TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)

THREE MONTHS FROM JANUARY 1, 2019 THROUGH MARCH 31, 2019

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)

THREE MONTHS FROM JANUARY 1, 2020 THROUGH MARCH 31, 2020

See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(UNAUDITED)

See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 20192020

(UNAUDITED)

NOTE A – BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying condensed consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated financial statements of Telkonet, Inc. (the “Company”, “Telkonet”) have been prepared in accordance with Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles 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. However, the results from operations for the three months ended March 31, 2019,2020, are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.2020. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, 20182019 financial statements and footnotes thereto included in the Company's Form 10-K filed with the SEC.

Business and Basis of Presentation

Telkonet, Inc. (the “Company”, “Telkonet”), formed in 1999 and incorporated under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”).

In 2007, the Company acquired substantially all of the assets of Smart Systems International (“SSI”), which was a provider of energy management products and solutions to customers in the United States and Canada and the precursor to the Company’s EcoSmart platform. The EcoSmart platform provides comprehensive savings, management reporting, analytics and virtual engineering of a customer’s portfolio and/or property’s room-by-room energy consumption. Telkonet has deployed more than a half million intelligent devices worldwide in properties within the hospitality, military, educational, healthcare and other commercial markets. The EcoSmart platform is recognized as a solution for reducing energy consumption, operational costs and carbon footprints, and eliminating the need for new energy generation in these marketplaces – all whilst improving occupant comfort and convenience.

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Telkonet Communications, Inc. We currently operate in a single reportable business segment.

Going Concern and Management’s Plan

The accompanying financial statements have been prepared on a going concern basis which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future and, thus, do not include any adjustments relating to the recoverability and classification of assets and liabilities that may be necessary if the Company is unable to continue as a going concern.

Since inception through March 31, 2019,2020, we have incurred cumulative losses of $124,017,010$125,758,040 and have never generated enough fundscash through operations to support our business. For the three-month period ended March 31, 2019,2020, we had an operatinga cash flow deficit from operations of $1,716,357$109,888. Since 2012, the Company has made significant investments in the engineering, development and marketing of an intelligent automation platform, including but not limited to, hardware and software enhancements, support services and applications. The funding for these development efforts has contributed to the ongoing operating losses and use of cash. Operating losses have been financed by debt and equity transactions, credit facility capacity, the sale of a wholly-owned subsidiary and management of working capital levels. The report from operations. our previous independent registered public accounting firm on our consolidated financial statements for the year ended December 31, 2019 stated there is substantial doubt about our ability to continue as a going concern.

The Company’s ability to continue as a going concern is dependent upon generating profitable operations in the future and obtaining the necessary financing to meet its obligations and repay its liabilities arising from normal business operations when they come due. There can be no assurance that the Company will be able to secure such financing at commercially reasonable terms, if at all. If cash resources become insufficient to meet the Company’s ongoing obligations, the Company will be required to scale back or discontinue portions of its operations or discontinue operations entirely, whereby, the Company’s shareholders may lose some or all of their investment.

WeThe Company’s operations and financial results have also been impacted by the COVID-19 pandemic. On January 30, 2020 the World Health Organization (“WHO”) announced a global health emergency because of a new strain of a novel coronavirus in Wuhan, China (the “COVID-19 outbreak”) and the risks to the international community as the virus spreads globally. In March 2020, the WHO classified the COVID-19 outbreak a pandemic, based on the rapid increase in exposure globally. The spread of the COVID-19 outbreak has caused significant volatility and uncertainty in U.S. and international markets.

The Company’s sales have been disrupted as a result of its customers furloughing and laying off their employees and/or suspending projects. Despite these challenges, quoting remains active and the aggregate pipeline has not identified,contracted significantly. Thus far, the impact has been delays as opposed to cancellations. Due to travel restrictions, social distancing and cannotshelter at home edicts, the hospitality industry, our largest market that generally contributes more than 50% of our revenue, has suffered as much as any. At this time, the disruption is expected to be temporary; however, the length or severity of this pandemic is unknown. Depending on the length and severity, the demand for our products, our customers’ ability to meet payment obligations to the Company, our supply chain and production capabilities, and our workforces’ ability to deliver our products and services could be impacted. Management is actively monitoring the impact of the global situation on its financial condition, liquidity, operations, suppliers, industry, and workforce. While we expect this disruption to have a material adverse impact our results of operations, financial condition and cash flows for the year 2020, the Company is unable to reasonably determine the impact at this time.

In response to the COVID-19 pandemic and its effects (and potential further effects) on the Company’s operations and financial results, the Company has taken and is continuing to take a number of actions to preserve cash. These actions include suspending the use of engineering consultants, and cancelling all travel and the Company’s attendance at tradeshows (implemented prior to applicable government stay-at-home orders being put in place). In addition, in early April of 2020, management made the decision to furlough certain we will beemployees, instituted pay cuts for certain other employees and suspended the Company’s 401(k) match through the end of 2020. With the receipt of the PPP Loan (discussed below), the Company was able to identify, a coursebring back the furloughed employees, restore payroll to prior levels and delay suspension of actionthe 401(k) match. The actions taken in response to the COVID-19 pandemic are in addition to the cost elimination and liquidity management actions that guarantees the achievementCompany began implementing in the second half of 2019, including reviewing opportunities to decrease spend with third party consultants and providers, strategically reviewing whether or not to fill employee positions in the event of vacancies, and implementing sales campaigns to sell slow-moving inventory and reducing existing inventory volumes. There is no guarantee, however, that these actions, nor any other actions identified, will yield profitable operations in the foreseeable future.

In June 2018,addition, on April 21, 2020, the Company entered into an unsecured promissory note, dated as of April 17, 2020 (“the PPP Loan”), with Heritage Bank of Commerce for a $913,063 loan under the Paycheck Protection Program (“PPP”) SBA 7(a) loan. The PPP SBA 7(a) loan program is being administered by the United States Small Business Administration (“SBA”) and was authorized by the Keeping American Workers Employed and Paid Act, which is part of the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act that was signed into law on March 27, 2020. The principal amount of the Loan is $913,063, bears interest of 1.0% per annum and has a maturity date of April 21, 2022. See Note N – Subsequent Event for a summary of the terms of the PPP Loan.

