Equity BALANCE DECEMBER 31, 2018 $ 250 $ 27 $ 15,610 $ (233 ) $ 5,436 $ 21,090 Net Loss - - - - (1,228 ) (1,228 ) Foreign Currency Translation Adjustment - - - (24 ) - (24 ) Compensation on Stock-based awards - - 268 - - 268 Share repurchases - - (130 ) - - (130 ) BALANCE DECEMBER 31, 2019 250 27 15,748 (257 ) 4,208 19,976 Net Loss - - - - (1,546 ) (1,546 ) Foreign currency translation adjustment - - - 220 - 220 Compensation on stock-based awards - - 68 - - 68 BALANCE DECEMBER 31, 2020 $ 250 $ 27 $ 15,816 $ (37 ) $ 2,662 $ 18,718 See accompanying notes to consolidated financial statements 33 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements of Nortech Systems, Incorporated and Subsidiaries (“the Company”, “we”, “our”) have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Nature of Business Our manufacturing services include complete medical devices, printed circuit board assemblies, wire and cable assemblies, and complex higher-level electromechanical assemblies for a wide range of medical, industrial and defense and aerospace industries. We provide a full "turn-key" contract manufacturing service to our customers. All products are built to the customer's design specifications. We also provide engineering services and repair services. Our manufacturing facilities are located in Bemidji, Blue Earth, Merrifield, Milaca, and Mankato, Minnesota as well as, Monterrey, Mexico and Suzhou, China. Products are sold to customers both domestically and internationally. Principles of Consolidation The consolidated financial statements include the accounts of Nortech Systems Incorporated and its wholly-owned subsidiaries, Manufacturing Assembly Solutions of Monterrey, Inc. and Nortech Systems Hong Kong Company, Limited and its subsidiary, Nortech Systems Suzhou Company, Limited. All significant intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Estimates also affect the reported amounts of revenue and expense during the reporting period. Significant items subject to estimates and assumptions include the valuation allowance for inventories, allowance for doubtful accounts, realizability of deferred tax assets, goodwill impairment and long-lived asset impairment testing. Actual results could differ from those estimates. Restricted Cash Cash and cash equivalents classified as restricted cash on our consolidated balance sheets are restricted as to withdrawal or use under the terms of certain contractual agreements. The December 31, 2020 balance included cash collateral required to be held against our corporate employee purchasing card program and lockbox deposits that are temporarily restricted due to timing at the period end. The lockbox deposits are applied against our line of credit the next business day. As of December 31, 2020 we had outstanding letters of credit for $500 in total to Essjay Bemidji Holdings, LLC and Essjay Mankato Holdings, LLC. Restricted cash as of December 31, 2020 and December 31, 2019 was $3,212 and $309, respectively. Accounts Receivable and Allowance for Doubtful Accounts We grant credit to customers in the normal course of business. Accounts receivable are unsecured and are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts was $343 and $335 at December 31, 2020 and 2019, respectively. We determine our allowance by considering a number of factors, including the length of time accounts receivable are past due, our previous loss history, the customers’ current ability to pay their obligations to us, and the condition of the general economy and the industry as a whole. We write-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. 34 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Inventories Inventories consist of finished goods, raw materials and work-in-process and are stated at the lower of average cost (which approximates first-in, first-out) or net realizable value. Costs include material, labor, and overhead required in the production of our products. Inventory reserves are maintained for inventories that may have a lower value than stated or quantities in excess of future production needs. We regularly review inventory quantities on-hand for excess and obsolete inventory and, when circumstances indicate, incur charges to write down inventories to their net realizable value. The determination of a reserve for excess and obsolete inventory involves management exercising judgment to determine the required reserve, considering future demand, product life cycles, introduction of new products and current market conditions. Inventories are as follows: 2020 2019 Raw materials $ 14,865 $ 15,245 Work in process 969 479 Finished goods 242 41 Reserves (2,159 ) (1,486 ) Total $ 13,917 $ 14,279 Property and Equipment Property and equipment are stated at cost less accumulated depreciation. Additions, improvements and major renewals are capitalized, while maintenance and minor repairs are expensed as incurred. When assets are retired or disposed of, the assets and related accumulated depreciation are removed from the accounts and the resulting gain or loss is reflected in operations. Leasehold improvements are depreciated over the shorter of their estimated useful lives or their remaining lease terms. All other property and equipment are depreciated by the straight-line method over their estimated useful lives, as follows: Buildings (in years) 39 Leasehold improvements (in years) 3-15 Manufacturing equipment (in years) 3-7 Office and other equipment (in years) 3-7 35 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Property and equipment at December 31, 2020 and 2019: 2020 2019 Land $ 176 $ 360 Building and Leasehold Improvements 5,999 9,660 Manufacturing Equipment 22,685 21,908 Office and Other Equipment 7,148 7,192 Accumulated Depreciation and Amortization (29,582 ) (29,539 ) Total Property and Equipment, Net $ 6,426 $ 9,581 Goodwill and Other Intangible Assets In accordance with ASC 350, Goodwill and Other Intangible Assets, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. We test impairment annually as of October 1st. In testing goodwill for impairment, we perform a quantitative or qualitative impairment test, including computing the fair value of the reporting unit and comparing that value to its carrying value. If the fair value is less than its carrying value, then the goodwill is determined to be impaired. In