1. OPERATIONS

LRAD^® Corporation, a Delaware corporation (the “Company”), is engaged in the design, development and commercialization of directed and omnidirectional sound technologies and products. The Company sells its proprietary sound reproduction technologies and products in markets around the world.

2. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

General

The Company’s unaudited interim condensed consolidated financial statements included herein have been prepared in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X and the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In management’s opinion, the accompanying statements reflect adjustments necessary to present fairly the financial position, results of operations, and cash flows for those periods indicated, and contain adequate disclosure to make the information presented not misleading. Adjustments included herein are of a normal, recurring nature unless otherwise disclosed in the footnotes. The condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended September 30, 20152016 included in the Company’s Annual Report on Form 10-K, as filed with the SEC on December 3, 2015.7, 2016. Results of operations for interim periods are not necessarily indicative of the results of operations for a full year.

Principles of Consolidation

The Company has a currently inactive wholly owned subsidiary, LRAD International Corporation, which the Company formed to conduct international marketing, sales and distribution activities. The condensed consolidated financial statements include the accounts of this subsidiary after elimination of intercompany transactions and accounts.

Reclassifications

Where necessary, the prior year’s information has been reclassified to conform to the current year presentation.

3. RECENT ACCOUNTING PRONOUNCEMENTS

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-09,Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This guidance changes how companies account for certain aspects of share-based payments to employees. Among other things, under the new guidance, companies will no longer record excess tax benefits and certain tax deficiencies in additional paid-in-capital (“APIC”), but will instead record such items as income tax expense or benefit in the income statement, and APIC pools will be eliminated. Companies will apply this guidance prospectively. Another component of the new guidance allows companies to make an accounting policy election for the impact of forfeitures on the recognition of expense for share-based payment awards, whereby forfeitures can be estimated, as required today, or recognized when they occur. If elected, the change to recognize forfeitures when they occur needs to be adopted using a modified retrospective approach. All of the guidance will be effective for the Company in the fiscal year beginning October 1, 2017. Early adoption is permitted. The Company is currently evaluating the impact of this guidance, if any, on its financial statements and related disclosures.

In February 2016, the FASB issued ASU 2016-02,Leases (Topic 842), which issued new guidance related to leases that outlines a comprehensive lease accounting model and supersedes the current lease guidance. The new guidance requires lessees to recognize lease liabilities and corresponding right-of-use assets for all leases with lease terms of greater than 12 months. It also changes the definition of a lease and expands the disclosure requirements of lease arrangements. The new guidance must be adopted using the modified retrospective approach and will be effective for the Company in the fiscal year beginning October 1, 2019. Early adoption is permitted. The Company is currently evaluating the impact of this guidance, if any, on its financial statements and related disclosures.

In July 2015, the FASB issued ASU No. 2015-11,Inventory (Topic 330): Simplifying the Measurement of Inventory. The guidance requires an entity to measure inventory at the lower of cost or net realizable value, which is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation, rather than the lower of cost or market in the previous guidance. This amendment applies to inventory that is measured using first-in, first-out (FIFO). This amendment is effective for public entities forthe Company in the fiscal yearsyear beginning after December 15, 2016, including interim periods within those years.October 1, 2017. A reporting entity should apply the amendments prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the impact of this guidance, if any, on its consolidated financial statements and related disclosures.

In May 2014, the FASB issued ASU No. 2014-09,Revenue from Contracts with Customers (“ASU 2014-09”), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. generally accepted accounting principles when it becomes effective.In July 2015, the FASB deferred the effective date of the standard by an additional year; however, it provided companies the option to adopt one year earlier, commensurate with the original effective date. Accordingly, the standard will be effective for the Company in the fiscal year beginning October 1, 2018, with an option to adopt the standard for the fiscal year beginning October 1, 2017. The Company is currently evaluating this standard and has not yet selected a transition method or the effective date on which it plans to adopt the standard, nor has it determined the effect of the standard on its financial statements and related disclosures.

The Company’s financial instruments consist principally of cash equivalents, short and long-term marketable securities, accounts receivable and accounts payable. The fair value of a financial instrument is the amount that would be received in an asset sale or paid to transfer a liability in an orderly transaction between unaffiliated market participants. Assets and liabilities measured at fair value are categorized based on whether or not the inputs are observable in the market and the degree that the inputs are observable. The categorization of financial instruments within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The hierarchy is prioritized into three levels (with Level 3 being the lowest) defined as follows:

Level 1:     Inputs are based on quoted market prices for identical assets or liabilities in active markets at the measurement date.

