1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

Datawatch Corporation (the “Company” or “Datawatch”) designs, develops, markets and distributes business computer software products. The Company also provides services, including implementation and support of its software products, as well as training on their use and administration. The Company is subject to a number of risks including dependence on key individuals, competition from substitute products and larger companies and the need for successful ongoing development and marketing of products.

Summary of Significant Accounting Policies

Principles of Consolidation

These consolidated financial statements include the accounts of Datawatch and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments, which are evaluated on an on-going basis, that affect the amounts and disclosures reported in the Company’s consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates and judgments. In particular, significant estimates and judgments include those related to revenue recognition, the allowance for doubtful accounts, sales returns reserve, useful lives of property and equipment, and the valuation of net deferred tax assets, acquired intellectual property, other intangible assets and share-based awards.

The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure.

Revenue Recognition

Revenue allocated to software products, specified upgrades and enhancements is recognized upon delivery of the related product, upgrades or enhancements. Revenue is allocated by vendor specific objective evidence (“VSOE”) of fair value to post-contract customer support (primarily maintenance) and is recognized ratably over the term of the support, and revenue allocated using VSOE to service elements (primarily training and consulting) is recognized as the services are performed. The residual method of revenue recognition is used for multi-element arrangements when the VSOE of the fair value does not exist for one of the delivered elements. Under the residual method, the arrangement fee is recognized as follows: (1) the total fair value of the undelivered elements, as supported by VSOE, is deferred and subsequently recognized as such items are delivered or completed and (2) the difference between the total arrangement fee and the amount allocated to the undelivered elements is recognized as revenue related to the delivered elements.

The Company licenses its software products directly to end-users, through value added resellers and through distributors. Sales to distributors and resellers accounted for approximately 31%, 41% and 43% of total sales for the years ended September 30, 2012, 2011 and 2010, respectively. Revenue from the sale of all software products (when separately sold) is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed or determinable, collectability is reasonably assured, persuasive evidence of the arrangement exists and there are no significant obligations remaining. Both types of the Company’s software product offerings are considered “off-the-shelf” as such term is customarily defined. The Company’s software products can be installed and used by customers on their own with little or no configuration required. Multi-user licenses marketed by the Company are sold as a right to use the number of licenses, and the license fee revenue is recognized upon delivery of all software required to satisfy the number of licenses sold. Upon delivery, the licensing fee is payable without further delivery obligations by the Company.

Datawatch software products are generally sold in multiple element arrangements which may include software licenses, professional services and post-contract customer support. In such multiple element arrangements, the Company applies the residual method in determining revenue to be allocated to the software license. In applying the residual method, the Company deducts from the sale proceeds the VSOE of fair value of the professional services and post-contract customer support in determining the residual fair value of the software license. The VSOE of fair value of the services and post-contract customer support is based on the amounts charged for these elements when sold separately. Professional services include implementation, integration, training and consulting services with revenue recognized as the services are performed. These services are generally delivered on a time and materials basis, are billed on a current basis as the work is performed, and generally do not involve modification or customization of the software or any unusual acceptance clauses or terms. We have established VSOE of fair value for the majority of our professional services using the bell-shaped curve method. Post-contract customer support is typically provided under a maintenance agreement which provides technical support and rights to unspecified software maintenance updates and bug fixes on a when-and-if available basis. Revenue from post-contract customer support services is deferred and recognized ratably over the period of support (generally one year). Such deferred amounts are recorded as part of deferred revenue in the Company’s consolidated balance sheets. We have established VSOE of fair value for the majority of our post-contract customer support based on stated renewal rates only if the rate is determined to be substantive and falls within the Company’s customary pricing practices. VSOE of fair value for sales through the Company’s distribution channel was established using the bell-shaped curve method. VSOE calculations are updated and reviewed quarterly.

