UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period endedSeptemberJune 30, 20172019.

or

For the transition period from __________ to __________.

Commission File Number:001-33899

Digital Ally, Inc.

(Exact name of registrant as specified in its charter)

9705 Loiret Blvd, Lenexa, KS 66219

(Address of principal executive offices) (Zip Code)

(913) 814-7774

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes [X] No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer”filer,” “accelerated filer”filer,” “smaller reporting company,” and “smaller reporting“emerging growth company” in Rule 12b-2 of Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [  ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes [  ] No [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

FORM 10-Q

DIGITAL ALLY, INC.

SEPTEMBERJUNE 30, 2017

(Unaudited)2019

PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

SEPTEMBERJUNE 30, 20172019 AND DECEMBER 31, 20162018

See Notes to Unaudited Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINESIX MONTHS ENDED

SEPTEMBERJUNE 30, 20172019 AND 20162018

(Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

FOR THE NINETHREE AND SIX MONTHS ENDED SEPTEMBERJUNE 30, 20172019 AND 2018
(Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINESIX MONTHS ENDED SEPTEMBERJUNE 30, 20172019 AND 20162018
(Unaudited)

See Notes to Unaudited Condensed Consolidated Financial Statements.

DIGITAL ALLY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business:

Digital Ally, Inc. and subsidiariessubsidiary (collectively, “Digital Ally,” “Digital,” the “Company,” “we,” “ours” and “us”“Company”) produces digital video imaging and storage products for use in law enforcement, security and commercial applications. Its products are an in-car digital video/audio recorder contained in a rear-view mirror for use in law enforcement and commercial fleets; a system that provides its law enforcement customers with audio/video surveillance from multiple vantage points and hands-free automatic activation of body-worn cameras and in-car video systems; a miniature digital video system designed to be worn on an individual’s body; a weather-resistant mobile digital video recording system for use on motorcycles, ATV’s and boats; a hand-held laser speed detection device that it is offering primarily to law enforcement agencies; and cloud storage solutions. The Company has active research and development programs to adapt its technologies to other applications. It can integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique solutions to address needs in a variety of other industries and markets, including mass transit, school bus, taxi cabtaxicab and the military. The Company sells its products to law enforcement agencies and other security organizations and consumer and commercial fleet operators through direct sales domestically and third-party distributors internationally.

The Company was originally incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. and had no operations until 2004. On November 30, 2004, Vegas Petra, Inc. entered into a Plan of Merger with Digital Ally, Inc., at which time the merged entity was renamed Digital Ally, Inc.

Recently Adopted Pronouncements

In February 2016, the FASB issued Accounting Standard Update (“ASU”) 2016-02,Leases(“Topic 842”). The guidance requires lessees to put most leases on their balance sheets but recognize expenses on their income statements in a manner similar to today’s accounting. Lessees initially recognize a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The lease liability is measured at the present value of the lease payments over the lease term. The right-of-use asset is measured at the lease liability amount, adjusted for lease prepayments, lease incentives received and the lessee’s initial direct costs. The standard is effective for public business entities for annual reporting periods beginning after December 15, 2018, and interim periods within that reporting period, which is the first quarter of 2019 for the Company.

The Company adopted the new guidance on January 1, 2019 using the optional transitional method and elected to use the package of three practical expedients which allows the Company not to reassess whether contracts are or contain leases, lease classification and whether initial direct costs qualify for capitalization. The Company has completed its assessment of the impact of the standard and determined that the only lease that the Company held was an operating lease for its office and warehouse space. Upon adoption of the standard, the Company recorded Right of Use (ROU) assets of approximately $501,000 and lease liabilities of approximately $582,000 related to it office and warehouse space operating leases. The Company also removed deferred rent of approximately $81,000 when adopting the new guidance.

Management’s Liquidity Plan

The Company incurred substantial operating losses in the ninesix months ended SeptemberJune 30, 20172019 and recent yearssubstantial operating losses for the year ended December 31, 2018 primarily due to reduced revenues and gross margins caused by specific product quality issues resultingcompetitors’ willful infringement of its patents, specifically the auto-activation of body-worn and in-car video systems, and by competitors’ introduction of newer products with more advanced features together with significant price cutting of their products. The Company incurred net losses of approximately $3.6 million for the six months ended June 30, 2019 and $15.5 million during the year ended December 31, 2018 and it had an accumulated deficit of $81.0 million as of June 30, 2019. During the six months ended June 30, 2019, the Company settled one of its patent infringement cases and received a lump sum payment of $6.0 million which was used to pay its obligations under its Proceeds Investment Agreement (the “PIA”), as more fully described in the significant delays in customer orders and product rework expenditures.Note 11. In addition,recent years the Company has accessed the public and private capital markets to raise funding through the issuance of debt and equity. In that regard, the Company raised $1,564,000 in the six months ended June 30, 2019 from the exercise of warrants. Additionally, the Company raised funding in the form of subordinated debt, secured debt and proceeds investment agreements totaling $16,500,000, and net proceeds of $7,324,900 from an underwritten public offering of common stock during the year ended December 31, 2018. The Company issued common stock with detachable common stock purchase warrants for $2,776,332 and raised funding from subordinated and secured debt totaling $1,608,500 during the year ended December 31, 2017. During 2016, the Company raised $4.0 million of funding in the form of convertible debentures and common stock purchase warrants. These debt and equity of approximately $300,000 on September 29, 2017, $3.0 million on August 23, 2017, $700,000 on June 30, 2017, $4.0 million in December 2016 and $11.0 million in 2015raises were utilized to fund its operations and management expects to continue this pattern until it achieves positive cash flows from operations. As of September 30, 2017,operations, although it can offer no assurance in this regard.