At March 31, 2020, the Company had $3,084,828 of cash and approximately $153,000 of availability on its credit facility. However, the credit facility requires that the Company maintain an unrestricted cash balance of $2,000,000, limiting the ability of the Company to use its cash reserves to fund its operations. As of March 31, 2020, the outstanding balance on the credit facility was $518,463. On average, during the twelve-month period between April 1, 2019 and March 31, 2020, the Company’s cash balance decreased $55,000 per month.

The Company is using the proceeds of the PPP Loan to support its ongoing operations and currently expects to also draw on its cash reserves and utilize the credit facility to finance its near-term working capital needs. It expects to continue to incur operating losses and negative operating cash flows for one year beyond the date of these financial statements. The Credit Facility provides us with needed liquidity to assist in meeting our obligations or pursuing strategic objectives. Continued operating losses will deplete these cash reserves and could result in a violation of the financial covenants. Consequently, repayment of amounts borrowed under the Credit Facility may be accelerated and Heritage Bank’s commitment to extend credit under the Heritage Bank Loan Agreement may be terminated. The occurrence of any of these events could have a material adverse effect on our business and results of operations.

The Company’s Board engaged an investment bankalso continues to identifyconsider strategic alternatives to maximize shareholder value, including but not limited to, a sale of the Company, an investment in the Company, a merger or other business combination, a sale of all or substantially all assets or a strategic joint venture. However, these actions are not solely within the control of the Company. At May 15, 2019,2020, no definitive alternatives had been identified.

At March 31, 2019, the Company had $3,745,998 of cash and approximately $1,043,000 of availability on its credit facility. The Company currently expects to draw on these cash reserves and utilize the credit facility to finance its near term working capital needs. It expects to continue to incur operating losses and negative operating cash flows for one year beyond the date of these financial statements. Accordingly, and in light of the Company’s historic and continuing losses, there is substantial doubt about the Company’s ability to continue as a going concern.

Income (Loss) per Common Share

The Company computes earnings per share under ASC 260-10, “Earnings Per Share”.  Basic net income (loss) per common share is computed using the weighted average shares outstanding. Diluted net income (loss) per common share is computed using the treasury stock method, which assumes that the proceeds to be received on exercise of outstanding stock options and warrants are used to repurchase shares of the Company at the average market price of the common shares for the year. Dilutive common stock equivalents consist of shares issuable upon the exercise of the Company's outstanding stock options and warrants. For both the three months ended March 31, 20192020 and 2018,2019, there were 3,559,793 and 3,557,3993,599,793 shares of common stock underlying options and warrants excluded due to these instruments being anti-dilutive, respectively.anti-dilutive.

Use of Estimates

The preparation of financial statements in conformity with United States of America (U.S.) generally accepted accounting principles (“GAAP”) requires management to make certain estimates, judgments 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 amounts of revenues and expenses during the reporting period. Estimates are used when accounting for items and matters such as revenue recognition and allowances for uncollectible accounts receivable, inventory obsolescence, depreciation and amortization, long-lived assets, taxes and related valuation allowance, and income tax provisions, stock-based compensation, and contingencies. The Company believes that the estimates, judgments and assumptions are reasonable, based on information available at the time they are made. Actual results may differ from those estimates.

Income Taxes

The Company accounts for income taxes in accordance with ASC 740-10 “Income Taxes.” Under this method, deferred income taxes (when required) are provided based on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely than not that the Company will not realize the benefits of its deferred income tax assets in the future.

The Company adoptedfollows ASC 740-10-25, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on de-recognition, classification, treatment of interest and penalties, and disclosure of such positions. The Securities and Exchange Commission issued Staff Accounting Bulletin 118 to address uncertainty regarding the application of ASC 740 to the income tax effects of the Tax Cuts and Jobs Act, signed into law on December 22, 2017. The bulletin provides a measurement period (not to exceed one year from the Tax Act enactment date) for companies to complete the accounting under ASC 740. To the extent that a company’s accounting for certain income tax effects is incomplete, but is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act. The company was able to make reasonable estimates of certain effects and, therefore, recorded non-material provisional adjustments.

Revenue from Contracts with Customers

Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (“ASC 606, the Standard”) supersedes nearly all legacy revenue recognition guidance. ASC 606, the Standard outlines a comprehensive five-step revenue recognition model based on the principle that an entity should recognize revenue based on when it satisfies its performance obligations by transferring control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for said goods or services.

Identify the customer contracts

The Company accounts for a customer contract under ASC 606 when the contract is legally enforceable. A contract is legally enforceable when all of the following criteria are met: (1) the contract has been approved by the Company and the customer and both parties are committed to perform their respective obligations, (2) the Company can identify each party’s rights regarding goods or services transferred, (3) the Company can identify payment terms for goods or services transferred, (4) the contract has commercial substance, and (5) collectability of all the consideration to which the Company is entitled in exchange for the goods or services transferred is probable.

A contract does not exist if each party to the contract has the unilateral right to terminate a wholly unperformed contract without compensating the other party (or parties). Nearly all of the Company’s contracts do not contain such mutual termination rights for convenience. All contracts are in written form.

Identify the performance obligations

The Company will enter into product only contracts that contain a single performance obligation related to the transfer of EcoSmart products to a customer.

The Company will also enter into certain customer contracts that encompass product and installation services, referred to as “turnkey” solutions. These contracts ultimately provide the customer with a solution that enhances the functionality of the customer’s existing equipment. For this reason, the Company has determined that the product and installation services are not separately identifiable performance obligations, but in essence represent one, combined performance obligation (“turnkey”).

The Company also offers technical phone support services to customers. This service is considered a separate performance obligation.

Determine the transaction price

The Company generally enters into contracts containing fixed prices. It is not customary for the Company to include contract terms that would result in variable consideration. In the rare situation that a contract does include this type of provision, it is not expected to result in a material adjustment to the transaction price. The Company regularly extends pricing discounts; however, they are negotiated up front and adjust the fixed transaction price set out in the contract.