The Company also licenses its enterprise software using a subscription model. At the time a customer enters into a binding agreement to purchase a subscription, the customer is invoiced for an initial 90 day service period and an account receivable and deferred revenue are recorded. Beginning on the date the software is installed at the customer site and available for use by the customer, and provided that all other criteria for revenue recognition are met, the deferred revenue amount is recognized ratably over the period the service is provided. The customer is then invoiced every 90 days and revenue is recognized ratably over the period of the subscription. The subscription arrangement includes software, maintenance and unspecified future upgrades on a when and if available basis including major version upgrades. The subscription renewal rate is the same as the initial subscription rate. Subscriptions can be cancelled by the customer at any time by providing 90 days prior written notice following the first year of the subscription term.

The Company’s software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. The Company also offers a 30 day money-back guarantee on its Monarch product sold directly to end-users. Additionally, the Company provides its distributors with stock-balancing rights. Revenue from the sale of software products to distributors and resellers is recognized at the time of shipment providing all other criteria for revenue recognition as stated above are met and (i) the distributor or reseller is unconditionally obligated to pay for the products, including no contingency as to product resale, (ii) the distributor or reseller has independent economic substance apart from the Company, (iii) the Company is not obligated for future performance to bring about product resale, and (iv) the amount of future returns can be reasonably estimated. The Company’s experience and history with its distributors and resellers allows for reasonable estimates of future returns. Among other things, estimates of potential future returns are made based on the inventory levels at, and the returns history with, the various distributors and resellers, which the Company monitors frequently.

Allowance for Doubtful Accounts

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company analyzes accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Actual results could differ from the allowances recorded, and this difference could have a material effect on the Company’s financial position and results of operations. Receivables are written off against these allowances in the period they are determined to be uncollectible.

For the fiscal years ended September 30, 2012, 2011 and 2010, changes to and ending balances of the allowance for doubtful accounts were approximately as follows:


	2012		2011		2010
	(in thousands)

Allowance for doubtful accounts balance - beginning of year	$	78	$	129	$	160
Additions to the allowance for doubtful accounts		93		92		99
Deductions against the allowance for doubtful accounts		(64)		(143)		(130)
Allowance for doubtful accounts balance - end of year	$	107	$	78	$	129

Sales Returns Reserve

The Company maintains reserves for potential future product returns from distributors. The Company estimates future product returns based on its experience and history with the Company’s various distributors and resellers as well as by monitoring inventory levels at such companies. Adjustments are recorded as increases or decreases in revenue in the period of adjustment. Actual returns have historically been within the range estimated by management. Actual results could differ from the reserve for sales returns recorded, and this difference could have a material effect on the Company’s financial position and results of operations.

For the fiscal years ended September 30, 2012, 2011 and 2010, changes to and ending balances of the sales returns reserve were approximately as follows:


	2012		2011		2010
	(in thousands)

Sales returns reserve balance - beginning of year	$	70	$	35	$	55
Additions to the sales returns reserve		117		101		12
Deductions against the sales returns reserve		(82)		(66)		(32)
Sales returns reserve balance - end of year	$	105	$	70	$	35

Capitalized Software Development Costs

The Company capitalizes certain software development costs as well as purchased software upon achieving technological feasibility of the related products. Software development costs incurred and software purchased prior to achieving technological feasibility are charged to engineering and product development expense as incurred. Commencing upon initial product release, capitalized costs are amortized to cost of software licenses using the straight-line method over the estimated life of the product (which approximates the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product), which is generally 18 to 24 months.

For the fiscal years ended September 30, 2012, 2011 and 2010, amounts related to capitalized and purchased software development costs were approximately as follows:


	2012		2011		2010
	(in thousands)

Capitalized and purchased software balance - beginning of year	$	14	$	396	$	1,106
Capitalized software development costs		54		-		3
Amortization of capitalized software development costs and
purchased software		(38)		(382)		(713)
Capitalized and purchased software balance - end of year	$	30	$	14	$	396

Cash and Equivalents

Cash and equivalents include cash on hand, cash deposited with banks and highly liquid securities consisting of money market investments with original maturities of 90 days or less.

