UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q/A

(Amendment No. 1)

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period endedSeptember 30, 20172018

OR

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______________ to ______________

Commission file number0-21617

ProPhase Labs, Inc.

(Exact name of registrant as specified in its charter)

(215) 345-0919

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or shorter period that the registration was required to submit and post such files). Yes [X] No [  ]

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

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

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

Yes [  ] No [X]

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

ProPhase Labs, Inc. and Subsidiaries

TABLE OF CONTENTS

explanatory note

On August 10, 2018, the Company’s management, after consultation and discussions with EisnerAmper LLP, the Company’s independent registered public accounting firm, and the Audit Committee of the Board of Directors, concluded that the Company’s previously issued audited consolidated financial statements for the fiscal year ended December 31, 2017 included in the Company’s Annual Report on Form 10-K for such period and unaudited condensed consolidated financial statements for the fiscal quarters ended March 31, 2017, June 30, 2017, September 30, 2017 and March 31, 2018 (collectively with the fiscal year ended December 31,2017, the “Restated and Revised Periods”) included in the Company’s Quarterly Reports on Form 10-Q for such periods should no longer be relied upon, and determined that these financial statements will be restated due to the identification of certain accounting errors related to income tax accounting.

The Company has determined that it miscalculated its income tax benefit by incorrectly utilizing certain net operating losses without taking into account the statutory limitation imposed by the State of Pennsylvania, which resulted in an overstatement of net income as discussed below. The Company also incorrectly determined the amount of income tax benefit allocable to continuing operations, which resulted in an overstatement of income from continuing operations, and an equal understatement of the gain on sale of discontinued operations, presented net of taxes, which had no impact on net income.

Based on its review, the Company has determined that its income tax expense was understated and its net income was overstated by approximately $1.2 million for the fiscal year ended December 31, 2017. Concurrently with the filing of this Form10-Q/A, the Company is filing an amendment on Form 10-K/A to its Annual Report on Form 10-K for the fiscal year ended December 31, 2017 to restate the audited consolidated financial statements included in the Form 10-K and amendments on Form 10-Q/A to its Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2017, June 30, 2017, September 30, 2017 and March 31, 2018 to correct the errors described above.

The corrections to the Restated and Revised Periods, which we refer to herein collectively as the “Restatement”, were prepared following an independent review by the Company.

Description of the Restatement

In completing our Federal and State income tax preparation review procedures for filing of the Federal and State income tax returns for the fiscal year ended December 31,2017 during the second quarter of fiscal 2018, the Company identified an error in the accounting treatment of state Net Operating Loss (NOL) limitations which resulted in understatement of state income tax liability and expense of approximately $0.8 million and a corresponding overstatement of net income for the nine months ended September 30, 2017. We also identified an error in our treatment of the reversal of certain valuation allowances in 2017 and their allocation between continuing and discontinued operations, resulting in the overstatement of the tax benefit allocated to continuing operations and an equal overstatement of the tax provision for discontinued operations of approximately $16.0 million for the nine months ended September 30, 2017, and the understatement of the tax benefit allocated to continuing operations and an equal understatement of the tax provision for discontinued operations of approximately $0.3 million for the three months ended September 30, 2017, which had no further impact on net income.

For additional information regarding the corrections to the financial statements in the Restated and Revised Periods, see Notes 2, 4 and 7 of the Condensed Consolidated Financial Statements included in Part I, Item 1, “Financial Statements”.

Internal Controls Over Financial Reporting

As a result of the Restatement, we also concluded that we had a material weakness related to our internal control over financial reporting. For more information regarding management’s assessment of internal control over financial reporting and disclosure controls and procedures, as well as the related remediation actions, refer to Item 4 “Controls and Procedures” in this Quarterly Report on Form 10-Q/A.

Items Amended by this Form 10-Q/A

This Form 10-Q/A amends and restates the entire contents of the original Form 10-Q. The portions of this Form 10-Q/A that have been revised to give effect to the Restatement and matters related thereto are as follows:

In addition, the Company’s Chief Executive Officer and Principal Accounting Officer have provided new certifications dated as of the date of this filing in connection with this Form 10-Q/A.

