EKCS Electronic Control Security Inc (CE)

Notes to the Consolidated Financial Statements

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements of Electronic Control Security Inc. and its subsidiaries (collectively "the Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and Article 8.03 of Regulation S-X. 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. Operating results for the three and nine month periods ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending June 30, 2013. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the year ended June 30, 2012, as filed with the Securities and Exchange Commission.

Certain items in prior period information have been reclassified to conform the current year’s presentation.

New Authoritative Pronouncements

The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on results of operations, financial condition, or cash flows, based on current information .

Note 2 - Earnings Per Share

Basic earnings per share is computed based on the weighted-average number of shares of the Company’s common stock, par value $0.001 per share, outstanding. Diluted earnings per share is computed based on the weighted-average number of shares of the Company’s common stock, including common stock equivalents outstanding. Certain common stock equivalents consisting of stock options and convertible preferred stock that would have an anti-dilutive effect were not included in the diluted earnings per share attributable to common stockholders for the nine month and three month periods ended March 31, 2013 and 2012.

The following is a reconciliation of the denominators of the basic and diluted earnings per share computations:

For the nine months ended March 31, 2013 and 2012, there were outstanding potential common stock equivalent shares of 3,863,092 and 4,179,710, respectively, which were excluded from the computation of diluted earnings per share because the effect would have been anti-dilutive. These potential dilutive common stock equivalent shares may be dilutive to future diluted earnings per share.

In October 2012, 2,000,000 shares of common stock were issued to certain officers in consideration of a reduction of $160,000 in interest bearing advances due to those officers. In March 2013, 2,000,000 shares of common stock were issued to certain officers in consideration of a reduction of $100,000 in amounts due to those officers, composed of $35,000 in interest bearing advances and in $65,000 in other accrued costs due to those officers.

Note 5 – Financing Agreements

On February 8, 2012, the Company, through its wholly owned subsidiary, ECSI International Inc., and Atlantic Stewardship Bank (the “Bank”) entered an agreement pursuant to which the maturity date for the amounts outstanding under the credit line established in March 2011 has been extended to May 15, 2013, and the interest rate changed to prime plus 1%, with the minimum rate unchanged at 4.5%. The principal amount outstanding at March 31, 2013 was $473,000 and at June 30, 2012, was $475,000. All other terms of the agreements were unchanged.

Note 6 – Legal Proceeding

On March 7, 2012, the Company, through its wholly-owned subsidiary, ECSI International, Inc. filed a lawsuit in the United States District Court for the District of New Jersey against Lockheed Martin Global Training and Logistics (“Lockheed Martin”). The lawsuit alleges breach of contract and tortious interference by Lockheed Martin and seeks actual damages of approximately $978,000, as well as punitive damages, costs and such further relief as the Court deems equitable and proper. In addition, the lawsuit seeks payment under Lockheed Martin’s payment bonds required by the United States Navy Facilities Engineering Command. At March 31, 2013, and June 30, 2012, the Company has included in its accounts receivable (prior to allowances) the amount of the actual damages claimed. Lockheed Martin has indicated that it may file counterclaim against ECSI International, Inc. seeking reimbursement of approximately $200,000 in costs alleged to have been incurred by Lockheed Martin on the project related to the above amount due to us, but, as of the date of this report no such counterclaim has been filed. In July 2012, Lockheed Martin moved to have the matter transferred to the United States District Court in Maryland and, in December 2012, the motion was granted. We filed an appeal with the United States Court of Appeals for the Third Circuit in January 2013, to transfer the matter back to the United District Court in New Jersey. As of the date of the filing of this report, the United States Court of Appeals for the Third Circuit has not ruled on the appeal. Discovery has been proceeding. We are aggressively pursuing our claim against Lockheed Martin and will vigorously defend against a counterclaim if one is asserted.