Customer contracts will typically contain upfront deposits that will be applied against future invoices, as well as customer retainage. The intent of any required deposit or retainage is to ensure that the obligations of either party are honored and follow customary industry practices. In addition, the Company will typically be paid in advance at the beginning of any support contracts, consistent with industry practices. None of these payment provisions are intended to represent significant implicit financing. The Company’s standard payment terms are thirty days from invoice date. Products are fully refundable when returned in their original packaging without damage or defacing less a restocking fee. Historical returns have shown to be immaterial. The Company offers a standard one-year assurance warranty. However customers can purchase an extended warranty. Under the new standard, extended warranties are accounted for as a service warranty, requiring the revenue to be recognized over the extended service periods. Contracts involving an extended warranty are immaterial and will continue to be combined with technical phone support services revenue and recognized on a straight-line basis over the term of the contract.

Allocate the transaction price to the performance obligations

Revenues from customer contracts are allocated to the separate performance obligations based on their relative stand-alone selling price (“SSP”) at contract inception. The SSP is the price at which the Company would sell a promised good or service separately. The best evidence of an SSP is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers. However, turnkey solutions are sold for a broad range of amounts resulting from, but not limited to, tiered discounting for value added resellers (“VAR”) based upon committed volumes and other economic factors. Due to the high variability of our pricing, the Company cannot establish a reliable SSP using observable data. Accordingly, the Company uses the residual approach to allocate the transaction price to performance obligations related to its turnkey solutions. When support services are not included within the turnkey solution, the residual method is not utilized and no allocation of the transaction price to the performance obligation is necessary.

All support service agreements, whether single or multi-year terms, automatically renew for one-year terms at a suggested retail price (“SRP”). Support service renewals are consistently priced and therefore would support the use of SRP as the best estimate of an SSP for such performance obligations.

Revenue Recognition

The Company recognizes revenues from product only sales at a point in time, when control over the product has transferred to the customer. As the Company’s principal terms of sale are FOB shipping point, the Company primarily transfers control and records revenue for product only sales upon shipment.

A typical turnkey project involves the installation and integration of 200-300 rooms in a customer-controlled facility and usually takes sixty days to complete. Since control over goods and services transfers to a customer once a room is installed, the Company recognizes revenue for turnkey solutions over time. The Company uses an outputs measure based on the number of rooms installed to recognize revenues from turnkey solutions.

Revenues from support services are recognized over time, in even daily increments over the term of the contract, and are presented as “Recurring Revenue” in the Statement of Operations.

Contracts are billed in accordance with the terms and conditions, either at periodic intervals or upon substantial completion. This can result in billing occurring subsequent to revenue recognition, resulting in contract assets. Contract assets are presented as current assets in the Condensed Consolidated Balance Sheet.

Contract liabilities include deferrals for the monthly support service fees. Long-term contract liabilities represent support service fees that will be recognized as revenue after March 31, 2020.2021.

Contract FulfillmentCompletion Cost

The Company recognizes related costs of the contract over time in relation to the revenue recognition. Costs included within the projects relate to the cost of the material, direct labor and costs of outside services utilized to complete projects. These are representedpresented as “Contract assets” in the condensed consolidated balance sheets.

Sales Taxes

Unless provided with a resale or tax exemption certificate, the Company assesses and collects sales tax on sales transactions and records the amount as a liability. It is recognized as a liability until remitted to the applicable state. Total revenues do not include sales tax as the Company is considered a pass through conduit for collecting and remitting sales taxes.

Guarantees and Product Warranties

The Company records a liability for potential warranty claims in cost of sales at the time of sale. The amount of the liability is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made. For the three months ended March 31, 20192020 and the year ended December 31, 2018,2019, the Company experienced returns of approximately 1% to 2%3% of materials included in the cost of sales. As of March 31, 20192020 and December 31, 2018,2019, the Company recorded warranty liabilities in the amount of $39,736$61,742 and $46,103,$58,791, respectively, using this experience factor range.

Product warranties for the three months ended March 31, 20192020 and the year ended December 31, 20182019 are as follows:

Advertising

The Company follows the policy of charging the costs of advertising to expenses as incurred. The Company incurred $5,893 and $10,805 in advertising costs during the three months ended March 31, 2020 and 2019, respectively.

Research and Development

The Company accounts for research and development costs in accordance with the ASC 730-10, “Research and Development”. Under ASC 730-10, all research and development costs must be charged to expense as incurred. Accordingly, internal research and development costs are expensed as incurred. Third-party research and development costs are expensed when the contracted work has been performed or as milestone results have been achieved. Company-sponsored research and development costs related to both present and future products are expensed in the period incurred. Total expenditures on research and product development for the three months ended March 31, 2020 and 2019 were $369,243 and $486,626, respectively.

Stock-Based Compensation

The Company accounts for stock-based awards in accordance with ASC 718-10, “Share-Based Compensation”, which requires a fair value measurement and recognition of compensation expense for all share-based payment awards made to the Company’s employees and directors, including employee stock options and restricted stock awards. The Company estimates the fair value of stock options granted using the Black-Scholes valuation model. This model requires the Company to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will hold vested stock options before exercising them, the estimated volatility of the Company’s common stock price and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in the Company’s consolidated statements of operations.

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For 2019 and prior years, expected stock price volatility is based on the historical volatility of the Company’s stock for the related expected term.

Stock-based compensation expense in connection with options granted to employees for both the three months ended March 31, 2020 and 2019 was $1,815.