the event that goodwill is impaired, an impairment charge to earnings would become necessary. To the extent the carrying amount of goodwill exceeds the implied goodwill, the difference is the amount of the goodwill impairment. Prior to completing the quantitative analysis described above, we have the option to perform a qualitative assessment of goodwill for impairment to determine whether it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If we conclude the fair value is more likely than not less than the carrying value, we perform the quantitative analysis. Otherwise, no further testing is needed. Long-Lived Asset Impairment We evaluate long-lived assets, primarily property and equipment, as well as the related depreciation periods, whenever current events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Recoverability for assets to be held and used is based on our projection of the undiscounted future operating cash flows of the underlying assets or asset group. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge might be required to reduce the carrying amount to equal estimated fair value. Assets held for sale are reported at the lower of the carrying amount or fair value less costs to dispose. 36 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Preferred Stock Preferred stock issued is non-cumulative and nonconvertible. The holders of the preferred stock are entitled to a non-cumulative dividend of 12% when and if declared. In liquidation, holders of preferred stock have preference to the extent of $1.00 per share plus dividends accrued but unpaid. No preferred stock dividends were declared or paid during the years ended December 31, 2020 and 2019. Revenue Recognition Our revenue is comprised of product, engineering services and repair services. All revenue is recognized when the Company satisfies its performance obligation(s) under the contract by transferring the promised product or service to our customer either when (or as) our customer obtains control of the product or service, with the majority of our revenue being recognized over time including goods produced under contract manufacturing agreements and services revenue. A performance obligation is a promise in a contract to transfer a distinct product or service to a customer. A contract’s transaction price is allocated to each distinct performance obligation. The majority of our contracts have a single performance obligation. Revenue is recorded net of returns, allowances and customer discounts. Our net sales for services were less than 10% of our total sales for all periods presented, and accordingly, are included in net sales in the Consolidated Statements of Operations and Comprehensive Loss. Sales, value add, and other taxes collected from customers and remitted to governmental authorities are accounted for on a net (excluded from revenues) basis. Shipping and handling costs charged to our customers are included in net sales, while the corresponding shipping expenses are included in cost of goods sold. Product Warranties We provide limited warranty for the replacement or repair of defective product within a specified time period after the sale at no cost to our customers. We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including, without limitation, warranties to merchantability, fit for a particular purpose or non-infringement of patent or the like unless agreed upon in writing. We estimate the costs that may be incurred under our limited warranty and provide a reserve based on actual historical warranty claims coupled with an analysis of unfulfilled claims at the balance sheet date. Our warranty claim costs are not material given the nature of our products and services. Advertising Advertising costs are charged to operations as incurred. The total amount charged to expense was $42 and $101 for the years ended December 31, 2020 and 2019, respectively. Income Taxes We account for income taxes under the asset and liability method. Deferred income tax assets and liabilities are recognized annually for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. We recognize interest and penalties accrued on any unrecognized tax benefits as a component on income tax expense. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. Management must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. Our estimates are based on the information available to us at the time we prepare the income tax provisions. Our income tax returns are subject to audit by federal, state, and local governments, generally three years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws. 37 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Incentive Compensation We use a Black-Scholes option-pricing model to determine the grant date fair value of our incentive awards and recognize the expense on a straight-line basis over the vesting period. See Note 8 for additional information. Net Income (Loss) Per Common Share Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding. Dilutive net income (loss) per common share assumes the exercise and issuance of all potential common stock equivalents in computing the weighted-average number of common shares outstanding, unless their effect is antidilutive. There were no dilutive shares in the years ended 2020 or 2019 due to the net loss. Fair Value of Financial Instruments The carrying amounts of all financial instruments approximate their fair values. The carrying amounts for cash, accounts receivable, accounts payable, and accrued liabilities approximate fair value because of the short maturity of these instruments. Based on the borrowing rates currently available to us for bank loans with similar terms and average maturities, the carrying value of our long-term debt and line of credit approximates its fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value framework requires the categorization of assets and liabilities into one of three levels based on the assumptions (inputs) used in valuing the asset or liability. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. The three levels are defined as follows: Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3: Unobservable inputs for the asset or liability, reflecting the reporting entity’s own assumptions about the assumptions that market participants would use in pricing Our assessment of the significance of a particular input to the fair value measurements requires judgment and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy. We endeavor to use the best available information in measuring fair value. