NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)(UNAUDITED)

1.            INTERIM FINANCIAL STATEMENTS

The Company consists of CPI Aerostructures, Inc. (“CPI”) and, Welding Metallurgy, Inc. (“WMI”), a wholly owned subsidiary acquired on December 20, 2018, and Compac Development Corporation (“Compac”), a wholly owned subsidiary of WMI, collectively the “Company.” The acquisition of WMI and Compac is referred to throughout this document as the “WMI Acquisition”.

An operating segment, in part, is a component of an enterprise whose operating results are regularly reviewed by the chief operating decision maker (the “CODM”) to make decisions about resources to be allocated to the segment and assess its performance. Operating segments may be aggregated only to a limited extent. The Company’s CODM, the Chief Executive Officer, reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues for purposes of making operating decisions and assessing financial performance. The Company has determined that it has a single operating and reportable segment.

The consolidated financial statements of the Company as of March 31, 2019June 30, 2020 and for the three and six months ended March 31,June 30, 2020 and 2019 and 2018 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and notes normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to those rules and regulations. The consolidated balance sheet as ofat December 31, 20182019 has been derived from audited consolidated financial statements as restated (see Note 15 and our Annual Report on Form 10-K for the year ended December 31, 2019 for more information on the effect of the restatement)at that date, but does not include all of the information and notes required by U.S. GAAP. The Company believes that the disclosures are adequate to make the information presented not misleading.

All adjustments that, in the opinion of the management, are necessary for a fair presentation for the periods presented have been reflected. Such adjustments are of a normal, recurring nature. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, which we expect to file subsequent to the filing of this Quarterly Report on Form 10Q/A.2019. The results of operations for interim periods are not necessarily indicative of the operating results to be expected for the full year or any other interim period.

The Company maintains its cash in five financial institutions. The balances are insured by the Federal Deposit Insurance Corporation. From time to time, the Company’s balances may exceed insurance limits. As of March 31, 2019,June 30, 2020, the Company had $511,170$6,647,111 of uninsured balances. The Company limits its credit risk by selecting financial institutions considered to be highly creditworthy.

The Company applied acquisition accountingcurrently has a shareholders' deficit and has experienced continuing losses from operations and negative cash flows from operations year to date that collectively represent significant risks to the Company to continue to operate as a going concern. To address these matters, the Company has a) negotiated a revised credit facility with BankUnited effective August 24, 2020, b) begun negotiations with customers to exit or renegotiate unprofitable contracts, c) obtained and is seeking additional progress payment and advance payment customer contract funding provisions, d) initiated new procedures to reduce investments in inventory and contract assets, e) remained focused on its military segment which has proven to be less susceptible to COVID-19 related impacts and f) maintained a strong (approximately $209 million) backlog of funded orders, 98% of which are for military programs. Based upon management's assessment of the identified significant risks and the execution of the plans described above, management believes that substantial risk does not exist as to whether the Company's liquidity and debt resources will be sufficient to meet its obligations as a going concern through a year and a day from the date of this filing.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

WMI Acquisition:

The Company completed the WMI Acquisition on December 20, 2018. The acquisition was accounted for as a business combination in accordance with Accounting Standards Codification (“ASC”)ASC Topic 805, “Business Combinations” (“ASC 805”)805. Accordingly, the Company recorded the fair value of the assets and liabilities assumed at the date of acquisition.

The purchase price for the acquisition was $7.9 million, which was subject to a post-closing working capital adjustment. $2 million of the purchase price was placed in escrow at closing and was to be released after the completion of the working capital adjustment and for the indemnification contingencies. Air Industries Group objected to the Company’s calculation of the post-closing working capital adjustment and rejected the determination of BDO USA, LLP, the independent accountant appointed by the parties to resolve the dispute. On September 27, 2019, the Company filed a notice of motion in the Supreme Court of the State of New York, County of New York, against Air Industries seeking, among other things, a judgment against Air Industries in the amount of approximately $4.1 million. In October 2019, Air Industries and the Company jointly authorized the release to the Company of approximately $619,000 from escrow, which represents the value of certain conceded items. The remaining escrowed amount of approximately $1,381,000 is shown as restricted cash on the consolidated balance sheet. The additional disputed amount of approximately $2.1 million is not on the Company’s consolidated balance sheet due to the uncertainty of collection. On October 1, 2020, the court denied the Company’s motion on procedural grounds, holding that the Company must commence a special proceeding to obtain the relief sought. The court’s decision was made without prejudice and does not resolve the working capital dispute. Acquisition accounting requires thatWe are evaluating whether to appeal the decision or commence a new proceeding, among other options.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

