Inventories are valued at the lower of cost, determined on the basis of standard costing, which approximates the first-in, first-out method, or net realizable value.  When the Company is the manufacturer, raw materials, labor, and manufacturing overhead are included in inventory costs. The Company records the raw materials at delivered cost. Standard labor and manufacturing overhead costs are applied to the finished goods based on normal production capacity as prescribed under ASC 330 Inventory Pricing.  A majority of the Company'sCompany’s products are manufactured overseas and are recorded at standard cost, which includes product costs for purchased and manufactured products, and freight and transportation costs for inbound freight from manufacturers.  Inventory values at September 30, 2017 and March 31, 2017 were as follows:

 

The Company determines an inventory obsolescence reserve based on management'smanagement’s historical experience and establishes reserves against inventory according to the age of the product. As of September 30,December 31, 2017 and March 31, 2017, the Company had reserved $286,000$271,000 and $362,000 for inventory obsolescence, respectively.  The inventory values are shown net of these reserves.

The Company recognizes revenue from product sales, net of estimated returns, when persuasive evidence of a sale exists including the following; (i) that is, a product is shipped under an agreement with a customer; (ii) the risk of loss and title has passed to the customer; (iii) the fee is fixed or determinable; and (iv) collection of the resulting receivable is reasonably assured.

The Company records estimated reductions to revenue for customer and distributor programs and incentive offerings, including promotions, rebates, and other volume-based incentives.  CertainSome of the incentive programs require the Company to estimate the number of customers who will actually redeem the incentive based on historical customer and industry experience. As of September 30,December 31, 2017 and March 31, 2017, the Company had accrued $634,000$942,000 and $304,000, respectively, as anits estimate forof the foregoing deductions and allowances within the "accrued expenses"accrued expenses line of the condensed balance sheets.sheet.

The Company records warranty liabilities at the time of sale for the estimated costs that may be incurred under its basic warranty program. The specific warranty terms and conditions vary depending upon the product sold, but generally include technical support, repair parts, and labor for periods up to one year. Factors that affect the Company'sCompany’s warranty liability include the number of installed units currently under warranty, historical and anticipated rates of warranty claims on those units, and cost per claim to satisfy the Company'sCompany’s warranty obligation.  Based upon the foregoing, the Company has recorded a provision for potential future warranty costs of $116,000$114,000 and $125,000 as of September 30,December 31, 2017 and March 31, 2017, respectively.  These expenses are recorded in the accrued expenses line of the condensed balance sheets.

The Company reserves for known and potential returns from customers and associated refunds or credits related to such returns based upon historical experience. In certain cases, retailer customers are provided a fixed allowance, usually in the 1% to 2% range, to cover returned goods and this allowance is deducted from payments made to us by such customers. As of September 30,December 31, 2017 and March 31, 2017, the Company has recorded a reserve for customer returns of $183,000$502,000 and $175,000, respectively.  These expenses are recorded in the accrued expenses line of the condensed balance sheets.

GAAP utilizes a management approach based on allocating resources and assessing performance as the source of the Company'sCompany’s reportable segments.  GAAP also requires disclosures about products and services, geographic areas and major customers.  At present, the Company operates in two segments, Direct-to-Consumer and Retail Sales.

 

In November 2016, the Financial Accounting Standards Board ("FASB"(“FASB”) issued Accounting Standards Update ("ASU"(“ASU”) 2016-18, "Statement“Statement of Cash Flows."”  The new guidance will require that the statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents are required to be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The new guidance is effective for interim and annual periods beginning after December 15, 2017 and early adoption is permitted. The amendment should be adopted retrospectively. The Company early adopted this new guidance in the first quarter of fiscal year 2018 and the adoption did not have a material impact on our financial statements.