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 provides guidance for estimating credit losses on certain types of financial instruments, including trade receivables, by introducing an approach based on expected losses. The expected loss approach will require entities to incorporate considerations of historical information, current information and reasonable and supportable forecasts. ASU 2016-13 also amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The guidance is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The guidance requires a modified retrospective transition method and early adoption is permitted. The Company does not expectIn November 2019, FASB issued ASU No. 2019-10, Financial Instruments – Credit Losses, Derivatives and Hedging, and Leases (“ASU 2019-10”), which defers the adoption of ASU 2016-13 for smaller reporting companies until January 1, 2023. The Company will continue to evaluate the impact of ASU 2016-13 on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This guidance modifies, removes, and adds certain disclosure requirements on fair value measurements. This ASU is effective for annual periods beginning after December 15, 2019, including interim periods therein. The adoption of this guidance did not have a material impact on itsthe Company’s consolidated financial statements.

Management has evaluated other recently issued accounting pronouncements and does not believe that any of these pronouncements will have a significant impact on our consolidated financial statements and related disclosures.

Accounting Standards Recently Adopted

Effective January 1, 2019, the Company has adopted ASU 2016-02, Leases (“ASU 2016-02”), subsequently amended in 2018 by ASU 2018-10, ASU 2018-11 and ASU 2018-20 and codified in ASC 842, Leases (“ASC 842”). ASC 842 is effective for annual periods beginning after December 15, 2018 and interim periods thereafter. Earlier application was permitted, however the Company did not elect to do so. ASC 842 supersedes current lease guidance in ASC 840 and requires a lessee to recognize a right-of-use asset and a corresponding lease liability for substantially all leases. The lease liability will be equal to the present value of the remaining lease payments while the right-of-use asset will be similarly calculated and then adjusted for initial direct costs. In addition, ASC 842 expands the disclosure requirements to increase the transparency and comparability of the amount, timing and uncertainty of cash flows arising from leases.

We chose to elect available practical expedients permitted under the guidance, which among other items, allowed the Company to carry forward its historical lease classification to not reassess leases for the definition of lease under the new standard, and to not reassess initial direct costs for existing leases. Refer below for practical expedient package adopted:

Upon the adoption of ASC 842, we have elected to not recognize a right-of-use asset and related lease liability for leases with an initial term of 12 months or less as an accounting policy choice and elected to account for lease and non-lease components as a single lease component.

The Company elected to utilize the new alternative transition approach introduced by ASU 2018-11, under which the standard is adopted and measured from the first date of the fiscal year under adoption, in this case January 1, 2019. Comparative periods are presented in accordance with Topic 840 and do not include any retrospective adjustments to comparative periods to reflect the adoption of Topic 842.

As of March 31, 2019, $1.01 million was included in total other assets, $0.22 million in total current liabilities, and $0.86 million in total long-term liabilities. There was no impact on our Condensed Consolidated Statements of Operations. Refer to Note K for further discussion.

NOTE C – REVENUE

The following table presents the Company’s product and recurring revenues disaggregated by industry for the three months ended March 31, 2020.

The following table presents the Company’s product and recurring revenues disaggregated by industry for the three months ended March 31, 2019.

Sales taxes and other usage-based taxes are excluded from revenues.

Remaining performance obligations

As of March 31, 2019,2020, the aggregate amount of the transaction price allocated to remaining performance obligations was approximately $1.2$0.29 million. Except for support services, the Company expects to recognize 100% of the remaining performance obligations over the next six months.

Contract assets and liabilities

Contracts are billed in accordance with the terms and conditions, either at periodic intervals or upon substantial completion. This can result in billings occurring subsequent to revenue recognition, resulting in contract assets. Contract assets are presented as current assets in the Condensed Consolidated Balance Sheet. There were $0.40 million of costs incurred to fulfill contracts in the closing balance of contract assets.

Often, the Company will require customers to pay a deposit upon contract signing that will be applied against work performed or products shipped. In addition, the Company will often invoice the full term of support at the start of the support period. Billings that occur prior to revenue recognition result in contract liabilities. The change in the contract liability balance during the three-month period ended March 31, 20192020 is the result of cash payments received and billing in advance of satisfying performance obligations.

NOTE D – ACCOUNTS RECEIVABLE

Components of accounts receivable as of March 31, 2019 and December 31, 2018 are as follows:

NOTE E – ACCRUED LIABILITIES

Accrued liabilities at March 31, 2019 and December 31, 2018 are as follows:

Contract costs

Costs to complete a turnkey contract primarily relate to the materials cost and direct labor and are recognized proportionately as the performance obligation is satisfied. The Company will defer costs to complete a contract when materials have shipped (and control over the materials has transferred to the customer), but an insignificant amount of rooms have been installed. The Company will recognize any deferred costs in proportion to revenues recognized from the related turnkey contract. The Company does not expect deferred contract costs to be long-lived since a typical turnkey project takes sixty days to complete. Deferred contract costs are generally presented as other current assets in the condensed consolidated balance sheets.

The Company incurs incremental costs to obtain a contract in the form of sales commissions. These costs, whether related to performance obligations that extend beyond twelve months or not, are immaterial and will continue to be recognized in the period incurred within selling, general and administrative expenses.

NOTE D – ACCOUNTS RECEIVABLE

Components of accounts receivable as of March 31, 2020 and December 31, 2019 are as follows:

NOTE E – INVENTORIES

Components of inventories as of March 31, 2020 and December 31, 2019 are as follows:

NOTE F – ACCRUED LIABILITIES AND EXPENSES

Accrued liabilities at March 31, 2020 and December 31, 2019 are as follows:

NOTE G – DEBT

Revolving Credit Facility

TheOn September 30, 2014, the Company is a party toentered into a loan and security agreement (the “Heritage Bank Loan Agreement”), with Heritage Bank of Commerce, a California state chartered bank (“Heritage Bank”), governing a new revolving credit facility in a principal amount not to exceed $2,000,000 (the “Credit Facility”). Availability of borrowings under the Credit Facility is subject to a borrowing base calculation based on the Company’s eligible accounts receivable and eligible inventory each multiplied by an applicable advance rate, with an overall limitation tied to the Company’s eligible accounts receivable. The Heritage Bank Loan Agreement is available for working capital and other general business purposes.

