NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements for the interim periods have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the financial information and footnotes required by GAAP for complete financial statements, although we believe the disclosures are adequate to make the information presented not misleading. It is suggested that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2016. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year or for any other interim period. In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In preparing these condensed consolidated financial statements, we have made our best estimates and judgments of certain amounts included in the condensed consolidated financial statements, giving due consideration to materiality. Changes in the estimates and assumptions used by us could have a significant impact on our financial results, since actual results could differ from those estimates.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of Nortech Systems Incorporated and its wholly-owned subsidiaries, Manufacturing Assembly Solutions of Monterrey, Inc., and Nortech Systems Hong Kong Company, Limited and its subsidiary, Nortech Systems Suzhou Company, Limited. All significant intercompany accounts and transactions have been eliminated.

Reclassifications

Certain reclassifications have been made to the prior year Condensed Consolidated Statement of Cash Flows for the six months ended June 30, 2016 to conform to the current year presentation. In the current year we revised our presentation of non-cash changes in the accounts receivable allowance and changes in inventory reserves on the Condensed Consolidated Statement of Statement of Cash Flows to show these amounts separately. Prior year amounts were reclassified to conform with current year presentation, which decreased cash provided by accounts receivable by $51,000 and increased cash used in inventories by $43,797 for the six months ended June 30, 2016. There was no change in total net cash provided by operating activities for the six months ended June 30, 2016. This change has no impact on the Condensed Consolidated Balance Sheets or the Condensed Consolidated Statements of Operations and Comprehensive Loss.

Revenue Recognition

We recognize manufacturing revenue when we ship goods or the goods are received by our customer, when title has passed, all contractual obligations have been satisfied, the price is fixed or determinable and collection of the resulting receivable is reasonably assured. Generally, there are no formal substantive customer acceptance requirements or further obligations related to manufacturing services. If such requirements or obligations exist, then we recognize the related revenues at the time when such requirements are completed and the obligations are fulfilled. We also provide engineering services separate from the manufacture of a product. Revenue for engineering services is generally recognized on a time and material basis or upon completion of the engineering process. In addition, we have another separate source of revenue that comes from short-term repair services, which are recognized when the repairs are completed and the repaired products are shipped back to the customer. Shipping and handling costs charged to our customers are included in net sales, while the corresponding shipping expenses are included in cost of goods sold.

Stock Options

Following is the status of all stock options as of June 30, 2017:

	Shares	Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Outstanding - January 1, 2017	37,750	$	4.75
Granted	150,000	3.43
Exercised	—	—
Cancelled	—	—

Outstanding - June 30, 2017	187,750	$	3.70	8.63	$	39,525

Exercisable - June 30, 2017	37,750	$	4.75	3.70	$	6,525

There were no options exercised during the three and six months ended June 30, 2017. For the three and six months ended June 30, 2016, 1,507 options were exercised. These exercised options had a total intrinsic value of $964 and resulted in cash proceeds of $4,822 for the three and six months ended June 30, 2016.

Under the 2005 Incentive Compensation Plan, there were no stock options granted during the three and six months ended June 30, 2016. In May 2017, the shareholders approved the 2017 Stock incentive Plan which authorized the issuance of 350,000 shares. During the three and six months ended June 30, 2017, 150,000 options were granted.

Total compensation expense related to stock options for the three months ended June 30, 2017 and 2016 was $8,640 and $0, respectively. Total compensation expense related to stock options for the six months ended June 30, 2017 and 2016 was $8,640 and $994, respectively. As of June 30, 2017, there was $198,720 of unrecognized compensation which will vest over the next 2.87 years.

Equity Appreciation Rights Plan

In November 2010, the Board of Directors adopted the Nortech Systems Incorporated Equity Appreciation Rights Plan (“2010 Plan”). The total number of Equity Appreciation Right Units (“Units”) that can be issued under the 2010 Plan shall not exceed an aggregate of 1,000,000 Units as amended and restated on March 11, 2015. The 2010 Plan provides that Units issued shall fully vest three years from the base date as defined in the agreement unless terminated earlier. Units give the holder a right to receive a cash payment equal to the appreciation in book value per share of common stock from the base date, as defined, to the redemption date. Unit redemption payments under the 2010 Plan shall be paid in cash within 90 days after we determine the book value of the Units as of the calendar year immediately preceding the redemption date. The Units are adjusted to market value for each reporting period.

During the three and six months ended June 30, 2017, a total of 100,000 Units were granted. During the three and six months ended June 30, 2016, no additional Units were granted.