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. We utilized a Level 3 valuation of in our testing of goodwill as of October 1, 2020. See Note 4, Goodwill and Intangible Assets, for more detail. Enterprise-Wide Disclosures Our results of operations for the years ended December 31, 2020 and 2019 represent a single operating and reporting segment referred to as Contract Manufacturing within the EMS industry. Consolidated financial information is available that is evaluated regularly by the chief operating decision maker in assessing performance and allocating resources. 38 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Export sales from our domestic operations represent approximately 2.1% and 3.1% of consolidated net sales for the years ended December 31, 2020 and 2019, respectively. Net sales by our major EMS industry markets for the years ended December 31, 2020 and 2019 are as follows: 2020 2019 Medical $ 55,098 $ 62,612 Aerospace and Defense 20,624 18,207 Industrial 28,384 35,514 Total Net Sales $ 104,106 $ 116,333 Noncurrent assets, excluding deferred taxes, by country are as follows: United States Mexico China Total December 31, 2020 Property and equipment, net $ 5,057 $ 681 $ 688 $ 6,426 Operating Lease Assets $ 5,574 3,117 307 $ 8,998 Other assets $ 1,173 - - $ 1,173 December 31, 2019 Property and equipment, net $ 8,024 $ 961 $ 596 $ 9,581 Operating Lease Assets $ 1,213 3,425 189 $ 4,827 Other assets $ 3,718 - - $ 3,718 Foreign Currency Transactions The functional currency for our Mexico subsidiary is the US dollar. Foreign exchange transaction gains and losses attributable to exchange rate movements related to transactions made in the local currency and on intercompany receivables and payables not deemed to be of a long-term investment nature are recorded in other income (expense). The functional currency for our China subsidiary is the Renminbi (“RMB”). Assets and liabilities of the China operation are translated from RMB into U.S. dollars at period-end rates, while income and expense are translated at the weighted-average exchange rates for the period. The related translation adjustments are reflected as a foreign currency translation adjustment in accumulated other comprehensive loss within shareholders’ equity. The total foreign currency translation adjustment increased shareholders’ equity by $220, from an accumulated foreign currency translation loss of $257 as of December 31, 2019 to an accumulated foreign currency translation loss of $37 as of December 31, 2020. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the Consolidated Statements of Operations. Net foreign currency transaction losses included in the determination of net earnings was $32 and $11 for the years ended December 31, 2020 and 2019, respectively. 39 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Liquidity and Capital Resources Our 2020 sales and shipment backlog were impacted by the ongoing COVID-19 pandemic. Due to the inherent uncertainty of this evolving situation, we are unable at this time to predict the likely impact of the COVID-19 pandemic on our future operations which has led to indicators of an inability to continue as a going concern. However, these indicators have been mitigated by our focus on reducing costs, minimizing capital expenditures, and managing working capital. In addition, we believe that cash provided by operations, funds available under the credit agreement with Bank of America, N.A. (BofA), funds available under a Promissory Note with BofA (“Promissory Note”) pursuant to the Paycheck Protection Program under the Coronavirus Aid, funds received from our sales leaseback transaction and cash on hand will be adequate to meet our liquidity needs, including working capital, capital expenditures, and debt payment obligations for at least the next 12 months from the financial statement release date. Recently Issued Accounting Standards In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments. This guidance introduces a new model for recognizing credit losses on financial instruments based on an estimate of current expected credit losses. The ASU also provides updated guidance regarding the impairment of available-for-sale debt securities and includes additional disclosure requirements. The new guidance is effective for public business entities that meet the definition of a Smaller Reporting Company as defined by the SEC for interim and annual periods beginning after December 15, 2022. Early adoption is permitted. We are currently evaluating the impact of this standard on our consolidated financial statements and related disclosures. NOTE 2. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and accounts receivable. With regard to cash, we maintain our excess cash balances in checking accounts at two high-credit quality financial institutions. These accounts may at times exceed federally insured limits. We grant credit to customers in the normal course of business and do not require collateral on our accounts receivable. Our largest customer has two divisions that together accounted for 20% or more of our net sales during the year ended December 31, 2020 and 2019. One division accounted for approximately 21.2% and 19.9% of net division sales for the years ended December 31, 2020 and 2019, respectively. The second division accounted for approximately 2.2% and 2.6% of net division sales for the years ended December 31, 2020 and 2019, respectively. Together they accounted for approximately for 23.4% and 22.5% of net sales for the years ended December 31, 2020 and 2019, respectively. Accounts receivable from the customer at December 31, 2020 and 2019 represented 19.6% and 35.6% of our total accounts receivable, respectively. NOTE 3. REVENUE Revenue recognition Our revenue is comprised of product, engineering services and repair services. All revenue is recognized when the Company satisfies its performance obligation(s) under the contract by transferring the promised product or service to our customer either when (or as) our customer obtains control of the product or service, with the majority of our revenue being recognized over time including goods produced under contract manufacturing agreements and services revenue. A performance obligation is a promise in a contract to transfer a distinct product or service to a customer. A contract’s transaction price is allocated to each distinct performance obligation. The majority of our contracts have a single performance obligation, as the promise to transfer products or services is not separately identifiable from other promises in the contract and, therefore, not distinct. 