In March 2016, the FASB issued ASU 2016-09, "Improvements“Improvements to Employee Share-Based Compensation Accounting,"” which requires excess tax benefits to be recorded on the income statement as opposed to additional paid-in-capital, and treated as an operating activity on the statement of cash flows. ASU 2016-09 also allows companies to make an accounting policy election to either estimate the number of awards that are expected to vest (current U.S. GAAP) or account for forfeitures when they occur. ASU 2016-09 further requires cash paid by an employer when directly withholding shares for tax-withholding purposes to be classified as a financing activity on the statement of cash flows. Due to the Company'sCompany’s valuation allowance on its deferred tax assets, no income tax benefit is recognized as a result of the adoption of ASU 2016-09.  There is no change to retained earnings with respect to excess tax benefits, as this is not applicable to the Company.  The treatment of forfeitures has not changed as we are electing to continue our current process of estimating the number of forfeitures.  We have elected to present the cash flow statement on a prospective transition method and no prior periods have been adjusted.

In February 2016, the FASB issued ASU 2016-02, "Leases."“Leases.” The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The adoption of this ASU is expected to result in all operating leases being capitalized and a current and long-term liability recorded in the Company'sCompany’s financial statements.

In August 2015, the FASB issued ASU 2015-14 to defer the effective date by one year of previously issued ASU 2014-09, "Revenue“Revenue from Contracts with Customers,"” which amended revenue recognition guidance to clarify the principles for recognizing revenue from contracts with customers.  The guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services.  The guidance also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract.   This accounting guidance is effective for the Company beginning in the first quarter of fiscal year 2019 using one of two prescribed retrospective methods.  Early adoption is permitted but not before annual periods beginning after December 15, 2016.  We anticipate we will adopt the full retrospective transition method and are currently evaluating the impact of adoption of this ASU on our consolidated financial statements and disclosures. 

In July 2015, the FASB issued ASU 2015-11, "Simplifying“Simplifying the Measurement of Inventory."” Under this ASU, inventory will be measured at the "lower“lower of cost and net realizable value"value” and alternatives that currently exist for "market value"“market value” will be eliminated. The ASU defines net realizable value as the "estimated“estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation."” No other changes were made to the current guidance on inventory measurement. ASU 2015-11 is effective for interim and annual periods beginning after December 15, 2016. Early application is permitted and should be applied prospectively. Management early adopted ASU 2015-11 and noted no material impact on the Company'sCompany’s financial position or results of operations. 

In August 2014, the FASB issued ASU 2014-15, "Presentation“Presentation of Financial Statements – Going Concern: Disclosures of Uncertainties about an Entity'sEntity’s Ability to Continue as a Going Concern,"” which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity'sentity’s ability to continue as a going concern within one year after the financial statements are issued. This ASU is effective for annual periods ending after December 15, 2016 and interim periods within annual periods beginning after December 15, 2016. The adoption of this ASU did not have a material impact on the Company'sCompany’s financial statements. 

3.    Notes Payable, Long Term Debt and Current Portion – Long Term Debt

 

For a detailed discussion on our previously outstanding Notes Payable, Long Term Debt and Current Portion – Long Term Debt, refer to the Company'sCompany’s Annual Report on Form 10-K for the year ended March 31, 2017, as filed with the SEC on June 26, 2017.  The following are the changes to our Notes Payable, Long Term Debt and Current Portion – Long Term Debt for the periods presented.

As of September 30,December 31, 2017 and March 31, 2017, the outstanding balance of the Company's notesCompany’s note payable and debt, including accrued interest, is as follows:

 

 

