A. Organization and Summary of Significant Accounting Policies

Organization

We provide private-label contract manufacturing services to companies that market and distribute vitamins, minerals, herbs, and other nutritional supplements, as well as other health care products, to consumers both within and outside the U.S. We also seek to commercialize our patent and trademark estate related to the ingredient known as beta-alanine through

direct raw material sales and various license and similar arrangements.

Subsidiaries

January

22,

1999,

Natural Alternatives International Europe S.A. (NAIE) was formed as our wholly owned subsidiary, based in Manno, Switzerland. In

September 1999,

NAIE opened its manufacturing facility and possesses manufacturing capability in encapsulation, powders, tablets, finished goods packaging, quality control laboratory testing, warehousing, distribution and administration.

Principles of Consolidation

The consolidated financial statements include the accounts of Natural Alternatives International, Inc. (NAI) and our wholly owned subsidiary, NAIE. All intercompany accounts and transactions have been eliminated. The functional currency of NAIE, our foreign subsidiary, is the U.S. Dollar. The financial statements of NAIE have been translated at either current or historical exchange rates, as appropriate,

with gains and losses included in the consolidated statements of operations.

Recent Accounting Pronouncements

March 2016,

the

FASB issued Accounting Standards Update

No.

2016

02,

Leases (Topic

842

) (ASU

2016

), which amends existing standards for leases to increase transparency and comparability among organizations by requiring recognition of lease assets and liabilities on the balance sheet and requiring disclosure of key information about such arrangements. ASU

2016

will be effective for us beginning in our

first

quarter of fiscal

2020.

Early adoption is permitted. We are currently evaluating the impact of adopting the new standard on our consolidated financial statements and the timing and presentation of our adoption.

March 2016,

the FASB issued Accounting Standards Update

No.

2016

09,

Compensation-Stock Compensation (Topic

718

) (ASU

2016

), which provides guidance improvements to employee share-based payment accounting. The standard amends several aspects of current employee share-based payment accounting including income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. ASU

2016

will be effective for us beginning in our

first

quarter of fiscal

2018.

We do

not

expect the new standard to have a material impact on our consolidated financial statements.

April 2016

, the FASB issued Accounting Standards Update

No.

2016

10,

Revenue from Contracts with Customers (Topic

606

)(ASU

2016

), which amends and adds clarity to certain aspects of the guidance set forth in the upcoming revenue standard (ASU

2014

) related to identifying performance obligations and licensing. In

May 2016,

the FASB issued Accounting Standards Update

No.

2016

11,

Revenue Recognition (Topic

605

) and Derivatives and Hedging (Topic

815

) (ASU

2016

), which amends and rescinds certain revenue recognition guidance previously released within ASU

2014

09.

May 2016

the FASB issued Accounting Standards Update

No.

2016

12,

Revenue from Contracts with Customers (Topic

606

) (ASU

2016

), which provides narrow scope improvements and practical expedients related to ASU

2014

09.

ASU

2014

defines a

five

step process to achieve this core principle and, in doing so, it is possible that more judgment and estimates

may

be required within the revenue recognition process than is required under present U.S. GAAP. These

may

include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price, and allocating the transaction price to each separate performance obligation. The new standard also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments.

All of these new standards will be effective for us concurrently with ASU

2014

09,

beginning in our

first

quarter of fiscal

2019.

Early adoption is

not

permitted.

Currently, w

e do

not

expect our annual revenue to be materially

different under Topic

606.

The most significant change will be to our quarterly and annual financial statement disclosures. We are continuing to evaluate the impact of adopting the new standard.

August

2017,

the FASB issued ASU

2017

12,

Derivatives and Hedging (Topic

815

): Targeted Improvements to Accounting for Hedging Activities. The ASU is intended to improve and simplify accounting rules around hedge accounting and improve the disclosures of hedging arrangements.

We are currently evaluating the impact of adopting the new standard on our consolidated financial statements. ASU

2017

will be effective for us beginning in our

first

quarter of fiscal

2020.

Cash and Cash Equivalents

We consider all highly liquid investments with a maturity of

three

months or less when purchased to be cash equivalents.

Fair Value of Financial Instruments

Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We use a

three

-level hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by

requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs are inputs that reflect our assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available under the circumstances.

The fair value hierarchy is broken down into

three

levels based on the source of inputs. In general, fair values determined by Level

inputs use quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. We classify cash, cash equivalents, and marketable securities balances as Level

assets. Fair values determined by Level

inputs are based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are

not

active and models for which all significant inputs are observable or can be corroborated, either directly or indirectly by observable market data. Level

inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. These include certain pricing models, discounted cash flow methodologies and similar techniqu

es that use significant unobservable inputs.

