Nature of Business and Summary of Significant Accounting Policies (Policies)

9 Months Ended

Mar. 31, 2020

Nature of Business and Summary of Significant Accounting Policies

Nature of Business

Nature of Business:

Napco Security Technologies, Inc. and Subsidiaries (the "Company") is a diversified manufacturer of security products, encompassing access control systems, door-locking products, intrusion and fire alarm systems and video surveillance products for commercial and residential use. The Company also provides wireless communication service for intrusion and fire alarm systems. These products are used for commercial, residential, institutional, industrial and governmental applications, and are sold worldwide principally to independent distributors, dealers and installers of security equipment.

The Company’s fiscal year begins on July 1 and ends on June 30. Historically, the end users of the Company's products want to install its products prior to the summer; therefore sales of its products historically peak in the period April 1 through June 30, the Company’s fiscal fourth quarter, and are reduced in the period July 1 through September 30, the Company’s fiscal first quarter. In addition, demand is affected by the housing and construction markets.

Principles of Consolidation

Principles of Consolidation

The unaudited condensed consolidated financial statements of the Company, including these notes, have been prepared by the Company in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the rules and regulations promulgated by the U.S. Securities and Exchange Commission (the “SEC”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been omitted or condensed. However, in the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended June 30, 2019 and the notes thereto included in the Company’s Annual Report on Form 10‑K filed with the SEC on September 13, 2019. Results of consolidated operations for the interim periods are not necessarily indicative of a full year’s operating results. The unaudited condensed consolidated financial statements include the accounts of Napco Security Technologies, Inc. and all of its wholly-owned subsidiaries. All inter-company balances and transactions have been eliminated in consolidation.

Accounting Estimates

Accounting Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent gains and losses at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Critical estimates include management’s judgments associated with reserves for sales returns and allowances, allowance for doubtful accounts, inventory reserves, intangible assets and income taxes. Actual results could differ from those estimates.

Fair Value of Financial Instruments

Fair Value of Financial Instruments

The methods and assumptions used to estimate the fair value of the following classes of financial instruments were: Current Assets and Current Liabilities - The carrying amount of cash and cash equivalents, certificates of deposits, current receivables and payables and certain other short-term financial instruments approximate their fair value as of March 31, 2020 and June 30, 2019 due to their short-term maturities.

Cash and Cash Equivalents

Cash and Cash Equivalents

Cash and cash equivalents include approximately $460,000 of short-term time deposits at March 31, 2020 and June 30, 2019. The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The Company has cash balances in banks in excess of the maximum amount insured by the Federal Deposit Insurance Corporation ("FDIC") and other international agencies as of March 31, 2020 and June 30, 2019. The Company has not historically experienced any credit losses with balances in excess of FDIC limits.

Accounts Receivable

Accounts Receivable

Accounts receivable is stated net of the allowances for doubtful accounts of $326,000 as of March 31, 2020 and $88,000 at June 30, 2019. Our allowances for doubtful accounts are subjective critical estimates that have a direct impact on reported net income. These allowances are based upon the evaluation of our accounts receivable aging, specific exposures, sales levels and historical trends.

Inventories

Inventories

Inventories are valued at the lower of cost or net realizable value, with cost being determined on the first-in, first-out ("FIFO") method. The reported net value of inventory includes finished saleable products, work-in-process and raw materials that will be sold or used in future periods. Inventory costs include raw materials, direct labor and overhead. The Company’s overhead expenses are applied based, in part, upon estimates of the proportion of those expenses that are related to procuring and storing raw materials as compared to the manufacture and assembly of finished products. These proportions, the method of their application, and the resulting overhead included in ending inventory, are based in part on subjective estimates and actual results could differ from those estimates.

