NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

Our manufacturing services include complete medical devices, printed circuit board assemblies, wire and cable assemblies, and complex higher level electromechanical assemblies for a wide range of medical, industrial and defense and aerospace industries. We provide a full “turn-key” contract manufacturing service to our customers. All products are built to the customer’s design specifications. We also provide engineering services and repair services.

Our manufacturing facilities are located in Bemidji, Blue Earth, Merrifield, Milaca and Mankato, Minnesota as well as, Monterrey, Mexico and Suzhou, China. Products are sold to customers both domestically and internationally.

Principles of Consolidation

The 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 in consolidation.

Reclassifications

Certain reclassifications have been made to the prior year Consolidated Statement of Operations for the year ended December 31, 2016 to conform to the current year presentation. In the current year we revised our prior year presentation of (Gain) Loss on Sale of Property and Equipment. There was no change in Net Income (Loss) for the year ended December 31, 2016. Additionally, certain reclassifications have been made to the prior year Consolidated Statement of Cash Flows for the year ended December 31, 2016 to conform to the current year presentation. In the current year we revised our prior year presentation of non-cash changes in the contingent consideration, accounts receivable allowance, and inventory reserves. There was no change in total net cash provided by operating activities for the year ended December 31, 2016. These changes have no impact on the Consolidated Balance Sheets.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Estimates also affect the reported amounts of revenue and expense during the reporting period. Significant items subject to estimates and assumptions include the valuation allowance for inventories, allowance for doubtful accounts, accrued warranties, realizability of deferred tax assets, goodwill impairment and long-lived asset impairment testing. Actual results could differ from those estimates.

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 December 31, 2017 balance included cash collateral required to be held against our corporate employee purchasing card program and lockbox deposits that are temporarily restricted due to timing at the period end. The lockbox deposits are applied against our line of credit the next business day. As of December 31, 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 $209,000 and $883,000 at December 31, 2017 and 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 doubtful accounts.

Inventories

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

Inventories are as follows:

	2017			2016
Raw materials	$	13,870,006		$	14,533,690
Work in process	3,112,407			4,104,968
Finished goods	2,388,496			2,688,596
Reserves	(844,187		)	(673,413		)

Total	$	18,526,722		$	20,653,841

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Additions, improvements and major renewals are capitalized, while maintenance and minor repairs are expensed as incurred. When assets are retired or disposed of, the assets and related accumulated depreciation are removed from the accounts and the resulting gain or loss is reflected in operations. Leasehold improvements are depreciated over the shorter of their estimated useful lives or their remaining lease terms. All other property and equipment are depreciated by the straight-line method over their estimated useful lives, as follows:

Buildings		39 Years
Leasehold improvements		3-15 Years
Manufacturing equipment		3-7 Years
Office and other equipment		3-7 Years

Property and equipment at December 31, 2017 and 2016:

	2017			2016
Land	$	359,500		$	375,000
Building and Leasehold Improvements	8,826,802			9,393,092
Manufacturing Equipment	21,267,133			19,632,033
Office and Other Equipment	6,034,726			5,455,459
Accumulated Depreciation	(26,312,628		)	(24,524,750		)

Total Property and Equipment, net	$	10,175,533		$	10,330,834

Other Intangible Assets

Finite life intangible assets at December 31, 2017 and 2016 are as follows:

	December 31, 2017
		Gross		Accumulated		Net Book
		Carrying		Amortization		Value
	Years	Amount		Amount		Amount
Customer Relationships	9	1,302,000		361,662		940,338
Intellectual Property	3	100,000		27,786		72,214
Trade Names	20	814,000		101,750		712,250
Other	7	13,819		—		13,819

Totals		$	2,229,819	$	491,198	$	1,738,621

	December 31, 2016
		Gross		Accumulated		Net Book
		Carrying		Amortization		Value
	Years	Amount		Amount		Amount
Bond Issue Costs	15	$	79,373	$	55,561	$	23,812
Customer Relationships	9	1,302,000		216,998		1,085,002
Trade Names	20	814,000		61,050		752,950

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

Amortization of finite life intangible assets was $236,962 and $190,654 for the years ended December 31, 2017 and 2016, respectively.

Estimated future annual amortization expense (except projects in process) related to these assets is approximately as follows:

Year	Amount
2018	$	218,712
2019	218,712
2020	190,918
2021	185,376
2022	185,376
Thereafter	725,708

	$	1,724,802

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. In testing goodwill for impairment we perform a quantitative impairment test, including computing the fair value of the reporting unit and comparing that value to its carrying value. If the fair value is less than its carrying value, then the goodwill is determined to be impaired. In the event that goodwill is impaired, an impairment charge to earnings would become necessary. Based upon our annual goodwill impairment test we concluded that goodwill was impaired due to a significant reduction of results from operations during the fourth quarter of 2017. We adopted Accounting Standards Update No, 2017-04, Simplifying the Test for Goodwill Impairment, and performed a single step in performing our impairment analysis, which is to determine the estimated fair value of our reporting unit and compare it to the carrying value of the reporting unit, including goodwill. To the extent the carrying amount of goodwill exceeds the implied goodwill, the difference is the amount of the goodwill impairment. Our annual impairment test as of October 1, 2017, resulted in $0.9 million of impairment charges related to our goodwill. The impairment charge was based on a combined approach using both the income approach which is based on discounted cash flows and the market approach which is based on the guideline public company method. Discounted cash flow models include assumptions related to our product revenue, gross margins, operating margins and other assumptions. There was no impairment of goodwill recorded in 2016.