As of

June 30,

2017

and

June 30, 2016,

we did

not

have any financial assets or liabilities classified as Level

except for assets and liabilities related to our pension plan. We classify derivative forward exchange contracts as Level

assets and liabilities. The fair value of our forward exchange contracts as of

June 30, 2017

was a net liability of

$521,000

and the value as of

June

30,

2016

was a net asset of

$250,000.

The fair values were determined based on obtaining pricing from our bank and corroborating those values with a

third

party bank. As of

June

30,

2017

and

June

30,

2016,

we did

not

have any financial assets or liabilities classified as Level

We did

not

transfer any assets or liabilities between any levels during fiscal

2017.

Accounts

Receivable

We perform ongoing credit evaluations of our customers and adjust credit limits based on payment history and customer credit-worthiness. An allowance for estimated doubtful accounts is maintained based on historical experience and identified customer credit issues. We monitor collections regularly and adjust the allowance for doubtful accounts as necessary to recognize any changes in credit exposure. Upon conclusion that a receivable is uncollectible, we record the respective amount as a charge against allowance for doubtful accounts. To date, such doubtful accounts reserves, in the aggregate, have been adequate to cover collection losses.

Inventories

We operate primarily as a private-label contract manufacturer that builds products based upon anticipated demand or following receipt of customer specific purchase orders. From time to time, we build inventory for private-label contract manufacturing customers under a specific purchase order with delivery dates that

may

subsequently be rescheduled or canceled at the customer

’s request. We value inventory at the lower of cost (

first

-in,

first

-out) or market (net realizable value) on an item-by-item basis, including costs for raw materials, labor and manufacturing overhead. We establish reserves equal to all or a portion of the related inventory to reflect situations in which the cost of the inventory is

not

expected to be recovered. This requires us to make estimates regarding the market value of our inventory, including an assessment for excess and obsolete inventory. Once we establish an inventory reserve in a fiscal period, the reduced inventory value is maintained until the inventory is sold or otherwise disposed of. In evaluating whether inventory is stated at the lower of cost or market, management considers such factors as the amount of inventory on hand, the estimated time required to sell such inventory, the remaining shelf life and efficacy, the foreseeable demand within a specified time horizon and current and expected market conditions. Based on this evaluation, we record adjustments to cost of goods sold to adjust inventory to its net realizable value.

Property and Equipment

We state property and equipment at cost. Depreciation of property and equipment is provided using the straight-line method over their estimated useful lives, generally ranging from

years. We amortize leasehold improvements using the straight-line method over the shorter of the life of the improvement or the term of the lease. Maintenance and repairs are expensed as incurred. Significant expenditures that increase economic useful lives are capitalized.

Impairment of Long-Lived Assets

We periodically evaluate the carrying value of long-lived assets to be held and used when events and circumstances indicate that the carrying amount of an asset

may

not

be recovered. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

We did

not

recognize any impairment losses during fiscal

2017

or fiscal

2016.

Derivative Financial Instruments

We currently

may

use derivative financial instruments in the management of our foreign currency exchange risk inherent in our forecasted transactions denominated in Euros. We

may

hedge our foreign currency exposures by entering into offsetting forward exchange contracts and currency options. To the extent we use derivative financial instruments, we account for them using the deferral method, when such instruments are intended to hedge identifiable, firm foreign currency commitments or anticipated transactions and are designated as, and effective as, hedges. Foreign exchange exposures arising from certain transactions that do

not

meet the criteria for the deferral method are marked-to-market through the Consolidated Statements of Operations and Comprehensive Income.

We recognize any unrealized gains and losses associated with derivative instruments in income in the period in which the underlying hedged transaction is realized. In the event the derivative instrument is deemed ineffective we would recognize the resulting gain or loss in income at that time. As of

June

30,

2017,

we held derivative contracts designated as cash flow hedges primarily to protect against the foreign exchange risks inherent in our forecasted sales of products at prices denominated in currencies other than the U.S. Dollar. As of

June

30,

2017,

the notional amounts of our foreign exchange contracts were

$26.1

million (EUR

23.1

million). These contracts will mature over the next

months.

Defined Benefit Pension Plan

formerly sponsored a defined benefit pension plan. Effective

June

21,

1999,

we adopted an amendment to freeze benefit accruals to the participants. The plan obligation and related assets of the plan are presented in the notes to the consolidated financial statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued based upon

third

party market quotations. Independent actuaries, through the use of a number of assumptions, determine plan obligation and annual pension expense. Key assumptions in measuring the plan obligation include the discount rate and estimated future return on plan assets. In determining the discount rate, we use an average long-term bond yield. Asset returns are based on the historical returns of multiple asset classes to develop a risk free rate of return and risk premiums for each asset class. The overall rate for each asset class was developed by combining a long-term inflation component, the risk free rate of return and the associated risk premium. A weighted average rate is developed based on the overall rates and the plan’s asset allocation.