Except as described above, no other changes have been made to the Company’s Quarterly Report on Form 10-Q ended September 30, 2017 (the “Original Filing”). This Form 10-Q/A speaks as of the date of the Original Filing and does not reflect events that may have occurred after the date of the Original Filing or modify or update any disclosures that may have been affected by subsequent events.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

ProPhase Labs, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

See accompanying notes to condensed consolidated financial statements

ProPhase Labs, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations and Other Comprehensive Income

(in thousands, except per share amounts)

(unaudited)

See accompanying notes to condensed consolidated financial statements

ProPhase Labs, Inc. and Subsidiaries

Condensed Consolidated Statement of

Stockholders’ Equity

(in thousands, except share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements

ProPhase Labs, Inc. and Subsidiaries

Condensed Consolidated StatementStatements of Stockholders’ EquityCash Flows

For the Nine Months Ended September 30, 2017

(in thousands, except share data)thousands)

(unaudited)

ProPhase Labs, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited)

(unaudited)

Note 1 – Organization and Business

ProPhase Labs, Inc. (“we”, “us” or the “Company”) was initially organized as a corporation in Nevada in July 1989. Effective June 18, 2015, we changed our state of incorporation from the State of Nevada to the State of Delaware. We are a manufacturer, marketervertically integrated and distributor of a diversified range of health carebranding, marketing and cold remedy products that are offered to the general public. We are alsotechnology company engaged in the research, development, manufacture, distribution, marketing and developmentsale of potential over-the-counter (“OTC”) drugconsumer healthcare products, dietary supplements and natural base health products includingother remedies in the United States. This includes the development and marketing of dietary supplements personal care and cosmeceutical products. On August 23, 2017,under the Company formed a new wholly-owned subsidiary, TK Supplements^®brand.

ProPhase Digital Media, Inc. (a Delaware corporation)(“PDM”), whicha wholly-owned subsidiary of ProPhase Labs, Inc., is an independent full-service direct marketing agency. PDM’s first initiative will be responsible for marketingto market the dietary TK Supplements^®product line, but could also marketline. If successful, this may lead to the marketing of other companies’ consumer products.

In addition, we also continue to actively pursue acquisition opportunities for other companies, technologies and products within and outside the consumer products industry.

We use a December 31 year-end for financial reporting purposes. References herein to “Fiscal 2018” shall mean the fiscal year ended December 31, 2018 and references to other “Fiscal” years shall mean the year, which ended on December 31 of the year indicated. The term “we”, “us” or the “Company” as well.used herein also refer, where appropriate, to the Company, together with its subsidiaries and consolidated variable interest entities unless the context otherwise requires.

Discontinued Operations

Prior to March 29, 2017, our flagship OTC drug brand was Cold-EEZE^® and our principal product was Cold-EEZE^®cold remedy zinc gluconate lozenges, proven in clinical studies to reduce the duration and severity of symptoms of the common cold.lozenges. In addition to Cold-EEZE^® cold remedy lozenges, we also marketed and distributed non-lozenge forms of our proprietary zinc gluconate formulation, (i) Cold-EEZE^® cold remedy QuickMelts^®, (ii) Cold-EEZE^®Gummies and (iii) Cold-EEZE^® cold remedy Oral Spray. Each of the Cold-EEZE^® QuickMelts^®and Gummies products are based on a proprietary zinc gluconate formulation in combination with certain (i) immune system support, (ii) energy, (iii) sleep and relaxation, and/or (iv) cold and flu symptom relieving active ingredients.oral spray.

On January 6,Effective March 29, 2017, we signed an asset purchase agreement (as amended, the “Asset Purchase Agreement”), by and among the Company, Meda Consumer Healthcare Inc. (“MCH”) and Mylan Inc. (together with MCH, “Mylan”), for the sale of assets by us to Mylan (see Note 4). The sale of assets (i) was subject to stockholder approval and other customary closing conditions and (ii) consisted principally of the sale ofsold our intellectual property rights and other assets relatingrelated to our Cold-EEZE^®brand and product line, (collectively, referred to herein as the “Cold-EEZE^® Business”) to Mylan, including all then current and pipeline over-the-counter allergy, cold, flu, multi-symptom relief and immune support treatments for adults and children to the extent each is,was, or iswas intended to be, branded “Cold-EEZE^®”, and all private label versions thereof, including all formulations and derivatives thereof (collectively referred to as set forth in the Asset Purchase Agreement.

