Nature of Business and Summary of Significant Accounting Policies

9 Months Ended

Mar. 31, 2023

Nature of Business and Summary of Significant Accounting Policies

Nature of Business and Summary of Significant Accounting Policies

NOTE 1 - Nature of Business and Summary of Significant Accounting Policies

Nature of Business:

Napco Security Technologies, Inc (“NAPCO”, “the Company”, “we”) is one of the leading manufacturers and designers of high-tech electronic security devices, cellular communication services for intrusion and fire alarm systems as well as a leading provider of school safety solutions. We offer a diversified array of security products, encompassing access control systems, door-locking products, intrusion and fire alarm systems and video surveillance products. 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. We have experienced significant growth in recent years, primarily driven by fast growing recurring service revenues generated from wireless communication services for intrusion and fire alarm systems, as well as our school security products that are designed to meet the increasing needs to enhance school security as a result of on-campus shooting and violence in the U.S. Our wireless communication services have led to the substantial growth in our monthly recurring revenues.

The Company's fiscal year begins on July 1 and ends on June 30. Historically, the end users of the Company’s hardware products want to install these products prior to the summer; therefore, sales of these 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 for all of our products may be affected by the housing and construction markets. Deterioration of the current economic conditions may also affect this trend. The monthly recurring service revenue, which is less susceptible to these fluctuations, allows us to generate a more consistent and predictable stream of income and mitigates the risk of fluctuation in market demand for our equipment products.

Significant Accounting Policies:

Principles of Consolidation

The consolidated financial statements include the accounts of Napco Security Technologies, Inc. and its wholly-owned subsidiaries. All inter-company balances and transactions have been eliminated in consolidation.

Stock Split

In December 2021, the Company's Board of Directors approved a two-for-one stock split in the form of a 100% stock dividend of the Company's common stock, payable to stockholders of record on December 20, 2021. The additional shares were distributed on January 4, 2022. All share and per share amounts (except par value) have been retroactively adjusted to reflect the stock split. There was no net effect on stockholders’ equity as a result of the stock split. Upon distribution of the dividend, the total number of shares outstanding increased from 18,365,878 to 36,731,756.

Accounting Estimates

The preparation of financial statements in conformity with Generally Accepted Accounting Principles (“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 credit losses, overhead expenses applied to inventory, inventory reserves, valuation of intangible assets, share based compensation and income taxes. Actual results could differ from those estimates.

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, 2023 and June 30, 2022 due to their short-term maturities. Long-term debt and lease liabilities reflect fair value based on prevailing market rates.

Cash and Cash Equivalents and Investments – other

Cash and cash equivalents include approximately $10,225,000 of short-term time deposits, consisting of several certificates of deposit totaling $10,162,000 and $63,000 in a money market fund as of March 31, 2023. Cash and cash equivalents include approximately $63,000 of short-term time deposits, consisting of $63,000 in a money market fund as of June 30, 2022. The Company classifies these highly liquid investments with original maturities of three months or less as cash equivalents. Certificates of Deposit with an original maturity greater than three months are classified as Investments-other.

Cash and cash equivalents consists of the following as of (in thousands):

	March 31, 2023		June 30, 2022
Cash	$	21,290	$	41,667
Money Market Fund		63		63
Certificates of Deposit		10,162		—
	$	31,515	$	41,730

Investments-other consists of the following as of (in thousands):

	March 31, 2023		June 30, 2022
Certificates of Deposit	$	20,271	$	—
	$	20,271	$	—

Certificates of deposit are recorded at the original cost plus accrued interest. The Company’s Certificates of Deposit consist of the following as of (in thousands):

March 31, 2023
Balance Sheet Classification	Interest Rate		Maturity Date		Cost		Carrying Value
Cash and Cash Equivalents		4.55% - 4.70%		4/24/2023 - 5/22/2023	$	10,000	$	10,162
Investments - other		4.75% - 4.90%		6/23/2023 - 9/21/2023		20,185		20,271

The Company has cash balances in banks in excess of the maximum amount insured by the FDIC and other international agencies as of March 31, 2023 and June 30, 2022. The Company has not historically experienced any credit losses with balances in excess of FDIC limits.