In addition, the Company records an inventory obsolescence reserve, which represents any excess of the cost of the inventory over its estimated realizable value, based on various product sales projections. This reserve is calculated using an estimated obsolescence percentage applied to the inventory based on age, historical trends, requirements to support forecasted sales, and the ability to find alternate applications of its raw materials and to convert finished product into alternate versions of the same product to better match customer demand. In addition, and as necessary, the Company may establish specific reserves for future known or anticipated events. There is inherent professional judgment and subjectivity made by both production and engineering members of management in determining the estimated obsolescence percentage.

The Company also regularly reviews the period over which its inventories will be converted to sales. Any inventories expected to convert to sales beyond 12 months from the balance sheet date are classified as non-current.

Property, Plant, and Equipment

Property, Plant, and Equipment

Property, plant, and equipment are carried at cost less accumulated depreciation. Expenditures for maintenance and repairs are charged to expense as incurred; costs of major renewals and improvements are capitalized. At the time property and equipment are retired or otherwise disposed of, the cost and accumulated depreciation are eliminated from the asset and accumulated depreciation accounts and the profit or loss on such disposition is reflected in income.

Depreciation is recorded over the estimated service lives of the related assets using primarily the straight-line method. Amortization of leasehold improvements is calculated by using the straight-line method over the estimated useful life of the asset or lease term, whichever is shorter.

Intangible Assets

Intangible Assets

Intangible assets with definite lives are amortized over their useful lives. Indefinite-lived intangible assets are reviewed for impairment at least annually at the Company’s fiscal year end of June 30 or more often whenever there is an indication that the carrying amount may not be recovered.

The Company’s acquisition of substantially all of the assets and certain liabilities of G. Marks Hardware, Inc. (“Marks”) in August 2008 included intangible assets recorded at fair value on the date of acquisition. The customer relationships are amortized over their estimated useful lives of twenty years. The Marks trade name was deemed to have an indefinite life.

Changes in intangible assets are as follows (in thousands):

	March 31, 2020						June 30, 2019
			Accumulated		Net book				Accumulated		Net book
	Cost		amortization		value		Cost		amortization		value
Customer relationships	$	9,800	$	(8,666)	$	1,134	$	9,800	$	(8,468)	$	1,332
Trade name		5,900		—		5,900		5,900		—		5,900
	$	15,700	$	(8,666)	$	7,034	$	15,700	$	(8,468)	$	7,232

Amortization expense for intangible assets subject to amortization was approximately $66,000 and $78,000 for the three months ended March 31, 2020 and 2019, respectively. Amortization expense for intangible assets subject to amortization was approximately $198,000 and $235,000 for the nine months ended March 31, 2020 and 2019, respectively. Amortization expense for each of the next five fiscal years is estimated to be as follows: 2020 -$264,000; 2021 - $223,000; 2022 - $188,000; 2023 - $159,000 and 2024 - $134,000. The remaining weighted average amortization period for intangible assets was 8.4 years and 9.4 years at March 31, 2020 and 2019, respectively.

During the nine months ended March 31, 2020, the Company experienced  a decline in revenues related to the Trade Name intangible asset compared to the nine months ended March 31, 2019. Management considered whether the decline in revenues and loss from continuing operations related to this intangible asset during the three and nine months ended March 31, 2020 constituted a triggering event requiring the assessment of the Trade Name for impairment.  It was determined that such decline in revenues did constitute a triggering event.  Management performed a preliminary impairment analysis, developing a fair value of the Trade Name as of March 31, 2020, utilizing estimates and assumptions related to future revenue growth, discount rates, and royalty rates and determined that no impairment was necessary to be recorded.

Based on the Company’s seasonal sales cycle, management believes that it is too early to assess if the unfavorable conditions are short-term in nature that will be recovered in the future. The fourth quarter of the fiscal year is typically the Company’s strongest quarter for revenue and gross margin generated from the Trade Name. As a result, management will continue to evaluate its forward projections, on-going operations and growth initiatives in light of the current economic conditions, which re-evaluation is scheduled to be completed in the fourth quarter in connection with the annual impairment test.  The continuing adverse economic conditions in the U.S. may reduce revenues and gross margins associated with the Company’s intangible assets and result in a reduction of future expected cash flows. If declines occur, they would likely affect the discount and royalty rates used in the annual impairment analysis of the Trade Name.  If any impairment is identified, the related adjustment to identifiable intangible assets will be recorded against the operations of the period in which such identification is made and may be material.

