Summary of Significant Accounting Policies

12 Months Ended

Dec. 31, 2012

Accounting Policies [Abstract]

Summary of Significant Accounting Policies

Note 3: Summary of Significant Accounting Policies

Revenue Recognition

The Company recognizes revenues when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collectability is reasonably assured. Revenue from the sale of the Company’s products is generally recognized when title and risk of loss transfers to the customer, the terms of which are generally free on board shipping point. The Company uses customer purchase orders to determine the existence of an arrangement. The Company uses shipping documents and third-party proof of delivery to verify that title has transferred. The Company assesses whether the fee is fixed or determinable based upon the terms of the agreement associated with the transaction. To determine whether collection is probable, the Company assesses a number of factors, including past transaction history with the customer and the creditworthiness of the customer.

Consolidation

The accompanying consolidated financial statements include the accounts of SpectraScience, Inc. and its wholly-owned subsidiaries LUMA, and International. All significant intercompany balances and transactions have been eliminated in consolidation.

Risks and Uncertainties

The Company operates in an industry that is subject to intense competition, government regulation and rapid technological change. The Company's operations are subject to significant risk and uncertainties including financial, operational, technological, regulatory and other risks, including the potential risk of business failure.

Use of Estimates

The Company prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, which requires management to make estimates and assumptions that affect the amounts reported in the financial statements and disclosures made in the accompanying notes to the financial statements. Significant estimates made by management include, among others, realization of long-lived assets including intangible assets, assumptions used to value stock options, assumptions used to value the common stock issued and assumptions related to the determination of the fair value of the derivative components associated with the Company’s Convertible Debentures. Actual results could differ from those estimates.

Liquidity

We expect to incur significant additional operating losses through at least 2013, as we complete proof-of-concept trials, begin outcome-based clinical studies and increase sales and marketing efforts to commercialize the WavSTAT4 Systems in Europe. If we do not receive sufficient funding, we may be unable to continue as a going concern. We may incur unknown expenses or we may not be able to meet our revenue forecast, and one or more of these circumstances would require us to seek additional capital. We may not be able to obtain equity capital or debt funding on terms that are acceptable. Even if the Company receives additional funding, such proceeds may not be sufficient to allow the Company to sustain operations until it attains profitability and positive cash flows from operations.

Inventory Valuation

We state our inventories at the lower of cost (using the first-in, first-out method) or market value, determined on a specific cost basis. We provide inventory reserves when conditions indicate that the selling price could be less than cost due to obsolescence and reductions in estimated future demand. We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for inventory reserves that could adversely impact our gross margins. Conversely, favorable changes in demand could result in higher gross margins when we sell products.

Valuation of Long-lived Assets

The Company’s long-lived assets consist of fixed assets and intangible assets. Equipment is carried at cost and is depreciated over the estimated useful lives of the assets, which are generally two to three years, and leasehold improvements are amortized over the lesser of the lease term or the estimated useful lives of the improvements. The straight-line method is used for depreciation and amortization. Intangible assets consist of patents, which are amortized using the straight-line method over the estimated useful lives of the patents. The Company does not capitalize external legal costs and filing fees associated with obtaining patents on its new discoveries. Acquired intellectual property is recorded at cost and is amortized over its estimated useful life. The Company believes the useful lives assigned to these assets are reasonable. The Company assesses the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. These computations utilize judgments and assumptions inherent in management’s estimate of future cash flows to determine recoverability of these assets. If management’s assumptions about these assets were to change as a result of events or circumstances, the Company may be required to record an impairment loss.  

Convertible Debentures/Warrants

We account for our Convertible Debentures, associated warrants and related conversion features under the provisions of FASB Topic 470, Debt, or ASC 470, which requires the measurement and recognition of the fair values for all components related to the Convertible Debentures at the end of each reporting period. We estimate the fair value of the resulting Beneficial Conversion Feature ("BCF"), holders warrants and agent warrants at each measurement date using a combination of the Black-Scholes-Merton and modified Binomial Lattice option-pricing models. These standards require us to record the fair value of the Convertible Debentures, BCF and warrants at the time of issuance and to remeasure these values and record associated income statement expense or benefit at the end of each reporting period. A description of these effects can be found in Note 5 of the financial statements. 