The Company retired all interest-bearing debt outstanding during the Company had an accumulated deficit of $57.5 million and has financed its recent operations primarily through debt and equity financings. During the nine months ended September 30, 2017 and year ended December 31, 2016,2018. The only long-term obligations outstanding as of June 30, 2019 are associated with the PIA that the Company incurredentered into during July 2018, as more fully described in Note 6. On August 5, 2019, the Company raised funds from the issuance of $2.78 million principal balance of convertible debentures with detachable warrants to purchase 571,248 shares of common stock with the net losses of approximately $7.85 and $12.7 million, respectively, andproceeds being used cashfor working capital purposes, as more fully described in operating activities of $5.8 million and $5.9 million, respectively. Note 15.

The $300,000 principal amount of subordinated notes payable (the “Notes”) matures on November 30, 2017Company settled its lawsuit with the PGA Tour and the remaining $350,000 principal amount maturescase was dismissed by the Plaintiff with prejudice on December 31, 2017.April 17, 2019. See Note 11, “Contingencies” for the details respecting the settlement. Additionally, the $4.0 million principal amount of 8% Secured Convertible Debentures (the “Debentures”) matures in March 2018 unlessCompany settled its lawsuit with WatchGuard on May 13, 2019 and the Debentures are converted by their holders ($5.00 per share conversion rate) before maturity. The Notes and Debentures represent current liabilities as of September 30, 2017 and will requirecase was dismissed. See Note 11, “Contingencies” for the Company to raise substantial funds to liquidate if operating results do not improve beforedetails respecting the maturity dates of such Notes and Debentures. These conditions indicate that there is substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the financial statements are issued.settlement.

The Company will needhave to restore positive operating cash flows and profitability over the next twelve monthsyear and/or raise additional capital to fund operations, accommodate the potential liquidity needs to retire the Debentures at their maturity,its operational plans, meet its customary payment obligations and otherwise execute its business plan. There can be no assurance that it will be successful in restoring positive cash flows and profitability, or that it can raise additional financing if and when needed, and obtain it on terms acceptable or favorable to the Company.

ManagementThe Company has implemented aan enhanced quality control function that is tasked with the detectionprogram to detect and correction ofcorrect product issues before they result in significant rework expenditures affecting the Company’sits gross margins.margins and has seen progress in that regard. In addition, the Company has undertakenundertook a number of cost reduction initiatives in 2018, including a reduction of its workforce by approximately 40%, restructuring its direct sales force and reducingcutting other selling, general and administrative costs. The Company has introduced a new full high definition in-car video system (DVM-800 HD), which is intended to help it regain market share and improve revenues in its law enforcement division. The Company has increased its addressable market to non-law enforcement customers and obtained significant new non-law enforcement contracts in 2017,2018, which contracts include recurring revenue overduring the 2017period 2019 to 2019 period. Management2020. The Company believes that its quality control, headcount reduction and cost cutting initiatives, introduction of the DVM-800 HD for law enforcement and expansion to non-law enforcement sales channels and new product introduction will eventually restore positive operating cash flows and profitability, during the next year, although it can offer no assurances in this regard.

In addition to the initiatives described above, the Board of Directors continues to conduct its review of a full range of strategic alternatives to best position the Company for the future, including, but not limited to, monetizing its patent portfolio and related patent infringement litigation against Axon Enterprise, Inc. (“Axon,” formerly Taser International, Inc.), the sale of all or certain assets, properties or groups of properties or individual businesses or merger or combination with another company. The result of this review may also include the continued implementation of the Company’s plan also includes raisingbusiness plan. The August 5, 2019 issuance of $2.78 million principal balance of convertible notes was part of this strategic alternatives review. While such funding addressed the Company’s near-term liquidity needs, it continues to consider strategic alternatives to address longer-term liquidity needs and operational issues. There can be no assurance that any additional capital if required. The Company has demonstrated its ability to raise new debttransactions or equity capital in recent years and believes that it could raise additional capital during the next 12 months if required, but again can offer no assurances infinancings will result from this regard. process.

Based on the uncertainties described above, the Company believes its business plan does not alleviate the existence of substantial doubt about its ability to continue as a going concern within one year afterfrom the date thatof the issuance of these condensed consolidated interim financial statements in this Report.statements.