Concentration of Credit Risks and Major Customers

The Company licenses its products and services to U.S. and non-U.S. distributors and other software resellers, as well as to end users, under customary credit terms. Two customers, Ingram Micro, Inc. and Lifeboat Distribution, individually accounted for the following percentages of total revenue and accounts receivable for the periods indicated:


	Percentage of total revenue			Percentage of total
	for the year ended			accounts receivable at
	September 30,			September 30,
	2012	2011	2010	2012	2011

Ingram Micro, Inc.	4%	13%	11%	0%	14%

Lifeboat Distribution	17%	15%	12%	19%	18%

The Company licenses to Lifeboat Distribution under a distribution agreement which automatically renews for successive one-year terms unless terminated. On December 6, 2011, the Company exercised a 90 day notice provision under a distribution agreement with Ingram Micro, Inc. to terminate its relationship with that distributor. The termination was effective March 6, 2012. Effective March 7, 2012, Lifeboat Distribution became the sole North American distributor for the Company’s Monarch Professional platform. In addition to the customers listed above, one additional customer, Unisys Belgium, individually accounted for 24% of total accounts receivable at September 30, 2012. Other than these customers, no other customer constitutes a significant portion (more than 10%) of revenues or accounts receivable for the periods presented. The Company performs ongoing credit evaluations of its customers and generally does not require collateral.

Deferred Revenue

Deferred revenue consisted of the following at September 30:


	2012		2011
	(in thousands)

Maintenance	$	5,167	$	3,794
License		1,257		33
Other		136		109
Total		6,560		3,936

Less: Long-term portion of deferred maintenance		(265)		(113)

Current portion of deferred revenue	$	6,295	$	3,823

Maintenance deferred revenue consists of the unearned portion of post-contract customer support services provided by the Company to customers who purchased maintenance agreements for the Company’s products. Maintenance revenues are recognized on a straight-line basis over the term of the maintenance period, generally 12 months.

Other deferred revenue consists of deferred subscription and professional services revenue generated from arrangements that are invoiced in accordance with the terms and conditions of the arrangement but do not meet all the criteria for revenue recognition and are, therefore, deferred until all revenue recognition criteria are met.

Inventories

Inventories consist of software components, primarily software manuals, compact disks and retail packaging materials. Inventories are valued at the lower of cost (first-in, first-out method) or market.

Property and Equipment

Property and equipment consists of office equipment, furniture and fixtures, software and leasehold improvements, all of which are recorded at cost. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets or over the terms, if shorter, of the related leases. Useful lives and lease terms range from three to seven years. Depreciation and amortization expense related to property and equipment was $137,000, $197,000 and $267,000, respectively, for the years ended September 30, 2012, 2011 and 2010.

Long-Lived Assets

The Company periodically evaluates whether events or circumstances have occurred that indicate that the estimated remaining useful lives of long-lived assets and certain identifiable intangibles may warrant revision or that the carrying value of these assets may be impaired. To determine whether assets have been impaired, the estimated undiscounted future cash flows for the estimated remaining useful life of the respective assets are compared to the carrying value. To the extent that the undiscounted future cash flows are less than the carrying value, the fair value of the asset is determined and an impairment is recognized. If such fair value is less than the current carrying value, the asset is written down to its estimated fair value.

Intangible Assets

Intangible assets consist of acquired intellectual property and internally developed software, patents and customer lists acquired through business combinations. The values allocated to the majority of these intangible assets are amortized using the straight-line method over the estimated useful life of the related asset and are recorded in cost of software licenses. The values allocated to customer relationships are amortized using the straight-line method over the estimated useful life of the related asset and are recorded in sales and marketing expenses. The values allocated to loan acquisition costs are amortized using the straight-line method over the estimated useful life of the related asset and are recorded in interest income and other income (expense), net. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable and an impairment loss is recognized when it is probable that the estimated cash flows are less than the carrying amount of the asset.