The following discussion should be read in conjunction with our financial statements and the notes related to those statements. Some of our discussion is forward-looking and involves risks and uncertainties. For information regarding risk factors that could have a material adverse effect on our business, refer to the risk factors section of the Annual Report on Form 10-K for the year ended June 30, 2012.

CAUTION REGARDING FORWARD-LOOKING STATEMENTS

Our Company and its representatives may from time to time make written or verbal forward-looking statements, including statements contained in this report and other Company filings with the Securities and Exchange Commission and in our reports to shareholders. Statements that relate to other than strictly historical facts, such as statements about our plans and strategies, expectations for future financial performance, new and existing products and technologies, and markets for our products are forward-looking statements. Generally, the words "believe," "expect," "intend," "estimate," "anticipate," "will" and other similar expressions identify forward-looking statements. The forward-looking statements are and will be based on our management's then-current views and assumptions regarding future events and operating performance, and speak only as of their dates. Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors including, but not limited to, our current and future capital needs, uncertainty of capital funding, our clients' ability to cancel contracts with little or no penalty, ongoing delays by federal agencies of approved projects; cash flow impact arising from the dispute with prime contractors; government initiatives to implement Homeland Security measures, the state of the worldwide economy, competition, customers’ ability to pay our invoices within our standard credit terms, and other risks detailed in our Company's most recent Annual Report on Form 10-K and other Securities and Exchange Commission filings. We undertake no obligation to publicly update or revise any forward-looking statements.

OVERVIEW

We design, develop, manufacture and market stand-alone and fully integrated state-of-the-art entry control and perimeter intrusion detection systems for Department of Defense, Department of Energy, nuclear power stations, and various international customers. We offer U.S. Air Force certified technology and a comprehensive services portfolio that includes: site survey/risk assessment, design & engineering, systems manufacturing and integration, factory acceptance testing, installation supervision, commissioning, operations and maintenance training.

We work closely with architects, engineers, systems integrators, construction managers and owners in the development and design of security monitoring and control systems that will afford a normative but secure environment for management, staff and visitors. To support such efforts, ECSI’s team of key personnel are technically accomplished and fully familiar with advances in planning, programming and designing systems utilizing standard peripheral components, mini/micro architecture, user friendly software/firmware selection and application.

Our mission is to establish ourselves as a Small Business (SB) prime contractor to take advantage of the small business opportunities that exist today and in the foreseeable future. To achieve that end we have formed a team of both small and large corporation agreements to support our company in the pursuit of this market. We believe that our past performance and in depth experience as well as that of our teaming partners will place us in a lead position to capture a good share of this market.

We entered into strategic partnerships, teaming, and representative relationships with major multi-national corporations in each of the industries that comprise our target markets. These companies generally enjoy a strong market presence in their respective industries and we believe that our teaming agreements with these entities afford us added credibility. These entities frequently subcontract our services and purchase our products in connection with larger projects and, in turn, support the company on projects we are pursuing as the prime contractor. During fiscal 2012 and fiscal 2013, we entered into teaming and marketing agreements with ITSI, SAIC, Fortis, Calnet, Honeywell, Culmen, ERIS, and Boeing.

During fiscal 2013 and fiscal 2012, we submitted proposals on projects for Department of Defense and Department of Energy facilities, certain nuclear power stations in the United States and South Korea, border and pipeline installations in the Middle East and Southeast Asia valued at approximately $146,550,000. We anticipate decisions relating to these proposals during the remainder of fiscal 2013 and during fiscal 2014.

Recent Developments

Our revenues and results from operations for the year ended June 30, 2012, and the nine and three month periods ended March 31, 2013, have continued to be negatively impacted by the ongoing delays by agencies of the U.S. Government in proceeding with approved projects, funding projects already awarded, and in awarding new contracts. We have invested significant time and personnel resources in fiscal 2012 and to date in fiscal 2013 in providing proposals on future projects, both as a prime contractor (Small Business) and as a subcontractor. In that regard, we have been named as an prime contractor on two contracts with the Department of Defense (DoD) and as a subcontractor on two others. We are awaiting the issuances of task orders on these contracts and of the results of the bidding process on the other outstanding proposals. No assurance can, however, be provided that we will be awarded any projects or task orders. Additionally, our cash flow and liquidity continue to be severely impacted by the refusal of Lockheed Martin to pay us for the accounts receivable due from them totaling almost $1 million. These amounts are the subject of litigation initiated by us in March 2012, as described in Item 1 of Part II of this Quaterly Report on Form 10-Q.