The outstanding principal balance of the Credit Facility bears interest at the Prime Rate plus 3.00%, which was 8.50%6.25% at March 31, 20192020 and 8.50% at7.75% December 31, 2018.2019. On October 9, 2014, as part of the Heritage Bank Loan Agreement, Heritage Bank was granted a warrant to purchase 250,000 shares of Telkonet common stock, for further information on the accounting for warrants, refer to Note I.J. The warrant has an exercise price of $0.20 and expires October 9, 2021. On February 13,November 6, 2019, the tentheleventh amendment to the Credit Facility was executed extendingto extend the maturity date to September 30, 2020,2021, unless earlier accelerated under the terms of the Heritage Bank Loan Agreement.  Agreement, and eliminate the maximum EBITDA loss covenant.  The eleventh amendment was effective as of September 30, 2019.

The Heritage Bank Loan Agreement also contains financial covenants that place restrictions on, among other things, the incurrence of debt, granting of liens and sale of assets. The Heritage Bank Loan Agreement also contains financial covenants, including a maximumcovenants. As discussed above, the EBITDA loss covenant measured quarterly,was eliminated in the eleventh amendment to the Credit Facility. The sole financial covenants are a minimum asset coverage ratio measured monthly, and a minimum unrestricted cash balance of $2 million. Duringmillion, both of which are measured at the quarter ended March 31, 2019 and the year ended December 31, 2018, the Company and Heritage Bank entered into several amendments to the Credit Facility to adjust these covenant levels. As long as the Company maintains the minimum unrestricted cash balanceend of $2 million, a violation of the minimum EBITDA level will not trigger an event of default.each month. A violation of any of these covenants could result in an event of default under the Heritage Bank Loan Agreement. Upon the occurrence of such an event of default or certain other customary events of defaults, payment of any outstanding amounts under the Credit Facility may be accelerated and Heritage Bank’s commitment to extend credit under the Heritage Bank Loan Agreement may be terminated. The Heritage Bank Loan Agreement contains other representations and warranties, covenants, and other provisions customary to transactions of this nature.

The outstanding balance on the Credit Facility was $907,241$518,463 and $121,474$624,347 at March 31, 20192020 and December 31, 20182019 and the remaining available borrowing capacity was approximately $1,043,000$153,000 and $499,000,$424,000, respectively. As of March 31, 2019,2020, the Company was in compliance with all financial covenants.

NOTE GH – REDEEMABLE PREFERRED STOCK

Series A

The Company has authorized 215 shares of preferred stock as Series A Preferred Stock (“Series A”). Each share of Series A is convertible, at the option of the holder thereof, at any time, into shares of the Company’s common stock at a conversion price of $0.363 per share. On November 16, 2009, the Company sold 215 shares of Series A with attached warrants to purchase an aggregate of 1,628,800 shares of the Company’s common stock at $0.33 per share. The Series A shares were sold at a price per share of $5,000 and each Series A share is convertible into approximately 13,774 shares of common stock at a conversion price of $0.363 per share. The Company received $1,075,000 from the sale of the Series A shares. In prior years, 30 of the preferred shares issued on November 16, 2009 were converted to shares of the Company’s common stock. In a prior year, the redemption feature available to the Series A holders expired.

Series B

The Company has authorized 567 shares of preferred stock as Series B Preferred Stock (“Series B”). Each share of Series B is convertible, at the option of the holder thereof, at any time, into shares of the Company’s common stock at a conversion price of $0.13 per share. On August 4, 2010, the Company sold 267 shares of Series B with attached warrants to purchase an aggregate of 5,134,626 shares of the Company’s common stock at $0.13 per share. The Series B shares were sold at a price per share of $5,000 and each Series B share was convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,335,000 from the sale of the Series B shares on August 4, 2010.  On April 8, 2011, the Company sold 271 additional shares of Series B with attached warrants to purchase an aggregate of 5,211,542 shares of the Company’s common stock at $0.13 per share. The Series B shares were sold at a price per share of $5,000 and each Series B share was convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,355,000 from the sale of the Series B shares on April 8, 2011. In prior years, 486 of the preferred shares issued on August 4, 2010 and April 8, 2011 were converted to shares of the Company’s common stock. In a prior year, the redemption feature available to the Series B holders expired.

Preferred stock carries certain preference rights as detailed in the Company’s Amended and Restated Articles of Incorporation related to both the payment of dividends and as to payments upon liquidation in preference to any other class or series of capital stock of the Company. As of March 31, 2020, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $461,094, which includes cumulative accrued unpaid dividends of $201,094, and second, Series A with a preference value of $1,692,649, which includes cumulative accrued unpaid dividends of $767,649. As of December 31, 2019, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $440,216,$455,904, which includes cumulative accrued unpaid dividends of $180,216,$195,904, and second, Series A with a preference value of $1,618,421,$1,674,195, which includes cumulative accrued unpaid dividends of $693,421. As of December 31, 2018, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $435,081, which includes cumulative accrued unpaid dividends of $175,081, and second, Series A with a preference value of $1,600,168, which includes cumulative accrued unpaid dividends of $675,168.$749,195.

NOTE HI – CAPITAL STOCK

The Company has authorized 15,000,000 shares of preferred stock, (designated and undesignated), with a par value of $.001 per share. The Company has designatedauthorized 215 shares as Series A preferred stock and 538567 shares as Series B preferred stock. At March 31, 20192020 and December 31, 2018,2019, there were 185 shares of Series A and 52 shares of Series B outstanding.outstanding, respectively.

The Company has authorized 190,000,000 shares of common stock with a par value of $.001 per share. As of March 31, 20192020 and December 31, 20182019, the Company had 135,085,519136,311,335 and 134,793,211135,990,491 common shares issued and outstanding, respectively.

During the three months ended March 31, 2020 and 2019, the Company issued 320,844 and 292,308 shares of common stock, respectively to directors for services performed during the three months ended March 31, 2020 and 2019. These shares were valued at $18,000 and $36,002, respectively, which approximated the fair value of the shares when they were issued.

During the three months ended March 31, 2020 and 2019, no warrants were exercised. These warrants were originally granted to shareholders of the April 8, 2011 Series B preferred stock issuance.