Other intangible assets, net, were comprised of the following as of September 30, 2012 and 2011:


	Weighted	September 30, 2012						September 30, 2011
	Average	Gross						Gross
Identified Intangible	Useful Life	Carrying		Accumulated		Net Carrying		Carrying		Accumulated		Net Carrying
Asset	in Years	Amount		Amortization		Amount		Amount		Amortization		Amount
			(in thousands)

Capitalized software	2	$	1,190	$	1,160	$	30	$	2,662	$	2,648	$	14
Purchased software	5		700		700		-		700		700		-
Patents	20		160		65		95		160		57		103
Customer lists	10		1,790		1,195		595		1,790		1,029		761
Non-compete agreements	4		640		640		-		640		640		-
Trademark	2		21		21		-		21		21		-
Loan acquisition costs	4		88		16		72		-		-		-

Total		$	4,589	$	3,797	$	792	$	5,973	$	5,095	$	878

The intangible asset amounts amortized to cost of software licenses totaled $46,000, $390,000 and $721,000 for fiscal 2012, 2011 and 2010, respectively. Intangible asset amounts amortized to sales and marketing expense totaled $166,000, $166,000 and $245,000, respectively. Intangible asset amounts amortized to interest income and other income (expense), net totaled $16,000 for fiscal 2012. There were no intangible asset amounts amortized to interest income and other income (expense), net in fiscal years 2011 or 2010.

As of September 30, 2012, the estimated future amortization expense related to amortizing intangible assets was as follows (in thousands):


Fiscal Years Ending September 30,

2013	$	235
2014		193
2015		179
2016		110
2017		13
Thereafter		62

Total estimated future amortization expense	$	792

Financial Instruments

The Company’s financial instruments consist primarily of cash and equivalents, accounts receivable and accounts payable and their carrying values approximate fair value because of their short-term nature.

Fair Value Measurements

Fair value is the price that would be received for an asset or the amount paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company is required to classify certain assets and liabilities based on the following fair value hierarchy.

·	Level 1 – Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities;

·	Level 2 – Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly; and

·	Level 3 – Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2012 and 2011 (in thousands):



	September 30, 2012									September 30, 2011
								Estimated								Estimated
	Fair Value Measurement							Fair		Fair Value Measurement						Fair
	Using Input Types							Value		Using Input Types						Value
	Level 1		Level 2		Level 3			Total		Level 1		Level 2		Level 3		Total

Assets:
Money market funds	$	2,234	$	-	$	-	$	2,234	$	2,233	$	-	$	-	$	2,233
Total assets at fair value		2,234		-		-		2,234		2,233		-		-		2,233

Liablities:
Line of credit	$	900	$	-	$	-	$	900	$	-	$	-	$	-	$	-
Note payable		4,000						4,000		-		-		-		-
Debt discount		-		(1,017)		-		(1,017)		-		-		-		-
Total liabilities at fair value	$	4,900	$	(1,017)	$	-	$	3,883	$	-		-		-		-

Income Taxes

Deferred income taxes are provided for the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and operating loss carryforwards and credits. Valuation allowances are recorded to reduce the net deferred tax assets to amounts the Company believes are more likely than not to be realized.

The Company follows the accounting guidance for uncertain tax positions. This guidance clarifies the accounting for income taxes by prescribing the minimum threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition.

Net Income Per Share

Basic net income per common share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted net income per share reflects the impact, when dilutive, of the exercise of stock options and the vesting of restricted stock units using the treasury stock method.

The following table presents the options and restricted stock units that were not included in the computation of diluted net income per share, because the effect was antidilutive for the years ended September 30, 2012 and 2011:



	2012		2011		2010

Quantity of option shares not included		123,105		105,819		270,916
Weighted-average exercise price	$	12.30	$	5.18	$	4.46

Foreign Currency Translations and Transactions

Assets and liabilities of foreign subsidiaries are translated into U.S. dollars at rates in effect at each balance sheet date. Revenues, expenses and cash flows are translated into U.S. dollars at average rates prevailing when transactions occur. The related translation adjustments are reported as a separate component of shareholders’ equity under the heading “Accumulated Other Comprehensive Loss.” Gains and losses resulting from transactions that are denominated in currencies other than the applicable unit’s functional currency are included in the operating results of the Company and were a loss of $126,000 for the year ended September 30, 2012 and gains of $89,000 and $24,000, respectively, for the years ended September 30, 2011 and 2010, respectively. The foreign currency loss in 2012 was attributable primarily to the settlement of intercompany balances due to the dissolution of one of the Company’s foreign subsidiaries and the repatriation of international funds to the U.S. required by the Company’s line of credit facility which was entered into in March 2012.