We recognize the assets acquired and liabilities assumed in business combinations on the basis of their fair values at the date of acquisition. We assess the fair value of assets, including intangible assets, using a variety of methods and each asset is measured at fair value from the perspective of a market participant. The method used to estimate the fair values of intangible assets incorporates significant assumptions regarding the estimates a market participant would make in order to evaluate an asset, including a market participant’s use of the asset and the appropriate discount rates for a market participant. Any excess purchase price over the fair value of the net tangible and intangible assets acquired is allocated to goodwill.

On July 1, 2015, we completed the acquisition of substantially all of the assets of Devicix, LLC upon the terms and conditions contained in an Asset Purchase Agreement entered into on June 17, 2015. The Devicix acquisition resulted in $3.2 million of goodwill, which is deductible for tax purposes. We recorded an impairment charge of $908,000 on the goodwill related to the Devicix, LLC purchase as of December 31, 2017.

Long-Lived Asset Impairment

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 or asset group. 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. Assets held for sale are reported at the lower of the carrying amount or fair value less costs to dispose. We determined there was a triggering event during the fourth quarter of 2017 and determined the undiscounted cash flows exceed the carrying amounts of long-lived assets.

Preferred Stock

Preferred stock issued is non-cumulative and nonconvertible. The holders of the preferred stock are entitled to a non-cumulative dividend of 12% when and if declared. In liquidation, holders of preferred stock have preference to the extent of $1.00 per share plus dividends accrued but unpaid. No preferred stock dividends were declared or paid during the years ended December 31, 2017 and 2016.

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 manufacturing of a product. Revenue for engineering services is generally recognized on a time and materials 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. Our net sales for services were less than 10% of our total sales for all periods presented, and accordingly, are included in net sales in the consolidated statement of income. 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.

Product Warranties

We provide limited warranty for the replacement or repair of defective product within a specified time period after the sale at no cost to our customers. We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including, without limitation, warranties to merchantability, fit for a particular purpose or non-infringement of patent or the like unless agreed upon in writing. We estimate the costs that may be incurred under our limited warranty and provide a reserve based on actual historical warranty claims coupled with an analysis of unfulfilled claims at the balance sheet date. Our warranty claim costs are not material given the nature of our products and services.

Advertising

Advertising costs are charged to operations as incurred. The total amount charged to expense was $68,000 and $131,000 for the years ended December 31, 2017 and 2016, respectively.

Income Taxes

We account for income taxes under the asset and liability method. Deferred income tax assets and liabilities are recognized annually for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. The company recognizes interest and penalties accrued on any unrecognized tax benefits as a component on income tax expense.

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. Management must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. Our estimates are based on the information available to us at the time we prepare the income tax provisions. Our income tax returns are subject to audit by federal, state, and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws.

Incentive Compensation

We use a Black-Scholes option-pricing model to determine the grant date fair value of our incentive awards and recognize the expense on a straight-line basis over the vesting period less awards expected to be forfeited using estimated forfeiture rates. See Note 6 for additional information.

Net Income (Loss) Per Common Share

Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding. Dilutive net income (loss) per common share assumes the exercise and issuance of all potential common stock equivalents in computing the weighted-average number of common shares outstanding, unless their effect is antidilutive.

A reconciliation of basic and diluted share amounts for the years ended December 31, 2017 and 2016 is as follows:

	2017	2016
Basic weighted average common shares outstanding	2,745,602	2,747,424
Weighted average common stock equivalents from assumed exercise of stock options	—	2,121

Diluted weighted average common shares outstanding	2,745,602	2,749,545

Due to the loss in 2017, basic and diluted shares are the same. Any outstanding shares would result in anti-dilution. Outstanding stock options totaling 23,250 for the year ended December 31, 2016, were excluded from the net income per share calculation because the shares would be anti-dilutive.

Fair Value of Financial Instruments

The carrying amounts of all financial instruments approximate their fair values. The carrying amounts for cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate fair value because of the short maturity of these instruments. Based on the borrowing rates currently available to us for bank loans with similar terms and average maturities, the carrying value of our long-term debt and line of credit approximates its fair value.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs.

The fair value framework requires the categorization of assets and liabilities into one of three levels based on the assumptions (inputs) used in valuing the asset or liability. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. The three levels are defined as follows:

Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3: Unobservable inputs for the asset or liability, reflecting the reporting entity’s own assumptions about the assumptions that market participants would use in pricing

Our assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy. We endeavor to use the best available information in measuring fair value. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Acquisition-Related Contingent Consideration

The Company acquired Devicix on July 1, 2015. The aggregate consideration paid to Devicix shareholders includes up to $2,500,000 of contingent consideration to be paid based on the achievement of certain performance-based milestones. The fair value of the contingent consideration was measured using an expected present value approach to estimate an expected value. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy.

