NOTE

ADOPTION OF ASC TOPIC

606,

“REVENUE FROM CONTRACTS WITH CUSTOMERS”

January 1, 2018,

the Company adopted Topic

606

using the modified retrospective method applied to those contracts which were

not

completed as of

January 1, 2018.

In addition, the Company has accounted for all contract modifications retrospectively for contracts in transition at the date of adoption by electing the contract modification practical expedient. Contract consideration has

not

been adjusted for the effects of a significant financing component if the time between the transfer of the good or service and payment timing is

one

year or less. Results for reporting periods beginning after

January 1, 2018,

are presented under Topic

606,

while prior period amounts are

not

adjusted and continue to be reported in accordance with the Company’s historical accounting under Topic

605.

Transactions under the Company’s major distribution agreements, which under prior guidance were recognized upon shipment from its distributors to the final customers, are now recognized upon transfer of control to its major distribution partners at the amount of consideration that the Company expects to be entitled to. As a result, the Company now records contract liabilities for the invoiced amounts that are estimated to be subject to significant reversal, including product revenue allowances for cash consideration paid to customers for services, discounts, rebate programs, chargebacks, and product returns. The constraint on variable consideration for product returns is a new estimation resulting from the earlier recognition under the new guidance. Based on this change, the entire deferred revenue and deferred cost of goods sold balances related to its distribution agreements were allocated to either contract liabilities and other liabilities associated with invoicing in periods prior to adoption or included in the cumulative adjustment to retained earnings upon adoption.

Milestone payments, which under the prior milestone recognition methodology, were

not

recognized until they are substantively achieved, are included in the estimated transaction price when they are considered probable of being achieved. This

may

result in earlier recognition of revenue for the portion of milestone payments deemed probable which are allocated to performance obligations that are satisfied before the milestones are achieved. For license and collaboration revenue for which contract deliverables were previously accounted for as a combined unit of accounting because products or services were

not

separable, the Company has identified that under the new guidance the separate performance obligations are capable of being distinct. As a result, the transaction price under these arrangements, including upfront fees and milestone payments, are allocated differently to each performance obligation and

may

be recognized at earlier points in time or with a different pattern of performance over time.

The following table shows the reconciliation of assets and liabilities disclosed in the Form

-K for the year ended

December 31, 2017,

as adjusted, due to the modified retrospective adoption of Topic

606

January 1, 2018 (

in thousands):

	As Reported Under Topic 605			Effect of Change			As Adjusted Under Topic 606

Accounts receivable	$	3,629		$	530		$	4,159
Inventory	$	504		$	(25	)	$	479
Accrued liabilities	$	1,672		$	1,166		$	2,838
Deferred revenue	$	2,841		$	(2,766	)	$	75
Deferred revenue, non-current	$	534		$	(534	)	$	-
Accumulated deficit	$	(111,074	)	$	2,639		$	(108,435	)

As a result of adopting Topic

606

using the modified retrospective approach, the following table shows the financial statement line items for the

first

quarter of

2018,

as if revenue from contracts with customers had been accounted for under Topic

605

(in thousands, except per share data):

	As Reported Under Topic 606			Effect of Change			As Revised Under Topic 605

Consolidated Balance Sheet:
Accounts receivable	$	2,225		$	(279	)	$	1,946
Inventory	$	479		$	27		$	506
Accrued liabilities	$	2,855		$	(1,269	)	$	1,586
Deferred revenue	$	62		$	3,227		$	3,289
Deferred revenue, non-current	$	-		$	488		$	488
Accumulated deficit	$	(110,585	)	$	(2,698	)	$	(113,283	)


Net product sales	$	2,947		$	(61	)	$	2,886
Cost of product sales	$	251		$	(2	)	$	249
Loss from operations	$	(2,368	)	$	(59	)	$	(2,427	)
Net loss	$	(2,150	)	$	(59	)	$	(2,209	)
Basic net loss per share	$	(0.13	)	$	-		$	(0.13	)
Diluted net loss per share	$	(0.14	)	$	(0.01	)	$	(0.15	)


Consolidated Statement of Cash Flows:
Net loss	$	(2,150	)	$	(59	)	$	(2,209	)
Adjustments to reconcile net loss to net cash used in operating activities:
Accounts receivable	$	1,934		$	(251	)	$	1,683
Inventory	$	-		$	(2	)	$	(2	)
Accrued liabilities	$	(161	)	$	(134	)	$	(295	)
Deferred revenue	$	(13	)	$	446		$	433

March 31, 2018,

approximately

$62,000

of the transaction price is allocated to unsatisfied performance obligations which the Company expects to be recognized during

2018.

For additional detail on the Company’s accounting policy regarding revenue recognition, refer to Note

above.

The following table presents changes in the Company’s contract assets and liabilities for the

three

months ended

March 31, 2018:

	Balance at Beginning of the Period		Additions		Deductions			Balance at the end of the Period
	(in thousands)
Contract Liabilities: Deferred Revenue	$	75	$	-	$	(13	)	$	62
Contract Liabilities: Accrued Liabilities	$	1,458	$	1,587	$	(1,425	)	$	1,620
Total	$	1,533	$	1,587	$	(1,438	)	$	1,682

During the

three

months ended

March 31, 2018,

the Company recognized the following revenues (in thousands):

Revenue recognized in the period from:
Amounts included in contract liabilities at the beginning of the period:
Performance obligations satisfied	$	13
New activities in the period:
Performance obligations satisfied	$	2,934
Total revenue	$	2,947

License Collaboration and Distribution Agreements

January 2012,

the Company entered into a distribution agreement with China Pioneer, a Shanghai-based company that markets high-end pharmaceutical products into China and an affiliate of Pioneer Singapore, for the commercialization of NeutroPhase in this territory. Under the terms of the agreement, NovaBay received an upfront payment of

$312,500.