In the fourth quarter of 2019, the Company recorded adjustments to the provisional estimates of the fair value of the assets acquired and liabilities assumed be recorded at their respective estimatedfrom WMI related to the BDO determination. The Company has determined the fair values atof the date of acquisition. The excess purchase price overassets and liabilities acquired and has recorded the fair value of the net assets acquired as of December 31, 2019 assuming only the collection of the remaining amount escrowed which is recorded as goodwill. expected to be realized in the next twelve months. Collection of the additional $2.1 million is uncertain.

COVID-19:

In determining estimated fair values, weMarch 2020, the novel coronavirus (“COVID-19”) was declared a pandemic by the World Health Organization. The pandemic has negatively affected the U.S. and global economy, disrupted global supply chains and financial markets, and has resulted in shelter in place orders. The Company has followed the recommendations of government and health authorities to minimize exposure risk for its employees, including having employees work modified hours or remotely since on or about March 19, 2020, practicing social distancing, and performing deep cleaning of its facilities. We have also taken actions to support our community in addressing challenges posed by the pandemic, including the donation of personal protective equipment.

There are required to make estimates and assumptions that affectmany uncertainties regarding the recorded amounts including, but not limited to, expected future cash flows, discount rates, remaining useful lives of long-lived assets, useful lives of identified intangible assets, replacement or reproduction costs of property and equipmentCOVID-19 pandemic, and the amountsCompany is closely monitoring the impact of the pandemic on all aspects of its business, including how it will impact its employees, customers, suppliers, and liquidity. On March 20, 2020, the Company was notified that it was considered part of the Defense Industrial Base Essential Critical Infrastructure Workforce and, as such, has remained open during the COVID-19 pandemic. However, the extent to be recovered inwhich COVID-19 may affect our operations will depend on future periods from acquired net operating lossesdevelopments which are highly uncertain, including the duration of the outbreak, new information which may emerge concerning the severity of the coronavirus and other deferred tax assets. Our estimates in this areathe actions to contain the coronavirus or address its impact, among other items,others. The Company is unable to predict the amount of depreciationimpact that COVID-19 will have on its financial position and amortization, impairment charges in certain instances if the asset becomes impaired, and income tax expense or benefit that we report. Our estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain. See Note 2, “Business Combinations” for a summary and status of the application of acquisition accounting.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTSoperating results.

(UNAUDITED) 

2.            REVENUE RECOGNITION

Effective January 1, 2018, the Company adopted Accounting Standards Codification Topic 606, "Revenue from Contracts with Customers" ("ASC 606"), using the modified retrospective method. In accordance with ASC 606, the

The Company recognizes revenue when it transfers control of a promised good or service to a customer in an amount that reflects the consideration it expects to be entitled to in exchange for the good or service. The majority of the Company’s performance obligations are satisfied over time as the Company (i) sells products with no alternative use to the Company and (ii) has an enforceable rightright to recover costs incurred plus a reasonable profit margin for work completed to date. Under the over time revenue recognition model, revenue and gross profit are recognized over the contract period as work is performed based on actual costs incurred and an estimate of costs to complete and resulting total estimated costs at completion.

The Company also has contracts that are considered point in time. Under the point in time revenue recognition model, revenue is recognized when control of the components has transferred to the customer,customer; in most cases this will be based on shipping terms.

The corrected adoption of ASC 606 resulted in a restatement of previously issued consolidated financial statements, see Note 15. See Note 3, “Revenue”, for additional information regarding the Company’s revenue recognition policy.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. Originally, entities were required to adopt ASU 2016-02 using a modified retrospective approach at the beginning of the earliest comparative period presented in the financial statements and the recognition of a cumulative-effect adjustment to the opening balance of retained earnings. The FASB subsequently issued Accounting Standards Update No. 2018-10 and Accounting Standards Update No. 2018-11 in July 2018, which provide clarifications and improvements to ASU 2016-02 (collectively, the “new lease standard”). Accounting Standards Update No. 2018-11 also provides the optional transition method which allows companies to apply the new lease standard at the adoption date instead of at the earliest comparative period presented and continue to apply the provisions of the previous lease standard in its annual disclosures for the comparative periods. The new lease standard requires lessees to present a right-of-use asset and a corresponding lease liability on the balance sheet. Lessor accounting is substantially unchanged compared to the current accounting guidance. Additional footnote disclosures related to leases will also be required.