The fair value of contingent consideration is measured using projected payment dates, discount rates and probabilities of payment. Projected contingent payment are discounted back to the current period using a discounted cash flow model. Changes in projected probabilities of payment, discount rates, or projected payment dates may result in higher or lower fair value measurements. The recurring Level 3 fair value measurements of contingent consideration include the following significant unobservable inputs:

	December 31, 2017		December 31, 2016
Discount Rate	21.0	%	21.0	%
Probability of payment	33.3	%	33.3	%
Projected fiscal years of payment(s)	2018 - 2019		2017 - 2019

The following table summarizes the contingent consideration balance and activity for the years ended December 31, 2017 and 2016:

Beginning fair value of contingent liability, December 31, 2015	$	851,000
Period change in valuation	(294,342		)
Payments	(658		)

Contingent liability balance, December 31, 2016	556,000
Period change in valuation	(483,465		)
Payments	(2,579		)

Contingent liability balance, December 31, 2017	$	69,956

Balance Sheet Classification	2017		2016
Other Accrued Liabilities	$	21,956	$	21,700
Other Long-Term Liabilities	48,000		534,300

Contingent liability balance	$	69,956	$	556,000

Goodwill

The changes in the carrying amount of goodwill for the years presented are as follows:

Carrying amount at December 31, 2015	$	3,283,454
Changes to the carrying amount	—

Carrying amount at December 31, 2016	3,283,454
Impairment of goodwill	(908,000		)

Carrying amount at December 31,2017	$	2,375,454

In determining the nonrecurring fair value measurements of impairment of goodwill we utilized a blend of the market value and discounted cash flow approach. Based on the blend of market value and discounted cash flow approach, we determined fair values for the identified assets and recorded an impairment charge of goodwill during the year ended December 31, 2017, set forth in the table below:

		Fair value as of mesurement date			Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)			Impairment Charge
Goodwill		$	2,375,454		—		—		$	2,375,454		$	908,000

Enterprise-Wide Disclosures

Our results of operations for the years ended December 31, 2017 and 2016 represent a single operating and reporting segment referred to as Contract Manufacturing within the EMS 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.

Export sales from our domestic operations represent approximately 4.5% and 8.0% of consolidated net sales for the years ended December 31, 2017 and 2016, respectively.

Net sales by our major EMS industry markets for the years ended December 31, 2017 and 2016 are as follows:

	2017		2016
Aerospace and Defense	$	15,682,635	$	16,114,759
Medical	51,448,581		53,835,916
Industrial	45,203,533		46,671,044

Total Net Sales	$	112,334,749	$	116,621,719

Noncurrent assets, excluding deferred taxes, by country are as follows:

	United States		Mexico		China		Total
December 31, 2017
Property and equipment, net	$	8,712,902	$	1,003,040	$	459,591	$	10,175,533
Other assets	4,114,075		7,726		—		4,121,801

December 31, 2016
Property and equipment, net	$	8,731,205	$	1,238,087	$	361,542	$	10,330,834
Other assets	5,145,218		7,726		—		5,152,944

Foreign Currency Transactions

The functional currency for our Mexico subsidiary is the US dollar. Foreign exchange transaction gains and losses attributable to exchange rate movements related to transactions made in the local currency and on intercompany receivables and payables not deemed to be of a long-term investment nature are recorded in other income (expense). The functional currency for our China subsidiary is the Renminbi (RMB). Assets and liabilities of the China operation are translated from RMB into U.S. dollars at period-end rates, while income and expense are translated at the weighted-average exchange rates for the period. The related translation adjustments are reflected as a foreign currency translation adjustment in accumulated other comprehensive income (loss) within shareholders’ equity. The total foreign currency translation adjustment decreased shareholders’ equity by $56,340, from an accumulated foreign currency translation loss of $44,445 as of December 31, 2016 to an accumulated foreign currency translation loss of $100,785 as of December 31, 2017.

Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the consolidated statements of income. Net foreign currency transaction losses included in the determination of net earnings was $192,187 and $82,000 for the years ended December 31, 2017 and 2016, respectively.

Recent Accounting Pronouncements

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 adopted ASU 2017-04 in 2017.

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.

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 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 goods or services. 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 will adopt the new guidance beginning January 1, 2018.

We have engaged the services of a third-party service provider and 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 continuing to work 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. Based on our assessment to date, we believe certain revenue will be recognized over time rather than the current method of at a point in time. In addition, our customer supplied material arrangements are being evaluated for the applicability of the provision of non-cash consideration whereby the fair value of the materials would be included in the sales price and related cost of sales. The Company is finalizing its review and evaluation of the impact of the accounting and disclosure changes on its business processes and controls for adoption in 2018.