40 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or providing services. As such, revenue is recorded net of returns, allowances and customer discounts. Sales, value add, and other taxes collected from customers and remitted to governmental authorities are accounted for on a net (excluded from revenues) basis. Shipping and handling costs are included in cost of goods sold. The majority of our revenue is derived from the transfer of goods produced under contract manufacturing agreements which have no alternative use and we have an enforceable right to payment for our performance completed to date. Our performance obligations within our contract manufacturing agreements are generally satisfied over time as the goods are produced based on customer specifications and we have an enforceable right to payment for the goods produced. If these requirements are not met, the revenue is recognized at a point in time, generally upon shipment. Revenue under contract manufacturing agreements that was recognized over time accounted for approximately 84% and 90% of our revenue for the years ended December 31, 2020 and 2019, respectively. Revenues under these agreements are generally recognized over time using an input measure based upon the proportion of actual costs incurred. Accounting for contract manufacturing agreements involves the use of various techniques to estimate total revenue and costs. We estimate profit on these agreements as the difference between total estimated revenue and expected costs to complete the performance obligation within the terms of the agreement and recognize the respective profit as the goods are produced. The estimates to determine the profit earned on the performance obligation are based on anticipated selling prices and historical cost of goods sold and represent our best judgement at the time. Changes in judgements on these above estimates could impact the timing and amount of revenue recognized with a resulting impact on the timing and amount of associated profit. On occasion our customers provide materials to be used in the manufacturing process and the fair value of the materials is included in revenue as noncash consideration at the point in time when the manufacturing process commences along with the same corresponding amount recorded as cost of goods sold. The inclusion of noncash consideration has no impact on overall profitability. 41 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Contract Assets Contract assets, recorded as such in the Consolidated Balance Sheet, consist of unbilled amounts related to revenue recognized over time. Significant changes in the contract assets balance during the years ended December 31, 2020 and 2019 was as follows: Outstanding at January 1, 2019 $ 6,431 Increase (decrease) attributed to: Transferred to receivables from contract assets recognized (5,180 ) Product transferred over time 6,408 Outstanding at December 31, 2019 7,659 Increase (decrease) attributed to: Transferred to receivables from contract assets recognized (6,795 ) Product transferred over time 5,035 Outstanding at December 31, 2020 $ 5,899 We expect substantially all of the remaining performance obligations for the contract assets recorded as of December 31, 2020, to be transferred to receivables within 90 days, with any remaining amounts to be transferred within 180 days. We bill our customers upon shipment with payment terms of up to 120 days. The following tables summarize our net sales by market for the years ended December 31, 2020 and 2019: Year Ending December 31, 2020 Product/ Service Transferred Over Time Product Transferred at Point in Time Noncash Consideration Total Net Sales by Market Medical $ 45,694 $ 6,398 $ 3,006 $ 55,098 Aerospace and Defense 18,948 454 1,222 20,624 Industrial 22,451 4,444 1,489 28,384 Total net sales $ 87,093 $ 11,296 $ 5,717 $ 104,106 Year Ending December 31, 2019 Product/ Service Transferred Over Time Product Transferred at Point in Time Noncash Consideration Total Net Sales by Market Medical $ 56,760 $ 3,021 $ 2,831 $ 62,612 Aerospace and Defense 16,892 462 853 18,207 Industrial 30,802 3,144 1,568 35,514 Total net sales $ 104,454 $ 6,627 $ 5,252 $ 116,333 42 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) NOTE 4. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill We evaluate the value of our goodwill annually as of October 1 st or more frequently such as when events or changes in circumstances indicate there may be an impairment. We test for impairment at the reporting unit level, which we had two reporting unit as of December 31, 2019 (Devicix and EMS) and one reporting unit (Nortech) at December 31, 2020. All of our goodwill was derived from our acquisition of the Devicix business in 2015 which was fully consolidated and managed in our Nortech (EMS) reporting unit as of October 1, 2020. We determined that we had a single reporting unit at October 1, 2020 as a result of fully integrating our former Devicix acquisition into our EMS operations which included consolidating the financial reporting and management decision making to the single reporting unit and operating as a single business. As a result, we tested goodwill for impairment at the Nortech reporting unit as of October 1, 2020. In determining the nonrecurring fair value measurements of goodwill, we utilized a discounted cash flow approach. Our discounted cash flow model includes assumptions related to our product revenue, gross margins, operating margins and other assumptions along with a weighted average cost of capital that is a combination of the risk free rate coupled with our company specific risk premium. In our goodwill impairment test as of October 1, 2020, we concluded that goodwill was impaired due to a significant reduction of results from operations during the fourth quarter of 2020 that was more than expected suggesting a greater impact of the COVID-19 pandemic and took a $2,375 impairment loss, which fully impaired our remaining goodwill. We determined there was no impairment of goodwill during the year ended December 31, 2019. The cumulative goodwill impairment loss is $3,283 and $908 as of December 31, 2020 and 2019, respectively. 