Marketable Securities

The Company’s marketable securities include investments in mutual funds, which invest primarily in various government and corporate obligations, stocks and money market funds. The Company’s marketable securities are reported at fair value with the related unrealized and realized gains and losses included in other expense (income). Realized gains or losses on mutual funds are determined on a specific identification basis. The Company would record an impairment charge if the cost of the available-for-sale securities exceeds the estimated fair value of the securities and the decline in value is determined to be other-than-temporary. During the nine months ended March 31, 2023, the Company did not record an impairment charge regarding its investment in marketable securities because

management believes, based on its evaluation of the circumstances, that the decline in fair value below the cost of certain of the Company’s marketable securities is temporary.

Accounts Receivable

Accounts receivable is stated net of the reserves for credit losses of $125,000 and $243,000 as of March 31, 2023 and June 30, 2022, respectively. Our reserves for credit losses are subjective critical estimates that have a direct impact on reported net earnings. These reserves are based upon the evaluation of our accounts receivable aging, specific exposures, sales levels and historical trends.

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. This reserve is calculated using an estimated obsolescence percentage applied to the inventory based on age, historical trends, product life cycle, 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 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.

Long-Lived and Intangible Assets

Long-lived assets are amortized over their useful lives and 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. Intangible assets determined to have indefinite lives were not amortized but were tested for impairment at least annually.

Intangible assets consisted of the follows (in thousands):

	March 31, 2023						June 30, 2022
	Carrying		Accumulated		Net book		Carrying		Accumulated		Net book
	value		amortization		value		value		amortization		value
Customer relationships	$	9,800		(9,262)	$	538	$	9,800		(9,143)	$	657
Trade name		4,048		(557)		3,491		4,048		(405)		3,643
	$	13,848	$	(9,819)	$	4,029	$	13,848	$	(9,548)	$	4,300

Amortization expense for intangible assets subject to amortization was approximately $90,000 and $98,000 for the three months ended March 31, 2023 and 2022, respectively. Amortization expense for intangible assets subject to amortization was approximately $271,000 and $293,000 for the nine months ended March 31, 2023 and 2022, respectively. Amortization expense for each of the next five fiscal years is estimated to be as follows: 2023 - $361,000; 2024 - $336,000; 2025 - $315,000; 2026 - $297,000; and 2027 - $283,000. The weighted average remaining amortization period for intangible assets was 15.7 years and 16.2 years at March 31, 2023 and June 30, 2022, respectively.

Revenue Recognition

Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services.

For product sales, the Company typically transfers control at a point in time upon shipment or delivery of the product. For monthly communication services the Company satisfies its performance obligation as the services are rendered and therefore recognizes revenue over the monthly period.

Typically timing of revenue recognition coincides with the timing of invoicing to the customers, at which time the Company has an unconditional right to consideration. As such, the Company typically records a receivable when revenue is recognized.

The contract with the customer states the final terms of the sale, including the description, quantity, and price of each product purchased. Payment for product sales is typically due within 30 and 180 days of the delivery date. Payment for monthly communication services is billed on a monthly basis and is typically due at the beginning of the month of service or in 30 days for customers with an open account.

The Company provides limited standard warranty for defective products, usually for a period of 24 to 36 months. The Company accepts returns for such defective products as well as for other limited circumstances. The Company also provides rebates to customers for meeting specified purchasing targets and other coupons or credits in limited circumstances. The Company establishes reserves for the estimated returns, rebates and credits and measures such variable consideration based on the expected value method using an analysis of historical data. Changes to the estimated variable consideration in subsequent periods are not material.