The following is a summary of the Company’s Significant Accounting Policies:

Basis of Consolidation:

The accompanying financial statements include the consolidated accounts of Digital Ally and its wholly-owned subsidiaries,subsidiary, Digital Ally International, Inc., MP Ally, LLC, Medical Devices Ally, LLC and Digitaldeck, LLC. All intercompany balances and transactions have been eliminated during consolidation.

The Company formed Digital Ally International, Inc. during August 2009 to facilitate the export sales of its products. In addition, Medical Devices Ally, LLC was formed in July 2014, MP Ally, LLC was formed in July 2015, and Digitaldeck, LLC was formed in June 2017, all of which have been inactive since formation.

Fair Value of Financial Instruments:

The carrying amounts of financial instruments, including cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short-term nature of these items. The Company accounts for its derivative liabilities and its secured convertible debenturesproceeds investment agreement on a fair value basis.

Revenue Recognition:

RevenuesThe Company applies the provisions of Accounting Standards Codification (ASC) 606-10,Revenue from Contracts with Customers, and all related appropriate guidance. The Company recognizes revenue under the salecore principle to depict the transfer of control to its customers in an amount reflecting the consideration to which it expects to be entitled. In order to achieve that core principle, the Company applies the following five-step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.

The Company considers customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with the customer. In situation where sales are to a distributor, the Company had concluded its contracts are with the distributor as the Company holds a contract bearing enforceable rights and obligations only with the distributor. As part of part of its consideration for the contract, the Company evaluates certain factors including the customers’ ability to pay (or credit risk). For each contract, the Company considers the promise to transfer products, each of which is distinct, to be the identified performance obligations. In determining the transaction price, the Company evaluates whether the price is subject to refund or adjustment to determine the net consideration to which it expects to be entitled. As the Company’s standard payment terms are recordedless than one year, it has elected the practical expedient under ASC 606-10-32-18 to not assess whether a contract has a significant financing component. The Company allocates the transaction price to each distinct product based on its relative standalone selling price. The product price as specified on the purchase order is considered the standalone selling price as it is an observable input which depicts the price as if sold to a similar customer in similar circumstances. Revenue is recognized when control of the product is shipped, title and risk of loss has transferred to the purchaser,customer (i.e. when the Company’s performance obligations is satisfied), which typically occurs at shipment. Further in determining whether control has been transferred, the Company considers if there is a present right to payment terms are fixed or determinable and payment is reasonably assured.legal title, along with risks and rewards of ownership having transferred to the customer. Customers do not have a right to return the product other than for warranty reasons for which they would only receive repair services or replacement product. The Company has also elected the practical expedient under ASC 340-40-25-4 to expense commissions for product sales when incurred as the amortization period of the commission asset the Company would have otherwise recognized is less than one year.

The Company sells its products and services to law enforcement and commercial customers in the following manner:

Sales taxes collected on products sold are excluded from revenues and are reported as an accrued expenseexpenses in the accompanying balance sheets until payments are remitted.

Service and other revenue is comprised of revenues from extended warranties, repair services, cloud revenue and software revenue. Revenue is recognized upon shipment of the product and acceptance of the service or materials by the end customer for repair services. Revenue for extended warranty, cloud service or other software-based are treated as deferred revenue and recognizedproducts is over the term of the contractedcontract warranty or service periodperiod. A time-elapsed method is used to measure progress because the Company transfers control evenly over the contractual period. Accordingly, the fixed consideration related to these revenues is generally recognized on a straight-line method.

Extended warranties are offered on selected products and when a customer purchases an extended warranty the associated proceeds are treated as deferred revenue and recognizedbasis over the contract term, ofas long as the extended warranty on a straight-line method.other revenue recognition criteria have been met.

Contracts with some of the Company’s customers contain multiple performance obligations that are distinct and accounted for separately. The transaction price is allocated to the separate performance obligations on a relative standalone selling price (“SSP”). The Company determined SSP for all the performance obligations using observable inputs, such as standalone sales and historical pricing. SSP is consistent with the Company’s overall pricing objectives, taking into consideration the type of service being provided. SSP also reflects the amount the Company would charge for the performance obligation if it were sold separately in a standalone sale. Multiple element arrangements consistingperformance obligations consist of product, software, cloud subscriptions and extended warranties are offered to our customers. Revenue arrangements with multiple deliverables are divided into separate units and revenue is allocated using the relative selling price method based upon vendor-specific objective evidence of selling price or third-party evidence of the selling prices if vendor-specific objective evidence of selling prices does not exist. If neither vendor-specific objective evidence nor third-party evidence exists, management uses its best estimate of selling price. The majority of the Company’s allocations of arrangement consideration under multiple element arrangements are performed using vendor-specific objective evidence by utilizing prices charged to customers for deliverables when sold separately. warranties.