43 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Other Intangible Assets Finite life intangible assets at December 31, 2020 and 2019 are as follows: December 31, 2020 Gross Accumulated Net Book Carrying Amortization Value Years Amount Amount Amount Customer Relationships 9 $ 1,302 $ 795 $ 507 Intellectual Property 3 100 100 - Trade Names 20 814 225 589 Other 7 77 - 77 Totals $ 2,293 $ 1,120 $ 1,173 December 31, 2019 Gross Accumulated Net Book Carrying Amortization Value Years Amount Amount Amount Customer Relationships 9 $ 1,302 $ 651 $ 651 Intellectual Property 3 100 95 5 Trade Names 20 814 183 631 Other 7 56 - 56 Totals $ 2,272 $ 929 $ 1,343 Amortization of finite life intangible assets was $191 and $219 for the years ended December 31, 2020 and 2019, respectively. Estimated future annual amortization expense (except projects in process) related to these assets is approximately as follows: Year Amount 2021 $ 185 2022 185 2023 185 2024 113 2025 41 Thereafter 387 Total $ 1,096 In the fourth quarter of 2020, we evaluated that there was a trigger event, largely driven by the ongoing impact of COVID-19, that indicated that the carrying amount of our long-lived assets may not be recoverable. We performed the recoverability test of our undiscounted cash flow forecast over the life of our primary asset and determined there was no impairment. We completed our qualitative assessment of our long lived assets as of December 31, 2019 and concluded it is more likely than not that our finite-lived intangible and other long lived assets were not impaired. 44 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) NOTE 5. FINANCING ARRANGEMENTS We have a credit agreement with Bank of America which was entered into on June 15, 2017 and provides for a line of credit arrangement of $16,000 that expires on June 15, 2022. The credit arrangement also has a $5,000 real estate term note outstanding with a maturity date of June 15, 2022. Under the Bank of America credit agreement, both the line of credit and real estate term notes are subject to variations in the LIBOR rate. Our line of credit bears interest at a weighted-average interest rate of 4.0% and 5.5% as of December 31, 2020 and 2019, respectively. We had borrowings on our line of credit of $3,328 and $10,088 outstanding as of December 31, 2020 and December 31, 2019, respectively. There are no subjective acceleration clauses under the credit agreement that would accelerate the maturity of our outstanding borrowings. The line of credit and real estate term notes with Bank of America contain certain covenants which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial performance, and limit the amount of annual capital expenditures. The availability under our line is subject to borrowing base requirements, and advances are at the discretion of the lender. The line of credit is secured by substantially all of our assets. The Bank of America Credit Agreement provides for, among other things, a Fixed Charge Coverage Ratio of not less than 1.0 to 1.0, for the twelve months ending December 31, 2020 and each Fiscal Quarter end thereafter subject only during a trigger period commencing when our availability under our line is less than $2,000 until availability is above that amount for 30 days due to amendment to our agreement dated in December of 2020. The Company met the covenants for the period ended December 31, 2020. The availability under the line is subject to borrowing base requirements, and advances are at the discretion of the lender. At December 31, 2020 and 2019, we had unused availability under our line of credit of $8,131 and $4,148, respectively, supported by our borrowing base. The line is secured by substantially all of our assets. On April 15, 2020, we entered into the Promissory Note, which provides for an unsecured loan of $6,077 pursuant to the Paycheck Protection Program under the Coronavirus Aid, Relief, and Economic Security Act and applicable regulations (the “CARES Act”) of which funds were received on April 22, 2020. The Promissory Note has a term of 2 years with a 1% per annum interest rate. Payments are deferred for 10 months after the end of the Promissory Note covered period (which is defined as 24 weeks after the date of the loan) and we can apply for forgiveness of the Promissory Note after 60 days. Forgiveness of the Promissory Note will be determined in accordance with the provisions of the Cares Act and applicable regulations. Any principal and interest amounts outstanding after the determination of amounts forgiven will be repaid on a monthly basis. In the second quarter of 2019, our China operations entered into a line of credit arrangement with China Construction Bank which provides for a line of credit arrangement of 6,000,000 Renminbi (RMB), approximately $860, that will expire on April 3, 2021. This line of credit bears an interest rate of 6% and we had no amounts outstanding as of both December 31, 2020 and 2019. 45 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Long-term debt balances at December 31, 2020 and 2019 consisted of the following (in thousands): December 31, December 31, 2020 2019 Term note payable - Bank of America Real estate term note bearing interest at one-month LIBOR + 2.25% (4.3% and 4.1% as of December 31, 2020 and 2019, respectively) maturing June 15, 2022 with monthly payments of approximately $41,000 plus interest secured by substantially all assets. $ 1,071 $ 3,755 Promissory Note 6,077 - 7,148 3,755 Debt issuance Costs (79 ) (132 ) Total long-term debt 7,069 3,623 Current maturities of long-term debt (1,204 ) (444 ) Long-term debt - net of current maturities $ 5,865 $ 3,179 Future maturity requirements for long-term debt outstanding as of December 31, 2020, are as follows: Years Ending December 31, Amount 2021 1,204 2022 5,944 Total $ 7,148 NOTE 6. LEASES We have operating leases for certain manufacturing sites, office space, and equipment. Most leases include the option to renew, with renewal terms that can extend the lease term from one to five years or more. Right-of-use lease assets and lease liabilities are recognized at the commencement date based on the present value of the remaining lease payments over the lease term which includes renewal periods we are reasonably certain to exercise. Our leases do not contain any material residual value guarantees or material restrictive covenants. At December 31, 2020, we do not have material lease commitments that have not commenced. We have financing leases for certain property and equipment used in the normal course of business. 