NovaBay also received

$312,500

January 2013,

related to the submission of the

first

marketing approval for the product to the CFDA (Chinese Food and Drug Administration). The deferred revenue was recognized as the purchase discounts were earned, with the remaining deferred revenue recognized ratably over the product distribution period. During the year ended

December 31, 2014,

NovaBay received

$625,000

upon receipt of a marketing approval of the product from the CFDA.

September 2012,

the Company entered into

two

agreements with China Pioneer: (

) an international distribution agreement (“Distribution Agreement”) and (

) a unit purchase agreement (“Purchase Agreement”). These agreements were combined and accounted for as

one

arrangement with

one

unit of accounting for revenue recognition purposes.

Pursuant to the terms of the Distribution Agreement, China Pioneer has the right to distribute NeutroPhase, upon a marketing approval from a Regulatory Authority, in certain territories in Asia (other than China). Upon execution of the Distribution Agreement, the Company received an upfront payment, which was recorded as deferred revenue. China Pioneer is also obligated to make certain additional payments to the Company upon receipt of the marketing approval. The Distribution Agreement further provides that China Pioneer is entitled to a cumulative purchase discount

not

to exceed

$500,000

upon the purchase of NeutroPhase product, payable in NovaBay unregistered restricted common stock.

Pursuant to the Purchase Agreement, we also received

$2.5

million from China Pioneer for the purchase of restricted units (comprising

one

share of common stock and a warrant for the purchase of

one

share of common stock). The unit purchase was completed in

two

tranches: (

)

800,000

units in

September 2012;

and (

)

1,200,000

units in

October 2012,

with both tranches at a purchase price of

$1.25

per unit. The fair value of the total units sold was

$3.5

million, based upon the trading price of our common stock on the dates the units were purchased and the fair value of the warrants based on the Black-Scholes Merton option pricing model. Because the aggregate fair value of the units on the dates of purchase exceeded the

$2.5

million in proceeds received from the unit purchase by approximately

million, we reallocated

$600,000

from deferred revenue to stockholders’ equity as consideration for the purchase of the units.

December 2013,

the Company announced it had expanded its NeutroPhase commercial partnership agreement with China Pioneer. The expanded agreement includes licensing rights to Avenova and CelleRx, which were developed internally by NovaBay. The expanded partnership agreement covers the commercialization and distribution of these products in China and

countries in Southeast Asia.

February 7, 2012,

the Company entered into a distribution agreement with Integrated Healing Technologies, LLC, (“IHT”) to distribute NeutroPhase. NovaBay received an upfront payment of

$750,000.

April 2013,

the Company entered into a collaboration and license agreement with Virbac. Under this agreement, Virbac acquired exclusive worldwide rights to develop the Company’s proprietary compound, auriclosene (NVC-

422

), for global veterinary markets for companion animals. The Company received an upfront payment of

$250,000.

June 1, 2013,

the Company entered into a distribution agreement with Principal Business Enterprise Inc., (“PBE”) to distribute NeutroPhase. NovaBay received an upfront payment of

$200,000.

Revenue has been recognized under these agreements as follows:

	Three months ended March 31,
(in thousands)	2018		2017
Amortization of upfront technology access fee	$	-	$	7
Product sales		-		73
Samples		13		-
Total revenue recognized	$	13	$	80

The Company had a deferred revenue balance of

$2.0

million at

December 31, 2017,

related to these agreements, which consisted of the unamortized balances from upfront technology and access fees. Upon the adoption of ASC

606,

deferred revenue decreased by

$1.96

million and was recorded as part of the cumulative adjustment to the accumulated deficit. The decrease in deferred revenue related primarily to the identification of the licenses as “right of use” licenses under the current guidance for which control transferred to the customer at the onset of each contract. At

March 31, 2018,

the Company had deferred revenue of

$62

thousand which relates to unsatisfied performance obligations of sample supply due Pioneer China and PBE and an incremental discount on future product sales due to Pioneer China.

Avenova Distribution Agreements

November 2014,

the Company signed a nationwide distribution agreement for its Avenova product with McKesson Corporation (“McKesson”) as part of the Company’s commercialization strategy. McKesson makes Avenova widely available in local pharmacies and major retail chains across the U.S., such as Wal-Mart, Costco, CVS and Target. In

January 2015,

the Company signed a nationwide distribution agreement with Cardinal Health. In

April 2015,

the Company also signed a distribution agreement with AmerisourceBergen to distribute Avenova nationwide.

During the

three

months ended

March 31, 2018

and

2017,

the Company earned

$2.6

million and

$2.8

million,

respectively, in product revenue under the Avenova distribution agreements.

The Company had a deferred revenue balance of

$1.3

million at

December 31, 2017,

related to these agreements, which consisted of product sales that our Customers had

not

resold to end users (sell-through approach). Upon the adoption of ASC

606,

deferred revenue decreased by

$1.3

million, with a portion associated with the constraint on variable consideration related to service fees/chargebacks, prompt payment discounts, rebates and returns in the amount of

$0.6

million being reclassified as a contract liability. The remaining

$0.7

million, including the net effect of deferred cost of goods sold, was recorded as part of the cumulative adjustment to the accumulated deficit. With the adoption of Topic

606,

we recognize product sales as revenue when our products are sold to our Customers.

March 31, 2018,

under the Avenova product distribution arrangements, the Company has a contract liability balance of

$1.6

million. The contract liability is included in accrued liabilities in the balance sheet (see Note