The Company’s multiple element arrangementsperformance obligations may include future in-car or body-worn camera devices to be delivered at defined points within a multi-year contract, and in those arrangements, the Company allocates total arrangement consideration over the life of the multi-year contract to future deliverables using management’s best estimate of selling price. The Company has not utilized third-party evidence

Contract liabilities consist of selling price.deferred revenue and include payments received in advance of performance under the contract and are reported separately as current liabilities and non-current liabilities in the Condensed Consolidated Balance Sheets. Such amounts consist of extended warranty contracts, prepaid cloud services and prepaid installation services and are generally recognized as the respective performance obligations are satisfied. Total contract liabilities consist of the following:

Sales returns and allowances aggregated $12,390$37,978 and $61,673$34,227 for the three months ended SeptemberJune 30, 20172019 and 2016,2018, respectively, and $(15,195)$112,237 and $263,663$54,246 for the ninesix months ended SeptemberJune 30, 20172019 and 2016,2018, respectively. Obligations for estimated sales returns and allowances are recognized at the time of sales on an accrual basis. The accrual is determined based upon historical return rates adjusted for known changes in key variables affecting these return rates. A customer paid under a sales transaction in March 2017 that had been accrued to be returned at December 31, 2016, whichrates

Revenues for six month ended June 30, 2019 and 2018 were derived from the caused the negative sales returns for the nine months ended September 30, 2017.following sources

Use of Estimates:

The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management 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 the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and cash equivalents:

Cash and cash equivalents include funds on hand, in bank and short-term investments with original maturities of ninety (90) days or less.

Cash and cash equivalents that are restricted as to withdrawal or use under the terms of the secured convertible debentures are presented as restricted cash separate from cash and cash equivalents on the accompanying balance sheet.

Accounts Receivable:

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a weekly basis. The Company determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.

A trade receivable is considered to be past due if any portion of the receivable balance is outstanding for more than thirty (30) days beyond terms. No interest is charged on overdue trade receivables.

Inventories:

Inventories consist of electronic parts, circuitry boards, camera parts and ancillary parts (collectively, “components”), work-in-process and finished goods, and are carried at the lower of cost (First-in, First-out Method) or market value. The Company determines the estimate for the reserve for slow moving or obsolete inventories by regularly evaluating individual inventory levels, projected sales and current economic conditions.

Furniture, fixtures and equipment:

Furniture, fixtures and equipment is stated at cost net of accumulated depreciation. Additions and improvements are capitalized while ordinary maintenance and repair expenditures are charged to expense as incurred. Depreciation is recorded by the straight-line method over the estimated useful life of the asset, which ranges from twothree to ten years. Amortization expense on capitalized leases is included with depreciation expense.

Intangible assets:

Intangible assets include deferred patent costs and license agreements. Legal expenses incurred in preparation of patent application have been deferred and will be amortized over the useful life of granted patents. Costs incurred in preparation of applications that are not granted will be charged to expense at that time. The Company has entered into several sublicense agreements under which it has been assigned the exclusive rights to certain licensed materials used in its products. These sublicense agreements generally require upfront payments to obtain the exclusive rights to such material. The Company capitalizes the upfront payments as intangible assets and amortizes such costs over their estimated useful life on a straight-line method.

Secured convertible debentures:Leases:

The Company determines if an arrangement contains a lease at inception. For arrangements where the Company is the lessee, the Company will evaluate whether to account for the lease as an operating or finance lease. Operating leases are included in the right of use assets (ROU) and operating lease liabilities on the condensed consolidated balance sheet as of June 30, 2019. Finance leases would be included in furniture, fixtures and equipment, net and long-term debt and finance lease obligations on the condensed balance sheet. The Company had an operating lease for office and warehouse space at June 30, 2019 but no financing leases.

ROU assets and lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. The Company uses its incremental borrowing rate based on the information available at the commencement date in determining the operating lease liabilities if the operating lease does not provide an implicit rate. Lease terms may include the option to extend when Company is reasonably certain that the option will be exercised. Lease expense for operating leases is recognized on a straight-line basis over the lease term

The Company elected to apply the short-term lease measurement and recognition exemption in which ROU assets and lease liabilities are not recognized for short term leases.

Proceeds investment agreement:

The Company has elected to record its Debenturesproceeds investment agreement at its fair value. Accordingly, the Debenturesproceeds investment agreement will be marked-to-market at each reporting date with the change in fair value reported as a gain (loss) in the statementCondensed Consolidated Statement of operations.Operations. All issuance costs related to the Debenturesproceeds investment agreement were expensed as incurred in the statementCondensed Consolidated Statement of operations.Operations.

Long-Lived Assets:

Long-lived assets such as property, plantfurniture, fixtures and equipment and purchased intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques, including discounted cash flow models, quoted market values and third-party appraisals, as considered necessary.

Warranties:

The Company’s products carry explicit product warranties that extend up to two years from the date of shipment. The Company records a provision for estimated warranty costs based upon historical warranty loss experience and periodically adjusts these provisions to reflect actual experience. Accrued warranty costs are included in accrued expenses. Extended warranties are offered on selected products and when a customer purchases an extended warranty the associated proceeds are treated as deferred revenuecontract liabilities and recognized over the term of the extended warranty.