On April 22, 2013, the Company and Scotts Miracle-Gro agreed to enter an Intellectual Property Sale Agreement, a Technology License Agreement, a Brand License Agreement, and a Supply Chain Services Agreement.  The Intellectual Property Sale Agreement and the Technology License constitute an agreement of sales of future revenues.  Because the Company received cash from Scotts Miracle-Gro and agreed to pay for a defined period a specified percentage of revenue, and because the Company has significant involvement in the generation of its revenue, the excess paid over net book value is classified as debt and is being amortized under the effective interest method.  As of September 30,December 31, 2017 and March 31, 2017, a liability of $98,000$89,000 and $117,000, respectively, was recorded on the balance sheets for the Intellectual Property Sale Agreement.  As of September 30,December 31, 2017 and March 31, 2017, the accrued liability for shares to be distributed at $1.51 per share: (i) the Technology Licensing Agreement was at $0 and $935,000, respectively; (ii) the Brand License Agreement at $0 and $1.6 million, respectively.  Accrued liabilities for the Technology Licensing Agreement and Brand License Agreement were recorded as a stock dividend to be distributed at period end, based on a value of $1.51 per share.  However, the Scotts Miracle-Gro and the Company settled their respective obligations under the Technology Licensing Agreement and Brand License Agreement in August 2017 and no further liabilities will be accrued that require shares to be distributed or a periodic fair value calculation to occur.

4.    Scotts Miracle-Gro Transactions – Convertible Preferred Stock, Warrants and Other Transactions

On April 22, 2013, the Company entered into a Securities Purchase Agreement with SMG Growing Media, Inc., a wholly owned subsidiary of Scotts Miracle-Gro (NYSE: "SMG"“SMG”), a worldwide marketer of branded consumer lawn and garden products.  Pursuant to the Securities Purchase Agreement, Scotts Miracle-Gro acquired 2,649,007 shares of the Company'sCompany’s Series B Convertible Preferred Stock, par value $0.001 per share (the "Series“Series B Preferred Stock"Stock”) and (ii) a warrant to purchase shares of the Company'sCompany’s common stock (the "Warrant,"“Warrant,” as described in greater detail below) for an aggregate purchase price of $4.0 million.  The Securities Purchase Agreement, Certificates of Designations for the Series B Preferred Stock, Form of Warrant, Indemnification Agreement, Investor'sInvestor’s Rights Agreement and Voting Agreement have been filed as exhibits to a Current Report on Form 8-K that was filed with the SEC on April 23, 2013.  After deducting offering expenses, including commissions and expenses paid to the Company'sCompany’s advisor, net cash proceeds totaled to $3.8 million.  The Company used $950,000 of the net proceeds to repay "in full"“in full” (with concessions) the Promissory Note due to a former supplier.   The Company used the remaining net proceeds for working capital and general corporate purposes.  On November 29, 2016 Scotts Miracle-Gro fully exercised the Warrant and upon exercise of the Warrant the Series B Preferred Stock converted into shares of common stock.  

The Series B Preferred Stock was convertible into 2,649,007 shares of common stock ($4.0 million divided by a conversion price of $1.51 per share).  The Series B Preferred Stock bore a cumulative annual dividend of 8.0%, payable in shares of the Company'sCompany’s common stock at a conversion price of $1.51 per share (subject to customary anti-dilution rights, as described in the Series B Preferred Stock Certificates of Designations).  The Series B Preferred Stock did not have a liquidation preference and was entitled to vote on an "as-converted"“as-converted” basis with the common stock.  The stock dividend accrued from day to day and was payable in shares of our common stock within thirty days after the end of each fiscal year end.  The stock dividend was recorded at the fair market value of our common stock at the end of each quarter in the equity section of the balance sheet.  The corresponding charge was recorded below net income to arrive at net income available to common shareholders.  The Series B Preferred Stock automatically converted into the Company'sCompany’s common stock: (i) upon the affirmative election of the holders of at least a majority of the then outstanding shares of the Series B Preferred Stock voting together as a single class on an as-if-converted to common stock basis; or (ii) if, at the date of exercise in whole or in part of the Warrant, the holder (or holders) of the Series B Preferred Stock own 50.1% of the issued and then-outstanding common stock of the Company, giving effect to the issuance of shares of common stock in connection with the conversion of the Series B Preferred Stock and such exercise of the Warrant.  By its terms, the Series B Preferred Stock automatically converted into the Company'sCompany’s common stock on November 29, 2016, when Scotts Miracle-Gro exercised the Warrant.  In addition, all shares related to this agreement were settled in the issuance in August 2017 and no accrual remains as of September 30,December 31, 2017 for the stock dividend.