Advertising and Promotional Materials

Advertising costs are expensed as incurred and amounted to $9,000, $138,000 and $151,000 in 2012, 2011 and 2010, respectively. Direct mail/direct response costs are expensed over the period in which the associated revenue is recognized, generally three to six months from the date of the mailing. Direct mail expense was $9,000, $52,000 and $48,000, respectively. There were no deferred direct mail/direct response costs at September 30, 2012 or 2011.

Share-Based Compensation

All share-based awards, including grants of employee stock options and restricted stock units, are recognized in the financial statements based on their fair value at date of grant.

The Company recognizes the fair value of share-based awards over the requisite service period of the individual awards, which generally equals the vesting period. All of the Company’s share-based awards are accounted for as equity instruments and there have been no liability awards granted. See additional share-based compensation disclosure in Note 7 to the Company’s consolidated financial statements.

Comprehensive Income

The only item other than net income that is included in comprehensive income is foreign currency translation adjustments. Foreign currency translation gains arising during fiscal 2012 were $82,000. Foreign currency translation losses arising during fiscal 2011 and 2010 were $121,000 and $60,000, respectively.

Segment Information

The Company has determined that it has only one reportable segment. The Company’s chief operating decision maker, its Chief Executive Officer, does not manage any part of the Company separately, and the allocation of resources and assessment of performance is based solely on the Company’s consolidated operations and operating results. See Note 9 for information about the Company’s revenue by product lines and geographic operations.

Guarantees and Indemnifications

The Company’s software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. The Company has never incurred significant expense under its product or service warranties and does not expect to do so in the future. As a result, the Company believes its exposure related to these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of September 30, 2012 or September 30, 2011.

The Company enters into indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify, hold harmless, and to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes its exposure related to these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of September 30, 2012 or 2011.

Certain of the Company’s agreements also provide for the performance of services at customer sites. These agreements may contain indemnification clauses, whereby the Company will indemnify the customer from any and all damages, losses, judgments, costs and expenses for acts of its employees or subcontractors resulting in bodily injury or property damage. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has general and umbrella insurance policies that would enable it to recover a portion of any amounts paid. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes its exposure related to these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of September 30, 2012 or 2011.

As permitted under Delaware law, the Company has agreements with its directors whereby the Company will indemnify them for certain events or occurrences while the director is, or was, serving at the Company’s request in such capacity. The term of the director indemnification period is for the later of ten years after the date that the director ceases to serve in such capacity or the final termination of proceedings against the director as outlined in the indemnification agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company’s director and officer insurance policy limits the Company’s exposure and would enable it to recover a portion of any future amounts paid. As a result of its insurance policy coverage for directors, the Company believes its exposure related to these indemnification agreements is minimal. The Company has no liabilities recorded for these potential obligations as of September 30, 2012 or 2011.

Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2011-04, “Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs” (“ASU 2011-04”). ASU 2011-04 changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between U.S. GAAP and IFRS. This standard also expands the disclosure requirements particularly for level 3 fair value measurements. This standard is effective on a prospective basis for reporting periods beginning on or after December 15, 2011. The adoption of this standard did not have a material effect on the Company’s consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income” (“ASU 2011-05”). ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of changes in equity. Under this standard, an entity can elect to present items of net income and other comprehensive income in one continuous statement of comprehensive income or in two separate but consecutive statements. This new guidance is to be applied retrospectively for fiscal years, and for interim periods within those years, beginning after December 15, 2011. The Company is currently evaluating what impact, if any, this standard will have on its consolidated financial statements.

In December 2011, the FASB issued ASU No. 2011-12, “Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05” (“ASU 2011-12”). ASU 2011-12 supersedes certain paragraphs in ASU 2011-05 which pertain to how, when and where reclassification adjustments out of accumulated other comprehensive income are presented. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is currently evaluating what impact, if any, this standard will have on its consolidated financial statements.