Level 2:     Inputs include quoted prices for similar assets or liabilities in active markets and/or quoted prices for identical or similar assets or liabilities in markets that are not active near the measurement date.

Level 3:     Inputs include management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument’s valuation.

The fair value of the Company’s cash equivalents and marketable securities was determined based on Level 1 and Level 2 inputs. The Company did not have any marketable securities in the Level 3 category as of June 30,December 31, 2016 or September 30, 2015.2016. The Company believes that the recorded values of its other financial instruments approximate their current fair values because of their nature and respective relatively short maturity dates or durations.

Instruments Measured at Fair Value

The following tables present the Company’s cash equivalents and marketable securities’ costs, gross unrealized gains and losses, and fair value by major security type recorded as cash equivalents or short-term or long-term marketable securities as of June 30,December 31, 2016 and September 30, 2015.2016.

5. INVENTORIES

Inventories consisted of the following:

6. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:

7. ACCRUED LIABILITIES AND OTHER LIABILITIES—NONCURRENT

Accrued liabilities consisted of the following:

Payroll and related

Payroll and related consists primarily of accrued payroll, benefits and related taxes for a Separation Agreement entered into with the Company’s CEO during the quarter ended March 31, 2016, as well as vacation, bonus, sales commissions, and payroll for the two week period ended June 30, 2016.benefits.

Deferred Revenue

Deferred revenue consists primarily of prepayments from customers in advance of product shipment as well as revenue for shipments to customers that can’t be recognized due to shipping terms.shipment.

Warranty Reserve

Changes in the warranty reserve and extended warranty were as follows:

Accrued contract costs

We have contracted with a third party service provider to administer the required services under the terms of a repair and maintenance agreement with a foreign military. This payment is made in arrears for each year.contract year ended March 26.

8. INCOME TAXES

At June 30,December 31, 2016, the Company had federal net operating losses (“NOLs”) and related state NOLs. The Company released $188,000 and $8,339,000 of its valuation allowance against its deferred tax assets induring the quarteryears ended September 30, 2016 and 2015, respectively, as it determined that it was more likely than not that those assets would be realized. The Company continues to maintain a valuation allowance of $12,175,000$12,109,000 at September 30, 2016 and December 31, 2016 as the Company believes that the negative evidence that it will be able to recover these net deferred tax assets outweighs the positive evidence.

The Company recorded an income tax benefit of $862,720$486,528 and income tax expense of $1,600,$309,595, reflecting effective tax rates of 52.9%37.4% and 0.2%44.9% for the ninethree months ended June 30,December 31, 2016 and 2015, respectively. The nine months ended June 30, 2015 also included a $9,266 income tax benefit adjustment from the year ended September 30, 2014. The changerecorded in the effective tax rate in the nine months ended June 30, 2016, comparedthese two periods is related to the same period incompany’s losses for those periods and the prior year, is primarily due to the partial release of ourdetermination that a valuation allowance inis not required on the prior year, resulting in current year tax benefit.benefit related to those losses.

ASCAccounting Standard Codification (“ASC”) 740,Accounting for Uncertainty in Income Taxes, requires the Company to recognize in its consolidated financial statements uncertainties in tax positions taken that may not be sustained upon examination by the taxing authorities. If interest or penalties are assessed, the Company would recognize these charges as income tax expense. The Company has not recorded any income tax expense or benefit for uncertain tax positions.

9. COMMITMENTS AND CONTINGENCIES

Litigation

The Company may at times be involved in litigation in the ordinary course of business. The Company will, from time to time, when appropriate in management’s estimation, record adequate reserves in the Company’s consolidated financial statements for pending litigation. Currently, there are no pending material legal proceedings to which the Company is a party or to which any of its property is subject.