Upon demand by Scotts Miracle-Gro, the Company must use its best efforts to file a Registration Statement on Form S-3, or, if the Company is not eligible for Form S-3, on Form S-1 (collectively, the "Registration Statement"“Registration Statement”), covering the shares of the Company'sCompany’s common stock issued upon conversion/exercise of the Preferred Stock and the Warrant, within 120 calendar days after receipt of Scotts Miracle-Gro'sMiracle-Gro’s demand for registration and shall use its best efforts to cause the Registration Statement to become effective as soon as possible thereafter.

The foregoing description of the Securities Purchase Agreement, the Certificates of Designations for the Series B Convertible Preferred Stock, the Warrant, and the resulting transaction is only a summary, does not purport to be complete, and is qualified in its entirety by reference to the full text of the applicable documents, each of which was included as an exhibit to the Company'sCompany’s Current Report on Form 8-K, as filed with the SEC on April 23, 2013. The warrant on the Series B Convertible Preferred Stock was accounted for as a liability at its estimated fair value. The derivative warrant liability was re-measured to fair value, on a recurring basis, at the end of each reporting period until it was exercised. The Company accounted for the warrant as a liability and measured the value of the warrant using the Monte Carlo simulation model as of the end of each quarterly reporting period until the warrant was exercised.  As of September 30,December 31, 2017 and March 31, 2017, the warrant had been exercised, and the fair value of the warrant was $0. On November 29, 2016, Scotts Miracle-Gro fully exercised its warrant to purchase 80% of the Company'sCompany’s outstanding stock, when the derivative warrant liability was extinguished and the Convertible Preferred Stock was converted to common stock.  As stated above, all shares related to this agreement were settled in the issuance in August 2017 and no accrual for the 8.0% stock dividend remains as of September 30,December 31, 2017.

In conjunction with the private offering described above, the Company and Scotts Miracle-Gro also agreed to enter an Intellectual Property Sale Agreement, a Technology License Agreement, a Brand License Agreement, and a Supply Chain Services Agreement.  The Intellectual Property Sale Agreement and the Technology License constitute an agreement of sales of future revenues. For more details regarding these agreements, please refer to Note 3 "Scotts“Scotts Miracle-Gro Transactions"Transactions” to the financial statements included in the Company'sCompany’s Annual Report on Form 10-K, as filed with the SEC on June 26, 2017.  See also Note 3 for the Term Loan with Scotts Miracle-Gro.

For the threethree- and six monthsnine-month periods ended September 30,December 31, 2017 and September 30,December 31, 2016, the Company did not grant any options to purchase shares ofthe Company’s common stock under the Company'sCompany’s 2005 Equity Compensation Plan (the "2005 Plan"“2005 Plan”) and no new options will be granted under this plan until a new plan is adopted.  

During the three and sixnine months ended September 30,December 31, 2017, and September 30, 2016, no options to purchase shares of common stock were cancelled or expired, and no shares of common stock were issued upon exercise of outstanding stock options under the 2005 Plan.  During the three and nine months ended December 31, 2016, no options to purchase shares of common stock were cancelled or expired, and 481,000 shares of common stock were issued upon exercise of outstanding stock options under the 2005 Plan.

As of September 30,December 31, 2017, the Company had no unvested outstanding options to purchase shares of the Company'sCompany’s common stock. 

Information regarding all stock options outstanding under the 2005 Plan as of September 30,December 31, 2017 is as follows:

The aggregate intrinsic value in the preceding table represents the difference between the Company'sCompany’s closing stock price and the exercise price of each in-the-money option on the last trading day of the period presented, which was SeptemberDecember 29, 2017.

6.    Income Taxes

The Company follows the guidance in ASC 740, Accounting for Uncertainty in Income Taxes ("(“ASC 740"740”) which clarifies the accounting for uncertainty in income taxes recognized in an enterprise'senterprise’s financial statements.  This interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements.

Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at the end of each period, based on enacted laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income.  Amounts payableAny liability for actual taxes to taxing authorities areis recorded as income tax liability.  

On December 22, 2017, the President signed into legislation the Tax Cuts and Jobs Act (“Act”), The effectAct changes existing U.S. tax law and includes numerous provisions that will affect our business, including our income tax accounting, disclosure and tax compliance. We believe the most impactful changes within the Act are those that will reduce the U.S. corporate tax rates, business-related exclusions and deductions and credits. ASC 740, requires the effects of changes in tax rates and laws on deferred tax balances to be recognized in the period in which the legislation is enacted. Consequently, as of the date of enactment, and during the three months ended December 31, 2017, the Company will value all deferred tax assets and liabilities of a change inat the newly enacted Corporate U.S income tax rates is recognized in income in the period that includes the enactment date.  rate. 

A valuation allowance is established against such assets where management is unable to conclude more likely than not that such asset will be realized. As of September 30,December 31, 2017 and March 31, 2017, the Company recognized a valuation allowance equal to 100% of the net deferred tax asset balance and the Company has no unrecognized tax benefits related to uncertain tax positions.

 

7.    Related Party Transactions

See Note 6 "Related“Related Party Transactions"Transactions” of Form 10-K for the year ended March 31, 2017, as filed with the SEC on June 26, 2017 for a detailed discussion of related party transactions.

On September 13, 2017, AeroGrow entered into a Term Loan Agreement in the principal amount of up to $2.0 million with Scotts Miracle-Gro.  Interest is charged at the stated rate of 10% per annum and will be paid quarterly in arrears, in cash at the end of each September, December and March.  The Company borrowed $1.0 million under the Term Loan in October 2017, but repaid the outstanding balance of the Term Loan and accrued interest in full as of December 31, 2017.  See Note 3 "Notes“Notes Payable, Long Term Debt and Current Portion – Long Term Debt"Debt” above.

A summary of the Company'sCompany’s common stock warrant activity for the period from April 1, 2017 through September 30,December 31, 2017 is presented below:

As of September 30,December 31, 2017, the Company had the following outstanding warrants to purchase shares of its common stock:

As discussed in Note 4 above, the Series B Preferred Stock was converted into 2,649,007 shares of common stock ($4.0 million divided by a conversion price of $1.51 per share) on November 29, 2016, concurrently with Scotts Miracle-Gro'sMiracle-Gro’s exercise of its Warrant.  The Series B Convertible Preferred Stock bore a cumulative annual dividend of 8.0%, payable in shares of the Company'sCompany’s common stock at a conversion price of $1.51 per share (subject to customary anti-dilution rights, as described in the Series B Convertible Preferred Stock Certificates of Designations).  All shares related to this agreement were settled in the issuance in August 2017 and no accrual remains as of September 30,December 31, 2017 for the stock dividend.  For additional details regarding the initial issuance of the Series B Convertible Preferred Stock and Warrant in March 2013 and the November 2016 conversation/exercise of the Series B Preferred Stock and Warrant, see "Note“Note 4 – Scotts Miracle-Gro Transaction"Transaction” above.

9.    Segment Information

The Company has determined that its reportable segments are those that are based on its method of internal reporting and the perspective of the chief operating decision maker. The company has two reportable segments,segments; Retail Sales and Direct-to-Consumers. The Company evaluates performance based on the primary financial measure of contribution margin ("(“segment profit"profit”). Segment profit reflects the income or loss from operations before corporate expenses, non-operating income, net interest expense, and income taxes.  The Company does not have any individually identified assets regarding specific segments as all processes to manufacture products are not different based on segment.

 

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A.

 

 

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A.

 

(1) Sales and marketing includes advertising, trade shows, media production and promotional products and other as discussed in the sales and marketing section of the MD&A.

10.    Subsequent Events