Revenue Recognition

To recognize revenue

four

basic criteria must be met:

) there is evidence that an arrangement exists;

) delivery has occurred;

) the fee is fixed or determinable; and

) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (a) the seller’s price to the buyer is substantially fixed or determinable at the date of sale; (b) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is

not

contingent on resale of the product; (c) the buyer’s obligation to the seller would

not

be changed in the event of theft or physical destruction or damage of the product; (d) the buyer acquiring the product for resale has economic substance apart from that provided by the seller; (e) the seller does

not

have significant obligations for future performance to directly bring about resale of the product by the buyer; and (f) the amount of future returns can be reasonably estimated. We recognize revenue upon determination that all criteria for revenue recognition have been met. The criteria are usually met at the time title passes to the customer, which usually occurs upon shipment. Revenue from shipments where title passes upon delivery is deferred until the shipment has been delivered.

We record reductions to gross revenue for estimated returns of

private-label contract manufacturing products and beta-alanine raw material sales. The estimated returns are based on the trailing

six

months of gross sales and our historical experience for both private-label contract manufacturing and beta-alanine raw material product returns. However, the estimate for product returns does

not

reflect the impact of a potential large product recall resulting from product nonconformance or other factors as such events are

not

predictable nor is the related economic impact estimable.

We currently own certain U.S. patents, and each patent

’s corresponding foreign patent applications. All of these patents and patent rights relate to the ingredient known as beta-alanine marketed and sold under the CarnoSyn® and SR CarnoSyn® trade names.

We recorded beta-alanine raw material sales and royalty and licensing income as a component of revenue in the amount of

$26.9

million during fiscal

2017

and

$21.8

million during fiscal

2016.

These royalty income and raw material sale amounts resulted in royalty expense paid to the original patent holders from whom NAI acquired its patents and patent rights. We recognized royalty expense as a component of cost of goods sold in the amount of

$1.0

million during fiscal

2017

and

$865,000

during fiscal

2016.

Cost of Goods Sold

Cost of goods sold includes raw material, labor, manufacturing overhead, and royalty expense.

Shipping and Handling Costs

We include fees earned on the shipment of our products to customers in sales and include costs incurred on the shipment of product to customers in costs of goods sold.

Research and Development Costs

As part of the services we provide to our private-label contract manufacturing customers, we

may

perform, but are

not

obligated to perform, certain research and development activities related to the development or improvement of their products. While our customers typically do

not

pay directly for this service, the cost of this service is included as a component of the price we charge to manufacture and deliver their products.

We also direct and participate in clinical research studies, often in collaboration with scientists and research institutions, to validate the benefits of a product and provide scientific support for product claims and marketing initiatives. We believe our commitment to research and development, as well as our facilities and strategic alliances with our suppliers and customers, allow us to effectively identify, develop and market high-quality and innovative products.

Research and development costs are expensed when incurred. Our research and development expenses for the last

two

fiscal years ended

June

were

$1.6

million for fiscal

2017

and

$1.1

million for fiscal

2016.

These costs were included in selling, general and administrative expenses and cost of goods sold.

Advertising Costs

We expense the production costs of advertising the

first

time the advertising takes place. We incurred and expensed advertising costs in the amount of $

598,000

during the fiscal year ended

June

30,

2017

and

$334,000

during fiscal

2016.

These costs were included in selling, general and administrative expenses.

Income Taxes

We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.

For each of the jurisdictions in which we operate, 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 operations in the period that includes the enactment date.

We account for uncertain tax positions using the more-likely-than-

not

recognition threshold. Our practice is to recognize interest and/or penalties related to income tax matters in income tax expense. As of

June

30,

2017

and

June

30,

2016,

we had

not

recorded any tax liabilities for uncertain tax positions.

We record valuation allowances to reduce our deferred tax assets to an amount that we believe is more likely than

not

to be realized. We consider estimated future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If we determine that it is more likely than

not

that we will

not

realize all or part of our deferred tax assets in the future, we will record an adjustment to the carrying value of the deferred tax asset, which would be reflected as income tax expense. Conversely, if we determine we will realize a deferred tax asset, which currently has a valuation allowance, we will reverse the valuation allowance, which would be reflected as an income tax benefit.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than

not

that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible

. There was

change in the valuation allowance during fiscal

2017.

During the

fourth

quarter of fiscal

2016,

we concluded that it was more likely than

not

that we would be able to realize the benefit of our federal and state deferred tax assets in the future. We based this conclusion on historical and projected operating performance, as well as our expectation that our operations will generate sufficient taxable income in future periods to realize the tax benefits associated with the deferred tax assets. As a result, we reduced the valuation allowance on our net deferred tax assets by

$193,000

June 30,

2016.