On January 1, 2019, the Company adopted the new lease standard using the optional transition method. The comparative financial information will not be restated and will continue to be reported under the previous lease standard in effect during those periods. In addition, the new lease standard provides a number of optional practical expedients in transition. The Company elected the package of practical expedients. As such, the Company will not reassess whether expired or existing contracts are or contain a lease; will not need to reassess the lease classifications or reassess the initial direct costs associated with expired or existing leases. The Company did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to the Company.

The new lease standard also provides practical expedients for an entity’s ongoing accounting. The Company elected the short-term lease recognition exemption for all leases that qualify. This means, for those leases that qualify, the Company will not recognize ROU assets or lease liabilities, and this includes not recognizing ROU assets or lease liabilities for existing short-term leases of those assets in transition. The Company elected the practical expedient to not separate lease and non-lease components for certain classes of assets (office buildings).

On January 1, 2019, the Company recognized ROU assets and lease liabilities of approximately $5.3 million and $5.9 million, respectively, on its consolidated balance sheet using an estimated incremental borrowing rate of 6%.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED) 

2.Business Combinations

As discussed in Note 1, the Company acquired WMI and Compac from Air Industries Group (“Air Industries”) on December 20, 2018. The WMI Acquisition was accounted for as a business combination in accordance with ASC 805. Accordingly, the Company is required to determine and record the estimated fair value of the assets acquired, including any potential intangible assets, and liabilities assumed at the date of acquisition. The acquisition was considered a stock purchase for tax purposes.

The purchase price for the acquisition was $7.9 million, which was subject to a post-closing working capital adjustment. $2 million dollars of the purchase price was placed in escrow at closing and may be released after the completion of the working capital adjustment and for the indemnification contingencies. The escrowed amount is shown as restricted cash on the consolidated balance sheet as of March 31, 2019. The working capital adjustment is based on the historical values of components of working capital as defined in the Stock Purchase Agreement (“SPA”). We calculated a post-closing working capital adjustment. Air Industries formally objected to our calculation. The SPA provided the parties 30 days to come to an agreement on the working capital adjustment, required that any areas of disagreement exceeding the 30 days must be submitted for a binding resolution to BDO USA, LLP (“BDO”) and provided that BDO would have a period of 30 days to resolve the disputes and determine the final working capital adjustment.

As of March 31, 2019, the Company was in process of determining the fair values of the assets and liabilities acquired and had recorded provisional estimates as of the acquisition date. As the Company completes this process and additional information becomes known concerning the acquired assets and assumed liabilities, management will likely make adjustments to the fair value of the amounts provisionally recorded in the opening balance sheet of WMI during the measurement period, which is no longer than a one-year period following the acquisition date. The determination of the fair values of the acquired assets and liabilities assumed (and the related determination of estimated lives of depreciable tangible and identifiable intangible assets) requires significant judgment. If the final aggregate fair value of the net assets acquired is less than the final purchase price paid, then the Company may be required to record goodwill. Conversely, if the final aggregate fair value of the net assets acquired is in excess of the final purchase price paid, then the Company may potentially conclude that the purchase of WMI was a “bargain purchase.”

As stated above, as of March 31, 2019, the Company determined the following provisional estimates of the fair value of the assets acquired and liabilities assumed from WMI:

Please see Note 14, “Subsequent Events” for additional discussion and final fair value of assets and liabilities assumed from WMI and the working capital dispute between CPI and Air Industries.

The following table presents the unaudited pro forma revenue and net income for the period presented as if the WMI Acquisition had occurred on January 1, 2018, based on the provisional estimates of the fair value of the net assets acquired:

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED) 

3.       REVENUE RECOGNITION

Contracts with Customers and Performance Obligations

The majority of the Company’s revenues are from long-term contracts with the U.S. government and commercial contractors. The Company accounts for a contract when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. For the Company, the contract under ASC 606 is typically established upon execution of a purchase order either in accordance with a long-term customer contract or on a standalone basis.