Contract Award

On February 14, 2013, we entered into a contract that was awarded to ECSI’s team, of which ECSI is small business prime contractor, for support and technology services to the Department of Defense (“DoD”). The cumulative contract ceiling of the award to include thirteen prime contractors and their respective subcontractors is $249,590,000 over five years. The contract is an Indefinite Delivery Indefinite Quantity (“IDIQ”) contract, and the work to be performed under it will be awarded to the thirteen teams on individual task orders on a competitive basis. With its subcontractors, ECSI has a strong competitive team; however, there is no assurance that ECSI will be awarded work under any task orders on the contract.

The contract is in response to initiatives promulgated by the DoD and other Government agencies, require engineering development, design, procurement, fabrication of entry control and perimeter detection technologies, installation, information assurance, logistics, maintenance, and life cycle support services for Infrastructure Protection purposes. These systems will support the operational requirements of high value DoD and other Government agencies where security is of high or vital interest. 

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires that we make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Management continually evaluates the accounting policies and estimates it uses to prepare the consolidated financial statements. We base our estimates on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates made by management.

We do not participate in, nor has there been created, any off-balance sheet special purpose entities or other off-balance sheet financing. In addition, we do not enter into any derivative financial instruments for speculative purposes.

We have identified the following critical accounting policies that affect the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.

INVENTORY VALUATION

Inventories are valued at the lower of cost or market. We routinely evaluate the composition of our inventory to identify obsolete or otherwise impaired inventories. Inventories identified as impaired are evaluated to determine if reserves are required. We currently have a reserve of $80,000 against inventory.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

The allowance for doubtful accounts is comprised of two parts, a specific account analysis and a general reserve. Accounts where specific information indicates a potential loss may exist are reviewed and a specific reserve against amounts due is recorded. As additional information becomes available, such specific account reserves are updated. Additionally, a general reserve is applied to the aging categories based on historical collection and write-off experience.

ACCOUNTING FOR INCOME TAXES

We record a valuation allowance to our deferred tax assets for the amount that is more likely than not to be realized. While we consider historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event that we determine that we would be able to realize deferred tax assets in the future in excess of the net amount recorded, an adjustment to the deferred tax asset would increase income in the period such determination has been made. Likewise, should we determine that we would not be able to realize all or part of the net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged against income in the period such determination was made.

FAIR VALUE OF EQUITY INSTRUMENTS

The valuation of certain items, including valuation of warrants or stock options that may be offered as compensation for goods or services, involve significant estimations with underlying assumptions judgmentally determined. Warrants are valued using the most reliable measure of fair value, such as the value of the goods or services rendered, if obtainable. If such value is not readily obtainable, the valuation of warrants and stock options are then based on the Black-Scholes valuation model, which involves estimates of stock volatility, expected life of the instruments and other assumptions.

RESULTS OF OPERATIONS

COMPARISON OF THE NINE AND THREE MONTH PERIODS ENDED MARCH 31, 2013 COMPARED TO THE NINE AND THREE MONTH PERIODS ENDED MARCH 31, 2012

REVENUES. We had net revenues for the nine months ended March 31, 2013 of $936,168 compared to $2,010,970 in the corresponding period in 2012, representing a decrease of approximately 53%. Revenues for the three months ended March 31, 2013 were $81,990 compared to $343,970, representing a decrease of approximately 76%. The decreases in net revenues in the nine and three month periods ended March 31, 2013 compared to the corresponding periods in 2012 were primarily attributable to the decrease in deliverable products and support services billings resulting from continuing delays in release of funding at the Department of Defense and Department of Energy on projects where we serve as a prime contractor and as a subcontractor as well as at other customers. The budget constraints and budget uncertainty at the U.S. government agencies have significantly reduced the issuance of orders and delayed projects for all participants in our industry.