Long-Lived Assets

Long-Lived Assets

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets in question may not be recoverable. Impairment would be recorded in circumstances where undiscounted cash flows expected to be generated by an asset are less than the carrying value of that asset.

Leases

Leases

Effective July 1, 2019, in accordance with Accounting Standards Codification ("ASC"), Topic 842, Leases at the inception of a contract, we assess whether the contract is, or contains, a lease. The assessment is based on (1) whether the contract involves the use of a distinct identified asset, (2) whether the Company obtains the right to substantially all the economic benefit from the use of the asset throughout the period, and (3) whether the Company has the right to direct the use of the asset.

All significant lease arrangements are generally recognized at lease commencement. Operating lease right-of-use (“ROU”) assets and lease liabilities are recognized at commencement. An ROU asset and corresponding lease liability are not recorded for leases with an initial term of 12 months or less (short term leases) and we recognize lease expense for these leases as incurred over the lease term.

ROU assets represent our right to use an underlying asset during the reasonably certain lease term and lease liabilities represent our obligation to make lease payments arising from the lease. We primarily use our incremental borrowing rate based on information available at the lease commencement date, in determining the present value of lease payments. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option.

Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. Lease payments may be fixed or variable, however, only fixed payments or in-substance fixed payments are included in determining the lease liability. See Note 11 - Commitments for additional accounting policies and transition disclosures.

Revenue Recognition

Revenue Recognition

The Company recognizes revenue when its customers obtain control of its products or services, in an amount that reflects the consideration that the Company expects to receive in exchange for those goods and services. See Note 2 – Revenue Recognition for additional accounting policies and transition disclosures.

Advertising and Promotional Costs

Advertising and Promotional Costs

Advertising and promotional costs are included in "Selling, General and Administrative" expenses in the consolidated statements of income and are expensed as incurred. Advertising expense for the three months ended March 31, 2020 and 2019 was $307,000 and $190,000, respectively. Advertising expense for the nine months ended March 31, 2020 and 2019 was $1,448,000 and $1,278,000, respectively.

Research and Development Costs

Research and Development Costs

Research and development costs incurred by the Company are charged to expense as incurred and are included in operating expenses in the consolidated statements of income. Company-sponsored research and development expense for the three months ended March 31, 2020 and 2019 was $1,816,000 and $1,851,000, respectively. Company-sponsored research and development expense for the nine months ended March 31, 2020 and 2019 was $5,387,000 and $5,358,000, respectively.

Income Taxes

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income tax expense represents the change during the period in the deferred tax assets and deferred tax liabilities. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company measures and recognizes the tax implications of positions taken or expected to be taken in its tax returns on an ongoing basis.

Net Income per Share

Net Income per Share

Basic net income per common share ("Basic EPS") is computed by dividing net income by the weighted average number of common shares outstanding. Diluted net income per common share ("Diluted EPS") is computed by dividing net income by the weighted average number of common shares and dilutive common share equivalents and convertible securities then outstanding.

The following provides a reconciliation of information used in calculating the per share amounts for the three months ended December 31 (in thousands, except per share data):

	Net Income				Weighted Average Shares		Net Income per Share
	2020		2019		2020	2019	2020		2019
Basic EPS	$	3,615	$	3,122	18,472	18,489	$	0.20	$	0.17
Effect of Dilutive Securities:
Stock Options		—		—	44	44		—		—
Diluted EPS	$	3,615	$	3,122	18,516	18,533	$	0.20	$	0.17

Options to purchase 44,000 and 0 shares of common stock were excluded for the three months ended March 31, 2020 and 2019, respectively were not included in the computation of Diluted EPS because their inclusion would be anti-dilutive. These options were still outstanding at the end of the respective periods.