A special meeting of our stockholders was held on March 29, 2017 (the “Special Meeting”). At the Special Meeting, our stockholders approved the sale of assets and the transactions contemplated by the Asset Purchase Agreement. Effective March 29, 2017, we completed the sale of the Cold-EEZE“Cold-EEZE^®Business Business”) to Mylan.Mylan Consumer Healthcare Inc. (formerly known as Meda Consumer Healthcare Inc.) (“MCH”) and Mylan Inc. (together with MCH, “Mylan”). As a consequenceresult of the sale of the Cold-EEZE^®Business, for the three and nine months ended September 30, 2017, and 2016, we have classified as discontinued operations (i) all income and expenses attributable to the Cold-EEZE^®Business, (ii) the gain from the sale of the Cold-EEZE^® Business, (ii) all income and expenses attributable to the Cold-EEZE^®Business, and (iii) the income tax expense attributed to the sale of the Cold-EEZE^® Business (see Notes 4 and 7).Business. Excluded from the sale of the Cold-EEZE^®Business were our accounts receivable and inventory, and weinventory. We have also retained all liabilities associated with our Cold-EEZE^®Business operations arising prior to March 29, 2017.

Continuing Operations

We continue to own and operate our manufacturing facility and manufacturing business in Lebanon, Pennsylvania, and our headquarters in Doylestown, Pennsylvania. As part of the sale of the Cold-EEZE^® Business, we entered into a manufacturing agreement (see Note 8) with Mylan and our wholly-owned subsidiary, Pharmaloz Manufacturing, Inc. (“PMI”), to supply various Cold-EEZE^®lozenge products to Mylan. In addition to the production services we provide to Mylan under the manufacturing agreement, we produce OTC drughealthcare and dietary supplement lozenges and other products for other third partythird-party customers in addition to performing operational tasks such as warehousing, customer order processing and shipping.

We are also pursuing a series of new product development and pre-commercialization and market testing initiatives in the OTC dietary supplement category. Initial OTC dietary supplement product development activities were completed in the fourth quarter of Fiscal 2015category under the brand name of TK Supplements^®. The TK Supplements^® product line comprises of three men’s health products: (i) Legendz XL^® for sexual health, (ii) Triple Edge XL^®, a dailyan energy booster plus testosterone support, and (iii) Super ProstaFlow Plus^TM for prostate and urinary health. In addition to developing direct-to-consumer (“Direct Response”) marketing strategies offor Legendz XL^®, we received initial product acceptance and shipped intoare currently in distribution in a national chain drug retailer and to several regional retailers during the Fiscal 2017.retailers.

For the three and nine months ended September 30, 2017 and 2016, our revenues from continuing operations have come principally from our OTC health care products.

ProPhase Labs, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 1 – Organization and Business – continued(unaudited)

We use a December 31 year-end for financial reporting purposes. References herein to “Fiscal 2017” shall mean the fiscal year ended December 31, 2017 and references to other “Fiscal” years shall mean the year, which ended on December 31 of the year indicated. The term “we”, “us” or the “Company” as used herein also refer, where appropriate, to the Company, together with its subsidiaries unless the context otherwise requires.

Note 2 - Restatement of Previously Issued Financial Statements

The Company determined that when calculating its income tax provision related to the gain on the sale of discontinued operations, it incorrectly utilized available net operating losses without considering the statutory limitations imposed by the state of Pennsylvania, and that it incorrectly allocated the amount of income tax benefit resulting from the reversal of certain valuation allowances to continuing operations, which resulted in an overstatement of income the tax benefit from continuing operations and an understatement of the gain on sale of discontinued operations, which is presented net of taxes. In the process of this determination, the Company determined that such information existed at September 30, 2017 which affected the income tax benefit/ provision from continuing and discontinued operations reported in the three and nine months ended September 30, 2017. The Company concluded that the impact of applying corrections for these errors and misstatements on the consolidated financial statements as of and for the three and nine months ended September 30, 2017 is material. As a result, the Company is restating its consolidated financial statements as of and for the three and nine months ended September 30, 2017. See below for a reconciliation of the previously reported amounts to the restated amounts.