Bonus Plan

The Company has an incentive bonus plan for fiscal year 20162017 designed to motivate its employees to achieve the Company’s financial objectives. All of the Company’s employees are entitled to participate in the incentive plan. Target Bonus Amounts (“Target”) vary based on a percentage of the employee’s base salary which range from 10% to 50%75% of base salary and a bonus payment may be made at three levels, including at 50% of Target, at 100% of Target and at 200% of Target, depending upon the achievement by the Company of specified earnings per shareperformance goals. Performance targets include certain fiscal 2017 metrics, including product bookings, net revenues, operating income and operating cash flow, depending on the employee’s position. Included in such calculation is the cost of the incentive plan. For purposes of the earnings per share calculation, the number of shares outstanding will be held constant as of October 1, 2015. During the ninethree months ended June 30,December 31, 2016 and 2015, the Company accrued $0$185,086 and $323,098,$0, respectively, for bonuses and related payroll tax expenses in connection with the bonus plans.

10.10. SHARE-BASED COMPENSATION

Stock Option Plans

At June 30,December 31, 2016, the Company had two equity incentive plans. The 2005 Equity Incentive Plan (“2005 Equity Plan”) was terminated with respect to new grants in March 2015, but remains in effect for grants issued prior to that time. The 2015 Equity Incentive Plan (“2015 Equity Plan”) was approved by the Company’s Board of Directors on January 19, 2015 and by the Company’s stockholders on March 18, 2015. The 2015 Equity Plan authorizes for issuance as stock options, restricted stock, stock appreciation rights, restricted stock units and performance awards, an aggregate of 5,000,000 new shares of common stock to employees, directors, advisors or consultants. At June 30,December 31, 2016, there were options outstanding covering 2,537,4192,477,502 and 813,7502,371,500 shares of common stock under the 2005 Equity Plan and 2015 Equity Plan, respectively.

Stock Option Activity

The following table summarizes information about stock option activity during the ninethree months ended June 30,December 31, 2016:

Options outstanding are exercisable at prices ranging from $0.93 to $3.17 and expire over the period from 20202018 to 2023 with an average life of 5.54.6 years. The aggregate intrinsic value of options outstanding and exercisable at December 31, 2016 was $149,619 and $127,298, respectively.

During the quarter ended December 31, 2016, the Company incurred non-cash share-based compensation expense of $307,324 resulting from the modification of stock options in accordance with a Separation Agreement and General Release related to the June 30, 2016 was $198,578departure of the Company’s prior chief executive officer (“CEO”). As per the agreement, all unvested options became fully vested on December 31, 2016 and $160,699, respectively.shall remain exercisable for a period of 24 months following the December 31, 2016 separation date as defined in the agreement. The expense is measured as the excess of the fair value of the modified awards over the fair value of the original awards immediately before its terms are modified as per ASC 718-20-35.

During the quarter ended December 31, 2016, the Board of Directors approved the grant of 25,000 restricted stock units to each of our non-employee directors, subject to stockholder approval of theAmended and Restated 2015 Equity Incentive Plan at the 2017 Annual Meeting of Stockholders. These restricted stock units were granted as replacements for 20,000 stock options that would have been granted on the date of the 2016 Annual Meeting of Stockholders and will vest on the first anniversary of the 2016 Annual Meeting of Stockholders, which is May 17, 2017.

Share-Based Compensation

The Company recorded share-based compensation expense and classified it in the condensed consolidated statements of operations as follows:

The employee stock options granted in the ninethree months ended June 30,December 31, 2016 and 2015 had a weighted-average estimated fair value of $0.62$0.71 per share and $1.13$0.63 per share, respectively, using the Black-Scholes option pricing model with the following weighted-average assumptions (annualized percentages):

The Company declared its firsta dividend infor the quarter ended December 31, 2015, sowhich reflects a dividend yield assumptions were added to the valuation of options grantedassumption based on the expected annual yield.yield, but the dividend was discontinued prior to the quarter ended December 31, 2016. Expected volatility is based on the historical volatility of the Company’s common stock over the period commensurate with the expected life of the options. The risk-free interest rate is based on rates published by the Federal Reserve Board. The expected life is based on observed and expected time to post-vesting exercise. The expected forfeiture rate is based on past experience and employee retention data. Forfeitures are estimated at the time of the grant and revised in subsequent periods if actual forfeitures differ from those estimates or if the Company updates its estimated forfeiture rate. Such amounts will be recorded as a cumulative adjustment in the period in which the estimate is changed.