GROSS MARGINS. Gross margins for the nine months ended March 31, 2013 were 46% as compared to 32% for the corresponding period in 2012. We had a lower negative gross margin for the three months ended March 31, 2013 as compared to the negative gross margin for the three months ended March 31, 2012. The improvement in gross margins for each of the nine and three month periods ended March 31, 2013 compared to the corresponding periods in 2012 was primarily attributable to a change in the mix of equipment sales and support services billings and a reduction in personnel costs due to the lower revenues, partially offset by the decrease in revenues discussed above.

RESEARCH AND DEVELOPMENT. Research and development expenses were $68,657 and $21,863 for the nine and three months ended March 31, 2013, respectively, compared to $104,167 and $35,156 for the corresponding nine months and three months, respectively, in 2012. The reduction in research and development expenses for the nine and three months periods ended March 31, 2013 compared to the corresponding periods in 2012 was due to reductions in personnel costs.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses were $758,020 for the nine months ended March 31, 2013 compared to $1,169,343 for the corresponding nine months in 2012. Selling, general and administrative expenses were $268,960 for the three months ended March 31, 2013 compared to $309,332 for the corresponding nine months in 2012. The decrease in selling, general and administrative expenses during the nine month period ended March 31, 2013 as compared to the corresponding period in 2012 was primarily attributable to an increase in the nine months ended March 31, 2012 in our allowance for doubtful accounts in the amount of $200,000. For the nine months ended March 31, 2013 as compared to the same period in 2012, the other components of the selling, general and administrative expenses decreased by 22% and by 13% in the three months ended March 31, 2013 as compared to the three months ended March 31, 2012, both primarily due to reduced personnel costs.

STOCK BASED COMPENSATION. From time to time, we issue stock options to our directors and employees and consultants. In the nine months ended March 31, 2012, we recognized expense for stock based compensation of $96,815. Stock-based compensation is non-cash and, therefore, has no impact on cash flow or liquidity. We issued no stock options in the nine and three month periods ended March 31, 2013.

LOSS FROM OPERATIONS. The loss from operations for the three months ended March 31, 2013 was $(338,238) compared to a loss of $(487,379) for the corresponding three months of 2012. The decrease in the loss from operations during the three months ended March 31, 2013 compared to the same period in 2012 was primarily attributable to reductions in personnel costs in fiscal 2013 substantially offset by the lower revenues in 2013. The loss from operations for the nine months ended March 31, 2013 was $(394,555) compared to a loss of $(733,192) for the corresponding nine months of 2012. The decrease in the loss from operations during the nine months ended March 31, 2013 compared to the same period in 2012 was primarily attributable to the 2011 increase in the allowance for doubtful accounts of $200,000, the 2011 stock based compensation of $96,815 and to reductions in personnel costs in 2012. In the three and nine month periods, these items were partially offset by the higher revenues in the three and nine month periods of 2013.

OTHER EXPENSE, NET. In the three months ended March 31, 2013, we recorded a loss of $20,000 related to the outcome of litigation with a former employee.

DIVIDENDS RELATED TO CONVERTIBLE PREFERRED STOCK. We recorded dividends totaling $109,455 on our Series B Convertible Preferred Stock in the nine months ended March 31, 2013 and $114,912 in the corresponding nine months in 2012. The reduction in these dividends is due to conversion in fiscal 2011 of a portion of the outstanding Series B Convertible Preferred Stock. In lieu of a cash payment, we have elected, under the terms of these securities, to add this amount to the stated value of the Series B Convertible Preferred Stock.