Shipping and Handling Costs:

Shipping and handling costs for outbound sales orders totaled $11,858$13,158 and $26,077$20,317 for the three months ended SeptemberJune 30, 20172019 and 2016,2018, respectively, and $51,949$31,578 and $72,296$34,284 for the ninesix months ended SeptemberJune 30, 20172019 and 2016,2018, respectively. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

Advertising Costs:

Advertising expense includes costs related to trade shows and conventions, promotional material and supplies, and media costs. Advertising costs are expensed in the period in which they are incurred. The Company incurred total advertising expense of approximately $346,935$510,792 and $615,586$111,677 for the three months ended SeptemberJune 30, 20172019 and 2016,2018, respectively, and $617,264$634,807 and $936,998$191,246 for the ninesix months ended SeptemberJune 30, 20172019 and 2016,2018, respectively. The increase was primarily attributable to our sponsorship of a NASCAR race in May 2019 and other related sponsorship opportunities. Such costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations.

Income Taxes:

Deferred taxes are provided for by the liability method in which deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

The Company applies the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) No. 740 - Income Taxes that provides a framework for accounting for uncertainty in income taxes and provided a comprehensive model to recognize, measure, present, and disclose in its financial statements uncertain tax positions taken or expected to be taken on a tax return. It initially recognizes tax positions in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. Application requires numerous estimates based on available information. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, and it recognized tax positions and tax benefits may not accurately anticipate actual outcomes. As it obtains additional information, the Company may need to periodically adjust its recognized tax positions and tax benefits. These periodic adjustments may have a material impact on its Condensed consolidated statementsStatements of operations.Operations.

The Company’s policy is to record estimated interest and penalties related to the underpayment of income taxes as income tax expense in the condensed consolidated statements of operations. There was no interest expense related to the underpayment of estimated taxes during the ninesix months ended SeptemberJune 30, 20172019 and 2016.2018. There have beenwere no penalties in the ninesix months ended SeptemberJune 30, 20172019 and 2016.2018.

The Company is subject to taxation in the United States and various states. As of SeptemberJune 30, 2017,2019, the Company’s tax returns filed for 2013, 2014,2015, 2016, and 20152017 and to be filed for 20162018 are subject to examination by the relevant taxing authorities. With few exceptions, as of SeptemberJune 30, 2017,2019, the Company is no longer subject to Federal, state, or local examinations by tax authorities for years before 2013.2015.

Research and Development Expenses:

The Company expenses all research and development costs as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established. Costs incurred subsequent to achievement of technological feasibility were not significant, and software development costs were expensed as incurred during the ninesix months ended SeptemberJune 30, 20172019 and 2016.2018.

Common Stock Purchase Warrants:

The Company has common stock purchase warrants that are accounted for as liabilities under the caption of derivative liabilities on the consolidated balance sheet and recorded at fair value due to the warrant agreements containing anti-dilution provisions. The change in fair value being recorded in the consolidated statement of operations.

The Company has common stock common stock purchase warrants that are accounted for as equity based on their relative fair value and are not subject to re-measurement.

Stock-Based Compensation:

The Company grants stock-based compensation to its employees, board of directors and certain third-party contractors. Share-based compensation arrangements may include the issuance of options to purchase common stock in the future or the issuance of restricted stock, which generally are subject to vesting requirements. The Company records stock-based compensation expense for all stock-based compensation granted based on the grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award.

The Company estimates the grant-date fair value of stock-based compensation using the Black-Scholes valuation model. Assumptions used to estimate compensation expense are determined as follows:

Segments of Business:

Management has determined that its operations are comprised of one reportable segment: the sale of digital audio and video recording and speed detection devices. For the three and ninesix months ended SeptemberJune 30, 20172019 and 2016,2018, sales by geographic area were as follows:

Sales to customers outside of the United States are denominated in U.S. dollars. All Company assets are physically located within the United States.

Reclassification of Prior Year Presentation:Recent Accounting Pronouncements

Certain prior year amounts have been reclassified for consistency withThere were no new material accounting pronouncements that were applicable to the current year presentation. These reclassifications had no effect on the reported results of operations.

Recent Accounting Pronouncements:

In May 2014, the FASB issued Accounting Standard Update (“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 entitledCompany for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The standard is effective for interim and annual periods beginning after December 15, 2017 and permits the use of either the retrospective or cumulative effect transition method. The Company has selected the cumulative effect transition method and is currently evaluating the guidance to determine the impact on retained earnings but it does not expect the adoption to have a material impact on the Company’s consolidated financial statements and footnote disclosures.

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330):Simplifying the Measurement of Inventory. The amendments in the ASU require entities that measure inventory using the first-in, first-out or average cost methods to measure inventory at the lower of cost and net realizable value. Net realizable value is defined as estimated selling price in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation. The Company adopted this new standard on January 1, 2017 and such adoption did not have any impact on its consolidated financial statements.