During the three months ended March 31, 2020 and 2019, no shares of Series A or B preferred stock were converted to shares of common stock.

NOTE IJ – STOCK OPTIONS AND WARRANTS

Employee Stock Options

The Company maintains an equity incentive plan (the “Plan”). The Plan was established in 2010 as an incentive plan for officers, employees, non-employee directors, prospective employees and other key persons. The Plan is administered by the Board of Directors or the compensation committee, which is comprised of not less than two non-employee directors who are independent. A total of 10,000,000 shares of stock were reserved and available for issuance under the Plan. The exercise price per share for the stock covered by a stock option granted shall be determined by the administrator at the time of grant but shall not be less than 100 percent of the fair market value on the date of grant. The term of each stock option shall be fixed by the administrator, but no stock option shall be exercisable more than ten years after the date the stock option is granted. As of March 31, 2020, there were approximately 85,425 shares remaining for issuance in the Plan.

It is anticipated that providing such persons with a direct stake in the Company’s welfare will assure a better alignment of their interests with those of the Company and its stockholders.

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under the Plan as of March 31, 2019.2020.

Transactions involving stock options issued to employees are summarized as follows:

No options were granted, and no options were exercised, during the three months ended March 31, 2019 and 2018. There were zero and 1,094,075 options cancelled or expired during the three months ended March 31, 2019 and 2018, respectively.2020 or 2019. Total stock-based compensation expense in connection with options granted to employees recognized in the condensed consolidated statements of operations for both the three months ended March 31, 2020 and 2019 and 2018 was $1,815 and $1,531, respectively.$1,815.

Warrants

The following table summarizes the changes in warrants outstanding and the related exercise prices for the warrants issued to the debt holder in relation to the revolving credit facility seefacility. See Note G.

Transactions involving warrants are summarized as follows:

ThereNo warrants were no warrants granted, exercised, cancelled or forfeited during the three months ended March 31, 2019 and 2018, respectively.2020 or 2019.

NOTE JK – RELATED PARTY TRANSACTIONSSTOCK ISSUANCE TO NON-EMPLOYEE DIRECTORS

During the three months ended March 31, 20192020 and during the year ended December 31, 2018,2019, the Company agreed to issueissued common stock in the amount of $36,002$18,000 and $144,000,$132,000 and paid cash consideration of $24,000 and $20,000, respectively, to the Company’s non-employee directors as compensation for their attendance and participation in the Company’s Board of Director and committee meetings.

NOTE L – COMMITMENTS AND CONTINGENCIES

Office Leases Obligations

In October 2013, the Company entered into a lease agreement for 6,362 square feet of commercial office space in Waukesha, Wisconsin for its corporate headquarters. The Waukesha lease would have expired in April 2021, but was subsequently amended and extended through April 2026. On April 7, 2017 the Company executed an amendment to its’ existing lease in Waukesha, Wisconsin to expand another 3,982 square feet, bringing the total leased space to 10,344 square feet. In addition, the lease term was extended from May 1, 2021 to April 30, 2026. The commencement date for this amendment was July 15, 2017.

NOTE K – COMMITMENTS AND CONTINGENCIESIn January 2016, the Company entered into a lease agreement for 2,237 square feet of commercial office space in Germantown, Maryland for its Maryland employees. The Germantown lease, as amended, was set to expire at the end of January 2018. In November 2017, the Company entered into a second amendment to the lease agreement extending the lease through the end of January 2019. In November 2018, the Company entered into a third amendment to the lease agreement extending the lease through the end of January 2022.

LeasesIn May 2017, the Company entered into a lease agreement for 5,838 square feet of floor space in Waukesha, Wisconsin for its inventory warehousing operations. The Waukesha lease expires in May 2024.

On January 1, 2019 theThe Company adopted ASC Topic 842 “Leases” (“ASC 842”), which supersedes ASC Topic 840 “Leases” (“ASC 840”), using the alternative transition method of adoption. Under this method of adoption, the Company have recognized and measured all leases that exist as at January 1, 2019 (the effective date) using a modified retrospective transition approach. Comparative periods are presented in accordance with Topic 840 and do not include any retrospective adjustments to comparative periods to reflect the adoption of Topic 842. Any cumulative-effect adjustments to retained earnings is recognized as of January 1, 2019. Upon adoption, we recognized our leases with greater than one year in duration on the balance sheet as right-of-use assets and lease liabilities. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. Classification is based on criteria that are largely similar to those applied in prior lease accounting, but without explicit lines. We have made certain assumptions in judgments when applying ASC 842. Those judgments of most significance are as follows:

We determinedetermines if an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys to the Company the right to control the use of an explicitly or implicitly identified fixed asset for a period of time in exchange for consideration. Control of an underlying asset is conveyed to the Company if the Company obtains the rights to direct the use of and to obtain substantially all of the economic benefits from using the underlying asset. The Company does not separate non-lease components from lease components to which they relate and accounts for the combined lease and non-lease components as a single lease component.

Operating leases are included in our condensed consolidated balance sheet as right-of-use assets, operating lease liabilities -– current and operating lease liabilities – long term. Upon adoption, the Company determined there were no financing leases.long-term. We do not recognize a right-of-use asset and lease liability for leases with a term of 12 months or less. Our current operating leases are for facilities and office equipment.facilities. Our leases may contain renewal options; however, we do not recognize right-of-use assets or lease liabilities for renewal periods unless it is determined that we are reasonably certain of renewing the lease at inception or when a triggering event occurs. Some of our lease agreements may contain rent escalation clauses, rent holidays, capital improvement funding, or other lease concessions.

In determining our right-of-use assets and lease liabilities, we apply a discount rate to the minimum lease payments within each lease agreement. ASC 842 requires us to use the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. When we cannot readily determine the discount rate implicit in the lease agreement, we utilize our current borrowing rate on our outstanding line of credit. The Company’s line of credit utilizes market rates to assess an interest rate. Refer to Note G for further discussion.