These dividends are non-cash and, therefore, have no impact on our net worth, cash flow or liquidity.

LIQUIDITY AND CAPITAL RESOURCES

Our cash flow continues to be adversely impacted by the refusal of Lockheed Martin to pay to us the amount due on our accounts receivable from Lockheed Martin. This matter is currently the subject matter of litigation initiated by us in March 2012 and discussed in Item 1 of Part II of this Quarterly Report on Form 10-Q. Nonetheless, we believe that cash on hand, together with anticipated collection of accounts receivable during the short term, will be sufficient to provide for our working capital needs for the next 12 months. However, we may need to raise funds in order to allow for shortfalls in anticipated revenue or to expand existing capacities and/or to satisfy any additional significant purchase orders that we may receive. At the present time, we have no assurances of additional revenue beyond the firm purchase orders we have received. We are in discussions with Atlantic Stewardship Bank regarding the existing line of credit, which was fully utilized with a balance of $473,000 at March 31, 2013. These discussions include potentially further extending the line of credit or converting it to a term loan. The line of credit has been extended and is now due on May 15, 2013. There can be no assurance that we will be successful in obtaining a further extension or converting the line of credit into a term loan.

Our working capital was approximately $398,000 at March 31, 2013 as compared to $501,000 at June 30, 2012. The decrease in working capital was primarily due to the net loss substantially offset by conversion by certain officers of $260,000 in amounts due to them into common stock. Net cash used in operating activities for the nine months ended March 31, 2013 was $(203,315) as compared to $(216,754) used in operating activities for the corresponding nine months in 2012.

Accounts receivable decreased by $62,571 in the nine months ended March 31, 2013 compared to an increase in the nine months ended March 31, 2012 of $161,334. Inventories increased by $73,870 in nine months ended March 31, 2013 compared to an increase in the nine months ended March 31, 2012 of $404,507.

Accounts payable and accrued expenses have increased by $150,171 to $1,182,369 for the nine months ended March 31, 2013 as compared to an increase of $672,799 in the corresponding nine months in 2012.

In order to conserve our cash resources, we did not purchase any property, plant and equipment during the nine months ended March 31, 2013. We do not have any major material commitments for capital expenditures going forward.

ITEM 4. CONTROLS AND PROCEDURES.

We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer (our principal executive officer) and our Chief Financial Officer (our principal financial and accounting officer), of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, management and our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.

During the quarter ended March 31, 2013, there was no change in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

In its quarterly report on Form 10-Q for the three months ended March 31, 2012, we first disclosed that in March 2012, the Company, through its wholly-owned subsidiary, ECSI International, Inc. filed a lawsuit in the United States District Court for the District of New Jersey against Lockheed Martin Global Training and Logistics (“Lockheed Martin”). The lawsuit alleges breach of contract and tortious interference by Lockheed Martin and seeks actual damages of approximately $978,000, as well as punitive damages, costs and such further relief as the court deems equitable and proper. In addition, the lawsuit seeks payment under Lockheed Martin’s payment bonds required by the United States Navy Facilities Engineering Command. At March 31, 2013, and June 30, 2012, the Company has included in its accounts receivable (prior to allowances) the amount of the actual damages claimed. Lockheed Martin has indicated that it may file counterclaim against ECSI International, Inc. seeking reimbursement of approximately $200,000 in costs alleged to have been incurred by Lockheed Martin on the project related to the above amount due to us, but as of the date of this report no such counterclaim has been filed. In July 2012, Lockheed Martin moved to have the matter transferred to the United States District Court in Maryland and, in December 2012, the motion was granted We filed an appeal with the United States Court of Appeals for the Third Circuit in January 2013,to transfer the matter back to the United States District Count in New Jersey. As of the date of the filing of this report, the United States Court of Appeals for the Third Circuit has not ruled on the appeal Discovery has been proceeding. We are aggressively pursuing our claim against Lockheed Martin and will vigorously defend against a counterclaim if one is asserted.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.