46 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) The components of lease expense were as follows: December 31, December 31, Lease Cost 2020 2019 Operating lease cost $ 1,643 $ 1,014 Finance lease interest cost 102 69 Finance lease amortization expense 637 306 Total lease cost $ 2,382 $ 1,389 Supplemental balance sheet information related to leases was as follows: Balance Sheet Location December 31, 2020 December 31, 2019 Assets Operating lease assets Operating lease assets $ 8,998 $ 4,827 Finance lease assets Property, Plant and Equipment 2,330 2,447 Total leased assets $ 11,328 $ 7,274 Liabilities Current Current operating lease liabilities Current Portion of Operating Lease Obligations $ 688 $ 858 Current finance lease liabilities Current Portion of Finance Lease Obligations 660 557 Noncurrent Long-term operating lease liabilities Long Term Operating Lease Liabilities, Net 8,889 4,366 Long term finance lease liabilities Long Term Finance Lease Obligations, Net 1,152 1,451 Total lease liabilities $ 11,389 $ 7,232 Supplemental cash flow information related to leases was as follows: December 31, December 31, 2020 2019 Operating leases Cash paid for amounts included in the measurement of lease liabilities $ 1,058 $ 777 Right-of-use assets obtained in exchange for lease obligations $ 4,999 $ 5,731 47 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) The right-of use-assets obtained in exchange in for lease obligations in the year ended December 31, 2020 was largely due to the sale leaseback transaction we completed relating to the manufacturing facilities in Bemidji and Mankato, Minnesota. Maturities of lease liabilities were as follows: Operating Leases Finance Leases Total 2021 $ 1,388 $ 738 $ 2,126 2022 1,403 587 1,990 2023 1,406 333 1,739 2024 1,374 280 1,654 2025 1,205 29 1,234 Thereafter 8,282 - 8,282 Total lease payments $ 15,058 $ 1,967 $ 17,025 Less: Interest (5,481 ) (155 ) (5,636 ) Present value of lease liabilities $ 9,577 $ 1,812 $ 11,389 The lease term and discount rate at December 31, 2020 were as follows: Weighted-average remaining lease term (years) Operating leases 10.7 Finance leases 3.1 Weighted-average discount rate Operating leases 7.5 % Finance leases 5.2 % NOTE 7. INCOME TAXES In December 2020, the Consolidated Appropriations Act, 2021 (“CAA”) was signed into law. The CAA included additional funding through tax credits as part of its economic package for 2021. The Company evaluated these items in its tax computation as of December 31, 2020 and determined that the items do not have a material impact on the Company’s financial statements as of December 31, 2020. Additionally, as part of the Paycheck Protection Program (“PPP”) established by the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), enacted on March 27, 2020, the Company received a PPP loan that is anticipated to be forgiven. The PPP loan does not have an impact on the Company’s financial statements as of December 31, 2020 since forgiveness has not occurred. The PPP loan forgiveness will be treated as tax-exempt income when forgiven due to the provisions in the CAA. 48 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) The income tax expense for the years ended December 31, 2020 and 2019 consists of the following: 2020 2019 Current taxes - Federal $ 121 $ 248 Current taxes - State 24 11 Current taxes - Foreign 165 150 Deferred taxes - Foreign - - Income tax expense $ 310 $ 409 The statutory rate reconciliation for the years ended December 31, 2020 and 2019 is as follows: 2020 2019 Statutory Rate $ (259 ) $ (172 ) State Income Tax 60 (29 ) Effect of foreign operations (18 ) (23 ) Uncertain tax benefits, including federal benefit for state reserves - 44 Change in State Deferred Rate (115 ) - Valuation allowance 101 790 US Permanent differences 5 36 Federal Tax Credits (108 ) (70 ) Global Intangible Low-Taxed Income Effect 125 80 Return to provision - credits, perm diffs 4 (240 ) Deferred Adjustment - (16 ) Goodwill Impairment 499 - Other 16 9 $ 310 $ 409 Loss from operations before income taxes was derived from the following sources: 2020 2019 Domestic $ (2,109 ) $ (1,512 ) Foreign 873 693 $ (1,236 ) $ (819 ) 49 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Deferred tax (liabilities) assets at December 31, 2020 and 2019, consist of the following: 2020 2019 Deferred Tax Allowance for uncollectable accounts $ 85 $ 79 Inventories reserve 531 348 Accrued vacation 115 112 Accrued bonus 57 171 Stock-based compensation and equity appreciation rights 78 62 Lease Accounting ASC 842 Lease Liability 1,405 1,230 Section 481(a) adjustment 798 716 Net operating loss carryforwards 82 97 Tax credit carryforwards 165 171 Unrealized Foreign Currency Gain 42 - Other 5 7 Total 3,363 2,993 Valuation allowance (1,504 ) (1,403 ) Deferred tax assets 1,859 1,590 Accumulated Other Comprehensive Income (61 ) - Lease Accounting ASC 842 Lease Asset (1,386 ) (1,158 ) Property and equipment (412 ) (432 ) Deferred tax liabilities (1,859 ) (1,590 ) Net deferred tax assets $ - $ - We currently have significant deferred tax assets as a result of temporary differences between taxable income on our tax returns and U.S. GAAP income, research and development tax credit carry forwards and state net operating loss carry forwards. A deferred tax asset generally represents future tax benefits to be received when temporary differences previously reported in our financial statements become deductible for income tax purposes, or when net operating loss carry forwards are applied against future taxable income, or when tax credit carry forwards are utilized on our tax returns. We assess the realizability of our deferred tax assets and the need for a valuation allowance based on the guidance provided in