The table below sets forth the condensed consolidated balance sheet, including the balances as originally reported, adjustments and the as restated balances (in thousands):

ProPhase Labs, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited)

The table below sets for the condensed consolidated statements of operations, including the balances as originally reported, adjustments, and the as restated amounts (in thousands):

ProPhase Labs, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited)

The table below sets forth the condensed consolidated statements of cash flows from operating activities, including the balances as originally reported, adjustments and as the restated balances (in thousands):

The restatement had no impact on cash flows from investing activities or financing activities or net increase in cash.

Note 32 – Summary of Significant Accounting Policies

For the three and nine months ended September 30, 2018 and 2017, our revenues from continuing operations have come principally from OTC health care contract manufacturing and sales to retail customers of dietary supplement products for third parties.

Basis of Presentation

The unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial statements and within the rules of the Securities and Exchange Commission (“SEC”) applicable to interim financial statements and therefore do not include all disclosures that might normally be required for financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The accompanying unaudited condensed consolidated financial statements have been prepared by management without audit and should be read in conjunction with our consolidated financial statements, including the notes thereto, appearing in our Annual Report, as amended on Form 10-K for Fiscal 2016.the fiscal year ended December 31, 2017. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial position, consolidated results of operations and consolidated cash flows, for the periods indicated, have been made. The results of operations for the three and nine months ended September 30, 20172018 are not necessarily indicative of operating results that may be achieved over the course of the full year. Historical financial statements have been reclassified to conform to the current period presentation, principally reflecting the sale of Cold-EEZE^® Business as discontinued operations.

Discontinued Operations Carve Out and ProPhase Allocations

For the three and nine months ended September 30, 2017, and 2016, results from operations for our Cold-EEZE^® Business are classified as discontinued operationsoperations. The carve out of the discontinued operations (i) were prepared in accordance with the SEC’s carve out rules under Staff Accounting Bulletin (“SAB”) Topic 1B1 and (ii) are derived from identifying and carving out the specific assets, liabilities, net sales, cost of sales, operating expenses and interest expense associated with the Cold-EEZE^®Business’s operations. General administrative and overhead expenses, including personnel expenses and bonuses, and research and development overhead expenses incurred by us (for which the discontinued operation benefits from such resources) are allocated to discontinued operations based upon the percentage of the Cold-EEZE^® Business’s net sales to our consolidated net sales. For the three and nine months ended September 30, 2017, and 2016, we allocated (i) zero and $406,000, respectively,$348,000 of administrative expenses and (ii) zero and $77,000, respectively,$52,000 of research and development expenses to discontinued operations in the accompanying condensed statements of operations. For the three and nine months ended September 30, 2017 and 2016, we allocated (i) $348,000 and $1.1 million respectively, of administrative expenses and (ii) $52,000 and $172,000, respectively, of research and development expenses, to2018, there were no discontinued operations in the accompanying condensed statements of operations (see Note 4)5).

Product Innovation, Seasonality of the Business and Liquidity

Our net sales are derived principally from our contract manufacturing of OTC heath carehealthcare and cold remedydietary supplements products sold in the United StatesStates. In addition, we are engaged in early stage commercialization and market testing activities for the TK Supplements^®product line of America. dietary supplements.

Our sales are influenced (i) by market acceptance of our TK Supplement^® products and subject to fluctuations in the timing of purchase and(ii) by the ultimate level of demand for our contract manufactured OTC healthcare and dietary supplement products which are a function of the timing, length and severity of each cold season. Generally, a cold season is defined as the period of September to March when the incidence of the common cold rises as a consequence of the change in weather and other factors. We generally experience in the first, third and fourth quarter higher levels of net sales. Revenues are generally at their lowest levels in the second quarter when customer demand generally declines.

For the three and nine months ended September 30, 2017 and 2016, our net sales were principally related to domestic markets.

As a consequence of the scope and timing of our TK Supplements^® product market launch and the seasonality of our contract manufacturing OTC business, we realize variations in operating results and demand for working capital from quarter to quarter. As of September 30, 2018, we had working capital of approximately $17.2 million, including $6.9 million marketable securities available for sale. We believe our current working capital at September 30, 2018 is at an acceptable and adequate level to support our business for at least the next twelve months.