Since the Company has an NOL carryforward as of June 30,December 31, 2016, no excess tax benefit for the tax deductions related to share-based awards was recognized for the ninethree months ended June 30,December 31, 2016 and 2015. As of June 30,December 31, 2016, there was approximately $600,000$900,000 of total unrecognized compensation cost related to non-vested share-based employee compensation arrangements. The cost is expected to be recognized over a weighted-average period of 1.42.2 years.

The discussion and analysis set forth below should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related notes included under Item 1 of this Quarterly Report on Form 10-Q, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended September 30, 2015.2016.

Forward Looking Statements

This report contains certain statements of a forward-looking nature relating to future events or future performance. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements. Prospective investors are cautioned that such statements are only predictions and actual events or results may differ materially. In evaluating such statements, prospective investors should specifically consider various factors identified in this report and any matters set forth under Part I, Item 1A (Risk Factors) of our Annual Report on Form 10-K, which could cause actual results to differ materially from those indicated by such forward-looking statements.

Overview

Our Company develops and delivers highly intelligible, directed Long Range Acoustic Devices^® (“LRAD^®”)that beam, focus and control sound over short and long distances. By placing sound only where needed, we not only enhance many typical speaker applications, but we offer novel sound applications that conventional speakers cannot achieve.

Our LRAD-X^® product line offers a variety of directed sound products, which use focused acoustic output to clearly transmit critical information, instructions and warnings over long distances. The LRAD-X product line features clear voice intelligibility and meets the military’s stringent environmental requirements in a number of packages and form factors, from our hand held LRAD 100X to our LRAD 2000X unit, which communicates up to 5,500 meters.Through the use of powerful voice commands, prerecorded messages in multiple languages, and warning tones, our LRAD-X products are designed to create large safety zones while determining the intent and influencing the behavior of an intruder.security threats. We continue to expand our LRAD-X product line to provide a complete range of systems and accessories, including a new, patent pending XL speaker technology introduced in 2014, which generates higher audio output in a smaller and lighter form factor, and has been incorporated in several new products in recent years. Our products are designed to meet a broad range of diverse applications including fixed and mobile military deployments, maritime security, critical infrastructure and perimeter security, commercial security, border and homeland security, law enforcement and emergency responder communications, asset protection and wildlife preservation and control.Our LRAD-X products have been competitively selected over other commercially available systems by the United States military and by several international militaries.

Building on the success of our LRAD-X directional technology, in 2012 we launched our first omnidirectional product, the LRAD 360X. Unlike the existingstandard siren based systems in the market, the LRAD 360X is designed with the same characteristics as our directed products - highly intelligible voice broadcastsclarity, and the ability to communicate and alert over long distances.distances, as in our directional products. Since the LRAD 360X product launch, we have developedexpanded our ONE VOICE^® omnidirectional mass communication product line which includesto include various size offerings, a 60-degree unit, a mobile fully-integrated, trailer-mounted mass communication system, and various configurations of amplifiers, power sources, software and other enhancementsproducts to provide a more fully integrated mass notification solution for municipalities, military bases, airports, college/business campuses, etc. We expect that the ONE VOICE product line will allow us to expand our business opportunities into the large and growing worldwide emergency warning and mass notification market. Through increased focus and investment in domestic and international sales and marketing activities, we have pioneered a new global market, selling our directional LRAD-X long-range acoustic hailing devices (“AHDs”) and advanced ONE VOICE omnidirectional mass notification systems into over 70 countries.