We recognize our minimum rental expense on a straight-line basis based on the fixed components of a lease arrangement. Payments are set on a pre-determined schedule within each lease agreement. We amortize this expense over the term of the lease beginning with the date of the standard adoption for current leases and beginning with the date of initial possession, which is the date we enter the leased space and begin to make improvements in the preparation for its intended use, for future leases. Variable lease components represent amounts that are not fixed in nature and are not tied to an index or rate, and are recognized as incurred. Variable lease components consist primarily of the Company's proportionate share of common area maintenance, utilities, taxes and insurance.

The Company does not, upon adoption of ASC 842, control a specific space or underlying asset used in providing a service by a third-party service provider, under any third party service agreements. Thereinsurance and are no such arrangements that meet the definition under ASC 842.

In determining our right-of-use assets and lease liabilities, we apply a discount rate to the minimum lease payments within each lease agreement. ASC 842 requires us to use the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. When we cannot readily determine the discount rate implicitpresented as operating expenses in the Company’s statements of operations in the same line item as expense arising from fixed lease agreement, we utilize our current borrowing rate on our outstanding line of credit. The Company’s line of credit utilizes market rates to assess an interest rate. Refer to Note F for further discussion.payments.

We lease certain property under non-cancelable operating leases, primarily facilities. The impact of the adoption of ASC 842 at January 1, 2019 created a right-of-use asset of $1,042,004, lease liability of $1,095,761 and unwound the $71,877 balance of the deferred lease liability account.

The components of lease expense for the three months ended March 31, 2020 were as follows:

Other information related to leases as of March 31, 20192020 was as follows:

Future annual minimum operating lease payments as of March 31, 20192020 were as follows:

Future annual minimum lease payments under non-cancelable leases as of December 31, 2018 prior to our adoption of ASU 2016-02, Leases (Topic 842) are as follows:

Rental expenses charged to operations for the three months ended March 31, 2020 and 2019 and 2018 was $89,526$97,511 and $83,882,

$89,526, respectively.

Litigation

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

Sales Tax

Unless provided with a resale or tax exemption certificate, the Company assesses and collects sales tax on sales transactions and records the amount as a liability. It is recognized as a liability until remitted to the applicable state. Total revenues do not include sales tax as the Company is considered a pass through conduit for collecting and remitting sales taxes.

The following table sets forth the change in the sales tax accrual as of March 31, 20192020 and December 31, 2018:2019:

NOTE LM – BUSINESS CONCENTRATION

For the three months ended March 31, 2020, there were two customers represented approximately 23% of total net revenues. For the three months ended March 31, 2019, two customers represented approximately 31% of total net revenues. For the three months ended March 31, 2018, one customer represented approximately 14% of total net revenues.

As of March 31, 2019, three2020, two customers accounted for approximately 51%29% of the Company’s net accounts receivable. As of December 31, 2018, three2019, two customers accounted for approximately 47%represented 36% of the Company’s net accounts receivable.

Purchases from one supplier approximated $775,000,$385,000, or 76%84%, of inventorytotal purchases for the three months ended March 31, 20192020 and $760,000,approximately $775,000, or 82%76%, of total purchases for the three months ended March 31, 2018. Deposits paid to this vendor were in excess of total accounts payable2019. The amount due to this supplier, in the amountnet of $697,405deposits paid, was approximately $71,000 and $579,000 as of March 30, 2020 and December 31, 2019, and $320,352respectively.

NOTE N – SUBSEQUENT EVENT

On April 21, 2020, Telkonet, Inc. (the “Company”) entered into an unsecured promissory note, dated as of December 31, 2018.April 17, 2020 (“the PPP Loan”), with Heritage Bank of Commerce under the Paycheck Protection Program (the “PPP”) administered by the United States Small Business Administration (“SBA”) and authorized by the Keeping American Workers Employed and Paid Act, which is part of the Coronavirus Aid, Relief, and Economic Security Act, enacted on March 27, 2020. The principal amount of the PPP Loan is $913,063, bears interest of 1.0% per annum and was disbursed on April 21, 2020.

The PPP Loan has a maturity date of April 21, 2022. No payments of principal or interest are required during the first six months, but interest accrues during this period. After this period, monthly payments of principal and interest are required and continue until maturity with respect to any portion of the PPP Loan not forgiven, as discussed below. The PPP Loan may be prepaid, in full or in part, at any time prior to maturity with no prepayment penalties. The note contains events of default and other provisions customary for a loan of this type.

Under the terms of the PPP, the Company can apply for, and be granted, forgiveness for all or a portion of the PPP Loan. Such forgiveness will be determined, subject to limitations and ongoing rulemaking by the SBA, based on the use of loan proceeds for eligible purposes, including payroll costs, mortgage interest, rent, utility costs and the maintenance of employee and compensation levels. At least 75% of such forgiven amounts must be used for eligible payroll costs. The amount of loan forgiveness will be reduced if the Company terminates employees or reduces salaries during the eight-week period following the date the proceeds are disbursed. No assurance is provided that the Company will obtain forgiveness of the PPP Loan in whole or in part.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the accompanying condensed consolidated financial statements and related notes thereto for the three months ended March 31, 2019,2020, as well as the Company’s consolidated financial statements and related notes thereto and management’s discussion and analysis of financial condition and results of operations in the Company’s Form 10-K for the year ended December 31, 2018,2019, filed with the US. Securities and Exchange Commission (the “SEC”) on April 1, 2019.March 30, 2020.

Business

Telkonet, Inc. (the “Company”, “Telkonet”), formed in 1999 and incorporated under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”). We currently operate in a single reportable business segment.

The Company’s direct sales effort targets the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment Act, the Company is focusing its sales efforts in areas with available public funding and incentives, such as rebate programs offered by utilities for efficiency upgrades. Through the Company’s proprietary platform, technology and partnerships with energy efficiency providers, the Company’s management intends to position the Company as a leading provider of energy management solutions.

Forward-Looking Statements

In accordance with the Private Securities Litigation Reform Act of 1995, the Company can obtain a “safe-harbor” for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements. Accordingly, the following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial results for the remainder of 20192020 and future periods. These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements.  Factors that could cause or contribute to such differences include those risks affecting the Company’s business as described in the Company’s filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference. The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.