Total compensation expense (income) related to the vested outstanding Units based on the estimated appreciation over their remaining terms was ($6,391) and $3,300 for the three months ended June 30, 2017 and 2016, respectively and $952 and ($6,422) for the six months ended June 30, 2017 and 2016, respectively. The income for the three months ended June 30, 2017 and six months ended June 30, 2016 was the result of a change in the estimate of the appreciation of book value per share of common stock.

As of June 30, 2017 and December 31, 2016, approximately $23,000 and $45,000 is accrued under this plan, respectively. As of June 30, 2017, approximately $11,000 of this balance was included in other accrued liabilities and approximately $12,000 of this balance was included in other long-term liabilities. As of December 31, 2016, approximately $23,000 of this balance was included in other accrued liabilities and the remaining $22,000 balance was included in other long-term liabilities.

Earnings per Common Share

For the three and six months ended June 30, 2017 and 2016, the effect of all stock options is antidilutive due to the net loss incurred and, therefore, was not included in the computation of earnings per-share amounts.

Segment Reporting Information

All of our operations fall under the contract manufacturing segment within the electronic manufacturing Services industry. We strategically direct production between our various manufacturing facilities based on a number of considerations to best meet our customers’ requirements. We share resources for sales, marketing, engineering, supply chain, information services, human resources, payroll, and all corporate accounting functions. Consolidated financial information is available that is evaluated regularly by the chief operating decision maker in assessing performance and allocating resources.

Restricted Cash

Cash and cash equivalents classified as restricted cash on our condensed consolidated balance sheets are restricted as to withdrawal or use under the terms of certain contractual agreements. The June 30, 2017 balance included cash collateral required to be held against letters of credit and our corporate employee purchasing card program. As of June 30, 2017 we had no outstanding letters of credit. We held no restricted cash as of December 31, 2016.

Accounts Receivable and Allowance for Doubtful Accounts

We grant credit to customers in the normal course of business. Accounts receivable are unsecured and are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts was approximately $144,000 and $883,000 at June 30, 2017 and December 31, 2016, respectively. We determine our allowance by considering a number of factors, including the length of time accounts receivable are past due, our previous loss history, the customers’ current ability to pay their obligations to us, and the condition of the general economy and the industry as a whole. We write-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for uncollectible accounts.

Inventories

Inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Costs include material, labor, and overhead required in the warehousing and production of our products. Inventory reserves are maintained for the estimated value of the inventories that may have a lower value than stated or quantities in excess of future production needs.

Inventories are as follows:

	June 30,			December 31,
	2017			2016
Raw Materials	$	15,323,226		$	14,533,690
Work in Process	4,516,643			4,104,968
Finished Goods	2,656,769			2,688,596
Reserves	(902,258		)	(673,413		)


Total	$	21,594,380		$	20,653,841

Other Intangible Assets

Other intangible assets at June 30, 2017 and December 31, 2016 are as follows:

	June 30, 2017
	Gross
	Carrying		Accumulated		Net Book
	Amount		Amortization		Value
Customer Relationships	$	1,302,000	$	289,331	$	1,012,669
Trade Names		814,000		81,400		732,600
Intellectual Property		100,000		11,111		88,889
Bond Issue Costs		79,373		58,207		21,166

Totals	$	2,295,373	$	440,049	$	1,855,324

	December 31, 2016
	Gross
	Carrying		Accumulated		Net Book
	Amount		Amortization		Value
Customer Relationships	$	1,302,000	$	216,998	$	1,085,002
Trade Names		814,000		61,050		752,950
Bond Issue Costs		79,373		55,561		23,812

Totals	$	2,195,373	$	333,609	$	1,861,764

Amortization expense for the three and six months ended June 30, 2017 was $55,997 and $106,440, respectively. Amortization expense for the three and six months ended June 30, 2016 was $47,666 and $95,329, respectively.

Estimated future amortization expense related to these assets is approximately as follows:

Remainder of 2017	$	112,002
2018	224,004
2019	224,004
2020	196,217
2021	188,020
Thereafter	911,077

Total	$	1,855,324

Impairment of Goodwill and Other Intangible Assets

In accordance with ASC 350, Goodwill and Other Intangible Assets, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. We test impairment annually as of October 1st. No events were identified during the three and six months ended June 30, 2017 that would require us to test for impairment.

Impairment Analysis

We evaluate long-lived assets, primarily property and equipment, as well as the related depreciation periods, whenever current events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Recoverability for assets to be held and used is based on our projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge might be required to reduce the carrying amount to equal estimated fair value.