Income Taxes

Income taxes are provided for the tax effects of transactions reported in the consolidated financial statements and consist of taxes currently due plus deferred income taxes. Deferred income taxes are recognized for temporary differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future. Deferred income taxes are also recognized for net operating loss carryforwards that are available to offset future taxable income and research and development credits. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

FASB ASC Topic 740, Income Taxes (“ASC 740”), clarifies the accounting for uncertainty in income taxes recognized in the financial statements. ASC 740 provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits of the position. Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. ASC 740 also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We have determined that the Company does not have any material uncertain tax positions on its tax returns for the years 2012 and prior that require measurement. Because the Company had a full valuation allowance on its deferred tax assets as of December 31, 2012 and 2011, the Company has not recognized any tax benefits since inception.

Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense. We had no accrual for interest or penalties on our consolidated balance sheets at December 31, 2012 or 2011, and have not recognized interest and/or penalties in the consolidated statement of operations for the years ended December 31, 2012 or 2011.

We are subject to taxation in the U.S. and the state of California. All of our tax years are subject to examination by the U.S. and California tax authorities due to the carry-forward of unutilized net operating losses.

Stock-Based Compensation

The Company accounts for stock-based compensation under the provisions of FASB ASC Topic 718, Compensation—Stock Compensation   (“ASC 718”), which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors based on estimated fair values on the grant date. The Company estimates the fair value of stock-based awards on the date of grant using the Black-Scholes-Merton option-pricing model (the “Black-Scholes Model”). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods using the straight-line method. The Company estimates forfeitures at the time of grant and revises its estimate in subsequent periods if actual forfeitures differ from those estimates.

The Company accounts for stock-based compensation awards to non-employees in accordance with FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees    (“ASC 505-50”). Under ASC 505-50, the Company determines the fair value of the warrants or stock-based compensation awards granted as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.

All issuances of stock options or other equity instruments to employees and non-employees as the consideration for goods or services received by the Company are accounted for based on the fair value of the equity instruments issued. Any stock options issued to non-employees are recorded in expense and additional paid-in capital in shareholders’ equity over the applicable service periods using variable accounting through the vesting dates based on the fair value of the options at the end of each reporting period.

As of December 31, 2012, the Company had one stock-based employee compensation plan under which it makes grants, the 2011 Equity Incentive Plan (the “EIP”). The EIP provides for the grant of incentive stock options (“ISOs”), nonqualified stock options (“NQSOs”) and restricted stock awards to full-time employees (who may also be directors) and NQSOs and restricted stock awards to non-employee directors, consultants, customers, vendors or providers of services. The exercise price of any ISO may not be less than the fair market value of the common stock on the date of grant and the term shall not exceed ten years. The amount reserved under the 2011 EIP is 15,000,000 shares of common stock.  At December 31, 2012, the Company had outstanding 19,491,667 options under the EIP and the Company’s prior Amended 2001 Stock Plan representing approximately 13% of the Company’s outstanding shares (9,470,417 of which were exercisable), with 6,453,333 available for future issuance under the 2011 EIP. Awards under the Company’s EIP generally vest over four years.

The fair value of options granted were estimated at the date of grant using a Black-Scholes Model which includes several variables including expected life, risk free interest rate, expected stock price volatility, stock option exercise patterns and expected dividend yield. The Company also must estimate forfeitures for employee stock options. These models and assumptions are complex and may change future expenses by increasing or decreasing stock-based compensation expense. Management used the following weighted average assumptions to value stock options granted during the fiscal years ended December 31, 2012 and 2011:

Non-Employee Stock Options	2012		2011
Expected life	-		5 years
Risk-free interest rate		-		0.83%
Expected volatility		-		114%
Expected dividend yield		-		0%

There were no non-employee stock option grants made during the fiscal year ended December 31, 2012. Existing non-employee stock option grants were valued at approximately $0 and $10,000 for the fiscal years ended December 31, 2012 and 2011, respectively.

Management used the following assumptions to value employee options over the past two years:

Employee Stock Options	2012		2011
Expected life	5 years		5 years
Risk-free interest rate		0.71%		1.97%
Expected volatility		102%		115%
Expected dividend yield		0%		0%

Employee and director stock option grants were valued at approximately $461,000 and $262,000 for the fiscal years ended December 31, 2012 and 2011, respectively.

In addition to the above, management estimated the forfeitures on employee options under the EIP would have negligible effects because such forfeitures would be a very small percentage. Management believes that options granted have been to a group of individuals that have a high desire to see the Company succeed and have aligned themselves to that end.