We will continue to assess the need for a valuation allowance on the deferred tax assets by evaluating both positive and negative evidence that

may

exist. Any adjustment to the net deferred tax asset valuation allowance would be recorded in the income statement for the period that the adjustment is determined to be required.

We do

not

record U.S. income tax expense for

NAIE’s retained earnings that are declared as indefinitely reinvested offshore, thus reducing our overall income tax expense. The amount of earnings designated as indefinitely reinvested in NAIE is based on the actual deployment of such earnings in NAIE’s assets and our expectations of the future cash needs of our U.S. and foreign entities. Income tax laws are also a factor in determining the amount of foreign earnings to be indefinitely reinvested offshore.

Stock-Based Compensation

We have an omnibus incentive plan that was approved by our Board of Directors effective as of

October

15,

2009

and approved by our stockholders at the Annual Meeting of Stockholders held on

November

30,

2009.

Under the

2009

Plan, we

may

grant nonqualified and incentive stock options and other stock-based awards to employees, non-employee directors and consultants. Our prior equity incentive plan was terminated effective as of

November

30,

2009.

We estimate the fair value of stock option awards at the date of grant using the Black-Scholes option valuation model. The Black-Scholes option valuation model was

developed for use in estimating the fair value of traded options that have

vesting restrictions and are fully transferable. Option valuation models require the use of highly subjective assumptions. Black-Scholes uses assumptions related to volatility, the risk-free interest rate, the dividend yield (which we assume to be zero, as we have

not

paid any cash dividends) and employee exercise behavior. Expected volatilities used in the model are based on the historical volatility of our stock price. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect in the period of grant. The expected life of stock option grants is derived from historical experience. The fair value of restricted stock shares granted is based on the market price of our common stock on the date of grant. We amortize the estimated fair value of our stock awards to expense over the related vesting periods.

The Company did

not

grant any options during fiscal

2017

2016.

We did

not

have any options exercised during fiscal

2017

or fiscal

2016.

All remaining outstanding stock options are fully vested and all related compensation cost was fully recognized at

June

30,

2014.

options vested during the fiscal years ended

June 30, 2017

and

June 30, 2016.

During fiscal

2017,

we granted a total of

155,000

restricted stock shares to the members of our Board of Directors and certain key members of our management team pursuant to the

2009

Plan. During fiscal

2016,

we granted a total of

208,000

restricted stock shares to the members of our Board of Directors and certain key members of our management team pursuant to the

2009

Plan. These restricted stock grants will vest over

three

five

years from the date of grant and the unvested shares cannot be sold or otherwise transferred and the rights to receive dividends, if declared by our Board of Directors, are forfeitable until the shares become vested. There were

319,335

vested restricted stock shares as of

June 30, 2017

and there were

193,012

vested restricted stock shares as of

June 30, 2016.

The total remaining unrecognized compensation cost related to unvested restricted stock shares amounted to

$2.5

million at

June 30, 2017

and the weighted average remaining requisite service period of unvested restricted stock shares was

2.4

years. The weighted average fair value of restricted stock shares granted during fiscal

2017

was

$8.82

per share. The weighted average fair value of restricted stock shares granted during fiscal

2016

was

$9.86

per share.

Use of

Estimates

Our management has made a number of estimates and assumptions relating to the reporting of assets and liabilities, revenue and expenses, and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates.

Net Income per Common Share

We compute basic net income per common share using the weighted average number of common shares outstanding during the period, and diluted net income per common share using the additional dilutive effect of all dilutive securities. The dilutive impact of stock options and restricted shares account for the additional weighted average shares of common stock outstanding for our diluted net income per common share computation. We

calculated basic and diluted net income per common share as follows (in thousands, except per share data):

	For the Years Ended June 30,
	201 7		201 6
Numerator
Net income	$	7,235	$	9,546
Denominator
Basic weighted average common shares outstanding		6,577		6,524
Dilutive effect of stock opt ions and restricted stock shares		79		117
Diluted weighted average common shares outstanding		6,656		6,641
Basic net income per common share	$	1.10	$	1.46
Diluted net income per common share	$	1.09	$	1.44

shares related to stock options were excluded for the

year ended

June 30, 2017.

Concentrations of Credit Risk

Financial instruments that subject us to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. We place our cash and cash equivalents with highly rated financial institutions. Credit risk with respect to receivables is concentrated with

our

three

largest customers, whose receivable balances collectively represented

65.6%

of gross accounts receivable at

June

30,

2017

and

58.7%

June

30,

2016.

Additionally, amounts due related to our beta-alanine raw material sales were

21.3%

of gross accounts receivable at

June 30, 2017,

and

14.6%

of gross accounts receivable at

June 30, 2016.

Concentrations of credit risk related to the remaining accounts receivable balances are limited due to the number of customers comprising our remaining customer base.