In November 2015, the FASB issued ASU 2015-17,Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This ASU simplifies the presentation of deferred income taxes by eliminating the requirement for entities to separate deferred tax liabilities and assets into current and noncurrent amounts in classified balance sheets. Instead, it requires deferred tax assets and liabilities be classified as noncurrent in the balance sheet. The Company adopted this new standard on January 1, 2017 and such adoption did not have any impact on its consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02,Leases (Topic 842). The objective of ASU 2016-02 is to recognize lease assets and lease liabilities by lessees for those leases classified as operating leases under previous U.S. GAAP. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption of ASU 2016-02 is permitted. The Company is evaluating the effects adoption of this guidance will have on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09,Compensation-Stock Compensation (Topic 718). The objective of ASU 2016-09 is to reduce the complexity of certain aspects of the accounting for employee share-based payment transactions. As a result of this ASU, there are changes to minimum statutory withholding requirements, accounting for forfeitures, and accounting for income taxes. The Company adopted this new standard on January 1, 2017 and elected to account for forfeitures as they occur and has resulted in a credit to stock-based compensation of $256,167 relative to forfeitures during the ninesix months ended SeptemberJune 30, 2017.2019.

In August 2016, the FASB issued ASU 2016-15,Clarification on Classification of Certain Cash Receipts and Cash Payments on the Statement of Cash Flows, to create consistency in the classification of eight specific cash flow items. This standard is effective for calendar-year SEC registrants beginning in 2018. The Company is evaluating the effects adoption of this guidance will have on its consolidated financial statements.

In November 2016, the FASB issued ASU 2016-18,Statement of Cash Flows - Restricted Cash (Topic 230), which amends the existing guidance relating to the disclosure of restricted cash and restricted cash equivalents on the statement of cash flows. ASU 2016-18 is effective for the fiscal year beginning after December 15, 2017, and interim periods within that fiscal year, and early adoption is permitted. The Company is evaluating the impact of adoption of ASU 2016-18 on its Consolidated Statements of Cash Flows.

In May 2017, the FASB issued ASU 2017-09,Stock Compensation (Topic 718)-Scope of Modification Accounting, to provide guidance on determining which changes to terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those annual periods. The Company is evaluating the effects adoption of this guidance will have on its consolidated financial statements.

NOTE 2. BASIS OF PRESENTATION

The condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and with the instructions to Form 10-Q and Article 108 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine-monththree and six-month period ended SeptemberJune 30, 20172019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.2019.

The balance sheet at December 31, 20162018 has been derived from the audited financial statements at that date but does not include all the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements.

For further information, refer to the financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2016.2018.

NOTE 3. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject the Company to concentrations of credit risk consist of accounts receivable. Sales to domestic customers are typically made on credit and the Company generally does not require collateral while sales to international customers require payment before shipment or backing by an irrevocable letter or credit. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated losses. Accounts are written off when deemed uncollectible and accounts receivable are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts totaled $90,000 as of June 30, 2019 and $70,000 as of September 30, 2017 and December 31, 2016.2018.

The Company uses primarily a network of unaffiliated distributors for international sales and employee-based direct sales force for domestic sales. No international distributor individually exceeded 10% of total revenues for the nine months ended September 30, 2017 or September 30, 2016. No individualand no customer receivable balance exceeded 10% of total accounts receivable as of Septemberfor the six months ended June 30, 2017 or September 30, 2016.2019 and 2018

The Company purchases finished circuit boards and other proprietary component parts from suppliers located in the United States and on a limited basis from Asia. Although the Company obtains certain of these components from single source suppliers, it generally owns all tooling and management has located alternative suppliers to reduce the risk in most cases to supplier problems that could result in significant production delays. The Company has not historically experienced significant supply disruptions from any of its principal vendors and does not anticipate future supply disruptions. The Company acquires most of its components on a purchase order basis and does not have long-term contracts with its suppliers.

NOTE 4. INVENTORIES

Inventories consisted of the following at SeptemberJune 30, 20172019 and December 31, 2016:2018:

Finished goods inventory includes units held by potential customers and sales agents for test and evaluation purposes. The cost of such units totaled $711,024$141,609 and $634,059$115,456 as of SeptemberJune 30, 20172019 and December 31, 2016,2018, respectively.

NOTE 5. FURNITURE, FIXTURES AND EQUIPMENT

Furniture, fixtures and equipment consisted of the following at SeptemberJune 30, 20172019 and December 31, 2016:2018:

Depreciation and amortization of furniture, fixtures and equipment aggregated $412,558$63,506 and $399,950$101,252 for the ninethree months ended SeptemberJune 30, 20172019 and 2016,2018, respectively, and $138,272 and $217,802 for the six months ended June 30, 2019 and 2018, respectively.