The following provides a reconciliation of information used in calculating the per share amounts for the nine months ended March 31 (in thousands, except per share data):

	Net Income				Weighted Average Shares		Net Income per Share
	2020		2019		2020	2019	2020		2019
Basic EPS	$	10,420	$	7,495	18,476	18,607	$	0.56	$	0.40
Effect of Dilutive Securities:
Stock Options		—		—	54	47		—		—
Diluted EPS	$	10,420	$	7,495	18,530	18,654	$	0.56	$	0.40

Options to purchase 27,000 and 3,942 shares of common stock were excluded for the nine months ended March 31, 2020 and 2019, respectively were not included in the computation of Diluted EPS because their inclusion would be anti-dilutive. These options were still outstanding at the end of the respective periods.

Stock-Based Compensation

Stock-Based Compensation

The Company has established three share incentive programs as discussed in Note 8.

Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the vesting period. Determining the fair value of share-based awards at the grant date requires assumptions and judgments about expected volatility and forfeiture rates, among other factors.

Stock-based compensation costs of $172,000 and $0 were recognized for the three months ended March 31, 2020 and 2019, respectively. Stock-based compensation costs of $497,000 and $152,000 were recognized for the nine months ended March 31, 2020 and 2019, respectively.

Foreign Currency

Foreign Currency

The Company has determined the functional currency of all foreign subsidiaries is the U.S Dollar. All foreign operations are considered a direct and integral part or extension of the Company’s operations. The day-to-day operations of all foreign subsidiaries are dependent on the economic environment of the U.S Dollar. Therefore, no realized or unrealized gains and losses associated with foreign currency translation are recorded for the nine months ended March 31, 2020 or 2019.

Comprehensive Income

Comprehensive Income

For the nine months ended March 31, 2020 and 2019, the Company’s operations did not give rise to material items includable in comprehensive income, which were not already included in net income. Accordingly, the Company’s comprehensive income approximates its net income for all periods presented.

Segment Reporting

Segment Reporting

The Company’s reportable operating segments are determined based on the Company’s management approach. The management approach is based on the way that the chief operating decision maker organizes the segments within an enterprise for making operating decisions and assessing performance. The Company’s results of operations are reviewed by the chief operating decision maker on a consolidated basis and the Company operates in only one segment. The Company has presented required geographical data in Note 12.

Shipping and Handling Revenues and Costs

Shipping and Handling Revenues and Costs

The Company records the amount billed to customers for shipping and handling in net sales ($135,000 and $109,000 in the three months ended March 31, 2020 and 2019, respectively and $355,000 and $313,000 in the nine months ended March 31, 2020 and 2019, respectively) and classifies the costs associated with these revenues in cost of sales ($300,000 and $280,000 in the three months ended March 31, 2020 and 2019, respectively and $831,000 and $827,000 in the nine months ended March 31, 2020 and 2019, respectively).

Recently Issued and Adopted Accounting Standards

Recently Issued and Adopted Accounting Standards

On July 1, 2019, we adopted Accounting Standards Update No. 2016-02, Leases (Topic 842) (ASU 2016-02), as amended, which supersedes the lease accounting guidance under Topic 840, and generally requires lessees to recognize operating and financing lease liabilities and corresponding right-of-use assets on the balance sheet and to provide enhanced disclosures surrounding the amount, timing and uncertainty of cash flows arising from leasing arrangements. We adopted the new guidance using the modified retrospective transition approach by applying the new standard to all leases existing at the date of initial application and not restating comparative periods. The most significant impact was the recognition of ROU assets and lease liabilities for operating leases. For information regarding the impact of Topic 842 adoption, see Significant Accounting Policies - Leases and Note 11— Leases.