current financial accounting standards. Significant judgment is required in determining the realizability of our deferred tax assets. The assessment of whether valuation allowances are required considers, among other matters, the nature, frequency and severity of any current and cumulative losses, forecasts of future profitability, the duration of statutory carry forward periods, our experience with loss carry forwards not expiring unused and tax planning alternatives. We have concluded that a valuation allowance is needed for all our United States based deferred tax assets due to the cumulative net losses we have sustained in the past three years. In analyzing the need for a valuation allowance, we considered our history of operating results for income tax purposes over the past three years in each of the tax jurisdictions where we operate, statutory carry forward periods and tax planning alternatives. Finally, we considered both our near and long-term financial outlook and timing regarding when we might return to profitability. After considering all available evidence both positive and negative, we concluded that the valuation allowance is needed for all our U.S. based deferred tax assets, no valuation allowance was placed on the foreign assets. 50 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) At December 31, 2020, for U.S. state tax purposes, we have Minnesota R&D credit carryforwards of $190 and various state net operating loss carryforwards of $212 for Iowa, $326 for Minnesota, $586 for Wisconsin. The state credits and NOLs expire at various years starting in 2024; we have a valuation allowance related to these state credits and NOLs of $302. The tax effects from an uncertain tax positions can be recognized in our consolidated financial statements, only if the position is more likely than not to be sustained on audit, based on the technical merits of the position. We recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more likely than not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. The following table sets forth changes in our total gross unrecognized tax benefit liabilities, excluding accrued interest, for the years ended December 31, 2020 and 2019 (in thousands): Balance at December 31, 2019 $ 44 Tax Positions - Additions 6 Tax Positions - Reductions - Balance at December 31, 2020 $ 50 Our policy is to accrue interest related to potential underpayment of income taxes within the provision for income taxes. The liability for accrued interest as of December 31, 2020 and 2019 was not significant. Interest is computed on the difference between our uncertain tax benefit positions and the amount deducted or expected to be deducted in our tax returns. We are subject to income taxes in the U.S. federal jurisdiction and various state jurisdictions. The Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. As of December 31, 2020, with few exceptions, the Company or its subsidiaries are no longer subject to examination prior to tax year 2017. Our tax year 2018 income tax return is currently under IRS audit. NOTE 8. 401(K) RETIREMENT PLAN We have a 401(k) profit sharing plan (the 401(k) Plan) for our employees. The 401(k) Plan is a defined contribution plan covering substantially all of our U.S. employees. Employees are eligible to participate in the Plan after completing three months of service and attaining the age of 18. Employees are allowed to contribute up to 60% of their wages to the 401(k) Plan. Historically we have matched 25% of the employees’ contributions up to 6% of covered compensation. We made contributions, net of forfeitures, of approximately $267 and $152 during the years ended December 31, 2020 and 2019, respectively. NOTE 9. INCENTIVE PLANS Stock Options In May 2017, the shareholders approved the 2017 Stock Incentive Plan which authorized the issuance of 400,000 shares. There were 42,300 and 186,200 options granted during the years ended December 31, 2020 and 2019, respectively. 51 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) We estimate the fair value of share-based awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense in the consolidated statements of operations over the requisite service periods. Because share-based compensation expense is based on awards that are ultimately expected to vest, share-based compensation expense will be reduced to account for estimated forfeitures. We estimate forfeitures at the time of grant and revise the estimate, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We used the Black-Scholes option-pricing model to calculate the fair value of option-based awards. Our determination of fair value of option-based awards on the date of grant using the Black-Scholes model is affected by our stock price as well as assumptions regarding a number of subjective variables. These variables include, but are not limited to, our expected stock price, volatility over the term of the awards, risk-free interest rate, and the expected life of the options. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of our stock options. The expected volatility and holding period are based on our historical experience. For all grants, the amount of compensation expense recognized has been adjusted for an estimated forfeiture rate, which is based on historical data. A summary of option activity as of and for the years ended December 31, 2020 and 2019 as follows: Shares Weighted- Average Exercise Price Per Share Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value Outstanding – January 1, 2019 224,750 $ 3.44 Granted 186,200 4.31 Exercised (2,250 ) (3.20 ) Cancelled (36,500 ) (3.66 ) Outstanding – December 31, 2019 372,200 $ 3.85 8.57 $ 379 Granted 42,300 4.34 Exercised (14,133 ) (3.78 ) Cancelled (37,727 ) (3.37 ) Outstanding – December 31, 2020 362,640 $ 3.96 7.78 $ 1,164 Exercisable on December 31, 2020 150,840 $ 3.61 7.09 $ 537 There were 14,133 options exercised during the year ended December 31, 2020 and 2,250 options exercised during the year ended December 31, 2019. Total compensation expense related to stock options for the years ended December 31, 2020 and 2019 was $68 and $268, respectively. As of December 31, 2020, there was $335 of unrecognized compensation which will vest over the next 2.4 years. Equity Appreciation Rights Plan In November 2010, the Board of Directors approved