NOTE 6. SECURED CONVERTIBLE DEBENTURES, SUBORDINATED NOTES PAYABLE, AND CAPITAL LEASEDEBT OBLIGATIONS

2016 Secured Convertible Debentures. Secured Convertible DebenturesProceeds investment agreement is comprised of the following:

2018 Proceeds Investment Agreement.

On December 30, 2016,July 31, 2018, the Company entered into a Proceeds Investment Agreement (the “PIA”) with Brickell Key Investments LP (“BKI”), pursuant to which BKI funded an aggregate of $500,000 (the “First Tranche”) to be used (i) to fund the Company’s litigation proceedings relating to the infringement of certain patent assets listed in the PIA and (ii) to repay the Company’s existing debt obligations and for certain working capital purposes set forth in the PIA. Pursuant to the PIA, BKI was granted an option to provide the Company with an additional $9.5 million, at BKI’s sole discretion (the “Second Tranche”). On August 21, 2018, BKI exercised its option on the Second Tranche for $9.5 million which completed the $10 million funding.

Pursuant to the PIA and in consideration for the $10.0 million in funding, the Company agreed to assign to BKI (i) 100% of all gross, pre-tax monetary recoveries paid by any defendant(s) to the Company or its affiliates agreed to in a private placementsettlement or awarded in judgment in connection with the patent assets, plus any interest paid in connection therewith by such defendant(s) (the “Private Placement”“Patent Assets Proceeds”), up to the minimum return (as defined in the Agreement) and (ii) if BKI has not received its minimum return by the earlier of a liquidity event (as defined in the Agreement) and July 31, 2020, then the Company agreed to assign to BKI 100% of the Patent Asset Proceeds until BKI has received an amount equal to the minimum return on $4.0 million.

Pursuant to the PIA, the Company granted BKI (i) a senior security interest in the Patent Assets, the claims (as defined in the Agreement) and the Patent Assets Proceeds until such time as the minimum return is paid, in which case, the security interest on the patent assets, the claims and the Patent Assets Proceeds will be released, and (ii) a senior security interest in all other assets of the Company until such time as the minimum return is paid on $4.0 million, in principalwhich case, the security interest on such other assets will be released.

The security interest is enforceable by BKI if the Company is in default under the PIA which would occur if (i) the Company fails, after five (5) days’ written notice, to pay any due amount payable to BKI under the PIA, (ii) the Company fails to comply with any provision of the DebenturesPIA Agreement or any other agreement or document contemplated under the PIA, (iii) the Company becomes insolvent or insolvency proceedings are commenced (and not subsequently discharged) with respect to the Company, (iv) the Company’s creditors commence actions against the Company (which are not subsequently discharged) that affect material assets of the Company, (v) the Company, without BKI’s consent, incurs indebtedness other than immaterial ordinary course indebtedness up to $500,000, (vi) the Company fails, within five (5) business days following the closing of the second tranche, to fully satisfy its obligations to certain holders of the Company’s senior secured convertible promissory notes listed in the PIA Agreement and fails to obtain unconditional releases from such holders as to the Company’s obligations to such holders and the security interests in the Company held by such holders or (vii) there is an uncured non-compliance of the Company’s obligations or misrepresentations by the Company under the PIA.

Under the PIA, the Company issued BKI a warrant to purchase up to 465,712 shares of the Company’s common stock, warrantspar value $0.001 per share (the “Warrants”“PIA Warrant”), at an exercise price of $2.60 per share provided that the holder of the PIA Warrant will be prohibited from exercising the PIA Warrant if, as a result of such exercise, such holder, together with its affiliates, would own more than 4.99% of the total number of shares of the Company’s common stock outstanding immediately after giving effect to two institutional investors.such exercise. However, such holder may increase or decrease such percentage to any other percentage not in excess of 9.99%, provided that any increase in such percentage shall not be effective until 61 days after such notice to the Company. The DebenturesPIA Warrant is exercisable for five years from the date of issuance and Warrantsis exercisable on a cashless exercise basis if there is no effective registration statement. No contractual registration rights were issued pursuant to a Securities Purchase Agreement (the “Purchase Agreement”) between the Company and the purchasers’ signatory thereto (the “Holders”). The Private Placement resulted in gross proceeds of $4.0 million before placement agent fees and other expenses associated with the transaction totaling $281,570, which was expensed as incurred.given.

The Company elected to account for the DebenturesPIA on the fair value basis. Therefore, the Company determined the fair value of the Debentures utilizing Monte Carlo simulation modelsPIA and PIA Warrants which yielded an estimated fair valuevalues of $4.0 million for the DebenturesPIA including their embedded derivatives as of the origination date. No value was allocated toand the detachable PIA Warrants as of the origination date because of the relative fair value of the convertible note including its embedded derivative features approximated the gross proceeds of the financing transaction. The Company made principal payments of $750,000 on August 24, 2017 against the Debentures. The change in the fair value of the Debentures between December 31, 2016 and September 30, 2017 was $(66,790) and was reflected as income in the Condensed Statement of Operations.follows:

Prior to the maturity date, the Debentures bear interest at 8% per annum with interest payable in cash quarterly in arrears on the first business day of each calendar quarter following the issuance date. The Debentures rank senior to the Company’s existing and future indebtedness and are secured by substantially all tangible and certain intangible assets of the Company.