Revenues in the thirdfirst fiscal quarter ended June 30,December 31, 2016, were $5.0$2.9 million, an increase from $3.5$2.8 million in the thirdfirst fiscal quarter of 2015.2016. The increase in revenues resulted from twowas driven by $708,000 of mass notification revenues compared to $277,000 in the first fiscal quarter of 2016. In addition to the improved shipments, we received several large shipments into Southeast Asia – $1.1mass notification orders in the first fiscal quarter of 2017, including a $1.3 million mobile mass notification systems order for public safety and $760,000 for navy vessels – as well as diverse shipments across a number of markets, including police, border and perimeter security,large oil and gas prisons,company in Eurasia for public address, emergency communication and early warning; a large order for a major maritime port installation and integration using LRAD command and control software; a 360X system and accessory order for a National Guard state headquarters and several follow-on orders for tsunami warning installations in Japan. U.S. revenues remained strong in the fiscal 2017 first quarter with an LRAD 1000RX systems order for perimeter safety and foreign militarysecurity for utility infrastructure, and military vehicles. Whilea U.S. Navy spares order. Our bookings during the fiscal 2017 first quarter were strong, which we continue to experience delays in projects in both U.S. and international markets due to various reasons, we saw some improvement during our thirdbelieve will be a good indicator for the second quarter of fiscal quarter. We are aggressively pursuing these opportunities to try to bring them to closure.2017. Based on the timing of budget cycles, as well as financial issues and military conflict in certain areas of the world, delays in awarding contracts often occur, resulting in uneven quarterly revenues. As a result of the U.S. presidential election and new administration, U.S. defense spending may increase, though it is too early to tell what the priorities will be. Demand for our products remains strong and we continue to build awareness and interest in our LRAD-X and ONE VOICE mass notification products throughout the world. On a quarter over quarter basis, our revenues are expected to remain uneven. Gross profit increaseddecreased compared to the same quarter in the prior year as a result of higher revenues and fixed overhead absorption, partially offset by lower product marginmargins due to product mix. Operating expenses increased by 21.8%26.3% from $1.8$2.0 million to $2.2$2.6 million in the quarter ended June 30,December 31, 2016, primarily due to increased salaries, benefitsan increase in non-cash share-based compensation expense from the modification of stock options in accordance with a Separation Agreement and consultants, recruiting expensesGeneral Release related to the June 30, 2016 departure of the Company’s prior CEO search and commissions due to increased revenues.a bonus accrual based on the Company’s expectation for meeting current year financial goals. We reported a net incomeloss of $277,000$812,680 for the quarter, or $0.01$0.03 per diluted share, compared to a net loss of $64,000,$380,073, or $0.00$0.01 per share for the same quarter in the prior year.

Overall Business Outlook

Our product line-up continues to gain worldwide awareness and recognition through media exposure, trade show participations, product demonstrations and word of mouth as a result of positive responses and increased acceptance of our products. We believe we have a solid global brand, technology and product foundation with our LRAD-X directed product line, which we have expanded over the years to service new markets and customers for greater business growth.  We have launched a line of omnidirectional products targeted to meet the needs of the large and growing mass notification market. We believe that we have strong market opportunities for our directional and omnidirectional product offerings within the global government and military sector, as well as increasing commercial applications as a result of continued threats to governments, commerce and law enforcement, and in wildlife preservation and control applications. We intend to continue expanding our international mass notification business, particularly in the Middle East, Europe and Asia where we believe there are greater market opportunities for our omnidirectional products. Our selling network has expanded through the addition of marketing and business development personnelsales consultants as well as continuing to improve and increase our relationships with key integrators and sales representatives within the United States and in a number of worldwide locations. However, we may continue to face challenges in fiscal 2016 and 2017 due to continuing economic and geopolitical conditions in some international regions, as well as the upcoming U.S. presidential election.regions. We anticipate continuedthat the new U.S. government administration will support U.S. Military spending, which we believe could benefit us, although there is uncertainty dueas to ongoing defense budget delayspriorities and spending reductions.timing. We continue to pursue large business opportunities, but it is difficult to anticipate how long it will take to close these opportunities, or if they will ever ultimately come to fruition. It is also difficult to determine whether our omnidirectional product will be accepted as a viable solution in the mass notification market, which includes a number of large, well-known competitors.

Critical Accounting Policies

We have identified a number of accounting policies as critical to our business operations and the understanding of our results of operations. These are described in our consolidated financial statements located in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended September 30, 2015.2016. The impact and any associated risks related to these policies on our business operations is discussed below and throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported and expected financial results.

The methods, estimates and judgments we use in applying our accounting policies, in conformity with generally accepted accounting principles in the U.S., have a significant impact on the results we report in our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The estimates affect the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

Comparison of Results of Operations for the Three Months EndedJune 30, December 31, 2016 and 20152015

Revenues

The following table sets forth for the periods indicated certain items of our condensed consolidated statements of operations expressed in dollars and as a percentage of net revenues. The financial information and the discussion below should be read in conjunction with the condensed consolidated financial statements and notes contained in this report.