ProPhase Labs, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 3 – Summary of Significant Accounting Policies – continued

Use of Estimates

The preparation of financial statements and the accompanying notes thereto, in conformity with GAAP, requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the respective reporting periods. ExamplesSpecific estimates include the provision for bad debt, sales returns and allowances, inventory obsolescence, useful lives of property and equipment and intangible assets, impairment of property and equipment and intangible assets, income tax valuations and assumptions related to accrued advertising. When providing for the appropriate sales returns, allowances, cash discounts and cooperative incentive promotion costs, we apply a uniform and consistent method for making certain assumptions for estimating these provisions. These estimates and assumptions are based on historical experience, current trends and other factors that management believes to be relevant at the time the financial statements are prepared. Management reviews the accounting policies, assumptions, estimates and judgments on a quarterly basis. Actual results could differ from those estimates.

Cash and Cash Equivalents

We consider all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. Cash equivalents include cash on hand and monies invested in money market funds. The carrying amount approximates the fair market value due to the short-term maturity of these investments.

Marketable Securities

We have classified our investments in marketable securities as available-for-sale and as a current asset. Our investments in marketable securities are carried at fair value, with unrealized gains and losses included as a separate component of stockholders’ equity. Realized gains and losses from our marketable securities are recorded as other interest income (expense). We initiated short term investments in marketable securities, which carry maturity dates underbetween one yearand three years from date of purchase with interest rates of 0.87%1.89% - 1.56%3.56%, during the third quarterfirst three quarters of Fiscal 2017.2018. For thosethe three and nine months ended September 30, 2017,2018, we reported an unrealized gain of $28,000 and $54,000 and have an accumulated unrealized loss of $35,000.$24,000. Unrealized gains and losses are classified as other comprehensive income (loss) and the cost is determined on a specific identification basis. The following is a summary of the components of our marketable securities and the underlying fair value input level tier hierarchy (see long-lived assets below) (in thousands):

We have determined that the unrealized losses are deemed to be temporary as of September 30, 2018. We believe that the unrealized losses generally are the result of increases in the risk premiums required by market participants rather than an adverse change in cash flows or a fundamental weakness in the credit quality of the issuer or underlying assets. We have the ability and intent to hold these investments until a recovery of fair value, which may be maturity. We do not consider the investment in corporate bonds to be other-than-temporarily impaired at September 30, 2018.

Inventory Valuation

Inventory is valued at the lower of cost, determined on a first-in, first-out basis (FIFO), or market.net realizable value. Inventory items are analyzed to determine cost and the marketnet realizable value and appropriate valuation adjustments are established. At September 30, 2017 and December 31, 2016,2018, after the 2018 write-off of certain inventory previously recorded, the financial statements include adjustments to reduce inventory for excess, obsolete or obsoleteshort-dated shelf-life inventory of $1.5$427,000, inclusive of adjustments of $165,000 for product samples of TK Supplements^® products. At December 31, 2017, the financial statements include adjustments to reduce inventory for excess, obsolete or short-dated shelf-life inventory of $1.1 million, inclusive of an adjustment of $541,000 for product samples of TK Supplements^® products.

ProPhase Labs, Inc. and $1.6 million, respectively. Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

The components of inventory are as follows (in thousands):

ProPhase Labs, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 3 – Summary of Significant Accounting Policies – continued

Property, Plant and Equipment

Property, plant and equipment are recorded at cost. We use the straight-line method in computing depreciation for financial reporting purposes. Depreciation expense is computed in accordance with the following ranges of estimated asset lives: building and improvements – ten to thirty-nine years; machinery and equipment – three to seven years; computer equipment and software – three to five years; and furniture and fixtures – five years.

Concentration of Risks

Future revenues, costs, margins and profits will continue to be influenced by our ability to maintain our manufacturing availability and capacity together with our marketing and distribution capabilities and the regulatory requirements associated with the development of OTC consumer healthcare products, dietary supplements and other personal care productsremedies in order to compete on a national level and/or international level.