the adoption of the Nortech Systems Incorporated Equity Appreciation Rights Plan (the 2010 Plan). The total number of Equity Appreciation Right Units (Units) the Plan can issue shall not exceed an aggregate of 1,000,000 Units as amended and restated on March 11, 2015 and approved by the shareholders on May 6, 2015. The 2010 Plan provides that Units issued shall fully vest three years from the base date as defined in the agreement unless terminated earlier. Units give the holder a right to receive a cash payment equal to the appreciation in book value per share of common stock from the base date, as defined, to the redemption date. Unit redemption payments under this plan shall be paid in cash within 90 days after we determine the book value of the Units as of the calendar year immediately preceding the redemption date. The Units are adjusted to each reporting period based on the expected appreciation of the Units as defined in the Plan. 52 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) During the year-ended December 31, 2020, no Units were granted. During the year-ended December 31, 2019, we granted a total of 100,000 Units with a vesting date of December 31, 2021. Total compensation expense related to the vested outstanding Units based on the estimated appreciation over their remaining terms was approximately $108 and $0 for the years ended December 31, 2020 and 2019, respectively. NOTE 10. COMMITMENTS AND CONTINGENCIES Litigation We are subject to various legal proceedings and claims that arise in the ordinary course of business. In our opinion, the amount of any ultimate liability with respect to these actions will not materially affect our consolidated financial statements or results of operations. Change of Control Agreements Since 2002, we entered into Change of Control Agreements (the Agreement(s)) with certain key executives (the Executive(s)). The Agreements provide an inducement for each Executive to remain as an employee in the event of any proposed or anticipated change of control in the organization, including facilitating an orderly transition, and to provide economic security for the Executive after a change in control has occurred. In the event of an involuntarily termination in connection with a change of control as defined in the agreements, each Executive would receive their base salary, annual bonus at time of termination, and continued participation in health, disability and life insurance plans for a period of three years for officers and two years for all other participants. Stock Repurchase Plan In August 2018, the Board of Directors approved a $250 share repurchase program. Under this repurchase program, we repurchased 32,769 shares totaling $133 commissions and fees during the year ended December 31, 2019. As of December 31, 2019, this share repurchase plan expired. We did not repurchase any shares in the year ended December 31, 2020 and no additional share repurchase programs were approved. Global Pandemic In March 2020, the World Health Organization recognized the outbreak of a novel coronavirus (“COVID-19”) as a pandemic. While the COVID-19 pandemic has had an impact on our operations, we have been able to continue to operate our manufacturing facilities and provide essential services to our customers. Additionally, in an effort to protect the health and safety of our employees and in compliance with state regulations, we have instituted a work-from-home policy for employees who can perform their job functions offsite, implemented social distancing requirements and other measures to allow manufacturing and other personnel essential to production to continue work within our manufacturing facilities, and suspended all non-essential employee travel. 53 NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) The full extent to which COVID-19 has and will continue to directly or indirectly impact our business, financial condition and results of operations will depend on future developments that are highly uncertain and cannot be accurately predicted, including new information that may emerge concerning COVID-19, the actions taken to contain it or treat its impact and the economic impact on local, regional, national and international markets. The ultimate impact of COVID-19 depends on factors beyond our knowledge or control, including the duration and severity of the outbreak, as well as third-party actions taken to contain its spread and mitigate its public health effects. As a result, we are unable to estimate the extent to which COVID-19 will negatively impact our financial results or liquidity. We will continue to assess the potential impact of the COVID-19 pandemic on our business, financial condition, and results of operations. We actively manage our cash and working capital to preserve adequate liquidity and ensure that our business can continue to operate during these uncertain times. NOTE 11. RELATED PARTY TRANSACTIONS During fiscal years ended December 31, 2020 and 2019 we did business with Printed Circuits, Inc. which is 90% owned by the Kunin family, of which, owns a majority of our stock. We made payments to Printed Circuits, Inc. totaling $28 and $131 in the years ended December 31, 2020 and 2019, respectively. The Company believes that these transactions are on terms comparable to those that the Company could reasonably expect in an arm's length transaction with an unrelated third party. David Kunin, our Chairman is a minority owner of Abilitech Medical, Inc. Mr. Kunin also was a consultant to Abilitech, which relationship ended on March 1, 2021. During 2020, Mr. Kunin earned $16 as a consultant to Abilitech. In 2020, Abilitech paid the Company $1,095 and in 2019, Abilitech paid the Company $537 for delivery of medical products. The Company believes that transactions with Abilitech are on terms comparable to those that the Company could reasonably expect in an arm's length transaction with an unrelated third party. NOTE 12. SUBSEQUENT EVENT We entered into an agreement on February 23, 2021 with a third-party agent to sell our facility in Merrifield, MN and some related assets. We expect the sale to close in the second quarter of 2021 near the carrying value of the assets, however a sale transaction and the expected sale value is not guaranteed. 54 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None.