The Company analyzes sales returns and is able to make reasonable and reliable estimates of product returns based on the Company’s past history. Estimates for sales returns are based on several factors including actual returns and based on expected return data communicated to it by its customers. Accordingly, the Company believes that its historical returns analysis is an accurate basis for its allowance for sales returns. Actual results could differ from those estimates.

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, 2023 and 2022 was $926,000 and

$655,000, respectively. Advertising expense for the three months ended March 31, 2023 and 2022 was $2,185,000 and $2,253,000, respectively.

Research and Development Costs

Research and development (“R&D”) 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 R&D expense for the three months ended March 31, 2023 and 2022 was $2,314,000 and $2,009,000, respectively. Company-sponsored R&D expense for the nine months ended March 31, 2023 and 2022 was $6,964,000 and $5,918,000, respectively.

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. The Company records uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority.

Net Income per Share (2023 amounts as restated)

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 March 31, 2023 and 2022 (in thousands, except share and per share data):

	Net Income				Weighted Average Shares		Net Income per Share
	2023		2022		2023	2022	2023		2022
Basic EPS	$	9,549	$	3,273	36,793	36,743	$	0.26	$	0.09
Effect of Dilutive Securities:
Stock Options		—		—	289	136		—		—
Diluted EPS	$	9,549	$	3,273	37,082	36,879	$	0.26	$	0.09

Options to purchase 0 and 388,000 shares of common stock were excluded for the three months ended March 31, 2023 and 2022, respectively, and 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 period.

The following provides a reconciliation of information used in calculating the per share amounts for the nine months ended March 31, 2023 and 2022 (in thousands, except share and per share data):

					Weighted Average		Net Income per
	Net Income				Shares		Share
	2023		2022		2023	2022	2023		2022
Basic EPS	$	16,562	$	12,062	36,736	36,723	$	0.45	$	0.33
Effect of Dilutive Securities:
Stock Options		—		—	247	150		—		—
Diluted EPS	$	16,562	$	12,062	36,983	36,873	$	0.45	$	0.33

Options to purchase 8,379 and 156,145 shares of common stock were excluded for the nine months ended March 31, 2023 and 2022, respectively, and 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 period.

Stock-Based Compensation

The Company has established four share incentive programs as discussed in Note 9.

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 $322,000 and $35,000 were recognized for the three months ended March 31, 2023 and 2022, respectively. Stock-based compensation costs of $1,134,000 and $1,379,000 were recognized for the nine months ended March 31, 2023 and 2022, respectively.

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 and unrealized gains and losses associated with foreign currency translation are recorded for the three or nine months ended March 31, 2023 or 2022.

Comprehensive Income

For the three and nine months ended March 31, 2023 and 2022, 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

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 14.

Shipping and Handling Sales and Costs

The Company records the amount billed to customers for shipping and handling in net sales ($106,000 and $106,000 in the three months ended March 31, 2023 and 2022, respectively, and $346,000 and $318,000 in the nine months ended March 31, 2023 and 2022, respectively); and classifies the costs associated with these sales in cost of sales ($437,000 and $339,000 in the three months ended March 31, 2023 and 2022, respectively, and $1,285,000 and $1,033,000 in the nine months ended March 31, 2023 and 2022, respectively).

Leases

The Company records lease assets and corresponding lease liabilities for the operating lease on our Consolidated Balance Sheets, excluding short-term leases (leases with terms of 12 months or less) as described under ASU No. 2016-02, Leases (Topic 842). Lease payments are discounted using a third-party secured incremental borrowing rate based on information available at lease commencement. The Company analyzes whether or not amendments to existing leases classify as a Lease Modification or a full or partial termination of the existing lease. See Note 13 – Commitments and Contingencies; Leases for additional accounting policies and disclosures.