To determine the proper revenue recognition for our contracts, we must evaluate whether two or more contracts should be combined and accounted for as a single contract, and whether the combined or single contract should be accounted for as one performance obligation or more than one performance obligation. This evaluation requires significant judgment, and the decision to combine a group of contracts or to separate a contract into multiple performance obligations could change the amount of revenue and profit recorded in a period. A performance obligation is a promise within a contract to transfer a distinct good or service to the customer in exchange for payment and is the unit of account for recognizing revenue. The Company’s performance obligations in its contracts with customers are typically the sale of each individual product contemplated in the contract or a single performance obligation representing a series of products when the contract contains multiple products that are substantially the same. The Company has elected to account for shipping performed after control over a product has transferred to a customer as fulfillment activities. When revenue is recognized in advance of incurring shipping costs, the costs related to the shipping are accrued. Shipping costs are included in costs of sales. The Company provides warranties on many of its products; however, since customers cannot purchase such warranties separately and they do not provide services beyond standard assurances, warranties are not separate performance obligations.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when or as the performance obligation is satisfied. For contracts with more than one performance obligation, the Company allocates the transaction price to each performance obligation based on its estimated standalone selling price. When standalone selling prices are not available, the transaction price is allocated using an expected cost plus margin approach as pricing for such contracts is typically negotiated on the basis of cost.

The contracts with the U.S. government typically are subject to the FAR (“Federal Acquisition Regulation”) which provides guidance on the types of costs that are allowable in establishing prices for goods and services provided under U.S. government contracts. The pricing for commercial contractorscontracts are based on the specific negotiations with each customer and any taxes imposed by governmental authorities are excluded from revenue. The transaction price is primarily comprised of fixed consideration as the customer typically pays a fixed fee for each product sold. The Company does not adjust the amount of revenue to be recognized under a customer contract for the effects of the time value of money when the timing difference between receipt of payment and transferring the good or service is less than one year.

The majority of the Company’s performance obligations are satisfied over time as the Company (i) sells products with no alternative use to the Company and (ii) has an enforceable right to recover costs incurred plus a reasonable profit margin for work completed to date. The Company uses the cost-to-cost input method to measure progress for its performance obligations because it best depicts the transfer of control to the customer which occurs as the Company incurs costs on its contracts.

The Company generally utilizes the portfolio approach to estimate the amount of revenue to recognize for its contracts and groups contracts together that have similar characteristics. Significant judgment is used to determine which contracts are grouped together to form a portfolio. The portfolio approach is utilized only when the result of the accounting is not expected to be materially different than if applied to individual contracts.

When changes are required for the estimated total revenue on a contract, these changes are recognized on a cumulative catch-up basis in the current period. A significant change in one or more estimates could affect the profitability of one or more of our performance obligations. If estimates of total costs to be incurred exceed estimates of total consideration the Company expects to receive, a provision for the remaining loss on the contract is recorded in the period in which the loss becomes evident.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Capitalized Contract Acquisition Costs and Fulfillment Costs

Contract acquisition costs are those incremental costs that the Company incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained. The Company does not typically incur contract acquisition costs or contract fulfillment costs that are subject to capitalization in accordance with the guidance in Accounting Standards Codification Subtopic 340-40, “Other Assets and Deferred Costs—Contracts with Customers.”

Disaggregation of Revenue

The following tables present the Company’s revenue disaggregated by contract type:

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED) 

Transaction Price Allocated to Remaining Performance Obligations

Our backlog represents the estimated transaction prices on performance obligations to our customers for which work remains to be performed. Backlog is converted into revenue in future periods as work is performed. As of March 31, 2019,June 30, 2020, the aggregate amount of transaction price allocated to the remaining performance obligations was approximately $113.5 $209 million. This represents the amount of revenue the Company expects to recognize in the future on contracts with unsatisfied or partially satisfied performance obligations as of March 31, 2019.June 30, 2020. The Company estimates that it will recognize approximately 63% 27% of this amount in fiscal year 2019 2020 and the remainder by fiscal year 2022.

4.       lEases3.            LEASE

The Company leases a building and equipment. Under ASC 842, at contract inception we determine whether the contract is or contains a lease and whether the lease should be classified as an operating or a financing lease. Operating leases are included in ROU (right-of-use) assets and operating lease liabilities in our consolidated balance sheets.

The Company leases manufacturing and office space under an agreement classified as an operating lease.

The lease agreement expires on April 30, 2022 and does not include any renewal options. The agreement provides for an initial monthly base amount plus annual escalations through the term of the lease.

In addition to the monthly base amounts in the lease agreement, the Company is required to pay real estate taxes and operating expenses during the lease terms.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The Company also leases office equipment in agreements classified as operating leases.