Our business is subject to federal and state laws and regulations adopted for the health and safety of users of our products. OurThe manufacturing and distribution of OTC health carehealthcare and dietary supplement products are subject to regulations by various federal, state and local agencies, including the Food and Drug Administration (“FDA”) and, as applicable, the Homeopathic Pharmacopoeia of the United States.

Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash investments, marketable securities, and trade accounts receivable. Our marketable securities are fixed income investments, which are highly liquid and can be readily purchased or sold through established markets.

We maintain cash and cash equivalents with certain major financial institutions. As of September 30, 2017,2018, our cash and cash equivalents balance was $3.9$2.3 million and our bank balance was $3.6$2.4 million. Of the total bank balance, $500,000 was covered by federal depository insurance and $3.1$1.9 million was uninsured at September 30, 2017.2018.

Trade accounts receivable potentially subject us to credit concentrations from time-to-time as a consequence of the timing, payment pattern and ultimate purchase volumes or shipping schedules with our customers. We extend credit to our customers based upon an evaluation of the customer’s financial condition and credit history and generally we do not require collateral. Our customers include consumer products companies and large national chain, regional, specialty and local retail stores. These credit concentrations may impact our overall exposure to credit risk, either positively or negatively, in that our customers may be similarly affected by changes in economic, regulatory or other conditions that may impact the timing and collectability of amounts due to us. As a consequence of an evaluation of our customer’s financial condition, payment patterns, balance due to us and other factors, we did not offset our account receivable with an allowance for bad debt at September 30, 20172018 and December 31, 2016.2017.

ProPhase Labs, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited)

Long-lived Assets

We review our carrying value of our long-lived assets with definite lives whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. When indicators of impairment exist, we determine whether the estimated undiscounted sum of the future cash flows of such assets is less than their carrying amounts. If less, an impairment loss is recognized in the amount, if any, by which the carrying amount of such assets exceeds their respective fair values. The determination of fair value is based on quoted market prices in active markets, if available, or independent appraisals; sales price negotiations; or projected future cash flows discounted at a rate determined by management to be commensurate with our business risk. The estimation of fair value utilizing discounted forecasted cash flows includes significant judgments regarding assumptions of revenue, operating and marketing costs; selling and administrative expenses; interest rates; property and equipment additions and retirements; industry competition; and general economic and business conditions, among other factors.

Fair value is based on the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, a three-tier fair value hierarchy prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.

ProPhase Labs, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 3 – Summary of Significant Accounting Policies – continued

Fair Value of Financial Instruments

Cash and cash equivalents, marketable securities, accounts receivable, assets held for sale, accounts payable, and accrued expenses and notes payable are reflected in the Condensed Consolidated Financial Statements at carrying value which approximates fair value. We account for our marketable securities at fair value pursuant to Accounting Standards Codification, or ASC, 820-10, with the net unrealized gains or losses reported as a component of accumulated other comprehensive income or loss.

There were no transfers of marketable securities between Levels 1, 2 or 3 for the nine months ended September 30, 2018 and 2017.

Revenue Recognition

We account for revenue in accordance with ASC Topic 606, which requires revenue recognized to represent the transfer of promised goods or services to customers at an amount that reflects the consideration which is expected to be received in exchange for those goods or services. We recognize revenue when its performance obligations with its customers have been satisfied. At contract inception, we determine if a contract is within the scope of ASC Topic 606 and then evaluate the contract using the following five steps: (1) identify the contract with the customer; (2) identify the performance obligations; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations; and (5) recognize revenue when (or as) the entity satisfies a performance obligation.

We have not made any significant changes to judgments in applying ASC 606 during the three or nine months ended September 30, 2018.

Performance Obligations

We generate sales principally through two types of customers, contract manufacturing customers and retail customers. Sales from product shipments to contract manufacturing and retailer customercustomers are recognized at the time ownership is transferred to the customer. Net sales from OTC healthcare contract manufacturing and retail dietary supplement product customers were $2.3 million and $115,000, respectively, for the three months ended September 30, 2018 and $3.0 million and $40,000, respectively, for the three months ended September 30, 2017. Net sales from contract manufacturing and retail customers was $8.8 million and $269,000, respectively, for the nine months ended September 30, 2018 and $5.6 million and $150,000, respectively, for the nine months ended September 30, 2017. Revenue from retailer customers is reduced for trade promotions, estimated sales returns, cash discounts and other allowances in the same period as the related sales are recorded. No such allowance is applicable to our contract manufacturing customers. We make estimates of potential future product returns and other allowances related to current period revenue. We analyze historical returns, current trends, and changes in customer and consumer demand when evaluating the adequacy of the sales returns and other allowances.