The Debentures are convertible at any time six months after their date of issue at the option of the holders into shares of the Company’s common stock at $5.00 per share (the “Conversion Price”). The Debentures mature on March 30, 2018. The Warrants are exercisable to purchase up to an aggregate of 800,000 shares of the Company’s common stock commencing on the date of issuance at an exercise price of $5.00 per share (the “Exercise Price”). The Warrants will expire on the fifth anniversary of their date of issuance. The Conversion Price and Exercise Price are subject to adjustment upon stock splits, reverse stock splits, and similar capital changes.

The Company has the right, subject to certain limitations, to redeem the Debenture with 30 days advance notice with the redemption amount determined as the sum of (a) 112% of the then outstanding principal amount of the Debenture, (b) accrued but unpaid interest and (c) all liquidated damages and other amounts due in respect of the Debenture, if any.

Additionally, if following the six-month anniversary of the Original Issue Date, the VWAP (volume weighted average price), for each of any ten (10) consecutive trading days exceeds $7.50 per share, the Company has the right, subject to certain limitations, to provide written notice to the Holders to cause them to convert all or part of the then outstanding principal amount of the Debenture plus accrued but unpaid interest.

Upon the occurrence of an event of default, the Debentures bear interest at 18% per annum and a Holder may require the Company to redeem all or a portion of its Debenture. The Company has agreed to maintain a cash balance of $500,000 while the Debentures are outstanding, which is reflected as restricted cash in the accompanying balance sheet. The Holders have agreed to beneficial conversion limitation that effectively blocks either Holder from converting the Debenture or exercising the Warrant to the extent that such conversion or exercise would result in the Holder being the beneficial owner in excess of 4.99% (or, upon election of purchaser, 9.99%), which beneficial ownership limitation may be increased or decreased up to 9.99% upon notice to the Company, provided that any increase in such limitation will not be effective until 61 days following notice to the Company.

During the ninesix months ended SeptemberJune 30, 2017,2019, the Company was required to make payments totaling $750,000 to the holderssettled its patent infringement litigation with WatchGuard and it received a lump-sum payment of the Debentures resulting from the repayment provisions of the Debentures relative to additional capital raises.

Subordinated Notes Payable. Subordinated notes payable is comprised of the following:

On June 30, 2017, the Company,$6.0 million as further described in two separate transactions, borrowed an aggregate of $700,000 under two unsecured notes payable to private, third-party lenders. The loans were funded on June 30, 2017 and both were represented by promissory notes (the “Notes”) that bore interest at the rate of 8% per annumNote 11. In accordance with principal and accrued interest payable on or before their maturity date of September 30, 2017. The Notes were unsecured and subordinated to all existing and future senior indebtedness, as such term is defined in the Notes. The Company granted the lenders warrants (the “Warrants”) exercisable to purchase a total of 200,000 shares of its common stock at an exercise price of $3.65 per share until June 29, 2022. The Company allocated $288,895 of the proceeds of the Notes to additional paid-in-capital, which represented the grant date relative fair value of the Warrants for 200,000 common shares issued to the lenders. The discount was amortized to interest expense ratably over the terms of the Note. On September 30, 2017,PIA, the Company obtained an extensionremitted the $6.0 as a principal payment toward its minimum return payment obligations under the PIA. The Company recorded the receipt of the maturity date of one of the Notes to December 31, 2017. The Company paid the second Note in full in August 2017.

On September 29, 2017, the Company borrowed $300,000 under an unsecured note payable with a private, third party lender (also referred to$6,000,000 settlement as the “Note”). The loan is represented by a promissory note that bears interest at 8% per annum and is payable in cash on or before the maturity date. The Note is due and payable in full on November 30, 2017 and may be prepaid without penalty at any time. The Note is unsecured and subordinated to all existing and future senior indebtedness, as such term is definedPatent litigation settlement income in the Note. The Company issued warrants to the lender exercisable to purchase 100,000 sharesaccompanying condensed consolidated statement of common stock for $2.75 per share until September 30, 2022. The Company allocated $117,000 of the proceeds of the Note to additional paid-in-capital, which represented the grant date relative fair value of the warrants issued to the lender. The discount will be amortized to interest expense ratably over the terms of the note.operations.

The discount amortized to interest expense totaled $288,895 and $-0- forfollowing represents activity in the ninePIA during the six months ended SeptemberJune 30, 2017, and 2016, respectively.2019:

Capital Leases. Future minimum lease payments under non-cancelable capital leases having terms in excess of one year are as follows:

Assets under capital leases are included in furniture, fixtures and equipment as follows:

NOTE 7. FAIR VALUE MEASUREMENT

In accordance with ASC Topic 820 —Fair Value Measurements and Disclosures (“ASC 820”), the Company utilizes the market approach to measure fair value for its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets or liabilities, such as a business.

ASC 820 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

The following table represents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of SeptemberJune 30, 20172019 and December 31, 2016.2018.