For the six and three months ended March 31, 2019,June 30, 2020, the Company’s operating lease expense was $438,328.$883,220 and $441,610 respectively.

Future minimum lease payments under non-cancellable operating leases as of March 31, 2019June 30, 2020 were as follows:

The following table sets forth the ROU assets and operating lease liabilities as of March 31, 2019:June 30, 2020:

The Company’s weighted average remaining lease term for its operating leases is 3.42.1 years.

4.            RECONCILIATION OF CASH AND RESTRICTED CASH

The following table provides a reconciliation of cash and restricted cash reported within the consolidated balance sheet that sum to the total of the same such amounts shown in the statement of cash flows:

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

5.            reconciliation of cash and restricted casHINVENTORY

6.inventory

The components of inventory consisted of the following:

7.stock-based compensation

6.            STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation based on the fair value of the stock or stock-based instrument on the date of grant.

In JanuaryJune 2019, a board member retired and 7,326 of his unvested RSUs (Restricted Stock Units) were forfeited which were valued at approximately $46,700. In addition, in April 2019, the Company granted 75,350 restricted stock units (“RSUs”)6,677 RSUs to one of its board of directorsmembers as partial compensation for the 2019 year. In January 2018, the Company granted 58,578 RSUs to its board of directors as partial compensation for the 2018 year. RSUs vest quarterly on a straight-line basis over a one-year period. The Company’s net loss for the threesix months ended March 31,June 30, 2019 and 2018 includes approximately $250,000 and $273,000, respectively,$15,000 of non- cash compensation expense related to the RSU grants to the board member. In June 2019, two board members were granted an additional 2,725 RSUs as partial compensation for the 2019 year. The Company’s net loss for the six months ended June 30, 2019 includes approximately $7,000 of non-cash compensation expense related to the RSU grants to the board of directors. This expense is recorded as a component of selling, general and administrative expenses.There were no similar grants in June 2020.

In January 2018,April 2019, the Company granted 5,1304,950 shares of common stock to various employees. For the threesix months ended March 31, 2018,June 30, 2019, approximately $10,000$6,000 of compensation expense is included in selling, general and administrative expenses and approximately $36,000$26,000 of compensation expense is included in cost of sales for this grant. There were no grants as of June 30, 2020.

In March 2018,April 2019, the Company granted 68,76494,972 shares of common stock to various employees. In the event that any of these employees voluntarily terminates their employment prior to certain dates, portions of the shares may be forfeited. In addition, if certain Company performance criteria are not achieved, portions of these shares may be forfeited. These shares will be expensed during various periods through March 20222023 based upon the service and performance thresholds. For the threesix months ended March 31, 2019,June 30, 2020, approximately $85,000$66,200 of compensation expense is included in selling, general and administrative expenses and approximately $16,100$16,500 of compensation expense is included in cost of sales for this grant. For the threesix months ended March 31, 2018,June 30, 2019, approximately $76,600$68,700 of compensation expense is included in selling, general and administrative expenses and approximately $16,100$20,800 of compensation expense is included in cost of revenuesales for this grant.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

On February 12,In April 2019, these employees returned 1,221 common shares, valued at approximately $7,893, to pay the employees’ withholding taxes.

In March 2018, 12,33011,193, 8,299 and 9,1308,593 of the shares granted in 2016, 2017 and 2017,2018, respectively, were forfeited because the Company failed to achieve certain performance criteria for the year ended December 31, 2017.2018. In addition, on March 22, 2018,April 2, 2019, these employees returned 7,5529,806 common shares, valued at approximately $62,000,$51,600, to pay the employees’ withholding taxes.

A summary of the status of the Company’s stock option plans as of March 31, 2019 and changes during the three months ended March 31, 2019 is as follows:

7.            FAIR VALUE

During the three months ended March 31, 2019, 35,000 stock options were exercised, pursuant to the provisions of the stock option plan, where the Company received no cash and 34,478 shares of its common stock in exchange for the 35,000 shares issued in the exercise. The 34,478 shares that the Company received were valued at $231,003, the fair market value of the shares on the date of exercise. During the three months ended March 31, 2018, no stock options were granted or exercised.

8.       Fair Value

Fair Value

At March 31, 2019June 30, 2020 and December 31, 2018,2019, the fair values of cash, accounts receivable, accounts payable and accrued expenses approximated their carrying values because of the short-term nature of these instruments.