The expected lives used in the calculations were selected by management based on past experience, forward looking profit forecasts and estimates of what the trading price of the Company’s stock might be at different future dates. Risk-free interest rates used are the five-year U.S. Treasury rate as published for the applicable measurement dates.

Volatility is a calculation based on fluctuations in the Company’s stock price over a historical time period consistent with the estimated life of the option.

Patents

The Company accounts for acquired intangible assets under FASB ASC Topic 350 Goodwill and Other Intangibles –General Intangibles Other than Goodwill. On August 2, 2004, at the inception of the successor company, the Company capitalized $290,000 to value eight WavSTAT System patents. On November 6, 2007, coincident with the acquisition of the LUMA assets, the Company capitalized $3,226,000 to value the 28 patents acquired. In both cases, the capitalized amounts were initially determined based upon management’s assessment of fair value using a market-based forecast, which utilized comparable assumed royalty revenue streams over several possible scenarios. These forecast cash flows were then discounted to present value to determine valuation. The Company reviews the fair value of intangible assets at the end of each reporting period. Based upon management’s review, there were no intangible asset impairments in 2012 or 2011. In the fiscal year ended December 31, 2012, as per review, management shortened the useful lives of certain LUMA patents related to disposable sheath products. The change in the useful life is due to the limited estimated use of the particular patents.

All patents are amortized over the shorter of their remaining legal lives or estimated economic lives. When acquired, the WavSTAT System patents had an average remaining useful life of 14 years, while the LUMA patents had an average remaining life of approximately 16 years. Amortization expense associated with patents for the fiscal years ended December 31, 2012 and 2011 was approximately $754,000 and $239,000 respectively. Patents are reported net of accumulated amortization of approximately $1,837,000 and $1,083,000 at December 31, 2012 and 2011, respectively. Amortization expense in each of the five years subsequent to December 31, 2012 is expected to approximate $167,000 per year.

Research and Development

Research and development costs are expensed as incurred. There may be cases in the future where certain research and development costs such as software development costs are capitalized. For the years ended December 31, 2012 and 2011, research and development costs were approximately $1,114,000 and $1,679,000, respectively.

Accounts Receivable

Accounts receivable are carried at original invoice amount less payment received and an estimate is made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Accounts receivable are generally considered past due 30 days after payment date as specified on the invoice. We determine allowance for doubtful accounts by regularly evaluating individual receivables and considering a creditor’s financial condition, credit history and current economic conditions. Accounts receivable are written off when deemed uncollectible. Recoveries of previously written off accounts receivables previously written off are recorded when received.

Fixed Assets

Fixed assets are stated at cost less accumulated depreciation. Depreciation expense is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to three years. For the years ended December 31, 2012 and 2011, depreciation expense was approximately $163,000 and $64,000, respectively. Repairs and maintenance are charged to expense as incurred while improvements are capitalized. Upon the sale, retirement or disposal of fixed assets, the accounts are relieved of the cost and the related accumulated depreciation with any gain or loss recorded to the consolidated statements of operations.

Fair Value of Financial Instruments

The carrying amount of the Company's cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate their estimated fair values due to the short-term maturities of those financial instruments, and were determined using the Level 1 fair value hierarchy.

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period of computation. Diluted earnings (loss) per share is computed similarly to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and only if the additional common shares would be dilutive. Potentially dilutive shares of common stock that have been excluded from the calculation of the weighted average number of dilutive common shares for the fiscal year ended December 31, 2012 include stock options to purchase 19,491,667 shares of common stock and preferred stock convertible into 3,585,000 shares of common stock.

The following table sets forth the computation of basic and diluted earnings per share and the additional income related to the change in fair value of derivative securities for the fiscal year ending December 31, 2012:

	For the Fiscal Year Ended December 31, 2012
Numerator:
Net (loss) for basic earnings per share	$	(9,092,598	)
Subtractions:
Change in fair value of derivative securities		(2,230,476	)
Net (loss) for diluted earnings per share	$	(11,323,074	)
Denominator:
Weighted average basic shares outstanding		118,764,366
Assumed conversion of dilutive securities
Warrants
Conversion feature – debentures		13,515,850
Potentially dilutive common shares		13,515,850
Denominator for diluted earnings per share – Adjusted weighted average shares		132,280,216
(Loss) per share
Basic	$	(0.08	)
Diluted	$	(0.09	)