In the second quarter of 2017, as a result of changes in the reporting unit’s forecast, goodwill was evaluated for impairment as of June 30, 2017. Based on the impairment analysis performed, it was concluded there was no impairment of goodwill and no impairment expense was recorded during the three and six months ended June 30, 2017 and 2016, respectively.

Recently Issued Accounting Standards

In May 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-09, Compensation — Stock Compensation (Topic 718), to reduce the diversity in practice and the cost and complexity for the accounting for a change in terms or conditions of a share-based award. ASU 2017-09 is to be applied on a prospective basis effective for interim and annual periods beginning after December 15, 2017, with early adoption permitted. We are currently evaluating the effect of this update on our consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment (Topic 350), to simplify the accounting for goodwill impairment. The guidance removes Step 2 of the goodwill impairment test. A goodwill impairment will now be measured as the amount by which a reporting unit’s carrying value exceeds its fair value, limited to the amount of goodwill allocated to that reporting unit. ASU 2017-04 is to be applied on a prospective basis effective for interim and annual periods beginning after December 15, 2019, with early adoption permitted for any impairment tests performed after January 1, 2017. We are currently evaluating the effect of this update on our consolidated financial statements.

In November 2016, the FASB issued ASU 2016-18, Restricted Cash in the Statement of Cash Flows (Topic 230), which prescribes that restricted cash should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This standard is effective for fiscal years beginning after December 15, 2017, although early adoption is permitted, including adoption in an interim period. We adopted this guidance in 2017. See Note 1, “Summary of Significant Accounting Policies,” of Condensed Notes to the Consolidated Financial Statements for further description of our restricted cash.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows — Classification of Certain Cash Receipts and Cash Payments (Topic 230). This guidance will be effective for us beginning in the first quarter of 2018, although early adoption is permitted. We are evaluating the impact, if any, that this new guidance will have on our Consolidated Statements of Cash Flows.

In March 2016, FASB issued ASU 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which changes how companies account for certain aspects of share-based payments to employees. The new guidance requires all income tax effects of awards to be recognized in the income statement when the awards vest or are settled, allows an employer to repurchase more of an employee’s shares than previously allowed for tax withholding purposes without triggering liability accounting, allows a company to make a policy election to account for forfeitures as they occur, and eliminates the requirement that excess tax benefits be realized before companies can recognize them. The new guidance also requires excess tax benefits and tax shortfalls to be presented on the cash flow statement as an operating activity rather than as a financing activity, and clarifies that cash paid to a tax authority when shares are withheld to satisfy its statutory income tax withholding obligation are to be presented as a financing activity. The standard is effective for our financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. The Company adopted the guidance in the current year. The adoption of ASU 2016-09 required no retrospective adjustments to the financial statements. In addition, there was no material cumulative-effect adjustment to retained earnings, nor did the adoption impact the tax provision for the current quarter.

During February 2016, the FASB issued ASU 2016-02, Leases. ASU 2016-02 was issued to increase transparency and comparability among organizations by recognizing all lease transactions (with terms in excess of 12 months) on the balance sheet as a lease liability and a right-of-use asset (as defined). ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with earlier application permitted. Upon adoption, the lessee will apply the new standard on a modified retrospective basis to all periods presented. We are currently assessing the effect that ASU 2016-02 will have on our consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. This standard changes the measurement principle for certain inventory methods from the lower of cost or market to the lower of cost and net realizable value. Net realizable value is defined as the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This standard does not apply to inventory that is measured using Last-in First-out (“LIFO”) or the retail inventory method. The provisions of ASU 2015-11 are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The Company adopted this guidance in the current year and there was no impact on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This standard outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that revenue is recognized when a customer obtains control of a good or service. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Transfer of control is not the same as transfer of risks and rewards, as it is considered in current guidance. We will also need to apply new guidance to determine whether revenue should be recognized over time or at a point in time. This standard will be effective for the first interim period within annual reporting periods beginning after December 15, 2017, using either of two methods: (a) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (b) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined in ASU 2014-09. We plan to adopt the new guidance beginning January 1, 2018.

We have performed a review of the requirements of the new guidance and have initially identified which of our revenue streams will be within the scope of ASU 2014-09. We are working through an adoption plan which includes a review of customer contracts, applying the five-step model of the new standard to each revenue stream and comparing the results to our current accounting; an evaluation of the method of adoption; and assessing changes that might be necessary to our processes, internal controls and changes in financial reporting. The Company expects to complete the review of contracts and evaluate the impact of the accounting and disclosure changes on its business processes and controls during the fourth quarter of 2017.