Critical Accounting Policies and Estimates and New Accounting Pronouncements

Please refer to the Company’s Form 10-K filed April 1, 2019March 30, 2020 for critical accounting policies and estimates. For information regarding recent accounting pronouncements and their effect on the Company, see “New Accounting Pronouncements” in Note B of the Notes to Unaudited Condensed Consolidated Financial Statements contained herein.

Revenues

The table below outlines product versus recurring revenues for comparable periods:

Product Revenue

Product revenue principally arises from the sale and installation of the EcoSmart energy management platform. The EcoSmart Suite of products consists of thermostats, sensors, controllers, wireless networking products, switches, outlets and a control platform.

For the three months ended March 31, 2019,2020, product revenue increasedrevenues decreased by 72%38% or $1.08$0.98 million when compared to the prior year period as a result of the Company beginning the quarter with a backlog of approximately $4.00 million, along with continued growth in channel sales. As a result of continued sales growth, the Company also finished the quarter with a backlog of approximately $4.00 million. The hospitality market sales for the three months ended March 31, 2019 increased $0.49 millionyear. Product revenues derived from the prior year period to $1.69 million, largely driven by international sales in the hospitality market due to contract for a modular home project sold through an OEM partner. In addition, the government market increased $0.43 million to $0.44 million and the Multiple Dwelling Unit (“MDU”) market increased $0.18 million to $0.20 million. This was partially offset by a decrease in the education market sales for the three months ended March 31, 2019 of $0.03 million from the prior year period to $0.26 million. The Company’s commitment to access distribution channels throughvalue added resellers and value added distribution partners continued to grow. Product revenue derived from channel partners increased $0.86 million to $2.13were $1.1 million for the three months ended March 31, 20192020, a decrease of 48% compared to the prior year period. The decrease was primarily driven by non-repeatable revenues in 2019 from three customers. Beginning in the third quarter of 2019, the Company began implementing portfolio pricing increases, which under normal circumstances would be expected to positively impact product revenue, but given the COVID-19 pandemic, the impact of these price increases has been offset by reduced demand for our products at this time.

For the three months ended March 31, 2020, all major industry sectors decreased when compared to the prior year. Hospitality revenues decreased $0.49 million to $1.2 million, government revenues decreased $0.37 million to $.06 million, education revenues decreased $0.01 million to $0.25 million and MDU revenues decreased $0.10 million to $.09 million. For the three months ended March 31, 2020, international revenues decreased $0.49 million to $0.06 million when compared to the prior year period. The decrease in international revenues was primarily driven by non-repeatable revenues from three customers in 2019 and limited international revenues in 2020.

Backlogs were approximately $2.8 million and $4.0 million at March 31, 2020 and 2019, respectively.

Recurring Revenue

Recurring revenue is attributed to our call center support services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers revenue for annual support services over the term of the service period. Recurring revenue consists of Telkonet’s EcoCare service and support program.

For the three months ended March 31, 2019,2020, recurring revenue increased by 74%10% when compared to the prior year period. NewThe increase was related to increased unit sales outpaced non-renewals. of call center support services.

Cost of Sales

The table below outlines product versus recurring cost of sales, along with respective amounts of those costs as a percentage of revenue for the comparable periods:

Costs of Product Sales

Costs of product revenue include equipment and installation labor related to EcoSmart technology. For the three months ended March 31, 2019, total2020, product costs increased by 70% compared to the prior year. Cost of materials increased by 82% or $0.42 milliondecreased 43% compared to the prior year period based upon lower revenues. The variance was primarily attributable to decreases in material costs of $0.35 million, logistical expenses of $0.22 million, inclusive of import tariffs and inventory adjustments of $0.08 million. Material costs as a percentage of product revenues were 43% for the quarter, an increase of 8%, compared to the prior year period. Our core products are manufactured in China and as a result of the increasetariffs imposed on Chinese imports resulted in sales. Thean adverse impact of tariffs resulted in a $0.25 million increase in freight expense. The Company’s use of outside contractorsapproximately 3% on the actual gross profit percentage for installations increased, resulting in a $0.12 million increase in contractor services costs. These increases were partially offset by a $0.10 million decrease in inventory adjustments.the quarter ended March 31, 2020, compared to approximately 9% for the quarter ended March 31, 2019.

Costs of Recurring Revenue

Recurring costs are comprised primarily of labor and telecommunication services for our customer service department.call center support labor. For the three months ended March 31, 2019,2020, recurring costs increaseddecreased by 43%74% when compared to the prior year period. This $0.03 millionThe variance was primarily due to an increasedecreases in salary, benefitscall center staffing as the Company evaluates internal staffing and temporary staffing.outsourcing arrangements.

Gross Profit

The table below outlines product versus recurring gross profit, along with respective actual gross profit percentages for the comparable periods:

Gross Profit on Product Revenue

Gross profit on product revenue for the three months ended March 31, 2019 increased by 76%2020 decreased 28% when compared to the prior year period. TheFor the three months ended March 31, 2020, the actual gross profit percentage increased from 34%5% to 40%. Contributing to the increase were decreases in material costs of $0.35 million, logistical expenses of $0.22 million, inclusive of import tariffs and inventory adjustments of $0.08 million. Tariffs imposed on Chinese imports resulted in an adverse impact of approximately 3% on the actual gross profit percentage for the three months ended March 31, 20182020, compared to 35%approximately 9% for the three months ended March 31, 2019. Contributing to the increase in margin were lower discounts utilized offsetting the increases in costs of product sales discussed above.prior year period.

Gross Profit on Recurring Revenue

The grossGross profit associated withon recurring revenue increased by 118% for the three months ended March 31, 20192020 increased 89% when compared to the prior year period. The increase was related toa combination of increased unit sales withof call center support services included.and decreased call center staffing. For the three months ended March 31, 2020, the actual gross profit percentage increased 37% when compared to the prior year period.

Operating Expenses