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account in ASC 606. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. The combined duties and responsibilities within each contract will be considered one single performance obligation under ASC 606 as these items would not be separately identifiable from each other promise in the contract and we provide a significant service of integrating the duties with other promises in the contracts.

Transaction Price

The transaction price is fixed based upon either (i) a combined Master Agreement and each related purchase order, or (ii) if there is no Master Agreement, the price per the individual purchase order received from each customer. The customers are invoiced at an agreed upon contractual price for each unit ordered and delivered by us.

Consistent with Company practice prior to the adoption of ASC 606, we do not collect sales tax or other similar taxes from customers. As such, there is no effect on the measurement of the transaction price.

Recognize Revenue When the Company Satisfies a Performance Obligation

Performance obligations related to contract manufacturing and retail customers are satisfied at a point in time when the goods are shipped to the customer as (i) we have transferred control of the assets to the customers upon shipping, and (ii) the customer obtains title and assumes the risks and rewards of ownership after the goods are shipped.

We do not accept returns in the contract manufacturing revenue stream. Our return policy for retailer customers accommodates returns for (i) discontinued products, (ii) store closings and (iii) products that have reached or exceeded their designated expiration date. We do not impose a period of time within which product may be returned. All requests for product returns must be submitted to us for pre-approval. The main components of our returns policy are: (i) we will accept returns that are due to damaged product that is un-saleable and such return request activity falls within an acceptable range, (ii) we will accept returns for products that have reached or exceeded designated expiration dates and (iii) we will accept returns in the event that we discontinue a product provided that the customer will have the right to return only such items that it purchased directly from us. We will not accept return requests pertaining to customer inventory “Overstocking” or “Resets”. We will only accept return requests for productonly products in its intended package configuration. We reserve the right to terminate shipment of product to customers who have made unauthorized deductions contrary to our return policy or pursue other methods of reimbursement. We compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed and in the case of discontinued product only, also by way of an exchange. We do not have any significant product exchange history.

Pursuant to the terms of the Asset Purchase Agreement,Under ASC 606, we are responsible for andwill continue to accept product returns of the Cold-EEZE^®Businessrecognize contract manufacturing and retail customers at a point in time as we have an enforceable right to payment for productgoods as products are shipped prior to March 30, 2017. Additionally, pursuantcustomers.

ProPhase Labs, Inc. and Subsidiaries

Notes to the terms of the Asset Purchase Agreement, we allocated and, in June 2017, issued a credit to Mylan in the aggregate amount of $400,000 for future sales returns and allowances relating to certain product returns that were sold by us prior to March 30, 2017.Condensed Consolidated Financial Statements

(unaudited)

As of September 30, 20172018 and December 31, 2016,2017, we included a provision for sales allowances from continuing operations of zero$1,000 and $108,000,$2,000, respectively. Additionally, accrued advertising and other allowances from discontinued operations as of September 30, 20172018 included (i) $902,000$260,000 for estimated future sales returns and (ii) $371,000$88,000 for cooperative incentive promotion costs. As of December 31, 2016,2017, accrued advertising and other allowances from discontinued operations included (i) $1.2 million$480,000 for estimated future sales returns and (ii) $1.5 million$200,000 for cooperative incentive promotion costs.

OneAs of ourSeptember 30, 2018, we have deferred revenue of $57,000 in relation to Research and Development (“R&D”) stability and release testing programs.

Disaggregation of Revenue

We disaggregate revenue from contracts with customers accountedinto two categories: contract manufacturing and retail customers. We determined that disaggregating revenue into these categories achieves the disclosure objective to depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors.

The following table disaggregates the Company’s revenue by revenue source for 50.7% of our revenues in the three and nine months ended September 30, 2017, compared2018 (in thousands):