Recently Issued Accounting Standards

Reference Rate Reform (ASC Topic 848)

In March 2020, the FASB issued authoritative guidance to provide optional relief for companies preparing for the discontinuation of interest rates such as the London Interbank Offered Rate (“LIBOR”), which is expected to be phased out for new arrangements at the end of calendar 2021, and applies to lease contracts, hedging instruments, held-to-maturity debt securities and debt arrangements that have LIBOR as the benchmark rate.

The Company’s bank has notified the Company that its LIBOR option will continue to be available to it through June 30, 2023, at which time the option will shift to the Benchmark Replacement as defined in the agreement with the bank (see Note 8). The Company does not believe that this transition will have a material impact on its financial condition.

NOTE 1A – Restatement of Previously Issued Financial Statements

During the preparation of the Company’s consolidated financial statements for the fiscal year ended June 30, 2023, management of the Company identified certain errors related to the Company’s calculation of cost of goods sold (“COGS”) and inventory for each of the first three quarters of fiscal 2023. Specifically, the costs of several raw materials fluctuated significantly during fiscal 2023, the Company’s costing procedures did not appropriately account for such fluctuations. As a result, inventories were overstated and COGS was understated, resulting in overstated gross profit, operating income and net income for each period.

The effects of the restatement resulted in a decrease to overall inventory (current and non-current inventory) and increase to cost of sales of $10,101,000, a decrease to the provision for income taxes of $975,000 and a decrease to net income and retained earnings of $9,126,000 as of and for the nine months ended March 31, 2023. Net cash provided by operating activities remained the same. The effects of the restatement resulted in an increase to cost of sales of $1,392,000, a decrease to the provision for income taxes of $101,000 and a decrease to net income of $1,291,000 for the three months ended March 31, 2023.

The table below sets forth the consolidated balance sheets information, including the balances originally reported and the restated balances as of March 31, 2023 (in thousands):

	As of March 31, 2023
	As
	previously		As
	reported		Restated
Inventory - Current	$	46,921	$	38,725
Income Tax Receivable		—		688
Inventory - Non-Current		13,865		11,960
Accrued Income Taxes		287		—
Retained earnings		138,599		129,473

The table below sets forth the consolidated statements of income information, including the balances originally reported and the restated balances for the three months ended March 31, 2023:

	Three Months ended March 31, 2023
	(in thousands, except for per share data)
	As
	previously
	reported		As Restated
Equipment-related expenses	$	19,388	$	20,780
Cost of sales		20,861		22,253
Gross profit		22,671		21,279
Operating income		11,932		10,540
Income before provision for income taxes		12,369		10,977
Provision for income taxes		1,529		1,428
Net income		10,840		9,549
Income per share:
Basic	$	0.29	$	0.26
Diluted	$	0.29	$	0.26

The table below sets forth the consolidated statements of income information, including the balances originally reported and the restated balances for the nine months ended March 31, 2023:

	Nine Months ended March 31, 2023
	(in thousands, except for per share data)
	As
	previously
	reported		As Restated
Equipment-related expenses	$	60,240	$	70,341
Cost of sales		65,039		75,140
Gross profit		60,300		50,199
Operating income		28,617		18,516
Income before provision for income taxes		29,138		19,037
Provision for income taxes		3,450		2,475
Net income		25,688		16,562
Income per share:
Basic	$	0.70	$	0.45
Diluted	$	0.69	$	0.45

The table below sets forth the consolidated statements of cash flows information, including the balances originally reported and the restated balances for the nine months ended March 31, 2023:

	Nine Months ended March 31, 2023
	(in thousands)
	As
	previously
	reported		As Restated
Net income	$	25,688	$	16,562
Change to inventory obsolescence reserve		960		(85)
Inventories		(11,959)		(813)
Income tax receivable		—		(688)
Accounts payable, accrued expenses, accrued salaries and wages, accrued income taxes		(8,560)		(8,847)
Net Cash Provided by Operating Activities		12,416		12,416

In addition to the restated consolidated financial statements, the information contained in notes 1, 5, 7 and 14 have been restated.